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Summary Corporate Finance
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Chapter 1 – Introduction to Corporate Finance1.1 Corporate Finance and the Financial Manager
The accounting function of a firm takes all the financial information and data that arises as a result of ongoing
business activities, and presents this in ways that allow management to assess the performance and risk of
their firm and make informed decisions on future corporate activity.
The finance function of a firm is related to these three questions:
1. What long-term investments should you make?
2. Where will you get the long-term financing to pay for your investment?
3. How will you manage your everyday financial activities?
The process of planning and managing a firm’s long-term investments is called capital budgeting. In capital
budgeting the financial manager tries to identify investment opportunities that are worth more to the firm
than they cost to acquire.
→ The value of the cash flow generated by an asset exceeds the cost of that asset.
Evaluating the size, timing and risk of future cash flows is the essence of capital budgeting.
A firm’s capital structure is the specific mixture of long-term debt and equity the firm uses to finance its
operations.
Two concerns:
1. How much should the firm borrow?
2. What are the least expensive sources of funds for the firm?
The term working capital refers to a firm’s short-term assets. Managing the firm’s working capital is a day-to-
day activity which ensures that the firm has sufficient resources to continue its operations and avoid costly
interruptions.
1.2 The Goal of Financial Management
The main goal of financial management is to make money or add value for the owners. The goals of financial
management fall into two classes:
1. Profitability
2. Controlling risk
The financial manager acts in the shareholders’ best interests by making decisions that increase the value of
the equity. The appropriate goal for the financial manager can thus be stated as:
The goal of financial management is to maximize the current value per share of the existing equity.
For a corporation with non-tradable equity, the goal is: maximize the market value of the existing owners’
equity.
1.3 Financial Markets and the Corporation
The primary advantage of financial markets is that they facilitate the flow of money from those that have
surplus cash to those that need financing.
,Figure 1.2 shows the interplay between the corporation and the financial markets. Suppose that we start with
the firm selling shares of equity and borrowing money to raise cash. Cash flows to the firm from the financial
markets (A). The firm invests the cash in assets (B). These can be short term (current) or long term (non-
current), and they generate cash (C), some of which goes to pay corporate taxes (D). After taxes are paid, some
of this cash flow is reinvested in the firm (E). The rest goes back to the financial market as cash paid to creditors
and shareholders (F).
The term primary market refers to the original sale of securities by governments and corporations. The
secondary markets are those in which these securities are bought and sold after the original sale.
In a primary market transaction the corporation is the seller, and the transaction raises money for the
corporation. Corporations engage in two types of primary market transaction:
• Public offerings: selling securities to the general public.
• Private placements: a negotiated sale involving a specific buyer.
By law, public offering of debt and equity must be registered with the securities regulator in the country where
the offerings are made. This requires the firm to disclose a great deal of information before selling any
securities.
A secondary market transaction involves one owner or creditor selling to another. Therefore the secondary
market provide the means for transferring ownership of corporate securities. Although a corporation is directly
involved only in a primary market transaction, the secondary markets are still critical to large corporations:
investors are much more willing to purchase securities in a primary market when they know that those
securities can later be resold if desired.
There are two kinds of secondary market:
• Auction markets: agents match buyers and sellers, but they do not actually own the commodity that is
bought or sold.
• Dealer markets: dealers buy and sell for themselves, at their own risk.
Dealer markets in equities and long-term debt are called over-the-counter (OTC) markets.
Auction markets differ from dealer markets in two ways:
1. An auction market or exchange has a physical location.
2. In a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an
auction market is to match those who wish to sell with those who wish to buy.
Securities that trade on an organized exchange are said to be listed on that exchanges. To be listed, firms must
meet certain minimum criteria concerning, for example, asset size and number of shareholders.
,Chapter 2 – Corporate Governance
2.1 Forms of Business Organization
A sole proprietorship is a business owned by one person. This is the simplest type of business to start, and is
the least regulated form of organization. The owner of a sole proprietorship keeps all the profits. The owner
also has unlimited liability of business debts. This means that creditors can look beyond business assets to the
proprietor’s personal assets for payment. Similarly, there is no distinction between personal and business
income, so all business income is taxed as personal income.
The life of a sole proprietorship is limited to the owner’s lifespan, and the amount of equity that can be raised
is limited to the amount of the proprietor’s personal wealth.
A partnership is similar to a proprietorship except that there are two or more owners (partners). In a general
partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts,
not just some particular share. The way partnership gains are divided is described in the partnership
agreement.
In a limited partnership one or more general partners will run the business and have unlimited liability, but
there will be one or more limited partners who will not actively participate in the business. A limited partner’s
liability for business debts is limited to the amount that the partner contributes to the partnership.
The primary disadvantages of sole proprietorships and partnerships as forms of business organization are:
1. Unlimited liability for business debts on the part of the owners.
2. Limited life of the business.
3. Difficulty of transferring ownership.
These disadvantages add up to a single, central problem: the ability of such businesses to grow can be seriously
limited by an inability to raise cash for investment.
The corporation is the most important form of business organization in the word. A corporation is a legal
‘person’ separate and distinct from its owners, and it has many of the rights, duties and privileges of an actual
person. Forming a corporation involves preparing articles of incorporation and a memorandum of association.
Several advantages:
• Ownership can be readily transferred, and the life of the corporation is therefore not limited.
• The corporation borrows money in its own name, so the shareholders in a corporation have limited
liability for corporate debts.
• Relative ease of transferring ownership
• Superior for raising cash
The corporate form has a significant disadvantage: because a corporation is a legal person, it must pay taxes.
Money paid out to the shareholders in the form of dividends is taxed again as income to those shareholders
→ Double taxation: corporate profits are taxed twice.
2.2 The Agency Problem and Control of the Corporation
The relationships between shareholders and management is called a type I agency relationship. Such a
relationship exists whenever someone (the principal) hires another (the agent) to represent his or her
interests. When there is a possibility there may be a conflict of interest, this is called type I agency problem.
Example:
Imagine that the firm is considering a new investment. The new investment is expected to impact favorably on
the share value, but it is also a relatively risky venture. The owners of the firm will wish to make the
investment, but the management may not, because there is the possibility that things will turn out badly, and
management jobs will be lost. If management do not make the investment, then the shareholders may lose a
valuable opportunity.
, The term agency costs refers to the cost of the conflict of interest between shareholders and management. It is
a lost opportunity.
Direct agency costs come in two forms:
• A corporate expenditure that benefits management but costs the shareholders.
• An expense that comes from the need to monitor management actions.
Management may tend to overemphasize organizational survival to protect job security. Also, management
may dislike outside interference, so independence and corporate self-sufficiency may be important goals.
Whether managers will, in fact, act in the best interests of shareholders depends on two factors:
1. How closely are management goals aligned with shareholders goals?
2. Can managers be replaced if they do not pursue shareholder goals?
Management will frequently have a significant economic incentive to increase share value, for two reasons:
1. Managerial compensation is usually tied to financial performance in general, and often to share value
in particular.
2. Better performers within the firm will tend to get promoted. More generally, managers who are
successful in pursuing shareholder goals will be in greater demand in the labor market, and thus
command higher salaries.
Control of the firm ultimately rests with shareholders. They elect the board of directors, who in turn hire and
fire managers.
The conceptual structure of the corporation assumes that shareholders elect directors, who in turn hire
managers to carry out their directives. Shareholders therefore control the corporation through the right to
elect the directors.
The effect of cumulative voting is to permit minority participation. If cumulative voting is permitted, the total
number of votes that each shareholder may cast is determined first. This is usually calculated as the number of
shares multiplied by the number of directors to be elected.
With straight voting the directors are elected one at a time. It is all or nothing and each share has one vote.
Staggering has two basic effects:
1. Staggering makes it more difficult for a minority to elect a director when there is cumulative voting,
because there are fewer directors to be elected at one time.
2. Staggering makes takeover attempts less likely to be successful, because it makes it more difficult to
vote in a majority of new directors.
A proxy is the grant of authority by a shareholder to someone else to vote his or her shares.
Some firms have more than one class of ordinary equity. Often the classes are created with unequal voting
rights. A primary reason for creating dual or multiple classes of equity has to do with control of the firm.
Shareholders usually have the following rights:
1. The right to share proportionally in dividends paid.
2. The right to share proportionally in assets remaining after liabilities have been paid in a liquidation.
3. The right to vote on shareholder matters of great importance.
In addition, shareholders sometimes have the right to share proportionally in any new equity sold: pre-emptive
right. A pre-emptive right means that a company that wishes to sell equity must first offer it to the existing
shareholders before offering it to the general public.
→ To give shareholders the opportunity to protect their proportionate ownership in the corporation.
Dividends paid to shareholders represent a return on the capital directly or indirectly contributed to the
corporation by shareholders. The payment of dividends is at the discretion of the board of directors.
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