Chapter One Overview of Corporate Finance

Principles of Corporate Finance Canadian Edition Lawrence J. Gitman and Sean Hennessey

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Learning Goals
Define finance and describe its three major areas and career opportunities. LG2 Review basic forms of business organization, their strengths and weaknesses. LG3 Describe managerial finance function and differentiate from economics and accounting.
LG1
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Learning Goals (continued)

Identify key activities of financial manager within the firm. LG5 Explain why wealth maximization is firms goal. LG6 Explain how EVA, stakeholder focus, and ethical behaviour relate to firms goal. LG7 Discuss agency issue as it relates to owner wealth maximization.
LG4
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What is Finance?
At the macro level, finance is the study of financial institutions and financial markets and how they operate within the financial system in both the Canadian and global economies. At the micro level, finance is the study of financial planning, asset management, and fund raising for businesses and financial institutions. Financial management can be described in brief using the following balance sheet.
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What is Finance?
Macro Finance
Assets: Current Assets Cash & M.S. Accounts receivable Inventory Liabilities & Equity: Current Liabilities Accounts payable Notes Payable Total Current Liabilities Long-Term Liabilities Total Liabilities Equity: Common Stock Paid-in-capital Retained Earnings Total Equity Total Liabilities & Equity

Working Capital

Total Current Assets Fixed Assets: Gross fixed assets Less: Accumulated dep. Goodw ill Other long-term assets Total Fixed Assets Total Assets

Working Capital

Investment Decisions

Financing Decisions

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What is Finance?
A well-developed financial system is a hallmark and essential characteristic of any modern developed nation. Financial markets, financial intermediaries, and financial management are the important components. Financial markets and financial intermediaries facilitate the flow of funds from borrowers to savers. Financial management involves the efficient use of financial resources in the production of goods.
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Areas of Specialization in Finance

Financial Markets
Markets of users and savers of funds.

Financial Services
Design and delivery of financial advice and products to individuals, businesses, government.

Managerial Finance
Financial management of business firms.
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Areas of Employment in Finance

Financial Analyst Capital budgeting analyst/manager Project finance manager Cash manager Credit analyst/manager Pension fund manager
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Basic Forms of Business Organization

Sole Proprietorship
Owned by one person, operated for personal profit.

Partnerships
Owned by two or more people, operated for joint profit.

Corporations
Legal entity, owned by individuals, operated for joint profit.
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Sole Proprietorship
STRENGTHS: Low organizational cost Income taxed once as personal income Independence Secrecy Ease of dissolution WEAKNESSES: Unlimited liability Limited funding Proprietor must be all Difficult to develop staff career opportunities Lack of continuity on death of proprietor
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Partnerships
STRENGTHS: Improved funding sources Increased managerial talent Income split by partnership contract, taxed as personal income WEAKNESSES: Unlimited liability to all partners Partnership dissolved upon death of partner Difficult to liquidate or transfer ownership

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Corporations
STRENGTHS: Owners liability limited Large capitalization possible, greater funding Ownership readily transferable Indefinite life Professional management
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WEAKNESSES: Higher tax rates Expensive organization Greater government regulation When publicly traded, lacks secrecy

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Corporate Organization Chart

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Organization of Finance Functions

CFO Chief Financial Officer Treasurer responsibilities:
Financial planning, fund raising, capital expenditure decisions, cash and credit management.

Controller responsibilities:
Corporate accounting, cost accounting, and tax management.
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Relationship to Economics
Fundamental Economic Principle: Marginal Analysis
Financial decisions should be made and actions taken only when the added benefits exceed the added costs.

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Relationship to Accounting
Cash Flows
Accrual Basis: recognizes sales revenue and expenses incurred to make sale at time of sale. Cash Basis: recognizes revenues and expenses as they occur.

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Accounting vs. Financial Views

Accounting View (Accrual Basis) Income Statement Peakes Quay, Inc. For year ended 12/31 Sales revenue Less: Costs Net Profit $100,000 80,000 $ 20,000 Financial View (Cash Basis) Cash Flow Statement Peakes Quay, Inc. For year ended 12/31 Cash inflow $ 0 Less: Cash outflow 80,000 Net cash flow ($80,000)

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Financial ManagerKey Activities

Financial Analysis & Planning Balance Sheet Making Investment Decisions Current Current Assets Liabilities _______________ _______________ Fixed Long-Term Funds Assets (Debt & Equity) Making Financing Decisions

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Should Firms Maximize Profit?

Corporations commonly define profit as Earnings per Share (EPS).
A measure of total earnings divided by total number of ownership shares.

EPS ignores critical factors of

the timing of the returns. cash flows available to common shareholders. risk factors facing the firm.
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Or Should Firms Maximize Shareholder Wealth?

Evaluating Shareholder Wealth addresses factors of timing, cash flows and risk ignored by the EPS. Therefore, Maximizing Shareholder Wealth is a more comprehensive goal for the firm, its managers and employees. This can be explored through economic valued added and a focus on stakeholders.
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Economic Value Added EVA

EVA measures whether an investment contributes to shareholder wealth. EVA is calculated by subtracting cost of funds used from after-tax operating profits. While popular, EVA is essentially derived from the concept of net present value.

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What about Stakeholders?

Stakeholders include groups that have direct economic links to the firm. Stakeholders include not only owners, but also employees, customers, suppliers, and creditors. Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders.
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Importance of Ethics
The standards of conduct or moral judgment: Honesty, trustworthiness, fair dealing are foundations of sustainable business relations:
With customers, With suppliers, With creditors, With employees, With owners.

Ethical behaviour is necessary to achieve the goal of maximizing shareholder wealth.

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Internal Ethical Review

Are rights of stakeholders being violated? Does firm have extra duties to stakeholders? Will a decision unfairly discriminate benefits among stakeholders? If stakeholders are harmed, should this be remedied? How? What is the relationship between shareholders and stakeholders?
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Financial Goals of a Company

Maximize sales. Maximize cash flow. Maximize market share. Maximize profit. Minimize costs. Maximize return on sales, investment, equity. Ensure earnings stability. Achieve target goals for sales, profits, market share or return.
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Agency Issues: The Principal-Agent Problem

Whenever ownership is independent of management there exists potential problem of conflicts. The owners goals for the firm are best described as maximizing shareholder wealth. Managers are also concerned with personal wealth, job security, lifestyle, and benefits. These concerns may conflict with shareholder interests.
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Resolving the Agency Problem

Good corporate governance by the Board of Directors is the heart of any resolution. Agency Costs the costs of this governance:
Monitoring costs, Bonding costs, Structuring compensation costs.

Market forces, such as the potential for hostile takeover provide some deterrence. Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well.
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Current View on Incentive Plans

Executive compensation packages generally include incentive plans that grant stock options, performance-based shares, or cash bonuses upon meeting or exceeding corporate goals. Such packages may also include long-term benefits that can protect the manager against poor corporate performance.
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Overview of Text
Part 1: Introduction to Corporate Finance Part 2: Financial Analysis and Planning Part 3: Important Financial Concepts Part 4: Long-Term Financial Decisions Part 5: Long-Term Investment Decisions Part 6: Working Capital Management Part 7: Special Topics in Corporate Finance
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