Chapter 1 Introduction to Corporate Finance 13
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managers, standards for accounting and disclosure to investors, requirements for boards of
directors, and legal sanctions for self-dealing by management. When scandals happen, we say
that corporate governance has broken down. When corporations compete effectively and ethi-
cally to deliver value to shareholders, we are comforted that governance is working properly.
1-3 Preview of Coming Attractions
Figure 1.2 illustrates how the financial manager can add value for the firm and its sharehold-
ers. He or she searches for investments that offer rates of return higher than the opportunity
cost of capital. But that search opens up a treasure chest of follow-up questions.
∙ How do I calculate the rate of return? The rate of return is calculated from the cash
inflows and outflows generated by the investment project. See Chapters 2 and 5.
∙ Is a higher rate of return on investment always better? Not always, for two reasons. First,
a lower-but-safer return can be better than a higher-but-riskier return. Second, an invest-
ment with a higher percentage return can generate less value than a lower-return invest-
ment that is larger or lasts longer. We show how to calculate the present value (PV) of
a stream of cash flows in Chapter 2. Present value is a workhorse concept of corporate
finance that shows up in almost every chapter.
∙ What are the cash flows? The future cash flows from an investment project should sum
up all cash inflows and outflows caused by the decision to invest. Cash flows are calcu-
lated after corporate taxes are paid. They are the free cash flows that can be paid out to
shareholders or reinvested on their behalf. Chapter 6 explains free cash flows in detail.
∙ How does the financial manager judge whether cash-flow forecasts are realistic? As Niels
Bohr, the 1922 Nobel Laureate in Physics, observed, “Prediction is difficult, especially if it’s
about the future.” But good financial managers take care to assemble relevant information
and to purge forecasts of bias and thoughtless optimism. See Chapters 6 and 9 through 11.
∙ How do we measure risk? We look to the risks borne by shareholders, recognizing that inves-
tors can dilute or eliminate some risks by holding diversified portfolios (Chapters 7 and 8).
∙ How does risk affect the opportunity cost of capital? Here we need a theory of risk and
return in financial markets. The most widely used theory is the Capital Asset Pricing
Model (Chapters 8 and 9).
∙ What determines value in financial markets? We cover valuation of bonds and common
stocks in Chapters 3 and 4. We will return to valuation principles again and again in later
chapters. As you will see, corporate finance is all about valuation.
∙ Where does financing come from? Broadly speaking, from borrowing or from cash
invested or reinvested by stockholders. But financing can get complicated when you get
down to specifics. Chapter 14 gives an overview of financing. Chapters 23 through 25
cover sources of debt financing, including financial leases, which are debt in disguise.
∙ Debt or equity? Does it matter? Not in a world of perfect financial markets. In the real
world, the choice between debt and equity does matter, but for many possible reasons,
including taxes, the risks of bankruptcy, information differences, and incentives. See
Chapters 17 and 18.
That’s enough questions to start, but you can see certain themes emerging. For example,
corporate finance is “all about valuation,” not only for the reasons just listed, but because
value maximization is the natural financial goal of the corporation. Another theme is the
importance of the opportunity cost of capital, which is established in financial markets. The
financial manager is an intermediary, who has to understand financial markets as well as the
operations and investments of the corporation.