ChapterOutline1.1WhatisCorporateFinance?1.2CorporateSecuritiesasContingentClaimsonTotalFirmValue1.3TheCorporateFirm1.4GoalsoftheCorporateFirm1.5FinancialMarkets1.6OutlineoftheTextChapterOutline1.1WhatisCorWhatisCorporateFinance?

CorporateFinanceaddressesthefollowingthreequestions:Whatlong-terminvestmentsshouldthefirmengagein?Howcanthefirmraisethemoneyfortherequiredinvestments?Howmuchshort-termcashflowdoesacompanyneedtopayitsbills?WhatisCorporateFinance? CorTheBalance-SheetModeloftheFirmCurrentAssetsFixedAssets1Tangible2IntangibleTotalValueofAssets:Shareholders’EquityCurrentLiabilitiesLong-TermDebtTotalFirmValuetoInvestors:TheBalance-SheetModeloftheTheBalance-SheetModeloftheFirmCurrentAssetsFixedAssets1Tangible2IntangibleShareholders’EquityCurrentLiabilitiesLong-TermDebtWhatlong-terminvestmentsshouldthefirmengagein?TheCapitalBudgetingDecisionTheBalance-SheetModeloftheTheBalance-SheetModeloftheFirmHowcanthefirmraisethemoneyfortherequiredinvestments?TheCapitalStructureDecisionCurrentAssetsFixedAssets1Tangible2IntangibleShareholders’EquityCurrentLiabilitiesLong-TermDebtTheBalance-SheetModeloftheTheBalance-SheetModeloftheFirmHowmuchshort-termcashflowdoesacompanyneedtopayitsbills?TheNetWorkingCapitalInvestmentDecisionNetWorkingCapitalShareholders’EquityCurrentLiabilitiesLong-TermDebtCurrentAssetsFixedAssets1Tangible2IntangibleTheBalance-SheetModeloftheCapitalStructureThevalueofthefirmcanbethoughtofasapie.Thegoalofthemanageristoincreasethesizeofthepie.TheCapitalStructuredecisioncanbeviewedashowbesttosliceupathepie.Ifhowyouslicethepieaffectsthesizeofthepie,thenthecapitalstructuredecisionmatters.50%Debt50%Equity25%Debt75%Equity70%Debt30%EquityCapitalStructureThevalueofHypotheticalOrganizationChartChairmanoftheBoardand

ChiefExecutiveOfficer(CEO)BoardofDirectorsPresidentandChief

OperatingOfficer(COO)VicePresidentand

ChiefFinancialOfficer(CFO)TreasurerControllerCashManagerCapitalExpendituresCreditManagerFinancialPlanningTaxManagerFinancialAccountingCostAccountingDataProcessingHypotheticalOrganizationCharTheFinancialManagerTocreatevalue,thefinancialmanagershould:Trytomakesmartinvestmentdecisions.Trytomakesmartfinancingdecisions.TheFinancialManagerTocreateCashflow

fromfirm(C)TheFirmandtheFinancialMarketsTaxes(D)FirmGovernmentFirmissuessecurities(A)Retained

cashflows(F)Invests

inassets

(B)Dividendsand

debtpayments(E)Currentassets

FixedassetsFinancial

marketsShort-termdebtLong-termdebtEquitysharesUltimately,thefirmmustbeacashgeneratingactivity.Thecashflowsfromthefirmmustexceedthecashflowsfromthefinancialmarkets.Cashflow

fromfirm(C)TheFir1.2CorporateSecuritiesasContingentClaimsonTotalFirmValueThebasicfeatureofadebtisthatitisapromisebytheborrowingfirmtorepayafixeddollaramountofbyacertaindate.Theshareholder’sclaimonfirmvalueistheresidualamountthatremainsafterthedebtholdersarepaid.Ifthevalueofthefirmislessthantheamountpromisedtothedebtholders,theshareholdersgetnothing.1.2CorporateSecuritiesasCoDebtandEquityasContingentClaims$F$FPayoffto

debtholdersValueofthefirm(X)Debtholdersarepromised$F.Ifthevalueofthefirmislessthan$F,theygetthewhateverthefirmifworth.Ifthevalueofthefirmismorethan$F,debtholdersgetamaximumof$F.$FPayoffto

shareholdersValueofthefirm(X)Ifthevalueofthefirmislessthan$F,shareholdersgetnothing.Ifthevalueofthefirmismorethan$F,shareholdersgeteverythingabove$F.Algebraically,thebondholder’sclaimis:Min[$F,$X]Algebraically,theshareholder’sclaimis:Max[0,$X–$F]DebtandEquityasContingentCombinedPayoffstoDebtandEquity$F$FCombinedPayoffstodebtholders

andshareholdersValueofthefirm(X)Debtholdersarepromised$F.PayofftodebtholdersPayofftoshareholdersIfthevalueofthefirmislessthan$F,theshareholder’sclaimis:Max[0,$X–$F]=$0andthedebtholder’sclaimisMin[$F,$X]=$X.Thesumoftheseis=$XIfthevalueofthefirmismorethan$F,theshareholder’sclaimis:Max[0,$X–$F]=$X–$Fandthedebtholder’sclaimis:Min[$F,$X]=$F.Thesumoftheseis=$XCombinedPayoffstoDebtandE1.3TheCorporateFirmThecorporateformofbusinessisthestandardmethodforsolvingtheproblemsencounteredinraisinglargeamountsofcash.However,businessescantakeotherforms.1.3TheCorporateFirmThecorpFormsofBusinessOrganizationTheSoleProprietorshipThePartnershipGeneralPartnershipLimitedPartnershipTheCorporationAdvantagesandDisadvantagesLiquidityandMarketabilityofOwnershipControlLiabilityContinuityofExistenceTaxConsiderationsFormsofBusinessOrganizationAComparisonofPartnershipandCorporations

CorporationPartnershipLiquiditySharescaneasilybeexchanged.Subjecttosubstantialrestrictions.VotingRightsUsuallyeachsharegetsonevoteGeneralPartnerisincharge;limitedpartnersmayhavesomevotingrights.TaxationDoublePartnerspaytaxesondistributions.ReinvestmentBroadlatitudeAllnetcashflowisdistributedtopartners.LiabilityLimitedliabilityGeneralpartnersmayhaveunlimitedliability.Limitedpartnersenjoylimitedliability.ContinuityPerpetuallifeLimitedlifeAComparisonofPartnershipan1.4GoalsoftheCorporateFirmThetraditionalansweristhatthemanagersofthecorporationareobligedtomakeeffortstomaximizeshareholderwealth.1.4GoalsoftheCorporateFirTheSet-of-ContractsPerspectiveThefirmcanbeviewedasasetofcontracts.Oneofthesecontractsisbetweenshareholdersandmanagers.Themanagerswillusuallyactintheshareholders’interests.Theshareholderscandevisecontractsthataligntheincentivesofthemanagerswiththegoalsoftheshareholders.Theshareholderscanmonitorthemanagersbehavior.Thiscontractingandmonitoringiscostly.TheSet-of-ContractsPerspectiManagerialGoalsManagerialgoalsmaybedifferentfromshareholdergoalsExpensiveperquisitesSurvivalIndependenceIncreasedgrowthandsizearenotnecessarilythesamethingasincreasedshareholderwealth.ManagerialGoalsManagerialgoaSeparationofOwnershipandControlBoardofDirectorsManagementAssetsDebtEquityShareholdersDebtholdersSeparationofOwnershipandCoDoShareholdersControlManagerialBehavior?Shareholdersvotefortheboardofdirectors,whointurnhirethemanagementteam.Contractscanbecarefullyconstructedtobeincentivecompatible.Thereisamarketformanagerialtalent—thismayprovidemarketdisciplinetothemanagers—theycanbereplaced.Ifthemanagersfailtomaximizeshareprice,theymaybereplacedinahostiletakeover.DoShareholdersControlManage1.5FinancialMarketsPrimaryMarketWhenacorporationissuessecurities,cashflowsfrominvestorstothefirm.UsuallyanunderwriterisinvolvedSecondaryMarketsInvolvethesaleof“used”securitiesfromoneinvestortoanother.Securitiesmaybeexchangetradedortradeover-the-counterinadealermarket.1.5FinancialMarketsPrimaryMFinancialMarketsFirmsInvestorsSecondaryMarketmoneysecuritiesSueBobStocksandBondsMoneyPrimaryMarketFinancialMarketsSecondaryMar1.6OutlineoftheTextOverviewValueandCapitalBudgetingRiskCapitalStructureandDividendPolicyLong-TermFinancingOptions,FuturesandCorporateFinanceFinancialPlanningandShort-TermFinanceSpecialTopics1.6OutlineoftheTextOvervieChapterOutline1.1WhatisCorporateFinance?1.2CorporateSecuritiesasContingentClaimsonTotalFirmValue1.3TheCorporateFirm1.4GoalsoftheCorporateFirm1.5FinancialMarkets1.6OutlineoftheTextChapterOutline1.1WhatisCorWhatisCorporateFinance?

CorporateFinanceaddressesthefollowingthreequestions:Whatlong-terminvestmentsshouldthefirmengagein?Howcanthefirmraisethemoneyfortherequiredinvestments?Howmuchshort-termcashflowdoesacompanyneedtopayitsbills?WhatisCorporateFinance? CorTheBalance-SheetModeloftheFirmCurrentAssetsFixedAssets1Tangible2IntangibleTotalValueofAssets:Shareholders’EquityCurrentLiabilitiesLong-TermDebtTotalFirmValuetoInvestors:TheBalance-SheetModeloftheTheBalance-SheetModeloftheFirmCurrentAssetsFixedAssets1Tangible2IntangibleShareholders’EquityCurrentLiabilitiesLong-TermDebtWhatlong-terminvestmentsshouldthefirmengagein?TheCapitalBudgetingDecisionTheBalance-SheetModeloftheTheBalance-SheetModeloftheFirmHowcanthefirmraisethemoneyfortherequiredinvestments?TheCapitalStructureDecisionCurrentAssetsFixedAssets1Tangible2IntangibleShareholders’EquityCurrentLiabilitiesLong-TermDebtTheBalance-SheetModeloftheTheBalance-SheetModeloftheFirmHowmuchshort-termcashflowdoesacompanyneedtopayitsbills?TheNetWorkingCapitalInvestmentDecisionNetWorkingCapitalShareholders’EquityCurrentLiabilitiesLong-TermDebtCurrentAssetsFixedAssets1Tangible2IntangibleTheBalance-SheetModeloftheCapitalStructureThevalueofthefirmcanbethoughtofasapie.Thegoalofthemanageristoincreasethesizeofthepie.TheCapitalStructuredecisioncanbeviewedashowbesttosliceupathepie.Ifhowyouslicethepieaffectsthesizeofthepie,thenthecapitalstructuredecisionmatters.50%Debt50%Equity25%Debt75%Equity70%Debt30%EquityCapitalStructureThevalueofHypotheticalOrganizationChartChairmanoftheBoardand

ChiefExecutiveOfficer(CEO)BoardofDirectorsPresidentandChief

OperatingOfficer(COO)VicePresidentand

ChiefFinancialOfficer(CFO)TreasurerControllerCashManagerCapitalExpendituresCreditManagerFinancialPlanningTaxManagerFinancialAccountingCostAccountingDataProcessingHypotheticalOrganizationCharTheFinancialManagerTocreatevalue,thefinancialmanagershould:Trytomakesmartinvestmentdecisions.Trytomakesmartfinancingdecisions.TheFinancialManagerTocreateCashflow

fromfirm(C)TheFirmandtheFinancialMarketsTaxes(D)FirmGovernmentFirmissuessecurities(A)Retained

cashflows(F)Invests

inassets

(B)Dividendsand

debtpayments(E)Currentassets

FixedassetsFinancial

marketsShort-termdebtLong-termdebtEquitysharesUltimately,thefirmmustbeacashgeneratingactivity.Thecashflowsfromthefirmmustexceedthecashflowsfromthefinancialmarkets.Cashflow

fromfirm(C)TheFir1.2CorporateSecuritiesasContingentClaimsonTotalFirmValueThebasicfeatureofadebtisthatitisapromisebytheborrowingfirmtorepayafixeddollaramountofbyacertaindate.Theshareholder’sclaimonfirmvalueistheresidualamountthatremainsafterthedebtholdersarepaid.Ifthevalueofthefirmislessthantheamountpromisedtothedebtholders,theshareholdersgetnothing.1.2CorporateSecuritiesasCoDebtandEquityasContingentClaims$F$FPayoffto

debtholdersValueofthefirm(X)Debtholdersarepromised$F.Ifthevalueofthefirmislessthan$F,theygetthewhateverthefirmifworth.Ifthevalueofthefirmismorethan$F,debtholdersgetamaximumof$F.$FPayoffto

shareholdersValueofthefirm(X)Ifthevalueofthefirmislessthan$F,shareholdersgetnothing.Ifthevalueofthefirmismorethan$F,shareholdersgeteverythingabove$F.Algebraically,thebondholder’sclaimis:Min[$F,$X]Algebraically,theshareholder’sclaimis:Max[0,$X–$F]DebtandEquityasContingentCombinedPayoffstoDebtandEquity$F$FCombinedPayoffstodebtholders

andshareholdersValueofthefirm(X)Debtholdersarepromised$F.PayofftodebtholdersPayofftoshareholdersIfthevalueofthefirmislessthan$F,theshareholder’sclaimis:Max[0,$X–$F]=$0andthedebtholder’sclaimisMin[$F,$X]=$X.Thesumoftheseis=$XIfthevalueofthefirmismorethan$F,theshareholder’sclaimis:Max[0,$X–$F]=$X–$Fandthedebtholder’sclaimis:Min[$F,$X]=$F.Thesumoftheseis=$XCombinedPayoffstoDebtandE1.3TheCorporateFirmThecorporateformofbusinessisthestandardmethodforsolvingtheproblemsencounteredinraisinglargeamountsofcash.However,businessescantakeotherforms.1.3TheCorporateFirmThecorpFormsofBusinessOrganizationTheSoleProprietorshipThePartnershipGeneralPartnershipLimitedPartnershipTheCorporationAdvantagesandDisadvantagesLiquidityandMarketabilityofOwnershipControlLiabilityContinuityofExistenceTaxConsiderationsFormsofBusinessOrganizationAComparisonofPartnershipandCorporations

CorporationPartnershipLiquiditySharescaneasilybeexchanged.Subjecttosubstantialrestrictions.VotingRightsUsuallyeachsharegetsonevoteGeneralPartnerisincharge;limitedpartnersmayhavesomevotingrights.TaxationDoublePartnerspaytaxesondistributions.ReinvestmentBroadlatitudeAllnetcashflowisdistributedtopartners.LiabilityLimitedliabilityGeneralpartnersmayhaveunlimitedliability.Limitedpartnersenjoylimitedliability.ContinuityPerpetuallifeLimitedlifeAComparisonofPartnershipan1.4GoalsoftheCorporateFirmThetraditionalansweristhatthemanagersofthecorporationareobligedtomakeeffortstomaximizeshareholderwealth.1.4GoalsoftheCorporateFirTheSet-of-ContractsPerspectiveThefirmcanbeviewedasasetofcontracts.Oneofthesecontractsisbetweenshareholdersandmanagers.Themanagerswillusuallyactintheshareholders’interests.Theshareholderscandevisecontractsthataligntheincentivesofthemanagerswiththegoalsoftheshareholders.Theshareholderscanmonitorthemanagersbehavior.Thiscontractingandmonitoring