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CHAPTER 1 McGraw-Hill/Irwin Introduction to Corporate Finance Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 2 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 various 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 McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 3 Chapter Outline 1.1 What is Corporate Finance? 1.2 The Corporate Firm 1.3 The Goal of Financial Management 1.4 The Agency Problem and Control of the Corporation 1.5 Financial Markets McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 4 1.1 What is Corporate Finance? Corporate Finance addresses the following three questions: • 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? McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 5 Balance Sheet Model of the Firm Total Value of Assets: Current Assets Total Firm Value to Investors: Current Liabilities Long-Term Debt Fixed Assets 1 Tangible 2 Intangible McGraw-Hill/Irwin Shareholders’ Equity Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 6 The Capital Budgeting Decision Current Liabilities Current Assets Long-Term Debt Fixed Assets 1 Tangible 2 Intangible McGraw-Hill/Irwin What long-term investments should the firm choose? Shareholders’ Equity Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 7 The Capital Structure Decision Current Liabilities Current Assets How should the firm raise funds for the selected Fixed Assets investments? 1 Tangible 2 Intangible McGraw-Hill/Irwin Long-Term Debt Shareholders’ Equity Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 8 Short-Term Asset Management Current Assets Fixed Assets 1 Tangible 2 Intangible McGraw-Hill/Irwin Current Liabilities Net Working Capital How should short-term assets be managed and financed? Long-Term Debt Shareholders’ Equity Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 9 Capital Structure The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie. The Capital Structure decision can be viewed as how best to slice the pie. 70%50%30% 25% DebtDebt Equity 75% 50% Equity If how you slice the pie affects the size of the pie, then the capital structure decision matters. McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 10 The Financial Manager The Financial Manager’s primary goal is to increase the value of the firm by: 1. Selecting value creating projects 2. Making smart financing decisions McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 11 Hypothetical Organization Chart Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operating Officer (COO) Vice President and Chief Financial Officer (CFO) Treasurer Controller Cash Manager Credit Manager Tax Manager Cost Accounting Capital Expenditures Financial Planning Financial Accounting Data Processing McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved The Firm and the Financial Markets Firm Firm issues securities (A) Invests in assets (B) Short-term debt Cash flow from firm (C) Ultimately, the firm must be a cash generating activity. McGraw-Hill/Irwin Financial markets Retained cash flows (F) Dividends and debt payments (E) Taxes (D) Current assets Fixed assets Slide 12 Government Long-term debt Equity shares The cash flows from the firm must exceed the cash flows from the financial markets. Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 13 1.2 The Corporate Firm • The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash. • However, businesses can take other forms. McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 14 Forms of Business Organization • The Sole Proprietorship • The Partnership – General Partnership – Limited Partnership • The Corporation McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 15 A Comparison Corporation Partnership Liquidity Shares can be easily exchanged Subject to substantial restrictions Voting Rights Usually each share gets one vote General Partner is in charge; limited partners may have some voting rights Taxation Double Partners pay taxes on distributions Reinvestment and dividend payout Broad latitude All net cash flow is distributed to partners Liability Limited liability General partners may have unlimited liability; limited partners enjoy limited liability Continuity Perpetual life Limited life McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 16 1.3 The Goal of Financial Management • What is the correct goal? – Maximize profit? – Minimize costs? – Maximize market share? – Maximize shareholder wealth? McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 17 1.4 The Agency Problem • Agency relationship – Principal hires an agent to represent his/her interest – Stockholders (principals) hire managers (agents) to run the company • Agency problem – Conflict of interest between principal and agent McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 18 Managerial Goals • Managerial goals may be different from shareholder goals – Expensive perquisites – Survival – Independence • Increased growth and size are not necessarily equivalent to increased shareholder wealth McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 19 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 intended goal • Corporate control – The threat of a takeover may result in better management • Other stakeholders McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 20 1.5 Financial Markets • Primary Market – Issuance of a security for the first time • Secondary Markets – Buying and selling of previously issued securities – Securities may be traded in either a dealer or auction market • NYSE • NASDAQ McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 21 Financial Markets Firms Stocks and Bonds Investors securities Money Bob Sue money Primary Market Secondary Market McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved Slide 22 Quick Quiz • What are the three basic questions Financial Managers must 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? McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved