Summary - Principles of Corporate Finance Part 1: Value
1 Introduction to Corporate Finance
Corporations invest in real assets ( = reële activa), which generate income.
Real assets:
a. Tangible: for example plants and machinery
b. Intangible: for example brand names and patents
Corporations finance their investments in different ways:
a. By borrowing
b. By retaining and reinvesting cash flow
c. By selling additional shares of stock to corporation’s shareholders
What investments should the corporation make? – involves spending money
How should it pay for those investments? – involves raising money
Shareholders usually want the financial manager to increase the value of the corporation
and its current stock price.
- The secret of success in financial management is to increase value.
- Financial managers increase value whenever the corporation earns a higher return
than shareholders can earn for themselves.
- The shareholder’s investment opportunities outside the corporation set the standard
for investments inside the corporation.
- Financial managers, therefore, refer to the opportunity cost of the capital
contributed by shareholders.
- Thoughtful shareholders do not want the maximum possible stock price, they want
maximum honest stock price.
Corporations must combine governance rules and procedures with appropriate incentives to
make sure that all managers and employees pull together to increase value.
1.1 Corporate Investment & Financing Decisions
To carry on business, a corporation needs an almost endless variety of real assets. The
corporation pays for its real assets by selling claims on them and on the cash flow that they
will generate. These claims are called financial assets or securities.
Investment decision = purchase of real assets
Financing decision = sale of securities and other financial assets
Investment decisions are often referred to as capital budgeting or capital expenditure
(CAPEX) decisions because most large corporations prepare an annual capital budget listing
the major projects approved for investment.
Investments build know-how, brand recognition, and reputation for the long run.
, A corporation can raise money from lenders or from shareholders
a. If it borrows, the lenders contribute the cash, and the corporation promises to pay
back the debt plus a fixed rate of interest.
b. If the shareholders put up the cash, they do not get a fixed return, but they hold
shares of stock and therefore get a fraction of future profits and cash flow. The
shareholders are equity investors, who contribute equity financing.
The choice between debt and equity financing is called the capital structure decision. Capital
refers to the firm’s sources of long-term financing.
Corporations raise equity financing in two ways:
1. They can issue new shares of stock. The investors who buy the new shares put up
cash in exchange for a fraction of the corporation’s future cash flow and profits.
2. The corporation can take the cash flow generated by its existing assets and reinvest
that cash in new assets. In this case the corporation is reinventing on behalf of
existing stockholders. No new shares are issued.
If a corporation does not reinvest all of the cash flow generated by its existing assets, it may
hold the cash in reserve for future investment, or it may pay the cash back to its
stockholders. The decision to pay dividends or repurchase shares is called the payout
decision.
Financing decisions may not add much value, compared with good investment decisions, but
they can destroy value if they are stupid or if they are ambushed by bad news.
Business is inherently risky. The financial manager needs to identify the risks and make sure
they are managed properly.
A corporation is a legal entity. In the view of law, it is a legal person that is owned by its
shareholders. As a legal person, the corporation can make contracts, carry on a business,
borrow or lend money, and sue ( = aanklagen) or be sued. One corporation can make a
takeover bid for another and then merge the two businesses. A corporation’s directors are
selected by the shareholders. A corporation is owned by its shareholders but is legally
distinct from them. Therefore the shareholders have limited liability, which means that they
cannot be held personally responsible for the corporation’s debt. Shareholders can lose their
entire investment in a corporation, but no more.
When a corporation is first established, its shares may be privately held by a small
group of investors, such as the company’s managers and a few backers. In this case,
the shares are not publicly traded and the company is closely held.
When a firm grows and new shares are issued to raise additional capital, its shares
are traded in public markets. These corporations are known as public companies.
A large public corporation may have hundreds of thousands of shareholders, who own the
business but cannot possibly manage or control it directly. This separation of ownership and
control gives corporations permanence.
The separation of ownership and control can also have a downside, for it can open the door
for managers and directors to act in their own interest rather than in the stockholder’s
interest.
1 Introduction to Corporate Finance
Corporations invest in real assets ( = reële activa), which generate income.
Real assets:
a. Tangible: for example plants and machinery
b. Intangible: for example brand names and patents
Corporations finance their investments in different ways:
a. By borrowing
b. By retaining and reinvesting cash flow
c. By selling additional shares of stock to corporation’s shareholders
What investments should the corporation make? – involves spending money
How should it pay for those investments? – involves raising money
Shareholders usually want the financial manager to increase the value of the corporation
and its current stock price.
- The secret of success in financial management is to increase value.
- Financial managers increase value whenever the corporation earns a higher return
than shareholders can earn for themselves.
- The shareholder’s investment opportunities outside the corporation set the standard
for investments inside the corporation.
- Financial managers, therefore, refer to the opportunity cost of the capital
contributed by shareholders.
- Thoughtful shareholders do not want the maximum possible stock price, they want
maximum honest stock price.
Corporations must combine governance rules and procedures with appropriate incentives to
make sure that all managers and employees pull together to increase value.
1.1 Corporate Investment & Financing Decisions
To carry on business, a corporation needs an almost endless variety of real assets. The
corporation pays for its real assets by selling claims on them and on the cash flow that they
will generate. These claims are called financial assets or securities.
Investment decision = purchase of real assets
Financing decision = sale of securities and other financial assets
Investment decisions are often referred to as capital budgeting or capital expenditure
(CAPEX) decisions because most large corporations prepare an annual capital budget listing
the major projects approved for investment.
Investments build know-how, brand recognition, and reputation for the long run.
, A corporation can raise money from lenders or from shareholders
a. If it borrows, the lenders contribute the cash, and the corporation promises to pay
back the debt plus a fixed rate of interest.
b. If the shareholders put up the cash, they do not get a fixed return, but they hold
shares of stock and therefore get a fraction of future profits and cash flow. The
shareholders are equity investors, who contribute equity financing.
The choice between debt and equity financing is called the capital structure decision. Capital
refers to the firm’s sources of long-term financing.
Corporations raise equity financing in two ways:
1. They can issue new shares of stock. The investors who buy the new shares put up
cash in exchange for a fraction of the corporation’s future cash flow and profits.
2. The corporation can take the cash flow generated by its existing assets and reinvest
that cash in new assets. In this case the corporation is reinventing on behalf of
existing stockholders. No new shares are issued.
If a corporation does not reinvest all of the cash flow generated by its existing assets, it may
hold the cash in reserve for future investment, or it may pay the cash back to its
stockholders. The decision to pay dividends or repurchase shares is called the payout
decision.
Financing decisions may not add much value, compared with good investment decisions, but
they can destroy value if they are stupid or if they are ambushed by bad news.
Business is inherently risky. The financial manager needs to identify the risks and make sure
they are managed properly.
A corporation is a legal entity. In the view of law, it is a legal person that is owned by its
shareholders. As a legal person, the corporation can make contracts, carry on a business,
borrow or lend money, and sue ( = aanklagen) or be sued. One corporation can make a
takeover bid for another and then merge the two businesses. A corporation’s directors are
selected by the shareholders. A corporation is owned by its shareholders but is legally
distinct from them. Therefore the shareholders have limited liability, which means that they
cannot be held personally responsible for the corporation’s debt. Shareholders can lose their
entire investment in a corporation, but no more.
When a corporation is first established, its shares may be privately held by a small
group of investors, such as the company’s managers and a few backers. In this case,
the shares are not publicly traded and the company is closely held.
When a firm grows and new shares are issued to raise additional capital, its shares
are traded in public markets. These corporations are known as public companies.
A large public corporation may have hundreds of thousands of shareholders, who own the
business but cannot possibly manage or control it directly. This separation of ownership and
control gives corporations permanence.
The separation of ownership and control can also have a downside, for it can open the door
for managers and directors to act in their own interest rather than in the stockholder’s
interest.
