It is sometimes helpful to relate corporate decisions to individual circumstances. For example, consider discussing how individuals choose to buy cars or homes and how this decision would affect a personal balance sheet.
Note, these actions explicitly relate to the three questions addressed in slide 3.
It may be beneficial to discuss S-Corporations and LLCs in the context of this slide.
It is important to remind students that net income is NOT cash flow.
A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyer’s price range. Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs. Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.
Incentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forego projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive. Corporate control – ask the students why the threat of a takeover might make managers work towards the goals of stockholders. Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.
Introduction to corporate finance
Introduction toCorporate Finance 1-1
Key Concepts and SkillsKnow the basic types of financial management decisions and the role of the Financial ManagerKnow the financial implications of the various forms of business organizationKnow the goal of financial managementUnderstand the conflicts of interest that can arise between owners and managersUnderstand the various regulations that firms face 1-2
Chapter Outline1.1 What is Corporate Finance?1.2 The Corporate Firm1.3 The Importance of Cash Flows1.4 The Goal of Financial Management1.5 The Agency Problem and Control of the Corporation1.6 Regulation 1-3
1.1 What Is Corporate Finance?Corporate Finance addresses the followingthree questions:1. What long-term investments should the firm choose?2. How should the firm raise funds for the selected investments?3. How should short-term assets be managed and financed? 1-4
Balance Sheet Model of the Firm Total Value of Assets: Total Firm Value to Investors: Current Liabilities Current Assets Long-Term Debt Fixed Assets 1 Tangible Shareholders’ 2 Intangible Equity 1-5
The Capital Budgeting Decision Current Liabilities Current Assets Long-Term Debt Fixed Assets What long-term 1 Tangible investments Shareholders’ should the firm 2 Intangible Equity choose? 1-6
The Capital Structure Decision Current Liabilities Current Assets Long-Term How should the Debt firm raise funds for the selected Fixed Assets investments? 1 Tangible Shareholders’ 2 Intangible Equity 1-7
Short-Term Asset Management Current Liabilities Current Net Assets Working Long-Term Capital Debt How should Fixed Assets short-term assets 1 Tangible be managed and financed? Shareholders’ 2 Intangible Equity 1-8
The Financial ManagerThe Financial Manager’s primary goal is toincrease the value of the firm by:2. Selecting value creating projects3. Making smart financing decisions 1-9
Hypothetical Organization Chart Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operating Officer (COO) Vice President and Chief Financial Officer (CFO) Treasurer Controller Cash Manager Credit Manager Tax Manager Cost AccountingCapital Expenditures Financial Planning Financial Accounting Data Processing 1-10
1.2 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. 1-11
Forms of Business Organization• The Sole Proprietorship• The Partnership – General Partnership – Limited Partnership• The Corporation 1-12
A Comparison Corporation PartnershipLiquidity Shares can be easily Subject to substantial exchanged restrictionsVoting Rights Usually each share gets one General Partner is in charge; vote limited partners may have some voting rightsTaxation Double Partners pay taxes on distributionsReinvestment and dividend Broad latitude All net cash flow ispayout distributed to partnersLiability Limited liability General partners may have unlimited liability; limited partners enjoy limited liabilityContinuity Perpetual life Limited life 1-13
1.3 The Importance of Cash Flow Firm Firm issues securities (A) Financial markets Invests Retained in assets cash flows (F) (B) Short-term debt Current assets Cash flow Dividends and Long-term debt Fixed assets from firm (C) debt payments (E) Equity shares Taxes (D) The cash flows fromUltimately, the firm the firm must exceedmust be a cash Government the cash flows fromgenerating activity. the financial markets. 1-14
1.4 The Goal of Financial Management• What is the correct goal? – Maximize profit? – Minimize costs? – Maximize market share? – Maximize shareholder wealth? 1-15
Maximize shareholder wealth• The shareholders have invested in the corporation, putting their money at risk to become the owners of the corporation.• Thus, the financial manager is a caretaker of the shareholders money, making decisions in the shareholders interests. 1-16
1.5 The Agency Problem• Agency relationship – Principal hires an agent to represent his/her interest – Stockholders (principals) hire managers (agents) to run the company• Agency problem – Conflict of interest between principal and agent 1-17
MINIMIZE POTENTIAL CONFLICT BETWEEN MANAGERS AND SHAREHOLDERS• Voting at annual general meetings. – Shareholders can vote at annual general meetings. At such meetings they vote in the members of the board of directors of the firm, who in turn, hire the financial managers of the business. – If the shareholders vote in reliable members to the board of directors, these directors would ensure that the managers pursue shareholder wealth maximization and look after the interests of the ordinary shareholders. These directors will also ensure that the financial managers 1-18
• Stock option plans – One way to encourage managers to act in the best interest of the shareholders of the business is to offer them share option schemes or performance shares. – Managers exercising these options actually become owners or shareholders of the company. If they accumulate sizeable amounts of common shares through such schemes (where shares are offered to managers at low prices for good performance), these managers will look after the interest of the common shareholders and will be less inclined to pursue their own goals. 1-19
• Fear of takeover of the company. – Managers who want job security will be more inclined to work in the interest of the owners of the company. Other firms may view companies which are not run well, but have the potential to be profitable, as potential targets for takeover or acquisition purpose. – This will pressure managers to maximize shareholder wealth, to ensure that the company will not become a target for others to take over or acquire. Shareholders whose interest have been well satisfied and taken care of by the managers, will also be less inclined to want to sell their shares in a potential takeover or acquisition of their company. 1-20
• Fear of being fired – Managers want to keep their jobs, and they will be more inclined to try to maximize shareholders wealth if this will ensure that they will be kept on as managers in the business. – If they do not perform, they can always be replaced by others who may be more competent and willing to look after the shareholders’ wealth. 1-21
Managerial Goals• Managerial goals may be different from shareholder goals – Expensive perquisites – Survival – Independence• Increased growth and size are not necessarily equivalent to increased shareholder wealth 1-22
Managing Managers• Managerial compensation – Incentives can be used to align management and stockholder interests – The incentives need to be structured carefully to make sure that they achieve their intended goal• Corporate control – The threat of a takeover may result in better management• Other stakeholders 1-23
1.6 Regulation• The Securities Act of 1933 and the Securities Exchange Act of 1934 – Issuance of Securities (1933) – Creation of SEC and reporting requirements (1934)• Sarbanes-Oxley (“Sarbox”) – Increased reporting requirements and responsibility of corporate directors 1-24