CHAPTER 1 Introduction to Corporate Finance

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CHAPTER 1Introduction to Corporate Finance

• What is finance?
• Book, market, and intrinsic values
• Forms of business organizations
• Financial goals of the corporation
• Separation of ownership and control
• Risk and investor attitudes toward risk

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Introduction to Finance?

• A foremost concept in finance concerns how
  individuals interact in order to allocate
  resources (capital) and/or shift consumption
  across time by borrowing or investing.
• If you receive 1 million today then what
  decision would you make regarding consumption and
  investment?
• Suppose you spend (consume) 100,000 now.
• This leaves you with 900,000. You can postpone
  consumption to future time periods by investing
  the 900,000 today.
• On the other hand, what if you have 20,000 but
  need to consume 30,000. You can borrow the
  10,000 and pay it back in a future period along
  with the interest.

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Two examples of common corporate financial
decisions

• A firm must spend 100 million for the required
  assets if a proposed project is approved.
  Important issues are
• Should the project be accepted or rejected? What
  do investors demand as a (minimum acceptable)
  project rate of return?
• What are the projects forecasted future cash
  flows? How risky are these forecasted cash
  flows?
• Where will the 100 million come from, i.e., what
  mix of equity and debt financing should be used?
• If a firm has 200 million of cash flow, but
  needs reinvest 120 million, what should be done
  with the remaining 80 million of cash.
• Pay it out as a dividend or repurchase some stock?

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Example of common investments type financial
decisions

• A mutual fund manager that manages a fund with
  10 billion portfolio receives an additional 100
  million in cash from new investors.
• Which stocks or bonds to purchase?
• How will any proposed new investments affect the
  expected return and risk of the overall
  portfolio?

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Forms of business organization

• Sole proprietorship
• Partnership
• Corporation
• Most large firms are organized as corporations.
• Advantages unlimited life, easy transfer of
  ownership (stock), limited liability for owners,
  relative ease of raising capital, and can use
  stock for acquisitions
• Disadvantages Double taxation of earnings, cost
  of set-up and report filing, and issues relating
  to the separation of ownership and control
• Hybrid forms Limited Liability Corporations
  (LLC), S Corporations, etc., firms having
  characteristics of the three forms above.

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Book versus Market values

• The book value of an asset is determined based on
  accounting rules.
• The book value is at best a rough approximation
  of the assets replacement cost.
• The market value of an asset is that investors
  are willing to pay today for stocks and bonds in
  order to receive a risky stream of future
  expected cash flows.
• Market values are forward looking.
• Stocks and bonds represent claims on the future
  cash flows that a firms assets generate.

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Book versus market values

• Market value of a firm

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Book versus market values

• The Book value of a firm often contrasts sharply
  with the Market value.

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Book versus market values a hypothetical example

• A firm begins with 2000 of debt and 4000 of
  equity in order to purchase 6000 of assets.
  These become the original accounting book values.
• In contrast, Market values are based on todays
  expectations of future performance, i.e., what
  cash amounts are expected to be paid out and the
  perception of risk. Assume the following
• Investors are willing to pay 2000 for the bonds.
• Investors are willing to pay 10,000 for the
  equity.

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Book versus market values for the hypothetical
example

• Book values of firm
• Market values of firm

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Intrinsic (fundamental) values

• Market values are what investors are willing to
  either buy or sell an asset for, based on
  investors expectations of future performance.
• Market values are very often publicly observed,
  e.g., the transactions in the stock markets.
• In contrast, intrinsic values are usually
  considered as private estimates of what
  something, e.g., a common stock, is actually
  worth.
• Intrinsic value is not something that you can
  prove.
• If ten analysts are asked to value IBM stock,
  then there will likely be ten different intrinsic
  value estimates!

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Intrinsic (fundamental) values

• Assume that a New York Stock Exchange listed firm
  has an equity market value of 10 billion.
• However, those that manage the firm (insiders)
  believe the firm is actually worth 12 billion
  (intrinsic value), based on their private or
  inside forecasts of future cash flow performance.
• For the most part, market prices are driven by
  public expectations and consensus, while
  intrinsic values represent private forecasts.

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Financial goals of the corporation

• The primary financial goal is shareholder wealth
  maximization a function of future cash flow and
  risk.
• In reality, this is maximizing intrinsic value
• For now we will assume that this is synonymous
  with maximizing the market value, i.e., stock
  price maximization.
• Warren Buffett states that his goal is to
  maximize Berkshire Hathaways intrinsic value,
  and hopefully, the stocks market value will be
  close to the intrinsic value.

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Stock price maximization is NOT profit or
earnings maximization?

• Market (and intrinsic) values are driven by risk
  and expectatons (forecasts) of future cash flows.
• Earnings and other accounting profitability
  measures are not cash flows and have limited use
  in estimating financial values.
• Some actions may cause an increase in reported
  earnings, yet cause the stock price to decrease
  (and vice versa).

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Wealth maximization and societal welfare

• Is the general welfare of society advanced when
  individual agents pursue wealth maximization?
• Is intrinsic or market value maximization good or
  bad for society. Should firms behave ethically?
• The following slide contains a quote is from Adam
  Smiths Inquiry into the Nature and Causes of the
  Wealth of Nations, 1776.
• Adam Smith believed that an economic system in
  which individual agents strive to increase their
  market value results in the most efficient level
  of general welfare, as it facilitates the
  allocation of resources to their most productive
  use.

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Wealth maximization and societal welfare (Adam
Smith, 1776)

• As every individual, endeavours as much as he
  can both to employ his capital in the industry,
  and to direct that industry that its produce may
  be of the greatest value, every individual
  necessarily labours to render the annual revenue
  of the society as great as he can. In doing so
  he generally, indeed, neither intends to promote
  the public interest, nor knows how much he is
  promoting it. By directing that industry in such
  a manner as its produce may be of the greatest
  value, he intends only his own gain, and he is in
  this, as in many other cases, led by an invisible
  hand to promote an end which was no part of his
  intention. Thus, by pursuing his own interest he
  frequently promotes that of the society more
  effectually than when he really intends to
  promote it. I have never known much good done by
  those who pretended to trade for the public good.

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Agency relationships the separation of
ownership and control

• An agency relationship exists whenever a
  principal (owner of a resource) hires an agent to
  act on their behalf. Examples are
• Citizen (principal) and elected official (agent)
• Stockholder (principal) and corporate manager
  (agent)
• Within a corporation, agency relationships exist
  between
• Shareholders and managers
• Shareholders and creditors

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Shareholders versus Managers

• Managers are naturally inclined to act in their
  own best interests.
• But the following factors affect managerial
  behavior
• Managerial compensation plans
• Direct intervention by shareholders
• The threat of firing
• The threat of corporate takeover

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Shareholders versus Creditors

• Shareholders (through managers) could take
  actions to maximize stock price that are
  detrimental to creditors, i.e., actions that
  result in a wealth transfer from creditors to
  stockholders.
• In the long run, such actions will raise the cost
  of debt and ultimately lower the stock price. We
  return to this issue in Chapter 16.

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Factors that affect stock prices

• As implied in earlier slides, stock prices are a
  function of
• Projected cash flows to shareholders
• Timing of the cash flow stream
• Riskiness of the cash flows
• The basic financial valuation model on the next
  slide will be addressed in detail in Chapters 4
  and 5 of the textbook.

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Basic financial valuation model

• To estimate any assets value, one must estimate
  the cash flow for each period t (CFt), the life
  of the asset (n), and the appropriate discount
  rate or cost of capital (k), based on the level
  of estimated risk.
• Throughout this course, we discuss how to
  estimate the models inputs and how financial
  management is used to improve them and thus
  maximize a firms value.

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Factors that affect the level and riskiness of
future cash flows

• Decisions made by financial managers
• Investment decisions, i.e., decisions concerning
  the firms assets.
• Financing decisions the combination of debt and
  equity financing used to finance the assets.
• The external environment
• Capital markets
• Industry and economic events

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Understanding risk and investor attitudes toward
risk

• The following two slides illustrate two possible
  investments that can be made today. The payoff
  of each will occur exactly one year from today.
  Investment 1 costs 100 today. The current cost
  of Investment 2 is not given.
• Assume that one of three possible states of the
  macroeconomy will prevail next year. Today, we
  can only assign probabilities to these future
  economic states.
• Good economy, probability of 30
• Average economy, probability of 40
• Bad economy, probability of 30
• Probabilities must sum up to 100.

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Investment 1, an apparently riskless investment

• Investment 1 next years payoff is identical
  (all result in 110) in each future economic
  state.

110
Good economy, probability30
Average economy, probability40
Investment costs 100 today
110
Bad economy, probability30
110
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Investment 2, an apparently risky investment

• Investment 2 next years payoff varies with
  future state of the economy.

130
Good economy, probability30
Average economy, probability40
110
Todays cost ?
Bad economy, probability30
90
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Summarizing riskless Investment 1 and risky
Investment 2

• Investment 1 costs 100 today and has a certain
  110 payoff in any economic state next year. It
  thus currently offers a riskless one year
  investment return of 10
• Investment 2, on the other hand, offers a risky
  payoff next year. However, a glance at the
  payoff pattern does reveal that the expected
  payoff is 110.
• Now, if riskless Investment 1 costs 100 today,
  then what would you be willing to pay today for
  risky Investment 2, given that each both
  investments offer an expected payoff of 110 next
  year?

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Summarizing riskless Investment 1 and risky
Investment 2

• Most individuals are averse to risk and would pay
  less than 100 for Investment 2, e.g., 85, 90,
  or 95, etc.
• Most risk averse individuals will accept risk,
  but only if they expect to earn a higher return
  than what they can already make on the riskless
  investment.
• The only way for Investment 2 to offer expected
  return greater than 10 is to pay less than 100
  today for Investment 2.
• Practical example Any corporations common
  stock is more risky that its bonds (and also U.S.
  Treasury bonds). Investors therefore expect to
  earn a higher return on the corporations common
  stock.