1. Corporations and Financial Markets

Goal of financial management

• Maximize the equity value

• This is equivalent to maximizing the total value of the firm for its owners

Main advantages of the corporation form

• Access to large capital via many investors

• Limited liability for shareholders

• Unlimited life

• Easy transfer of ownership

Main drawbacks of the corporate form

• Double taxation of profits (corporate tax then personal tax on payouts)

• Separation of ownership and control creates agency problems and governance costs

Separation of ownership and control in a corporation

• Shareholders own the firm but typically do not manage it

• Board of directors hires and monitors managers

• Managers make operating and investment decisions

Role of the board of directors

• Represents shareholders’ interests

• Hires and fires top management

• Approves major investments, financing decisions and payout policy

Role of the CEO and CFO

• CEO has ultimate responsibility for running the firm and implementing strategy

• CFO oversees financing decisions, cash management, capital structure, and financial planning

Primary vs secondary financial markets

• Primary market transactions involve the firm issuing new securities to investors (e.g. IPO, SEO, new bond issue)

• Secondary market transactions are trades of existing securities between investors, the firm does not receive cash

Typical example of primary market trade

• Firm sells new shares to investors in an IPO or SEO

• Firm issues new bonds to raise debt capital

Typical example of secondary market trade

• Investor A sells existing shares or bonds to Investor B on an exchange

• The issuing firm’s balance sheet is unchanged

Capital markets vs money markets

• Capital markets trade long term securities like stocks and long maturity bonds

• Money markets trade short term safe instruments like T-bills and commercial paper

Financial intermediaries vs financial markets

• Financial intermediaries (banks, mutual funds, insurers) stand between savers and borrowers and hold securities on their balance sheet

• Financial markets (exchanges, OTC) allow savers and borrowers to trade securities directly

Why value-based decision rules matter

• Firm should accept investments that increase firm value (positive NPV)

• Other rules like IRR or payback are only useful as support and must be checked against NPV