1 Intro to Corp Fin

1.1 Corp Fin & Fin Mana

2501220320 3 Roles of Corp Fin (Fin
Mana Decisions)
3 Roles of Corp Fin (Fin Mana
Decisions)

1. FA: Capital budgeting

Q: What long-term investments or projects should the firm
undertake?
Goal: Increase profitability (i.e. laying off employees,
invest in new tech, etc.)
- → Identify invsmt opps
- → Evaluate size, timing, and risk of future cash flows

<< Profit = Revenue (value of cash flow generated by

asset) – Cost

2. LTD + E: Capital/Financial structure

Q: Where will we get the long-term financing to pay for our
assets? What mixture of debt or equity should we use to
 fund operations?
Goal: Raise funds at reasonable cost

<< Debt-to-equity ratio: how much goes to creditors /

shareholders
<< Microecs: Marginal benefit = Marginal cost

3. CA – CL: Working capital management

Q: How do we manage the everyday financial activities of
the firm?

Goal:
Pay debt that is due (short-term, 1yr)
Operate smoothly & contnsly, i.e. manage invt

References

2501220223 Definition of Corp Finance

Definition of Corp Finance
Finance = money that flows between 2 parties
→ Finance refers to the monetary relationship between two
parties, e.g.
Personal finance: Individual <>
Public finance: Govt <>
Intl. finance: Country <>
Corp finance: Corp/Firm with
+ <> Customer (purchase products)
+ <> Supplier (sell raw materials)
+ <> Govt (pay tax)
<> Investors (share/bondholders)
<> Employees
- <> Comm. bank / fin mkt

<< Financial market: a place to buy/sell financial

instruments
→ Corp Finance: the study of the relationship between business
decisions and the value of the stock in the business

References

Structure of an organization: 2501220547 Structure of Org,

Managers vs. Shareholder, Stockholder
Shareholders want managers to increase existing stock
value: 2501220557 Goal of Fin Mana, 2501222029 Goal of
Management

1.2 Forms of BS Org

2501220449 Sole Proprietorship
Sole proprietorship
Def: BS owned by one person.

Advantages
Easiest to start
Least regulated
Owner keeps all the profits
Income taxed once as personal income

<< Revenue – Cost = Earnings before tax

– Income tax = Net income

Disadvantages
Limited to life of owner
Equity limited to owner’s personal wealth
Unlimited liability (for debts): when company winds up,
owner must use beyond business assets to personal assets to
pay up debts
Difficult to transfer/sell ownership interest
(small/non-existent mkt)
 (value of whole company is illiquid)

References

2501220422 Forms of BS Organization

Sole prop and partnership shares similar disadvantages,

income is taxed once: 2501220532 Primary Disadvantages of
Soleprop & Partner

2501220454 Partnership
Partnership
Def: BS owned by 2-20 owners (general + limited partners)

|@@| Partnership company is usually a law firm

Advantages
Two or more owners
Relatively easy to start
More equity/capital combined
Income taxed once as personal income

|@@| Gains/losses are divided according to the

partnership agreement

Disadvantages
General partners have unlimited liab
Limited partners have limited liab (up to the amount
contributed)
Partnership dissolves when one partner dies or wishes to
sell
Difficult to transfer ownership (needs mutual agreement
between members)

References

2501220422 Forms of BS Organization

 2501220524 Partnership agreement math example
Sole prop and partnership shares similar disadvantages,
income is taxed once: 2501220532 Primary Disadvantages of
Soleprop & Partner

2501220524 Partnership agreement math

example
Partnership agreement math example
e.g. A partnership has 40%/60% money contributed by
general/limited.
General member will receive 20% of profit, the remaining will
be shared by all members. Net profit = $200

→ General members
= 0.2x200 + 0.4x(200 - 0.2x200)
= $104

→ Limited members
= 0.6x(200-0.2x200)
= $96

References

2501220454 Partnership

2501220532 Primary Disadvantages of

Soleprop & Partner
Primary Disadvantages of Soleprop &
Partner
1. Unlimited liability for debts
2. Limited life of business
3. Difficulty of transferring ownership
4. Cannot issue stocks → Cannot observe stock price of its
company
→ Inability to raise cash for invsmt hinders business
growth
References

Common advantage: income is taxed once as personal income

2501220449 Sole Proprietorship
2501220454 Partnership

2501220537 Corporation
Corporation
Def: a legal entity separate and distinct from its owners,
divided into small equal parts → share/stockholders

Advantages
Shareholders have limited liability (up to amount invested)
Unlimited life
Separation of ownership and management
(when owner dies, still operates)
(managers only need mana skills and focus on perf of
company)
Easier to transfer of ownership (sell in stock mkt)
Easier to raise capital
→ Superior to other forms in terms of raising money &
transferring onwership interests

Disadvantages
Double taxation

<< Corp: Revenue – Cost = Earnings before tax, then –

Corp income tax = Net income / shareholders = Dividends,
then – Personal income tax

References

Other variations/names:
Joint Stock Company
Public Limited Company
Limited Liability Company
2501220547 Structure of Org, Managers
vs. Shareholder, Stockholder
Stockholder & Managers
In a large corp, stockholders and managers are usually
separate groups.
Stockholders elect Board of Directors, who then select the
managers (Board of Management)
→ Stockholders control the corp.

The top financial manager within a firm is usually the

Chief Financial Officer (CFO).

References

1.3 Goal of Fin Mana

2501220557 Goal of Fin Mana
Goal of Fin Mana
Leans towards either:
1. Profitability: sales, mkt share, cost control, …
2. Risk control: bankruptcy avoidance, stability and
safety, …
→ Contradicting
 Goal of fin mana: maximize current value per share of
existing stock → maximize mkt value of existing owners’
equity.
Ultimate goal: increase owner’s wealth.

<||Owner’s wealth: amount of money the company is worth

when sold (detmn by supply and demand of mkt)

References

The goal of fin mana is to maximize the mkt value of the

stock, not its book value: 2501251054 Balance sheet, Net
working capital, NWC
Growth is a reflection of the final goal of fin mana:
2501272117 Growth as a Fin Mana Goal
The fin manager usually face the problem of estimating mkt
value of invsmt/project/asset/debt using only indirect mkt
info

1.5 Fin Mkts & Corp

2501222133 Cash flows between Firm &
Fin mkt
Cash flows between Firm & Fin mkt
Implication: if any flow stops, the whole system collapses
→ As a firm manager, we need to sustain the flows smoothly.
References

The bond crisis of 2022, big firms could not pay up bonds →
stop trusting small firms
Cash activities of a firm can be summarized by a single
identity:
CF from assets = CF to creditors + CF to owners…

2501231835 Dealer vs. Auction Mkts (2nd

Mkts)
Dealer vs. Auction Mkts (2nd Mkts)
1. Dealers: Buy & sellfor themselves, at their own risk
2. Brokers & Agents: Match buyers & sellers, but don’t own the
commodity.

Stocks listed on an exchg = trade on it

Dealer mkts in stocks & long-term debt = Over-the-counter
(OTC) mkts:
 Today, most trading takes place OTC, mkts have no central
location; many dealers are connected digitally → intl mkt
e.g. NASDAQ (companies are smaller & trade less)
Auction mkts/exchg ≠ dealer mkts:
1. has a physical location e.g. Wall Street, NYSE;
2. purpose: match sellers with buyers

References

Total value of NASDAQ stocks << NYSE stocks

To be listed on the NYSE, company’s mkt value of public
shares must be at least $100M

2501222139 Primary vs Secondary mkts

Primary vs Secondary mkts
2 mkts are equally important:
Primary:
initial sale of secrt by corp/govt
2 types of transct:
public offering (to public, costly registration to
SEC),
private placements (to buyer)
raise capital for corp
Second:
generate liquidity of share
Why buy stock: to gain profit from increase in stock price
Issuer has to lower the price for new investors, but risk
sacrificing ownership.

Math example: A company has 10M shares, needs $4M to

invest.
Og ownership proportion: 10M shares (100%)
If issuing price = $4 → issue 1M stocks => 10/(10+11) =
91%
If issuing price = $1 → issue 4M stocks => 10 / (10+4)
= 71%
References

2 types of secondary mkts: 2501231835 Dealer vs. Auction

Mkts (2nd Mkts)

1.4 Agency Problem & Corp Control

2501220440 Stakeholder vs. Shareholder,
Stockholder
Stakeholder ≠ Shareholder
Stockholder: owner(s) of the company
Stakeholder = any party that has a rltsp with the company
(claim on cash flows) – (bondholder + shareholder)
e.g. employees, customers, suppliers, govt may attempt to
exert control over the firm

References

In a large corp, stockholders and managers are usually

separate groups…: 2501220547 Structure of Org, Managers vs.
Shareholder, Stockholder

2501220640 The Agency Problem

The Agency Problem
Agency relationship between principal <> agent
principal: possess/own asset
agent: manage asset
→ Stockholders (principals) hire managers (agents) to act
in stockholders’ best interests and run the company
Agency problem: conflict of interest between principal and
agent
Agency cost: costs of conflict between stockholders’ &
management’s interests,
indirect cost: lost opp
 direct cost: corp expenditure (private jet), monitor
expense (auditing)

References

Managers won’t always act in the best interests of

stockholders…
Direct cost – private jet example

2501222027 Agency cost in equity & debt

Agency cost in equity, shareholders vs.
managers
Princi = shareholders; Agent = managers
Solution: Princi must provide the managers a reasonable
compensation package, including:
monthly salary
bonus
stock option: rights to buy stock at a predetmn price,
regardless of mkt price

Agency cost in debt: debtholders vs.

shareholders
Princi = debtholders (lender, has money)
→ Goal: receive fixed amount of $ for each period
regardless of stock price → invest in safe projects
Agent = shareholders
→ Goal: increase stock price → invest in risky projects
→ Solution: The debt contract must be strict

<< Restrictive covenant

References

2501222055 Compensation package

 << Sole prop is the only form of org that does not have
agency cost (owns 100% of company): 2501220449 Sole
Proprietorship

2501222029 Goal of Management

Goal of Management
Maximize corp power or wealth → Overemphasize corp
size/growth/survival
Final goal: independence and corp self-sufficiency
There will be times when management goals are pursued at
the expense of the stockholders, at least temporarily.

References

Goal of management conflicts with goal of shareholders:

2501220557 Goal of Fin Mana
This overemphasis tend to cause mana overpaying to buy
another company just to increase bs size, or demonstrate
corp power → Direct agency cost – corp expenditure:
2501220640 The Agency Problem

2501222055 Compensation package

Managerial/Executive compensation
package
This is managers’ economic incentive to increase share
value, which includes:
monthly salary
bonus
stock option: rights to buy stock at a predetmnd price,
regardless of mkt price

References

This is the solution to agency costs in equity: 2501222027

Agency cost in equity & debt
 The use of clawbacks (bonus reclaim) and deferred
compensation (circumstances warrant) have increased to
combat concernable payments

2501222038 Managing Managers

Managing Managers
Managers will act in the best interests of stockholders when
they are:

1. compensated, or
2. threatened to be replaced if acting otherwise

References

1. 2501222055 Compensation package

2. 2501222056 Corp control

2501222146 Direct agency cost – private

jet example
Direct agency cost – private jet
example
A company is going to buy a $1M jet for only CEO to use.
When CEO uses the jet, his benefits = $80k. The CEO owns 5%
of the company. Does the CEO decide to buy the jet?
→ Compare marginal benefits & costs
Benefits = $80k > Costs = $1M x 5% = $50k → BUY

References
2501222027 Agency cost in equity & debt

2501222056 Corp control

Corp control
Proxy fight: stockholders can replace existing BoD, thereby
replacing existing BoM.
 Takeover: firms are more attractive when they are poorly
managed = not achieving their fullest profit potential
Management want to avoid takeover → incentive to act in
stockholders’ interests.

References

2501220547 Structure of Org, Managers vs. Shareholder,

Stockholder