CHAPTER 1
An Overview of Corporate Finance &
the Financial Environment
Introduction
Forms of business organization
Primary objective of the
corporation
Agency Relationship
Finance
• What is Finance?
• Areas of Finance:
- Corporate Finance
- Investments
- Financial Institutions
- International Finance.
• Three sub-categories of Finance:
- Personal Finance
- Corporate Finance
- Public Finance.
What Is Corporate Finance?
• Every decision that a business makes has
financial implications, and any decision which
affects the finances of a business is a
corporate finance decision.
• Defined broadly, everything that a business
does fits under the topic of corporate finance.
Alternative Forms of
Business Organization
• Sole proprietorship
• Partnership
• Corporation
Sole Proprietorship
• Advantages:
– Ease of formation/inexpensive
– Subject to few gov’t regulations
– No corporate income taxes
• Disadvantages:
– Limited life
– Unlimited liability
– Difficult to raise capital
Partnership
• Exists when >=2 persons associate to
conduct a noncorporate bus.
• May operate under different degrees of
formality.
• A partnership has roughly the same
advantages and disadvantages as a sole
proprietorship.
Corporation
• Legal entity created by state, separate & distinct from its
owners and managers.
• Advantages:
– Unlimited life
– Easy transfer of ownership
– Limited liability
– Ease of raising capital
• Disadvantages:
– Double taxation
– Cost of set-up and report filing
– Agency Problem
Hybrid forms of Organizations
• Limited Partnership
- limited partners, general partners
• Limited Liability Partnership (Limited Liability
Company)
Cxs
- limited liab. (corporation)
- tax advantage (partnership)
Goals of the Corporation
• Shareholders elect Directors, an in turn hire
mgt.
• =>Mgt has to strive to enhance SH value.
• The primary goal is shareholder wealth
maximization, which translates to maximizing
stock price.
Is maximizing stock price good for
society, employees, and customers? Y
• Unless engaged in creating monopoly,
violating safety codes, polluting env’t; the
same actions that maximize stock prices will
also benefit the society.
• Some reasons
– To a large extent, the owners of stock are society
– consumers benefit from efficiency
– Employees benefit (additional emp’t, pay)
Managers actions to maximize SH
wealth
• What determines the stock prices?
- The Co.’s ability to generate CF now and in the
future.
- 3 basic facts
i. Any financial asset, including a Co.’s stock, is valuable
only to the extent that it generates CF;
ii. The timing of CF matters
iii.Investors generally are averse to risk.
Factors that Affect Stock Price
• Amount of cash flows expected by
shareholders
• Timing of the cash flow stream
• Risk of the cash flows
* Managers can enhance their Co.’s stock
price by increasing the size of expected CF,
by speeding up their receipts, and by
reducing their risk.
• FMgers must decide where to invest.
• FMgers must also decide how to finance the firm:
- What mix of debt and equity should be used?
- What specific types of debt & equity securities should be issued?
- What %age of current earning should be retained & reinvested rather than
paid out as dividends. (div. pol. dec)
• Fmgers should manage the day to day operations of
the firm.
• Each of these inv’t and financing decisions is likely to affect
the level, timing and risk of the Co.’s CFs, and therefore, price
of its stock.
• There are other (external) factors, too, which affect stock
prices.
Three Determinants of Cash Flows
• Sales
– Current level
– Short-term growth rate in sales
– Long-term sustainable growth rate in sales
• Operating margin after tax
• Capital requirements
Does it make sense to try to Maximize
Earnings per Share (EPS)?
• Maximizing profit?
• Maximizing EPS?
• Even though CFs ultimately determine SH value, financial
managers cannot ignore EPS, b/c earnings announcement
send messages to investors.
Agency Relationships
• An agency relationship exists whenever a
principal hires an agent to act on his or
her behalf.
• Within a corporation, agency
relationships exist between:
– Shareholders and managers
– Shareholders and creditors
– Major shareholders & minorities (in
developing economies)
Shareholders versus Managers
• Managers are naturally inclined to act in
their own best interests.
• But the following factors affect managerial
behavior:
– Managerial compensation plans
– Direct intervention by shareholders
– The threat of firing
– The threat of takeover
Shareholders versus Creditors
• Shareholders (through managers) could
take actions to maximize stock price
that are detrimental to creditors.
• In the long run, such actions will raise
the cost of debt and ultimately lower
stock price.
