Transcript Investment and Financing Decisions

Introduction to Finance
Lecture 1
1-1
Goals and Governance of the
Corporation
This chapter introduces the corporation, its goals, and the roles
of financial managers.
Number of Firms in the U.S.
1,011,973
1,292,081
Corporation
S-Corporation
Partnership
Sole Proprietorship
622,908
2,584,427
Source: U.S. Census 2008 SUSB Annual Data
1-2
Investment and Financing Decisions
The Investment Decision – Decision to
invest in tangible or intangible assets.
Also known as the “capital budgeting” or
“CAPEX” decision.
Real Assets: Assets used to produce goods and
services.
•
The Financing Decision – The form and
amount of financing of a firm’s investments.
Financial Assets – Financial claims to the
income generated by the firm’s real assets.

1-3
Investment and Financing
Decisions
Are the following capital budgeting or financing decisions?

Apple decides to spend $500 million to develop a new iPhone.

GE borrows $400 million from bond investors.

Microsoft issues 100 million shares to buy a small technology
company.
1-4
What is a Corporation?
 Corporation-A business organized as a
separate legal entity owned by stockholders.
 Types of Corporations:
Public Corporations
 Private Corporations

1-5
Benefits of the Corporation
 Limited liability
 Infinite lifespan
 Ease of raising capital
1-6
Drawbacks of the Corporation
 Corporations face the problem of double taxation
Double Taxation – Corporations pay taxes
on their profits and the
shareholders are taxed again when they receive dividends
realize capital gains.
or
 Improper corporate structures may lead to “Agency Problems”
Agency Problem – Managers are agents of the shareholders, but the
managers may
act in their own interests rather than maximize value.
1-7
Goals of The Corporation
 Shareholders want wealth maximization
 Wealth maximization vs. profit maximization:

Pitfall: Profits from which period?
A corporation can make short term wasteful investments to increase profits, but long-term profits and value
will be damaged.

Pitfall: Cutting dividends to increase cash reserves
A company may increase future profits by cutting today’s dividend and reinvesting the cash in the firm. In
most cases, this decreases the value of shareholder investment in the firm.
1-8
The Ethics of Maximizing Value
Does value maximization justify unethical behavior?
Recent examples:

Enron

WorldCom

Bernard Madoff
1-9
Agency Problem
Do managers really maximize value?

Agency Problems
• Managers are agents for stockholders, but the
managers may act in their own interests rather than
maximizing value
Shareholders vs. Stakeholders
Shareholders want managers to maximize the market
value of the firm. However, managers are often
obliged to appease not only the shareholders but all of
the stakeholders as well.
1-10
Agency Problem
Different Information
 Stock prices vs. returns
 Dividend Policy
 Financing Decisions
Different Objectives
 Managers vs.
shareholders
 Top managers vs. lower
managers
 Stockholders vs. banks
and lenders
1-11
Agency Problem Solutions
Compensation plans
Provide managers with incentive schemes that produce big returns if shareholders gain but little or
nothing if they do not.
Board of Directors
Through a vote, the board of directors gives shareholders an opportunity to have a say in the operations
of a firm.
Blockholders
Individual investors who hold 5% or more of the company. These blockholders may offer some
solutions to agency problems by closely monitoring the firm.
1-12
Agency Problem Solutions
Takeovers
Poorly performing companies are more likely to be taken over by another firm. The further a
company’s stock price falls, the easier it is for another company to buy up a majority of its shares.
Specialist Monitoring
Managers are subject to the scrutiny of specialists. Their actions are monitored by the security analysts
who advise investors to buy, hold, or sell the company’s shares
Legal and Regulatory Requirements
CEOs and financial managers have a legal duty to act responsibly and in the interests of investors.
1-13
Role of the Financial Manager
Firm’s
Operations
(1)
(2)
Investors
Financial
Manager
(4a)
Financial
Assets
Real assets
(3)
(4b)
1. Cash raised from investors (how?)
2. Cash invested in firm
3. Cash generated by operations
4A. Cash reinvested in the firm
4B. Cash returned to investors
1-14
The Financial Manager
Most large companies have 3 top-level financial managers:
1-15