Fundamentals of Corporate Finance
Types of corporations:
Corporate finance: is the area of finance dealing with the sources of funding
and the capital structure of corporations and the action that managers take
to increase the value of the firm to stakeholders (anyone with a financial
interest in the firm), as well as the tools and analysis used to allocate financial
resources.
Corporate finance = about financial (investment and financing) decisions made
by corporations.
Objective of the corporation: Why not maximize profits?
Maximize the current market value of 1. A corporation may be able to
shareholders’ investment in the firm. increase current profits by
(not growth) cutting back on outlays for
maintenance or staff training,
See figure below.. but that will not add value unless
the outlays were wasteful in the
first place. Shareholders will not
welcome higher short-term
profits if long term profits are
damaged.
2. A company may be able to
increase future profits by cutting
this year’s dividend and
investing the freed-up cash in
the firm. That is not in the
shareholders’ best interest if the
company earns only a very low
rate of return on the extra
investment.
, Separation of ownership and control
When the founder or owner of the company is no longer the same person as the
manager, we call this separation of ownership and control.
When corporations grow they appoint professional managers.
Shareholders are investors (‘owners’)
Managers manage
Advantages Disadvantages
1. Professional management 1. Information-asymmetry
2. Limited liability 2. Goal incongruence (conflicting
3. Liquidity goals)
3. Double taxation (corporate and
professional)
1 and 2 are agency problems!
Financial manager
Anyone responsible for a significant investment or financing decision
1. Managing firms in cash flows (cash management) ensure that the firm
has enough cash on hand to meet its day to day obligations.
2. The choice of projects and financing of the firm
Determining which projects are attractive (investment decision)
o Tangible and/or intangible (such as R&D, software) assets
o Capital budgeting decisions long-term decision.
Determining how projects should be financed (financial decision)
o Internal: retained earnings (generate its own cash)
o External: bonds (debt) or shares (equity) (go to the market)
o Capital structure decision long-term decision, select
between debt or equity financing.
Financial market
Where securities are issued and traded.
A security is just a traded financial asset, such as a share of stock.
Primary market: Market of sale of new securities by corporations. (companies)
Secondary market: Market in which previously issued securities are traded
among investors. (people)
Function of financial markets:
1. Provide liquidity
2. Provide opportunities to invest
3. Provide risk transfer and diversification
, Accounting and finance
What information is available to determine the market value of the firm? How can
accounting information be used and what corrections are needed in the
determination of market value?
One could look at publicly available accounting information to determine
firm value.
Corporations must publish financial information according to accounting
rules.
Financial accounting provides book values.
Corporate finance needs market values.
Book value Market value
What you payed for it What you could get for it if you sold in on
the market
Value of assets or liabilities The value of assets or liabilities were
according to the balance they to be resold in a market
sheet. (market price).
Values recorded at their The present value of all future cash
historical cost adjusted for flows.
depreciation.
GAAP (General Accepted
Accounting Principles)
IFRS (International Financial
Reporting Standards)
Balance sheet
, Income
statement
Statement of
cash flows
From income to cash flow
Net income or profit (as determined by the accountant) usually does not
equal cash flows (amount of money that actually comes in or goes out of
the firm).
o Net income = revenues – costs
o Cash flow = inflows - outflows
So net income cannot be used directly to determine the value of the firm.
Differences between profit and cash flow:
1. Revenues that are not inflows: Credit sales leads to debtors.
2. Costs that are not outflows: Depreciation (of fixed assets), credit purchases
leads to creditors.
3. Outflows that are not costs: Investment in building (fixed assets).
4. Inflows that are not revenues: Loan
Free cash flows
The cash flow available for distribution to investors after the firm pays for new
investments or additions to working capital.
Types of corporations:
Corporate finance: is the area of finance dealing with the sources of funding
and the capital structure of corporations and the action that managers take
to increase the value of the firm to stakeholders (anyone with a financial
interest in the firm), as well as the tools and analysis used to allocate financial
resources.
Corporate finance = about financial (investment and financing) decisions made
by corporations.
Objective of the corporation: Why not maximize profits?
Maximize the current market value of 1. A corporation may be able to
shareholders’ investment in the firm. increase current profits by
(not growth) cutting back on outlays for
maintenance or staff training,
See figure below.. but that will not add value unless
the outlays were wasteful in the
first place. Shareholders will not
welcome higher short-term
profits if long term profits are
damaged.
2. A company may be able to
increase future profits by cutting
this year’s dividend and
investing the freed-up cash in
the firm. That is not in the
shareholders’ best interest if the
company earns only a very low
rate of return on the extra
investment.
, Separation of ownership and control
When the founder or owner of the company is no longer the same person as the
manager, we call this separation of ownership and control.
When corporations grow they appoint professional managers.
Shareholders are investors (‘owners’)
Managers manage
Advantages Disadvantages
1. Professional management 1. Information-asymmetry
2. Limited liability 2. Goal incongruence (conflicting
3. Liquidity goals)
3. Double taxation (corporate and
professional)
1 and 2 are agency problems!
Financial manager
Anyone responsible for a significant investment or financing decision
1. Managing firms in cash flows (cash management) ensure that the firm
has enough cash on hand to meet its day to day obligations.
2. The choice of projects and financing of the firm
Determining which projects are attractive (investment decision)
o Tangible and/or intangible (such as R&D, software) assets
o Capital budgeting decisions long-term decision.
Determining how projects should be financed (financial decision)
o Internal: retained earnings (generate its own cash)
o External: bonds (debt) or shares (equity) (go to the market)
o Capital structure decision long-term decision, select
between debt or equity financing.
Financial market
Where securities are issued and traded.
A security is just a traded financial asset, such as a share of stock.
Primary market: Market of sale of new securities by corporations. (companies)
Secondary market: Market in which previously issued securities are traded
among investors. (people)
Function of financial markets:
1. Provide liquidity
2. Provide opportunities to invest
3. Provide risk transfer and diversification
, Accounting and finance
What information is available to determine the market value of the firm? How can
accounting information be used and what corrections are needed in the
determination of market value?
One could look at publicly available accounting information to determine
firm value.
Corporations must publish financial information according to accounting
rules.
Financial accounting provides book values.
Corporate finance needs market values.
Book value Market value
What you payed for it What you could get for it if you sold in on
the market
Value of assets or liabilities The value of assets or liabilities were
according to the balance they to be resold in a market
sheet. (market price).
Values recorded at their The present value of all future cash
historical cost adjusted for flows.
depreciation.
GAAP (General Accepted
Accounting Principles)
IFRS (International Financial
Reporting Standards)
Balance sheet
, Income
statement
Statement of
cash flows
From income to cash flow
Net income or profit (as determined by the accountant) usually does not
equal cash flows (amount of money that actually comes in or goes out of
the firm).
o Net income = revenues – costs
o Cash flow = inflows - outflows
So net income cannot be used directly to determine the value of the firm.
Differences between profit and cash flow:
1. Revenues that are not inflows: Credit sales leads to debtors.
2. Costs that are not outflows: Depreciation (of fixed assets), credit purchases
leads to creditors.
3. Outflows that are not costs: Investment in building (fixed assets).
4. Inflows that are not revenues: Loan
Free cash flows
The cash flow available for distribution to investors after the firm pays for new
investments or additions to working capital.
