corporate finance 1-0 © professor ho-mou wu introduction to corporate finance corporate finance...
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Corporate Finance 1-1© Professor Ho-Mou Wu
Introduction to Corporate FinanceIntroduction to Corporate Finance
Corporate Finance addresses the following three questions:
1. What long-term investments should the firm engage in?
2. How can the firm raise money for the required investments?
3. How much short-term cash flow does a company need to pay its bills?
(RWJ ch.1)
1-2Corporate Finance© Professor Ho-Mou Wu
The Balance-Sheet Model of the Firm
Current Assets
Fixed Assets
1 Tangible
2 Intangible
Total Value of Assets:
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Total Firm Value to Investors:
1-3Corporate Finance© Professor Ho-Mou Wu
The Balance-Sheet Model of the Firm
Current Assets
Fixed Assets
1 Tangible
2 IntangibleShareholders’
Equity
Current Liabilities
Long-Term Debt
What long-term investments should the firm engage in?
The Capital Budgeting Decision
(Investment Decision)
1-4Corporate Finance© Professor Ho-Mou Wu
The Balance-Sheet Model of the Firm
How can the firm raise the money for the required investments?
The Capital Structure Decision
(Financing Decision)
Current Assets
Fixed Assets
1 Tangible
2 IntangibleShareholders’
Equity
Current Liabilities
Long-Term Debt
1-5Corporate Finance© Professor Ho-Mou Wu
The Balance-Sheet Model of the Firm
How much short-term cash flow does a company need to pay its bills?
The Net Working Capital Investment Decision
(Financial Decision)
Net Working Capital
Shareholders’ Equity
Current Liabilities
Long-Term Debt
Current Assets
Fixed Assets
1 Tangible
2 Intangible
1-6Corporate Finance© Professor Ho-Mou Wu
Capital Structure
The value of the firm can be thought of as a pie.
The goal of the manager is to increase the size of the pie.
The Capital Structure decision can be viewed as how best to slice up a the pie.If how you slice the pie affects the size of the pie, then the capital structure decision matters.
50% Debt
50% Equity
25% Debt
75% Equity
70% Debt
30% Equity
1-7Corporate Finance© Professor Ho-Mou Wu
Cash flowfrom firm (C)
The Firm and the Financial Markets
Tax
es (D)
Firm
Government
Firm issues securities (A)
Retained cash flows (F)
Investsin assets(B)
Dividends anddebt payments (E)
Current assetsFixed assets
Financialmarkets
Short-term debt
Long-term debt
Equity shares
Ultimately, the firm must be a cash generating activity.
The cash flows from the firm must exceed the cash flows from the financial markets.
1-8Corporate Finance© Professor Ho-Mou Wu
Financial Markets
• Primary Market– When a corporation issues securities, cash flows from
investors to the firm.– Usually an underwriter is involved
• Secondary Markets– Involve the sale of “used” securities from one investor
to another.– Securities may be exchange traded or trade over-the-
counter in a dealer market.
1-9Corporate Finance© Professor Ho-Mou Wu
Financial Markets
FirmsInvestors
Secondary Market
money
securitiesSueBob
Stocks and Bonds
Money
Primary Market
1-10Corporate Finance© Professor Ho-Mou Wu
Financial Markets Financial Institutions Financial Instruments
Financial Institutions
(Banks)
Primary market
Secondary market
Consumers (Savers)
Firms (Spenders)
Financial Markets
CD’s $
$ $
$
exchange ownership
Short term Long term
Stocks & Bonds
Stocks & Bonds
real investment
Loans
$
Investment Environment
1-11Corporate Finance© Professor Ho-Mou Wu
Investment=Activities that sacrifice present consumption for
future (uncertain) rewards.
Riskless Investment: (1) the asset is default-free.
(2) the maturity of the asset matches the investment horizon of the investor.
represented by dollar returns represented by the rate of return
Riskless Investment deals with the time value of money
$100 $110 10%
Two Elements of Investment: Time and Risk
1-12Corporate Finance© Professor Ho-Mou Wu
Risky Investment and Capital Budgeting
H o l d i n g P e r i o d R a t e o f R e t u r n r t + 1 =t
1tt1t
P
DPP
T h e C a p i t a l B u d g e t i n g D e c i s i o n = > H o w t o c h o o s e i n v e s t m e n t p r o j e c t s ?
$ 8 0
$ 9 0
$ 1 0 0
$ 1 3 0
$ 1 4 0
$ 1 0 0
- 2 0 %
- 1 0 %
0 %
3 0 %
4 0 %
1-13Corporate Finance© Professor Ho-Mou Wu
• The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date.
• The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid.
• If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.
Capital Structure :Debt and Equity
1-14Corporate Finance© Professor Ho-Mou Wu
Debt and Equity as Options
$F
$F
Payoff to debt holders
Value of the firm (X)
Debt holders are promised $F. If the value of the firm is less than $F, they get the whatever the firm if worth.
If the value of the firm is more than $F, debt holders get a maximum of $F.
$F
Payoff to shareholders
Value of the firm (X)
If the value of the firm is less than $F, share holders get nothing.
If the value of the firm is more than $F, share holders get everything above $F.
Algebraically, the bondholder’s claim is: Min[$F,$X]
Algebraically, the shareholder’s claim is: Max[0,$X – $F]
1-15Corporate Finance© Professor Ho-Mou Wu
Combined Payoffs to Debt and Equity
$F
$F
Combined Payoffs to debt holders and shareholders
Value of the firm (X)
Debt holders are promised $F.
Payoff to debt holders
Payoff to shareholders
If the value of the firm is less than $F, the shareholder’s claim is: Max[0,$X – $F] = $0 and the debt holder’s claim is Min[$F,$X] = $X.
The sum of these is = $X
If the value of the firm is more than $F, the shareholder’s claim is: Max[0,$X – $F] = $X – $F and the debt holder’s claim is:
Min[$F,$X] = $F.
The sum of these is = $X
1-16Corporate Finance© Professor Ho-Mou Wu
Corporate Governance Separation of Ownership and Control
Board of Directors
Management
AssetsDebt
Equity
Shareholders
Debtholders
1-17Corporate Finance© Professor Ho-Mou Wu
Asymmetric Information and Agency Costs
• There is asymmetric information between shareholders and managers.
• How to induce managers to act in the shareholders’ interests ?– The shareholders can devise contracts that align the incentives
of the managers with the goals of the shareholders.
– The shareholders can monitor the managers behavior.
• (Agency Cost) This contracting and monitoring is costly.