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Chapter 1

FIN 300 - Chapter 1 Notes.docx

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FIN 300
Mike Inglis

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FIN 300 – Chapter 1: Introduction to Corporate Finance 1.1 Corporate Finance and the Financial Manager What is Corporate Finance?  Most large corporations centralize their finance function and use it to measure performance in other areas. The Financial Manager  Shareholders are usually not directly involved in making business decisions. o Managers are hired to represent shareholder’s interest. Financial Management Decisions  Capital Budgeting – The process of planning and managing a firm’s investment in long-term assets. o Financial manager identifies investment opportunities that are worth more to the form than they will cost to acquire. (value of the cash flow generated by an asset exceeds the cost of the asset) o Evaluating the size, timing, and risk of future cash flows is the essence of CB.  Capital Structure (Financial Structure) – The mix of debt and equity maintained by a firm. o Great deal of flexibility in choosing financial structure. o Determining where to borrow money, how much, and in what mix – manger’s job.  Working capital Management – Planning and managing the firm’s current assets and liabilities. o Working capital refers to firm’s short-term assets (inventory, payment to suppliers).  Managing is a day-to-day activity that ensures the firm has sufficient resources to continue its operations. 1.2 Forms of Business Organizations Sole Proprietorship  Sole Proprietorship – A business owned by a single individual. o Simplest type of business to start and the least regulated. o Keep all the profits, but have unlimited liability.  Creditors can look beyond assets to personal assets for payment. o All business income is taxed as personal income Partnership  Partnership – A business formed by two or more co-owners. o General Partnership – all partners share gains/losses, and all have unlimited liability.  Division of gains/losses described in partnership agreement. o Limited Partnership – general partners run business for limited partners.  General has unlimited liability whereas limited has liability for only the amount that is contributed to the partnership. Corporation  Corporation – A business created as a distinct legal entity owned by one or more individuals or entities. o To start a business, the preparation of the articles of incorporation (or a charter) is required.  Must include corporations name, intended life, purpose, number of shares issued. o Shareholders and management are separate groups in corporations. o Ownership can be readily transferred in form of shares of stock.  Shareholders have limited liability. o Double taxation is occurred as taxes of the corporation and also dividend tax. Income Trust  An income trust is a non-corporate form of business organization.  Business income trusts (also called income funds) hold the debt and equity of an underlying business and distribute the income generated to unit holders. o Since they are not corporations, they are not subject to corporate income tax.  Investors view trusts as tax-efficient and have been showing more interest for organizations with this form of business.  In 2006, the government accounted to tax trusts like corporations by 2011. o Many trusts are reverting to corporations in 2011. 1.3 The Goal of Financial Management Possible Goals  Surviving in business, beating competition, maximizing sales/market share, minimizing costs, etc., are possible financial goals.  Profit maximization is the most cited goal.  All goals usually fall into two categories; first is profitability and second is controlling risk. o Profitability – involves sales, market share, and cost control. All are related in ways of earning or increasing profits. o Controlling Risk – involves bankruptcy avoidance, stability, and safety.  Contradictory goals because pursuit of profit usually involves some element of risk. It is not really possible to maximize both safety and profit. The Goal of Financial Management  Goal: The goal of financial management is to maximize the current value per share of existing stock.  Corporate finance is the study of the relationship between business decisions and the value of stock in the business.  To make the market value of the stock a valid measure of financial decisions requires an efficient capital market. o In a efficient capital market,  Security prices fully reflect available information.  Market sets the stock price to give the firm an accurate report card on its decisions. A More General Goal  The goal of maximizing stock does not take into account of privately owned business and no traded stock companies.  To create a general goal, the value of stock in a corporation is equal to the value of the owner’s equity. o General Goal: To maximize the market value of the owners’ equity. 1.4 The Agency Problem & Control of the Corporation Agency Relationships  Agency Relationship – the relationship between shareholders and management. o Someone (the principal) hires another (the agent) to represent his/her interests.  Agency Problem – The possibility of conflicts of interest between the shareholders and management of a firm. Management Goals  Agency Cost – The cost of the conflict of interests between shareholders and management. o Can be indirect or direct.  Indirect is a lost opportunity o Ex. Management might not take risky ventures because of the fear of losing jobs if investment goes bad, however, shareholders might want to take risk as stock price rises.  Management might try to overemphasize organizational survival to protect job security. o May dislike outside interference, so independence and corporate self-sufficiency may be important goals. Do Managers Act in the Shareholders’ Interest?  Managers act in the shareholders interest depends on two factors. o How close management goals align with shareholders goals  Managers compensation o Can managers be replaced if they do not pursue shareholder goals  Relates to control of the firm  Management have significant economic incentive to increase share value for two reasons. o Managerial compensation is usually tied to financial pe
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