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Chapter One

Introduction Corporate Finance to Ross Westerfield Jaffe Corporate Finance

Sixth Edition

Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut
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Chapter Outline
1.1 What is Corporate Finance?

1.2 Corporate Securities as Contingent Claims on Total Firm Value

1.3 The Corporate Firm

1.4 Goals of the Corporate Firm

1.5 Financial Institutions, Financial Markets, And The Corporation

1.6 Trends in Financial Markets and Management

1.7 Outline of the Text
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What is 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 the money for the required investments? 3. How much short-term cash flow does a company need to pay its bills?
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The Balance-Sheet Model of the Firm

Total Value of Assets: Total Firm Value to Investors:

Current Assets

Current Liabilities
Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

Shareholders Equity

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The Balance-Sheet Model of the Firm

The Capital Budgeting Decision
Current Liabilities
Long-Term Debt

Current Assets

Fixed Assets 1 Tangible 2 Intangible

What longterm investments should the firm engage in?

Shareholders Equity

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The Balance-Sheet Model of the Firm

The Capital Structure Decision
Current Liabilities
Long-Term Debt

Current Assets

How can the firm raise the money for the required Fixed Assets investments? 1 Tangible
2 Intangible

Shareholders Equity

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The Balance-Sheet Model of the Firm

The Net Working Capital Investment Decision
Current Liabilities
Net Working Capital

Current Assets

Long-Term Debt

Fixed Assets 1 Tangible 2 Intangible

How much shortterm cash flow does a company need to pay its bills?

Shareholders Equity

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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 the pie. 70% 30% 25%50% DebtDebt Equity 75% 50% Equity

If how you slice the pie affects the size of the pie, then the capital structure decision matters.
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Hypothetical Organization Chart

Board of Directors Chairman of the Board and Chief Executive Officer (CEO)

President and Chief Operating Officer (COO)

Vice President Finance

Treasurer

Controller

Cash Manager
Capital Expenditures
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Credit Manager Financial Planning

Tax Manager
Financial Accounting

Cost Accounting Data Processing

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The Financial Manager

To create value, the financial manager should: 1. Try to make smart investment decisions. 2. Try to make smart financing decisions.

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The Firm and the Financial Markets

Firm
Invests in assets (B) Firm issues securities (A) Retained cash flows (D) Short-term debt

Financial markets

Current assets Fixed assets

Cash flow from firm (C)

Dividends and debt payments (F)

Taxes (E)

Long-term debt
Equity shares

Ultimately, the firm must be a cash generating activity.

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Government

The cash flows from the firm must exceed the cash flows from the financial markets.
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1.2 Corporate Securities as Contingent Claims on Total Firm Value

The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount by a certain date. The shareholders 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.
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Debt and Equity as Contingent Claims

Payoff to debt holders If the value of the firm is more than $F, debt holders get a maximum of $F. $F Payoff to shareholders If the value of the firm is less than $F, share holders get nothing.

$F Value of the firm (X)

$F Value of the firm (X)

If the value of the firm Debt holders are promised $F. is more than $F, share If the value of the firm is less than $F, they holders get everything get whatever the firm is worth. above $F. Algebraically, the bondholders Algebraically, the shareholders claim is: Min[$F,$X] claim is: Max[0,$X $F]
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Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders and shareholders If the value of the firm is less than $F, the shareholders claim is: Max[0,$X $F] = $0 and the debt holders claim is Min[$F,$X] = $X.

The sum of these is = $X Payoff to shareholders $F

If the value of the firm is more than Payoff to debt holders $F, the shareholders claim is: Max[0,$X $F] = $X $F and the $F debt holders claim is: Value of the firm (X)
Min[$F,$X] = $F. The sum of these is = $X

Debt holders are promised $F.

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1.3 The Corporate Firm

The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash. However, businesses can take other forms.

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Forms of Business Organization

The Sole Proprietorship The Partnership
General Partnership Limited Partnership

The Corporation Advantages and Disadvantages

Liquidity and Marketability of Ownership Control Liability Continuity of Existence Tax Considerations
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A Comparison of Partnership and Corporations

Corporation Partnership

Liquidity

Shares can easily be exchanged

Usually each share gets one vote

Subject to substantial restrictions.

General Partner is in charge; limited partners may have some voting rights. Partnership income is taxable. All net cash flow is distributed to partners. General partners may have unlimited liability. Limited partners enjoy limited liability. Limited life
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Voting Rights

Taxation Reinvestment

Double with dividend tax credit Broad latitude

Liability

Limited liability

Continuity
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Perpetual life

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1.4 Goals of the Corporate Firm

What are firm decision-makers hired to do? The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.

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The Set-of-Contracts Perspective

The firm can be viewed as a set of contracts. One of these contracts is between shareholders and managers. The managers will usually 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 behaviour.

This contracting and monitoring is costly.

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Managerial Goals
Managerial goals may be different from shareholder goals
Expensive perquisites Survival Independence

Increased growth and size are not necessarily the same thing as increased shareholder wealth.

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Separation of Ownership and Control

Board of Directors Debtholders Shareholders Management

Assets

Debt Equity

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The Agency Problem

The agency relationship Will managers work in the shareholders best interests?
Agency costs Direct agency costs Indirect agency costs

Control of the firm How do agency costs affect firm value (and shareholder wealth)?
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Do Shareholders Control Managerial Behaviour? Shareholders vote for the board of directors, who in turn hire the management team. Contracts can be carefully constructed to be incentive compatible. There is a market for managerial talentthis may provide market discipline to the managersthey can be replaced. If the managers fail to maximize share price, they may be replaced in a hostile takeover.
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1.5 Financial Institutions, Financial Markets, and the Corporation

Financial Institutions
Indirect finance
Funds suppliers Deposits Financial intermediaries Loans Funds demanders

Direct finance
Funds suppliers Financial intermediaries Funds demanders

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Financial Markets
Money versus Capital Markets Money Markets For short-term debt instruments Capital Markets For long-term debt and equity

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Financial Markets
Primary versus Secondary 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 overthe-counter in a dealer market.
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Financial Markets

Firms

Stocks and Bonds Money Bob

Investors securities Sue

money
Primary Market Secondary Market

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1.6 Trends in Financial Markets and Management

Integration and globalization Increased volatility Financial Engineering reduces costs related to Risk Taxes Fnancing costs Improved computer technology allows Economies of scale and scope Regulatory dialectic
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1.7 Outline of the Text

I. Overview

II.

Value and Capital Budgeting

III. Risk IV. Capital Structure and Dividend Policy

V.

Long-Term Financing

VI. Options, Futures, and Corporate Finance VII. Financial Planning and Short-Term Finance VIII.Special Topics

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