Corporate Finance

BTH3_FINFINL3G0022

Introduction

Narita AQUARINI
[email protected]
Learning Objectives
•
1.1 Identify the goal of the firm.
•
1.2 Understand the basic principles of finance,
their importance, and the importance of ethics
and trust.
•
1.3 Describe the role of finance in business.
•
1.4 Distinguish among the different legal forms
of business organization.
•
1.5 Explain what has led to the era of the
multinational corporation.
•
1.6 Describe how this course and the skills you
will develop in it will help you in your career and
in your life.
The Goal of the
Firm
The Goal of the Firm
• The goal of the firm is to create value for the
firm’s owners (that is, its shareholders). Thus the
goal of the firm is to “maximize shareholder
wealth” by maximizing the price of the existing
common stock.
• Good financial decisions will increase stock price,
and poor financial decisions will lead to a decline
in stock price.
Five Principles That
Form the
Foundations of
Finance
Principle 1: Cash Flow Is What
Matters
• Accounting profits are not equal to cash flows. It
is possible for a firm to generate accounting
profits but not have cash or to generate cash
flows and not report accounting profits in the
books.
• Cash flow, and not profits, drive the value of a
business.
• We must determine incremental or marginal
cash flows when making financial decisions.
• Incremental cash flow is the difference
between the projected cash flows if the project
is selected versus what they will be if the
project is not selected.
Principle 2: Money Has a Time
Value (1 of 2)

• A dollar received today is worth more than a

dollar received in the future.
• Because we can earn interest on money
received today, it is better to receive money
sooner rather than later.
Principle 2: Money Has a Time
Value (2 of 2)

• Opportunity Cost – It is the cost of making a

choice in terms of next best alternative that must
be forgone.
• Example: By lending money to your friend at
zero percent interest, there is an opportunity
cost of 1% that could potentially be earned by
depositing the money in a savings account in a
bank.
Principle 3: Risk Requires a
Reward
• Investors will not take on additional risk unless
they expect to be compensated with additional
reward or return.
• Investors expect to be compensated for “delaying
consumption’’ and “taking on risk.’’
• Thus, investors expect a return when they
deposit their savings in a bank (e.g., delayed
consumption), and they expect to earn a
relatively higher rate of return on stocks
compared to a bank savings account (e.g.,
taking on risk).
Figure 1.1 The Risk-Return Trade-
off
Principle 4: Market Prices Are
Generally Right
• In an efficient market, the market prices of all
traded assets (such as stocks and bonds) fully
reflect all available information at any moment in
time.
• Thus stock prices are a useful indicator of the
value of the firm. Price changes reflect changes in
expected future cash flows. Good decisions will
tend to increase in stock price and vice versa.
• Note there are inefficiencies in the market that
may distort the market prices from value of
assets. Such inefficiencies are often caused by
behavioral biases.
Principle 5: Conflicts of Interest
Cause Agency Problems
• The separation of management and the
ownership of the firm creates an agency
problem. Managers may make decisions
that are not consistent with the goal of
maximizing shareholder wealth.
• Agency conflict is reduced through
monitoring (e.g., annual reports),
compensation schemes (e.g., stock
options), and market mechanisms (e.g.,
takeovers).
Ethics and Trust in Business
• Ethical behavior is doing the right thing! But what
is the right thing?
• Ethical dilemma—Each person has his or her own
set of values, which forms the basis for personal
judgments about what is the right thing.
• Sound ethical standards are important for
business and personal success. Unethical
decisions can destroy shareholder wealth (e.g.,
Enron scandal).
The Role of Finance
in Business
The Role of Finance in
Business (1 of 2)

• Three basic issues are addressed by the study of

finance:
• What long-term investments should the firm
undertake? (Capital budgeting decision)
• How should the firm raise money to fund these
investments? (Capital structure decision)
• How should cash flows arising from day-to-day
operations be managed? (Working capital
decision)
The Role of Finance in Business
(2 of 2)

• Knowledge of financial tools is relevant for

decision making in all areas of business (be it
marketing, production, etc.) and also in managing
personal finances.
• Decisions involve an element of time and
uncertainty; financial tools help adjust for time
and risk.
• Decisions taken in business should be financially
viable; financial tools help determine the financial
viability of decisions.
Figure 1.2 How the Finance Area
Fits into a Firm
The Legal Forms of
Business
Organization (1 of 2)
The Legal Forms of Business
Organization (2 of 2)
• Business Forms
• Sole Proprietorship
• Partnership
• Corporation
• Hybrid
• S-Type
• LLC
Sole Proprietorship
• Business owned by an individual
• Owner maintains title to assets and profits
• Unlimited liability
• Termination occurs on owner’s death or by the
owner’s choice
Partnership
• Two or more persons come together as co-owners.
• General Partnership: All partners are fully
responsible for liabilities incurred by the
partnership.
• Limited Partnerships: One or more partners can
have limited liability, restricted to the amount of
capital invested in the partnership. There must be
at least one general partner with unlimited
liability. Limited partners cannot participate in the
management of the business, and their names
cannot appear in the name of the firm.
Corporation
• Functions legally as a separate entity and apart
from its owners.
• Corporation can sue, be sued, purchase, sell,
and own property.
• Owners (shareholders) dictate direction and
policies of the corporation, oftentimes through
elected board of directors.
• Shareholder’s liability is restricted to amount of
investment in company.
• Life of corporation does not depend on the
owners; corporation continues to be run by
managers after transfer of ownership through sale
or inheritance.
The Trade-Offs: Corporate Form
• Benefits: Limited liability, easy to transfer
ownership, easier to raise capital, unlimited life
(unless the firm goes through corporate
restructuring such as mergers and bankruptcies)
• Drawbacks: No secrecy of information, maybe
delays in decision making, greater regulation,
double taxation
Double Taxation Example (1 of 2)

• Assume earnings before tax = $1,000

• Federal tax @ 25% = $250
• After-tax income available for distribution to
shareholders = $750
• Compute the taxes if the company chooses to
distribute the entire after-tax profits to
shareholders as dividends.
Double Taxation Example (2 of 2)

• If corporation distributes profits as dividends to

shareholders, shareholders will be taxed again.
• Assuming dividends are taxed @ 15%
• Dividend tax = 15% of $750 = $112.50

• = Total tax = 250 +112.5 = $362.5 or 36.25%

=
>
S-Corporations and Limited
Liability Companies (LLCs) (1 of 2)
• S-Type Corporations
• Benefits
• Limited liability
• Taxed as partnership (no double taxation
like corporations)
• Limitations
• Owners must be people so cannot be used
for a joint ventures between two
corporations
S-Corporations and Limited
Liability Companies (LLCs) (2 of 2)
• Limited Liability Companies (LLC)
• Benefits
• Limited liability
• Taxed like a partnership
• Limitations
• Qualifications vary from state to state
• Cannot appear like a corporation otherwise
it will be taxed like one
Table 1.1 The Different Business
Organizational Forms
 Finance and the
Multinational Firm:
The New Role
Finance and the Multinational
Firm: The New Role
• Coca-Cola, among other companies, receives
significant profits from overseas sales.
• U.S. firms are looking to international expansion
to discover profits.
• In addition to U.S. firms going abroad, we have
also witnessed many foreign firms making their
mark in the United States. For example, auto
industry dominated by Toyota, Honda, Nissan, and
BMW.
Developing Skills for Your Career
• Finance is a skill needed regardless of career
choice. In this class, you will learn:
• Critical thinking skills
• Excel skills
• Data analysis skills
• Collaboration and communication skills
Key Terms (1 of 2)

• Agency problem
• Capital budgeting
• Capital structure decisions
• Corporation
• Efficient market
• Financial markets
• Incremental cash flow
Key Terms (2 of 2)

• Limited partnership
• Partnership
• Opportunity cost
• Working capital management