CHAPTER 1

Introduction to Corporate Finance

❖ Finance
Finance is defined as the management of money and includes activities such as investing,
borrowing, lending, budgeting, saving, and forecasting. There are three main types of
finance: (1) personal, (2) corporate, and (3) public/government.
Basically, finance manages funds or Manage money.
1. Personal Finance: Personal finance is the process of planning and managing personal
financial activities such as income generation, spending, saving, investing, and
protection.
2. Corporate Finance: Corporate finance is a branch of finance that focuses on how
corporations approach capital structuring, funding sources, investments, and accounting
decisions. 1. Its primary goal is to maximize shareholder value
3. Public Finance: Public Finance, the field of economics concerned. With how
governments raise money, how that. Money is spent, and the effects of these. activities on
the economy and society.

Corporate Finance
1. What Is Corporate Finance?
Suppose you decide to start a firm to make tennis balls. To do this, you hire
managers to buy raw materials, and you assemble a workforce that will produce
and sell finished tennis balls. In the language of finance, you invest in assets
such as inventory, machinery, land, and labor. The amount of cash you invest
in assets must be matched by an equal amount of cash raised by financing.
When you begin to sell tennis balls, your firm will generate cash. This is the
basis of value creation. The purpose of the firm is to create value for you, the
owner. The value is reflected in the framework of the simple balance sheet model
of the firm.
❖ Main tasks of corporate finance:
1. Capital budgeting: the process of planning and managing a firm’s long-term
investments = fixed assets
Features of capital budgeting
● High risk
● Requires a large amount of capital
● They will ensure the value creation of the company
● Usually, the longer the time to cash, the riskier the project.
2. Capital structure: the mixture of debt and equity maintained by the firm =S-
T and L-T debt and equity.
 ● 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 up
the pie.
● If how you slice the pie affects the size of the pie, then the capital
structure decision matters.
3. Working capital management: a firm’s short-term assets and liabilities =
current assets and current liabilities. Ex: Inventory and supplier
Ensures the firm has sufficient resources to continue its operations and
avoid costly interruption
4. Dividend Decision: The way the company decides how much of NI will be
retained and how much will be distributed as a dividend.
● How much dividend will be declared with shareholders
● How much will be retained in the company
● Has impact on share price

❖ THE BALANCE SHEET MODEL OF THE FIRM

The assets of the firm are on the left side of the balance sheet. These assets can be
thought of as current and fixed. Fixed assets are those that will last a long time, such as
buildings. Some fixed assets are tangible, such as machinery and equipment.
Other fixed assets are intangible, such as patents and trademarks. The other category
of assets, current assets comprise those that have short lives, such as inventory.

Before a company can invest in an asset, it must obtain financing, which means that it
must raise the money to pay for the investment. The forms of financing are represented
on the right side of the balance sheet. A firm will issue (sell) pieces of paper called debt
(loan agreements) or equity shares (stock certificates). Just as assets are classified as
long-lived or short-lived, so too are liabilities. A short-term debt is called a current
liability. Short-term debt represents loans and other obligations that must be repaid within
one year. Long-term debt is debt that does not have to be repaid within one year.
Shareholders ’ equity represents the difference between the value of the assets and the
debt of the firm. In this sense, it is a residual claim on the firm’s assets. From the balance
sheet model of the firm, it is easy to see why finance can be thought of as the study of the
following three questions:
● In what long-lived assets should the firm invest? This question concerns the left
side of the balance sheet. Of course the types and proportions of assets the firm
needs tend to be set by the nature of the business. We use the term capital
budgeting to describe the process of making and managing expenditures on long-
lived assets.
● How can the firm raise cash for required capital expenditures? This question
concerns the right side of the balance sheet. The answer to this question involves
the firm’s capital structure, which represents the proportions of the firm’s
financing from current and long-term debt and equity.
● How should short-term operating cash flows be managed? This question
concerns the upper portion of the balance sheet. There is often a mismatch
between the timing of cash inflows and cash outflows during operating activities.
Furthermore, the amount and timing of operating cash flows are not known with
certainty. Financial managers must attempt to manage the gaps in cash.

Flow. From a balance sheet perspective, short-term management of cash flow is

associated with a firm’s net working capital. Net working capital is defined as
current assets minus current liabilities. From a financial perspective, short-term
cash flow problems come from the mismatching of cash inflows and outflows.
This is the subject of short-term finance.
❖ Hypothetical Organization Chart
❖ The Corporate Firm
The corporate form of business is the standard method for solving the problems
encountered in raising large amounts of cash.
The firm is a way of organizing the economic activity of many individuals. A
basic problem of the firm is how to raise cash. The corporate form of business, that
is, organizing the firm as a corporation, is the standard method for solving
problems encountered in raising large amounts of cash. However, businesses can
take other forms.
Forms of Business Organization:
• The Sole Proprietorship
• The Partnership
● General Partnership
● Limited Partnership
• The Corporation

1. THE SOLE PROPRIETORSHIP:

A sole proprietorship is a business owned by one person. Suppose you decide to
start a business to produce mousetraps. Going into business is simple: You
announce to all who will listen, “ Today, I am going to build a better mousetrap. ”
Most large cities require that you obtain a business license. Afterward, you can
begin to hire as many people as you need and borrow whatever money you need.
At year-end, all the profits and the losses will be yours. Here are some factors that
are important in considering a sole proprietorship:
1. The sole proprietorship is the cheapest business to form. No formal charter
is required, and few government regulations must be satisfied for most
industries.
 2. A sole proprietorship pays no corporate income taxes. All profits of the
business are taxed as individual income.
3. The sole proprietorship has unlimited liability for business debts and
obligations. No distinction is made between personal and business assets.
4. The life of the sole proprietor limits the life of the sole proprietorship.
5. Because the only money invested in the firm is the proprietor’s, the equity
money that the sole proprietor can raise is limited to the proprietor s wealth.

❖ THE PARTNERSHIP
Any two or more people can get together and form a partnership. Partnerships fall
into two categories: (1) general partnerships and (2) limited partnerships. In a
general partnership, all partners agree to provide some fraction of the work and
cash and to share the profits and losses. Each partner is liable for all of the debts of
the partnership. A partnership agreement specifies the nature of the arrangement.
The partnership agreement may be an oral agreement or a formal document setting
forth the understanding.
Limited partnerships permit the liability of some of the partners to be limited to
the amount of cash each has contributed to the partnership. Limited partnerships
usually require that (1) at least one partner be a general partner and (2) the limited
partners do not participate in managing the business. Here are some things that are
important when considering a partnership:
1. Partnerships are usually inexpensive and easy to form. Written documents are
required in complicated arrangements. Business licenses and filing fees may be
necessary.
2. General partners have unlimited liability for all debts. The liability of limited
partners is usually limited to the contribution each has made to the partnership. If
one general partner is unable to meet his or her commitment, the shortfall must be
made up by the other general partners.
3. The general partnership is terminated when a general partner dies or withdraws
(but this is not so for a limited partner). It is difficult for a partnership to transfer
ownership without dissolving. Usually, all general partners must agree. However,
limited partners may sell their interest in a business.
4. It is difficult for a partnership to raise large amounts of cash. Equity contributions
are usually limited to a partner’s ability and desire to contribute to the partnership.
Many companies, such as Apple, Inc., start life as a proprietorship or partnership,
but at some point, they choose to convert to corporate form.
5. Income from a partnership is taxed as personal income to the partners.
 6. Management control resides with the general partners. Usually, a majority vote is
required on important matters, such as the amount of profit to be retained in the
business.
It is difficult for large business organizations to exist as sole proprietorships or
partnerships. The main advantage to a sole proprietorship or partnership is the
cost of getting started. Afterward, the disadvantages, which may become severe, are
(1) unlimited liability, (2) limited life of the enterprise, and (3) difficulty of transferring
ownership. These three disadvantages lead to (4) difficulty in raising cash.

❖ THE CORPORATION
The corporation is by far the most important. It is a distinct legal entity. As such, a
corporation can have a name and enjoy many of the legal powers of natural
persons. For example, corporations can acquire and exchange property.
Corporations can enter contracts and may sue and be sued. For jurisdictional
purposes, the corporation is a citizen of its state of incorporation (it cannot vote,
however). Starting a corporation is more complicated than starting a
proprietorship or partnership. The incorporators must prepare articles of
incorporation and a set of bylaws.
The articles of incorporation must include the following:
● Name of the corporation.
● The intended life of the corporation (it may be forever).
● Business purpose.
● Number of shares of stock that the corporation is authorized to issue, with
a statement of limitations and rights of different classes of shares.
● Nature of the rights granted to shareholders.
● Number of members of the initial board of directors.
The by-laws are the rules to be used by the corporation to regulate its existence, and they
concern its shareholders, directors, and officers. Bylaws range from the briefest possible
statement of rules for the corporation’s management to hundreds of pages of text. In its
simplest form, the corporation comprises three sets of distinct interests: the shareholders
(the owners), the directors, and the corporation officers (the top management).
Traditionally, the shareholders control the corporation’s direction, policies, and activities.
The shareholders elect a board of directors, who in turn select top management. Members
of top management serve as corporate officers and manage the operations of the
corporation in the best interest of the shareholders. In closely held corporations with few
shareholders, there may be a large overlap among the shareholders, the directors, and the
top management. However, in larger corporations, the shareholders, directors, and the top
management are likely to be distinct groups. The potential separation of ownership from
management gives the corporation several advantages over proprietorships and
partnerships:
● Because shares of stock represent ownership in a corporation, ownership can be
readily transferred to new owners. Because the corporation exists independently of
those who own its shares, there is no limit to the transferability of shares as there
is in partnerships.
● The corporation has an unlimited life. Because the corporation is separate from its
owners, the death or withdrawal of an owner does not affect the corporation ’ s
legal existence. The corporation can continue on after the original owners have
withdrawn.
● The shareholders ’ liability is limited to the amount invested in the ownership
shares. For example, if a shareholder purchased $1,000 in shares of a corporation,
the potential loss would be $1,000. In a partnership, a general partner with a
$1,000 contribution could lose the $1,000 plus any other indebtedness of the
partnership.
Limited liability, ease of ownership transfer, and perpetual succession are the major
advantages of the corporate form of business organization. These give the corporation an
enhanced ability to raise cash. There is, however, one great disadvantage to
incorporation. The federal government taxes corporate income (the states do as well).
This tax is in addition to the personal income tax that shareholders pay on dividend
income they receive. This is double taxation for shareholders when compared to taxation
on proprietorships and partnerships. Table 1.1 summarizes our discussion of partnerships
and corporations. Today all 50 states have enacted laws allowing for the creation of a
relatively new form of business organization, the limited liability company (LLC). The
goal of this entity is to operate and be taxed like a partnership but retain limited liability
for owners, so an LLC is essentially a hybrid of partnership and corporation. Although
states have differing definitions for LLCs, the more important scorekeeper is the Internal
Revenue Service (IRS). The IRS will consider an LLC a corporation, thereby subjecting
it to double taxation, unless it meets certain specific criteria. In essence, an LLC cannot
be too corporation-like, or it will be treated as one by the IRS. LLCs have become
common. For example, Goldman, Sachs and Co., one of Wall Street ’ s last remaining
partnerships, decided to convert from a private partnership to an LLC (it later “ went
public, ” becoming a publicly held corporation). Large accounting firms and law firms by
the score, have converted to LLCs.

❖ A Comparison of Partnerships and Corporations

❖ The Firm and the Financial Markets
The most important job of a financial manager is to create value from the firm’s
capital budgeting, financing, and net working capital activities. How do financial
managers create value? The answer is that the firm should:
1. Try to buy assets that generate more cash than they cost.
2. Sell bonds, stocks, and other financial instruments that raise more cash than
they cost.
Thus, the firm must create more cash flow than it uses. The cash flows paid to
bondholders and stockholders of the firm should be greater than the cash flows put
into the firm by the bondholders and stockholders. To see how this is done, we can
trace the cash flows from the firm to the financial markets and back again.
The interplay of the firm’s activities with the financial markets is illustrated in
Figure 1.3. The arrows in Figure 1.3 trace the cash flow from the firm to the
financial\
Markets and back again. Suppose we begin with the firm’s financing activities. To
raise money, the firm sells debt and equity shares to investors in the financial
markets. This results in cash flows from the financial markets to the firm ( A ).
This cash is invested in the investment activities (assets) of the firm ( B ) by the
firm’s management.
The cash generated by the firm ( C ) is paid to shareholders and bondholders ( F ).
The shareholders receive cash in the form of dividends; the bondholders who lent
funds to the firm receive interest and, when the initial loan is repaid, the principal.
Not all of the firm’s cash is paid out. Some are retained ( E ), and some are paid to
the government as taxes ( D ).
Over time, if the cash paid to shareholders and bondholders ( F ) is greater than the
cash raised in the financial markets ( A ), value will be created.

Identification of Cash Flows Unfortunately, it is sometimes not easy to observe

cash flows directly. Much of the information we obtain is in the form of
accounting statements, and much of the work of financial analysis is to extract
cash flow information from accounting statements. The following example
illustrates how this is done.

Timing of Cash Flows The value of an investment made by a firm depends on the
timing of cash flows. One of the most important principles of finance is that
 individuals prefer to receive cash flows earlier rather than later. One dollar
received today is worth more than one dollar received next year.

Risk of Cash Flows The firm must consider risk. The amount and timing of cash
flows are not usually known with certainty. Most investors have an aversion to
risk.

❖ The Goal of Financial Management

Assuming that we restrict our discussion to for-profit businesses, the goal
of financial management is to make money or add value for the owners.
This goal is a little vague, of course, so we examine some different ways of
formulating it to come up with a more precise definition. Such a definition
is important because it leads to an objective basis for making and
evaluating financial decisions.
POSSIBLE GOALS If we were to consider possible financial goals, we
might come up with some ideas like the following:
● Survive.
● Avoid financial distress and bankruptcy.
● Beat the competition.
● Maximize sales or market share.
● Minimize costs.
● Maximize profits.
● Maintain steady earnings growth.

These are only a few of the goals we could list. Furthermore, each of these possibilities
presents problems as a goal for the financial manager. For example, it ’ 's easy to increase
market share or unit sales: All we have to do is lower our prices or relax our credit terms.
Similarly, we can always cut costs simply by doing away with things such as research
and development. We can avoid bankruptcy by never borrowing any money or never
taking any risks, and so on. It ’ 's not clear that any of these actions are in the
stockholders ’ best interests.
Profit maximization would probably be the most commonly cited goal, but even this is
not a precise objective. Do we mean profits this year? If so, then we should note that
actions such as deferring maintenance, letting inventories run down, and taking other
short-run cost-cutting measures will tend to increase profits now, but these activities aren
’ t necessarily desirable.
The goal of maximizing profits may refer to some sort of “ long-run ” or “ average ”
profits, but it ’ s still unclear exactly what this means. First, do we mean something like
accounting net income or earnings per share? As we will see in more detail in the next
chapter, these accounting numbers may have little to do with what is good or bad for the
firm. We are actually more interested in cash flows. Second, what do we mean by the
long run? As a famous economist once remarked, in the long run, we ’ re all dead! More
to the point, this goal doesn’t tell us what the appropriate trade-off is between current and
future profits.
The goals we ’ ve listed here are all different, but they tend to fall into two classes. The
first of these relates to profitability. The goals involving sales, market share, and cost
control all relate, at least potentially, to different ways of earning or increasing profits.
The goals in the second group, involving bankruptcy avoidance, stability, and safety,
relate in some way to controlling risk. Unfortunately, these two types of goals are
somewhat contradictory. The pursuit of profit normally involves some element of risk, so
it isn ’ t really possible to maximize both safety and profit. What we need, therefore, is a
goal that encompasses both factors.

❖ The Agency Problem and Control of the Corporation

We’ve seen that the financial manager acts in the best interests of the stockholders
by taking actions that increase the value of the stock. However, in large corporations,
ownership can be spread over a huge number of stockholders. 1 This dispersion
of ownership arguably means that management effectively controls the firm. In
this case, will management necessarily act in the best interests of the stockholders?
Put another way, might not management pursue its own goals at the stockholders ’
expense? In the following pages, we briefly consider some of the arguments relating
to this question.
AGENCY RELATIONSHIPS
The relationship between stockholders and management is called an agency relationship.
Such a relationship exists whenever someone (the principal) hires another (the agent) to
represent his or her interests. For example, you might hire someone (an agent) to sell a
car that you own while you are away at school. In all such relationships, there is a
possibility of a conflict of interest between the principal and the agent. Such a conflict is
called an agency problem.
Suppose you hire someone to sell your car and you agree to pay that person a flat fee
when he or she sells the car. The agent’s incentive, in this case, is to make the sale, not
necessarily to get you the best price. If you offer a commission of, say, 10 percent of the
sales price instead of a flat fee, then this problem might not exist. This example illustrates
that the way in which an agent is compensated is one factor that affects agency problems.