Chapter 1: Introduction to corporate finance

Corporate Finance

Ross, Westerfield & Jaffe

Outline

1.1 What is corporate finance?

1.2 The goal of financial management

1.3 The agency problem and control of the corporation

1.4 Ethics and corporate governance

1.5 Financial markets

Main tasks of corporate finance

• Capital budgeting: the process of planning and managing a firm’s long-term investments ⇒ fixed assets.

• Capital structure: the mixture of debt and equity maintained by the firm ⇒ S-T and L-T debt and equity.

• Working capital management: a firm’s short-term assets and liabilities ⇒ current assets and current liabilities.

The Capital Budgeting Decision

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders

’ Equity

Current Liabilities

Long-Term Debt

What long-term investments should the firm choose?

Modern form of firms

Corporation: a business created as a distinct legal entity composed of one or more individuals or entities, e.g., IBM.

– Separation of control (shareholders) and management (professionals).

– Ownership can be easily transferred.– Limited liability.– Double taxation.– Rather expensive to form.– Agency problems.

Who make the decisions?

Owners (typically in small businesses). Professional managers.

Financial managers

Frequently, financial managers try to address these tasks.

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.

Possible goals of financial management

Survive Beat the competition Maximize sales Maximize net income Maximize market share Minimize costs Maximize the value of (stock) shares

The “appropriate” goal of financial management

Maximize the (fundamental or economic) value of (stock) shares is the right goal.

Why? Shareholders own shares. Managers, as agents, ought to act in a way to benefit shareholders; i.e., to enhance the value of the shares.

A limitation of this goal is that value is not directly observable.

Home Depot CEO gets $210 million severance for sucking at job

Robert L. Nardelli, the CEO of Home Depot, who came under heavy criticism for his pay package and failure to lift the chain ’s stagnant stock price, has abruptly resigned. He will receive about $210 million in compensation from the company, including the current value of retirement and other benefits. Who would blame him for quitting?

Source:digg.com; submitter: tennova.

Value vs. price

The value of shares are not observable. In contrast, the price of shares can be observable.

If one believes that share price is an accurate/good estimate of share value, the appropriate goal would be to maximize the price of shares.

This belief/assumption is, however, questionable. But the previous slide (Home Depot ex-CEO),

nevertheless, showed that investors care about stock price, and that stock price performance is very important to the tenure of managers.

The agency problem

Agency relationship:– Principals (citizens) hire an agent (the president) to

represent their interest.– Principles (stockholders) hire agents (managers) to run the

company. Agency problem:

– Conflict of interest between principals and agents.– This occurs in a corporate setting whenever the agents do

not hold 100% of the firm’s shares.– The source of agency problems is the separation of

(owners’) control and management.

Agency costs

Direct costs: (1) unnecessary expenses, such as a corporate jet, and (2) monitoring costs.

Indirect costs. For example, a manager may choose not to take on the optimal investment. She/he may prefer a less risky project so that she/he has a higher probability keeping her/his tenure.

Managerial incentives

Managerial goals are frequently different from shareholders’ goals.– Expensive perks.– Survival.– Independence.

Growth and size (related to compensation) may not relate to shareholders’ wealth.

Corporate governance

Compensation:– Incentives ($$$, options, threat of dismissal, etc.) used to

align management and stockholder interests.

Corporate control:– Managers may take the threat of a takeover seriously and

run the business in the interest of shareholders.

Pressure from other stakeholders (e.g., CalPERS, a powerful corporate police).

Sarbanes-Oxley Act (2002)

“Sarbox.” 10K must have an assessment of the firm’s

internal control structure and financial reporting.

The officers must explicitly declare that 10K does not contain any false statements or material omissions.

The officers are responsible for all internal controls.

Ethics

Managers are expected to behave in an ethical manner.

The province of ethics is to sort out what is good and bad.

But, what is the criterion or guideline for doing so? Philosophers came up with some criteria, but none

of them makes sorting out what is good and bad an easy task.

Here, we introduce two of these criteria.

Principle 1

Golden rule: Do unto others as you would have others do onto you.

But the next example, the so-called Sopranoism, shows the limitation of this principle: Whack the next guy with the same respect you’d like to be whacked with, you know? (Source: Cathcart and Klein, 2007).

Principle II

Confucianism: Do not do to others what you do not want done to yourself.

This is a rather robust (but passive) criterion. But its limitation is that it says nothing about

what you should do.

Dilemma

Ethical decisions often yield a dilemma. Suppose that you were the CEO of investment bank

XYZ in 2005. The debt/equity ratio of the bank was 20. All of your competitors raised their debt/equity ratios to 30 to please the stock market so that their stock prices could be higher than otherwise would be. You knew that raising the debt/equity ratio to 30 was rather risky and could destroy the bank if business went wrong. But you knew the investors would be disappointed by the otherwise lower share price if you did not raise the debt/equity ratio.

So, what is the answer?

I do not have an answer for this kind of ethical question because it is a dilemma; otherwise, I would not use the word “dilemma.”

All I know is that you, as professional managers, are expected to behave ethically.

One thing I know for sure is that never do anything that will put you in a prison cell; you are too cute for a prison cell.

Financial markets

Cash flows (i.e., financing and payoffs/dividends/interests) between firms and financial markets.

Primary markets. Secondary markets.- NYSE.- Nasdaq.

Info about financial markets

Yahoo! Finance.

End-of-chapter

Concept questions: 1-10.