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COMM 121 (16)
Chapter 1

Chapter 1

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Queen's University
COMM 121
Blair Robertson

Chapter 1: Introduction to Corporate Finance What is Corporate Finance? The Balance Sheet Model of a Firm  Fixed assets are those that last for a long period of time, like a building  Current assets are those that have short lived lives in a business  less than 1 year  Before investinf in an asset, a company must obtain financing  raise money to pay for it o This is represented in the right side of the balance sheet (i.e. liabilities and equity)  Finance can be thought of as the study of the following questions: o What long lived assets should the firm invest? Capital Budgeting describes the process of making and managing expenditures on these assets. o How can the firm raise cash for the expenditures? Capital Structure represents the proportions of the firm’s financing from current/long term debt & equity o How should short-term operating cash flows be managed? Net working capital is defined as current assets minus current liabilities Capital Structure  The individuals/institutions that buy debt from firms are called creditors; those that buy equity are called shareholders o The value of the firm=The value of the debt (bonds) + the value of equity (shares) The Financial Manager  The finance activity is usually associated with a senior officer (VP finance) and lesser officers (Treasurer and Controller) who report to the level above o Treasurer is responsible for handling cash flows, analysing capital expenditures, and making financing plans o Controller handles accounting functions (tax, financial accounting, info systems..)  Financial managers must create value from firm’s capital budgeting, financing, and liquidity activities  they create this value by: o Buying assets that generate more cash than they cost o Selling bonds, shares, etc. that raise more cash than they cost  The cash flow paid to bondholders and shareholders of the firm should be higher than the cash flows put into the firm by the bondholders ad shareholders Cash Flows between the firm and the Financial Market 1. To finance an investment, the firms sells debt and equity to the financial market 2. This cash is invested in the firm’s investment activities by management 3. The cash generated by the firm is paid to bond/shareholders 4. Some of the cash not given in interest/dividends is retained and some is paid in taxes 5. Over time, cash paid to bond/shareholders will be less than the cash raised in the financial markets and value will be created Timing of Cash Flows  An imp principle is that individuals prefer to receive cash flows earlier rather than later o One dollar today is worth more than one dollar tomorrow because I can take that dollar, invest it/earn interest, and have more tomorrow  time value of money  There is also a certain element of risk involved  the amount and timing of cash flows are not usually know with certainty – most investors have an aversion to risk Corporate Securities as Contingent Claims on Total Firm Value  Debt is a promise by the borrowing firm to repay a fixed dollar amount by a certain date o If the borrowing firm doesn’t have the cash on hand to pay back this money, it will be force to liquidate assets until the amount is reached or there is nothing left  The shareholder’s claim on the value on a firm is what remains after all debt holders have been paid o Shareholders get nothing if value of the firm the amount owed to debt holders  Debt and equity securities derive their value from the total value of the firm o i.e. they are contingent claims on the total firm value The Corporate Firm The Sole Proprietorship  Owned by one person, cheapest type of business to own, no formal charter required, few gov’t regulations, no corporate income taxes (only individual)  Have unlimited liability  business debts are their personal debts  The life of the sole proprietorship is determined by the life of the sole proprietor  Hard to raise money  equity is limited the owner’s personal wealth The Partnership  In a general partnership all partners agree to provide some fraction of work and cash to share the profits/losses  each partner is responsible for the debts of the other partner  Limited partnerships permit the liability of some partners to be limited to the amount they have invested  must be at least one general partner  Partnerships are inexpensive and easy to form (some documents may be required)  General partnerships is end once a partner dies/leaves  difficult to transfer ownership  Difficult for the partnership to raise cash  limited to their personal wealth  Income is taxed as personal income to the partners; mgmt. control resides in partners The Corporation  Starting a corp. is more complicated: Need name, business purpose, number of shares the business is authorized to issue, rights granted to shareholders, # of members in BoD  Corporations are separate legal entities apart from the owners  offer limited liability  Looks after interests of the shareholders, the Board of Directors, and top management Advantages of Separation of Ownership from Management 1. Ownership can be readily transferred through the use of shares 2. The corporation has an unlimited life since the corporation and its mgmt. are separate 3. The shareholder’s liability is limited to the amount invested into the ownership shares 4. BIG DISADVANTAGE: Federal and provincial gov’ts tax corporate income, dividends received by shareholders are also taxed The Income Trust  This is a non-corporate form of a business  Business income trusts hold the debt and equity of and underlying business and distribute the income generated to unitholders  Since they are not corporations, they used to not have to pay corporate taxes o Companies would transfer from corp. to trust to avoid these taxes o They get taxed at the same rate now Goals of the Corporate Firm  The traditional answers is that man
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