Corporate Finance Ross  Westerfield  Jaffe

1. Chapter One 1 Introduction to Corporate Finance Corporate Finance Ross Westerfield  Jaffe Sixth Edition Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

2. Chapter Outline 1.1 What is Corporate Finance? 1.2 Corporate Securities as Contingent Claims on Total Firm Value 1.3 The Corporate Firm 1.4 Goals of the Corporate Firm 1.5 Financial Institutions, Financial Markets, And The Corporation 1.6 Trends in Financial Markets and Management 1.7 Outline of the Text

3. What is Corporate Finance? Corporate Finance addresses the following three questions: • What long-term investments should the firm engage in? • How can the firm raise the money for the required investments? • How much short-term cash flow does a company need to pay its bills?

4. Total Value of Assets: Total Firm Value to Investors: Current Liabilities Current Assets Long-Term Debt Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity The Balance-Sheet Model of the Firm

5. The Balance-Sheet Model of the Firm The Capital Budgeting Decision Current Liabilities Current Assets Long-Term Debt What long-term investments should the firm engage in? Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity

6. The Balance-Sheet Model of the Firm The Capital Structure Decision Current Liabilities Current Assets Long-Term Debt How can the firm raise the money for the required investments? Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity

7. The Balance-Sheet Model of the Firm The Net Working Capital Investment Decision Current Liabilities Current Assets Net Working Capital Long-Term Debt How much short-term cash flow does a company need to pay its bills? Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity

8. 25% Debt 70% Debt 30% Equity 75% Equity Capital Structure The value of the firm can be thought of as a pie. 50% Debt The goal of the manager is to increase the size of the pie. 50% Equity The Capital Structure decision can be viewed as how best to slice up the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters.

9. Financial Accounting Capital Expenditures Financial Planning Cost Accounting Data Processing Credit Manager Cash Manager Tax Manager Vice President Finance Board of Directors Controller Treasurer Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operating Officer (COO) Hypothetical Organization Chart

10. The Financial Manager To create value, the financial manager should: • Try to make smart investment decisions. • Try to make smart financing decisions.

11. Firm Financialmarkets Government The Firm and the Financial Markets Firm issues securities (A) Retained cash flows (D) Investsin assets(B) Cash flowfrom firm (C) Dividends anddebt payments (F) Short-term debt Long-term debt Equity shares Current assetsFixed assets Taxes (E) The cash flows from the firm must exceed the cash flows from the financial markets. Ultimately, the firm must be a cash generating activity.

12. 1.2 Corporate Securities as Contingent Claims on Total Firm Value • The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount by a certain date. • The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid. • If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

13. Payoff to debt holders Payoff to shareholders $F $F Value of the firm (X) Value of the firm (X) Debt and Equity as Contingent Claims If the value of the firm is more than $F, debt holders get a maximum of $F. If the value of the firm is less than $F, share holders get nothing. $F If the value of the firm is more than $F, share holders get everything above $F. Debt holders are promised $F. If the value of the firm is less than $F, they get whatever the firm is worth. Algebraically, the bondholder’s claim is: Min[$F,$X] Algebraically, the shareholder’s claim is: Max[0,$X –$F]

14. Combined Payoffs to debt holders and shareholders Payoff to shareholders Payoff to debt holders $F Value of the firm (X) Combined Payoffs to Debt and Equity If the value of the firm is less than $F, the shareholder’s claim is: Max[0,$X –$F] = $0 and the debt holder’s claim is Min[$F,$X] = $X. The sum of these is = $X $F If the value of the firm is more than $F, the shareholder’s claim is: Max[0,$X –$F] = $X –$F and the debt holder’s claim is: Min[$F,$X] = $F. The sum of these is = $X Debt holders are promised $F.

15. 1.3 The Corporate Firm • The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash. • However, businesses can take other forms.

16. Forms of Business Organization • The Sole Proprietorship • The Partnership • General Partnership • Limited Partnership • The Corporation • Advantages and Disadvantages • Liquidity and Marketability of Ownership • Control • Liability • Continuity of Existence • Tax Considerations

17. Corporation Partnership Liquidity Shares can easily be exchanged Subject to substantial restrictions. Voting Rights Usually each share gets one vote General Partner is in charge; limited partners may have some voting rights. Taxation Double with dividend tax credit Partnership income is taxable. Reinvestment Broad latitude All net cash flow is distributed to partners. Liability Limited liability General partners may have unlimited liability. Limited partners enjoy limited liability. Continuity Perpetual life Limited life A Comparison of Partnership and Corporations

18. 1.4 Goals of the Corporate Firm • What are firm decision-makers hired to do? • The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.

19. The Set-of-Contracts Perspective • The firm can be viewed as a set of contracts. • One of these contracts is between shareholders and managers. • The managers will usually act in the shareholders’ interests. • The shareholders can devise contracts that align the incentives of the managers with the goals of the shareholders. • The shareholders can monitor the managers’ behaviour. • This contracting and monitoring is costly.

20. Managerial Goals • Managerial goals may be different from shareholder goals • Expensive perquisites • Survival • Independence • Increased growth and size are not necessarily the same thing as increased shareholder wealth.

21. Separation of Ownership and Control Board of Directors Management Debtholders Shareholders Debt Assets Equity

22. The Agency Problem • The agency relationship • Will managers work in the shareholders’ best interests? • Agency costs • Direct agency costs • Indirect agency costs • Control of the firm • How do agency costs affect firm value (and shareholder wealth)?

23. Do Shareholders Control Managerial Behaviour? • Shareholders vote for the board of directors, who in turn hire the management team. • Contracts can be carefully constructed to be incentive compatible. • There is a market for managerial talent—this may provide market discipline to the managers—they can be replaced. • If the managers fail to maximize share price, they may be replaced in a hostile takeover.

24. Funds suppliers Financial intermediaries Funds demanders 1.5 Financial Institutions, Financial Markets, and the Corporation • Financial Institutions Indirect finance • Direct finance Deposits Loans Funds suppliers Financial intermediaries Funds demanders

25. Financial Markets • Money versus Capital Markets • Money Markets • For short-term debt instruments • Capital Markets • For long-term debt and equity

26. Financial Markets • Primary versus Secondary Markets • Primary Market • When a corporation issues securities, cash flows from investors to the firm. • Usually an underwriter is involved • Secondary Markets • Involve the sale of “used” securities from one investor to another. • Securities may be exchange traded or trade over-the-counter in a dealer market.

27. Stocks and Bonds Money Primary Market Secondary Market securities money Financial Markets Investors Firms Bob Sue

28. 1.6 Trends in Financial Markets and Management • Integration and globalization • Increased volatility • Financial Engineering reduces costs related to • Risk • Taxes • Fnancing costs • Improved computer technology allows Economies of scale and scope • Regulatory dialectic

29. 1.7 Outline of the Text • Overview • Value and Capital Budgeting • Risk • Capital Structure and Dividend Policy • Long-Term Financing • Options, Futures, and Corporate Finance • Financial Planning and Short-Term Finance • Special Topics