FIN 300 Chapter 1: Introduction to Corporate Finance 1.1 Corporate Finance and the Financial Manager What is Corporate Finance? Most large corporations centralize their finance function and use it to measure performance in other areas. The Financial Manager Shareholders are usually not directly involved in making business decisions. o Managers are hired to represent shareholder s interest. Financial Management Decisions Capital Budgeting The process of planning and managing a firm s investment in long-term assets. o Financial manager identifies investment opportunities that are worth more to the form than they will cost to acquire. (value of the cash flow generated by an asset exceeds the cost of the asset) o Evaluating the size, timing, and risk of future cash flows is the essence of CB. Capital Structure (Financial Structure) The mix of debt and equity maintained by a firm. o Great deal of flexibility in choosing financial structure. o Determining where to borrow money, how much, and in what mix manger s job. Working capital Management Planning and managing the firm s current assets and liabilities. o Working capital refers to firm s short-term assets (inventory, payment to suppliers). Managing is a day-to-day activity that ensures the firm has sufficient resources to continue its operations. 1.2 Forms of Business Organizations Sole Proprietorship Sole Proprietorship A business owned by a single individual. o Simplest type of business to start and the least regulated. o Keep all the profits, but have unlimited liability. Creditors can look beyond assets to personal assets for payment. o All business income is taxed as personal income Partnership Partnership A business formed by two or more co-owners. o General Partnership all partners share gains/losses, and all have unlimited liability. Division of gains/losses described in partnership agreement. o Limited Partnership general partners run business for limited partners. General has unlimited liability whereas limited has liability for only the amount that is contributed to the partnership. Corporation Corporation A business created as a distinct legal entity owned by one or more individuals or entities. o To start a business, the preparation of the articles of incorporation (or a charter) is required. Must include corporations name, intended life, purpose, number of shares issued. o Shareholders and management are separate groups in corporations.
o o Ownership can be readily transferred in form of shares of stock. Shareholders have limited liability. Double taxation is occurred as taxes of the corporation and also dividend tax. Income Trust An income trust is a non-corporate form of business organization. Business income trusts (also called income funds) hold the debt and equity of an underlying business and distribute the income generated to unit holders. o Since they are not corporations, they are not subject to corporate income tax. Investors view trusts as tax-efficient and have been showing more interest for organizations with this form of business. In 2006, the government accounted to tax trusts like corporations by 2011. o Many trusts are reverting to corporations in 2011. 1.3 The Goal of Financial Management Possible Goals Surviving in business, beating competition, maximizing sales/market share, minimizing costs, etc., are possible financial goals. Profit maximization is the most cited goal. All goals usually fall into two categories; first is profitability and second is controlling risk. o Profitability involves sales, market share, and cost control. All are related in ways of earning or increasing profits. o Controlling Risk involves bankruptcy avoidance, stability, and safety. Contradictory goals because pursuit of profit usually involves some element of risk. It is not really possible to maximize both safety and profit. The Goal of Financial Management Goal: The goal of financial management is to maximize the current value per share of existing stock. Corporate finance is the study of the relationship between business decisions and the value of stock in the business. To make the market value of the stock a valid measure of financial decisions requires an efficient capital market. o In a efficient capital market, Security prices fully reflect available information. Market sets the stock price to give the firm an accurate report card on its decisions. A More General Goal The goal of maximizing stock does not take into account of privately owned business and no traded stock companies. To create a general goal, the value of stock in a corporation is equal to the value of the owner s equity. o General Goal: To maximize the market value of the owners equity. 1.4 The Agency Problem & Control of the Corporation Agency Relationships Agency Relationship the relationship between shareholders and management. o Someone (the principal) hires another (the agent) to represent his/her interests.
Agency Problem The possibility of conflicts of interest between the shareholders and management of a firm. Management Goals Agency Cost The cost of the conflict of interests between shareholders and management. o Can be indirect or direct. Indirect is a lost opportunity o Ex. Management might not take risky ventures because of the fear of losing jobs if investment goes bad, however, shareholders might want to take risk as stock price rises. Management might try to overemphasize organizational survival to protect job security. o May dislike outside interference, so independence and corporate self-sufficiency may be important goals. Do Managers Act in the Shareholders Interest? Managers act in the shareholders interest depends on two factors. o How close management goals align with shareholders goals Managers compensation o Can managers be replaced if they do not pursue shareholder goals Relates to control of the firm Management have significant economic incentive to increase share value for two reasons. o Managerial compensation is usually tied to financial performance. o Job prospects (promotions) are given to managers who pursue shareholders goals. Sarbanes-Oxley Act in 2002 was created to protect investors from corporate abuses. o Excessive pay and unauthorized consumption are examples of agency costs. Control of the firm ultimately rests on the shareholders. o Elect board of directors, who, in turn, hire and fire management. Management can also be replaced after a takeover. o Poor managed firms are more attractive because of greater turnaround potential. Avoiding a takeover is another incentive for management to pursue goals. Corporate Governance Rules for corporate organization and conduct. Stakeholder Anyone who potentially has a claim on a firm. o Shareholder, creditor, customer, suppliers, government, and any individual that potentially has a claim on the cash flow of the firm. Stakeholders can exert control over the firm by introducing alternate, socially oriented goals. This occurs because stakeholder satisfaction is consistent with shareholders wealth maximization. Corporate Social Responsibility & Ethical Investing Well-managed corporations maintain a good reputation with citizens with detailed policies on important social issues. o Investors concerned with corporate social responsibility (CSR) o Jantzi Research provides a social responsibility rating for corporations. 1.5 Financial Markets and the Corporation Cash Flows to and from the Firm Cash flows to firm from financial markets, firm invests the cash in current and fixed assets, assets generate cash, which pays government taxes, some is reinvested into firm, the rest goes back to the financial market.
Money versus Capital Markets Money Markets Financial markets where short-term debt securities are bought and sold. (IOU s) Capital Markets Financial markets where long-term debt and equity securities are bought and sold. Primary versus Secondary Markets Financial markets function as both primary and secondary markets for debt and equity securities. Primary Markets Refers to the original sale of securities by governments and corporations. Secondary Markets Where these securities are bought and sold after the original sale. Equity is sold solely by corporations, but debt securities are issued by both government and firms. Primary Markets Corporation is seller and the transactions raises money for the firm. Corporations engage in two types of transactions: public offerings and private placements. o Public Offering selling securities to the general public. Most securities offered are underwritten and are conducted by investment dealers. Underwritten means that an investment dealer or group of investment dealers (aka syndicate) typically purchase the securities from the firm and market them to the public at a higher price than they pay the firm. To avoid various regulatory requirements and the expense of public offerings, debt and equity securities are often sold privately to large financial institutions (life insurance/mutual funds). o Private Placement negotiated sale involving a specific buyer. Secondary Markets Involves one owner or creditor selling to another. It provides the means for transferring ownership of corporate securities. Two types of secondary markets: auction markets & dealer markets. o Dealer Markets In stocks and long-term debt are called over-the-counter (OTC) markets. Trading in Corporate Securities Large firms in Canada trade in organized auction and dealer markets (TSX). Smaller or emerging companies trade on the Venture Exchange. o Top 4 on the exchange: biotech, I.T., mining, and oil & gas.
Listing Auction markets differ from dealer markets in two ways: o An auction market has a physical location. o In a dealer market, most of the buying and selling is done by the dealer. Primary purpose of auction market is to match those who wish to sell with those who wish to buy. Dealer plays limited role To be listed on an exchange, certain minimum criteria concerning size and number of shareholders need to be met. o Varies from each exchange. Research suggests that listing on exchanges adds valuable liquidity to a company s shares. 1.6 Financial Institutions Institutions act as intermediaries between investors (funds suppliers) and firms raising funds. o Also to households and individuals Medium where people can save and borrow money. Justify existence by providing variety of services to allocate funds efficiently. Banks make their income from the spread between the interests paid on deposits and the higher rate earned on loans, this is called indirect finance. Direct finance funds do not pass through the bank s B/S in the form of deposit and loan. o Called securitization because a security is created (banker s acceptance). Banker s acceptance an IOU stamped by the bank guaranteeing borrower s credit. Bank receives a stamping fee as income. Trust companies engage in fiduciary activities managing assets for estates, RRSP, and so on. o Accept deposits and loans. Similar to credit unions. 1.7 Trends in Financial Markets & Financial Managements Experiencing rapid globalization. o Harder for investors to shelter their portfolios from financial shocks in other countries. o Interest rates, foreign exchange rates, and other macroeconomic variables are more volatile. Financial Engineering Creation of new securities or financial processes. o Managers or investment dealers design new securities or financial processes. o Reduces and controls risk and minimizes taxes. Derivative Securities Options, futures, and other securities, whose value derives from the price of another, underlying asset. o Useful in controlling risk Regulatory Dialectic The pressures financial institutions and regulatory bodies exert on each other. o Creation of larger institutions through combination of different types of financial institutions to take advantage of economies of scale and scope. (Ex. RBC Royal Trust & RBC Dominion Securities).