Introduction to Corporate Finance

PART 1: INTROdUCTION

■ Companies can obtain capital either by

borrowing (debt capital) or by selling shares

(equity capital), which represents permanent

ownership in the company. Companies can

obtain debt capital either by selling securities

to investors or from a financial intermediary,

such as a commercial bank. The initial sale

of securities is called a primary-market

transaction, whereas all subsequent trades

between investors are considered secondary-

market transactions.

■ The three key legal forms of business

organisation are sole proprietorships,

partnerships and companies. Sole

proprietorships are most common, but

companies dominate economically. Limited

partnerships are hybrid forms, combining

the limited liability of companies with the

favourable tax treatment of partnerships.

Similar forms of business organisation exist in

other industrialised economies.

■ The goal of the company’s managers should

be to maximise shareholder wealth, not to

maximise profits. Maximising profits focuses

on the past rather than the future, ignores the

timing of profits, relies on accounting values

rather than future cash flows, and ignores

risk. Maximising shareholder wealth is socially

optimal because shareholders are residual

claimants who profit only after all other claims

are paid in full.

■ Agency costs that result from the separation

of ownership and management must be

addressed satisfactorily for companies to

prosper. These costs can be overcome (or at

least reduced) by relying on the workings of

the market for corporate control, incurring

monitoring and bonding costs, and using

executive compensation contracts designed

to align the interests of shareholders and

managers.

■ Ethical behaviour is viewed as necessary

for achievement of the companies’ goal

of maximising owner wealth. The ASX

established rules and procedures in 2002

aimed at eliminating the potential for

unethical acts and conflicts of interest in

public companies.

KEY TERMS

agency costs, 19

agency problems, 23

Australian Securities and

Investments Commission

(ASIC), 12

Australian Securities Exchange

(ASX), 12

board of directors, 18

capital budgeting function, 11

chief financial officer (CFO), 7

collective action problem, 12

company, 18

constitution, 18

corporate finance, 10

corporate governance function,

12

corporation, 18

debt capital, 14

equity capital, 14

equity claimants, 19

executive compensation plans,

24

fiduciary, 9

financial intermediary, 14

financial management function,

11

financing function, 10

firm, 5

general partners, 17

hedge, 12

hostile takeover, 24

initial public offering (IPO), 11

joint and several liability, 17

limited liability company

(LLC), 19

limited partners, 17

limited partnership (LP), 17

managing director or chief

executive officer (CEO), 19

partnership, 17

primary-market transactions, 15

proprietary limited company , 18

public company, 18

residual claimants, 22

risk management function, 11

risk shifting, 11

risk spreading or diversification,

11

secondary-market

transactions, 15

shareholder, 18

share options, 24

sole proprietorship, 15

stakeholders, 21

venture capitalists, 11

LO1.3

LO1.4