Chapter 1

Chapter 1
Corporate
Finance and
the Financial
Manager
Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Chapter Outline
1.1 Why Study Finance?

1.2 The Four Types of Firms
1.3 The Financial Manager
1.4 Principles of financial management
1.5 Financial Markets

1-2
Learning Objectives
• Grasp the importance of financial information in both your

personal and business lives
• Understand the important features of the four main types of
firms and see why the advantages of the corporate form
have led it to dominate economic activity
• Explain the goal of the financial manager and the reasoning
behind that goal, as well as understand the three main
types of decisions a financial manager makes
• Understand the importance of financial markets, such as
stock markets, to a corporation and the financial manager’s
role

1-3
Learning Objectives
• Grasp the importance of financial information in both your

personal and business lives
• Understand the important features of the four main types of
firms and see why the advantages of the corporate form
have led it to dominate economic activity
• Explain the goal of the financial manager and the reasoning
behind that goal, as well as understand the three main
types of decisions a financial manager makes
• Understand the importance of financial markets, such as
stock markets, to a corporation and the financial manager’s
role

1-4
• Individuals are taking charge of their

personal finances with decisions such as:
– When to start saving and how much to save for
retirement
– Whether a car loan or lease is more
advantageous
– Whether a particular stock is a good
investment
– How to evaluate the terms for a home
mortgage

1-5
• In your business career, you may face

such questions such as:
– Should your firm launch a new product?
– Which supplier should your firm choose?
– Should your firm produce a part or outsource
production?
– Should your firm issue new stock or borrow
money instead?
– How can you raise money for your start-up
firm?

1-6
• Financial Management
– The financial manager plays a critical role
inside any business enterprise. Potential
decisions include:
• What products to launch
• How to pay to develop those products
• What profits to keep and how to return profits to
investors

1-7
1. Sole Proprietorships
2. Partnerships
3. Limited Liability Companies
4. Corporations

1-8
• Sole Proprietorship
– Straightforward and many new businesses use
this organizational form
– Principal limitation is that there is no separation
between the firm and the owner
• The firm can have only one owner

1-9
• Sole Proprietorship
– The owner has unlimited personal liability for
any of the firm’s debts
– The life of a sole proprietorship is limited to the
life of the owner
– It is difficult to transfer ownership of a sole
proprietorship

1-10
• Partnership
– All partners are liable for the firm’s debt
• A lender can require any partner to repay all the
firm’s outstanding debts.
– The partnership ends on the death or
withdrawal of any single partner

1-11
• Partnership
– A limited partnership is a partnership with two
kinds of owners, general partners and limited
partners
• General partners
– Have the same rights and privileges as partners in any
general partnership
– Are personally liable for the firm’s debt obligations
• Limited partners
– Have limited liability and their ownership interest is
transferable
– They have no management authority

1-12
• Limited Liability Companies (LLC)

– No general partner
– All the owners have limited liability, but they
can also run the business

1-13
• Corporations
– A corporation is a legally defined, artificial
being, separate from its owners.
• It has many of the legal powers that people have.
– It can enter into contracts, acquire assets, incur
obligations, and it enjoys protection under the U.S.
Constitution against the seizure of its property.

1-14
• Corporations
– A corporation is solely responsible for its own
obligations
– The owners of a corporation are not liable for
any obligations the corporation enters into
– The corporation is not liable for any personal
obligations of its owners

1-15
• Formation of a Corporation
– Must be legally formed
• Must be chartered in the state in which it is
incorporated
• Corporate charter specifies the initial rules that
govern how the corporation is run
• More costly than setting up a sole proprietorship

1-16
• Ownership of a Corporation
– No limit on the number of owners
– The entire ownership stake of a corporation is
divided into shares known as stock
– The collection of all the outstanding shares of a
corporation is known as the equity of the
corporation

1-17
• Ownership of a Corporation
– An owner of a share of stock in the corporation
is known as a shareholder, stockholder, or
equity holder
– Shareholders are entitled to dividend payments
• Usually receive a share of the dividend payments that
is proportional to the amount of stock they own
– No limitation on who can own its stock

1-18
• Tax Implications for Corporate Entities

– A corporation’s profits are subject to taxation
separate from its owners’ tax obligations.
– Shareholders of a corporation pay taxes twice
• The corporation pays tax on its profits
• When the remaining profits are distributed to the
shareholders, the shareholders pay their own
personal income tax on this income

1-19
Example 1.1a
Taxation of Corporate Earnings
Problem:
• You are a shareholder in a corporation. The corporation
earns $10 per share before taxes. After it has paid taxes, it
will distribute the rest of its earnings to you as a dividend.
The dividend is income to you, so you will then pay taxes
on these earnings. The corporate tax rate is 35% and your
tax rate on dividend income is 10%. How much of the
earnings remains after all taxes are paid?

1-20
Example 1.1a
Solution:
Plan:
• Earnings before taxes: $10
• Tax Rate: 35%
• Personal Dividend Tax Rate: 10%
• We need to first calculate the corporation’s earnings after
taxes by subtracting the taxes paid from the pre-tax
earnings of $10. The taxes paid will be 35% (the corporate
tax rate) of $10. Since all of the after-tax earnings will be
paid to you as a dividend, you will pay taxes of 10% on that
amount. The amount leftover is what remains after all taxes
are paid.

1-21
Example 1.1a
Execute:
• $10 per share  0.35 = $3.50 in taxes at the corporate
level, leaving $10 - $3.50 = $6.50 in after-tax earnings per
share to distribute.
• You will pay $6.50  0.10 = $0.65 in taxes on that dividend,
leaving you with $5.85 from the original $10 after all taxes.

1-22
Example 1.1a
Evaluate:
• As a shareholder you keep $5.85 of the original $10 in
earnings; the remaining $3.50 + $0.65 = $4.15 is paid as
taxes. Thus, your total effective tax rate is $4.15/$10 =
41.5%.

1-23
• S Corporations
– The firm’s profits/losses are not subject to
corporate taxes
• Instead profits/losses are allocated directly to
shareholders based on their ownership share
• Shareholders must include these profits as income on
their individual tax returns, even if no money is
distributed to them

1-24
• C Corporations
– Most corporations are C corporations.
– Must pay corporate taxes on its profits.
• Since individuals must pay personal income taxes on
these dividends, shareholders in a C corporation
effectively must pay taxes twice

1-25
Table 1.1 Characteristics of the
Different Types of Firms

1-26
Homework 1
• Compare what you learn with Vietnam

Company Law 2015

1-27
Financial Manager (CFO)
• Video clip
• What is the role of CFO??
• What is the role of Treasurer?
• What is the role of Controller?

1-28
• The financial manager has three main

tasks:
– Make investment decisions
– Make financing decisions
– Manage cash flow from operating activities
– Dividend decisions

1-29
• Making Investment Decisions

– The financial manager must weigh the costs
and benefits of each investment or project
– They must decide which investments or
projects qualify as good uses of the
stockholders’ money

1-30
• Making Financing Decisions

– The financial manager must decide whether to
raise more money from new and existing
owners by selling more shares of stock or to
borrow the money instead

1-31
• Managing Short-Term Cash Needs

– The financial manager must ensure that the
firm has enough cash on hand to meet its
obligations at each point in time
– This job is also known as managing working
capital

1-32
Role of The Financial Manager
(2) (1)
Firm's Financial Financial

(4a)
operations manager markets
(3) (4b)
(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
1-33
• (1) How much cash and inventory should
we keep on hand?
• (2) Should we sell on credit? If so, what
terms will we offer, and to whom will we
extend them?
• (3) How will we obtain any needed short-
term financing? Will we purchase on credit
or will we borrow in the short term and pay
cash? If we borrow in the short term, how
and where should we do it?
1-34
Issues to discuss
• You have decided to form a new start-

up company developing applications
for the iPhone. Give examples of the
three distinct types of financial
decisions you will need to make.

1-35
Homework 2
• List out at least 3 different financial

decisions of listed companies on Vietnam
stock market that you read on public media

1-36
• The Goal of the Financial Manager

• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s stock?
– Survive?

1-37
• The Goal of the Financial Manager
The overriding goal of financial management is

to maximize the wealth of the stockholders

1-38
Role of The Financial Manager
NPV A
NPV B
Corporate net present
value
NPV C Share price SHWM
(sum of individual
Projects’ NPVs)
NPV D (2) (3) (4)
NPV E (1)

1-39
The Financial Manager’s Place
in the Corporation
• Stockholders own the corporation but rely
on financial managers to actively manage
the corporation
– The board of directors and the management
team headed by the CEO possess direct control
of the corporation

1-40
Figure 1.1 The Financial Functions
Within a Corporation

1-41
1.4 The Financial Manager’s Place in
the Corporation
• Ethics and Incentives in Corporations
– Agency Problems
• When managers put their own self-interest ahead of
the interests of those shareholders->>>Conflicts
Agency cost (Corporate expenditure and
Monitoring cost)
– The CEO’s Performance
• When the stock performs poorly:
– The board of directors might react by replacing the CEO
– A corporate raider may initiate a hostile takeover

1-42
• You are the CEO of a company and you are
considering entering into an agreement to
have your company buy another company.
You think the price might be too high, but
you will be the CEO of the combined, much
larger company. You know that when the
company gets bigger, your pay and
prestige will increase. What is the nature of
the agency conflict here and how is it
related to ethical considerations?

1-43
Issues to discuss
• Corporate managers work for the owners of

the corporation. Consequently, they should
make decisions that are in the interests of
the owners, rather than their own. What
strategies are available to shareholders to
help ensure that managers are motivated
to act this way?

1-44
1.4 Principles of Financial Management
1) Risk - return trade-off

2) Time value of money
3) Cash is king
4) Efficient capital markets
5) The agency problem
6) Taxes bias business decisions
7) All risk is not equal
8) Ethical Behavior

1-45
The Risk-Return Trade-off
• The more risk an investment has, the higher will
be its expected return.
• Investment alternatives have different amounts

of risk and expected returns.
• We won’t take on additional risk unless we

expect to be compensated with additional return.

1-46
Risk and return
• Risk refers to the possibility that actual outcome may

differ from expected outcome.
• Risk can be measured by standard deviation.
• Investors require increasing compensation (return)
for taking on increasing risk.
• Return on an investment can be measured over a
standard period such as 1 year.

1-47
Risk and return (Continued)
• Shareholder return is annual dividend (D1) plus

share price increase (P1 – P0).
• Relative return in percentage terms is
100 × [(P1 – P0) + D1]/P0.
• This is called total shareholder return.

1-48
The Risk-Return Trade-off
Copyright © 2012 Pearson Prentice Hall. All rights reserved. 49 1-49

The Time Value of Money
• A dollar received today is worth more than
a dollar received in the future.
• Because we can earn interest on money

received today, it is better to receive
money earlier rather than later.

1-50
Cash—Not Profits—Is King
• Cash Flow, not accounting profit, is used to
measure wealth.
– Accounting profit: accrual base,depreciation,
etc.
• Cash flows, not profits, are actually

received by the firm and can be reinvested.

1-51
Efficient Capital Markets
• The markets are quick and the prices are right
• The values of all assets and securities at any
instant in time fully reflect all available
information.
– Information is reflected in security prices with such speed that
there are no opportunities for investors to profit from publicly
available information

1-52
1-53
1-54
Agency & Corporate Governance
• Managers do not always act in the best interest of

their shareholders, giving rise to what is called
the ‘agency’ problem.

1-55
The agency problem
Why does it arise?

• Divergence of ownership and control
• Managers’ goals differ from shareholders’
• Asymmetry of information.
What are the consequences?
• Shareholder wealth is no longer maximised.

1-56
Consequences of an agency problem
• Managers will follow their own objectives
i.e. increasing their…
– power
– job security
– pay and rewards
• Shareholders need to ensure that their own wealth
is maximised.

1-57
Signs of an agency problem
• Managers finance a company mainly with equity

finance.
• Managers accept low risk, short payback
investment projects.
• Managers diversify business operations.
• Managers follow ‘pet projects’.
• Managers are rewarded for performance that is
‘below average’.

1-58
Optimal contracts and agency
• Best solution to the agency problem is to design

managerial contracts that minimise the sum of the
following costs:
– financial contracting costs
– monitoring costs
– divergent behaviour costs.

1-59
Option 1: do nothing
Leaving managers to their own devices is

problematic:
• Given human nature, managers will engage in
suboptimal behaviour.
• Shareholders are satisficed rather than satisfied.
• No action is not really an option.

1-60
Option 2: monitoring
Problems associated with monitoring:

• Costly in terms of both time and money.
• Who will pay? Large shareholders? What about
‘free-riding’ smaller investors?
• Some managerial actions are hard to follow.
• May drive ‘bad managers’ underground.

1-61
Option 3: reward good behaviour
• What do we link managerial rewards to?

• Most commonly linked to:
– profits
– share price (e.g. via share options).
• Rewarding is more common than monitoring.
• But…tying rewards to profits may encourage short-
termism and creative accounting.

1-62
Option 3: reward good behaviour
(Continued)
• There are also problems using share options:
– how many options should managers be awarded?
– at what share price should managers be able to exercise
their options?
– managers can get rewarded for poor performance if there is
a ‘bull’ stock market.

1-63
Other areas of agency
Companies are made up of a series of agency
relationships:
Shareholders
Creditors
i.e.banks,
suppliers and
Managers
bondholders
Employees
The
Company
Customers
N.B. Arrows goes from ‘principal’ to ‘agent’ and show capital flows.
1-64
Other areas of agency (Continued)
• Debt holders (principals) and shareholders (agents)
• Solutions: security, restrictive covenants
• Managers (principles) and employees (agents)
• Solutions: executive share option plans (ESOPs),
monitoring, performance-related pay (PRP).

1-65
Corporate governance
Corporate governance is the system by which companies

are directed and controlled.
The UK Corporate Governance Code 2010
Who is responsible for what?

1-66
Continued
• Boards of directors are responsible for the

governance of their companies.
• The shareholders’ role in governance is to
appoint the directors and the auditors and
to satisfy themselves that an appropriate
governance structure is in place.

1-67
Corporate governance
• Corporate governance is about promoting corporate

fairness, transparency and accountability.
• It can be seen as an attempt to solve agency
problem using externally imposed regulation.

1-68
Taxes Bias Business Decisions
• When a new project is evaluated, the after-
tax incremental cash flows are considered.
• Government use taxes to encourage

spending in certain ways – e.g., investment
tax credit.

1-69
All Risk is Not Equal
• Some risk can be diversified away, and some
cannot.
– Diversification allows good and bad events or observations to
cancel each other out, thus reducing total variability without
affecting expected return.

1-70
All Risk is Not Equal
Keown, Martin, Petty - Chapter 1

Copyright © 2012 Pearson Prentice Hall. All rights reserved. 71 1-71
Ethical Behavior Is Doing The Right
Thing, and Ethical Dilemmas Are
Everywhere In Finance
• Ethics, or rather the lack of ethics in
finance, is a recurring theme in the news.
• Why is ethics relevant?
– Unethical behavior eliminates trust, and without
trust, businesses cannot interact.
• Example: Arthur Andersen.
• Ethical conduct involves abiding by
society’s rules.
• Examples of recent unethical conduct:
– Enron, WorldCom

1-72
Corporate Fraud: ENRON
• ENRON:
– Boosted profits and hid
debts totaling over $1
billion by improperly
using off-the-books
partnerships
– Manipulated the Texas
power market; bribed
foreign governments to
win contracts abroad;
manipulated California
energy market
• Result: Bankrupt

1-73
Corporate Fraud: Worldcom/MCI
• BERNARD EBBERS built a small Mississippi company, Long Distance Discount Service (LDDS),
into a telecommunications giant through dozens of acquisitions, including MCI. But a massive
fraud and mounting debt forced the company, later called WorldCom, into bankruptcy, wiping
out more than $100 billion in market value. In July 2005, a judge sentenced the 63-year-old to
25 years in prison, saying that "Mr. Ebbers was the instigator of the fraud" at WorldCom.

FIN 320 – Prof. Akbulut 1-74
1.5 The Financial Markets
• Primary/Secondary Markets
• Money/Capital Markets

1-75
1.5 The Financial Markets
• Corporations can be private or public

– A private corporation has a limited number of
owners and there is no organized market for its
shares
– A public corporation has many owners and its
shares trade on an organized market, called a
stock market

1-76
Figure 1.2 Worldwide Stock Markets
Ranked by Volume of Trade

1-77
Financial Institutions
• Financial Institutions
– Entities that provide financial services, such as
taking deposits, managing investments,
brokering financial transactions, or making
loans

1-78
1.6 Financial Institutions
• The Financial Cycle

– In the financial cycle:
1. People invest and save their money
2. Through loans and stock, that money flows to
companies who use it to fund growth through new
products, generating profits and wages
3. The money then flows back to the savers and
investors

1-79
Figure 1.3 The Financial Cycle

1-80
Chapter Quiz
1. What are the advantages and

disadvantages of organizing a business
as a corporation?
2. What are the main types of decisions that
a financial manager makes?
3. How do shareholders control a
corporation?
4. What is the importance of a stock market
to a financial manager?

1-81
Chapter Quiz
5. What are the three main roles financial

institutions play?

1-82

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Copyright © 2012 Pearson Prentice Hall. All rights reserved.

1.1 Why Study Finance?

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

• Grasp the importance of financial information in both your

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

• Grasp the importance of financial information in both your

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

• Individuals are taking charge of their

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

• In your business career, you may face

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

• Limited Liability Companies (LLC)

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• Tax Implications for Corporate Entities

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• Compare what you learn with Vietnam

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Copyright © 2012 Pearson Prentice Hall. All rights reserved.

• The financial manager has three main

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• Making Investment Decisions

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• Making Financing Decisions

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• Managing Short-Term Cash Needs

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Firm's Financial Financial

(1) Cash raised from investors

• You have decided to form a new start-

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• List out at least 3 different financial

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

• The Goal of the Financial Manager

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• The Goal of the Financial Manager

The overriding goal of financial management is

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• Corporate managers work for the owners of

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1) Risk - return trade-off