Introduction to Corporate Finance

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					CHAPTER 1
Introduction to Corporate
   What is finance?
   Book, market, and intrinsic values
   Forms of business organizations
   Financial goals of the corporation
   Separation of ownership and control
   Risk and investor attitudes toward risk

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    Introduction to Finance?
   A foremost concept in finance concerns how individuals
    interact in order to allocate resources (capital) and/or shift
    consumption across time by borrowing or investing.
   If you receive $1 million today then what decision would you
    make regarding consumption and investment?
        Suppose you spend (consume) $100,000 now.
        This leaves you with $900,000. You can postpone consumption to
         future time periods by investing the $900,000 today.
   On the other hand, what if you have $20,000 but need to
    consume $30,000. You can borrow the $10,000 and pay it
    back in a future period along with the interest.

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    Two examples of common corporate
    financial decisions
   A firm must spend $100 million for the required assets if a
    proposed project is approved. Important issues are:
       Should the project be accepted or rejected? What do investors
        demand as a (minimum acceptable) project rate of return?
       What are the project’s forecasted future cash flows? How risky are
        these forecasted cash flows?
       Where will the $100 million come from, i.e., what mix of equity and
        debt financing should be used?
   If a firm has $200 million of cash flow, but needs reinvest
    $120 million, what should be done with the remaining $80
    million of cash.
       Pay it out as a dividend or repurchase some stock?

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    Example of common investments
    type financial decisions
   A mutual fund manager that manages a fund
    with $10 billion portfolio receives an
    additional $100 million in cash from new
       Which stocks or bonds to purchase?
       How will any proposed new investments affect
        the expected return and risk of the overall

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    Forms of business organization
   Sole proprietorship
   Partnership
   Corporation
        Most large firms are organized as corporations.
      Advantages: unlimited life, easy transfer of ownership (stock), limited
         liability for owners, relative ease of raising capital, and can use stock
         for acquisitions
      Disadvantages: Double taxation of earnings, cost of set-up and report
         filing, and issues relating to the separation of ownership and control
   Hybrid forms; Limited Liability Corporations (LLC), S Corporations,
    etc., firms having characteristics of the three forms above.

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    Book versus Market values
   The book value of an asset is determined based on
    accounting rules.
   The book value is at best a rough approximation of
    the asset’s replacement cost.
   The market value of an asset is that investors are
    willing to pay today for stocks and bonds in order to
    receive a risky stream of future expected cash flows.
       Market values are forward looking.
       Stocks and bonds represent claims on the future cash
        flows that a firm’s assets generate.

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    Book versus market values
   Market value of a firm

      Assets                    Liabilities + Equity
      Market value of the       Mkt. value of debt
      asset’s earning power
                                Mkt. value of equity
      (as a going concern)

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    Book versus market values
   The Book value of a firm often contrasts
    sharply with the Market value.
      Assets                     Liabilities + Equity
      Physical assets at         Book debt
      historical book value
                                 Book equity

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    Book versus market values: a
    hypothetical example
   A firm begins with $2000 of debt and $4000 of
    equity in order to purchase $6000 of assets. These
    become the original accounting book values.
   In contrast, Market values are based on today’s
    expectations of future performance, i.e., what cash
    amounts are expected to be paid out and the
    perception of risk. Assume the following:
       Investors are willing to pay $2000 for the bonds.
       Investors are willing to pay $10,000 for the equity.

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    Book versus market values for the
    hypothetical example
   Book values of firm:
         Assets                     Liabilities + Equity
         $6,000 physical assets $2,000 Book debt
                                    $4,000 Book equity
   Market values of firm:
         Assets                     Liabilities + Equity
         $12,000 M.V. as a          $2,000 M.V. debt
         going concern
                                    $10,000 M.V. equity
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    Intrinsic (fundamental) values
   Market values are what investors are willing to
    either buy or sell an asset for, based on investors’
    expectations of future performance.
       Market values are very often publicly observed, e.g., the
        transactions in the stock markets.
   In contrast, intrinsic values are usually considered as
    private estimates of what something, e.g., a common
    stock, is actually worth.
       Intrinsic value is not something that you can prove.
       If ten analysts are asked to value IBM stock, then there
        will likely be ten different intrinsic value estimates!

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    Intrinsic (fundamental) values
   Assume that a New York Stock Exchange listed firm
    has an equity market value of $10 billion.
   However, those that manage the firm (insiders)
    believe the firm is actually worth $12 billion
    (intrinsic value), based on their private or inside
    forecasts of future cash flow performance.
   For the most part, market prices are driven by public
    expectations and consensus, while intrinsic values
    represent private forecasts.
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    Financial goals of the corporation
   The primary financial goal is shareholder
    wealth maximization — a function of future
    cash flow and risk.
   In reality, this is maximizing intrinsic value
        For now we will assume that this is synonymous
         with maximizing the market value, i.e., stock price
   Warren Buffett states that his goal is to
    maximize Berkshire Hathaway’s intrinsic
    value, and hopefully, the stock’s market value
    will be close to the intrinsic value.

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    Stock price maximization is NOT
    profit or earnings maximization?
   Market (and intrinsic) values are driven by risk and
    expectatons (forecasts) of future cash flows.
   Earnings and other accounting profitability
    measures are not cash flows and have limited use in
    estimating financial values.
   Some actions may cause an increase in reported
    earnings, yet cause the stock price to decrease (and
    vice versa).

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    Wealth maximization and societal
   Is the general welfare of society advanced when
    individual agents pursue wealth maximization?
       Is intrinsic or market value maximization good or bad for
        society. Should firms behave ethically?
   The following slide contains a quote is from Adam
    Smith’s Inquiry into the Nature and Causes of the
    Wealth of Nations, 1776.
       Adam Smith believed that an economic system in which
        individual agents strive to increase their market value
        results in the most efficient level of general welfare, as it
        facilitates the allocation of resources to their most
        productive use.

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Wealth maximization and societal
welfare (Adam Smith, 1776)
 “As every individual, endeavours as much as he can both
 to employ his capital in the industry, and to direct that
 industry that its produce may be of the greatest value,
 every individual necessarily labours to render the annual
 revenue of the society as great as he can. In doing so he
 generally, indeed, neither intends to promote the public
 interest, nor knows how much he is promoting it. By
 directing that industry in such a manner as its produce
 may be of the greatest value, he intends only his own
 gain, and he is in this, as in many other cases, led by an
 invisible hand to promote an end which was no part of
 his intention. Thus, by pursuing his own interest he
 frequently promotes that of the society more effectually
 than when he really intends to promote it. I have never
 known much good done by those who pretended to trade
 for the public good.”

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    Agency relationships — the
    separation of ownership and control
   An agency relationship exists whenever a principal
    (owner of a resource) hires an agent to act on their
    behalf. Examples are:
       Citizen (principal) and elected official (agent)
       Stockholder (principal) and corporate manager (agent)
   Within a corporation, agency relationships exist
       Shareholders and managers
       Shareholders and creditors

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    Shareholders versus Managers
   Managers are naturally inclined to act in their
    own best interests.
   But the following factors affect managerial
       Managerial compensation plans
       Direct intervention by shareholders
       The threat of firing
       The threat of corporate takeover

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    Shareholders versus Creditors
   Shareholders (through managers) could take
    actions to maximize stock price that are
    detrimental to creditors, i.e., actions that
    result in a wealth transfer from creditors to
   In the long run, such actions will raise the
    cost of debt and ultimately lower the stock
    price. We return to this issue in Chapter 16.

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    Factors that affect stock prices
   As implied in earlier slides, stock prices are a
    function of:
       Projected cash flows to shareholders
       Timing of the cash flow stream
       Riskiness of the cash flows
   The basic financial valuation model on the next slide
    will be addressed in detail in Chapters 4 and 5 of the

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    Basic financial valuation model
                       CF1      CF2          CFn
           Value                     
                     (1  k)1 (1  k)2     (1  k)n
                              .
                 t 1 (1  k)

   To estimate any asset’s value, one must estimate the
    cash flow for each period t (CFt), the life of the asset
    (n), and the appropriate discount rate or cost of capital
    (k), based on the level of estimated risk.
   Throughout this course, we discuss how to estimate the
    model’s’ inputs and how financial management is used
    to improve them and thus maximize a firm’s value.
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    Factors that affect the level and
    riskiness of future cash flows
   Decisions made by financial managers:
       Investment decisions, i.e., decisions concerning
        the firm’s assets.
       Financing decisions; the combination of debt and
        equity financing used to finance the assets.
   The external environment
       Capital markets
       Industry and economic events

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    Understanding risk and investor
    attitudes toward risk
   The following two slides illustrate two possible investments
    that can be made today. The payoff of each will occur
    exactly one year from today. Investment #1 costs $100
    today. The current cost of Investment #2 is not given.
   Assume that one of three possible states of the
    macroeconomy will prevail next year. Today, we can only
    assign probabilities to these future economic states.
       Good economy, probability of 30%
       Average economy, probability of 40%
       Bad economy, probability of 30%
   Probabilities must sum up to 100%.

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Investment #1, an apparently riskless
   Investment #1: next year’s payoff is identical (all
    result in $110) in each future economic state.
                   Good economy,

                         Average economy,
Investment costs         probability=40%
 $100 today                                     $110

                   Bad economy,

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 Investment #2, an apparently risky
    Investment #2: next year’s payoff varies with
     future state of the economy.
                   Good economy,

                         Average economy,
Today’s cost = ?                                $110

                   Bad economy,

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    Summarizing riskless Investment #1
    and risky Investment #2
   Investment #1 costs $100 today and has a certain $110 payoff
    in any economic state next year. It thus currently offers a
    riskless one year investment return of 10%
   Investment #2, on the other hand, offers a risky payoff next
    year. However, a glance at the payoff pattern does reveal
    that the expected payoff is $110.
   Now, if riskless Investment #1 costs $100 today, then what
    would you be willing to pay today for risky Investment #2,
    given that each both investments offer an expected payoff of
    $110 next year?

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    Summarizing riskless Investment #1
    and risky Investment #2
   Most individuals are averse to risk and would pay less than
    $100 for Investment #2, e.g., $85, $90, or $95, etc.
   Most risk averse individuals will accept risk, but only if they
    expect to earn a higher return than what they can already
    make on the riskless investment.
   The only way for Investment #2 to offer expected return
    greater than 10% is to pay less than $100 today for
    Investment #2.
   Practical example: Any corporation’s common stock is more
    risky that its bonds (and also U.S. Treasury bonds). Investors
    therefore expect to earn a higher return on the corporation’s
    common stock.

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Description: What is finance? Book, market, and intrinsic values Forms of business organizations Financial goals of the corporation Separation of ownership and control Risk and investor attitudes toward risk