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Chapter 1

FIN 3715 Chapter Notes - Chapter 1: Capital Budgeting, Cash Flow, Financial Statement

Course Code
FIN 3715

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Chapter 1: Introduction to Corporate
1.1Corporate Finance and Financial Manager
What is Corporate Finance?
Corporate finance is the study of ways to answer these three questions when opening
a business
oWhat long-term investments should you take on? That is, what lines of business
will you be in and what sorts of buildings, machinery, and equipment will you
oWhere will you get the long-term financing to pay for your investment? Will you
bring in other owners or will you borrow the money?
oHow will you manage your everyday financial activities such as collecting from
customers and paying suppliers?
The Financial Manager
The corporation employs managers to represent the owners’ interests and make
decisions on their behalf
In a large corporation, the financial manager would be in charge of answering the three
questions we raised in the preceding section
Their function is usually associated with a top officer of the firm, such as the vice
president of finance or some other chief financial officer (CFO)
Figure 1.1 page 3
Financial Management Decisions
The financial manager must be concerned with three basic types of questions
Capital Budgeting
The first question concerns the firm’s long-term investments
Capital budgeting is the process of planning and managing a firm’s long-term
The financial manager tries to identify investment opportunities that are worth more to
the firm than they cost to acquire
oThis means that the value of the cash flow generated by an asset exceeds the
cost of that asset

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The types of investment opportunities that would typically be considered depend in part
of the nature of the firm’s business
Financial managers must be concerned not only with how much ash 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
Capital Structure
The second question for the financial manager concerns ways in which the firm obtains
and manages the long-term financing it needs to support its long-term investments
Capital structure (or financial structure) is the specific mixture of long-term debt and
equity the firm uses to finance its operations
The financial manager has two concerns in this area
oFirst, how much would the firm borrow
What mixture of debt and equity is best?
The mixture chosen will affect both the risk and the value of the
oSecond, what are the least expensive sources of the funds for the firm?
What percentage of the firm’s cash flow goes to creditors and what
percentages goes to share holders
Firms have great deal of flexibility in choosing a financial structure
In addition to deciding on the financing mix, the financial manager has to decide exactly
how much and where to raise the money
oThe expenses associated with raising long-term financing can be considerable,
so different possibilities must be carefully evaluated
oCorporations borrow money from a variety of lenders in a number of different,
and sometimes exotic ways
Working Capital Management
The third question concerns working capital management
Working capital refers to a firm’s short-term assets, such as inventory, and its short-
term liabilities, such as money owned to suppliers
Managing the firm’s working capital is a day-to-day activity that ensures that the firm has
sufficient resources to continue its operations and avoid costly interruptions
Questions that must be answered about working capital
oHow much cash and inventory should we keep on hand?

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oShould we sell on credit?
If so, what terms will we offer, and whom will we extend them
oHow will we obtain any needed short-term financing?
Will we purchase on credit, or will we borrow in the short term and pay
If we borrow in the short term how and where should we do it?
1.2Forms of Business Organization
A key observation is that as a firm grown, the advantages of the corporate form may
come to outweigh the disadvantages
Sole Proprietorship
Sole proprietorship is a business owned by one person
Simplest type of business to start and is the least regulated form of organization
There are more proprietorships than any other type of business, and many businesses
that later become large corporations start out as small proprietorships
The owner keeps all the profits
Unlimited liability for business debts
oMeans that creditors can look beyond business assets to the proprietor’s
personal assets for payments
oBusiness income is taxed as personal income
The life of a sole proprietorship is limited to the amount of proprietors personal wealth
oMeans that business is unable to exploit new opportunities because of
insufficient capital
May be difficult to transfer because this transfer requires the sale of the entire business
to a new owner
Partnership is similar to a proprietorship except that there are two or more owners
General partnership, all the partners share in gains or losses, and all have unlimited
liability for all partnership debts, not just some particular share
The way partnership gains (and loses) are divided is described in the partnership
oThis agreement can be an informal oral agreement or a lengthy, formal written
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