FIN

1. Introduction to Corporate Finance

1.1. Define Corporate Finance

a. Define Finance as making capital budgeting, capital structure and net working capital decisions

Corporate finance: This involves choosing lines of business, making strategic and long-term investment decisions (left hand side of the balance sheet), structuring the financing (right hand side of the balance sheet) as well as managing the day to operations of the company, i.e., its net working capital (current assets and current liabilities).

Long-term investment decisions: This is also known as capital budgeting which impacts the long-term assets on a balance sheet. The company identifies profitable projects to invest in to increase its value to shareholders.

Financing: This is also known as capital structure and refers to the split between trade payables, short-term debt, long-term debt and shareholders’ equity. This is essentially the right hand side of the balance sheet.

Net working capital: This refers to the difference between the current assets and current liabilities of a corporation. These are discussed in detail later. So, a typical balance sheet can be recast as follows:

TOTAL ASSETS	TOTAL LIABILITIES & SHAREHOLDER EQUITY
Net Fixed Assets	Long-term Debt
Net Working Capital (=CA – CL)	Shareholder Equity
Intangible Assets	Paid-in Capital
	Retained Earnings

Total Assets	Total Liabilities & Shareholder Equity
Note: Net Working Capital = Current Assets (CA) – Current Liabilities (CL), so CL are not shown separately as they have been netted out from CA.

b. Describe the reporting structure of the typical finance function

Finance reporting structure: The finance function is typically split into parallel paths: (1) Controllership, and (2) Treasury Functions. Both report to the Chief Financial Officer (CFO). The Controller supervises the accounting systems and reporting, taxation and costing, along with internal controls, whereas, the Treasurer interfaces with the external world raising capital and managing banking relationships. (S)he also manages cash and supervises capital expenditures, relying on accounting information generated by the Controller’s department. The two divisions work closely with one another.

It would be helpful to view a large corporation in the following manner to understand the responsibilities of the finance function and its interactions with other corporate departments:

1.2. Compare and contrast the three main forms of business organization (sole proprietorship, partnership, corporation) plus limited partnerships and LLCs, in terms of:

a. Ease of creation

b. Access to capital

c. Pass-through vs. double taxation

d. Limited vs. unlimited liability for owners

e. Limited vs. unlimited life of the business

f. Liquidity of ownership

Comparison of different business organizations:

Attribute	Sole Proprietorship	Partnership	Corporation	Limited Partnership	LLC
Ease with which it can be created	Simplest to start, least regulated	Similar to proprietorship. Two or more partners	Separate legal entity and complicated to start	Similar to general partnership. Has limited and general partners.	Partnership & corporation hybrid. Easy to create
Capital accessibility	Limited ability to raise capital	Limited ability to raise capital	Easier to raise debt and equity	Limited ability to raise capital	Greater access than partnership but less than corporation
Double taxation and pass-through (disregarded entity)	Owner taxed for business profits	Taxed directly to partners	Corporation is taxed. Shareholders taxed on dividends	Taxed directly to partners	Taxed directly to owners (members). Avoids double taxation
Extent of liability	Unlimited personal liability	General partners have unlimited liability	Shareholders have limited liability – to their initial investment	General partner has unlimited liability	Limited liability
Duration of life	Limited to owner’s life	When general partner sells or dies	Unlimited	When general partner sells or dies	Can live beyond members’ lives
Owners’ liquidity	Difficult ro transfer	General partner share hard to sell	Owners’ shares can be transferred with ease	Limited partner share hard to sell	More than partnership, less than corporation

1.3. Define the goal of financial management; that is, the goal of the corporation

a. Understand that “the goal of the corporation is to maximize the current value per share of the existing stock”

Goal of a corporation: Since the ownership and control are separated in a corporation, managers and shareholders have an agency conflict. Shareholders want the managers to maximize the value of the firm.

b. Generalize the goal to “maximize the value of existing owners’ equity” to apply to all forms of business

Goal of a business: In addition to maximizing the value of firm, managers should focus on maximizing the wealth of the owners in all forms of business. This means that they should maximize the value or price of a share of stock of existing shareholders, not new shareholders unless they have already purchased the stock. If equity is illiquid then maximizing value of equity should be the target.

c. Explain the necessary constraints to maximizing shareholder wealth

Constraints preventing maximization of shareholder wealth: Lack of liquidity of shareholder equity (non-traded) makes value measurement difficult.

1.4. Define the agency relationship in a corporation

a. Identify agency problems and how they create agency costs:

Agency problem and its costs: Agency problem refers to non-congruence of interest of two parties when one is the principal and the other is an agent. This misalignment leads to different goals and a potential breakdown of the team. Shareholders are the principals and managers are the agents in a corporation. The misalignment of incentives leads to monitoring costs and on-job-consumption by managers diverting shareholders’ assets.

b. Identify mechanisms employed to control agency costs:

Controlling agency costs: Top management compensation can be tied to firm performance. Employees can be offered performance bonuses, stock options and restricted stock units (RSUs) so they benefit from better corporate performance along with the shareholders, thus aligning their interests.

c. Differentiate between stockholders and stakeholders:

Difference between stockholders and stakeholders: While shareholders have a direct and formal claim on the earnings and assets of the firm and control the board of directors, there are others who also have a claim on a firm’s cash flows. They may also include outsiders. Stakeholders are comprised of employees, customers, suppliers, creditors, regulators, and the government who may have a competing claim against shareholders in the form of taxes. In recent years, environmentalists have also claimed to be stakeholders who are concerned about the impact of a corporation’s actions on the environment and the sustainability of its operations without degradation of the environment. You will study more about externalities later in the course under project analysis and evaluation.

d. Explain key provisions of Sarbanes-Oxley and why it exists:

Provisions of Sarbanes-Oxley Act: The Sarbanes-Oxley Act was designed to prevent management from misreporting and misrepresenting the earnings and financial condition of the firm to stockholders and stakeholders. It is also meant to prevent the abuse of corporate assets by managers, while prohibiting personal loans from the corporation to managers. Furthermore, it requires that corporate accounts are subject to internal control procedures, independent of the management, preferably overseen by the board of directors. The senior officers of a public corporation are required to sign the annual reports vouching for their accuracy and fair representation of the financial position of the company under the threat of prosecution and potential incarceration with penalties.