corporate finance chapter1.docx

corporate finance chapter1.docx

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corporatefinancechapter1

Chapter1

TheFinancialManagerandtheFirm

LearningObjectives

1.Identifythekeyfinancialdecisionsfacingthefinancialmanagerofanybusinessfirm.

2.IdentifythebasicformsofbusinessorganizationusedintheUnitedStates,andreviewtheirrespectivestrengthsandweaknesses.

3.Describethetypicalorganizationofthefinancialfunctioninalargecorporation.

4.Explainwhymaximizingthecurrentvalueofthefirm’sstockpriceistheappropriategoalformanagement.

5.Discusshowagencyconflictsaffectthegoalofmaximizingstockholderwealth.

6.Explainwhyethicsisanappropriatetopicinthestudyofcorporatefinance.

I.ChapterOutline

1.1TheRoleoftheFinancialManager

A.It’sAllaboutCashFlows

∙Thefinancialmanagerisresponsibleformakingdecisionsthatareinthebestinterestofthefirm’sowners.

∙Afirmgeneratescashflowsbysellingthegoodsandservicesproducedbyitsproductiveassetsandhumancapital.Aftermeetingitsobligations,thefirmcanpaytheremainingcash,calledresidualcashflows,totheownersasacashdividend,oritcankeepthemoneyandreinvestthecashinthebusiness.

∙Afirmisunprofitablewhenitfailstogeneratesufficientcashflowstopayoperatingexpenses,creditors,andtaxes.Firmsthatareunprofitableovertimewillbeforcedintobankruptcybytheircreditors.Inbankruptcy,thecompanywillbereorganized,orthecompany’sassetswillbeliquidated,whicheverismorevaluable.Ifanythingisleftafterallcreditorandtaxclaimshavebeensatisfied,whichusuallydoesnothappen,theremainingcash,orresidual,isdistributedtotheowners.

B.ThreeFundamentalDecisionsinFinancialManagement

∙Thecapitalbudgetingdecision:

Whichproductiveassetsshouldthefirmbuy?

Thisthemostimportantdecisionbecausetheydrivethefirm’ssuccessorfailure.

∙Thefinancingdecision:

Howshouldthefirmfinanceorpayforassets?

∙Workingcapitalmanagementdecisions:

Howshouldday-to-dayfinancialmattersbemanagedsothatthefirmcanpayitsbills,andhowshouldsurpluscashbeinvested?

1.2FormsofBusinessOrganization

A.Asoleproprietorshipisabusinessownedbyoneperson.

∙Thereisalsonolegaldistinctionbetweenpersonalandbusinessincomeforasoleproprietor.

∙Allbusinessincomeistaxedaspersonalincome.

∙Asoleproprietorisresponsibleforpayingallthefirm’sbillsandhasunlimitedliabilityforallbusinessdebtsandotherobligationsofthefirm.

B.Apartnershipconsistsoftwoormoreownersjoinedtogetherlegallytomanageabusiness.

∙Ageneralpartnershiphasthesamebasicadvantagesanddisadvantagesasasoleproprietorship.

∙Whenatransferofownershiptakesplace,suchaswhenapartnerwantstosellout,thepartnershipisterminated,andanewpartnershipisformed.

oTheproblemofunlimitedliabilitycanbeavoidedinalimitedpartnershipwheretheremuststillbeageneralpartnerwithunlimitedliability.

C.Corporationsarelegalentitiesauthorizedunderastatecharter.

∙Inalegalsense,itisa“person”distinctfromitsowners.

∙Theownersofacorporationareitsstockholders,orshareholders.

∙Amajoradvantageofthecorporateformofbusinessisthatstockholdershavelimitedliabilityfordebtsandotherobligationsofthecorporation.

∙Amajordisadvantageofcorporateorganizationistaxes.

oTheownersofcorporationsaresubjecttodoubletaxation—firstatthecorporatelevelandthenatthepersonallevelwhendividendsarepaidtothem.

∙Someoperateasapubliccorporation,whichcanselltheirdebtorequityinthepublicsecuritiesmarkets.

∙Othersoperateasaprivatecorporation,wherethecommonstockisoftenheldbyasmallnumberofinvestors,typicallythemanagementandwealthyprivatebackers.

D.HybridFormsofBusinessOrganization

∙Limitedliabilitypartnerships（LLPs）combinethelimitedliabilityofacorporationwiththetaxadvantageofapartnership—thereisnodoubletaxation.

∙Limitedliabilitycompanies（LLCs）

∙Professionalcorporations（PCs）

1.3ManagingtheFinancialFunction

A.TheChiefExecutiveOfficer

∙Hastheultimatemanagementresponsibilityanddecision-makingpowerinthefirm.

∙Reportsdirectlytotheboardofdirectors,whichisaccountabletothecompany’sowners.

B.TheChiefFinancialOfficer

∙HastheresponsibilityforseeingthatthebestpossiblefinancialanalysisispresentedtotheCEO,alongwithanunbiasedrecommendation.

∙TheCFO’sKeyFinancialReports

oThecontrollertypicallypreparesthefinancialstatements,overseesthefirm’sfinancialandcostaccountingsystems,preparesthetaxes,andworkscloselywiththefirm’sexternalauditors.

oThetreasurerlooksafterthecollectionanddisbursementofcash,investingexcesscashsothatitearnsinterest,raisingnewcapital,handlingforeignexchangetransactions,andoverseeingthefirm’spensionfundmanagers.

oTheinternalauditorisresponsibleforin-depthriskassessmentsandforperformingauditsofareasthathavebeenidentifiedashigh-riskareas,wherethefirmhasthepotentialtoincursubstantiallosses.

C.ExternalAuditors

∙Provideanindependentannualauditofthefirm’sfinancialstatements.

oEnsurethatthefinancialnumbersarereasonablyaccurateandthataccountingprincipleshavebeenconsistentlyappliedyeartoyearandnotinamannerthatsignificantlydistortsthefirm’sperformance.

D.TheAuditCommittee

∙Approvestheexternalauditor’sfeesandengagementletter.Theexternalauditorcannotbefiredorterminatedwithouttheauditcommittee’sapproval.

1.4TheGoaloftheFirm

A.WhatShouldManagementMaximize?

∙Minimizingriskormaximizingprofitswithoutregardtotheotherisnotasuccessfulstrategy.

B.WhyNotMaximizeProfits?

∙Toaskilledaccountant,however,adecisionthatincreasesprofitsunderonesetofaccountingrulescanreduceitunderanother.

∙Accountingprofitsarenotnecessarilythesameascashflows.

∙Theproblemwithprofitmaximizationasagoalisthatitdoesnottelluswhencashflowsaretobereceived.

∙Profitmaximizationignorestheuncertaintyorriskassociatedwithcashflows.

C.MaximizingtheValueoftheFirm’sStockPrice

∙Whenanalystsandinvestorsdeterminethevalueofafirm’sstock,theyconsider:

1.thesizeoftheexpectedcashflows,

2.thetimingofthecashflows,and

3.theriskinessofthecashflows.

∙Thus,themechanismfordeterminingstockpricesovercomesallthecash-flowobjectionsweraisedwithregardtoprofitmaximizationasagoal.

D.CanManagementDecisionsAffectStockPrices?

∙Yes,managementmakesaseriesofdecisionswhenexecutingthefirm’sstrategythataffectthefirm’scashflowsand,hence,thepriceofthefirm’sstock.

1.5AgencyConflicts:

SeparationofOwnershipandControl

A.OwnershipandControl

∙Foralargecorporation,theownershipofthefirmisspreadoverahugenumberofshareholdersandthefirm’sownersmayeffectivelyhavelittlecontrolovermanagementwheremanagementmaymakedecisionsthatbenefittheirself-interestratherthanthoseofthestockholders.

B.AgencyRelationships

∙Anagencyrelationshipariseswheneveroneparty,calledtheprincipal,hiresanotherparty,calledtheagent,toperformsomeserviceorrepresenttheprincipal’sinterest.

C.DoManagersReallyWanttoMaximizeStockPrice?

∙Shareholdersownthecorporation,butmanagerscontrolthemoneyandhavetheopportunitytouseitfortheirownbenefit.

D.AgencyCosts

∙Thecostsoftheconflictofinterestbetweenthefirm’sownersanditsmanagement.

E.AligningtheInterestsofManagementandStockholders

∙ManagementCompensation:

Asignificantportionofmanagementcompensationistiedtotheperformanceofthefirm,usuallytothefirm’sstockprice.

∙ControloftheFirm:

Iftheinterestsofthemanagerandthefirmarenotaligned,theneventuallythefirmwillunderperformrelativetoitstruepotential,andthefirm’sstockpricewillfallbelowitsmaximumpotentialprice.Withitsstockunderpriced,thefirmwillbecomeaprimetargetforatakeoverbyso-calledcorporateraidersorbyothercorporatebuyers.

∙ManagementLaborMarket

oFirmsthathaveahistoryofpoorperformanceorareputationfor“shadyoperations”orunethicalbehaviorhavedifficultyhiringtopmanagerialtalent.

oThepenaltyforextremelypoorperformanceoracriminalconvictionisasignificantreductioninthemanager’slifetimeearningspotential.Managersknowthis,andthefearofsuchconsequenceshelpskeepthemworkinghardandhonestly.

∙AnIndependentBoardofDirectors:

Regulatorsbelieveoneoftheprimaryreasonsformisalignmentbetweenboardmembers’andstockholders’interestsisthelackofboardindependence.

F.Sarbanes-Oxleyandotherregulatoryreformsinclude

∙Greaterboardindependence

∙Internalaccountingcontrols

∙Complianceprograms

∙Ethicsprogram

∙Expansionofauditcommittee’soversightpowers

1.6TheImportanceofEthicsinBusiness

A.Businessethics—asociety’sideasaboutwhatactionsarerightandwrong.

B.AreBusinessEthicsDifferent?

∙Studiessuggestthattraditionsofmoralityareveryrelevanttobusinessandtofinancialmarketsinparticular.

∙Corruptioninbusinesscreatesinefficienciesinaneconomy,inhibitsthegrowthofcapitalmarkets,andslowsacountry’srateofeconomicgrowth.

C.TypesofEthicalConflictsinBusiness

∙ConflictsofInterest—occurwhenaconflictarisesbetweenaperson’spersonalorinstitutionalgainandtheobligationtoservetheinterestofanotherparty.

∙InformationAsymmetry—occurswhenonepartyinabusinesstransactionhasinformationthatisunavailablet