Chapter One

Overview of Corporate Finance

Principles of Corporate Finance
Canadian Edition
Lawrence J. Gitman and Sean Hennessey

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 Learning Goals
LG1 – Define finance and describe its three
major areas and career opportunities.
LG2 – Review basic forms of business
organization, their strengths and
weaknesses.
LG3 – Describe managerial finance function and
differentiate from economics and
accounting.

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 Learning Goals (continued)
LG4 – Identify key activities of financial
manager within the firm.
LG5 – Explain why wealth maximization is
firm’s goal.
LG6 – Explain how EVA, stakeholder focus,
and ethical behaviour relate to firm’s
goal.
LG7 – Discuss agency issue as it relates to
owner wealth maximization.
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 What is Finance?
• At the macro level, finance is the study of financial
institutions and financial markets and how they operate
within the financial system in both the Canadian and
global economies.
• At the micro level, finance is the study of financial
planning, asset management, and fund raising for
businesses and financial institutions.
• Financial management can be described in brief using
the following balance sheet.

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 What is Finance?
Macro Finance

Assets: Liabilities & Equity:

Current Assets Current Liabilities
Cash & M.S. Accounts payable
Accounts receivable Notes Payable
Inventory Total Current Liabilities
Working Total Current Assets Long-Term Liabilities
Working
Fixed Assets: Total Liabilities
Capital Capital
Gross fixed assets Equity:
Less: Accumulated dep. Common Stock
Goodw ill Paid-in-capital
Other long-term assets Retained Earnings
Investment Total Fixed Assets Total Equity
Financing
Decisions Total Assets Total Liabilities & Equity
Decisions

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 What is Finance?
• A well-developed financial system is a hallmark and
essential characteristic of any modern developed
nation.
• Financial markets, financial intermediaries, and
financial management are the important components.
• Financial markets and financial intermediaries
facilitate the flow of funds from borrowers to savers.
• Financial management involves the efficient use of
financial resources in the production of goods.
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Areas of Specialization in Finance

• Financial Markets
– Markets of users and savers of funds.
• Financial Services
– Design and delivery of financial advice and
products to individuals, businesses, government.
• Managerial Finance
– Financial management of business firms.

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Areas of Employment in Finance
• Financial Analyst
• Capital budgeting analyst/manager
• Project finance manager
• Cash manager
• Credit analyst/manager
• Pension fund manager

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 Basic Forms of Business
Organization
• Sole Proprietorship
– Owned by one person, operated for personal profit.
• Partnerships
– Owned by two or more people, operated for joint
profit.
• Corporations
– “Legal entity”, owned by individuals, operated for
joint profit.
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 Sole Proprietorship
STRENGTHS: WEAKNESSES:
• Low organizational cost • Unlimited liability
• Income taxed once as • Limited funding
personal income • Proprietor must be all
• Independence • Difficult to develop staff
• Secrecy career opportunities
• Ease of dissolution • Lack of continuity on
death of proprietor
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 Partnerships
STRENGTHS: WEAKNESSES:
• Improved funding • Unlimited liability to
sources all partners
• Increased managerial • Partnership dissolved
talent
upon death of partner
• Income split by
partnership contract, • Difficult to liquidate
taxed as personal or transfer ownership
income

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 Corporations
STRENGTHS: WEAKNESSES:
• Owners’ liability limited • Higher tax rates
• Large capitalization • Expensive organization
possible, greater funding • Greater government
• Ownership readily regulation
transferable • When publicly traded,
• Indefinite life lacks secrecy
• Professional management
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 Corporate Organization Chart

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Organization of Finance Functions

• CFO – Chief Financial Officer

• Treasurer responsibilities:
– Financial planning, fund raising, capital
expenditure decisions, cash and credit
management.
• Controller responsibilities:
– Corporate accounting, cost accounting, and tax
management.
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 Relationship to Economics
Fundamental Economic Principle:
• Marginal Analysis
– Financial decisions should be made and actions
taken only when the added benefits exceed the
added costs.

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 Relationship to Accounting
• Cash Flows
– Accrual Basis: recognizes sales revenue and
expenses incurred to make sale at time of sale.
– Cash Basis: recognizes revenues and expenses
as they occur.

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Accounting vs. Financial Views
Accounting View Financial View
(Accrual Basis) (Cash Basis)
Income Statement Cash Flow Statement
Peakes Quay, Inc. Peakes Quay, Inc.
For year ended 12/31 For year ended 12/31

Sales revenue $100,000 Cash inflow $ 0

Less: Costs 80,000 Less: Cash outflow 80,000
Net Profit $ 20,000 Net cash flow ($80,000)

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Financial Manager–Key Activities

Financial Analysis & Planning

Balance Sheet
Current Current
Making Assets Liabilities Making
Investment _______________ _______________ Financing
Decisions Fixed Long-Term Funds Decisions
Assets (Debt & Equity)

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Should Firms Maximize Profit?
• Corporations commonly define profit as
“Earnings per Share” (EPS).
– A measure of total earnings divided by total
number of ownership shares.
• EPS ignores critical factors of
– the timing of the returns.
– cash flows available to common shareholders.
– risk factors facing the firm.

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 Or Should Firms Maximize
Shareholder Wealth?
• Evaluating Shareholder Wealth addresses
factors of timing, cash flows and risk
ignored by the EPS.
• Therefore, Maximizing Shareholder Wealth
is a more comprehensive goal for the firm,
its managers and employees.
• This can be explored through “economic
valued added” and a focus on stakeholders.

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Economic Value Added – EVA®
• EVA measures whether an investment
contributes to shareholder wealth.
• EVA is calculated by subtracting cost of
funds used from after-tax operating profits.
• While popular, EVA is essentially derived
from the concept of “net present value.”

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 What about Stakeholders?
• Stakeholders include groups that have direct
economic links to the firm.
• Stakeholders include not only owners, but
also employees, customers, suppliers, and
creditors.
• Maintaining positive stakeholder
relationships helps maximize long-term
benefits to shareholders.

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 Importance of Ethics
The standards of conduct or moral judgment:
• Honesty, trustworthiness, fair dealing are
foundations of sustainable business relations:
– With customers,
– With suppliers,
– With creditors,
– With employees,
– With owners.
• Ethical behaviour is necessary to achieve the goal
of maximizing shareholder wealth.
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 Internal Ethical Review
• Are rights of stakeholders being violated?
• Does firm have extra duties to stakeholders?
• Will a decision unfairly discriminate benefits
among stakeholders?
• If stakeholders are harmed, should this be
remedied? How?
• What is the relationship between shareholders
and stakeholders?
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Financial Goals of a Company
• Maximize sales. • Maximize return on
• Maximize cash flow. sales, investment,
• Maximize market equity.
share. • Ensure earnings
• Maximize profit. stability.
• Achieve target goals
• Minimize costs.
for sales, profits,
market share or return.

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 Agency Issues:
The Principal-Agent Problem
• Whenever ownership is independent of
management there exists potential problem of
conflicts.
• The owner’s goals for the firm are best described
as maximizing shareholder wealth.
• Managers are also concerned with personal
wealth, job security, lifestyle, and benefits. These
concerns may conflict with shareholder interests.

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 Resolving the Agency Problem
• Good corporate governance by the Board of
Directors is the heart of any resolution.
• Agency Costs – the costs of this governance:
– Monitoring costs,
– Bonding costs,
– Structuring compensation costs.
• Market forces, such as the potential for hostile
takeover provide some deterrence.
• Legal forces, fraud, and fiduciary misconduct laws
aim to act as deterrents as well.
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Current View on Incentive Plans
• Executive compensation packages generally
include incentive plans that grant stock
options, performance-based shares, or cash
bonuses upon meeting or exceeding
corporate goals.
• Such packages may also include long-term
benefits that can protect the manager
against poor corporate performance.
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 Overview of Text
Part 1: Introduction to Corporate Finance
Part 2: Financial Analysis and Planning
Part 3: Important Financial Concepts
Part 4: Long-Term Financial Decisions
Part 5: Long-Term Investment Decisions
Part 6: Working Capital Management
Part 7: Special Topics in Corporate Finance
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