LECTURE 1

INTRODUCTION TO CORPORATE FINANCE

1-1 CORPORATE INVESTMENT AND FINANCING
DECISIONS
Real Assets
Used to produce goods and services

Financial Assets/Securities
Financial claims on income generated by firms
real assets
Capital Budgeting/Capital Expenditure
(CAPEX)
Decision to invest in tangible or intangible
assets
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1-1 CORPORATE INVESTMENT AND FINANCING
DECISIONS
Investment Decision
Purchase of real assets

Financing Decision
Sale of financial assets

Capital Structure
Choice between debt and equity financing

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1-1 CORPORATE INVESTMENT AND FINANCING
DECISIONS
Capital Budgeting Examples
Tangible Assets
i.e. Expanding stores
Intangible Assets
i.e. Research and development for new drug

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 TABLE 1.1 RECENT INVESTMENT/ FINANCING
DECISIONS
Company Recent Investment Decisions Recent Financing Decisions

Boeing (U.S.) Delivers first Dreamliner after investing a Reinvests $1.7 billion of profits.
reported $30 billion in development costs.
ExxonMobil Spends $7 billion to develop oil sands at Fort Spends $12 billion buying back shares.
(U.S.) McMurray in Alberta.
GlaxoSmith- Spends $4 billion on research and Pays $3.2 billion as dividends.
Kline (UK) development for new drugs.
LVMH (France) LVMH acquires the Italian Jeweler, Bulgari, Pays for the acquisition with a mixture of cash and
for $5 billion. shares.
Procter & Spends $8 billion on advertising. Raises 100 billion Japanese yen by an issue of 5-
Gamble (U.S.) year bonds.
Tata Motors Opens a plant in India to produce the world's Raises $400 million by the sale of new shares.
(India) cheapest car, the Nano. The facility costs
$400 million.
Union Pacific Invests $330 million in 100 new locomotives Repays $1.4 billion of debt.
(U.S.) and 10,000 freight cars and chassis.
Vale (Brazil) Opens a copper mine at Salobo in Brazil. The Maintains credit lines with its banks that allow the
project cost nearly $2 million. company to borrow at any time up to $1.6 billion.
Walmart (U.S.) Invests 12.7 billion, primarily to open 458 Issues $5 billion of long-term bonds in order to
new stores around the world. repay short-term commercial paper borrowings.
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1-1 CORPORATE INVESTMENT AND FINANCING
DECISIONS
What Is a Corporation?
Legal entity, owned by shareholders
Can make contracts, carry on business, borrow,
lend, sue, and be sued
Shareholders have limited liability and cannot
be held personally responsible for corporations
debts

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FIGURE 1.1 CASH FLOW BETWEEN FINANCIAL
MARKETS AND FIRMS OPERATIONS

(2) (1)

Firm's Financial Financial

operations manager (4a) markets

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
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1-2 THE FINANCIAL GOAL OF THE CORPORATION

Stockholders Want Three Things

To maximize current wealth
To transform wealth into most desirable time
pattern of consumption
To manage risk characteristics of chosen
consumption plan

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1-2 THE FINANCIAL GOAL OF THE CORPORATION

Profit Maximization
Not a well-defined financial objective
Which years profits?
Shareholders will not welcome higher short-term
profits if long-term profits are damaged
Company may increase future profits by
cutting years dividend, investing freed-up
cash in firm
Not in shareholders best interest if company earns
less than opportunity cost of capital
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1-2 THE FINANCIAL GOAL OF THE CORPORATION

Shareholders desire wealth maximization

Managers have many constituencies,
stakeholders
Agency Problems represent the conflict of
interest between management and owners

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1-2 THE FINANCIAL GOAL OF THE CORPORATION

The Investment Trade-off

Hurdle Rate/Cost of Capital
Minimum acceptable rate of return on
investment
Opportunity Cost of Capital
Investing in a project eliminates other
opportunities to use invested cash

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FIGURE 1.2 THE INVESTMENT TRADE-OFF

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1-2 THE FINANCIAL GOAL OF THE CORPORATION

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

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1-2 THE FINANCIAL GOAL OF THE CORPORATION

Agency ProblemsOwnership versus

Management

Difference in Different Objectives

Information Managers vs.
Stock prices and returns stockholders
Issues of shares and Top mgmt vs. operating
other securities mgmt
Dividends Stockholders vs. banks
Financing
and lenders

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1-2 THE FINANCIAL GOAL OF THE CORPORATION

Agency costs are incurred when:

Managers do not attempt to maximize firm
value
Shareholders incur costs to monitor managers
and constrain their actions

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1-2 THE FINANCIAL GOAL OF THE CORPORATION

Tools to Ensure Management Pays

Attention to the Value of the Firm
Managers actions subject to the scrutiny of
board of directors
Shirkers are likely to find they are ousted by
more energetic managers
Financial incentives provided, such as stock
options

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