Chapter 1 Introduction to Corporate Finance
1.1 What is Corporate Finance?
Corporate finance is the study of the relationship between business decisions
and the value of the shares in the business. It has three main areas of concern:
Capital budgeting: What long-term investments should the firm take? (left
side balance sheet)
Capital structure: Where will the firm get the long-term financing to pay for its
investments? Also, what mixture of debt and equity should it use to fun
operations? (right side balance sheet) The value (V) of the firm in the financial
markets is the market value of the debt (D) and the market value of the
equity (E) added together.
Working capital management: How should the firm manage its everyday
financial activities? Net working capital is equal to current assets minus
current liabilities. From a financial perspective, short-term cash flow problems
come from the mismatching of cash inflows and outflows.
The goal of financial management in a for-profit business is to make decisions
that increase the value of the shares, or, more generally, increase the market
value of the equity. They should either buy assets that generate more cash than
they cost, or sell bonds, shares and other financial instruments that raise more
cash than they cost. Over time, if the cash paid to shareholders and bondholders
is greater than the cash raised in the financial market, value will be created.
Opposed to accounting, corporate finance is interested in the cash flows and only
recognises them when they are actually performed, not when they will be
performed in the future. In finance, individuals prefer to receive cash flows
earlier rather than later, because it will be more worth in the future.
1.2 The Goal of Financial Management
The goal of financial management is to maximise the value of a company’s
equity shares. Shareholders are entitled to what is left after employees, suppliers
and creditors are paid their due. Thus, by maximising the value of shares,
everyone is winning within the company.
In case businesses don’t recognise shares, the goal can be adjusted to
maximising the market value of the existing owners’ equity. The total value of
the shares in a corporation is simply equal to the value of the owner’s equity.
1.3 Financial Markets
Financial markets are composed of the money markets and the capital markets.
Money markets are the markets for debt securities that will pay off in the short
term (usually less than one year). Within the money markets, a lot of loosely
connected groups exist they are dealer markets. Dealers acquire the securities,
opposed to agents, who are hired for commission. Therefore, agents do not bear
inventory risk. The markets for long-term debt (with a maturity of over one year)
and for equity shares, are the capital markets.
The financial markets can be classified further as the primary market and
secondary market. The primary market is used when governments and public
corporations initially sell securities. Corporations engage in two types of primary
market sales of debt and equity: public offerings and private placements. A
secondary market transaction involves one owner or creditor selling to another,
it therefore provides the means for transferring ownership of corporate securities.
There are two kinds of secondary markets: dealer markets and auction markets.
Dealers buy and sell for themselves, at their own risk. Dealer markets in equities
,and long-term debt are called over-the-counter markets. Auction markets, in
contrast, have a physical location and most of the buying and selling is done by
the dealer. Dealers play only a limited role.
1.4 Corporate Finance in Action: The Case of Google
Google was a success, not only because of its fantastic concept, but it
understood the fundamental basis of good business and corporate finance.
, Chapter 2 Corporate Governance
2.1 The Corporate Firm
There are three basic legal forms of organising firms, and we see how firms go
about the task of raising large amounts of money under each form.
Sole proprietorship = A business owned by one person. At year-end, all the
profits and losses will
belong to the owner and this becomes his or her annual
income. Factors:
The sole proprietorship is the cheapest business to form;
A sole proprietorship pays no corporate income taxes;
Unlimited liability for business debts and obligations: no
distinction is made between personal and business assets
(e.g. own possessions to pay);
The life of the sole proprietorship is limited by the life of
the owner;
The cash that can be raised by the sole proprietor is
limited to the proprietor’s own personal wealth.
Partnership = A business owned by two or more people. In a general
partnership, all partners
agree to provide some fraction of the work and cash, share
the profits and
losses of the firm. Limited partnerships permit the liability of
some of the
partners to be limited to the amount of cash each has
contributed to the
partnership. At least one partner is a general partner, the rest
does not have to
participate in managing the business. Factors:
Inexpensive and easy to form;
If one partner fails to meet his or her commitment, the
other general partners must made up for this;
The general partnership is terminated when a general
partner dies or withdraws. Ownership can be transferred
when all general partners agree;
It is difficult for a partnership to raise large amounts of
cash;
Income from a partnership is taxed as personal income to
the partners;
Management control resides with the general partners. On
important matters, a majority votes.
Thus, an advantage of the first two forms is low start-up costs. However, later,
unlimited liability, limited life of the enterprise and difficulty of transferring
ownership lead to difficulty in raising cash.
Corporation = A distinct legal entity; it has a name and enjoys many of
the legal powers of
natural persons. Corporations can acquire and exchange
property, can enter
contracts and may sue and be sued.
1.1 What is Corporate Finance?
Corporate finance is the study of the relationship between business decisions
and the value of the shares in the business. It has three main areas of concern:
Capital budgeting: What long-term investments should the firm take? (left
side balance sheet)
Capital structure: Where will the firm get the long-term financing to pay for its
investments? Also, what mixture of debt and equity should it use to fun
operations? (right side balance sheet) The value (V) of the firm in the financial
markets is the market value of the debt (D) and the market value of the
equity (E) added together.
Working capital management: How should the firm manage its everyday
financial activities? Net working capital is equal to current assets minus
current liabilities. From a financial perspective, short-term cash flow problems
come from the mismatching of cash inflows and outflows.
The goal of financial management in a for-profit business is to make decisions
that increase the value of the shares, or, more generally, increase the market
value of the equity. They should either buy assets that generate more cash than
they cost, or sell bonds, shares and other financial instruments that raise more
cash than they cost. Over time, if the cash paid to shareholders and bondholders
is greater than the cash raised in the financial market, value will be created.
Opposed to accounting, corporate finance is interested in the cash flows and only
recognises them when they are actually performed, not when they will be
performed in the future. In finance, individuals prefer to receive cash flows
earlier rather than later, because it will be more worth in the future.
1.2 The Goal of Financial Management
The goal of financial management is to maximise the value of a company’s
equity shares. Shareholders are entitled to what is left after employees, suppliers
and creditors are paid their due. Thus, by maximising the value of shares,
everyone is winning within the company.
In case businesses don’t recognise shares, the goal can be adjusted to
maximising the market value of the existing owners’ equity. The total value of
the shares in a corporation is simply equal to the value of the owner’s equity.
1.3 Financial Markets
Financial markets are composed of the money markets and the capital markets.
Money markets are the markets for debt securities that will pay off in the short
term (usually less than one year). Within the money markets, a lot of loosely
connected groups exist they are dealer markets. Dealers acquire the securities,
opposed to agents, who are hired for commission. Therefore, agents do not bear
inventory risk. The markets for long-term debt (with a maturity of over one year)
and for equity shares, are the capital markets.
The financial markets can be classified further as the primary market and
secondary market. The primary market is used when governments and public
corporations initially sell securities. Corporations engage in two types of primary
market sales of debt and equity: public offerings and private placements. A
secondary market transaction involves one owner or creditor selling to another,
it therefore provides the means for transferring ownership of corporate securities.
There are two kinds of secondary markets: dealer markets and auction markets.
Dealers buy and sell for themselves, at their own risk. Dealer markets in equities
,and long-term debt are called over-the-counter markets. Auction markets, in
contrast, have a physical location and most of the buying and selling is done by
the dealer. Dealers play only a limited role.
1.4 Corporate Finance in Action: The Case of Google
Google was a success, not only because of its fantastic concept, but it
understood the fundamental basis of good business and corporate finance.
, Chapter 2 Corporate Governance
2.1 The Corporate Firm
There are three basic legal forms of organising firms, and we see how firms go
about the task of raising large amounts of money under each form.
Sole proprietorship = A business owned by one person. At year-end, all the
profits and losses will
belong to the owner and this becomes his or her annual
income. Factors:
The sole proprietorship is the cheapest business to form;
A sole proprietorship pays no corporate income taxes;
Unlimited liability for business debts and obligations: no
distinction is made between personal and business assets
(e.g. own possessions to pay);
The life of the sole proprietorship is limited by the life of
the owner;
The cash that can be raised by the sole proprietor is
limited to the proprietor’s own personal wealth.
Partnership = A business owned by two or more people. In a general
partnership, all partners
agree to provide some fraction of the work and cash, share
the profits and
losses of the firm. Limited partnerships permit the liability of
some of the
partners to be limited to the amount of cash each has
contributed to the
partnership. At least one partner is a general partner, the rest
does not have to
participate in managing the business. Factors:
Inexpensive and easy to form;
If one partner fails to meet his or her commitment, the
other general partners must made up for this;
The general partnership is terminated when a general
partner dies or withdraws. Ownership can be transferred
when all general partners agree;
It is difficult for a partnership to raise large amounts of
cash;
Income from a partnership is taxed as personal income to
the partners;
Management control resides with the general partners. On
important matters, a majority votes.
Thus, an advantage of the first two forms is low start-up costs. However, later,
unlimited liability, limited life of the enterprise and difficulty of transferring
ownership lead to difficulty in raising cash.
Corporation = A distinct legal entity; it has a name and enjoys many of
the legal powers of
natural persons. Corporations can acquire and exchange
property, can enter
contracts and may sue and be sued.
