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Chapter 1

FIN 300 Chapter Notes - Chapter 1: Limited Liability, Agency Cost, Corporate Finance

Course Code
FIN 300
Michael Inglis

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Finance 300
Chapter 1 - Notes
What is Corporate Finance?
1. What long-term investment should you take on?
-What lines of business? What sorts of buildings, machinery, equipment,
research and development facilities will you need?
2. Where will you get the long-term financing to pay for your investment?
-Will you bring in other owner or borrow the money?
3. How will you manage day to day financial activities?
-Collecting from clients and paying clients/suppliers
The Finance Manager
-Striking feature of large corporations - owners(shareholders) are usually not
directly involved in making business decisions. Financial Managers are hired
in their position (they answer the 3 questions above)
-Financial Management reports to the CFO -> COO -> CEO
Capital Budgeting: The process of planning and managing a firm’s
investment in long-term assets.
-In capital budgeting, the financial manager tries to identify investment
opportunities that are worth more to the firm than they will cost to acquire.
-The value of the cash flow generated by an asset exceeds the cost of that
-For example, for a restaurant chain like Tim Hortons, deciding whether or
not to open stores would be a major capital budgeting decision. Some
decisions, such as what type of computer system to buy, might not depend
so much on a particular line of business.
-Financial managers must be concerned not only with how much cash they
expect to receive but also with when they expect to receive it and how likely
they are to receive it. Evaluating the size, timing, and risk of future cash
flows is the essence of capital budgeting.
Capital Structure: The mix of debt and equity maintained by a firm.
-The financial manager has two concerns in this area; First - How much
should the firm borrow; that is, what mixture is best? The mixture chosen
affects both the risk and value of the firm. Second, what are the latest
expensive sources of funds for the firm?
-What percentage of the firm’s cash flow goes to the creditors and what
percentage goes to shareholders? Management has a great deal of flexibility
in choosing a firm’s financial structure.
-Besides deciding on the financing mix, the financial manager has to decide
exactly how and where to raise the money. The expenses associated with
raising long-term financing can be considerable, so different possibilities
must be carefully evaluated.

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Working Capital Management: Planning and managing the firm’s current
assets and liabilities.
-Working capital refers to short-term assets (inventory) and its short-term
liabilities (money owed to suppliers).
-This involves a number of activities, all related to the firm’s receipt and
disbursement of cash
Forms of Business Organization
Sole Proprietorship: A business owned by a single individual
-Simplest and is the least regulated form of organization
-Negatives: the owner has unlimited liability for business debts; meaning
that creditors can look beyond assets to the proprietor’s personal assets for
Partnership: A business formed by two or more CO-owners.
-In a general partnership all the partners share in gains and losses, and all
have unlimited liability for all partnership debts, not just some particular
-General partners have unlimited liability for partnerships debts, and the
partnership concludes when a general partner wishes to sell out or dies. All
income is taxed as a personal income to the partners, and the amount of
equity that can be raised is limited to the partner’s combined wealth.
-In a limited partnership, one or more general partners have unlimited
liability and runs the business for one or more limited partners who don’t
actively participate in the business.
-The primary disadvantages of sole proprietorship and partnership as forms
of business organization are (1) unlimited liability for business debts on the
part of the owners, (2) limited life of the business, and (3) difficulty of
transferring ownership.
Corporation: A business created as a distinct legal entity owned by one or
more individuals or entities.
-Corporations can borrow money and won property, can sue and be sued,
and can enter into contracts.
-Advantages: Ownership (represented by shares of stock) can be readily
transferred, and the life of the corporation is therefore not limited. - Are the
reasons why the corporate form is superior when it comes to raising cash
-While limited liability makes the corporate form attractive to equity
investors, lenders sometimes view the limited liability feature as a
disadvantage. If the borrower experiences financial distress and is unable to
repay its debt, limited liability blocks lenders’ access to the owners’ personal
- The corporate form has a significant disadvantage because a corporation is
a legal entity, it must pay taxes.

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Income Trust:
-Starting in 2001, the income trust, a non-corporate form of business
organization, grew in importance in Canada. Business income trusts (also
called income funds) hold the debt and the equity of an underlying business
and distribute the income generated to unit holders - their income is typically
taxed only in the hands of unit holders.
-Investors have viewed trusts as tax-efficient and have been generally
willing to pay more for a company after it has converted from a corporation
to a trust - this advantaged disappeared on Halloween 2006
*Table 1.1 - Summary of the Notes Above
The Goal of Financial Management is to make money or add value for the
Possible Goals:
1. Survive in Business
2. Avoid financial distress and bankruptcy
3. Beat the competition
4. Maximize sales or market share
5. Minimize costs
6. Maximize profits
7. Maintain steady earnings growth
-The goals above are all different, they fall into two classes. The first of these
relates to profitability. The goals involving sales, market share, and cost
control all related, at least potentially, to different ways of earning or
increasing profits.
-The second groups, involving bankruptcy avoidance, stability, and safety,
relate in some way to controlling risk.
The Goal of Financial Management
What is a good financial management decision?
-Good decisions increase the value of the stock; goal is to maximize the
current value per share of existing stock.
-Shareholders are entitled to what is left after employees, suppliers, and
creditors are paid their due. If any of these go unpaid, the shareholders get
nothing. If the shareholders are winning in the sense that the leftover portion
is growing, it must mean that everyone else is winning also.
-To make the market value of the stock a valid measure of financial decisions
requires an efficient capital market. In an efficient capital market, security
prices fully reflect available information. The market sets the stock price to
give the firm an accurate report card on its decisions.
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