Chapter 1

Advanced Corporate Finance

Prof. GOHAR G. STEPANYAN
Chapter Outline
1.1 Why Study Finance?
1.2 The Four Types of Firms
1.3 The Financial Manager
1.4 The Financial Manager’s Place in the Corporation
1.5 The Stock Market
1.6 Financial Institutions

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Learning Objectives
Grasp the importance of financial information in both
your personal and business lives
Understand the important features of the four main
types of firms and see why the advantages of the
corporate form have led it to dominate economic
activity
Explain the goal of the financial manager and the
reasoning behind that goal, as well as understand the
three main types of decisions a financial manager
makes
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Learning Objectives
Know how a corporation is managed and controlled,
the financial manager’s place in it, and some of the
ethical issues financial managers face
Understand the importance of financial markets, such
as stock markets, to a corporation and the financial
manager’s role as liaison to those markets
Recognize the role that financial institutions play in
the financial cycle of the economy

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1.1 Why Study Finance?
Individuals are taking charge of their personal
finances with decisions such as:
When to start saving and how much to save for
retirement
Whether a car loan or lease is more advantageous
Whether a particular stock is a good investment
How to evaluate the terms of a home mortgage

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1.1 Why Study Finance?
In your business career, you may face questions such
as:
Should your firm launch a new product?
Which supplier should your firm choose?
Should your firm produce a part of the product or
outsource production?
Should your firm issue new stock or borrow money
instead?
How can you raise money for your start-up firm?

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1.2 The Four Types of Firms
1. Sole Proprietorships
2. Partnerships
3. Limited Liability Companies
4. Corporations

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1.2 The Four Types of Firms
Sole Proprietorship
Straightforward to set up and many new businesses use
this organizational form
Principal limitation is that there is no separation
between the firm and the owner
 The firm can have only one owner

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1.2 The Four Types of Firms
Sole Proprietorship
The owner has unlimited personal liability for the firm’s
debts
The life of a sole proprietorship is limited to the life of
the owner
It is difficult to transfer ownership of a sole
proprietorship

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1.2 The Four Types of Firms
Partnership
More than one owner
All partners are liable for the firm’s debt
A lender can require any partner to repay all the firm’s
outstanding debts
The partnership ends on the death or withdrawal of any
single partner
Partners can avoid liquidation if the partnership
agreement provides for alternatives such as a buyout of
a deceased or withdrawn partner

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1.2 The Four Types of Firms
Partnership
A limited partnership is a partnership with two kinds of
owners, general partners and limited partners
 General partners
 Have the same rights and privileges as partners in any general
partnership
 Are personally liable for the firm’s debt obligations

 Limited partners
 Have limited liability and their ownership interest is
transferable
 They have no management authority

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1.2 The Four Types of Firms
Limited Liability Companies (LLC)
No general partner
All the owners have limited liability, but they can also
run the business
Have different names in different countries

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1.2 The Four Types of Firms
Corporations
A corporation is a legal entity that is separate from its
owners
 It has many of the legal powers that people have
 It can enter into contracts, acquire assets, and incur
obligations, and it enjoys protection under most jurisdictions
against the seizure of its property

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1.2 The Four Types of Firms
Corporations
A corporation is solely responsible for its own
obligations
The owners of a corporation are not liable for any
obligations the corporation enters into
The corporation is not liable for any personal
obligations of its owners

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1.2 The Four Types of Firms
Corporations
Formation of a Corporation
 Must be legally formed
 Setting up a corporation is more costly than setting up a sole
proprietorship
 A corporate charter includes formal articles of incorporation

and a set of bylaws – i.e., specifies the initial rules that govern
how the corporation is run

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1.2 The Four Types of Firms
Corporations
Ownership of a Corporation
 No limit on the number of owners
 The entire ownership stake of a corporation is divided into

shares known as stock

 The collection of all the outstanding shares of a

corporation is known as the equity of the corporation

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1.2 The Four Types of Firms
Corporations
Ownership of a Corporation
 An owner of a share of stock in the corporation
is known as a shareholder, stockholder, or
equity holder
 Shareholders are entitled to dividend payments
 Usually receive a share of the dividend payments that is
proportional to the amount of stock they own
 No limitation on who can own its stock

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Example: Types of U.S. Firms

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1.2 The Four Types of Firms
Tax Implications for Corporate Entities
A corporation’s profits are subject to taxation separate
from its owners’ tax obligations
Shareholders of a corporation pay taxes twice
 The corporation pays tax on its profits
 When the remaining profits are distributed to the

shareholders, the shareholders pay their own personal

income tax on this income

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Example 1.1
Taxation of Corporate Earnings
Problem:
 You are a shareholder in a corporation. The corporation earns $5 per
share before taxes. After it has paid taxes, it will distribute the rest of
its earnings to you as a dividend (we make this simplifying
assumption, but should note that most corporations retain some of
their earnings for reinvestment). The dividend is income to you, so
you will then pay taxes on these earnings. The corporate tax rate is
40% and your tax rate on dividend income is 15%. How much of the
earnings remains after all taxes are paid?

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Example 1.1
Taxation of Corporate Earnings
Solution:
 $5 per share  0.40 = $2 in taxes are paid at the corporate level, leaving
$5 - $2 = $3 in after-tax earnings per share to distribute.
 You will pay $3  0.15 = $0.45 in taxes on that dividend, leaving you
with $2.55 from the original $5 after all taxes.

Evaluation:
 As a shareholder you keep $2.55 of the original $5 in earnings; the
remaining $2 + $0.45 = $2.45 is paid as taxes. Thus, your total effective
tax rate is 2.45/5 = 49%.

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Table 1.1 Characteristics of the
Different Types of Firms

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1.3 The Financial Manager
The financial manager has three main tasks:
Make investment decisions
Make financing decisions
Manage short-term cash needs

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1.3 The Financial Manager
Making Investment Decisions
The financial manager must weigh the costs and
benefits of each investment or project
They must decide which investments or projects qualify
as good uses of the money stockholders have invested
in the firm

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1.3 The Financial Manager
Making Financing Decisions
The financial manager must decide whether to raise
more money from new and existing owners by selling
more shares of stock (equity) or to borrow the money
instead (bonds and other debt)

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1.3 The Financial Manager
Managing Short-Term Cash Needs
The financial manager must ensure that the firm has
enough cash on hand to meet its obligations from day
to day
This job is also known as managing working capital

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1.3 The Financial Manager
The Goal of the Financial Manager
The overriding goal of financial management is to
maximize the wealth of the owners, the stockholders
Shareholder (investisseur) value vs. stakeholder (partie
prenante) value
Stakeholder : collectif ou individual concerné par une decision : intérêt peut être affectés positivement ou
négativement

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1.4 The Financial Manager’s Place
in the Corporation
Stockholders own the corporation but rely on
financial managers to actively manage the corporation
The board of directors and the management team
headed by the CEO possess direct control of the
corporation

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1.4 The Financial Manager’s Place
in the Corporation
The Corporate Management Team
Board of Directors
A group of people elected by shareholders who have the
ultimate decision-making authority in the corporation
Chief Executive Officer (CEO)
 The person charged with running the corporation by
instituting the rules and policies set by the board of
directors

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Figure 1.1 The Financial Functions
Within a Corporation

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1.4 The Financial Manager’s Place
in the Corporation
Ethics and Incentives in Corporations
Agency Problems
 When managers put their own self-interest ahead of the
interests of the shareholders
The CEO’s Performance
 When the stock performs poorly:
 The board of directors might react by replacing the CEO
 A corporate raider may initiate a hostile takeover

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1.5 The Stock Market
Corporations can be private or public
A private corporation has a limited number of owners
and there is no organized market for its shares
A public corporation has many owners and its shares
trade on an organized market, called a stock market

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Figure 1.2 Worldwide Stock
Markets Ranked by Volume of
Trade

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1.5 The Stock Market
Primary vs. Secondary Markets
Physical Stock Markets
Auction Market
 NYSE

Designated Market Makers (DMM)

 Specialists

Bid-Ask Spread
 Bidprice
 Ask price

 Transaction Cost

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1.5 The Stock Market
Over-the-Counter Stock Markets
Dealer Markets
 NASDAQ

Listing Standards
Outlines of the requirements a company must meet to
be traded on the exchange
 TheNYSE’s listing standards are more stringent than those
of NASDAQ

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1.5 The Stock Market
Other Financial Markets
Bond Market
Foreign Exchange Market
Commodities Market
Derivative Securities

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1.6 Financial Institutions
Financial Institutions
Entities that provide financial services, such as taking
deposits, managing investments, brokering financial
transactions, or making loans

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1.6 Financial Institutions
The Financial Cycle
In the financial cycle:

1. People invest and save their money

2. Through loans and stock, that money flows to
companies who use it to fund growth through new
products, generating profits and wages
3. The money then flows back to the savers and investors

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Figure 1.3 The Financial Cycle

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1.6 Financial Institutions
Types of Financial Institutions
Banks and Credit Unions
Insurance Companies
Mutual Funds
Pension Funds
Hedge Funds
Venture Capital Funds
Private Equity Funds

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1.6 Financial Institutions
Types of Financial Institutions
Financial conglomerates/financial services firms
combine more than one type of institution

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Table 1.2 Financial Institutions and
Their Roles in the Financial Cycle

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1.6 Financial Institutions
Role of Financial Institutions
Financial institutions:
 Move funds from savers to borrowers
 Move funds through time
 Help spread out risk-bearing

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Chapter Quiz
1. What are the advantages and disadvantages of
organizing a business as a corporation?
2. What are the main types of decisions that a
financial manager makes?
3. How do shareholders control a corporation?
4. What is the importance of a stock market to a
financial manager?
5. What are the three main roles financial institutions
play?

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