CHAPTER ONE

INTRODUCTION TO
CORPORATE FINANCE

What is Corporate Finance?

Basically, corporate finance is the
study of how capital investments are
evaluated, how funds are raised to
purchase the investments, and how
short-term operating cash flows are
managed.

Corporate Finance Decisions

1. What long-term investments should
the firm undertake? (capital
budgeting decisions)
2. How should the firm fund these
investments? (capital structure
decisions)
3. How will the firm manage its
everyday financial activities?
(working capital management
decisions)

Financial Manager

Financial Manager

Legal Forms of Business

Organization
Forms of
Business
Organization

Sole
Proprietorship
s

Partnerships

Corporations

The goal of financial

management

The goal of the financial manager must

be consistent with the mission of the
corporation.
What are among the possible goals?
Survive, avoid bankruptcy, maximize
sales, maximize profits, maintain growth.
The appropriate goal: To maximize
shareholders wealth (as measured
by current value per share of the
existing stock)
Why?

The goal of financial management

Because maximizing shareholder
wealth properly considers cash flows,
the timing of these cash flows, and the
risk of these cash flows.
level & timing of
cash flows

Share Price = Future

Dividends
Required Return

risk of cash flows

A more general goal

Maximize the value of the existing
owners equity
- Can apply to any form of business
entity
- Can even apply to not-for-profit
sector
- Increasing value doesnt justify illegal
or
unethical actions.

The Agency Problems

Agency problem is the problem that arise
due to the conflict of interest between the
stockholders and management of a firm
Example:
Not pursuing risky project for fear of losing
jobs, manipulating the accounts,
expensive perks.
Agency costs are costs that the corporation
has to bear to mitigate the agency problems
and these costs will reduce the firm value.

How to Reduce Agency Costs?

1. Monitoring
(Examples: Reports, Meetings, Auditors, board
of directors, financial markets, bankers, credit
agencies)
2. Compensation plans
(Examples: Performance based bonus, salary,
stock options [ESOS], benefits)
3. Others
(Examples: Threat of being fired, Threat of
takeovers, Stock market, regulations)
The above will help to reduce agency problems/costs.

Financial markets & institutions

Primary Market
Market in which new issues of a
security are sold to initial buyers.
Secondary Market
Market in which previously issued
securities are traded.

Financial markets and institutions

cash

Corporation

securities
Investment in
Current assets
Fixed assets

Financial
markets
Short-term debt
Long-term debt
Equity shares

reinvest
Cash flow

Dividends
tax

Government

Principles underlying the financial

management
PRINCIPLE 1: Money Has a Time
Value.
PRINCIPLE 2: There is a Risk-Return
Trade-off.
PRINCIPLE 3: Cash Flows Are The
Source of Value.
http://
PRINCIPLE 4: Market Prices Reflect
www.youtube.com/watch?feature=player_detailpage&v=f8
Information.
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