Corporate Finance by Ross et al. Chapter 1

1. Chapter 1
Introduction to
Corporate Finance
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Key Concepts and Skills
• Know the basic types of financial
management decisions and the role of the
financial manager
• Know the financial implications of the
different forms of business organization
• Know the goal of financial management
• Understand the conflicts of interest that can
arise between owners and managers
• Understand the various types of financial
markets
1-1

3. Chapter Outline
• Corporate Finance and the Financial
Manager
• Forms of Business Organization
• The Goal of Financial Management
• The Agency Problem and Control of
the Corporation
• Financial Markets and the
Corporation
1-2

4. What Is Corporate Finance?
• Corporate finance provides answers
to some important questions:
– What long-term investments should the
firm take on?
– Where will the firm get the long-term
financing to pay for the investments?
– How will the firm manage its everyday
financial activities?
1-3

5. The Financial Manager
• Financial managers try to answer some or all
of these questions
• 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
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6. Financial Management Decisions
• Capital budgeting
– What long-term investments or projects
should the business take on?
• Capital structure
– How much should the firm borrow to pay
for its assets?
• What is the best mixture of debt and equity?
• The least expensive sources of funds?
• Working capital management
– How do we manage the day-to-day
finances of the firm? 1-5

7. Forms of Business Organization
• Three major forms
– Sole Proprietorship
– Partnership
• General
• Limited
– Corporation
• Limited Liability Company
• Limited Liability Partnerships
1-6

8. Sole Proprietorship
• Advantages
– Easiest to start
– Least regulated
– Single owner keeps
all the profits
– Taxed once as
personal income
• Disadvantages
– Limited to life of
owner
– Equity capital
limited to owner’s
personal wealth
– Unlimited liability
– Difficult to sell
ownership interest
1-7

9. Partnership
• Advantages
– Two or more
owners
– More capital
available
– Relatively easy to
start
– Income taxed once
as personal income
• Disadvantages
– Unlimited liability
• General partnership
• Limited partnership
– Partnership
dissolves when one
partner dies or
wishes to sell
– Difficult to transfer
ownership
1-8

10. Corporation
• Advantages
– Limited liability
– Unlimited life
– Separation of
ownership and
management
– Transfer of
ownership is easy
– Easier to raise
capital
• Disadvantages
– Separation of
ownership and
management
– May involve double
taxation in some
countries (income
taxed at the
corporate rate and
then dividends
taxed at the
personal rate)
1-9

11. Summary of
3 Business Forms
1-10

12. Goal of Financial Management
• What should be the goal of a corporation?
– Maximize profits?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s
stock?
1-11

13. Maximizing Shareholders’ Wealth
• Maximizing the share price is
equivalent to maximizing
shareholders’ wealth
• Why is this a valid goal?
– Decisions are made in shareholders‘
best interest
– Considers cash flows not profits
– Incorporates time dimension
– Does not consider profitability but
also risk

14. The Agency Problem
• Agency relationship
– The relationship exists when a principal
hires an agent to represent his/her
interests
– Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
– Conflict of interest between principal and
agent
• Agent may not work in the best interest of the
principal
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15. Management Goals
• Management goals may be different
from shareholder s’ goals
– Management may be more interested in:
• Consuming expensive perks
• It’s own survival
• It’s independence
• Management may focus on increased
growth and size rather than increasing
shareholders’ wealth

16. Agency Costs
• Costs due to the conflict of interest
between shareholders and management
– Direct
• Corporate expenditure that benefits
management but costs shareholders,
e.g. country club membership
• Costs to monitor management actions,
e.g. auditor costs
– Indirect
• Lost opportunity due to management forgoing
profitable but risky projects for fear of losing job
if project fails
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17. 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 goal
• Corporate control
– The threat of a takeover may result in better
management
• Other stakeholders
1-16

18. Work the Web Example
• The Internet provides a wealth of information
about individual companies
• One excellent site is finance.yahoo.com
• Click on the web surfer to go to the site,
choose a company and see what information
you can find!
1-17

19. Financial Markets
• Primary market
– A market where the firm sells its
securities to public for the first time
• Secondary markets
– A market in which the securities issued
by firms are traded
• Listed securities trade in an organized
exchange, e.g. the stock market (NYSE)
• Over-the-counter securities are bought from
or sold to a dealer
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20. Quick Quiz
• What are the three types of financial
management decisions and what questions
are they designed to answer?
• What are the three major forms of business
organization?
• What is the goal of financial management?
• What are agency problems and why do they
exist within a corporation?
• What is the difference between a primary
market and a secondary market?
1-19

21. Ethics Issues
• Is it ethical for tobacco companies to sell a
product that is known to be addictive and a
danger to the health of the user? Is it relevant
that the product is legal?
• Should boards of directors consider only price
when faced with a buyout offer?
• Is it ethical to concentrate only on shareholder
wealth, or should stakeholders as a whole be
considered?
• Should firms be penalized for attempting to
improve returns by stifling competition (e.g.,
Microsoft)? 1-20

22. End of Chapter
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