CHAPTER I

INTRODUCTION TO
CORPORATE FINANCE

The Faculty of Finance

University of Economics, The University of Danang

1
 Reading
• Chapter 1, Fundamentals of Corporate
Finance; Stephen A. Ross, Randolph W.
Westerfield, Bradford D. Jordan; McGraw-Hill
(2010).

2
 Chapter Outline
• Corporate Finance
• Forms of Business Organization
• Financial Manager
• The Goal of Financial Management
• The Agency Problem and Control of the
Corporation
• Financial Markets and the Corporation

3
 Key Concepts and Skills
• Know the basic types of financial management
decisions and the role of the financial manager
• Know the financial implications of the different forms
of business organization
• Know the goal of financial management
• Understand the conflicts of interest that can arise
between owners and managers
• Understand the various types of financial markets
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 Corporate Finance
Some important questions that are answered
using finance:
➢What long-term investments should the firm
take on?
➢Where will we get the long-term financing to pay
for the investment?
➢How will we manage the everyday financial
activities of the firm?

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 Forms of Business Organization

• Three major forms in the United States

–Sole Proprietorship
–Partnership
• General
• Limited
–Corporation

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 Sole Proprietorship
• Advantages • Disadvantages
– Easiest to start – Limited to life of owner
– Least regulated – Equity capital limited to
– Single owner keeps owner’s personal
all the profits wealth
– Taxed once as – Unlimited liability
personal income – Difficult to sell
ownership interest
A sole proprietorship is a business owned by one person.

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 Partnership

• Advantages • Disadvantages
– Two or more – Unlimited liability
owners • General partnership
– More capital • Limited partnership
available – Partnership dissolves
– Relatively easy to when one partner dies
start or wishes to sell
– Income taxed once – Difficult to transfer
as personal income ownership
A partnership is similar to a proprietorship except that there are two or more owners (part-
ners) 8
 Corporation
A business created as a distinct legal entity composed of one or more individuals
or entities
• Advantages • Disadvantages
– Limited liability – Separation of
– Unlimited life ownership and
management
– Separation of
ownership and – Double taxation
management (income taxed at the
corporate rate and
– Transfer of ownership
then dividends taxed
is easy
at the personal rate)
– Easier to raise capital
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10
 Financial Manager
Board of
Directors

Chairman and
chief executive
officer (CEO)

Vice president
Vice president Vice president Vice president
human
marketing finance (CFO) production
resource

Financial Accounting
Department Department

Figure 1.1: A sample simplified Organization Chart 11

 Financial Manager
• Financial managers try to answer some or all of
these questions
• 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
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 Financial Management Decisions
• Capital budgeting
– What long-term investments or projects
should the business take on?
• Capital structure
– How should we pay for our assets?
– Should we use debt or equity?
• Working capital management
– How do we manage the day-to-day finances of
the firm?
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 Goal of Financial Management

• What should be the goal of a corporation?

– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s
stock?
• Does this mean we should do anything and
everything to maximize owner wealth?

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 The Agency Problem
• Agency relationship
– Principal hires an agent to represent his/her
interests
– Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
– Conflict of interest between principal and agent
• Management goals and agency costs

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 The Agency Problem

❖Agency costs: costs of the conflict of interest

between stockholders and management.
➢Indirect agency costs
➢Direct agency costs

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 Managing Managers
• Managerial compensation
– Incentives can be used to align management
and stockholder interests
– The incentives need to be structured carefully
to make sure that they achieve their goal
• Corporate control
– The threat of a takeover may result in better
management
• Other stakeholders

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 Work the Web Example
• The Internet provides a wealth of information
about individual companies
• One excellent site is finance.yahoo.com
• Click on the web surfer to go to the site, choose a
company and see what information you can find!

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 Financial Markets

• Cash flows to the firm

• Primary vs. secondary markets
– Dealer vs. auction markets
– Listed vs. over-the-counter securities
• NYSE
• NASDAQ

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Figure 1.2: Cash Flows between the Firm and the Financial Markets

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 Financial Markets

Primary vs. secondary markets

✓ Primary market: original sale of securities by
governments and corporations. The corporation is
the seller, and the transaction raises money for the
corporation
✓ Secondary markets: securities are bought and
sold after the original sale. Secondary markets
provide the means for transferring ownership of
corporate securities

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 Financial Markets

Dealer vs. auction markets

✓ Dealers buy and sell for themselves, at their own
risk. In a dealer market, most of the buying and
selling is done by the dealer. Dealer markets in
stocks and long-term debt are called over-the-
counter (OTC) markets.
✓ Auction market or exchange has a physical
location. Purpose of an auction market: match
those who wish to sell with those who wish to buy.

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 Ethics Issues
• Is it ethical for tobacco companies to sell a product
that is known to be addictive and a danger to the
health of the user? Is it relevant that the product is
legal?
• Should boards of directors consider only price when
faced with a buyout offer?
• Is it ethical to concentrate only on shareholder
wealth, or should stakeholders as a whole be
considered?
• Should firms be penalized for attempting to improve
returns by stifling competition (e.g., Microsoft)?
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 Quick Quiz
• What are the three types of financial
management decisions and what questions are
they designed to answer?
• What are the three major forms of business
organization?
• What is the goal of financial management?
• What are agency problems and why do they
exist within a corporation?
• What is the difference between a primary market
and a secondary market?
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