Introduction to Corporate Finance,Corporate Finance addresses the following three questions: What long-term investments should the firm engage in? How can the firm raise money for the required investments? How much short-term cash flow does a company need to pay its bills? (RWJ ch.1),The Balance-Sheet Model of the Firm,The Balance-Sheet Model of the Firm,Current Assets,Fixed Assets 1 Tangible 2 Intangible,Shareholders Equity,Current Liabilities,Long-Term Debt,What long-term investments should the firm engage in?,The Capital Budgeting Decision (Investment Decision),The Balance-Sheet Model of the Firm,How can the firm raise the money for the required investments?,The Capital Structure Decision (Financing Decision),Current Assets,Fixed Assets 1 Tangible 2 Intangible,Shareholders Equity,Current Liabilities,Long-Term Debt,The Balance-Sheet Model of the Firm,How much short-term cash flow does a company need to pay its bills?,The Net Working Capital Investment Decision (Financial Decision),Net Working Capital,Shareholders Equity,Current Liabilities,Long-Term Debt,Current Assets,Fixed Assets 1 Tangible 2 Intangible,Capital Structure,The value of the firm can be thought of as a pie.,The goal of the manager is to increase the size of the pie.,The Capital Structure decision can be viewed as how best to slice up a the pie.,If how you slice the pie affects the size of the pie, then the capital structure decision matters.,50% Debt,50% Equity,Cash flow from firm (C),The Firm and the Financial Markets,Taxes (D),Firm issues securities (A),Retained cash flows (F),Invests in assets (B),Dividends and debt payments (E),Current assets Fixed assets,Short-term debt Long-term debt Equity shares,Ultimately, the firm must be a cash generating activity.,The cash flows from the firm must exceed the cash flows from the financial markets.,Financial Markets,Primary Market When a corporation issues securities, cash flows from investors to the firm. Usually an underwriter is involved Secondary Markets Involve the sale of “used” securities from one investor to another. Securities may be exchange traded or trade over-the-counter in a dealer market.,Financial Markets,Firms,Investors,Sue,Bob,Investment Environment,Two Elements of Investment: Time and Risk,Risky Investment and Capital Budgeting,The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date. The shareholders claim on firm value is the residual amount that remains after the debtholders are paid. If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.,Capital Structure :Debt and Equity,Debt and Equity as Options,$F,Debt holders are promised $F.,If the value of the firm is less than $F, they get the whatever the firm if worth.,If the value of the firm is more than $F, debt holders get a maximum of $F.,If the value of the firm is less than $F, share holders get nothing.,If the value of the firm is more than $F, share holders get everything above $F.,Algebraically, the bondholders claim is: Min$F,$X,Algebraically, the shareholders claim is: Max0,$X $F,Combined Payoffs to Debt and Equity,$F,Debt holders are promised $F.,If the value of the firm is less than $F, the shareholders claim is: Max0,$X $F = $0 and the debt holders claim is Min$F,$X = $X. The sum of these is = $X,If the value of the firm is more than $F, the shareholders claim is: Max0,$X $F = $X $F and the debt holders claim is: Min$F,$X = $F. The sum of these is = $X,Corporate Governance Separation of Ownership and Control,Board of Directors,Management,Assets,Debt,Equity,Shareholders,Debtholders,Asymmetric Information and Agency Costs,There is asymmetric information between shareholders and managers. How to induce managers to act in the shareholders interests ? The shareholders can devise contracts that align the incentives of the managers with the goals of the shareholders. The shareholders can monitor the managers behavior. (Agency Cost) This contracting and monitoring is costly.,