Introduction to corporate finance ch1

Introduction to
Corporate Finance
Chapter One


FIN 6301
Financial Management
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Instructor:
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Mary Chaffin
SOM 2.208
972-883-2646


Office Hours:
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Monday 4:00-6:30 p.m.
Wednesday 2:00-3:30 p.m.


Corporate Finance

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Ross, Westerfield and Jaffee, 7th Edition
www.utdallas.edu/~chaf
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Copies of the transparencies.
Solutions to end of chapter problems.
Old exams.

www.mhhe.com/rwj
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Appendix D: Using a Financial Calculator.
Review material and practice quizzes.


Grading
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Exam I
30% or 15%
Exam II
30% or 15%
Final Exam 40%
Assignments
15%
Formula sheet allowed on exams - not
quizzes.
Notice of Policy on Cheating


Other Resources
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Wall Street Journal
Barron’s
Financial Calculator


The Four Basic Areas of
Finance
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Corporate Finance
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Investments
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Interrelation on a smaller scale then money and capital
markets

Money and Capital Markets
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Broadest field
Specific to operations of a business

Workings of the financial system
Broad flow of money

International Finance


Areas of Finance

Financial Markets

Investors

The Firm
Financial
Intermediaries


Financial Calculators
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HP 10B ($30)
HP 17B II ($80)
HP 12C ($70)
HP 19B II ($100+)
TI BA II + ($30)


Financial Calculators
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HP 10B
TI BA II+
Tips on using calculator:
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Set p/y=1 (This comes set at 12 on a new
calculator)
Clear registers before each use
Set decimals to 4 places


Solution Methods
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Numerical – using regular calculator
without financial functions.
Interest Tables - end of text.
Financial Calculator – using five
specific keys which correspond to the
five most commonly used DCF
variables:
N
i
PV
PMT
FV

What is Corporate Finance?
Corporate Finance addresses the
following three questions:
1.

2.

3.

What long-term investments should the firm
engage in?
How can the firm raise the money for the
required investments?
How much short-term cash flow does a
company need to pay its bills?


Microsoft to Dole Out
Its Cash Hoard
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In an extraordinary move to shower its cash hoard
upon shareholders, Microsoft Corp. said it will make
a one-time dividend payment this year of $32 billion
and buy back up to $30 billion of the company's
stock over the next four years. The company also
said it will double the dividend it pays out annually
to $3.5 billion, or 32 cents a share.

The plans, which Microsoft valued at up to $75
billion over four years, are believed to represent the
largest corporate cash disbursement in history.
They mark a turning point for high technology's
most successful company.


Capital Structure
The value of the firm can be
thought of as a pie.
The goal of the manager is
to increase the size of the
pie.

70%50%30%
25%
DebtDebt
Equity
75%
50%
Equity

The Capital Structure
decision can be viewed as
how best to slice up a the
pie.
If how you slice the pie affects the size of the
pie, then the capital structure decision matters.

The Financial Manager
To create value, the financial manager
should:
1. Try to make smart investment
decisions.
2. Try to make smart financing
decisions.


Corporate Securities as
Contingent Claims on Total Firm
 The basic feature of a debt is that it is a
Value
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promise by the borrowing firm to repay a
fixed dollar amount of by a certain date.
The shareholder’s claim on firm value is
the residual amount that remains after
the debtholders are paid.
If the value of the firm is less than the
amount promised to the debtholders, the
shareholders get nothing.


Debt and Equity as
Payoff to
Payoff to

Contingent
Claims
debt holders
shareholders
If the value of the firm
is more than $F, debt
holders get a
maximum of $F.

If the value of the
firm is less than $F,
share holders get
nothing.

$F

$F
Value of the firm (X)

$F
Value of the firm (X)

If the value of the firm
Debt holders are promised
is more than $F, share
$F.
If the value of the firm is less than $F,
holders get everything
they get the whatever the firm if worth.
above $F.

Algebraically, the bondholder’s
Algebraically, the shareholder’s
claim is: Min[$F,$X]
claim is: Max[0,$X – $F]


Combined Payoffs to Debt and Equity
Combined Payoffs to debt holders
and shareholders

If the value of the firm is less than
$F, the shareholder’s claim is:
Max[0,$X – $F] = $0 and the debt
holder’s claim is Min[$F,$X] = $X.

The sum of these is = $X
Payoff to shareholders
$F

If the value of the firm is more than
Payoff to debt holders $F, the shareholder’s claim is:
Max[0,$X – $F] = $X – $F and the
$F
debt holder’s claim is:
Value of the firm (X)

Debt holders are promised
$F.

Min[$F,$X] = $F.

The sum of these is = $X


The Corporate Firm
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The corporate form of business is the
standard method for solving the
problems encountered in raising large
amounts of cash.
However, businesses can take other
forms.


Forms of Business
Organization
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The Sole Proprietorship
The Partnership
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General Partnership

Limited Partnership

The Corporation
Advantages and Disadvantages
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Liquidity and Marketability of Ownership
Control
Liability
Continuity of Existence
Tax Considerations


Goals of the Corporate Firm
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The traditional answer is that the
managers of the corporation are
obliged to make efforts to maximize
shareholder wealth.


The Set-of-Contracts
Perspective
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The firm can be viewed as a set of contracts.
One of these contracts is between shareholders
and managers.
The managers will usually act in the
shareholders’ interests.
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The shareholders can devise contracts that align the
incentives of the managers with the goals of the
shareholders.
The shareholders can monitor the managers behavior.

This contracting and monitoring is costly.


Managerial Goals
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Managerial goals may be different
from shareholder goals
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Expensive perquisites
Survival
Independence

Increased growth and size are not
necessarily the same thing as
increased shareholder wealth.


Do Shareholders Control
Managerial Behavior?
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Shareholders vote for the board of
directors, who in turn hire the management
team.
Contracts can be carefully constructed to
be incentive compatible.
There is a market for managerial talent—
this may provide market discipline to the
managers—they can be replaced.

If the managers fail to maximize share price,
they may be replaced in a hostile takeover.


Financial Markets
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Primary Market
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When a corporation issues securities, cash flows
from investors to the firm.
Usually an underwriter is involved

Secondary Markets
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Involve the sale of “used” securities from one
investor to another.
Securities may be exchange traded or trade overthe-counter in a dealer market.


Exchange Trading of Listed
Stocks

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Auction markets are different from
dealer markets in two ways:
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Trading in a given auction exchange takes place
at a single site on the floor of the exchange.
Transaction prices of shares are communicated
almost immediately to the public.