2007 Thomson South-Western

Corporate Finance, 2e
by Smart, Megginson, Gitman



2007 Thomson South-Western
Chapter 1
The Scope Of Corporate Finance
Professor XXXXX
Course Name / Number
1 - 3
What is Corporate Finance?
The activities involved in managing
cash flows in a business
environment
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The Core Principles of Finance
The time value of money
The opportunity to earn a return on
invested funds means that a dollar today is
worth more than a dollar in the future.
Compensation for risk
Investors expect compensation for bearing
risk.
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The Core Principles of Finance
Dont put your eggs in one basket
Investors can achieve a more favorable
trade-off between risk and return by
diversifying their portfolios.
Markets are smart
Competition for information tends to make
markets efficient.
No arbitrage
Arbitrage opportunities are extremely
scarce.
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The 5 Basic Corporate Finance Functions
Financing
(Capital-Raising)
Capital Budgeting
Financial Management
Corporate Governance
Risk Management
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The Financing Function
Businesses can raise money in 2 ways:
externally from investors or creditors
IPOs
Primary market transactions
Secondary market transactions
internally by retaining operating cash flows
Most common method


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Raising Capital: Key Facts
Primary vs. secondary market transactions or
offerings
Most financing from internal rather than
external sources
Most external financing is debt
Financial intermediaries declining as a source
of capital for large firms
Securities markets growing in importance
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The Total Value of Primary (Capital-Raising)
Corporate Security Issues, 1990 2004

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Growth in Global Security Issues
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Capital Budgeting
selecting the best projects
in which to invest the firms
resources
The Capital Budgeting Function
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The Capital Budgeting Function
The capital budgeting process consists
of three steps.
Step 1 - identifying potential investments
Step 2 - analyzing those investments to
identify which will create
shareholder value
Step 3 - implementing and monitoring the
investments selected in step 2
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The Financial Management Function
Managing daily cash inflows and outflows
Forecasting cash balances
Building a long-term financial plan
Choosing the right mix of debt and equity
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The Corporate Governance Function
Hires and promotes qualified, honest people,
and structures employees financial incentives
to motivate them to maximize firm value
In practice the incentives of stockholders,
managers, and other stakeholders often
conflict.
Dimensions of corporate governance:
Board of directors
Securities and Exchange Commission
Sarbanes-Oxley Act of 2002

1 - 15
Value of Global Mergers & Acquisitions
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The Risk Management Function
Identifying, measuring, and managing all
types of risk exposures
Some risks are insurable, and some risks can
be reduced through diversification.
Financial instruments like forwards, futures,
options, and swaps may also be used to
hedge market risks such as interest-rate,
price, and currency fluctuations.
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Sole
Proprietorships
No Distinction Between Business & Owner
Easy To Set Up, Operate; Business Earnings
Taxed As Personal Income
Limited Life, Limited Access to Capital,
Unlimited Personal Liability
Partnerships
Two Or More Owners
Joint and Several Liability
Limited Life, Limited Access to Capital,
Unlimited Personal Liability
Limited
Partnerships
One Or More General Partners with Unlimited
Personal Liability
Most Partners are Totally Passive with
Limited Liability - Limited Partners; Share of
Profits Taxed as Partnership Income
Business Organizational Forms
in the United States
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Are there any disadvantages for corporations?
YES! Double taxation
Corporations
Separate Legal Entity With Many of the
Economic Rights & Responsibilities of
Individuals
Unlimited Life, Limited Liability,
Separable Contracting, Unlimited Access
to Capital
Owned by Shareholders, Who Elect the
Board of Directors
In the U.S., Incorporation is Executed At
State Level and Governed by State Law
Business Organizational Forms
in the United States
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Taxation of Business Income
AFTER the Jobs and Growth Tax Relief Reconciliation Act of 2003
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S Corporations
Shareholders are taxed as partners while
still retaining Limited Liability as
Corporate Shareholders
Status is Subject to Several Eligibility
Requirements
Limited-
Liability
Companies
Combines the Partnerships Pass-
Through Taxation with the S
Corporations Limited Liability
Business Organizational Forms
in the United States
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Britain: public limited companies (PLC)
Germany: Aktiengesellschaft (AG)
France: Socit Gnrale
Spain, Mexico, and elsewhere in Latin
America: Sociedad Annima
Historically, the telephone, television,
utility, airline and railroad companies in
many European countries
Privatization programs have reduced the
role of the states around the world
How much has been raised through Privatization Programs?
State-Owned
Enterprises
Limited-
Liability
Companies
Forms of Business Organizations
Used by Non-U.S. Companies
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Worldwide Privatization Revenues
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What Should a Financial Manager Try to
Maximize?
Maximize Profit?
Earnings per share are backward-looking,
dependent on accounting principles,
Do not fully consider cash flow timing
Ignores risk
Maximize Shareholder Wealth?
Maximize stock price, not profits
Shareholders, as residual claimants, have
better incentives to maximize firm value.
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30000
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United States United Kingdom Japan Other Developed Emerging Markets
World Stock Market Capitalization
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Agency Costs
Managers act as agents of the owners
who hired them and gave them
decision-making authority to manage
the firm for the owners benefit.
In practice however, self-interests may
cause managers to pursue objectives
other than shareholder-wealth
maximization.
This conflict of goals gives rise to
managerial agency problems.
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How Agency Costs Can Be Controlled
Ways to overcome agency problems:
Takeovers
Monitoring and bonding
Compensation contracts
Executive compensation packages
1 - 27
Importance of Ethics
Widespread publicity surrounding
numerous ethical violations began with
the Enron collapse in late 2001.
Society in general and the financial
community in particular are developing
and enforcing ethical standards.
Ethical behavior is necessary in order to
maximize shareholders wealth.