1.1 What Is Corporate Finance?

1.1 What Is Corporate Finance?
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Suppose you decide to start a firm to make tennis balls. To do this, you hire managers to buy raw materials, and you assemble a work force that will produce and sell finished tennis balls. In the language of finance, you make an investment in assets such as inventory, machinery, land, and labor. The amount of cash you invest in assets must be matched by an equal amount of cash raised by financing. When you begin to sell tennis balls, your firm will generate cash. This is the basis of value creation. The purpose of the firm is to create value for you, the owner. The value is reflected in the framework of the simple balance sheet model of the firm.

The Balance Sheet Model of the Firm

Suppose we take a financial snapshot of the firm and its activities at a single point in time. Figure 1.1 shows a graphic conceptualization of the balance sheet, and it will help introduce you to corporate finance.

FIGURE 1.1

The Balance Sheet Model of the Firm

Left side, total value of assets. Right side, total value of the firm to investors, which determines how the value is distributed.

The assets of the firm are on the left-hand side of the balance sheet. These assets can be thought of as current and fixed. Fixed assets are those that will last a long time, such as buildings. Some fixed assets are tangible, such as machinery and equipment. Other fixed assets are intangible, such as patents and trademarks. The other category of assets, current assets, comprises those that have short lives, such as inventory. The tennis balls that your firm has made, but has not yet sold, are part of its inventory. Unless you have overproduced, they will leave the firm shortly.

Before a company can invest in an asset, it must obtain financing, which means that it must raise the money to pay for the investment. The forms of financing are represented on the right-hand side of the balance sheet. A firm will issue (sell) pieces of paper called debt (loan agreements) or equity shares (stock certificates). Just as assets are classified as long-lived or short-lived, so too are liabilities. A short-term debt is called a current liability. Short-term debt represents loans and other obligations that must be repaid within one year. Long-term debt is debt that does not have to be repaid within one year. Shareholders' equity represents the difference between the value of the assets and the debt of the firm. In this sense, it is a residual claim on the firm's assets.

From the balance sheet model of the firm, it is easy to see why finance can be thought of as the study of the following three questions:

In what long-lived assets should the firm invest? This question concerns the left-hand side of the balance sheet. Of course, the types and proportions of assets the firm needs tend to be set by the nature of the business. We use the term capital budgeting to describe the process of making and managing expenditures on long-lived assets.
How can the firm raise cash for required capital expenditures? This question concerns the right-hand side of the balance sheet. The answer to this involves the firm's capital structure, which represents the proportions of the firm's financing from current and long-term debt and equity.
How should short-term operating cash flows be managed? This question concerns the upper portion of the balance sheet. There is often a mismatch between the timing of cash inflows and cash outflows during operating activities. Furthermore, the amount and timing of operating cash flows are not known with certainty. The financial managers must attempt to manage the gaps in cash flow. From a balance sheet perspective, short-term management of cash flow is associated with a firm's net working capital. Net working capital is defined as current assets minus current liabilities. From a financial perspective, the short-term cash flow problem comes from the mismatching of cash inflows and outflows. It is the subject of short-term finance.

Capital Structure

Financing arrangements determine how the value of the firm is sliced up. The persons or institutions that buy debt from (i.e., loan money to) the firm are called creditors.¹ The holders of equity shares are called shareholders.

Sometimes it is useful to think of the firm as a pie. Initially, the size of the pie will depend on how well the firm has made its investment decisions. After a firm has made its investment decisions, it determines the value of its assets (e.g., its buildings, land, and inventories).

The firm can then determine its capital structure. The firm might initially have raised the cash to invest in its assets by issuing more debt than equity; now it can consider changing that mix by issuing more equity and using the proceeds to buy back (pay off) some of its debt. Financing decisions like this can be made independently of the original investment decisions. The decisions to issue debt and equity affect how the pie is sliced.

The pie we are thinking of is depicted in Figure 1.2. The size of the pie is the value of the firm in the financial markets. We can write the value of the firm, V, as

where B is the value of the debt and S is the value of the equity. The pie diagrams consider two ways of slicing the pie: 50 percent debt and 50 percent equity, and 25 percent debt and 75 percent equity. The way the pie is sliced could affect its value. If so, the goal of the financial manager will be to choose the ratio of debt to equity that makes the value of the pie—that is, the value of the firm, V—as large as it can be.

FIGURE 1.2	Two Pie Models of the Firm

The Financial Manager

For current issues facings CFOs, see www.cfo.com.

In large firms, the finance activity is usually associated with a top officer of the firm, such as the vice president and chief financial officer, and some lesser officers. Figure 1.3 depicts a general organizational structure emphasizing the finance activity within the firm. Reporting to the chief financial officer are the treasurer and the controller. The treasurer is responsible for handling cash flows, managing capital expenditure decisions, and making financial plans. The controller handles the accounting function, which includes taxes, cost and financial accounting, and information systems.

FIGURE 1.3	Hypothetical Organization Chart

We think the most important job of a financial manager is to create value from the firm's capital budgeting, financing, and net working capital activities. How do financial managers create value? The answer is that the firm should:

Try to buy assets that generate more cash than they cost.
Sell bonds and stocks and other financial instruments that raise more cash than they cost.

Thus, the firm must create more cash flow than it uses. The cash flows paid to bondholders and stockholders of the firm should be greater than the cash flows put into the firm by the bondholders and stockholders. To see how this is done, we can trace the cash flows from the firm to the financial markets and back again.

The interplay of the firm's activities with the financial markets is illustrated in Figure 1.4. The arrows in Figure 1.4 trace cash flow from the firm to the financial markets and back again. Suppose we begin with the firm's financing activities. To raise money, the firm sells debt and equity shares to investors in the financial markets. This results in cash flows from the financial markets to the firm (A). This cash is invested in the investment activities (assets) of the firm (B) by the firm's management. The cash generated by the firm (C) is paid to shareholders and bondholders (F). The shareholders receive cash in the form of dividends; the bondholders who lent funds to the firm receive interest and, when the initial loan is repaid, principal. Not all of the firm's cash is paid out. Some is retained (E), and some is paid to the government as taxes (D).

FIGURE 1.4

Cash Flows Between the Firm and the Financial Markets

(A) Firm issues securities to raise cash (the financing decision).
(B) Firm invests in assets (capital budgeting).
(C) Firm’s operations generate cash flow.
(D) Cash is paid to government as taxes.
(E) Retained cash flows are reinvested in firm.
(F) Cash is paid out to investors in the form of interest and dividends.

Over time, if the cash paid to shareholders and bondholders (F) is greater than the cash raised in the financial markets (A), value will be created.

IDENTIFICATION OF CASH FLOWS Unfortunately, it is not all that easy to observe cash flows directly. Much of the information we obtain is in the form of accounting statements, and much of the work of financial analysis is to extract cash flow information from accounting statements. The following example illustrates how this is done.

EXAMPLE 1.1

Accounting Profit Versus Cash Flows

The Midland Company refines and trades gold. At the end of the year, it sold 2,500 ounces of gold for $1 million. The company had acquired the gold for $900,000 at the beginning of the year. The company paid cash for the gold when it was purchased. Unfortunately, it has yet to collect from the customer to whom the gold was sold. The following is a standard accounting of Midland's financial circumstances at year-end:

By generally accepted accounting principles (GAAP), the sale is recorded even though the customer has yet to pay. It is assumed that the customer will pay soon. From the accounting perspective, Midland seems to be profitable. However, the perspective of corporate finance is different. It focuses on cash flows:

The perspective of corporate finance is interested in whether cash flows are being created by the gold trading operations of Midland. Value creation depends on cash flows. For midland, value creation depends on whether and when it actually receives $1 million.

TIMING OF CASH FLOWS The value of an investment made by a firm depends on the timing of cash flows. One of the most important principles of finance is that individuals prefer to receive cash flows earlier rather than later. One dollar received today is worth more than one dollar received next year.

EXAMPLE 1.2

Cash Flow Timing

The Midland Company is attempting to choose between two proposals for new products. Both proposals will provide additional cash flows over a four-year period and will initially cost $10,000. The cash flows from the proposals are as follows:

At first it appears that new product A would be best. However, the cash flows from proposal B come earlier than those of A. Without more information, we cannot decide which set of cash flows would create the most value to the bondholders and shareholders. It depends on whether the value of getting cash from B up front outweighs the extra total cash from A. Bond and stock prices reflect this preference for earlier cash, and we will see how to use them to decide between A and B.

RISK OF CASH FLOWS The firm must consider risk. The amount and timing of cash flows are not usually known with certainty. Most investors have an aversion to risk.

EXAMPLE 1.3

Risk

The Midland Company is considering expanding operations overseas. It is evaluating Europe and Japan as possible sites. Europe is considered to be relatively safe, whereas operating in Japan is seen as very risky. In both cases, the company would close down operations after one year.

After doing a complete financial analysis, Midland has come up with the following cash flows of the alternative plans for expansion under three equally likely scenarios—pessimistic, most likely, and optimistic:

If we ignore the pessimistic scenario, perhaps Japan is the best alternative. When we take the pessimistic scenario into account, the choice is unclear. Japan appears to be riskier, but it also offers a higher expected level of cash flow. What is risk and how can it be defined? We must try to answer this important question. Corporate finance cannot avoid coping with risky alternatives, and much of our book is devoted to developing methods for evaluating risky opportunities.

¹We tend to use the words creditors, debtholders, and bondholders interchangeably. In later chapters we examine the differences among the kinds of creditors. In algebraic notation, we will usually refer to the firm's debt with the letter B (for bondholders).

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