The Scope Of Corporate Finance

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Chapter 1
The Scope Of Corporate Finance
Professor Megginson FIN 5043/BAD 5283
Spring 2007
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What is Corporate Finance?

• The activities involved in managing cash flows in
  a business environment

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The Core Principles of Finance

• The time value of money
• The opportunity to earn a return on invested
  funds means that a dollar today is worth more
  than a dollar in the future.
• Compensation for risk
• Investors expect compensation for bearing risk.

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The Core Principles of Finance

• Dont put your eggs in one basket
• Investors can achieve a more favorable trade-off
  between risk and return by diversifying their
  portfolios.
• Markets are smart
• Competition for information tends to make markets
  efficient.
• No arbitrage
• Arbitrage opportunities are extremely scarce.

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The 5 Basic Corporate Finance Functions
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The Financing Function

• Businesses can raise money in 2 ways
• externally from investors or creditors
• IPOs
• Primary market transactions
• Secondary market transactions
• internally by retaining operating cash flows
• Most common method

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Raising Capital Key Facts
Most financing from internal rather than external
sources
Most external financing is debt
Primary vs. secondary market transactions or
offerings
Financial intermediaries declining as a source of
capital for large firms
Securities markets growing in importance
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Global Security Issues 1990-2006 (Bn)
Global debt equity
U.S. Issuers worldwide
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Number And Value Of Worldwide Security Issues In
2005
1 Totals do not include sovereign debt
offerings. Source Investment Dealers Digest,
early January 2006
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World Stock Market Capitalization, 1983-July 2006
(US Billions)
Sources World Bank, World Federation
of Exchanges
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Growth of World Stock Market Trading Volume,
1983-2006
Annualized, based on January-July 2006 data.
Source World Federation of Exchanges
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The Capital Budgeting Function
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The Capital Budgeting Function

• The capital budgeting process consists of three
  steps.
• Step 1 - identifying potential investments
• Step 2 - analyzing those investments to identify
  which will create shareholder value
• Step 3 - implementing and monitoring the
  investments selected in step 2

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The Financial Management Function
Managing daily cash inflows and outflows
Forecasting cash balances
Building a long-term financial plan
Choosing the right mix of debt and equity
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The Corporate Governance Function

• Hires and promotes qualified, honest people, and
  structures employees financial incentives to
  motivate them to maximize firm value
• In practice the incentives of stockholders,
  managers, and other stakeholders often conflict.
• Dimensions of corporate governance
• Board of directors
• Securities and Exchange Commission
• Sarbanes-Oxley Act of 2002

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Global Mergers And Acquisitions, 1991-2006 (US
Billions)
Source Investment Dealers Digest, early January
editions, 1990-2007
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The Risk Management Function

• Identifying, measuring, and managing all types of
  risk exposures
• Some risks are insurable, and some risks can be
  reduced through diversification.
• Financial instruments like forwards, futures,
  options, and swaps may also be used to hedge
  market risks such as interest-rate, price, and
  currency fluctuations.

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Forms Of Business Organization In The U.S.
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Business Organizational Formsin the United States

• Shareholders are taxed as partners while still
  retaining Limited Liability as Corporate
  Shareholders
• Status is Subject to Several Eligibility
  Requirements

S Corporations
Limited- Liability Companies

• Combines the Partnerships Pass-Through Taxation
  with the S Corporations Limited Liability

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The Double Taxation of Dividends
Taxation of Business Income Corporations vs
Partnerships(Corporate Tax Rate (tc) 0.35
Personal Tax Rate (tp) 0.38)
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The Tax Relief Act of 2003
Dividends are treated as capital gains, dividend
tax rate 0.15 Corporate Tax Rate (tc) 0.35
Personal Tax Rate (tp) 0.35
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Forms of Business OrganizationsUsed by Non-U.S.
Companies
Limited-Liability Companies

• Britain public limited companies (PLC)
• Germany Aktiengesellschaft (AG)
• France Société Générale
• Spain, Mexico, and elsewhere in Latin America
  Sociedad Anónima

State-Owned Enterprises

• Historically, the telephone, television, utility,
  airline and railroad companies in many European
  countries
• Privatization programs have reduced the role of
  the states around the world

How much has been raised through Privatization
Programs?
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Worldwide Revenues From Privatizations, 1988-2005
(US Bn)
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What Should a Financial Manager Try to Maximize?

• Maximize Profit?
• Earnings per share are backward-looking,
  dependent on accounting principles,
• Do not fully consider cash flow timing
• Ignores risk
• Maximize Shareholder Wealth?
• Maximize stock price, not profits
• Shareholders, as residual claimants, have better
  incentives to maximize firm value.
  

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Agency Costs

• Managers act as agents of the owners who hired
  them and gave them decision-making authority to
  manage the firm for the owners benefit.
• In practice however, self-interests may cause
  managers to pursue objectives other than
  shareholder-wealth maximization.
• This conflict of goals gives rise to managerial
  agency problems.

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How Agency Costs Can Be Controlled
Ways to deal with agency costs

• Takeovers
• Monitoring and bonding costs
• Compensation contracts
• Controversial method executive compensation
• Average pay in 2005 for CEOs of 500 largest US
  firms 10.9 million (Source Forbes, April 20,
  2006)

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Importance of Ethics

• Widespread publicity surrounding numerous ethical
  violations began with the Enron collapse in late
  2001.
• Society in general and the financial community in
  particular are developing and enforcing ethical
  standards.
• Ethical behavior is necessary in order to
  maximize shareholders wealth.