Chapter 1: Introduction to

corporate finance

Corporate Finance
Ross, Westerfield &
Jaffe
Outline

1.1 What is corporate finance?

1.2 The goal of financial management
1.3 The agency problem and control of the
corporation
1.4 Ethics and corporate governance
1.5 Financial markets
Main tasks of corporate finance

Capital budgeting: the process of planning

and managing a firms long-term
investments fixed assets.
Example: deciding whether or not to open a new
restaurant.
Capital structure: the mixture of debt and
equity maintained by the firm S-T and L-
T debt and equity.
Working capital management: a firms
short-term assets and liabilities current
assets and current liabilities.
The Capital Budgeting Decision

Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets What long-term

1 Tangible
investments
should the firm Shareholders
2 Intangible choose? Equity
Modern form of firms

Corporation: a business created as a distinct legal

entity composed of one or more individuals or
entities, e.g., IBM.
Separation of control (shareholders) and management
(professionals).
Ownership can be easily transferred.
Limited liability.
Double taxation.
Rather expensive to form.
Agency problems.
Who make the decisions?

Owners (typically in small businesses).

Professional managers.
Financial managers

Frequently, financial managers try to address

these tasks.
The top financial manager within a firm is
usually the Chief Financial Officer (CFO).
Treasurer oversees cash management, credit
management, capital expenditures and financial
planning.
Controller oversees taxes, cost accounting,
financial accounting and data processing.
Possible goals of financial
management

Survive
Beat the competition
Maximize sales
Maximize net income
Maximize market share
Minimize costs
Maximize the value of (stock) shares
The appropriate goal of financial
management

Maximize the (fundamental or economic) value of

(stock) shares is the right goal.
Why? Shareholders own shares. Managers, as
agents, ought to act in a way to benefit
shareholders; i.e., to enhance the value of the
shares.
A limitation of this goal is that value is not directly
observable.
A sample question

The primary goal of financial management is to:

a. maximize current dividends per share of
the existing stock.
b. maximize the current value per share of
the existing stock.
c. avoid financial distress.
d. minimize operational costs and maximize
firm efficiency.
e. maintain steady growth in both sales and
net earnings.
Home Depot CEO gets $210 million
severance for sucking at job

Robert L. Nardelli, the CEO of Home Depot,

who came under heavy criticism for his pay
package and failure to lift the chain s
stagnant stock price, has abruptly resigned.
He will receive about $210 million in
compensation from the company, including
the current value of retirement and other
benefits. Who would blame him for quitting?
Source:digg.com; submitter: tennova.
Value vs. price

The value of shares are not observable. In contrast,

the price of shares can be observable.
If one believes that share price is an accurate/good
estimate of share value, the appropriate goal would
be to maximize the price of shares.
This belief/assumption is, however, questionable.
But the previous slide (Home Depot ex-CEO),
nevertheless, showed that investors care about
stock price, and that stock price performance is very
important to the tenure of managers.
Value maximization and sustainability

Business sustainability: often viewed as

managing the triple bottom line - a process
by which companies manage their
economic/financial, ecological, and social
opportunities and risks.
Sustainability and value maximization are
somewhat different.
3 aspects of sustainability

Economic/financial here is more about

economic viability and profitability, and not
directly about value maximization.
Ecological reaching your financial goals
should not impose burden on the current
natural environment.
Social reaching your financial goals should
not damage the well-being of the society
(employees, etc.).
Shareholders and other stakeholders
Shareholders and other stakeholders

Customers
Suppliers
Employees (human capital and assets)
Creditors (bondholders, banks, debtholders)
Government: tax and regulations
Community (local / global)
Owner/shareholder
The agency problem

Agency relationship:
Principals (citizens) hire an agent (the president) to
represent their interest.
Principles (stockholders) hire agents (managers) to run the
company.
Agency problem:
Conflict of interest between principals and agents.
This occurs in a corporate setting whenever the agents do
not hold 100% of the firms shares.
The source of agency problems is the separation of
(owners) control and management.
Agency costs

Direct costs: (1) unnecessary expenses,

such as a corporate jet, and (2) monitoring
costs.
Indirect costs. For example, a manager
may choose not to take on the optimal
investment. She/he may prefer a less risky
project so that she/he has a higher
probability keeping her/his tenure.
Managerial incentives

Managerial goals are frequently different

from shareholders goals.
Expensive perks.
Survival.
Independence.
Growth and size (related to compensation)
may not relate to shareholders wealth.
Corporate governance

Compensation:
Incentives ($$$, options, threat of dismissal, etc.) used to
align management and stockholder interests.
Corporate control:
Managers may take the threat of a takeover seriously and
run the business in the interest of shareholders.
Pressure from other stakeholders (e.g., CalPERS, a
powerful corporate police).
Sarbanes-Oxley Act (2002)

Sarbox.
10K must have an assessment of the firms
internal control structure and financial
reporting.
The officers must explicitly declare that 10K
does not contain any false statements or
material omissions.
The officers are responsible for all internal
controls.
Ethics

Managers are expected to behave in an ethical

manner.
The province of ethics is to sort out what is good and
bad.
But, what is the criterion or guideline for doing so?
Philosophers came up with some criteria, but none
of them makes sorting out what is good and bad an
easy task.
Here, we introduce two of these criteria.
Principle 1

Golden rule: Do unto others as you would

have others do onto you.
But the next example, the so-called
Sopranoism, shows the limitation of this
principle: Whack the next guy with the same
respect youd like to be whacked with, you
know? (Source: Cathcart and Klein, 2007).
Principle II

Confucianism: Do not do to others what you

do not want done to yourself.
This is a rather robust (but passive) criterion.
But its limitation is that it says nothing about
what you should do.
Dilemma

Ethical decisions often yield a dilemma.

Suppose that you were the CEO of investment bank
XYZ in 2005. The debt/equity ratio of the bank was
20. All of your competitors raised their debt/equity
ratios to 30 to please the stock market so that their
stock prices could be higher than otherwise would
be. You knew that raising the debt/equity ratio to 30
was rather risky and could destroy the bank if
business went wrong. But you knew the investors
would be disappointed by the otherwise lower share
price if you did not raise the debt/equity ratio.
So, what is the answer?

I do not have an answer for this kind of

ethical question because it is a dilemma;
otherwise, I would not use the word
dilemma.
All I know is that you, as professional
managers, are expected to behave ethically.
One thing I know for sure is that never do
anything that will put you in a prison cell; you
are too cute for a prison cell.
Financial markets

Cash flows (i.e., financing and

payoffs/dividends/interests) between firms
and financial markets.
Primary markets.
Secondary markets.
- NYSE.
- Nasdaq.
Info about financial markets

Yahoo! Finance.
End-of-chapter

Concept questions: 1-10.