2/6/2012

The Balance
Balance--Sheet Model of the
Firm
Corporate Finance

KUSOM
Lecture 1
Spring 2012

The Balance
Balance--Sheet Model of the The Balance
Balance--Sheet Model of the
Firm Firm

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The Theory of Corporate Finance Course Objective

y Corporate finance addresses the
following general questions
1. What long term investment should the firm
focus in?
2. How can firm raise the money for the
required investment?
3. How much short-term cash flow does a
company need to pay its bills?
4. Should company hold money or pay
dividend?
y Capital Structure Choice – how should
the firm raise money to finance the long
term investment plan of the firm?
◦ Builds on the Capital
p Budgeting
g g decision –
what long term investment should the firm
engage in?

Forms of Business Organization Comparison

Corporation Partnership
y The Sole Proprietorship
Liquidity Shares can be easily Subject to substantial
ƒ Single owner, manager and financier exchanged restrictions
ƒ The Partnership Voting Rights Usually each share gets one General Partner is in
ƒ General Partners vote charge; limited partners
may have some voting
ƒ Managing Partner and financier rights
ƒ Limited Partners Taxation Double Partners pay taxes on
distributions
ƒ Contribute to financing only
ƒ The Corporation Reinvestment and
dividend payout
Broad latitude All net cash flow is
distributed to partners
ƒ Distinct legal entity
Liability Limited liability General partners may have
ƒ Separation of ownership from management unlimited liability; limited
ƒ Easier to raise financing partners enjoy limited
liability
Continuity Perpetual life Limited life

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The Corporate Firm
y The corporate form of business is the
standard method for solving the problems
encountered in raising large amounts of
cash
The Firm and the Financial Markets
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Separation of Ownership and
Control
Goal of the Corporate Firm
y The traditional answer:
The managers of the corporations are
obliged to maximize shareholders wealth
y The goal of the manager is to create
value. i.e. to maximize firm value
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Debt and Equity as Contingent Corporate Securities as Contingent

Claims Claims on Total Firm Value
y Debt for a firm is a commitment to repay a
fixed dollar amount by a certain date
y The claim of shareholders on the firm is the
residual amount that remains after the debt
holders are paid.
paid
y If the value of the firm is less than the
amount promised to the debt holders, the
shareholders get nothing.
y The value of debt being constant, higher the
value of firm, higher the value of equity

Combined Payoffs to Debt and

The Agency Problem
Equity
y Agency relationship
◦ Principal hires an agent to represent his/her
interest
◦ Stockholders (principals) hire managers
(agents) to run the company
y Agency problem
◦ Conflict of interest between principal and
agent

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Managerial Goals Managing Managers

y Managerial goals may be different from
shareholder goals
◦ Expensive perquisites
◦ Survival
◦ Independence
y Increased growth and size are not
necessarily equivalent to increased
shareholder wealth
y Managerial compensation
◦ Incentives can be used to align management and
stockholder interests
◦ The incentives need to be structured carefully to
make sure that they achieve their intended goal
y Corporate control
◦ The threat of a takeover may result in better
management
y Other stakeholders