Introduction to Corporate Finance

Introduction to Corporate Finance

What is Finance? 

The short, quick and easy answer is “money management” – the science of managing money

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What is the difference between Finance and Accounting and Finance and Economics?

 Accounting is about the recording of transactions in terms of money – it just says what happened.  In Economics you are focused on resources and production process.  Finance is in between – you want to deal with the real side of things (production, etc.), but you want also to deal with the money side of things. 

Finance is a very recent field developed and separated only in the last 20-30 years that has separated from Economics and Financial Economics

Finance within an Organization Board of Directors Chief Executive Officer (CEO) Chief Operating Officer (COO)

Chief Financial Officer (CFO)

Marketing, Production, Human Resources, and Other Operating Departments

Accounting, Treasury, Credit, Legal, Capital Budgeting, and Investor Relations

Financial Decisions 

Financial decision is a decision about money – to buy or not to buy, how to spend money, how to get money, how to invest money.

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Financial decisions require the application of the most elementary basic economic decision principle of benefits vs. costs.

Finance as a Subject The major areas of Finance include: 

Financial Management

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Financial Economics

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Investments

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Personal Finance

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Public Finance

Financial Management 

It is about managing the finances of businesses;

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It is simply known as Corporate Finance or Business Finance;

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It is predominantly associated with managing the assets and managing the liabilities of a corporation and that is why Finance requires a good understanding of all assets and liabilities, as well as general understanding of accounting.

Financial Economics It comprises of three subfields: 

Financial Markets

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Financial Institutions

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Financial Instruments

These three fields jointly form the Financial System => Financial Economics is the subject which studies the Financial System.

Investments 

Security Analysis

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Portfolio Theory

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Market Analysis

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Behavioral Finance

Personal Finance and Public Finance 

Personal Finance is the subject of Finance that studies the finances of a particular person or family.

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Public Finance is the subject of how to manage the money of the government.

Forms of Business Organizations 

Sole Proprietorship

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Partnership

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Corporation

Proprietorships and Partnerships 

Advantages ◦ Ease of formation ◦ Subject to few regulations ◦ No corporate income taxes

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Disadvantages ◦ Difficult to raise capital ◦ Unlimited liability ◦ Limited life

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Often set up through LLCs/LLPs.

Corporation 

Advantages ◦ Unlimited life ◦ Easy transfer of ownership ◦ Limited liability ◦ Ease of raising capital

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Disadvantages ◦ Double taxation ◦ Cost of setup and report filing

Important Concepts  

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Shareholder Wealth – it is basically whatever the shareholder owns; the value of the assets owned by the shareholder. Shares outstanding – the number of shares which are sold to the public and owned by the public. Market Price – actually we like to call it stock price; the price for which you can sell the stock on the financial/stock market. Value – we like to use what is called fundamental value or intrinsic value; the fundamental value in finance is based/calculated as a discounted value – a present discounted value of all future cash flows; intrinsic value is an estimate of a stock (investment) true value based on accurate/true risk and on accurate evaluation of returns (returns are associated with cash flows); based on complete information, correct information of cash flows and proper risk; Risk – the probability of unfavorable outcome, an outcome that is not favorable; the probability of things going wrong; True risk vs. perceived risk– the risk associated with particular asset if all information is known about; the opposite is perceived risk – different people have different perception of risk based on their age, different knowledge, experience, information, background, expectations, etc.

Relationship between Stock Price and Intrinsic Value Managerial Actions, the Economic Environment, Taxes, and the Political Climate

“True” Investor Cash Flows

“True” Risk

“Perceived” Investor Cash Flows

Stock’s Intrinsic Value

Market Equilibrium: Intrinsic Value = Stock Price

“Perceived” Risk

Stock’s Market Price

Recent Business Trends 

Corporate scandals have reinforced the importance of business ethics, and have spurred additional regulations and corporate oversight.

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Increased globalization of business.

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The effects of ever-improving information technology have had a profound effect on all aspects of business finance.

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Stockholders now have more control of corporate governance.

Potential Conflicts within an Organization 

Principal-Agent Conflict

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Conflicts between Bondholders

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Socially responsible management

Stockholders

and