Chapter 1: Introduction to corporate finance

1. Chapter 1: Introduction to corporate finance Corporate Finance Ross, Westerfield & Jaffe

2. Outline 1.1 What is corporate finance? 1.2 The goal of financial management 1.3 The agency problem and control of the corporation 1.4 Ethics and corporate governance 1.5 Financial markets

3. Main tasks of corporate finance • Capital budgeting: the process of planning and managing a firm’s long-term investments  fixed assets. • Example: deciding whether or not to open a new restaurant. • Capital structure: the mixture of debt and equity maintained by the firm  S-T and L-T debt and equity. • Working capital management: a firm’s short-term assets and liabilities  current assets and current liabilities.

4. Introduction • Business concern needs finance to meet their requirements in the economic world. • Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. • Whether the business concerns are big or small, they need finance to fulfil their business activities

5. MEANING OF FINANCE • Finance may be defined as the art and science of managing money. • It includes financial service and financial instruments. • Finance also is referred as the provision of money at the time when it is needed. Finance function is the procurement of funds and their effective utilization in business concerns.

6. MEANING OF FINANCE • The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. • Studying and understanding the concept of finance become an important part of the business concern.

7. DEFINITION OF FINANCE • According to Oxford dictionary, the word ‘finance’ connotes ‘management of money’.

8. DEFINITION OF FINANCIAL MANAGEMENT • The term financial management has been defined by Solomon, “It is concerned with the efficient use of an important economic resource namely, capital funds”. • The most popular and acceptable definition of financial management as given by S.C. Kuchal is that “Financial Management deals with procurement of funds and their effective utilization in the business”.

9. DEFINITION OF FINANCIAL MANAGEMENT • Howard and Upton : Financial management “as an application of general managerial principles to the area of financial decision-making. • Weston and Brigham : Financial management “is an area of financial decision-making, harmonizing individual motives and enterprise goals”.

10. DEFINITION OF FINANCIAL MANAGEMENT • Joshep and Massie : Financial management “is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. • Thus, Financial Management is mainly concerned with the effective funds management in the business. In simple words, Financial Management as practiced by business firms can be called as Corporation Finance or Business Finance.

11. THE FINANCIAL MANAGER • A striking feature of large corporations is that the owners (the stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. • Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf. • In a large corporation, the financial manager would be in charge of answering the three questions

12. THE FINANCIAL MANAGER • Capital Budgeting • The process of planning and managing a firm’s long-term investments is called capital budgeting . • In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire

13. The Capital Budgeting Decision Current Assets Current Liabilities Long-Term Debt Fixed Assets 1 Tangible 2 Intangible What long-term investments should the firm choose? Shareholders’ Equity

14. THE FINANCIAL MANAGER • Capital Structure A firm’s capital structure (or financial structure) is the specific mixture of long-term debt and equity the firm uses to finance its operations.

15. THE FINANCIAL MANAGER • The third question concerns working capital management • The term working capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers

16. Forms of Business Organization • SOLE PROPRIETORSHIP • A sole proprietorship is a business owned by one person. • This is the simplest type of business to start and is the least regulated form of organization. • Depending on live, you might be able to start a proprietorship by doing little more than getting a business license and opening your doors .

17. Forms of Business Organization • For this reason, there are more proprietorships than any other type of business, and many businesses that later become large corporations start out as small proprietorships. • The owner of a sole proprietorship keeps all the profits. That’s the good news. • The bad news is that the owner has unlimited liability for business debts. This means that creditors can look beyond business assets to the proprietor’s personal assets for payment.

18. Forms of Business Organization • Similarly, there is no distinction between personal and business income, so all business income is taxed as personal income. • The life of a sole proprietorship is limited to the owner’s life span, and the amount of equity that can be raised is limited to the amount of the proprietor’s personal wealth. • This limitation often means that the business is unable to exploit new opportunities because of insufficient capital.

19. Forms of Business Organization • Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the sale of the entire business to a new owner.

20. Forms of Business Organization • PARTNERSHIP • A partnership is similar to a proprietorship except that there are two or more owners (partners). • In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share.

21. Forms of Business Organization • The way partnership gains (and losses) are divided is described in the partnership agreement. • This agreement can be an informal oral agreement, such as “let’s start a lawn mowing business,” or a lengthy, formal written document.

22. Forms of Business Organization • Corporation: a business created as a distinct legal entity composed of one or more individuals or entities, e.g., IBM. • Not surprisingly, starting a corporation is somewhat more complicated than starting the other forms of business organization. • Forming a corporation involves preparing articles of • incorporation (or a charter) and a set of bylaws .

23. Forms of Business Organization • The articles of incorporation must contain a number of things, including the corporation’s name, its intended life (which can be forever), its business purpose, and the number of shares that can be issued. • This information must normally be supplied to the state in which the firm will be incorporated. For most legal purposes, the corporation is a “resident” of that state.

24. Forms of Business Organization • Features of corporation • Separation of control (shareholders) and management (professionals). • Ownership can be easily transferred. • Limited liability. • Double taxation. • Rather expensive to form. • Agency problems.

25. A CORPORATION BY ANOTHER NAME . . . • The corporate form of organization has many variations around the world. • The exact laws and regulations differ from country to country, of course, but the essential features of public ownership and limited liability remain. • These firms are often called joint stock companies, public limited companies, or limited liability companies, depending on the specific nature of the firm and the country of origin.

26. Who make the decisions? • Owners (typically in small businesses). • Professional managers.

27. Financial managers • Frequently, financial managers try to address these tasks. • The top financial manager within a firm is usually the Chief Financial Officer (CFO). • Treasurer – oversees cash management, credit management, capital expenditures and financial planning. • Controller – oversees taxes, cost accounting, financial accounting and data processing.

28. The Goal of Financial Management • The goal of financial management is to make money or add value for the owners. • This goal is a little vague, of course, so we examine some different ways of formulating it to come up with a more precise definition. • Such a definition is important because it leads to an objective basis for making and evaluating financial decisions.

29. Possible goals of financial management • Survive • Beat the competition • Maximize sales • Maximize net income • Maximize market share • Minimize costs • Maximize the value of (stock) shares

30. Possibilities presents problems • These are only a few of the goals we could list. • Furthermore, each of these possibilities presents problems as a goal for the financial manager. • For example, it’s easy to increase market share or unit sales: All we have to do is lower our prices or relax our credit terms. • Similarly, we can always cut costs simply by doing away with things such as research and development.

31. Possibilities presents problems • We can avoid bankruptcy by never borrowing any money or never taking any risks, and so on. • It’s not clear that any of these actions are in the stockholders’ best interests.

32. Profit t maximization the most commonly goal, but not a precise objective. • Profit maximization would probably be the most commonly cited goal, but even this is not a precise objective. • Do we mean profits this year? If so, • we should note that actions such as deferring maintenance, letting inventories run down, and taking other short-run cost-cutting measures will tend to increase profits now, but these activities aren’t necessarily desirable.

33. Profit t maximization the most commonly goal, but not a precise objective. • The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it’s still unclear exactly what this means. • First, do we mean something like accounting net income or earnings per share? As we will see in more detail in the next chapter, these accounting numbers may have little to do with what is good or bad for the firm.

34. Profit t maximization the most commonly goal, but not a precise objective. • Second, what do we mean by the long run? As a famous economist once remarked, in the long run, we’re all dead! More to the point, this goal doesn’t tell us what the appropriate trade-off is between current and future profits.

35. A sample question • The primary goal of financial management is to: a. maximize current dividends per share of the existing stock. b. maximize the current value per share of the existing stock. c. avoid financial distress. d. minimize operational costs and maximize firm efficiency. e. maintain steady growth in both sales and net earnings.

36. Profit t maximization the most commonly goal, but not a precise objective. • The goals we’ve listed here are all different, but they tend to fall into two classes. • The first of these relates to profitability. The goals involving sales, market share, and cost control all relate, at least potentially, to different ways of earning or increasing profits. • The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in some way to controlling risk.

37. Profit t maximization the most commonly goal, but not a precise objective. • Unfortunately, these two types of goals are somewhat contradictory. • Thepursuit of profit normally involves some element of risk, so it isn’t really possible to maximize both safety and profit. • What we need, therefore, is a goal that encompasses both factors.

38. The “appropriate” goal of financial management • The financial manager in a corporation makes decisions for the stockholders of the firm. • Given this, instead of listing possible goals for the financial manager, we really need to answer a more fundamental question: From the stockholders’ point of view, what is a good financial management decision? • If we assume that stockholders buy stock because they seek to gain financially, then the answer is obvious: Good decisions increase the value of the stock, and poor decisions decrease the value of the stock.

39. The “appropriate” goal of financial management • Given our observations, it follows that the financial manager acts in the shareholders’ best interests by making decisions that increase the value of the stock. • The appropriate goal for the financial manager can thus be stated quite easily:

40. The “appropriate” goal of financial management • The goal of financial management is to maximize the current value per share of the existing stock. • Why? Shareholders own shares. Managers, as agents, ought to act in a way to benefit shareholders; i.e., to enhance the value of the shares. • A limitation of this goal is that value is not directly observable.

41. Value vs. price • The value of shares are not observable. In contrast, the price of shares can be observable. • If one believes that share price is an accurate/good estimate of share value, the appropriate goal would be to maximize the price of shares. • This belief/assumption is, however, questionable.

42. The agency problem • Agency relationship: • Principals (citizens) hire an agent (the president) to represent their interest. • Principles (stockholders) hire agents (managers) to run the company. • The relationship between stockholders and management is called an agency relationship . • Agency problem: • Conflict of interest between principals and agents. • This occurs in a corporate setting whenever the agents do not hold 100% of the firm’s shares. • The source of agency problems is the separation of (owners’) control and management.

43. Example • Suppose you hire someone to sell your car and agree to pay that person a flat fee when he or she sells the car. • The agent’s incentive in this case is to make the sale, not necessarily to get you the best price. If you offer a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist.

44. Agency costs • To see how management and stockholder interests might differ, imagine that the firm is considering a new investment. • The new investment is expected to favorably impact the share value, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the stock value will rise), but management may not because there is the possibilitythat things will turn out badly and management jobs will be lost.

45. Agency costs • If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost. These costs can be indirect or direct • Direct costs: Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders.

46. Agency costs Perhaps the purchase of a luxurious and unneeded corporate jet would fall under this heading. • The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.

47. Agency costs • Indirect costs. For example, a manager may choose not to take on the optimal investment. She/he may prefer a less risky project so that she/he has a higher probability keeping her/his tenure.

48. Managerial incentives • Managerial goals are frequently different from shareholders’ goals. • Expensive perks. • Survival. • Independence. • Growth and size (related to compensation) may not relate to shareholders’ wealth.

49. Corporate governance • Compensation: • Incentives ($$$, options, threat of dismissal, etc.) used to align management and stockholder interests. • Corporate control: • Managers may take the threat of a takeover seriously and run the business in the interest of shareholders. • Pressure from other stakeholders (e.g., CalPERS, a powerful corporate police).

50. Sarbanes-Oxley Act (2002) • “Sarbox.” • 10K must have an assessment of the firm’s internal control structure and financial reporting. • The officers must explicitly declare that 10K does not contain any false statements or material omissions. • The officers are responsible for all internal controls.