Fundamentals of Corporate Finance - Chapter 1

Fundamentals of Corporate Finance - Chapter 1

• This is a fourth edition textbook on corporate finance.
• Key figures are Robert Parrino, David S. Kidwell, Thomas W. Bates, and Stuart Gillan.
• The chapter focuses on the financial manager and the firm.

Learning Objectives (1 of 2)

• Identify key financial decisions facing financial managers.
• Identify common business organizations in the United States and their strengths/weaknesses.
• Describe the typical financial function in a large corporation.
• Explain the appropriate goal for management: maximizing firm stock value.

Learning Objectives (2 of 2)

• Discuss how agency conflicts affect the goal of maximizing stockholder value.
• Explain why ethics is important in corporate finance.

The Role of the Financial Manager (1 of 5)

• Maximize shareholder wealth by maximizing the firm's stock price.
• Stakeholders encompass managers, employees, suppliers, creditors, and the government.

The Role of the Financial Manager (2 of 5)

• Firm value is tied to positive cash flow.
• Positive residual cash flow can be paid as dividends or reinvested to boost value.
• Sustained negative cash flow leads to business failure or bankruptcy.

The Role of the Financial Manager (3 of 5)

• Cash flows are generated by selling goods and services.
• Management invests in current and long-term assets—cash, inventory, accounts receivable, plant, equipment, buildings, technology.
• Residual cash flow after asset investments, salaries, and expenses are directed to stakeholders (including stockholders, suppliers, creditors, and the government).
• Reinvested cash flows can grow the business.

The Role of the Financial Manager (4 of 5)

• Three fundamental decisions of financial management are:
  • Capital budgeting (acquiring long-term assets).
  • Financing (determining how to pay for assets).
  • Working capital (managing short-term resources).
• Poor decisions in these areas can lead to bankruptcy.

The Role of the Financial Manager (5 of 5)

• The three key financial management decisions (capital budgeting, financing, working capital) affect the balance sheet.
• Working capital decisions affect current assets, liabilities, and net working capital.
• Capital budgeting decisions determine the firm's long-term assets.
• Financing decisions decide the proportions of long-term debt and equity.

Forms of Business Organization

• Key types: sole proprietorships, partnerships, and corporations.
• Hybrid forms: limited liability partnerships (LLPs) and limited liability companies (LLCs).

Sole Proprietorship

• Owned by one person.
• Advantages: easy to create and control, easy to dissolve, right to all profits.
• Disadvantages: owner's personal assets are at risk, equity is limited to owner's funds, difficult to transfer ownership, limited access to capital.

Partnership

• Owned by two or more people.
• Advantages: limited protection of owner's personal assets; owner's limited liability for firm's obligations; more sources of equity; more expertise.
• Disadvantages: shared control, shared profit, harder to dissolve, and limited access to capital.

Corporation

• Owned by more than one person.
• Advantages: protects personal assets, easier to change ownership, and greatest access to sources of funds.
• Disadvantages: most difficult and expensive to establish, ownership is diluted, and overall higher taxes for shareholders.

Hybrid Forms of Business Organization

• Combinations of characteristics from various forms to achieve specific benefits.
• Key characteristics are considered, such as cost to establish; life of entity; control exercised by founders; and access to capital.

Agency Relationship

• Created when a principal hires an agent to manage the business.
• Ownership is separated from control, creating conflicts of interest.

Agency Conflicts

• Conflicts of interest between stockholders (principals) and management (agents).
• Shared ownership in corporations often means management has less direct control by shareholders.
• Thus, managers have the ability to invest firm assets for their own benefit.

Agency Costs

• Stem from conflicts between owners and managers.
• Increase oversight and align incentives to reduce these costs.

Aligning Interests of Managers and Stockholders

• Board of directors oversees CEOs and major decisions.
• Labor markets offer incentives for managers to perform well.
• Competition among managers is an internal check.
• Large shareholders can monitor management decisions, and corporations can be targeted by raiders.
• Laws and regulations constrain managerial behavior.

Sarbanes-Oxley and Regulatory Reform (1 of 5)

• Better corporate governance reduces agency costs through requirements.
• Key requirements include more effective monitoring of managerial activity, promotion of appropriate behaviors, and penalties for insufficient fiduciary responsibilities.

Sarbanes-Oxley and Regulatory Reform (2 of 5)

• New regulations require public corporations to ensure greater board independence, create internal accounting controls, implement compliance programs, establishes ethics programs, and expands audit committee powers.

Sarbanes-Oxley and Regulatory Reform (3 of 5)

• Regulations aim to reduce agency costs by improving corporate governance, especially board of directors' oversight and processes.
• Board has fiduciary responsibility for shareholders.
• Majority of the board should be independent.
• Firms require codes of ethics.

Sarbanes-Oxley and Regulatory Reform (4 of 5)

• Regulations require an ethics program with a hotline/whistleblower protection.
• The separation of roles of chairperson and CEO is advised.
• Board members can face fines/jail if they fail fiduciary responsibilities

Sarbanes-Oxley and Regulatory Reform (5 of 5)

• Lead external auditors need to change every five years to avoid biases.
• There are limits on non-audit consulting services offered by external auditors.

The Importance of Ethics in Business

• Ethics are societal standards for judging actions as right or wrong.
• Business ethics are specific societal standards for behavior in business/financial markets.

Ethics in Corporate Finance (1 of 4)

• Examples show ethical conflicts in business, including agency costs (employee misuse of company resources).
• Conflicts of interest can occur, such as a mortgage contract benefiting the broker more than the buyer.
• Information asymmetry exists when one party has more relevant information than another party, such as in vehicle sales.

Ethics in Corporate Finance (2 of 4)

• Regulation and marketplace forces alone cannot maintain integrity—ethical beliefs, customs, and practices are crucial.
• Ethical behavior is complex; judgments about behavior can be difficult.
• Questions include whether a manager took too little or too much risk.

Ethics in Corporate Finance (3 of 4)

• Framework for ethical conflict analysis includes several inquiries: legal requirements; profession codes/obligations; party interests/desires; in addition to the financial impacts of actions.

Ethics in Corporate Finance (4 of 4)

• Further questions include: stockholder interests; conflict of interest; information asymmetry; and whether actions would stand up to public scrutiny.

This quiz covers the key concepts from Chapter 1 of the fourth edition of 'Fundamentals of Corporate Finance'. It focuses on the role of financial managers in maximizing shareholder value, the impact of agency conflicts, and the importance of ethics in corporate finance. Test your understanding of business organizations and financial decision-making in the U.S.