McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-1 Chapter Outline 1.1 What is Corporate Finance? 1.2 Corporate Securities as Contingent Claims on Total Firm Value 1.3 The Corporate Firm 1.4 Goals of the Corporate Firm 1.5 Financial Markets 1.6 Outline of the Text McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-2 What is Corporate Finance? Corporate Finance addresses the following three questions: What long-term investments should the firm engage in? How can the firm raise the money for the required investments? How much short-term cash flow does a company need to pay its bills? McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-3 The Balance-Sheet Model of the Firm Current Assets Fixed Assets 1 Tangible 2 Intangible Total Value of Assets: Shareholders Equity Current Liabilities Long-Term Debt Total Firm Value to Investors: McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-4 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 McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-5 The Balance-Sheet Model of the Firm How can the firm raise the money for the required investments? The Capital Structure Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders Equity Current Liabilities Long-Term Debt McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-6 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 Net Working Capital Shareholders Equity Current Liabilities Long-Term Debt Current Assets Fixed Assets 1 Tangible 2 Intangible McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-7 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 25% Debt 75% Equity 70% Debt 30% Equity McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-8 Hypothetical Organization Chart Chairman of the Board and Chief Executive Officer (CEO) Board of Directors President and Chief Operating Officer (COO) Vice President and Chief Financial Officer (CFO) TreasurerController Cash Manager Capital Expenditures Credit Manager Financial Planning Tax Manager Financial Accounting Cost Accounting Data Processing McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-9 The Financial Manager To create value, the financial manager should: Try to make smart investment decisions. Try to make smart financing decisions. McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-10 Cash flow from firm (C) The Firm and the Financial Markets Taxes (D) Firm Government Firm issues securities (A) Retained cash flows (F) Invests in assets (B) Dividends and debt payments (E) Current assets Fixed assets Financial markets 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. McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-11 1.2 Corporate Securities as Contingent Claims on Total Firm Value 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. McGraw-Hill/Irwin Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 1-12 Debt and Equity as Contingent Claims $F $F Payoff to debt holders Value of the firm (X) 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. $F Payoff to shareholders Value of the firm (X) 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 McGraw-Hill/Irwin Copyright 20