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Introduction to FinanceLecture 1

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Goals and Governance of the Corporation

This chapter introduces the corporation, its goals, and the roles of financial managers.

Source: U.S. Census 2008 SUSB Annual Data

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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.

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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.

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What is a Corporation?

Corporation-A business organized as a separate legal entity owned by stockholders.

Types of Corporations: Public Corporations Private Corporations

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Benefits of the Corporation

Limited liability

Infinite lifespan

Ease of raising capital

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Drawbacks of the Corporation

Corporations face the problem of double taxationDouble Taxation – Corporations pay taxes on their profits and the shareholders are taxed again when they receive dividends or realize capital gains.

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.

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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 reservesA 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.

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The Ethics of Maximizing ValueDoes value maximization justify unethical behavior?

Recent examples: Enron

WorldCom

Bernard Madoff

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Agency ProblemDo 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. StakeholdersShareholders 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.

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Agency ProblemDifferent Information

Stock prices vs. returns

Dividend Policy

Financing Decisions

Different Objectives Managers vs.

shareholders Top managers vs. lower

managers Stockholders vs. banks

and lenders

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Agency Problem SolutionsCompensation plansProvide managers with incentive schemes that produce big returns if shareholders gain but little or nothing if they do not.

Board of DirectorsThrough a vote, the board of directors gives shareholders an opportunity to have a say in the operations of a firm.

BlockholdersIndividual investors who hold 5% or more of the company. These blockholders may offer some solutions to agency problems by closely monitoring the firm.

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Agency Problem Solutions

TakeoversPoorly 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 MonitoringManagers 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 RequirementsCEOs and financial managers have a legal duty to act responsibly and in the interests of investors.

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4A. Cash reinvested in the firm4B. Cash returned to investors

Role of the Financial Manager

FinancialManager

(1)(2)

(3)

(4a)

(4b)Real assets

Investors

Financial Assets

Firm’sOperations

1. Cash raised from investors (how?)2. Cash invested in firm3. Cash generated by operations

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The Financial ManagerMost large companies have 3 top-level financial managers: