Chapter 1
The Scope of Corporate
Finance
What Companies Do
Prior to the iPad’s launch, financial experts at Apple:
• evaluated the potential market for such a device,
• estimated the cost of producing it,
• calculated the unit volume that the company would have to achieve to earn a satisfactory rate of return,
• developed a plan to manage the risks that Apple would confront when making transactions in foreign
currencies.
Corporate Finance in Modern Business
• By taking actions that generate benefits in
excess of costs, firms generate wealth for their investors.
When contemplating all business decisions, managers should ask:
Does this action create value for the
firm’s shareholders?
Career Opportunities in Finance
Corporate Finance
• Budgeting, financial forecasting, cash management, credit administration,
investment analysis, fund procurement
Commercial
Banking • Consumer banking
• Corporate banking
Investment
Banking • High income potential
• Very competitive industry
Money
Management
• Opportunities in investment advisory firms, mutual fund companies, pension funds, investment arms of financial departments
Consulting • Advise on business practices and strategies
Corporate Finance Essentials
• Every business requires money to operate, &
corporate finance seeks to acquire and manage this money.
• Financial management concepts of companies
• We first anlyze debt & equity capital, the two principal types of long term funding for all
businesses.
Debt & Equity: Two Flavors of Capital
Debt Capital
• Borrowed money.
• The borrower is obliged to pay interest, at a specified annual rate, on the full amount borrowed, as well as to repay the principal amount at the debt’s
maturity.
Equity Capital
• An ownership interest usually in the form of common or preferred stock.
• Common stockholders receive returns on their investments only after
creditors and preferred stockholders
are paid in full.
Financial Intermediation
Financial Intermediary
• An institution that raises capital by issuing liabilities against itself, and then lends that capital to corporate and individual borrowers.
• Examples: insurance companies, savings and loan institutions, credit unions, commercial banks, pension funds, mutual funds.
• Pension funds and mutual funds, have surged to prominence as corporate finance shifts towards greater reliance on market-based external
funding.
Financial Management External Financing
Capital Budgeting
Corporate Governance
Risk Management
Corporate Finance Functions
Corporate Finance Functions
The External Financing Function
• Raising capital to support companies’
operations and investment programs externally, from
– either shareholders (equity) or – creditors (debt).
• Corporations can raise equity capital privately,
• or they may go public by conducting an initial
public offering (IPO) of stock.
The Financial Management Function
• Managing firms’ internal cash flows,
• and its mix of debt and equity financing,
• to maximize the value of the debt and equity claims on firms, and
• to ensure that companies can pay off their obligations when they come due.
Involves obtaining seasonal financing, managing inventories, paying suppliers, collecting from
customers, and investing surplus cash
Capital Budgeting – selecting the best projects in which to invest the resources of the firm, based
on each project’s perceived risk and expected return.
Select investments for which the marginal benefits exceed the marginal costs.
The Capital Budgeting Function
The Risk Management Function
• Managing firms’ exposures to all types of risk,
• both insurable (such as loss caused by fire or flood) and uninsurable,
• in order to maintain optimum risk-return trade- offs and thereby maximize shareholder value.
• Modern risk management focuses on adverse interest rate movements, commodity price
changes, and currency value fluctuations.
The Corporate Governance Function
Developing ownership and corporate governance structures for companies that ensure that managers
behave ethically and make decisions that benefit shareholders.
Dimensions of corporate governance
• Boards of directors
• Compensation packages
• Auditors
• Country’s legal environment - in U.S., Sarbanes-Oxley Act of 2002
The takeover market disciplines firms that do not
govern themselves.
What Companies Do
Total Value of Primary Corporate Security Issues,
1990 - 2006
Sole
Proprietorships
• No distinction between business and person
• Easy to set up, operate; taxed as personal income
• Personal liability, limited life, difficult to transfer
Partnerships • Two or more business owners
• Partners - liable for every partner’s actions
Limited Partnerships
• One or more general partners & many limited partners
• Limited liability of corporation, tax benefits of partnership
Business Organizational Forms in the U.S.
Corporations
• Legal entity with all the economic rights and responsibilities of a person
• Incorporation occurs at state level; based on state law
• Strengths - limited liability for investors, unlimited business life
Business Organizational Forms in the U.S.
The Finance Function
in the
Organizational Structure
of a Typical Large
Corporation
Corporations in the U.S.
• The Jobs and Growth Tax Relief Reconciliation Act of 2003 (Tax Relief Act of 2003) dramatically reduced the double taxation problem.
Double Taxation Problem
• Taxation of corporate income at both the company and the personal levels.
• This is the single greatest disadvantage
of the corporate form.
Taxation of Business Income for Corporations and Partnerships
Before the Tax Relief Act of 2003
After the Tax Relief Act of 2003
