CHAPTER 1
Overview of Corporate Finance
INSTRUCTOR’S RESOURCES
Overview
Chapter 1 is an introduction to corporate finance. It introduces the student to the field of finance
and explores career opportunities in both financial services and corporate finance. There are
three basic legal forms of business organization: sole proprietorships, partnerships, and
corporations. In addition, income trusts have become an important alternative form of business
organization for publicly traded companies. An income trust is created through the conversion
of a regular corporation to a trust structure. The business then becomes a different type of legal
entity and benefits from a significant reduction in taxes.
Finance processes and procedures are important to all areas within a firm. The discipline
is closely related to both economics and accounting but the key difference between accounting
and finance is that financial managers focus on cash flows and decision making as opposed to
accrual methods and gathering and presenting data. The three key activities of the financial
manager are: performing financial analysis and planning, making investment decisions, and
making financing decisions.
The goal of the firm is to maximize shareholder wealth, rather than profits. EVA is a
measure used to determine whether the company is being managed in a way that positively
contributes to shareholders’ wealth. A triple bottom line approach helps management and the
organization focus on their financial, societal, and environmental obligations.
An important problem facing large corporations is the agency issue: the idea that
managers may put their own personal goals ahead of the goals of the organization. Corporate
governance is the set of actions and procedures used to ensure a company is managed so that
shareholders receive a return on their investment that is reasonable given the risks. There are
four approaches to corporate governance: the board of directors, management compensation
plans, the mechanism of the market, and takeovers.
ANSWERS TO REVIEW QUESTIONS
1-1 Finance is the art and science of managing money. Finance affects all individuals,
businesses, and governments in the process of the transfer of money through institutions,
markets, and instruments.
1-2 Financial markets is a branch in the study of macroeconomics. Individuals, governments,
and business organizations participate in the financial market. In financial markets, cash
moves from savers to users, and users provide a financial security in return.
1-3 Financial services is the area of finance concerned with the design and delivery of advice
and financial products to individuals, businesses, and government.
© 2008 Pearson Education Canada 1
, 1-4 Managerial finance encompasses the functions of budgeting, financial forecasting, credit
administration, investment analysis, and funds procurement for the firm. Managerial
finance is the management of the firm's funds within the firm. This field offers many
career opportunities, including financial analyst, capital budgeting analyst, and cash
manager (Note: Other answers possible).
The study of managerial finance is important regardless of the specific area of
responsibility one has within the business firm because all managers in the firm,
regardless of their job descriptions, work with financial personnel to justify manpower
requirements, negotiate operating budgets, deal with financial performance appraisals,
and sell proposals based at least in part on their financial merits.
1-5 Sole proprietorships are the most common form of business organization. Partnerships,
which account for a small percentage of all businesses, are typically larger than sole
proprietorships. Corporations are responsible for the majority of business receipts and
profits. Corporations account for the majority of business receipts and profits because
they receive certain tax advantages and can expand more easily due to access to capital
markets.
1-6 The common shareholders are the true owners, through their holdings of common shares
of a corporation. They elect the board of directors, which has the ultimate authority to
guide corporate affairs and set general policy. The board is usually composed of key
corporate personnel and outside directors. The president (CEO) reports to the board. He
or she is responsible for day-to-day operations and carrying out policies established by
the board. The owners of the corporation do not have a direct relationship with
management but give their input through the election of board members and voting on
major charter issues. The owners of the firm are compensated through the receipt of cash
dividends paid by the firm or by realizing capital gains through increases in the price of
their common stock shares.
1-7 The major disadvantage of the sole proprietorship and partnership is the unlimited
liability of the business owners. In a corporation, the owners have limited liability, which
guarantees that they cannot lose more than they invested.
1-8 An income trust is a different type of legal entity and is created through the conversion of
a regular corporation to a trust structure. The benefit is a reduction in taxes; it avoids the
double taxation problem that exists in Canada. An income trust avoids paying any tax on
profits assuming the profits are distributed to the holders of the trust (the unitholders).
Income trusts should be based on businesses that are stable, relatively mature and have a
generous and predictable cash flow. The four basic types of income trusts are resource,
business, real estate, and utility.
Advantages of income trusts include: significant tax advantages enjoyed by income trusts
and unitholders; they are attractive to individual investors due to their high yields; they
can provide an investor with stable cash flows over a long time horizon as well as
potential for capital appreciation.
© 2008 Pearson Education Canada 2
Overview of Corporate Finance
INSTRUCTOR’S RESOURCES
Overview
Chapter 1 is an introduction to corporate finance. It introduces the student to the field of finance
and explores career opportunities in both financial services and corporate finance. There are
three basic legal forms of business organization: sole proprietorships, partnerships, and
corporations. In addition, income trusts have become an important alternative form of business
organization for publicly traded companies. An income trust is created through the conversion
of a regular corporation to a trust structure. The business then becomes a different type of legal
entity and benefits from a significant reduction in taxes.
Finance processes and procedures are important to all areas within a firm. The discipline
is closely related to both economics and accounting but the key difference between accounting
and finance is that financial managers focus on cash flows and decision making as opposed to
accrual methods and gathering and presenting data. The three key activities of the financial
manager are: performing financial analysis and planning, making investment decisions, and
making financing decisions.
The goal of the firm is to maximize shareholder wealth, rather than profits. EVA is a
measure used to determine whether the company is being managed in a way that positively
contributes to shareholders’ wealth. A triple bottom line approach helps management and the
organization focus on their financial, societal, and environmental obligations.
An important problem facing large corporations is the agency issue: the idea that
managers may put their own personal goals ahead of the goals of the organization. Corporate
governance is the set of actions and procedures used to ensure a company is managed so that
shareholders receive a return on their investment that is reasonable given the risks. There are
four approaches to corporate governance: the board of directors, management compensation
plans, the mechanism of the market, and takeovers.
ANSWERS TO REVIEW QUESTIONS
1-1 Finance is the art and science of managing money. Finance affects all individuals,
businesses, and governments in the process of the transfer of money through institutions,
markets, and instruments.
1-2 Financial markets is a branch in the study of macroeconomics. Individuals, governments,
and business organizations participate in the financial market. In financial markets, cash
moves from savers to users, and users provide a financial security in return.
1-3 Financial services is the area of finance concerned with the design and delivery of advice
and financial products to individuals, businesses, and government.
© 2008 Pearson Education Canada 1
, 1-4 Managerial finance encompasses the functions of budgeting, financial forecasting, credit
administration, investment analysis, and funds procurement for the firm. Managerial
finance is the management of the firm's funds within the firm. This field offers many
career opportunities, including financial analyst, capital budgeting analyst, and cash
manager (Note: Other answers possible).
The study of managerial finance is important regardless of the specific area of
responsibility one has within the business firm because all managers in the firm,
regardless of their job descriptions, work with financial personnel to justify manpower
requirements, negotiate operating budgets, deal with financial performance appraisals,
and sell proposals based at least in part on their financial merits.
1-5 Sole proprietorships are the most common form of business organization. Partnerships,
which account for a small percentage of all businesses, are typically larger than sole
proprietorships. Corporations are responsible for the majority of business receipts and
profits. Corporations account for the majority of business receipts and profits because
they receive certain tax advantages and can expand more easily due to access to capital
markets.
1-6 The common shareholders are the true owners, through their holdings of common shares
of a corporation. They elect the board of directors, which has the ultimate authority to
guide corporate affairs and set general policy. The board is usually composed of key
corporate personnel and outside directors. The president (CEO) reports to the board. He
or she is responsible for day-to-day operations and carrying out policies established by
the board. The owners of the corporation do not have a direct relationship with
management but give their input through the election of board members and voting on
major charter issues. The owners of the firm are compensated through the receipt of cash
dividends paid by the firm or by realizing capital gains through increases in the price of
their common stock shares.
1-7 The major disadvantage of the sole proprietorship and partnership is the unlimited
liability of the business owners. In a corporation, the owners have limited liability, which
guarantees that they cannot lose more than they invested.
1-8 An income trust is a different type of legal entity and is created through the conversion of
a regular corporation to a trust structure. The benefit is a reduction in taxes; it avoids the
double taxation problem that exists in Canada. An income trust avoids paying any tax on
profits assuming the profits are distributed to the holders of the trust (the unitholders).
Income trusts should be based on businesses that are stable, relatively mature and have a
generous and predictable cash flow. The four basic types of income trusts are resource,
business, real estate, and utility.
Advantages of income trusts include: significant tax advantages enjoyed by income trusts
and unitholders; they are attractive to individual investors due to their high yields; they
can provide an investor with stable cash flows over a long time horizon as well as
potential for capital appreciation.
© 2008 Pearson Education Canada 2
