This chapter introduces key concepts in corporate finance. It discusses that corporate finance addresses three questions: what long-term investments to choose, how to raise funds for investments, and how to manage short-term assets. It also covers different business organizations like sole proprietorships, partnerships, and corporations. The goal of financial management is to maximize shareholder wealth. Agency problems can arise between owners and managers due to conflicting interests. Financial markets include primary markets for new securities and secondary markets for existing securities.

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Introduction to Corporate Finance
Chapter 1

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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 various
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

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Chapter Outline
1.1 What is Corporate Finance?
1.2 The Corporate Firm
1.3 The Goal of Financial Management
1.4 The Agency Problem and Control of the
Corporation
1.5 Financial Markets

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1.1 What is Corporate Finance?
Corporate Finance addresses the following
three 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?

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

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The Capital Budgeting Decision
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
What long-term
investments
should the firm
choose?

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The Capital Structure Decision
How should the
firm raise funds
for the selected
investments?
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt

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Short-Term Asset Management
How should
short-term assets
be managed and
financed?
Net
Working
Capital
Shareholders’
Equity
Current
Liabilities
Long-Term
Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible

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

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The Financial Manager
The Financial Manager’s primary goal is to
increase the value of the firm by:
1. Selecting value creating projects
2. Making smart financing decisions

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

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

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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.

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Forms of Business Organization
 The Sole Proprietorship
 The Partnership
 General Partnership
 Limited Partnership
 The Corporation

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A Comparison
Corporation Partnership
Liquidity Shares can be easily
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 Partners pay taxes on
distributions
Reinvestment and dividend
payout
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

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1.3 The Goal of Financial Management
 What is the correct goal?
 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize shareholder wealth?

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1.4 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

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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

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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

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1.5 Financial Markets
 Primary Market
 Issuance of a security for the first time
 Secondary Markets
 Buying and selling of previously issued securities
 Securities may be traded in either a dealer or
auction market
 NYSE
 NASDAQ

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

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Quick Quiz
 What are the three basic questions Financial
Managers must 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?