The Scope of Corporate Finance 1
Chapter 1: The Scope of Corporate Finance
Answers to Questions
1-1. A financial manager needs to know all five basic finance areas because they all impact his or her
job. While the manager’s primary responsibilities may be raising money or choosing investment
projects, the manager also needs to know about capital markets and debt/equity optimal levels,
and be able to manage risks of the business and governance of the corporation. Corporate
governance is a finance function because a manager wants to act in the best interest of its
shareholders. New methods of managing risk have been developed in recent years, and a
manager must be aware of these in order to maximize shareholder value.
1-2. The core principles are: (1) Time Value of Money; (2) Compensation for Risk; (3) Don’t Put
Your Eggs in One Basket (diversification); (4) Markets are Smart; and (5) No Arbitrage.
Basic Finance Function:
Financing: Raising money can involve external markets suggesting that all five core
principles are relevant as investors seek to diversify, value the security using the time
value of money, seek sufficient compensation for risk, and the stock’s price will be fairly
valued based upon smart markets with no arbitrage.
Capital Budgeting: Involves the time value of money, determining whether or not a
project is expected to offer adequate compensation for risk, and the firm perhaps seeking
to diversify.
Financial Management: As the question of the appropriate capital structure for the firm
involves the financial markets, again, the principles of no arbitrage and smart markets
come into play, as well as that of adequate risk compensation.
Corporate Governance: Again, as this can involve the financial markets in the sense
that the stockholders “grade” those who govern the corporation, the principle of smart
markets comes into play.
Risk Management: Risk management can involve diversification, or the principle of not
putting all of one’s eggs in a single basket, hedging against risk using derivatives which
involve the smart market and no arbitrage principles along with the time value of money
principle.
1-3.
Advantages of Proprietorships and Partnerships Disadvantages
Easy to form Limited life
Few regulations Unlimited liability
No corporate income taxes Hard to raise capital
Being one’s own boss
Advantages of Corporations Disadvantages
Unlimited life Double taxation
Easy to transfer ownership Costly setup
Limited liability Costly periodic reports required
Easier to raise capital
The fact that corporations have limited liability could lead to an agency conflict between
stockholders and bondholders. Stockholders (acting through managers) may be tempted to take
Chapter 1: The Scope of Corporate Finance
Answers to Questions
1-1. A financial manager needs to know all five basic finance areas because they all impact his or her
job. While the manager’s primary responsibilities may be raising money or choosing investment
projects, the manager also needs to know about capital markets and debt/equity optimal levels,
and be able to manage risks of the business and governance of the corporation. Corporate
governance is a finance function because a manager wants to act in the best interest of its
shareholders. New methods of managing risk have been developed in recent years, and a
manager must be aware of these in order to maximize shareholder value.
1-2. The core principles are: (1) Time Value of Money; (2) Compensation for Risk; (3) Don’t Put
Your Eggs in One Basket (diversification); (4) Markets are Smart; and (5) No Arbitrage.
Basic Finance Function:
Financing: Raising money can involve external markets suggesting that all five core
principles are relevant as investors seek to diversify, value the security using the time
value of money, seek sufficient compensation for risk, and the stock’s price will be fairly
valued based upon smart markets with no arbitrage.
Capital Budgeting: Involves the time value of money, determining whether or not a
project is expected to offer adequate compensation for risk, and the firm perhaps seeking
to diversify.
Financial Management: As the question of the appropriate capital structure for the firm
involves the financial markets, again, the principles of no arbitrage and smart markets
come into play, as well as that of adequate risk compensation.
Corporate Governance: Again, as this can involve the financial markets in the sense
that the stockholders “grade” those who govern the corporation, the principle of smart
markets comes into play.
Risk Management: Risk management can involve diversification, or the principle of not
putting all of one’s eggs in a single basket, hedging against risk using derivatives which
involve the smart market and no arbitrage principles along with the time value of money
principle.
1-3.
Advantages of Proprietorships and Partnerships Disadvantages
Easy to form Limited life
Few regulations Unlimited liability
No corporate income taxes Hard to raise capital
Being one’s own boss
Advantages of Corporations Disadvantages
Unlimited life Double taxation
Easy to transfer ownership Costly setup
Limited liability Costly periodic reports required
Easier to raise capital
The fact that corporations have limited liability could lead to an agency conflict between
stockholders and bondholders. Stockholders (acting through managers) may be tempted to take
