© 2007 Thomson South-Western

Corporate Finance, 2eby Smart, Megginson, Gitman

© 2007 Thomson South-Western

Chapter 1The Scope Of Corporate Finance

Professor XXXXX

Course Name / Number

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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 moneyThe opportunity to earn a return on

invested funds means that a dollar today is worth more than a dollar in the future.

Compensation for riskInvestors expect compensation for

bearing risk.

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The Core Principles of Finance

Don’t put your eggs in one basketInvestors can achieve a more

favorable trade-off between risk and return by diversifying their portfolios.

Markets are smartCompetition for information tends to

make markets efficient.

No arbitrageArbitrage 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

IPOsPrimary market transactionsSecondary market transactions

internally by retaining operating cash flowsMost 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 firm’s

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

investmentsStep 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

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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 Proprietorshi

ps

• 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 Formsin 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 Formsin the United States

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Taxation of Business IncomeAFTER 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 Partnership’s Pass-Through Taxation with the S Corporation’s Limited Liability

Business Organizational Formsin the United States

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• Britain: public limited companies (PLC)

• Germany: Aktiengesellschaft (AG)• France: Société Générale• Spain, Mexico, and elsewhere in

Latin America: Sociedad Anónima• 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 OrganizationsUsed 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 profitsShareholders, as residual claimants, have

better incentives to maximize firm value.

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0

5000

10000

15000

20000

25000

30000

35000

40000

1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

US

$ in

Bill

ions

.

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:TakeoversMonitoring and bondingCompensation contracts

Executive compensation packages

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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 shareholder’s wealth.