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Theory of Corporate Finance
RWJ-Chapter 1
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What is Corporate Finance?
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What long-term investments should the firm engage in?
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How can the firm raise money for the required investments?
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Capital Budgeting: The process of planning and managing a firm’s longterm investments
Investment opportunities: value vs. cost of these opportunities
What do we need to learn?
Capital Structure: The mixture of debt and equity to support long-term
investments
What do we know? And Why is important?
How much short-term cash flow does a company need to pay its
bills?
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Working Capital Management: Capital required for the firm’s day to day
activities (current assets and liabilities)
What do we know? And why is it important?
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What is our Strategy?
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We learn:
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The basic tools to answer these questions
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Financial Statements
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Cost of Equity
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Cost of Debt
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Project Evaluation
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Firm and Bond Valuations
To link these tools in our 3 fundamental questions
Moreover, corporate finance is a very important tool for
investments? Why?
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Let’s examine these questions in a
Balance-Sheet Model
The Capital Budgeting Decision
Current
Liabilities
Current Assets
Fixed Assets
1. Tangible
2. Intangible
What long-term
investments
should the firm
engage?
Long-Term
Debt
Shareholders’
Equity
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The Capital Structure Decision
Current
Liabilities
Current Assets
How can the firm
raise the money
for the required
investments?
Fixed Assets
1. Tangible
2. Intangible
Long-Term
Debt
Shareholders’
Equity
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The Net Working Capital Investment Decision
Current
Liabilities
Current Assets
Net
Working
Capital
Fixed Assets
1. Tangible
2. Intangible
How much
short-term cash
flow does a
company need
to pay its bills?
Long-Term
Debt
Shareholders’
Equity
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Goals of Financial Management
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Maximize the current value of the firm.
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How can a financial manager do it?
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Identify the best investments
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Find the best financial arrangements (i.e., best capital structure)
Who are the owners of the firm?
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Shareholders: “Residual Owners”
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Agency Problem and Agency Cost
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Agency problem exists whenever the principal hires another
agent to represent his/her interest
Two types of agency problems:
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Between shareholders and managers (equity-related agency
problems)
Between shareholders and bondholders (debt-related agency
problems)
Agency costs: the costs of devising appropriate incentives for
managers and then monitoring their behavior
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Agency Problem between
Shareholders and Managers
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Managerial goals may be different from shareholder goals
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Expensive perquisites
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Risk aversion (managers might be more risk averse)
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Free cash related problems (Hubris)
How can shareholders control managerial behavior?
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Directors (Board of Directors)
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BOD can devise compensation plan to align the management
incentives
BOD can also fire badly performing managers