Corporate Finance

Lecture 01: Introduction

Course Info

Guangyu Nie
Office: SIBA 402
Email: nie.guangyu@mail.shufe.edu.cn
Office Hours: Wednesday, 3:00 4:00 p.m.

Course Info
Prerequisites: basic level math and statistics
Calculator: any calculator with will do.
Textbook: Ross, Westerfield, Jaffee: Corporate

Finance, 10th. ed., ISBN 0077511387 / 9780077511388.

Scores:

Class Participation (20%).

Final Exam (80%)

What is Corporate Finance?

Corporate Finance addresses the following two questions:

1.
2.
3.

What investments should the firm engage in?

How can the firm raise the money for the required investments?
How much short-term cash flow does a company need to pay its
bills?

The Balance-Sheet Model of the

Firm
Total Value of Assets:

Total Firm Value to Investors:

Current Assets

Fixed Assets
1 Tangible
2 Intangible

Shareholders
Equity

The Balance-Sheet Model of the

Firm
The Capital Budgeting Decision

Current
Liabilities

Current Assets

Long-Term
Debt

What longterm
investments
should the
firm engage
in?

Shareholders
Equity

The Balance-Sheet Model of the

Firm
The Capital Structure Decision
Current Assets

How can the firm

raise the money
for the required
Fixed Assets
investments?
1 Tangible
2 Intangible

Current
Liabilities
Long-Term
Debt

Shareholders
Equity

The Balance-Sheet Model of the

Firm
The Net Working Capital Investment Decision

Current Assets

Fixed Assets
1 Tangible
2 Intangible

Current
Liabilities
Net
Working
Capital

How much shortterm cash flow

does a company
need to pay its
bills?

Long-Term
Debt

Shareholders
Equity

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 up 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.

The Financial Manager

To create value, the financial manager
should:

1.Try to make smart investment

decisions.

2.Try to make smart financing decisions.

The Firm and the Financial Markets

Firm

Firm issues securities (A)

Invests
in assets
(B)

Retained
cash flows (D)
Short-term debt
Cash flow
from firm (C)

Dividends and
debt payments (F)
Taxes (E)

Current assets
Fixed assets

Financial
markets

Ultimately, the firm

must be a cash
generating activity.

Government

Long-term debt
Equity shares

The cash flows from

the firm must exceed
the cash flows from
the financial markets.

Accounting Profits v.s. Cash

Flow
Example 1: The Midland Company refines and trades

gold. At the end of the year, it sold 2,500 ounces of gold

for $1 million. The company had acquired the gold for
$900,000 at the beginning of the year. The company paid
cash for the gold when it was purchased. Unfortunately it
has yet to collect from the customer to whom the gold was
sold.

Accounting Profits v.s. Cash

Flow

Cash Flow Timing

Example 2: Evaluate two projects, A and B, with the same
initial cost, $10,000.

Risk of Cash Flows

Example 3: Evaluate two projects in Europe and in Japan
with the same initial investment:

Corporate Securities as Contingent Claims

on Total Firm Value

The basic feature of a debt is that it is a promise by the

borrowing firm to repay a fixed dollar amount by a certain

date.

The shareholders claim on firm value is the residual amount

that remains after the debtholders are paid.

If the value of the firm is less than the amount promised to

the debtholders, the shareholders get nothing.

Debt and Equity as Contingent

ClaimsPayoff to
Payoff to
debt holders
If the value of the firm
is more than $F, debt
holders get a
maximum of $F.
$F

$F
Value of the firm (X)

shareholders
If the value of the
firm is less than $F,
share holders get
nothing.

$F
Value of the firm (X)

If the value of the firm

Debt holders are promised
is more than $F, share
$F.
If the value of the firm is less than $F,
holders get everything
they get whatever the firm is worth.
above $F.
Algebraically, the bondholders
Algebraically, the shareholders
claim is: Min[$F,$X]
claim is: Max[0,$X $F]

Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders
and shareholders

If the value of the firm is less than

$F, the shareholders claim is:
Max[0,$X $F] = $0 and the debt
holders claim is Min[$F,$X] = $X.

The sum of these is = $X

Payoff to shareholders
$F

If the value of the firm is more than

Payoff to debt holders $F, the shareholders claim is:
Max[0,$X $F] = $X $F and the
$F
debt holders claim is:
Value of the firm (X)

Debt holders are promised

$F.

Min[$F,$X] = $F.
The sum of these is = $X

Forms of Business Organization

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.

Forms of Business Organization

The Sole Proprietorship

The Partnership

General Partnership
Limited Partnership

The Corporation

Advantages and Disadvantages

The Limited Liability company (LLC).

Liquidity and Marketability of Ownership

Control
Liability
Continuity of Existence
Tax Considerations

A Comparison of Partnership and

Corporations
Corporation

Partnership

Liquidity

Shares can easily be

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 with dividend tax

credit

Partnership income is
taxable.

Reinvestment

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

Goals of the Corporate Firm

What are firm decision-makers hired to do?

The traditional answer is that the managers of the

corporation are obliged to make efforts to maximize

shareholder wealth.

Goals of the Corporate Firm

POSSIBLE
GOALS
Survive.

Avoid financial distress and bankruptcy.

Beat the competition.
Maximize sales or market share.
Minimize costs.
Maximize profits.
Maintain steady earnings growth.

Goals of the Corporate Firm

For listed companies, the goal of financial management is

to maximize the current value per share of the existing
stock.

Managerial Goals
Managerial goals may be different from shareholder goals

Expensive perquisites, a jet, etc.

Secure the job.
Independence

Increased growth and size are not necessarily the same

thing as increased shareholder wealth.

Separation of Ownership and

Control
Board of Directors

Equity

Shareholders

Assets

Debt

Debtholders

Management

The Agency Problem

The agency relationship
Will managers work in the shareholders best
interests?
Agency costs
Direct agency costs
Indirect agency costs

Control of the firm

How do agency costs affect firm value (and
shareholder wealth)?

Do Shareholders Control Managerial

Behaviour?

Shareholders vote for the board of directors, who in turn hire

the management team.

Contracts can be carefully constructed to be incentive

compatible.

There is a market for managerial talentthis may provide

market discipline to the managersthey can be replaced.

If the managers fail to maximize share price, they may be

replaced in a hostile takeover / proxy fight.

Financial Institutions, Financial Markets,

and the Corporation
Financial Institutions
Indirect finance
Funds
suppliers

Deposits

Financial
intermediaries

Loans

Funds
demanders

Direct finance
Funds
suppliers

Financial
intermediaries

Funds
demanders

Financial Markets
Money versus Capital Markets
Money Markets
For short-term debt instruments
Capital Markets
For long-term debt and equity

Financial Markets
Primary versus Secondary Markets
Primary Market
When a corporation issues securities, cash flows
from investors to the firm.
Usually an underwriter is involved

Secondary Markets
Involve the sale of used securities from one
investor to another.
Securities may be exchange traded or trade overthe-counter in a dealer market.

Financial Markets

Firms

Stocks and
Bonds
Money

Investors
Bob

securities

Sue

money
Primary Market
Secondary
Market