Introduction to Corporate Finance
Apple Computer began as a two-man partnership in a garage. It grew rapidly and, by 1985, became a large publicly traded corporation with 60 million shares of stock and a total market value in excess of $1 billion. At that time, the firm’s more visible cofounder, 30-year-old Steven Jobs, owned 7 million shares of Apple stock worth about $120 million.
Despite his stake in the company and his role in its founding and success, Jobs was forced to relinquish operating responsibilities in 1985 when Apple’s financial performance turned sour, and he subsequently resigned altogether.
Of course, you can’t keep a good entrepreneur down. Jobs formed Pixar Animation Studios, the company that is responsible for the animation in the hit movies Toy Story, A Bug’s Life, and Toy Story 2. Pixar went public in 1995, and, following an enthusiastic reception by the stock market, Jobs’s 80 percent stake was valued at about $1.1 billion. Finally, just to show that what goes around comes around, in 1997, Apple’s future was still in doubt, and the company, struggling for relevance in a “Wintel” world, decided to go the sequel route when it hired a new interim chief executive officer (CEO): Steven Jobs! How successful was he at his new (old) job?
In January 2000, Apple’s board of directors granted Jobs stock options worth $200 million and threw in $90 million for the purchase and care of a Gulfstream V jet. Board member Edgar Woolard stated, “This guy has saved the company.”
Understanding Jobs’s journey from garage-based entrepreneur to corporate executive to ex-employee and, finally, to CEO takes us into issues involving the corporate form of organization, corporate goals, and corporate control, all of which we discuss in this chapter.
To begin our study of modern corporate finance and financial management, we need to address two central issues. First, what is corporate finance and what is the role of the financial manager in the corporation? Second, what is the goal of financial management? To describe the financial management environment, we consider the corporate form of organization and discuss some conflicts that can arise within the corporation. We also take a brief look at financial markets in the United States.
CORPORATE FINANCE AND THE FINANCIAL MANAGER
In this section, we discuss where the financial manager fits in the corporation. We start by defining corporate finance and the financial manager’s job.
What Is Corporate Finance?
Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another:
- What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need?
- Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money?
- How will you manage your everyday financial activities such as collecting from customers and paying suppliers?
These are not the only questions by any means, but they are among the most important. Corporate finance, broadly speaking, is the study of ways to answer these three questions. Accordingly, we’ll be looking at each of them in the chapters ahead.
The Financial Manager
A striking feature of large corporations is that the owners (the stockholders) are usually not directly involved in making business decisions, particularly on a day-to-day basis. Instead, the corporation employs managers to represent the owners’ interests and make decisions on their behalf. In a large corporation, the financial manager would be in charge of answering the three questions we raised in the preceding section.
The financial management function is usually associated with a top officer of the firm, such as a vice president of finance or some other chief financial officer (CFO). Figure 1.1 is a simplified organizational chart that highlights the finance activity in a large firm. As shown, the vice president of finance coordinates the activities of the treasurer and the controller. The controller’s office handles cost and financial accounting, tax payments, and management information systems.
The treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures. These treasury activities are all related to the three general questions raised earlier, and the chapters ahead deal primarily with these issues. Our study thus bears mostly on activities usually associated with the treasurer’s office.
Financial Management Decisions
As the preceding discussion suggests, the financial manager must be concerned with three basic types of questions. We consider these in greater detail next.
The first question concerns the firm’s long-term investments. The process of planning and managing a firm’s long-term investments is called capital budgeting. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Loosely speak- ing, this means that the value of the cash flow generated by an asset exceeds the cost of that asset.
The types of investment opportunities that would typically be considered depend in part on the nature of the firm’s business. For example, for a large retailer such as Wal-Mart, deciding whether or not to open another store would be an important capital budgeting decision. Similarly, for a software company such as Oracle or Microsoft, the decision to develop and market a new spreadsheet would be a major capital budgeting decision. Some decisions, such as what type of computer system to purchase, might not depend so much on a particular line of business.
Regardless of the specific nature of an opportunity under consideration, financial managers must be concerned not only with how much cash they expect to receive, but also with when they expect to receive it and how likely they are to receive it. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. In fact, as we will see in the chapters ahead, whenever we evaluate a business decision, the size, timing, and risk of the cash flows will be, by far, the most important things we will consider.
Capital Structure The second question for the financial manager concerns ways in which the firm obtains and manages the long-term financing it needs to support its long- term investments. A firm’s capital structure (or financial structure) is the specific mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm. Second, what are the least expensive sources of funds for the firm?
If we picture the firm as a pie, then the firm’s capital structure determines how that pie is sliced—in other words, what percentage of the firm’s cash flow goes to creditors and what percentage goes to shareholders. Firms have a great deal of flexibility in choosing a financial structure. The question of whether one structure is better than any other for a particular firm is the heart of the capital structure issue.
In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money. The expenses associated with raising long-term financing can be considerable, so different possibilities must be carefully evaluated. Also, corporations borrow money from a variety of lenders in a number of different, and sometimes exotic, ways. Choosing among lenders and among loan types is another job handled by the financial manager.
Working Capital Management The third question concerns working capital management. The term working capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm’s working capital is a day-to-day activity that ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm’s receipt and disbursement of cash.
Some questions about working capital that must be answered are the following: (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? These are just a small sample of the issues that arise in managing a firm’s working capital.
The three areas of corporate financial management we have described— capital budgeting, capital structure, and working capital management—are very broad categories. Each includes a rich variety of topics, and we have indicated only a few of the questions that arise in the different areas. The chapters ahead contain greater detail.