Introduction (Text reference: Chapter 1) Topics Balance sheet model Interactions with financial markets Emphasis on cash flows Corporate securities as contingent claims orms of business organization Goals of the corporate firm Ownership and control AM 271 - Course Introduction Slide 1 Balance Sheet Model Current Assets ixed Assets Current Liabilities Long-term Debt Shareholders Equity Some Key Issues in Corporate inance: 1. Capital budgeting 2. Capital structure 3. Payout policy 4. Short term finance AM 271 - Course Introduction Slide 2
Interactions With inancial Markets irm s Operations (2) (3) inancial Management (1) (4) (5) inancial Markets (1) firm raises cash from investors (2) firm invests in real assets (3) real assets generate cash (4) cash re-invested (5) cash returned to investors AM 271 - Course Introduction Slide 3 Emphasis on Cash lows finance generally emphasizes cash flows, not accounting earnings accounting statements contain many non-cash items, e.g. depreciation, deferred taxes, receivables, etc. (see chapter 2 for more details) in most financial situations, we are interested in (forecasted) future cash flows have to calculate present values timing risk AM 271 - Course Introduction Slide 4
Corporate Securities as Contingent Claims two general types of securities: debt and equity promised payoff to debtholders is fixed debtholders have higher priority than (i.e. get paid before) shareholders shareholders are not required to guarantee that debtholders are paid in full for simplicity, assume that the firm has a single outstanding debt issue with a total face value of, a maturity date of T, and zero coupons at T, debtholders will get if the firm can afford to pay it (i.e. if firm value V T ); otherwise debtholders can take over the firm s assets, get V T AM 271 - Course Introduction Slide 5 Cont d at T, shareholders get nothing if V T, and the remaining value after debtholders have been paid (i.e. V T ) if V T > Debtholders Payoff at T Shareholders Payoff at T Total Payoff to Investors at T irm Value irm Value irm Value note that the value of debt and equity securities is derived from, or contingent upon, total firm value AM 271 - Course Introduction Slide 6
orms of Business Organization Sole Proprietorship Partnership Corporation - single owner - general vs. limited - separate legal entity - inexpensive to form - inexpensive to form - limited owner liability - income taxed as personal - income taxed as personal - easy to transfer ownership income income - limited life - limited life - unlimited life - unlimited liability for - general partners have - taxed at corporate rate business debts unlimited liability - equity limited to owner s - management control by - greater access to financial personal wealth general partners markets - difficult to transfer ownership - hard to raise large amounts of capital AM 271 - Course Introduction Slide 7 Goals of the Corporate irm we cannot assess whether financial decisions are good or bad unless we know what the objective is, i.e. what is financial management trying to achieve? some possible goals: three important elements of most goals: AM 271 - Course Introduction Slide 8
Ownership and Control do managers act in the interests of shareholders? how can shareholders control managerial behaviour? conflicts of interest between shareholders and managers are costly to mitigate ( agency costs ) AM 271 - Course Introduction Slide 9 Cont d the firm can be viewed as a set of legal contracts: debtholders claim on the firm s assets and cash flow shareholders residual claim on the firm s assets and cash flow shareholders contract with management to run the corporation management s contract with employees firm s contracts with suppliers and purchasers conflicts of interest can also arise between debtholders and shareholders, or among these groups of investors themselves AM 271 - Course Introduction Slide 10