Chapter 1 Introduction to Corporate Finance
Corporate Investment and Financing Decisions
The five themes that recur throughout the book:
1. Corporate finance is all about maximizing value.
2. The opportunity cost of capital sets the standard for investment decisions.
3. A safe dollar is worth more than a risky dollar.
4. Smart investment decisions create more value than smart financing decisions.
5. Good governance (= wijze van besturen) matters.
Opportunity costs = the potential benefits an individual, investor or business misses out on
when choosing one alternative over another.
Real assets = physical assets that have intrinsic worth due to their substance and properties
(metals, commodities).
Financial assets / securities = claims on the real assets and the cash flow they will generate
within a company; corporations sell these to finance their needed real assets (bank loans,
stocks); securities can be traded between investors (shares, stocks, bonds).
Bond = fixed income instrument that represents a loan made by an investor to a borrower; it
is a security because it can be traded between investors.
Dividend = the distribution of some of the company’s earnings to a class of its shareholders,
as determined by the company’s board of directors.
Investing decision = purchase of real assets (by corporation); what investment?
Financing decision = sale of financial assets (by corporation); how do we pay for the
investment?
Investment Decisions
Capital budgeting / capital expenditure (CAPEX) = investment decisions of corporations
annually in the capital budging list of projects that are approved for investment.
The longer a corporation has to wait for a cash flow back of their investment (such as
building a new nuclear plant), the greater the cash inflow required to justify the investment.
Financing Decisions
Examples of financing decisions: raising money from lenders (fixed return) or shareholders
(stocks), meeting obligations to banks, bondholders and stockholders (paying money).
Capital structure decision = the choice between debt (loan) and equity financing (stocks).
Equity financing = when a corporation raises money by selling shares; two ways: 1. issue new
shares of stock and sell them, 2. reinvest the cash flow generated by existing assets in new
assets this happens on behalf of existing shareholders.
Payout decision = the decision to pay dividends or repurchase shares.
, What is a corporation?
Corporation = a legal entity that is owned by shareholders; in the US they are formed under
state law, based on articles of incorporation that set out the purpose of the corporation and
how it is to be governed; shareholders have limited liability risk of losing their investment.
Closely held companies = owned by a hand full of shareholders.
Public companies = a lot of shareholders; stocks are traded; there is a separation between
ownership and control over the company (therefore shares can be traded); separation
between ownership and control can lead to the managers and directors acting in their own
interest rather that the shareholders’.
Disadvantages of being a corporation: the cost of managing the legal machinery, taxed
separately.
Other Forms of Business Organization for Smaller Businesses
Partnership = solution for a bigger business that doesn’t want to be a corporation; partners
face unlimited liability; tax advantage.
Limited partnership = tax advantage of a partnership + limited liability of a corporation;
general partners have unlimited liability, limited partners have limited liability.
Limited liability partnerships (LLP’s) = all partners have limited liability.
Professional corporation (PC) = limited liability, but the professionals can still be sued
personally for example, for malpractice (doctors, lawyers, accountants).
The Role of The Financial Manager
Figure 1 One of the roles of a financial manager, where he stands between the firm and outside investors
The Financial Goal of the Corporation
Shareholders Want Managers to Maximize Market Value
Shareholders agree on the financial objective to maximize the current market value of the
investment of the shareholders in the firm. The shareholders are okay with risky projects,
given that the expected profits more than enough to offset the risk. If the firm gets too risky
for their taste, they will shift their portfolio in a less risky direction (with US government
bonds for example).
A Fundamental Result
The only way a financial manager can help the shareholders is by increasing their wealth,
which means increasing the market value of the firm. The shareholders can achieve their
desired pattern of consumption and manage the risk of their portfolio with access to
competitive financial markets, by selling their owned shares at certain times.
Corporate Investment and Financing Decisions
The five themes that recur throughout the book:
1. Corporate finance is all about maximizing value.
2. The opportunity cost of capital sets the standard for investment decisions.
3. A safe dollar is worth more than a risky dollar.
4. Smart investment decisions create more value than smart financing decisions.
5. Good governance (= wijze van besturen) matters.
Opportunity costs = the potential benefits an individual, investor or business misses out on
when choosing one alternative over another.
Real assets = physical assets that have intrinsic worth due to their substance and properties
(metals, commodities).
Financial assets / securities = claims on the real assets and the cash flow they will generate
within a company; corporations sell these to finance their needed real assets (bank loans,
stocks); securities can be traded between investors (shares, stocks, bonds).
Bond = fixed income instrument that represents a loan made by an investor to a borrower; it
is a security because it can be traded between investors.
Dividend = the distribution of some of the company’s earnings to a class of its shareholders,
as determined by the company’s board of directors.
Investing decision = purchase of real assets (by corporation); what investment?
Financing decision = sale of financial assets (by corporation); how do we pay for the
investment?
Investment Decisions
Capital budgeting / capital expenditure (CAPEX) = investment decisions of corporations
annually in the capital budging list of projects that are approved for investment.
The longer a corporation has to wait for a cash flow back of their investment (such as
building a new nuclear plant), the greater the cash inflow required to justify the investment.
Financing Decisions
Examples of financing decisions: raising money from lenders (fixed return) or shareholders
(stocks), meeting obligations to banks, bondholders and stockholders (paying money).
Capital structure decision = the choice between debt (loan) and equity financing (stocks).
Equity financing = when a corporation raises money by selling shares; two ways: 1. issue new
shares of stock and sell them, 2. reinvest the cash flow generated by existing assets in new
assets this happens on behalf of existing shareholders.
Payout decision = the decision to pay dividends or repurchase shares.
, What is a corporation?
Corporation = a legal entity that is owned by shareholders; in the US they are formed under
state law, based on articles of incorporation that set out the purpose of the corporation and
how it is to be governed; shareholders have limited liability risk of losing their investment.
Closely held companies = owned by a hand full of shareholders.
Public companies = a lot of shareholders; stocks are traded; there is a separation between
ownership and control over the company (therefore shares can be traded); separation
between ownership and control can lead to the managers and directors acting in their own
interest rather that the shareholders’.
Disadvantages of being a corporation: the cost of managing the legal machinery, taxed
separately.
Other Forms of Business Organization for Smaller Businesses
Partnership = solution for a bigger business that doesn’t want to be a corporation; partners
face unlimited liability; tax advantage.
Limited partnership = tax advantage of a partnership + limited liability of a corporation;
general partners have unlimited liability, limited partners have limited liability.
Limited liability partnerships (LLP’s) = all partners have limited liability.
Professional corporation (PC) = limited liability, but the professionals can still be sued
personally for example, for malpractice (doctors, lawyers, accountants).
The Role of The Financial Manager
Figure 1 One of the roles of a financial manager, where he stands between the firm and outside investors
The Financial Goal of the Corporation
Shareholders Want Managers to Maximize Market Value
Shareholders agree on the financial objective to maximize the current market value of the
investment of the shareholders in the firm. The shareholders are okay with risky projects,
given that the expected profits more than enough to offset the risk. If the firm gets too risky
for their taste, they will shift their portfolio in a less risky direction (with US government
bonds for example).
A Fundamental Result
The only way a financial manager can help the shareholders is by increasing their wealth,
which means increasing the market value of the firm. The shareholders can achieve their
desired pattern of consumption and manage the risk of their portfolio with access to
competitive financial markets, by selling their owned shares at certain times.
