What is corporate finance

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Introduction

• What is corporate finance?
• Ex Suppose you open a coffee shop across the
  street.
• Pool savings of 150,000 ( 3 individuals
  together )
• Customers - students, faculty and staff from UH
• Gross revenues of 300,000 a year, profits of
  75,000
• 3 years down the line
• Faced with following alternatives
• Distribute your profits and continue with
  existing operations
• Proposal to expand into the sale of teas - this
  project requires 100,000 in initial outlay
• If the new project is accepted, also think about
  ways to raise the outlay of 100,000

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Three key decisions in corporate finance

• One - Should you accept the proposal to sell
  teas?
• Depends on the financial viability of the
  proposal
• Cash outlays and revenues
• Two - What is the best method of financing the
  new project - initially how should the outlay of
  100,000 be raised?
• Borrow from the bank (Debt)
• Rely on savings (equity)
• Raise money on the public markets
• Raise money privately
• Three - How should the cash flows be distributed?
• Retained earnings (for future projects)
• Distribute to owners (Dividends)

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• Responsibilities of the financial manager
• One - Capital Budgeting (Investment) decision
• Two - Capital structure decision
• Three - Dividend policy decision
• All firms - individual proprietorships to large
  multinational corporations face these decisions
• Common tool to analyze all these decisions (and
  much more)
• These decisions are made within the context of
  financial markets

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Responsibilities of the financial manager

• Company uses real assets
• Tangible - building, plant
• Intangible -trademarks, patents
• To pay for these real assets
• Company sells claims
• On the assets
• And the cash they generate
• Financial assets or securities
• Stocks and bonds
• Leases

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Responsibilities of the financial manager

• Financial manager stands between
• Cash flows generated by the real assets of the
  firm, and
• Financial markets
• Investors, holding financial assets
• Equity, receiving share of profits
• Debt, receiving set payments

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Financial Markets

• Money Market
• Market for debt securities that have short
  maturities (less than one year)
• Capital Market
• Long term securities market (equity and debt)
• Primary market -
• Market for new issues
• Private placements
• Public offerings through investment banks
• Secondary market
• Auction markets (NYSE,AMEX)
• Dealer markets (OTC, Debt markets)

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Corporate Finance - The Big Picture

(1)
(2)
Financial
Firm's
Financial
(4a)
manager
operations
markets
(4b)
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
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Firm - Forms of organization

• Sole Proprietorship
• Owned by one person ( More sole proprietorships
  than any other type of business organization )
• No formal charter
• Taxes - Taxed as personal income - No distinction
  between business income and personal income
• Unlimited liability - Creditors can look beyond
  business assets to personal assets
• Limited transferability

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Parntership

• General
• Partners provide a fraction of the work and the
  cash needed
• Each partner is liable for the debt of the
  partnership
• Each partner has unlimited liability for all
  partnership debts
• Not just partners share
• All partners share in gains and losses
• Gains and losses usually based on capital
  contributions
• Described in partnership agreement

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Partnership

• Limited Partnership
• Limited partners do not participate in managing
  the business
• General partner runs business and has unlimited
  liability
• Liability (but not tax liability) limited to
  contribution to partnership
• Income taxed as personal income to partners
• Reported on Schedule E of form 1040
• Limited transferability of partnership interest
• Examples - Real estate, Oil and gas,Warehouses

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Corporation

• Most important form of business organization
• Legal person
• Separate and distinct from owners
• Can borrow money
• Enter into contracts
• Own property
• Sue and be sued
• Can own stock in another corporation

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Corporation

• Requires articles of incorporation
• Name
• Intended life
• Business Purpose
• Authorized capital - May be amended by
  shareholders
• Rights to shareholders
• Number of directors on the board
• How directors are elected
• Filed in a given state
• Corporation is a resident of that state

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Corporation

• Stockholders elect board of directors
• Board of directors has the legal authority
• To declare a dividend
• Issue securities
• Commit large investment outlays
• Directors select senior management
• CEO, president
• To run corporation in interests of shareholders

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Corporation

• Advantages
• Unlimited life
• Independent of shareholders or managers
• Limited liability
• Stockholders have limited liability for debts of
  corporation
• Easy to raise new capital by issuing more equity
  or debt

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Corporation

• Disadvantages
• Double taxation
• Dividends paid to stockholders out of after - tax
  profits
• Dividends then taxed again as income to
  shareholders
• Most countries (but not the United States)
• Give shareholders credit for taxes already paid
  at corporate level
• In Greece and Norway, dividends are paid out of
  before tax income - dividends are treated like
  interest

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Corporation - Organization of financial officers

• Treasurer
• Capital budgeting
• Financing
• Cash management
• Recommending dividend policy
• Insurance
• Pension plans
• Controller
• Accounting
• Preparation of financial statements
• Preparing budgets
• Internal auditing

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Objective of the firm

• Individual owner
• Maximize profits
• Maximize the value of the business
• Corporation -
• Maximize the value of the firm
• Maximize shareholder value
• Maximize price per share
• These objectives are generally considered
  interchangeable

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Objectives of the firm

• Is maximizing firm value Maximizing shareholder
  value?
• Modern day large corporations
• Stakeholders
• Shareholders
• Managers
• Lenders
• Employees
• Customers
• Society
• Objectives of these groups may not always be
  aligned

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Objectives of the firm

• 1. Shareholder control of management
• 1. A. Annual Meeting
• How many shareholders attend these?
• How many shareholders fill out proxy statements
  when
• they are unable to attend annual meetings?

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Objectives of the firm

• 1. B. Board of directors discipline management
• Korn Ferry Survey
• In 1988 the average director spent 108 hours a
  year on board meetings and was paid 19,544 while
  in 1992, the hours spent decreased to 92 and the
  compensation went up to 32,352
• In 74 of the companies surveyed, boards used CEO
  recommendations to appoint new directors only
  16 used search firms
• Institutional Shareholder Survey
• 27 directors at 275 of the nations largest
  corporations owned no shares in the firms

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Objectives of the firm

• 1.C. Threat of a takeover
• Greenmail Purchase by the target firm of a
  hostile acquirers stake at a large premium to
  avoid takeover
• Golden Parachute Provision in a managers
  contract of a lump sum amount to be paid in the
  event the manager loses his/her job on account of
  a takeover
• 1. D. Institutional shareholders
• CALPERS - California Public Employees Retirement
  System is one of the most active of institutional
  investors - They forced the Board at GM to
  require a majority of outside directors

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Objectives of the firm

• 2. Shareholders versus bondholders
• 2.A. Source of conflict
• Difference in the nature of claims
• Debt - Fixed claim, Equity - Residual claim
• Bondholders discount risk more than shareholders
  since they do not participate in the upside
  element of risk
• Increases in financial leverage
• Makes existing bondholders worse off
• 1988 Leveraged Buy Out (LBO) by RJR Nabisco -
• Prices of existing bonds dropped by 20 at
  announcement (default probability increased)

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Objectives of the firm

• Dividend policy
• Bondholders react negatively to large dividend
  increases

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Objectives of the firm

• 2.B. Protective covenants
• Covenants are restrictions built into contractual
  agreements (Bonds in this case) that place
  restrictions on the firms investment and
  financing decisions
• Ex Limitations on the amount of debt issued,
  dividends paid, requirements on working capital
• Convertible bonds
• Enable bond holders to convert their debt (bonds)
  to equity (shares) under certain conditions
• Aligns bond holder and shareholder interests

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Objectives of the firm

• These and other problems can be reduced
• Tie manager compensation to the performance of
  the firm - warrants, options
• Convertible debt
• Hence, the basic objective of the firm (at least
  for this course) is to

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Maximize share value