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Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Chapter 1: The Financial Manager and the Firm

Learning Objectives

1. IDENTIFY THE KEY FINANCIAL DECISIONS FACING THE FINANCIAL MANAGER OF ANY BUSINESS FIRM.

2. IDENTIFY THE BASIC FORMS OF BUSINESS ORGANIZATION IN THE UNITED STATES AND THEIR RESPECTIVE STRENGTHS AND WEAKNESSES.

Learning Objectives

3. DESCRIBE THE TYPICAL ORGANIZATION OF THE FINANCIAL FUNCTION IN A LARGE CORPORATION.

4. EXPLAIN WHY MAXIMIZING THE CURRENT VALUE OF THE FIRM’S STOCK IS THE APPROPRIATE GOAL FOR MANAGEMENT.

5. DISCUSS HOW AGENCY CONFLICTS AFFECT THE GOAL OF MAXIMIZING SHAREHOLDER VALUE.

Learning Objectives

6. EXPLAIN WHY ETHICS IS AN APPROPRIATE TOPIC IN THE STUDY OF CORPORATE FINANCE.

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Capital Budgeting: decide which long-term

assets to acquire

• Financing: decide how to pay for short-term and

long-term assets

• Working Capital: decide how to manage short-

term resources and obligations

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Capital Budgeting

Choose the long-term assets that will yield the greatest net benefits for the firm.

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Financing

Finance assets with the optimal combination of short- term debt, long-term debt, and equity.

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Working Capital Management

Adjust current assets and current liabilities as needed to promote growth in cash flow.

Cash Flows Between the Firm and Its Stakeholders and Owners

How the Financial Manager’s Decisions Affect the Balance Sheet

The Role of the Financial Manager

o THREE KEY FINANCIAL DECISIONS

• Poor decisions about capital budgeting,

financing, or working capital may lead to

bankruptcy or business failure

Basic Forms of Business Organization

o BUSINESS STRUCTURE

• Sole Proprietorship

• Partnership

• Corporation

Basic Forms of Business Organization

o SOLE PROPRIETORSHIP

• Owned by a single person who is financially

responsible for the actions and obligations of

the business

Basic Forms of Business Organization

o SOLE PROPRIETORSHIP

• Advantages

easiest to create

easiest to control

easiest to dissolve

right to all profit

Basic Forms of Business Organization

o SOLE PROPRIETORSHIP

• Disadvantages

owner’s personal assets at risk

owner’s unlimited liability for firm obligations

equity only from owner or business profit

business income taxed as personal income

difficult to transfer ownership

Basic Forms of Business Organization

o PARTNERSHIP

• A business owned by more than one person; one

or more of them financially responsible for the

actions and obligations of the business

Basic Forms of Business Organization

o PARTNERSHIP

• Advantages vs. sole proprietorship

limited protection of owners’ personal assets

owners’ limited liability for firm obligations

more sources of equity

more sources of expertise

Basic Forms of Business Organization

o PARTNERSHIP

• Disadvantages vs. proprietorship

shared control

shared profit

harder to dissolve

Basic Forms of Business Organization

o CORPORATION

• A business owned by more than one person;

none of them financially responsible for the

actions and obligations of the business. The

corporation is responsible for its obligations and

actions.

Basic Forms of Business Organization

o CORPORATION

• Advantages

protects personal assets

no shareholder liability for business

easiest to change ownership

greatest access to sources of funds

Basic Forms of Business Organization

o CORPORATION

• Disadvantages

most difficult and expensive to establish

dilutes individual control over the firm

overall higher taxes on income for shareholders

Basic Forms of Business Organization

o HYBRID FORMS OF BUSINESS ORGANIZATION

• Limited Liability Partnerships (LLPs)

• Limited Liability Companies (LLCs)

• Professional Companies (PCs)

All have the limited liability of a corporation and tax advantage of a partnership.

Organization of the Financial Function

o CHIEF EXECUTIVE OFFICER (CEO)

• Chief manager in the firm

• Ultimate power to make decisions and ultimate

responsibility for decisions

• Reports directly to the board-of-directors who

protect shareholder’s interests

Simplified Corporate Organization Chart

Organization of the Financial Function

o CHIEF FINANCIAL OFFICER (CFO)

• The V.P. of Finance/CFO is responsible for the

quality of the financial reports received by the

CEO

Organization of the Financial Function

o KEY FINANCIAL REPORTS

• The Treasurer manages and reports on the

collection and disbursement of cash

• The Risk Manager manages and reports on

activities to limit the firm’s risks in financial and

commodity markets

Organization of the Financial Function

o KEY FINANCIAL REPORTS

• The Controller is the firm’s accountant and

prepares its financial reports

• The Internal Auditor controls and reports on

activities to limit the firm’s exposure to internal

threats such as fraud and inefficient use of

resources

Organization of the Financial Function

o EXTERNAL AUDITOR

• Conducts an independent audit of a firm’s

financial activities

• Provides an opinion about whether the financial

reports the firm prepared are reasonably

accurate and conform to generally accepted

accounting principles

The Goal of the Firm

o DO NOT MAXIMIZE MARKET SHARE

• Giving away goods or services for free will

maximize a firm’s market share for a while, but

the firm will not be able to pay its bills and stay

in business

The Goal of the Firm

o DO NOT MAXIMIZE PROFIT

• Accounting profit differs from economic profit

• Profit earned may not equal cash received

Cash not received can’t be used to pay bills

• The strategy ignores the timing of future cash

flows

• The strategy ignores the risks associated with

having to wait for cash flows

The Goal of the Firm

o MAXIMIZE SHAREHOLDERS’ WEALTH!

• Future cash flows are considered

• The timing of future cash flows is considered

• The risks associated with having to wait to for

cash flows are considered

The Goal of the Firm

o MAXIMIZE SHAREHOLDERS’ WEALTH!

• Maximizing the price of a firm’s stock will

maximize the value of a firm and the wealth of

its shareholders (owners)

The Goal of the Firm

o ITS ALL ABOUT CASH FLOW!

• Positive residual cash flow may be paid to firm

owners as dividends or invested in the firm

• The larger the positive residual cash flow, the

greater the value of a firm

• Negative residual cash flow – over the long run –

leads to bankruptcy or closing a business

Agency Conflicts

o AGENCY RELATIONSHIP

• An agency relationship is created when the

owner (a principal) of a business hires an

employee (an agent)

• The owner surrenders some control over the

enterprise and its resources to the employee

• Separating ownership from control creates the

potential for agency conflicts

Agency Conflicts

o AGENCY RELATIONSHIP

• An agency relationship exists between

stockholders (principals) and the firm’s hired

management (agents)

• In large corporations, shared ownership among

many shareholders may result in relatively little

control over management

Agency Conflicts

o OWNERSHIP AND CONTROL

• Shareholders own the corporation, but

managers control the firm’s assets and may use

them for their own benefit

Major Factors Affecting Stock Prices

Agency Conflicts

o AGENCY COSTS

• Arise from (incurring and preventing) conflicts-

of-interests between a firm’s owners and its

managers

• May reduce positive residual cash flow, stock

price, and shareholder wealth

Agency Conflicts

o GIVING AGENTS THE RIGHT INCENTIVE

• Managers tend to focus on wealth maximization

when their compensation depends on stock

price

Agency Conflicts

o GIVING AGENTS THE RIGHT INCENTIVE

• Today, the firm’s stock trades at $0.95 per share.

The CEO has an option to buy 2.5 million

shares from the firm for $1.15 per share at any

time, beginning one year from today. If the

stock price rises to $3.15, the option will be

worth $5 million.

Agency Conflicts

o GIVING AGENTS THE RIGHT INCENTIVE

• Want to keep their jobs

• Oversight by the board of directors

• Oversight by large blockholders

• Potential takeover of the firm

• The legal and regulatory environment.

Agency Conflicts

o SARBANES-OXLEY AND REGULATORY REFORM

• Better corporate governance reduces agency

costs by requiring

more effective monitoring of managers’ activities

programs that promote appropriate behavior by managers

penalties for executives who do not fulfill their fiduciary responsibilities

Corporate Governance Regulations Designed to Reduce Agency Costs

Ethics in Corporate Finance

o WHAT ARE ETHICS?

• Ethics

society’s standards for judging whether an action is right or wrong

• Business Ethics

society’s standards for acceptable behavior applied to business and financial markets

Ethics in Corporate Finance

o EXAMPLES OF ETHICAL CONFLICT IN BUSINESS

• Agency Cost

employee’s unacceptable use of employer’s computer

• Conflict of Interest

mortgage contract which a home-buyer is unlikely to fulfill but earns a mortgage broker more money

• Information Asymmetry

seller knows about prior damage to the vehicle but the potential buyer does not

Ethics in Corporate Finance

o BUSINESS BEHAVIOR

• Regulation and market forces are not enough to

maintain integrity in the marketplace

• Business norms must be based on ethical

beliefs, customs, and practices

Ethics in Corporate Finance

o CONSEQUENCES OF UNETHICAL BEHAVIOR

• Inefficiency in the economy and costs to society

• High legal and social costs

• Problems such as the recent financial crisis in

the U.S.

Ethics in Corporate Finance

o ETHICAL BEHAVIOR

• Sometimes, it is difficult to judge whether

behavior is ethical or not

Was the manager too careful?

Did the manager take too much risk?

Was it an honest mistake?

Was it against policy, but well-intentioned?

A Framework for the Analysis of Ethical Conflicts

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D. DAVID S. KIDWELL, PH.D. THOMAS W. BATES, PH.D.

Chapter 2: The Financial System and the Level of Interest Rates

Learning Objectives

1. DESCRIBE THE ROLE OF THE FINANCIAL SYSTEM IN THE ECONOMY AND THE TWO BASIC WAYS IN WHICH MONEY FLOWS THROUGH THE SYSTEM.

2. DISCUSS DIRECT FINANCING AND THE IMPORTANT ROLE THAT INVESTMENT BANKS PLAY IN THIS PROCESS.

Learning Objectives

3. DESCRIBE THE PRIMARY, SECONDARY, AND MONEY MARKETS, EXPLAINING THE SPECIAL IMPORTANCE OF SECONDARY AND MONEY MARKETS TO BUSINESS ORGANIZATIONS.

4. EXPLAIN WHAT AN EFFICIENT MARKET IS AND WHY MARKET EFFICIENCY IS IMPORTANT TO FINANCIAL MANAGERS.

Learning Objectives

5. EXPLAIN HOW FINANCIAL INSTITUTIONS SERVE THE NEEDS OF CONSUMERS, SMALL BUSINESSES, AND CORPORATIONS.

6. COMPUTE THE NOMINAL AND THE REAL RATES OF INTEREST, DIFFERENTIATING BETWEEN THEM.

The Financial System

o FINANCIAL MARKETS AND INSTITUTIONS

• Financial markets include markets for trading

financial assets such as stocks and bonds

• Financial institutions include banks, credit

unions, insurance companies, and finance

companies

The Financial System

o THE FINANCIAL SYSTEM AT WORK

• The financial system is competitive

• Money is borrowed in small amounts and

loaned in large amounts

• The system directs money to the best

investment opportunities in the economy

• Lenders earn profit from the spread between

lending and borrowing rates

The Financial System

o MOVE FUNDS FROM LENDER TO BORROWER

• The primary function of a financial system is to

efficiently transfer funds from lender-savers to

borrower-spenders

• Basic mechanisms by which funds are

transferred in the financial system

Direct Financing

Indirect Financing

The Flow of Funds Through the Financial System

Direct Financing

o DIRECT TRANSFER OF FUNDS

• lender-saver contracts with a borrower-spender

• minimum transaction $1 million

• investment banks and money center banks help

with origination, underwriting and distribution

of new debt and equity

Direct Financing

o DIRECT TRANSFER OF FUNDS

• Underwriting is a service to assist firms in

selling their debt or equity securities in a direct

financing market

Types of Financial Markets

o WHOLESALE AND RETAIL MARKETS

• Primary Market

wholesale market where firms’ new securities are issued and sold for the first time

• Secondary Market

retail market where previously issued securities are resold (traded)

Types of Financial Markets

o MARKETABILITY AND LIQUIDITY

• Marketability

ease with which a seller or buyer for an asset can be found

• Liquidity

ease with which an asset can be converted into cash without loss of value

Types of Financial Markets

o MARKETABILITY AND LIQUIDITY

• Financial markets increase marketability and

liquidity of securities

• Financial markets lower the costs of making

transactions and make participants more willing

and able to pay higher prices

Types of Financial Markets

o BROKERS AND DEALERS

• A broker brings a seller and a buyer together but

does not buy or sell in the transaction

broker does not take on risk

• A dealer participates in trades as a buyer or

seller using her own inventory of securities

dealer takes on risk

Types of Financial Markets

o EXCHANGES & OVER-THE-COUNTER MARKETS

• Exchange

location where sellers and buyers meet to conduct transactions – New York Stock Exchange (NYSE)

– Chicago Board Options Exchange (CBOE)

Types of Financial Markets

o EXCHANGES & OVER-THE-COUNTER MARKETS

• Over-the-Counter Market

dealers conduct transactions over the phone or via computer. – National Association of Securities Dealers Automated

Quotations (NASDAQ)

Types of Financial Markets

o MONEY AND CAPITAL MARKETS

• Money Market

market for low-risk securities with maturities of less than one year. – Treasury Bills (T-bills)

– Commercial Paper

Types of Financial Markets

o MONEY AND CAPITAL MARKETS

• Capital Market

market for securities with maturities longer than one year – bonds

– common stock

Selected Money Market and Capital Market Instruments June 2010

Market Efficiency

o EFFICIENT MARKET

• Current prices of securities incorporate the

knowledge and expectations of all participants

• Security prices are correct: securities are not

over-valued or under-valued.

• Participants are confident they pay or receive

the intrinsic (fair) value of a security

Market Efficiency

o MARKET EFFICIENCY

• Operational Efficiency

extent to which transaction costs are minimized

• Informational Efficiency

extent to which security prices reflect all relevant information

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• A theory about how efficiently the stock market

processes and incorporates information

available from

private sources of information

public sources of information

historical stock prices

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• Strong-Form Efficiency

Security prices always reflect all information, from every source. Even inside, or confidential information, is reflected.

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• Semistrong-Form Efficiency

Security prices always reflect all public information. Inside, or confidential information, is not reflected.

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• Weak-Form Efficiency

Security prices always reflect the information in past prices. No other information is reflected.

Market Efficiency

o EFFICIENT MARKET HYPOTHESIS

• Public markets, such as the NYSE are more

efficient than private markets due to the

information provided by a large number of

participants and effective regulation

Financial Institutions and Indirect Financing

o INDIRECT FINANCING

• An institution is both a borrower and lender

borrows money from a saver

lends money to a borrower

must repay funds to the saver – whether or not it is repaid by the borrower – Examples: banks & insurance companies

Financial Institutions and Indirect Financing

o FINANCIAL INSTITUTIONS

• Provide lending and borrowing opportunities at

the retail level for small customers and

wholesale level for large customers

• Efficiently collect funds in small amounts and

lend them in larger amounts

• Tailor loan amounts and contract terms to fit the

needs of consumers, corporations, and small

businesses

Cash Flows Between the Firm and the Financial System

The Determinants of Interest Rate Levels

o INTEREST RATE

• The fee for borrowing money expressed as a

percentage of a loan

real rate of interest – interest rate that would exist in the absence of inflation

(deflation)

nominal ate of interest – interest rate adjusted for inflation (deflation)

The Determinants of Interest Rate Levels

o REAL RATE OF INTEREST

• Determinants of the real rate of interest

expected return on productive assets

time preference for consumption

The Determinants of Interest Rate Levels

o EQUILIBRIUM RATE OF INTEREST

• Is a function of supply and demand

savers supply more funds at higher rates

spenders borrow (demand) less at higher rates

• Is the interest rate at which the quantity of

funds supplied equals the quantity of funds

demanded

The Determinants of the Equilibrium Rate of Interest

The Determinants of Interest Rate Levels

o INFLATION AND LOAN CONTRACTS

• Lenders want the interest rates in loan contracts

to include compensation for the inflation

predicted to occur over the life of the contract

• Compensation for expected inflation adjusts

loan rates to offset the higher prices for goods

and services expected to exist when a loan is

repaid and a lender spends the money

The Determinants of Interest Rate Levels

o FISHER EQUATION & NOMINAL INTEREST RATE

• The Fisher Equation

o

Where:

i = nominal interest rate

r = real rate of interest

∆Pe = expected annualized price-level change

r∆Pe = adjustment for expected price-level

change

)1.2( ee

PrPri 

The Determinants of Interest Rate Levels

o FISHER EQUATION & NOMINAL INTEREST RATE

• Simplified Fisher Equation

)2.2( e

Pri 

The Determinants of Interest Rate Levels

o FISHER EQUATION EXAMPLE

14.40% or 0.1440

0.10) x (0.04 0.10 0.04

Pr P r i

? i0.10 P0.04 r

ee

e









The Determinants of Interest Rate Levels

o SIMPLIFIED FISHER EQUATION EXAMPLE

14% or 0.14

0.10 0.04

Pe r i

? i0.10 Pe0.04 r









The Determinants of Interest Rate Levels

o REAL RATE OF INTEREST EXAMPLE

r 0.04

r 0.10 – 0.14

0.10 r 0.14

P r i

? r0.10 P0.14 i

e

e











The Determinants of Interest Rate Levels

o CYCLICAL & LONG-TERM INTEREST RATES

• Interest rates tend to rise and fall with changes

in the rate of inflation

• Rates tend to rise when the growth rate of the

economy increases and tend to fall when the

growth rate of the economy slows

The Determinants of Interest Rate Levels

o INTEREST RATE, BUSINESS CYCLE & INFLATION

• Interest rates

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