The Introduction: Corporate Finance

The Scope of Corporate Finance:

The objective function of Financial Manager

There are three main issues/ decisions of a Financial Manager:

1. What the long term investments should the firm choose? (Capital Budgeting Decision)
2. How should the firm raise funds for the selected investments? (Capital Structure Decisions)
3. How should short – term assets be managed and financed?

Balance sheet model of the firm:

Total value of assets:

• Current Assets
• Fixed Assets : Tangible & Intangible

Total firms value to investors:

• Current liabilities
• Long – term debt
• Shareholder’s Equity

Capital Budgeting Decision

What the long – term investment should the firm choose? This related to  Fixed Assets (Tangible and Intangible).

Capital Structure Decision

How should the firm raise funds for the selected investments? This related to Current Liabilities, Long – Term debt and Shareholder’s Equity

The value of the firm can be though of as a pie. The goal of the manager is to increase the size of the pie. The capital structure decision can be view as how best to slice the pie. If you slice the pie affects the size of the pie, the the capital structure decisions matters.

Short – term assets management

How should short term assets be managed and financed? This related to Current Assets and Current Liabilities as Net Working Capital

The Financial Manager’s primary task is to increase the value of the firm by:

• Selecting value creating projects (Capital Budgeting Decisions)
• Making smart financing decisions (Capital Structure Decisions)

The goal of Financial Manager/Firm

There are many goals that may be adopted by the firm:

What is the correct goals?

• Maximize profit?
• Minimize cost?
• Maximize market share?
• Maximize shareholders wealth?

Agency problem in Corporation

Agency relationship

• Principal hires an agent to represent his/her interest
• Stockholders (principals) hire managers (agents) to run the company

Agency problem

• Conflict of interest between principal and agent

Why the agency problem exist?

• Managerial goals may be different from shareholders goals : expensive perquisites, survival, independence
• Increased growth and size (managerial goal) are not necessarily equivalent to increased shareholders wealth (principals)

Managing Agency Problem

• Managerial compensation : incentive can be used to align management and stockholders interests and incentive need to be structured carrefully to make sure that the achieve their intended goal
• Corporate Control: the threat of takeover may result in better management
• Other stakeholders

The Financial Markets that the Manager operates in

The firm and the Financial Market

The firm, ultimately the firm must be a cash generating activity. The cash flows from the firm must exceed the cash flows from the financial markets.

Financial Markets

• Primary Market: - issuance of a security for the first time
• Secondary Market: - Buying and selling of previously issued securities and securities may be traded either by dealer or on organized exhanges.

Closing Remarks:

• There are three main area of corporate finance: Capital Budgeting, Capital Structure and Working Capital Management
• Goal of the Financial Manager is maximization of shareholders wealth
• Agency problem exist due to separation of ownership and control
• Financial markets assist to facilitate in the flow of funds between firms and shareholders

Source: Modern Financial Management, Ross, Westerfiled, Jaffe & Jordan - 2010