Chapter 1: Introduction to Corporate Finance

Why might one expect managers to act in shareholders' interests, and what principles should guide their decision? Give 7 reasons.

- They have a legal duty to act in shareholders' interests. Laws and regulations. - Compensation. - Fear of personal reputational damage. - Disclosure requirements and accounting standards that keep public firms reasonably transparent. - Monitoring by banks and other financial intermediaries. - Monitoring by boards of directors. - The threat of takeover.

Which of the following are real assets, and which are financial? a. A share of stock. b. A personal IOU. c. A trademark. d. A factory. e. Undeveloped land. f. The balance in the firm's checking account. g. An experienced and hardworking sales force. h. A corporate bond.

A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets. Real assets are identifiable as items with intrinsic value. The others in the list are financial assets, that is, these assets derive value because of a contractual claim.

What are the benefits and negative externalities for investors of corporations separating ownership and management?

Benefits: - Investors have the ability to diversify their investments among uncorrelated assets. - Investors are able to quickly enter, exit, or short-sell an investment. Creating a liquid market for corporations. Negative externalities: - Agency problems - The corporation's separate legal personality makes it difficult to enforce accountability if they externalize costs onto society.

Investment and financing decisions Vocabulary test. Explain the differences between: Capital budgeting and financing decisions.

Capital budgeting means investment in real assets. Financing means raising the cash for this investment.

Investment and financing decisions Vocabulary test. Explain the differences between: Real and financial assets.

Financial assets, such as stocks or bank loans, are claims held by investors. Corporations sell financial assets to raise the cash to invest in real assets such as plant and equipment. Some real assets are intangible.

Ms. Espinoza is retired and depends on her investments for her income. Mr. Liu is a young executive who wants to save for the future. Both are stockholders in Scaled Composites LLC, which is building SpaceShipOne to take commercial passengers into space. This investment's payoff is many years away. Assume it has a positive NPV for Mr. Liu. Explain why this investment also makes sense for Ms. Espinoza.

If the investment increases the firm's wealth, it will increase the value of the firm's shares. Ms. Espinoza could then sell some or all of these more valuable shares in order to provide for her retirement income.

Which of the following statements always apply to corporations? a. Unlimited liability. b. Limited life. c. Ownership can be transferred without affecting operations. d. Managers can be fired with no effect on ownership.

Items c and d always apply to corporations.

Many firms have devised defenses that make it more difficult or costly for other firms to take them over. How might such defenses affect the firm's agency problems? Are managers of firms with formidable takeover defenses more or less likely to act in the shareholders' interests rather than their own? What would you expect to happen to the share price when management proposes to institute such defenses?

Managers that are insulated from takeovers may be more prone to agency problems and therefore more likely to act in their own interests rather than in shareholder's. If a firm instituted a new takeover defense, we might expect to see the value of its shares decline as agency problems increase and less shareholder value maximization occurs. The counterargument is that defensive measures allow managers to negotiate for a higher purchase price in the face of a takeover bid—to the benefit of shareholder value.

In most large corporations, ownership and management are separated. What are the 4 key attributes of a corporation?

Separation of ownership facilitates the key attributes of a corporation: - Limited liability for investors - Transferability of ownership - A separate legal personality of the corporation - Delegated centralized management.

We can imagine the financial manager doing several things on behalf of the firm's stockholders. For example, the manager might: a. Make shareholders as wealthy as possible by investing in real assets. b. Modify the firm's investment plan to help shareholders achieve a particular time pattern of consumption. c. Choose high- or low-risk assets to match shareholders' risk preferences. d. Help balance shareholders' checkbooks. But in well-functioning capital markets, shareholders will vote for only one of these goals. Which one? Why?

Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their pattern of consumption through borrowing and lending, match risk preferences, and hopefully balance their own checkbooks (or hire a qualified professional to help them with these tasks).

Why may the practice of Short Selling and Corporate Riders be categorized as unethical behavior?

Short selling Short selling can be an important component of efficient markets, by keeping prices in line with a corporation's intrinsic value. Because short-selling bears risk and short-sellers are required to post margin if prices move too far against them, the practice is rarely unethical. Perhaps this practice crosses the line if unscrupulous actors are able to defame or destroy a company's value, and use short selling to profit as a result. Corporate Raiders Corporate raiders or activist investors similarly serve a valuable role in the market for corporations. However, this practice can result in the destruction of value if performed carelessly. Often the target company is loaded with a heavy debt burden from the acquisition. The practice may cross into unethical territory if the raiders begin to make decisions that benefit their position, such as taking extreme risks in line with their upside exposure, at the expense of the limited partners in the venture and at the expense of the other key stakeholders of the operation (employees, customers, governments, etc).

The Beyond the Page feature, "Goldman Sachs causes a ruckus," describes the controversial involvement of Goldman Sachs in a mortgage-backed securities deal in 2006. When this involvement was revealed, the market value of Goldman Sachs' common stock fell overnight by $10 billion. This was far more than any fine that might have been imposed. Explain.

The firm's reputation suffers in a financial scandal, and this can have a much larger effect than the fines levied.

Investment and financing decisions Vocabulary test. Explain the differences between: Closely held and public corporations.

The shares of public corporations are traded on stock exchanges and can be purchased by a wide range of investors. The shares of closely held corporations are not publicly traded and are held by a small group of private investors.

Investment and financing decisions Vocabulary test. Explain the differences between: Limited and unlimited liability.

Unlimited liability: Investors are responsible for all the firm's debts. A sole proprietor has unlimited liability. Investors in corporations have limited liability. They can lose their investment, but no more.

F&H Corp. continues to invest heavily in a declining industry. Here is an excerpt from a recent speech by F&H's CFO: We at F&H have of course noted the complaints of a few spineless investors and uninformed security analysts about the slow growth of profits and dividends. Unlike those confirmed doubters, we have confidence in the long-run demand for mechanical encabulators, despite competing digital products. We are therefore determined to invest to maintain our share of the overall encabulator market. F&H has a rigorous CAPEX approval process, and we are confident of returns around 8% on investment. That's a far better return than F&H earns on its cash holdings. The CFO went on to explain that F&H invested excess cash in short-term U.S. government securities, which are almost entirely risk-free but offered only a 4% rate of return. a. Is a forecasted 8% return in the encabulator business necessarily better than a 4% safe return on short-term U.S. government securities? Why or why not? b. Is F&H's opportunity cost of capital 4%? How in principle should the CFO determine the cost of capital?

a. Assuming that the encabulator market is risky, an 8% expected return on the F&H encabulator investments may be inferior to a 4% return on U.S. government securities, depending on the relative risk between the two assets. b. Unless their financial assets are as safe as U.S. government securities (i.e. risk-free), their cost of capital would be higher. The CFO could consider what the expected return is on assets with similar risk.