FMGT 3510 - Chapter 1 Page 1
Introduction to Corporate Finance
What is Finance?
An organizational discipline concerned with determining value and making
resource allocation decisions. These decisions are focused on the following
? Selecting long-term investments (Capital budgeting)
? Financing long-term investments (Capital structure)
? Managing everyday financial activities (Working capital management)
Key Concepts of Finance
1) Primary objective of finance: maximize the market value of the firm’s
? Our resource allocation decisions must always be made in the
context of this objective.
2) Financial markets are efficient.
? Prices quickly reflect all available information about the firm.
? If a market is efficient we should trust market prices.
3) Individuals act in their own self-interest.
? This leads to agency conflicts between different stakeholders:
o Management vs. owners
o Equity holders vs. debt holders
? Agency conflicts lead to increased costs (agency costs) for the firm.
4) The focus should be on cash flows (not accounting earnings)
? Cash flow is an unambiguous and objective measure of the
performance of the firm.
? “You cannot spend net income!”
5) Money has time value.
? “A dollar today is worth more than a dollar tomorrow”.
6) Risk and return go hand in hand.
? The required rates of return demanded by investors increase as
their exposure to risk increases.
? “There is no such thing as a free lunch!” – If you want higher
returns, you have to be prepared to take on more risk.
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Factors Influencing a Firm’s Market Value
? Financial markets
? Government rules and regulations
? Tax structure
? General business conditions
? World economy
? Many others
Strategic and policy decisions controlled by management
? Types of products or services offered
? Marketing and production systems
? Investment policies
? Amount of debt used
? Dividend policy
? Working capital policies
? Employee policies
Characteristics of cash flows
The value of a firm or an individual investment that a firm might make is a
function of the following:
1) Magnitude (amount) of expected cash flows
2) Timing of expected cash flows
3) Riskiness of expected cash flows Firm value equation
V?Firm(totalasset)value D?Marketvalueoffirm'sdebtE ? Marketvalueof firm's equity
? If V > D, everything is fine:
o Shareholders’ claim is V - D
o Debt holders’ claim is D ? If V < D, the shareholders walk away from the firm:
o Shareholders receive nothing (lose investment)
o Debt holders take over the firm
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Forms of Business Organization
Form Advantages Disadvantages
? Unlimited liability
(creditors can look to
personal assets for
payment of business Sole proprietorship:
debts). unincorporated business
owned by one individual. ? Simplest type of ? Life is limited to There is no distinction business to start owner’s lifespan. between personal and ? Little regulation and ? Limitations on the business income so all reporting required amount of capital that business income is taxed can be raised (based as personal income. on personal net worth
? Difficult to transfer
ownership of the
? Unlimited liability
(general partnership). Partnership:
unincorporated business ? Limited life of the ? Based on a relatively
owned by two or more partnership. informal agreement
owners (partners). between partners – ? Limitations on the Partners’ share of easy and inexpensive amount of capital that business income is taxed to form can be raised. as personal income. ? Difficult to transfer
a legal entity separate
and distinct from its ? More complex and ? Limited liability for the owners. Corporations costly to form. owners (owners are have many of the same ? Subject to more not responsible for the rights, duties and regulations and liabilities of the privileges of an actual ongoing reporting corporation). person (e.g. borrow requirements. money, own property, ? Easier to transfer ? Income is subject to enter into contracts, can ownership (via sale of double taxation (at the sue and be sued etc.) shares). corporate level and Business income is taxed ? Easier to raise capital. again when it is in the hands of the ? Life is not limited to distributed to corporation - owners are lifespan of owners. shareholders). not taxed on income until
it is distributed to them.
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Private vs. public corporations
? The shares of public corporations are publicly traded on stock exchanges (e.g.
TSX, NYSE) or on the “over-the-counter-market” (e.g. Nasdaq). Public
corporations are subject to stringent disclosure and reporting requirements.
They are often followed closely by financial analysts and investment advisors
and detailed information pertaining to the operations and financial health of
these companies is often widely circulated.
? The shares of private corporations are not publicly traded and are usually
owned by only a small number of shareholders. Private companies are not
subject to the same level of public scrutiny and usually very little information
is disclosed about their financial status.
Overview of the Canadian Financial System
? The purpose of the financial system: bring together demanders of funds
(spenders) and suppliers of funds (savers).
? The financial system is comprised of financial markets and financial
? A financial market provides a mechanism for creating and exchanging
financial assets. Financial assets are intangible assets that represent a claim
to future cash.
? Financial markets provide the following economic functions:
1) Determine the prices of assets traded (price discovery)
2) Offer the ability to convert an asset into cash (liquidity)
3) Reduce transaction costs
? Classification of financial markets:
? Money markets vs. capital markets:
o Money markets are where short-term debt securities are
bought and sold primarily by dealers (dealers buy or sell for
themselves at their own risk).
o Capital markets are where long-term debt and shares of
stock are sold primarily by brokers and agents (brokers
match buyers and sellers but do not take ownership of the
? Primary vs. secondary markets:
o Primary market is when the original sale of the security
occurs. The corporation or government that issues the
security receives the proceeds from the sale.
o Secondary market is when the securities are bought or sold
after the original sale. The entity that originally issued the
security is not involved in a secondary market transaction. A
strong secondary market is required in order to have a
successful primary market.
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? Financial institutions act as intermediaries between investors (suppliers of
funds) and entities that require funds.
? Advantages of financial institutions:
? Flexibility and liquidity
? Provide expertise and specialization
? Spread risk ? Examples:
? Chartered banks
? Credit unions
? Insurance companies
? Pension funds
? Investment companies
? Finance companies
? Mortgage loan companies