Introduction to Corporate Finance

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Introduction to
Corporate Finance
2-208-97 Basic Corporate
Finance
Albert Lee Chun
Lecture 1

Albert Lee Chun Basic Corporate Finance 1
E-mail: albert-lee.chun@hec.ca
Phone: 514-340-5661
Office: 4.257
Office hours: 1) By Appointment Only
2) Immediately after each class
Prof. Albert’s Contact Info

Evaluation
 Grade Distribution
 Midterm exam : 40%
 Final exam : 40%
 Other (Quizes) : 20%
 A laptop (and Excel) will be required for the
exams and the assignment.

This course will provide YOU
with
 Knowledge of the basic concepts in corporate
finance.
 Key tools and problem solving skills for tackling
problems in corporate finance.
 Basic foundation that will be used in later finance
courses!
 The ability to make important financial decisions in
life – both personally and professionally!

Readings
 Required
 Fundamentals of Corporate Finance by Ross, Westerfield, Jordan,
and Roberts, 6th Canadian edition, McGraw-Hill Ryerson
 If you use an older version of the book, that should be OK,
but check the new version to see if there are any differences.
 Lecture Notes and Course Website
 Optional
 Lecture Notes from the French version of the course.
 Study guide, CD ROM, online resources, the financial press.

Keys to Success
 Attend all lectures and review the lecture notes.
 Do the math!
- Focus on solving problems, doing the calculations as well as
mastering the intuition.
- master all examples done in class!
- build library of excel spreadsheets, so you don’t have to
reinvent everything on the exam.
 Read the Textbook
 Ask questions!
- Chat with me after class or during office hours
- Form study groups

Preliminary Course Outline
 Overview of Corporate Finance (Chapter 1) Today
 Time Value of Money and Discounting
 Interest Rates and Bond Valuation
 Stock Valuation
 Investment Criteria
 Cash Flow and Taxes
 Capital Investment Decisions
 Capital Markets
 Risk and the Capital Asset Pricing Model
 Weighted Average Cost of Capital
 Raising Capital
 Leverage and Capital Structure

Roadmap for Today
 Forms of business organization
 What is corporate finance?
 Role of the financial manager
 The goal of financial management
 Agency Problems
 Overview of Financial Markets

Forms of Business Organization
We look at three different legal forms:
 Sole proprietorship
 General or limited partnership
 Corporation

Sole Proprietorship
 No distinction between owner and business
 Owner Keeps all profits
 Unlimited Liability
 Small ventures owned by a single person
- Doctor or dentist’s practice
- Lemonade Stand at HEC
- Reindeer Farm in Finland
- Tea House in the Mile End

Sole Proprietorship
 Easy and inexpensive to
setup
 Profits are taxed once as
personal income
 Unlimited liability – can
lose personal assets.
 Equity capital limited to
proprietor’s wealth
 Difficult to transfer –
must sell entire business
to new owner
 Life of business limited to
life of owner
Advantages Disadvantages

Partnership
 Similar to a proprietorship, but
 Two or more owners
 Shared resources, revenues and responsibilities
 One partner can act on behalf of others
 Two types of partnership agreements:
 General partnership
 Limited partnership

General Partnership
 Everything is shared
 All general partners have unlimited liability
 Partnership terminates when a general partner
wishes to sell out or dies

Limited Partnership
 General partners run the business and have
unlimited liability, but some partners have
limited liability.
 Limited partners do not actively participate in
the business and liability is limited to what they
contributed to the business.
 A limited partner’s interest can be sold without
dissolving the partnership

Partnership
 Relatively easy to start
 Profits taxed once as
personal income
 More capital available
 Unlimited liability for
general partners
 Partnership dissolves
when one general partner
wishes to sell or dies
 Difficult to transfer
ownership

Corporation
 Most important form of business organization.
 Exists as a separate legal entity from the owners.
 Unique powers
- can occur debts
- can sue and be sued
- enter into legal contracts
- limited liability of owners (shareholders)
- shares of common stock easily transferred.

Corporation
 Separation of ownership
and management
 Limited liability
 Transfer of ownership is
easy
 Unlimited lifespan
 Easier to raise capital
 Separation of ownership and
management
 Double taxation
- corporate income tax
- dividends are taxed
 Slightly complicated to setup
 Articles of incorporation (charter)
 Bylaws

What is Corporate Finance?
 Corporate finance is a specific area of finance
that analyzes the financial decisions of
corporations.
- Investment or capital budgeting decisions
- Financing decision
- Day-to-day operations

3 Key Questions in Corporate Finance
 1. What long-term investments should the firm
undertake?
 Capital budgeting decision
 2. What is the best way to finance these long-
term investments? Debt or equity?
 Capital structure decision
 3. How should the firm manage its short-term
assets and liabilities, such as cash?
 Working capital managment

1. Capital Budgeting
 Process of planning and managing a firm’s long-
term investments.
 Financial manager identifies investment
opportunities that are worth more to the firm
than they cost to acquire.
 Example: A chocolate firm deciding whether or
not to open a new factory is a capital budgeting
decision.

Key Questions
 How much cash does the firm expect to receive?
- size of cash inflows and outflows
 When does the firm expect to receive it?
- timing of cash flows
 How likely is the firm to receive it?
- riskiness of cash flows

2. Capital Structure
 How should the firm obtain and manage the
long-term financing it needs to support its long
term investments?
 Capital Structure is the specific mix of short-
term debt, long-term debt and equity.
 Raising long-term financing can be expensive,
so the different possibilities must considered
carefully.

Key Questions
 How should the firm pay for its assets? Debt or
equity?
 How much should the firm borrow?
 What is the least expensive source of funds?
 How, when and where to raise the money?

3. Working Capital Management
 Working capital refers to the firm’s short-term
assets including inventory and liabilities, such as
cash owed to suppliers.
 Managing working capital is a day to day activity
related to the firm’s receipt and disbursement of
cash.

Key Questions
 How should the firm manage the receipt and
disbursement of cash - current assets and
current liabilities?
 What is the best way to manage day-to-day,
short term assets such as inventory?
 How should the firm obtain short-term
financing?
 Should the firm sell or purchase on credit? On
what terms?

Once Again...
 Capital Budgeting: The process of planning and
managing a firm’s investment in long-term
assets.
 Capital Structure: The mix of debt and equity
maintained by a firm.
 Working Capital Management: Planning and
managing the firm’s current assets and liabilities.

A Simplified Organizational
Chart
Source: Ross, Westerfield, Jordan, and Roberts, Fundamentals of Corporate
Finance, 5th Canadian edition, McGraw-Hill Ryerson.
Shareholders are
the owners.
Managers
represent the
owners.

Chief Financial Officer (CFO)
Profiles
Source: Meier and Tarhan (2005), Corporate Investment Decision Practices and
the Hurdle Rate Premium Puzzle, Working Paper.

Chart
Financial
Manager
coordinates
the activities
of the
Treasurer and
Controller

Financial Manager
 This course focuses on the role of the Financial
Manager
 Chief financial officer (CFO) or the vice-president of
finance.
 Reports to the president or Chief Operating Officer
(COO) and coordinates the activities of the treasurer
and controller. We focus on the Treasurer.
 Successful financial managers increase value – “buy low,
sell high”.
 CFO is concerned with answering the 3 basic questions.

Chart
Corporate
Finance
primarily
concerned
with activities
of the
treasurer’s
office

Our Course in a Nutshell
Stockholders
Bondholders
Financial
Manager
Projects
Investments
Cash flow
Interest
Dividends
The Firm
Capital Budgeting
The Market
Capital Structure
Equity
Debt
Government
Corporate
Taxes
Personal
Taxes

Our Course in a Nutshell
Stockholders
Bondholders
Financial
Manager
Projects
Investments
Cash flow
Interest
Dividends
The Firm
Capital Budgeting
The Market
Capital Structure
Equity
Debt
Government
Corporate
Taxes
Personal
Taxes
Society
Ethical
Pressures
Ethical
Cooperation vs.
Social Costs
Politics

Goal of Financial Management?
What should be the firm’s objective?
 Maximize market value?
 Maximize sales revenue or market share?
 Maximize profits?
 Minimize costs?
 To avoid bankruptcy and financial distress?
 Maintain steady earnings growth?
 Maximize CEO wealth?

Goal in a For-Profit Business
 Managers work for the board of directors, who
represent shareholders, the owners.
 Goal is to make money for the shareholders.
 Shareholders are better off when the value of the stock
is high.
 Maximize the current price per share of the firm’s
existing stock.
 Managers should maximize the value of the
firm’s equity!

Maximize Value of Equity
 When the shares are privately held, the goal is to
maximize the owner’s equity.
 When equity is traded on the market, then the
goal is to maximize the stock price.
 We are interested in the relation between
business decisions and the value of the equity.
 Stock prices are observable and updated to
incorporate new information in an efficient
market. Accurate measure of firm’s decisions.

What About These Goals?
 Maximize customer satisfaction
 Environmental responsibility
 Ethical behavior

Agency Problems
 Agency relationship
Shareholders (principals) hire managers (agents)
to run the company
 Agency problem
Conflict of interest between the shareholders
(pricipals) and management of a firm (agents)
 Agency costs are defined as the costs from these
conflicts of interest.

An Example

Two Forms of Agency Costs
 Direct Agency Costs
 Corporate expenditure that benefits the manager but cost the
shareholders, e.g., luxury corporate jet.
 Excessive management pay and unauthorized compensation.
 Monitoring costs, e.g., paying outside auditors to monitor
management actions.
 Indirect Agency Costs
 Foregone investment opportunities
 Excessive investment to increase the firm’s size may not
necessarily increase value of the firm’s stock.

Stake of Senior Management
 The equity stake of top management in the firm is 5%
or less for half of the firms
Source: Graham and Harvey (2001):
The top three executives own at least
5% of the common stock of their firm
in 44% of the sample.
Source: Meier and Tarhan (2005): The
equity stake of senior management in
the firm is 5% or less for half of the
respondents (53.3%), and 1% or less
for 13.1% of the firms.

Answers to Agency Problems
 Compensation plans tied to increases in firm
value. Aligns management and shareholder
interests.
 Control of the firm. Takeovers can result in
loss of jobs for management.
 Outside monitoring and auditing.
 Stakeholders – creditors, clients, suppliers and
others who have a stake on the cash flows of
the firm. Important long-term relationships.

Financial Markets
 Money markets versus capital markets
 Primary markets versus secondary markets

Money and Capital Markets
 Money Markets
- short-term debt securities
- dealer market : brokers and agents match buyers and sellers.
 Capital Markets
- long-term debt securities : govt and corporate bonds
- shares of stocks
Dealer markets are OTC (over-the-counter) markets, e.g.,
NASDAQ
Auction Markets, e.g., Toronto Stock Exchange, NYSE

Primary vs Secondary Markets
 Primary Market
- original sale, or issue of a security
- IPOs are underwriten by dealers that purchase
and resell to public at a higher price
 Secondary Market
- one owner selling to another
- Auction market or OTC dealer markets

Financial Market Cash Flows

Summary For Today
 Three basic forms of business organization
 The three main areas of corporate finance
 The role of the financial manager
 Goals of financial management
 Agency problems in achieving those goals
 Overview of Financial Markets

Introduction to Corporate Finance

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