Chapter 1 —The Scope of Corporate Finance

The first three chapters introduce us to finance. In this chapter, we begin by ...
Part 1: Introduction

    •    Financial intermediaries, such as commercial banks, savings and loans, pension funds,
Chapter 1: The Scope of Corporate Finance

    •   Corporations have access to large amounts of debt and equity capital th...
Part 1: Introduction

12.___ Partnership income is taxed only at the personal level.

13.___ A potential disadvantage of ...
Chapter 1: The Scope of Corporate Finance

22. A firm is attempting to decide whether to offer credit to customers. What t...
Part 1: Introduction

    C. Leveraged buyout specialists
    D. Financial intermediaries
29. Individuals and institutions...
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The Scope of Corporate Finance


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The Scope of Corporate Finance

  1. 1. Chapter 1 —The Scope of Corporate Finance The first three chapters introduce us to finance. In this chapter, we begin by exploring career areas within the field of finance. We then focus on how financial managers work within a corporation to add value. We begin to understand and expand upon the idea that we should make decisions where the marginal benefits of the decision outweigh the marginal costs. In the next chapter, we will consider how financial professionals use financial statements to help them make good decisions. In the last chapter in this section, we learn one of the very basic and generally useful concepts in finance, time value of money, that is, how and why a dollar today is worth more than one we might receive a year from now. Global Concepts • The role of finance in business continues to evolve, moving toward a more comprehensive approach to using financial resources to generate return for investors. • While the environment within which financial managers work is widely varied, all corporate financial managers share core concerns. • Financial managers must understand the pros and cons of various legal forms of business organization. • For financial managers, successful decisions are those that increase shareholder wealth or, put another way, those where the marginal benefits exceeds marginal costs. Conceptual Summary 1.1 —The Role of Corporate Finance in Modern Business • The five major career areas in finance are o corporate finance o commercial banking o investment banking o money management o consulting • All of these areas require people who can make decisions based on sound financial theory. • The focus of this book is corporate finance or the duties of a financial manager within a firm, typically one whose common stock trades publicly. The same principles apply, however, to privately held companies and for finance professionals in the other career of finance. 1.2 —Corporate Finance Essentials • All firms, regardless of size, rely on capital (money) to operate, grow and evolve. • The two major types of capital available to firms are • Debt is borrowed capital that firms eventually pay back to creditors. • Equity is invested capital that represents an ownership interest in the firm. 1
  2. 2. Part 1: Introduction • Financial intermediaries, such as commercial banks, savings and loans, pension funds, mutual funds and insurance companies, play an important role in corporate finance by putting excess capital to work in firms that are growing. • With improved technology and communication, financial markets are more efficient than they used to be, and have assumed a larger, almost universal, role distributing capital. • Two basic classifications of financial markets are o Primary markets are those in which firms issue securities by selling equity or debt directly to investors to raise capital. o Secondary markets are those in which investors trade securities with other investors. The issuing company receives no money since it already received the capital upon issuance of the security in the primary market. o Secondary markets are important to companies, however, because the prices in the secondary markets provide a lot of information to financial managers. More about this later when we discuss the goal of financial managers. • The five broad functions of corporate finance are all concerned with making decisions where marginal benefits exceed marginal costs: o Raising capital from outside the firm: external financing o Making decisions about the firm’s acquisition of fixed assets: capital budgeting o Managing the cash inflows and outflows and determining the best mix of debt and equity capital: financial management o Determining the legal form of organization that maximizes the firm’s ability to create and maintain wealth: corporate governance o Analyzing and limiting the firm’s exposure to risk: risk management • The chief financial officer (CFO) of a firm ultimately is responsible for each of these functions. 1.3 —Legal Forms of Business Organization • There are several choices for business organization with advantages and disadvantages as shown in the following table: • More than 70% of existing Description Form Brief firms originally organize as sole proprietorships, but a large Advantages Disadvantages The firm has one owner  Ease of formation  Unlimited personal Sole Proprietorship who is indistinguishable liability from the firm itself  Complete control  Limited life The firm has two or more  No corporate taxes  Limited life owners, all of whom are Partnership responsible for the firm’s  Tight control  Limited access to capital liabilities markets The firm’s owners buy  Limited personal  Corporate taxes shares in the company and liability Corporations hire managers to oversee  Access to capital  Loss of control by operations founders/entrepreneurs markets  Limited personal  Limited size S-Corporations A hybrid of corporations liability  Creditors may require and LLCs and partnerships personal guarantees from  No corporate taxes owners 2
  3. 3. Chapter 1: The Scope of Corporate Finance • Corporations have access to large amounts of debt and equity capital that other forms of business do not. A successful, growing firm will eventually need a lot of capital to continue to grow and becoming a corporation is a natural step in the life of the company. 1.4 —The Corporate Financial Manager’s Goals • The financial manager’s ultimate goal is to make its shareholders as wealthy as possible, in other words, to maximize the shareholders’ wealth. • A manager, the shareholders and the board of directors can all see the effects of managers’ decisions in the stock price trading in the secondary market. o Maximization of shareholders’ wealth is a concept that includes consideration of not only the cash flows (returns) to shareholders, but also risk. • Much of what we study in this text helps financial managers make decisions that maximize wealth and/or measure whether they reach this goal. • Because managers of corporations are often not shareholders, they will sometimes make decisions that are not in shareholders’ best interest. o If managers are not shareholders, they are the agents for shareholders, that is, they make decisions for shareholders. That is why we call the cost of making sure managers make good decisions for shareholders agency costs. • Agency costs accrue to stakeholders as well as evidenced by recent accounting scandals at firms such as Enron and WorldCom. o The abuses of managers, financial managers in particular, resulted in an increased interest in ethical behavior in business, as well as legislation such as the Sarbanes-Oxley (SOX) act of 2002. Concept Test Fill in the Blank • A wealth of choices faces students looking for careers in finance. Within corporate finance, for example, (1______________) maintain and control the firm’s collection and disbursal of cash. (2______________) analysts evaluate and analyze investments in assets, particularly fixed assets. • The credit manager monitors and administers the firm’s investments in (3______________). All of these individuals likely report to the (4______________), who is ultimately responsible for developing financial strategies to create shareholder wealth. • When it comes to raising capital, financial managers have two basic sources: (5______________) and equity. An advantage of equity financing is that the claimants (shareholders) cannot force the firm into (6______________) if the firm chooses not to — or is unable to — pay a dividend. • (7______________) is a hybrid of debt and equity: like debt because it pays a fixed return and like equity because the firm is not obligated to pay the return in times of financial distress. • A new, relatively non-traditional role of the financial manager is (8______________), an increasingly important function because prices, interest rates and exchange rates have become increasingly variable or volatile. In addition to insurance, financial managers increasingly rely on (9______________), such as options, to help them offset volatility. (10______________) is the process of managing risk by using derivative securities. True/False 11.___ The vast majority of businesses in the U.S. are corporations. 3
  4. 4. Part 1: Introduction 12.___ Partnership income is taxed only at the personal level. 13.___ A potential disadvantage of the corporate form of business organization is the unlimited liability faced by the owners of the firm. 14.___ In the case of corporate liquidation (bankruptcy), common shareholders have a senior claim against the assets of the firm. 15.___ The earnings of corporations may be subject to double taxation, a serious disadvantage of the corporate form of organization. 16.___ S-corporations are formed primarily to ensure limited personal liability of the owners against legal claims. 17.___ C-corporations are formed primarily to ensure the greatest possible access to capital markets. 18.___ In all industrialized nations, the primary engines of economic growth are large, publicly traded corporations. Multiple Choice 19. Which of the following would most likely be an agency cost? A. the cost of adding scrubbers to a smokestack to comply with environmental regulations B. the difference between the exercise price and the market value of stock purchased by top executives C. tariffs paid on exports to China that exceed export quotas D. all are agency costs 20. Which of the following is a direct result of the Sarbanes-Oxley Act of 2002? A. mandatory personal certification of financial documents by management B. mandatory inclusion of audit committee on corporate board of directors C. separation of audit and consulting functions D. all are results of the Sarbanes-Oxley Act 21. Which of the following is NOT a common approach to overcoming agency costs? A. relying on market forces such as hostile takeovers B. monitoring and bonding (such as outside auditors to review financial documents) C. relying on owners of the company to manage the company D. structuring compensation to reflect company performance 4
  5. 5. Chapter 1: The Scope of Corporate Finance 22. A firm is attempting to decide whether to offer credit to customers. What type of financial decision is this? A. capital budgeting B. capital structure C. financial management D. risk management 23. Which of the following is an example of a primary market transaction? A. Tim Smith sells Firm A stock to John Williams B. Tim Smith buys Firm A’s bonds issued 5 years ago from a broker C. Tim Smith and John Williams buy stock at an initial public offering (IPO) by Firm A D. None of the above is examples of primary market transactions 24. Enroff, Inc. is considering three strategic goals for the coming year. Which of the following would be most in line with the goals of financial management? A. A plan which would increase profits by 20% B. A plan which would increase revenues by 20% C. A plan which would increase the price of Enroff stock by 20% D. None of the above is in line with the goals of financial management. 25. Firm X is considering investing in an expensive piece of equipment. According to the principles presented in the text , the machine should be purchased if A. doing so reduces the risk of the firm B. doing so produces accounting profit C. doing so produces positive cash flow D. doing so produces benefits in excess of costs 26. The top company official with overall responsibility for managing the company’s affairs who reports to the Board of Directors: A. CFO B. CEO C. Chairman of the Board D. Corporate charter 27. An institution that raises capital by issuing liabilities against itself A. Secondary market B. Primary market C. Financial intermediary D. S Corporation 28. Professional investors who specialize in high-risk, high-return investments, particularly in rapidly growing industries, are A. Investment bankers B. Venture capitalists 5
  6. 6. Part 1: Introduction C. Leveraged buyout specialists D. Financial intermediaries 29. Individuals and institutions directly affected by the fortunes of a firm are A. Shareholders B. Capitalists C. Stakeholders D. Creditors 30. A form of business organization with limited personal liability whose earning are NOT subject to double taxation is a A. C corporation B. Limited Liability Institution C. Limited partnership D. S Corporation Synthesis Review the discussion of debt and equity on page 13 of the text. One decision that financial managers always face is the capital structure decision — do we borrow funds to finance assets or do we allow people to buy part of the firm by selling stock? As a business student, you are probably familiar with the concepts of fixed, variable and marginal costs, especially as they relate to costs of production. Keep the concept of fixed, variable and marginal costs in mind as you evaluate the following question regarding financial costs: Assume two companies are investing in roughly identical new product projects. You are the financial manager of Tweedledee Company and you chose to finance the project by selling bonds (bonds are a form of long-term corporate debt). Your buddy Joe Bob is the financial manager of Tweedledumb, Inc., on the other hand, and he chose to sell stock (ownership) and used the proceeds to finance the project. After two years, all experts agree: the new product is a huge success. Ignoring the tax characteristics of debt and equity (which is discussed in Chapter 12), who made the smarter financial decision? How would your answer change if the project had proven to be a bust? 6