Summary Corporate Finance
§1.1
Capital budgeting / capital expenditure decision: decisions to invest in tangible or intangible
assets.
Financing decisions: the form and the amount of financing a firm‟s investments.
Real assets: assets used to produce goods and services
Financial assets: financial claims to the income generated by the firm‟s real assets. Shares of stock
and other financial assets that can be purchased and traded by investors are called securities.
§1.2
Corporation: a business organized as a separate legal entity owned by stockholders. These
shareholders/stockholders are the owners of the corporation, but managers control these entities.
Therefore, the shareholders have limited liability and cannot be held personally responsible for the
corporation‟s debts. Shareholders can lose their entire investment in a corporation, but no more.
Partnerships, unlike corporations, do not have to pay income taxes and have therefore a tax
advantage. Corporations are treated like persons in society (they only do not have voting rights unlike
humans). Some business are hybrids that combine the tax advantage of a partnership with the limited
liability advantage of a corporation:
Limited partnership. Partners are classified as general or limited. General partners manage
the business and have unlimited personal liability for its debts. The limited partners are liable
only for the money they invest and do not participate in management.
Limited liability partnerships (LLPs) / Limited liability companies (LLCs). The partners all
have limited liability. A variation on this theme is the professional corporation (PC), which is
commonly used by doctors, lawyers, and accountants. In this case, the business has limited
liability, but the professionals can still be sued personally.
§1.3
Chief financial officer (CFO): sets overall financial strategy.
Treasurer: responsible for financing, cash management, and relationships with banks and other
financial institutions.
Controller: responsible for budgeting, accounting and taxes.
§1.4
There is a natural financial objective, which almost all shareholders can agree: maximize the current
market value of shareholders‟ investment in the firm. Profit maximization is not a well-defined
corporate objective. There are two reasons:
1. Maximize profits? Which year‟s profits? Shareholders will not welcome higher short-term
profits if long-term profits are damaged.
, 2. A company may be able to increase future profits by cutting this year‟s dividend and investing
the freed-up cash in the firm. That is not in the shareholder‟s best interest if the company
earns only a very low rate of return on the extra investment.
The firm can either keep and reinvest cash or return the cash to the investors. If cash is reinvested,
the opportunity cost is the expected rate of return that shareholders could have obtained by investing
in financial assets.
Opportunity cost of capital: minimum acceptable rate of return on capital investment. The
opportunity cost of capital depends on the risk of the proposed investment project. This is besides the
fact that investors are risk-averse because shareholders have to trade off risk against return when
they invest on their own.
Most established corporations can add value by building long-term relationships. The firm‟s reputation
is one of the most important assets and therefore playing fair and keeping one‟s word are simply good
business practices.
Agency problems: managers are agents for stockholders, but the managers may act in their own
interest rather than maximizing value.
Agency problems are mitigated in practice in several ways:
Legal and regulatory standards;
Compensation plans that tie the fortunes of the managers to the fortunes of the firm;
Monitoring by lenders, stock market analysts, and investors;
The threat that poorly performing managers will be fired.
Stakeholder: anyone with a financial interest in the firm.
§2.2
Money that corporation invest in real assets comes ultimately from savings by investors. But there can
be many stops on the road between savings and corporate investment. The road can be pass through
financial markets, financial intermediaries, or both. Cash retained and reinvested in the firm‟s
operations is cash saved and invested on behalf of the firm‟s shareholders.
Differences between figure 2.1 & 2.2:
1. Public corporations can draw savings from investors worldwide;
2. The savings flow through financial markets, financial intermediaries, or both.
A financial market is a market where securities are issued and traded. A security is just a traded
financial asset, such as a share of stock. For a corporation, the stock market is probably the most
important financial market. As corporations grow, their requirements for outside capital can expand
dramatically. At some point, they decide to „go public‟ by issuing shares on an organized exchange;
that first issue is called an initial public offering (IPO). The buyers of the IPO are helping to finance
, the firm‟s investment in real assets. In return, the buyers become part-owners of the firm and share in
its future success or failure.
A new issue of shares increases both the amount of cash held by the company and the number of
shares held by the public. Such an issue is known as a primary issue, and it is sold in the primary
market (market for the sale of new securities by corporations). The secondary market is the market
in which previously issued securities are traded among investors. Stock markets are also called equity
markets, since stockholders are said to own the common equity of the firm.
Debt securities as well as equities are traded in financial markets. A few corporate deb securities are
traded on the exchanges, but most of them are traded over the counter, through a network of banks
and securities dealers. Government debt is also traded over the counter. A bond is more complex than
a share of stock. A share is just a proportional ownership claim on the firm, with no definite maturity.
Bonds and other debt securities can vary in maturity, in the degree of protection or collateral offered
by the issuer, and in the level and timing of the interest payments.
Fixed-income market: market for debt securities.
Capital market: market for long-term financing.
Money market: market for short-term financing (less than 1 year).
Financial intermediary: an organization that raises money from investors and provides financing for
individuals, corporations, or other organizations. Why it is different from a manufacturing corporation?
1. It may raise money in different ways, for example, by taking deposits or selling insurance
policies.
2. It invests that money in financial assets.
Two important classes of intermediaries:
1. Mutual funds: an investment company that pools the savings of many investors and invests
in a portfolio of securities. Mutual funds offer investors low-cost diversification and
professional management. For most investors, it is more efficient to buy a mutual fund than to
assemble a diversified portfolio of stocks and bonds.
2. Hedge funds: a private investment pool, open to wealthy or institutional investors, that is only
lightly regulated and therefore can pursue more speculative policies than mutual funds. Why
they differ from mutual funds:
a. They usually follow complex, high-risk investment strategies, therefore, access is
restricted to knowledgeable investors such as pension funds, endowment funds, and
wealthy individuals.
b. Hedge funds try to attract the most talented managers by compensation them with
potentially lucrative performance-related fees. In contrast, mutual funds usually
charge a fixed percentage of assets under management.
3. Pension funds: fund set up by an employer to provide for employees‟ retirement.
