Chapter 1Principles of

Corporate FinanceTenth Edition

Goals and Governance of the

Firm

Lectures

Prof. Scott Brown

1-2

Topics Covered

Corporate Investment and Financing DecisionsThe Role of the Financial Manager and the

Opportunity Cost of CapitalGoals of the CorporationAgency Problems and Corporate Governance

1-3

Common Finance Terminology– Real assets– Financial assets / Securities– Capital markets and financial

markets– Investment / capital budgeting– Financing

Investment and Financing Decisions

1-4

Investment and Financing Decisions

Real Assets– Assets used to produce goods and services.

Financial Assets– Financial claims to the income generated by the

firm’s real assets.

1-5

Investment and Financing Decisions

Investment decision – purchase of real assets

Financing decision – sale of financial assets

1-6

Capital Budgeting Decision– Decision to invest in tangible or intangible

assets.

…also called the Investment Decision…also called Capital Expenditures or

(CAPEX)

Investment and Financing Decisions

1-7

– “Capital Budgeting”

Tangible Assets

Expand Stores

@ $800 million

Intangible Assets

New Drug R&D

@ $800 million

Investment and Financing Decisions

1-8

Company (revenue in billions for 2007 or 2008)

Recent Investment Decision Recent Financing Decision

Boeing ($61 billion) Began production of its 787 Dreamliner

aircraft, at a forecast cost of more than

$10 billion.

The cash flow from Boeing’s

operations allowed it to repay some

of its debt and repurchase $2.8 billion

of stock.

Royal Dutch Shell ($458 billion) Invests in a $1.5 billion deepwater oil

and gas field in the .

In 2008 returned $13.1 billion of cash

to its stockholders by buying back

their shares.

(¥26,289 billion) In 2008 opened new engineering and

safety testing facilities in .

Returned ¥443 billion to shareholders

in the form of dividends.

GlaxoSmithKline (£24 billion) Spent £3.7 billion in 2008 on research

and development of new drugs.

Financed R&D expenditures largely

with reinvested cash flow generated

by sales of pharmaceutical products.

Wal-Mart ($379billion) In 2008 announced plans to invest over a

billion dollars in 90 new stores in .

In 2008 raised $2.5 billion by an

issue of 5-year and 30-year bonds.

Union Pacific ($18 billion) Acquired 315 new locomotives in 2007. Largely financed its investment in

locomotives by long-term leases.

Wells Fargo ($52 billion) Acquired Wachovia Bank in 2008 for

$15.1 billion.

Financed the acquisition by an

exchange of shares.

LVMH (€17 billion ) Acquired the Spanish winery, Bodega

Numanthia Termes.

Issued a 6-year bond in 2007, raising

300 million Swiss francs.

Lenovo ($16 billion) Expanded its chain of retail stores to

cover over 2,000 cities.

Borrowed $400 million for 5 years

from a group of banks

Investment and Financing Decisions

1-9

Role of The Financial Manager

Financial

managerFirm's

operations

Financial

markets

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

1-10

Who is The Financial Manager?

Chief Financial Officer

ControllerTreasurer

1-11

The Investment Trade-off

1-12

The Investment Trade-off

Hurdle rateCost of capitalOpportunity cost of capital

1-13

Goals of The CorporationEach stockholder wants three things:

1. To be as rich as possible, that is, to maximize his or her current wealth.

2. To transform that wealth into the most desirable time pattern of consumption either by borrowing to spend now or investing to spend later.

3. To manage the risk characteristics of that consumption plan.

1-14

Goals of The Corporation Profit maximization is not a well-defined financial objective, for at least two

reasons:

1. Maximize profits? Which year’s profits? A corporation may be able to increase current profits by cutting back on outlays for maintenance or staff training, but that may add value. Shareholders will not welcome higher short-term profits if long-term profits are damaged.

2. A company may be able to increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. That is not in the shareholders’ best interest if the company earns less than the opportunity cost of capital.

1-15

Whose Company Is It?

24

29

78

83

97

76

71

22

17

3

0 20 40 60 80 100 120

United States

United Kingdom

France

Germany

Japan

% of responsesThe Shareholders

All Stakeholders

** Survey of 378 managers from 5 countries

1-16

Dividends vs. Jobs

11

11

59

60

97

89

89

41

40

3

0 20 40 60 80 100 120

United States

United Kingdom

France

Germany

Japan

% of responsesDividends

Job Security

** Survey of 399 managers from 5 countries. Which is more important...jobs or paying dividends?

1-17

Goals of The Corporation

Shareholders desire wealth maximization Do managers maximize shareholder

wealth? Mangers have many constituencies

“stakeholders” “Agency Problems” represent the conflict

of interest between management and owners

1-18

Agency Problem

Difference in Information

Stock prices and returns

Issues of shares and other securities

DividendsFinancing

Different ObjectivesManagers vs.

stockholdersTop mgmt vs.

operating mgmtStockholders vs.

banks and lenders

Ownership vs. Management

1-19

Agency Problem

Agency costs are incurred when:1. managers do not attempt to maximize firm value and

2. shareholders incur costs to monitor the managers and constrain their actions.

1-20

Agency Problem

Agency Problems– Managers, acting as agents for stockholders, may

act in their own interests rather than maximizing value.

Stakeholder– Anyone with a financial interest in the firm.

1-21

Agency Problem

Tools to Ensure Management Pays Attention to the Value of the Firm

– Manger’s actions are subject to the scrutiny of the board of directors.

– Shirkers are likely to find they are ousted by more energetic managers.

– Financial incentives such as stock options

1-22

Agency Problem

Agency Problem and Corporate Governance Solutions

1. Legal and Regulatory Requirements

2. Compensation plans

3. Board of Directors

4. Monitoring

5. Takeovers

6. Shareholder pressure

1-23

Web Resources

Click to access web sitesInternet connection required

www.corpgov.net

www.thecorporatelibrary.com

www.riskmetrics.com