FUNDAMENTALS OFFUNDAMENTALS OFCORPORATE FINANCECORPORATE FINANCE

Fourth Canadian Edition

Stephen A. RossRandolph W. Westerfield

Bradford D. JordanGordon S. Roberts

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Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson,Ltd.

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc. 1999

The University of Lethbridge - Faculty of Management

Management 3040Y - Finance

Terry D. Harbottle

Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd.

Part I: Overview of Corporate Finance

Part II: Financial Statements and Long-Term Financial Planning

Part III: Valuation of Future Cash Flows

Part IV: Capital Budgeting

Part V: Risk and Return

Part VI: Cost of Capital and Long-Term Financial Policy

Part VII: Short-Term Financial Planning and Management

Part VIII: Topics in Corporate Finance

Part IX: Derivative Securities and Corporate Finance

Outline of the Text

Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd.

Chapter 1 Introduction to Corporate Finance

Chapter 2 Financial Statements, Taxes, and Cash Flow

Chapter 3 Working with Financial Statements

Chapter 4 Long-Term Financial Planning and Corporate Growth

Chapter 5 Introduction to Valuation: The Time Value of Money

Chapter 6 Discounted Cash Flow Valuation

Chapter 7 Interest Rates and Bond Valuation

Chapter 8 Stock Valuation

Chapter 9 Net Present Value and Other Investment Criteria

Chapter 10 Making Capital Investment Decisions

Chapter 11 Project Analysis and Evaluation

Chapter 12 Some Lessons from Capital Market History

Chapter 13 Return, Risk, and the Security Market Line

Chapter 14 Cost of Capital

Table of Contents

Chapter 15 Raising Capital

Chapter 16 Financial Leverage and Capital Structure Policy

Chapter 17 Dividends and Dividend Policy

Chapter 18 Short-Term Finance and Planning

Chapter 19 Cash and Liquidity Management

Chapter 20 Credit and Inventory Management

Chapter 21 International Corporate Finance

Chapter 22 Leasing

Chapter 23 Mergers and Acquisitions

Chapter 24 Risk Management: An Introduction to Financial Engineering

Chapter 25 Options and Corporate Securities

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Table of Contents (continued)

T1.1 Chapter Outline Chapter 1Introduction to Corporate Finance

Chapter Organization

1.1 Corporate Finance and the Financial Manager

1.2 Forms of Business Organization

1.3 The Goal of Financial Management

1.4 The Agency Problem and Control of the Corporation

1.5 Financial Markets, Financial Insts, & the Corporation

1.6 Trends in Financial Markets & Financial Mgmt.

1.7 Outline of the Text

1.8 Summary and Conclusions

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T1.2 The Four Basic Areas of Finance - Corporate Finance

Corporate Finance

Long-term investments Capital Budgeting

Long-term financing Capital Structure

Short-term financing Working Capital Management

Financial Risk management Derivative securities

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Capital Budgeting

‘The Process of planning and managing a firm’s long term investments’

evaluating the size, timing and risk of future cash flows are the key components of capital budgeting

overall objective is to identify and invest in projects & assets that will generate a return greater than the firm’s cost of capital

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Cqpital Structure

‘addresses the the question of how a firm should obtain and manage the long term financing needed to support its long term investments and’

it is the specific mixture of long term debt and equity capital

the decision on how much debt vs. Equity impacts the risk level for the firm and the firm’s

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Working Capital Management

Working capital refers to a firms short term assets and short term liabilities

includes accounts receivable, inventory and accounts payable

how much cash to keep on hand, inventory to carry, credit terms to offer to customers are examples of working capital management decisions

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Financial Risk Management

The process of identifying, quantifying and decisions to manage certain types of risk:

currency risks interest rate risks commodity price risk

Other risks such as strategic, operating and commerical risks need to be considered by the firm as a whole - ideally looking at risk on an enterprise wide basis (holistic risk management)

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T1.2 A Simplified Organizational Chart (Figure 1.1)

Chairman of the Board andChief Executive Officer (CEO)

Board of Directors

President and ChiefOperations Officer (COO)

Vice PresidentMarketing

Vice PresidentFinance (CFO)

Vice PresidentProduction

Treasurer Controller

Cash Manager Credit Manager Tax ManagerCost AccountingManager

CapitalExpenditures

FinancialPlanning

FinancialAccountingManager

Data ProcessingManager

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Forms of Organization

Sole Proprietorship

Partnership

General Partnership / Limited Partnership

CorporationLimited Liability Company

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Corporations

A corporation is a legal entity separate and distinct from its owners

has many of the same rights, duties and privileges of an actual person:

borrow money can own property can enter into contracts

shareholders and management are usually separate in most larger corporations

the sharedolders elect the board of directors the board then selects the senior managers who in theory are

charged with running the affairs in the interests of the shareholders

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Advantages/Dis-advantages of the Corporate Form

Advantages

ownership (shares) can be readily transferrred

life of the corporation is not limited

limited liability makes this form attractive to investors

all of the above make it easy to raise cash - sells new stock

Dis-advantages

double taxation of its profits

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The Goal of Financial Management

What are firm decision-makers hired to do?

“General Motors is not in the business of making automobiles. General Motors is in the business of making money.”

Alfred P. Sloan

Possible goals

Maximize profits

Maximize shareholder wealth/value

Maximize share price

Maximize firm value

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The Agency Problem and Control of the Firm

Agency Relationships and Management Goals potential for conflict - is their too much emphasis on

corporate survival, job security and (more recently) with mangement wealth creation?

Do managers Act in the Shareholders’ interests? They are influenced by:

• how they are compensated - does their compensation encourage them to make decisions that will enhance shareholder value

• how easily are they replaced if they do not pursue shareholder goals - control here is with the board of directors

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T1.6 The Agency Problem Continued

Agency costs

Agency Costs - defined as the costs associated with the

conflict of interests :

Direct agency costs

Indirect agency costs

Impact of Agency Costs on Shareholder Wealth or Value direct - expenditures benefiting Management e.g. the

unneeded corporate jet or direct - monitoring costs e.g. outside auditors indirect - lost opportunity where Management is not acting in

the best interests of its shareholders e.g. costly acquisitions driven more by desire for power and prestige

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Conflict of Interest

Will Managers work in the Shareholder’s best interest?

Mechanisms to ensure Managers are acting in shareholders’ interest:

• managerial compensation

• active and knowledgable iboard of directors

• Active institutional investors

• Takeover activity

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T1.7 Financial Markets

Financial Institutions, Markets and the Corporation

Financial Institutions

Act as intermediaries between investors and firms raising funds - banks, trust companies, investment dealers, insurance companies, etc. direct finance

indirect finance

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T1.7 Financial Markets Continued

Financial Markets - brings buyers and sellers of debt and equity securities together

How do financial markets differ? Type of securities traded/how trading is conducted and

who the buyers and sellers are

Money markets and capital markets money market - short term debt securities

capital market - long term debt and equity

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T1.7 Financial Markets Continued

Primary vs. secondary markets

Primary Market- where the original sale of issue of a

security by a government or corporation occurs

• public offering - underwritten by an investment

dealer and registered with provincial securities

commissions

• private placement - debt and equity sold directly to

a buyer - typically life insurance companies and ,

pension funds

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T1.7 Financial Markets Continued

Secondary Market - trading of securities subsequent to

the initial sale - enables the transfer of ownership

• auction market - TSE

• dealer market - ‘over the counter (OTC) ‘

How do financial markets benefit society?

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Financial Markets and Society

what is the benefit to society? Channel savings into investment produce and transmit information on returns and

risk provide a media and a payments system enable the shifting of the timing of consumption

over a life cycle enable the management of risk enable the diversification of portfolios

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T1.9 Financial Markets and the Corporation - Cash Flows Between the Firm and the Financial Markets (Figure 1.2)

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T1.9 Chapter 1 Quick Quiz

Quick Quiz

1. Who performs the financial management function in the typical corporation?

2. What are the major advantages and disadvantages of the corporate form of organization?

3. Why is shareholder wealth maximization a more appropriate goal than profit maximization?