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MSBC 5060Chapter 1

Introduction to Corporate Finance

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Chapter 1 Outline:1. What is Corporate Finance?2. The Corporate Firm3. The Importance of Cash Flows4. The Goal of Financial Management5. The Agency Problem and Control of the

Corporation6. Regulation

A Quick LookFour Basic Areas of Finance1. Corporate Finance

A. Capital Budgeting: Buy fixed assets (capital) to undertake a proposed long-term project

B. Capital Structure: How do you pay for the project? (firm’s “saved” cash, equity or debt)

C. Working Capital Management: Financing short term assets (inventory)

2. Investments3. Financial Institutions4. International Finance

Lets go over these in more detail

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1st Area of Finance: Corporate FinanceA. Capital Budgeting – Undertake a proposed project?• You have an idea. Will it make money? • In other words: Will the idea Increase the firm’s value?

– How many units can we sell? (Marketing)– How much will it cost to make the units? (Operations)

B. Capital Structure - How do you pay for the project? 1. Sell a piece of the company

• Sell an Equity stake a.k.a. sell stock

2. Borrow the money • Sell Debt securities a.k.a. sell bonds

3. Retain Earnings • Use past “retained” profits to finance expansion

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C. Working Capital Management• Make Sure there is enough cash and inventory on hand.

• The BLUE ones are Working Capital Accounts• Too Much Cash? Payoff ST Debt (Lower Interest Expense)• Not Enough cash? Borrow More (Increase Interest Expense)

Net Working Capital = Cash + Inv + A/R – (ST Debt + A/P)

Assets Liabilities & EquityCash ST Debt

Inventory A/PA/R LT DebtPPE Equity

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The Textbooks Version of the same thing:

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2nd Area of Finance: Investments– Firms sell securities (stocks and bonds)– Someone buys them– Which ones should you buy? – What are the worth?• This is called Securities Analysis

– If I hold a bunch of different securities (which is called a portfolio), how do the different securities combine into portfolios?• This is called Portfolio Analysis

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3rd Area of Finance: Financial InstitutionsTypes:• Commercial Banks – Chase, Wells Fargo…• Investment Banks – Goldman Sachs, Morgan Stanley…• Insurance Companies – GEICO, Anthem …• Investment Companies

o Mutual funds – Janus, Fidelity…o Hedge Funds – Bridgewater Associates, Fortress

• The study of financial institutions relates to risk management

• This means making sure they don’t blow up• Or at least trying to decrease the likelihood of them

blowing up

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4th Area of Finance: International Finance• More of a specialization than an area of finance • But also must deal additional risks, customs and

institutions• For example, currency exchange rates, exchange rate

risk, hedging with derivatives• You sell your product for Euros but need Dollars to pay

suppliers, employees, bondholders and shareholders

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Why Study Corporate Finance?• The Corporation is the basic unit of finance

– Note: in economics the word “firm” is used. • We will use the terms interchangeably.

– Firms (or corporations) are the way we convert real assets to financial assets

– Assets generate income. Through the firm, income is paid to those that financed the assets – holders of claims on the assets

• Everything a firm does must be paid for– New assets, replacement assets, labor, ad campaigns…– Marketing, Management, Accounting, Information Systems…– All costs must be justified: Does a new machine make enough

money to compensate those that will pay for it?• Compensate for the risk they incur.

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Business Finance and the Financial Manager• What do corporate financial professionals do?

1. Decide if a new business venture will be profitable:• Both CURRENT business and potential NEW business• We already make red pens. Should we make blue pens?• We already make pens. Should we make pencils?• We already make pens and pencils. Should we deliver them to stores

(buy our own trucks)?• We make and deliver pens and pencils. Should we make hotdogs-on-

a-stick? 2. How to pay for new business?

• Take on New Owners (sell stock) or Borrow (sell bonds)3. Manage the everyday financial activities of the firm

• Called Working Capital Management • Collect from customers, pay suppliers, pay expenses…• Sell stocks, bonds, commercial paper, borrow from banks…

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Corporate Organization – Figure 1.2 page 3

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Forms of Business1. Sole Proprietorship• Owned by one Person• Pass-through• Unlimited liability

2. Partnership• General Partnership• Limited Partnership• Also a pass-through

3. Corporations• Shareholders, Board of Directors, Managers, Employees• A corporation is a separate entity for tax and liability purposes

4. Limited Liability Company• Hybrid - certain characteristics of both a corp and a

partnership

Corporation vs. PartnershipTable 1.1

Corporation Partnership

Liquidity of claims Shares and (many) debt instruments can be easily exchanged

Subject to substantial restrictions – often not liquid

Voting Rights Usually each share gets one vote

General Partner is in charge; limited partners may have some voting rights

Taxation Double – Firm’s profits are and distributions are taxed

Partners pay taxes on distributions

Reinvestment and dividend payout

Broad latitude All net cash flow is distributed to partners

Liability Limited liability General partners may have unlimited liability; limited partners enjoy limited liability

Continuity Perpetual life Limited life

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Types of Corps• C Corporation– Default type of corporation

• S Corporation (Small business)– A “pass-through” like a partnership – Restrictions (fewer than 100 shareholders…)

• B Corporation (Benefit)– Goals include positive impact on society or the

environment in addition to profit

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Goals of Financial Management

First talk about Stakeholders:1. Owners (Stockholders also called Shareholders)2. Debtors (Bondholders, CP holders, banks…)3. Employees4. Suppliers5. Customers6. Community

So what is the goal of financial management?• Maximize Shareholder Value (Help the Owners)

• What about the rest of the stakeholders?• Ignore them• In our simple models.

– Better models will of course consider all stakeholders

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So how do you maximize shareholder value?• Generate Cash Flows!– Cash Flows are not the same as Net Income! (Why?)

Process:1. Sell stocks and bonds (claims on firm’s assets) through

financial markets to raise money2. Invest money in assets - which generate cash3. Pay some of the cash to bondholders (interest payments)

and stockholders (dividends)4. If return paid to stockholders exceeds amount required,

stock price increases– How much return is required? – We’ll get to that soon…

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Agency Problem and Corporate Control

Managers vs. Stockholders:• Stockholders want to maximize wealth– Maximize share price – Or maybe maximize income from shares

(dividends)• What do managers want to maximize?– Perquisites (perks): jets, cars, apartments…– Control: size of their division: assets, employees…

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So try to align manager and stockholder incentives:1. Bonuses2. ESOPs (Employee Stock Ownership Plans)

• Stock sold to the employees by the company (new shares issued)• Has the effect of diluting the existing shareholder’s stake

3. Stock Options• A stock option is the ability to buy company stock two years from

now (for example) at the current stock price (say $25)• The Options will only be valuable if the stock’s price increases in the

next two years (above $25)• Again, shares sold to the employee by the company (dilution)

• Problems with these three: – Short term vs. Long term– Employees only care about price being high in two years– This caused many of the prominent accounting scandals

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Regulation• The Securities Act of 1933 – Issuance of Securities– Registration and Disclosure

• The Securities Exchange Act of 1934 – Creation of SEC – Set Reporting Requirements (List of SEC filings)– Filings are available on the SEC EDGAR site

• Sarbanes-Oxley (“Sarbox”)– After Enron (discussion), WorldCom, Tyco– Increased reporting requirements and

responsibility of corporate directors

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Financial Markets and LiquidityFirms raise money by selling securities:1. Sell Stocks

• Percentage of Ownership - dilution• Stock holders have rights to a percent of profits and assets• After “borrowers” have been paid • Residual claim

2. Sell bonds or other debt instruments (like CP)• Sell Debt or borrowing money• Coupon Bonds or Zero-Coupon Bonds• Paid BEFORE profits are paid to stock holders• Primary claim

Investors value securities based on:1. Expected payments: dividends, coupons, price appreciation2. Risk: Volatility of payments or price, probability of default3. Liquidity: Can’t sell the security pay less for it

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Securities Markets Increase Liquidity • Liquidity is the ability to convert an asset to

cash (sell it)Two Components of Liquidity:1. How quickly can I get “full price”?2. How much do I have to drop the price to get cash right now?

Note: • The word “Liquidity” can also refer to a company’s

ability to meet it’s current payment obligations• Often through short-term borrowing – Recall the definition of working capital management

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Brokers versus Dealers• Broker introduces buyer and seller

– Earns a commission

• Dealer buys the asset from the seller and then sells is to the buyer– Earns the “spread”

Consider the liquidity of:• A used car

– Sell using a newspaper or internet add– Used car Dealer

• A house• 1,000 shares of IBM• 100,000 shares of IBM• 10% ownership of McGuckin’s

What kind of markets have brokers? What kind have dealers?

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Back to Securities Markets:• Primary Markets

• The issuing firm sells the stocks or bonds for the first time (like new cars)

• The issuing firm gets the money• The transactions are done through an investment bank• The transaction is called underwriting • Done by an investment banker

• Secondary Markets• Secondary market transactions involve an owner selling to a

different owner (like used cars)• The issuing firm does NOT get the money

• The transaction is done through a market• Stocks (NYSE, NASDAQ, OTC), Bonds, Currency, Futures, Options…

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What’s Next• Financial Statement Analysis• Financing Models