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Chapter 1 Principles of Corporate Finance Tenth Edition Goals and Governance of the Firm Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. Topics Covered Corporate Investment and Financing Decisions The Role of the Financial Manager and the Opportunity Cost of Capital Goals of the Corporation Agency Problems and Corporate Governance 1-2 Investment and Financing Decisions Common Finance Terminology – Real assets – Financial assets / Securities – Capital markets and financial markets – Investment / capital budgeting – Financing 1-3 Investment and Financing Decisions Real Assets – Assets used to produce goods and services. Financial Assets – Financial claims to the income generated by the firm’s real assets. 1-4 Investment and Financing Decisions Investment decision – purchase of real assets Financing decision – sale of financial assets 1-5 Investment and Financing Decisions Capital Budgeting Decision – Decision to invest in tangible or intangible assets. …also called the Investment Decision …also called Capital Expenditures or (CAPEX) 1-6 Investment and Financing Decisions – “Capital Budgeting” Tangible Assets Intangible Assets Expand Stores New Drug R&D @ $800 million @ $800 million 1-7 Investment and Financing Decisions Company (revenue in billions for 2007 or 2008) Recent Investment Decision Recent Financing Decision Boeing ($61 billion) Began production of its 787 Dreamliner The cash flow from Boeing’s aircraft, at a forecast cost of more than operations allowed it to repay some $10 billion. of its debt and repurchase $2.8 billion of stock. Royal Dutch Shell ($458 billion) Invests in a $1.5 billion deepwater oil In 2008 returned $13.1 billion of and gas field in the . cash to its stockholders by buying back their shares. (¥26,289 billion) GlaxoSmithKline (£24 billion) In 2008 opened new engineering and Returned ¥443 billion to shareholders safety testing facilities in . in the form of dividends. Spent £3.7 billion in 2008 on research Financed R&D expenditures largely and development of new drugs. with reinvested cash flow generated by sales of pharmaceutical products. Wal-Mart ($379billion) Union Pacific ($18 billion) In 2008 announced plans to invest over In 2008 raised $2.5 billion by an a billion dollars in 90 new stores in . issue of 5-year and 30-year bonds. Acquired 315 new locomotives in 2007. Largely financed its investment in locomotives by long-term leases. Wells Fargo ($52 billion) LVMH (€17 billion ) Lenovo ($16 billion) Acquired Wachovia Bank in 2008 for Financed the acquisition by an $15.1 billion. exchange of shares. Acquired the Spanish winery, Bodega Issued a 6-year bond in 2007, raising Numanthia Termes. 300 million Swiss francs. Expanded its chain of retail stores to Borrowed $400 million for 5 years cover over 2,000 cities. from a group of banks 1-8 Role of The Financial Manager (2) (1) Financial manager Firm's operations (3) 1-9 (4a) (4b) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors Financial markets Who is The Financial Manager? Chief Financial Officer Treasurer Controller 1-10 The Investment Trade-off 1-11 The Investment Trade-off Hurdle rate Cost of capital Opportunity cost of capital 1-12 Goals of The Corporation Each stockholder wants three things: 1. To be as rich as possible, that is, to maximize his or her current wealth. 2. To transform that wealth into the most desirable time pattern of consumption either by borrowing to spend now or investing to spend later. 3. To manage the risk characteristics of that consumption plan. 1-13 Goals of The Corporation Profit maximization is not a well-defined financial objective, for at least two reasons: 1. Maximize profits? Which year’s profits? A corporation may be able to increase current profits by cutting back on outlays for maintenance or staff training, but that may add value. Shareholders will not welcome higher short-term profits if long-term profits are damaged. 2. A company may be able to increase future profits by cutting this year’s dividend and investing the freed-up cash in the firm. That is not in the shareholders’ best interest if the company earns less than the opportunity cost of capital. 1-14 1-15 Whose Company Is It? ** Survey of 378 managers from 5 countries 3 Japan 97 17 Germany 22 France United States 71 76 24 0 All Stakeholders 78 29 United Kingdom The Shareholders 83 20 40 60 80 % of responses 100 120 1-16 Dividends vs. Jobs ** Survey of 399 managers from 5 countries. Which is more important...jobs or paying dividends? 3 Japan 97 40 Germany 41 France United States 89 89 11 0 Job Security 59 11 United Kingdom Dividends 60 20 40 60 80 % of responses 100 120 Goals of The Corporation Shareholders desire wealth maximization Do managers maximize shareholder wealth? Mangers have many constituencies “stakeholders” “Agency Problems” represent the conflict of interest between management and owners 1-17 Agency Problem 1-18 Ownership vs. Management Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders Agency Problem Agency costs are incurred when: 1. managers do not attempt to maximize firm value and 2. shareholders incur costs to monitor the managers and constrain their actions. 1-19 Agency Problem Agency Problems – Managers, acting as agents for stockholders, may act in their own interests rather than maximizing value. Stakeholder – Anyone with a financial interest in the firm. 1-20 Agency Problem 1-21 Tools to Ensure Management Pays Attention to the Value of the Firm – Manger’s actions are subject to the scrutiny of the board of directors. – Shirkers are likely to find they are ousted by more energetic managers. – Financial incentives such as stock options Agency Problem Agency Problem and Corporate Governance Solutions 1. Legal and Regulatory Requirements 2. Compensation plans 3. Board of Directors 4. Monitoring 5. Takeovers 6. Shareholder pressure 1-22 Web Resources Click to access web sites Internet connection required www.corpgov.net www.thecorporatelibrary.com www.riskmetrics.com 1-23