CHAPTER 1
INTRODUCTION TO CORPORATE FINANCE
Learning Objectives
LO1 The basic types of financial management decisions and the role of the financial manager.
LO2 The financial implications of the different forms of business organization.
LO3 The goal of financial management.
LO4 The conflicts of interests that can arise between managers and owners.
LO5 The roles of financial institutions and markets.
LO6 Types of financial institutions.
LO7 Trends in financial markets.
Answers to Concepts Review and Critical Thinking Questions
1. The Financial Management Decision Process (LO1) What are the three types of
financial management decisions? For each type of decision, give an example of a
business transaction that would be relevant. (LO1) Capital budgeting (deciding on
whether to expand a manufacturing plant), capital structure (deciding whether to issue new
equity and use the proceeds to retire outstanding debt), and working capital management
(modifying the firm’s credit collection policy with its customers). (LO1)
2. Sole Proprietorships and Partnerships (LO2) What are the three primary
disadvantages to the sole proprietorship and partnership forms of business
organization? What benefits are there to these types of business organization as
opposed to the corporate form? (LO2) Disadvantages: unlimited liability, limited life,
difficulty in transferring ownership, hard to raise capital funds. Some advantages: simpler,
less regulation, the owners are also the managers.
3. Corporate Organization (LO2) What is the primary disadvantage of the corporate
form of organization? Name at least two advantages of corporate organization. (LO2)
The primary disadvantage of the corporate form is the double taxation to shareholders of
distributed earnings and dividends. Some advantages include: limited liability, ease of
transferability, ability to raise capital, unlimited life, and so forth.
4. Corporate Finance Organizational Structure (LO4) In a large corporation, what are
the two distinct groups that report to the CFO? Which group is the focus of corporate
finance? (LO4) The treasurer’s office and the controller’s office are the two primary
organizational groups that report directly to the chief financial officer. The controller’s office
handles cost and financial accounting, tax management, and management information
systems, while the treasurer’s office is responsible for cash and credit management, capital
budgeting, and financial planning. Therefore, the study of corporate finance is concentrated
within the treasury group’s functions.
5. The Goal of Financial Management (LO3) What goal should always motivate the
actions of the firm’s financial manager? (LO3) To maximize the current market value
(share price) of the equity of the firm (whether it’s publicly-traded or not).
6. Corporate Agency Issues (LO4) Who owns a corporation? Describe the process
whereby the owners control the firm’s management. What is the main reason that an
agency relationship exists in the corporate form of organization? In this context, what
kind of problems can arise? (LO4) In the corporate form of ownership, the shareholders are
the owners of the firm. The shareholders elect the directors of the corporation, who in turn
appoint the firm’s management. This separation of ownership from control in the corporate
form of organization is what causes agency problems to exist. Management may act in its
own or someone else’s best interests, rather than those of the shareholders. If such events
occur, they may contradict the goal of maximizing the share price of the equity of the firm.
7. Financial Markets (LO5) An IPO of a company’s securities is a term you’ve probably
noticed in the financial press. Is an IPO a primary market transaction or a secondary
market transaction? (LO5) A primary market transaction. A secondary market transaction
would entail the sale between two 3rd parties (i.e. not the corporation).
8. Financial Markets (LO5) What does it mean when we say the Toronto Stock Exchange
is both an auction market and a dealer market? How are auction markets different
from dealer markets? What kind of market is the Nasdaq? (LO5) In auction markets like
the Toronto Stock Exchange (TSX), brokers and agents meet at a central location (the
exchange) to match buyers and sellers of assets. Physical locations for stock markets are
disappearing as trading becomes more electronic. Dealer markets like Nasdaq consist of
dealers operating at dispersed locales who buy and sell assets themselves, communicating
with other dealers either electronically or literally over-the-counter. Dealer markets are less
transparent than auction markets where trades are reported publicly almost immediately. The
auction market run by the TSX is where the stocks of larger Canadian companies are traded;
the TSX also operates a dealer market called the Venture Exchange for companies too small
to qualify for the TSX auction exchange.
9. Not-for-Profit Firm Goals (LO3) Suppose you were the financial manager of a not-for-
profit business such as the Mountain Equipment Co-op. What kinds of goals do you
think would be appropriate? (LO3) Such organizations frequently pursue social or
political missions, so many different goals are conceivable. One goal that is often cited is
revenue minimization; i.e., provide whatever goods and services are offered at the lowest
possible cost to society. Another would be to best serve the maximum possible number of
stakeholders at the lowest cost. A better approach might be to observe that even a not-for-
profit business has equity. Thus, one answer is that the appropriate goal is to maximize the
value of the equity.
10. Firm Goals and Stock Value (LO3) Evaluate the following statement: “Managers
should not focus on the current stock value because doing so will lead to an
overemphasis on short-term profits at the expense of long-term profits.” (LO3)
Presumably, the current stock value reflects the risk, timing, and magnitude of all future
cash flows, both short-term and long-term. If this is correct, then the statement is false.
11. Firm Goals and Ethics (LO3) Can our goal of maximizing the value of the stock conflict
with other goals, such as avoiding unethical or illegal behaviour? In particular, do you
think subjects like customer and employee safety, the environment, and the general
good of society fit in this framework, or are they essentially ignored? Try to think of
some specific scenarios to illustrate your answer. (LO3) An argument can be made either
way. At the one extreme, we could argue that in a market economy, all of these things are
priced. There is thus an optimal level of, for example, ethical and/or illegal behavior, and the
framework of stock valuation explicitly includes these. At the other extreme, we could argue
that these are non-economic phenomena and are best handled through the political process.
A classic (and highly relevant) thought question that illustrates this debate goes something
like this: “A firm has estimated that the cost of improving the safety of one of its products is
$30 million. However, the firm believes that improving the safety of the product will only
save $20 million in product liability claims and lost customer goodwill. What should the
firm do?”
12. Firm Goals and Multinational Firms (LO3) Would our goal of maximizing the value of
the stock be different if we were thinking about financial management in a foreign
country? Why or why not? (LO3) The goal will be the same, but the best course of action
toward that goal may be different because of differing social, political, and economic
institutions.
13. Agency Issues and Corporate Control (LO4) Suppose you own shares in a company.
The current price per share is $25. Another company has just announced that it wants
to buy your company and will pay $35 per share to acquire all the outstanding shares.
Your company’s management immediately begins fighting off this hostile bid. Is
management acting in the shareholders’ best interests? Why or why not? (LO4) The
goal of management should be to maximize the share price for the current shareholders. If
management believes that it can improve the profitability of the firm so that the share price
will exceed
$35, then they should fight the offer from the outside company. If management believes that
this bidder or other unidentified bidders will actually pay more than $35 per share to acquire
the company, then they should still fight the offer. However, if the current management
cannot increase the value of the firm beyond the bid price, and no other higher bids come in,
then management is not acting in the interests of the shareholders by fighting the offer. Since
current managers often lose their jobs when the corporation is acquired, poorly monitored
managers have an incentive to fight corporate takeovers in situations such as this.
14. Agency Issues and International Finance (LO4) Corporate ownership varies around
the world. Historically, individuals have owned the majority of shares in public
corporations in the United States. In Canada this is also the case, but ownership is
more often concentrated in the hands of a majority shareholder. In Germany and
Japan, banks, other financial institutions, and large companies own most of the shares
in public corporations. How do you think these ownership differences affect the
severity of agency costs in different countries? (LO4) We would expect agency problems
to be less severe in other countries, primarily due to the relatively small percentage of
individual ownership. Fewer individual owners means that each individual owner has a
greater incentive to monitor and control the firm—i.e. there is less free-riding. The high
percentage of institutional ownership might lead to a higher degree of agreement between
owners and managers on decisions concerning risky projects. In addition, institutions may be
better able to implement effective monitoring mechanisms on managers than can individual
owners, based on the institutions’ deeper resources and experiences with their own
management. The increase in institutional ownership of stock in Canada and in the United
States and the growing activism of these large shareholder groups may lead to a reduction in
agency problems for Canadian and U.S. corporations and a more efficient market for
corporate control.
15. Major Institutions and Markets (LO5) What are the major types of financial institutions
and financial markets in Canada? (LO5) Major institutions:
Chartered banks -accept deposits and issue commercial loans, corporate loans, personal
loans and mortgages.
Trust companies-accept deposits and make loans, but also engage in fiduciary activities
such as managing assets for estates, registered retirement savings plans, etc.
Investment dealers -non-depository institutions that assist firms in issuing new securities.
Insurance companies -engage in indirect financing by accepting funds in a form similar to a
deposit and making loans.
Pension funds -invest contributions from employers and employees in securities offered by
financial markets.
Mutual funds -pool individual investments to purchase a diversified portfolio.
Hedge funds -cater to sophisticated investors and seek high returns by using aggressive
financial strategies prohibited by mutual funds.
Note that larger financial institutions may embody many of these different institution. For
example, CIBC is a chartered bank that owns an investment dealer and mutual funds.
Furthermore, it has an insurance arm “CIBC Insurance”
Major markets:
Money market -financial markets where short-term debt instruments are bought and sold.
Capital markets -financial markets where long-term debt and equity securities are bought and
sold. Derivatives markets – where options and futures are traded on financial instruments and
commodities Primary markets are where securities are sold for the first time; secondary
markets are where outstanding securities trade.
16. Direct versus Indirect Finance (LO5) What is the difference between direct and indirect
finance? Give an example of each. (LO5) Spread versus Fee Income:
Banks earn spread or interest income by borrowing from depositors and lending to borrowers (at
a higher yield). An example is a retail deposit and a mortgage. Banks make non-interest or fee
income when they charge commissions or fees for services. An example is an overdraft fee or
ATM fee, or the example in the text, the stamping fee on a banker’s acceptance (which is a form
of insurance and arranging fee).
17. Current Major Trends (LO5) What are some of the major trends in Canadian financial
markets? Explain how these trends affect the practice of financial management in Canada
(LO5) Trends:
Financial engineering -the creation of new securities or financial processes. This engineering
could be used to package and sell risky assets to investors; for example, banks can package
and sell mortgages into mortgage backed securities and sell these on to other investors.
Derivative securities -options, futures, forwards, and other securities whose value is derived
from the price of another, underlying asset. For example, a futures contract to purchase oil
sets a fixed purchase/selling price for a future date, but its value depends on the price of oil.
These derivatives can help businesses divest risks that are not core to their business, such as
foreign exchange and input price (like oil) risk.
Regulatory dialectic -the pressures that financial institutions and regulatory bodies exert on
each other. For example, when restrictions are removed, growth opportunities may increase.
However, the absence of regulatory restrictions may also lead to problems such as the global
financial crisis starting in 2007 caused by excessive financial leverage, so it is important that
there be an appropriate level of regulatory oversight.
ESG –Investors and corporations (and their many stakeholders) are increasingly focused on
Environmental, Societal, and Governance issues. This includes employee and customer
welfare as well as climate change and pollution.
These trends have made financial management a much more complex and technical activity.