Introduction to Corporate Finance

Chapter 1

1.1. What is Corporate Finance?

1.2. What are the functions and goals of the financial

manager?

Introduction to Corporate Finance

The financial reports made by the financial
management of the company:
Balance

Sheet
Income Statement
Statement of cash flows
Statement of stockholders equity

1.1. What is finance?

1.2. What are the functions and goals of the financial
manager?
FINANCE AND ACCOUNTING
The accountant
concerned with providing data
for measuring the performance
of the firm, assessing its
financial position, and paying
taxes.
recognizing:
revenues
point of sale
(accounts receivable)
expenses
when incurred
(accounts payable)

The financial manager

concerned with maintaining a
firms solvency by providing the
necessary cash flows.

recognizing:
revenues

expenses

when inflows of
cash occur
when outflows of
cash occur

A firm may be profitable but still fail because it has an insufficient inflow
of cash to meet its obligations as they come due.

1.1. What is finance?

1.2. What are the functions and goals of the
financial manager?
FINANCE AND ACCOUNTING

Accounts receivable are revenues resulting from the

sale of merchandise on credit, for which the actual cash
payment has not yet been received.

Expenses are treated in a similar fashion that is, certain

liabilities are established to represent goods or services
that have been received but have yet to be paid for.
These items are usually listed on the balance sheet as
accounts payable.

1.1. What is finance?

The Balance Sheet
provides a snapshot of the firms financial
position
THE BALANCE-SHEET MODEL OF THE FIRM
Fixed Assets
1. Tangible fixed assets
2. Intangible fixed
assets

Shareholders equity

Long-term debt
Current assets
1. Inventories
2. Account receivable
3. Cash

Current liabilities
Net
working
capital

Left side, total value of assets. Right side, total value of the firm to
investors, which determines how the value is distributed.

1.1. What is finance?

Net working capital

Net working capital is defined as current assets

minus current liabilities.

From a financial perspective, the short-term cash

flow problem comes from the mismatching of cash
inflows and outflows.

It is the subject of short-term finance.

1.1. What is finance?

Tangible fixed assets: buildings, lands,

machinery, transportation means.

Intangible fixed assets: know-how, research and

development, software, goodwill.

Inventories: raw materials, work in process,

materials, packaging.

1.1. What is finance?

The Balance Sheet
providing a snapshot of the firms financial
position

The Balance Sheet Identity

Assets = Liabilities + Shareholders Equity

Book value of an asset = acquisition cost

accumulated depreciation

Market capitalization = market price per share *

number of shares

1.1. What is finance?

THE BALANCE-SHEET MODEL OF THE FIRM

1. In what long-lived assets should the firm invest?

Capital budgeting/Capital expenditure

How can the firm raise cash for required capital expenditures?
Capital structure

How should short-term operating cash-flows be managed?

Net working capital

1.1. What is finance?

1.
2.

Capital structure:
Equity
Medium and long term debt:
Banking loans
Leasing
Bonds issues

3. Long term liabilities

1.1. What is finance?

THE FUNCTIONS OF THE FINANCIAL MANAGER
1.
2.
3.

Financial analysis and planning.

Managing the firms asset structure.
Managing the firms financial structure.

All three functions are clearly reflected in the firms balance sheet,
which shows the current financial position of the firm.

1.2. What are the Functions and Goals of the

Financial Manager?
THE INTERPLAY OF THE FIRMS FINANCE WITH THE FINANCIAL MARKETSS

Firm invests in
assets

Firm issues securities (F)

Retained cash
flows (C)
Current assets
Fixed assets
(A)

Dividends
and
interest
payments

Cash flow from

firm (B)
Taxes
Government
(D)

Financial
markets

Short-term debt
Long-term debt
Equity shares
(E)

1.2. What are the Functions and

Goals of the Financial Manager?
A. Firm invests in assets (capital budgeting).
B. Firms operations generate cash flow.
C. Retained cash flows are reinvested in firm.
D. Cash is paid to government as taxes.
E. Cash is paid out to investors in the form of
interests and dividends.
F. Firm issues securities to raise cash (the
financing decision).

What are the Functions and Goals

of the Financial Manager?

In theory, the goal of a firm should be determined by

the firms owners.
Many corporations have thousands of owners
(shareholders).
Each owner is likely to have different interests and
priorities.
Whose interests and priorities determine the goals of
a firm?

1.2. What are the Functions and Goals of the

Financial Manager?
Some people believe that the owners objective is always the
maximization of profits; others believe it is the maximization of
wealth.
Wealth maximization is the preferred approach for five basic
reasons: it considers

1. Owners realizable return

2. Long-run viewpoint
3. Timing of returns
4. Risk
5. Distribution of returns

EXAMPLE
Four years ago, Harold Jenks purchased one share of Alpha
Company and one share of Beta Company stock, each at a price of
$100. Both companies are in the same line of business.
1. OWNERS REALIZABLE RETURN

Alpha Company
- Annual dividend $1 per share
- Annual profit $2 per share
- Developed an innovative new
product
- Current stock price $130 per
share

Beta Company
- Annual dividend $1 per share
- Annual profit $3 per share
-

- Current stock price $110 per

share

This situation reflects the fact that although the profits of Beta
Company are greater, Alpha Company has a higher stock price. The
higher price of Alpha shares can be attributed to the expectation that
the successful sale of the new product will provide increased future
profits.
Harolds wealth in Alpha Company is greater than his wealth in Beta
Company in spite of the fact that Betas profits are larger.

1.2. What are the Functions and Goals of the

Financial Manager?
2. LONG-RUN VIEWPOINT

Profit maximization is a short-run approach

Wealth maximization considers the long-run

3. TIMING OF RETURNS

The profit maximization approach fails to reflect

differences in the timing of returns, whereas wealth
maximization tends to consider such differences.

EXAMPLE
Conan Manufacturing is considering expanding its production into
either of two new products, C or D. Product C is considered to be a
relatively safe investment, while product D is considered a risky fad
item.
4. RISK

After considering all costs, the two products are expected to

provide the profits per share over their five-year lives as shown:

If we ignore the risk differences and

use a profit maximization approach,
it would appear that product D is
1 $ 2.00
$ 2.20
preferred. The firm may only need to
2
2.00
2.20
earn 10 percent on product C, but as
compensation for the greater risk of
3
2.00
2.20
product D it must earn 15 percent.
4
2.00
2.20
Applying certain financial analysis
5
2.00
2.20
techniques that reflect differences in
the timing of the returns, it is found
Total $ 10.00
$ 11.00
that product C is likely increase the
share price by $7.58, while product D is likely to result in a $7.37
increase in share price.
Product
Year
C

Product
D

1.2. What are the Functions and Goals of the

Financial Manager?
5. DISTRIBUTION OF RETURNS

The profit maximization goal fails to consider that stockholders

may wish to receive a portion of the firms returns in the form of
periodic dividends.

The wealth maximization strategy takes into consideration the

fact that many owners place a value on the receipt of the
regular dividend, regardless of its size (clientele effect).

1.2. What are the Functions and

Goals of the Financial Manager?

This clientele effect is used to explain the influence

of dividend policy on the market value of shares.
Making sure that stockholders receive the return they
expect is believed to have a positive effect on stock
prices.

1.2. What are the Functions and Goals

of the Financial Manager?

A firm interested in maximizing owners wealth may

therefore pay dividends on a regular basis.

A firm that wishes to maximize profits may opt to pay no

dividends.

But stockholders would certainly prefer an increase in

wealth to the generation of an increasing flow of profits

without concern for the market value of their holdings.

1.2. What are the Functions and Goals

of the Financial Manager?

Because the stock price explicitly reflects the owners

realizable return, considers the firms long-run prospects,
reflects differences in the timing of returns, considers risk,
and recognizes the importance of the distribution of returns,
maximization of wealth as reflected in share price is viewed
as the proper goal of financial management.

1.2. What are the Functions and

Goals of the Financial Manager?

Profit maximization can be part of a wealth

maximization strategy.
Quite often, the two objectives can be
pursued simultaneously. But maximization of
profits should never be permitted to
overshadow the broader objective of wealth
maximization.

Bibliografy

Dinc M., Gestiunea financiar a firmei,

Editura Universitii Transilvania, Brasov,
2011
Brealey & Myers, Corporate Finance,
seventh edition, McGraw -Hill, 2003
Peterson P., Financial Management and
Analysis, McGraw Hill, 2004