Principles of Corporate Finance 11th Global Edition INTRODUCTION TO CORPORATE FINANCE 1 Copyright 2014 by The McGraw-Hill Companies, I nc. All rights reserved. McGraw-Hill Education 1-2 1-1 CORPORATE INVESTMENT AND FINANCING DECISIONS Real Assets Used to produce goods and services Financial Assets/Securities Financial claims on income generated by firms real assets Capital Budgeting/Capital Expenditure (CAPEX) Decision to invest in tangible or intangible assets 1-3 1-1 CORPORATE INVESTMENT AND FINANCING DECISIONS Investment Decision Purchase of real assets Financing Decision Sale of financial assets Capital Structure Choice between debt and equity financing 1-4 1-1 CORPORATE INVESTMENT AND FINANCING DECISIONS Capital Budgeting Examples Tangible Assets i.e. Expanding stores Intangible Assets i.e. Research and development for new drug 1-5 TABLE 1.1 RECENT INVESTMENT/ FINANCING DECISIONS Company Recent Investment Decisions Recent Financing Decisions Boeing (U.S.) Delivers first Dreamliner after investing a reported $30 billion in development costs. Reinvests $1.7 billion of profits. ExxonMobil (U.S.) Spends $7 billion to develop oil sands at Fort McMurray in Alberta. Spends $12 billion buying back shares. GlaxoSmith- Kline (UK) Spends $4 billion on research and development for new drugs. Pays $3.2 billion as dividends. LVMH (France) LVMH acquires the Italian Jeweler, Bulgari, for $5 billion. Pays for the acquisition with a mixture of cash and shares. Procter & Gamble (U.S.) Spends $8 billion on advertising. Raises 100 billion Japanese yen by an issue of 5- year bonds. Tata Motors (India) Opens a plant in India to produce the world's cheapest car, the Nano. The facility costs $400 million. Raises $400 million by the sale of new shares. Union Pacific (U.S.) Invests $330 million in 100 new locomotives and 10,000 freight cars and chassis. Repays $1.4 billion of debt. Vale (Brazil) Opens a copper mine at Salobo in Brazil. The project cost nearly $2 million. Maintains credit lines with its banks that allow the company to borrow at any time up to $1.6 billion. Walmart (U.S.) Invests 12.7 billion, primarily to open 458 new stores around the world. Issues $5 billion of long-term bonds in order to repay short-term commercial paper borrowings. 1-6 1-1 CORPORATE INVESTMENT AND FINANCING DECISIONS What Is a Corporation? Legal entity, owned by shareholders Can make contracts, carry on business, borrow, lend, sue, and be sued Shareholders have limited liability and cannot be held personally responsible for corporations debts 1-7 FIGURE 1.1 CASH FLOW BETWEEN FINANCIAL MARKETS AND FIRMS OPERATIONS Financial manager Firm's operations Financial markets (1) Cash raised from investors (1) (2) Cash invested in firm (2) (3) Cash generated by operations (3) (4a) Cash reinvested (4a) (4b) Cash returned to investors (4b) 1-8 1-2 THE FINANCIAL GOAL OF THE CORPORATION Stockholders Want Three Things To maximize current wealth To transform wealth into most desirable time pattern of consumption To manage risk characteristics of chosen consumption plan 1-9 1-2 THE FINANCIAL GOAL OF THE CORPORATION Profit Maximization Not a well-defined financial objective Which years profits? Shareholders will not welcome higher short-term profits if long-term profits are damaged Company may increase future profits by cutting years dividend, investing freed-up cash in firm Not in shareholders best interest if company earns less than opportunity cost of capital
1-10 1-2 THE FINANCIAL GOAL OF THE CORPORATION Shareholders desire wealth maximization Managers have many constituencies, stakeholders Agency Problems represent the conflict of interest between management and owners
1-11 1-2 THE FINANCIAL GOAL OF THE CORPORATION The Investment Trade-off Hurdle Rate/Cost of Capital Minimum acceptable rate of return on investment Opportunity Cost of Capital Investing in a project eliminates other opportunities to use invested cash 1-12 FIGURE 1.2 THE INVESTMENT TRADE-OFF 1-13 1-2 THE FINANCIAL GOAL OF THE CORPORATION Agency Problems Managers, acting as agents for stockholders, may act in their own interests rather than maximizing value Stakeholder Anyone with a financial interest in the firm
Agency ProblemsOwnership versus Management Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders
1-2 THE FINANCIAL GOAL OF THE CORPORATION 1-14 1-15 1-2 THE FINANCIAL GOAL OF THE CORPORATION Agency costs are incurred when: Managers do not attempt to maximize firm value Shareholders incur costs to monitor managers and constrain their actions
1-16 1-2 THE FINANCIAL GOAL OF THE CORPORATION Tools to Ensure Management Pays Attention to the Value of the Firm Managers actions subject to the scrutiny of board of directors Shirkers are likely to find they are ousted by more energetic managers Financial incentives provided, such as stock options