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Corporate Finance Unit 1: Goals of the Firm and Financial Statements

Corporate finance asks how a firm should invest, finance and manage cash so that the value of the owners' shares is as high as possible. This unit sets that goal and teaches you to read the financial statements in terms of cash flow, which every later unit relies on.

Covers: Goal of the firm and shareholder wealth, Agency problems and corporate governance, Business organization forms, Balance sheet and market vs book value, Income statement and taxes, Cash flow from assets and the cash flow identity

Study guide

Financial managers make three kinds of decisions. Capital budgeting decides which long-term assets to buy. Capital structure decides how to pay for them with debt and equity. Working capital management handles day-to-day cash, inventory and credit. The goal behind all three is to maximize the current value per share of existing stock. This goal beats 'maximize profit' because share price reflects the size, timing and risk of every future cash flow, while accounting profit for one year ignores timing and risk and can be pumped up by cutting investment that the firm needs.

Most large firms are corporations. A corporation is a legal entity separate from its owners, so shareholders have limited liability, can sell their shares easily, and the firm can raise large amounts of capital and outlive its founders. The cost is double taxation: profits are taxed at the corporate level and again when paid out as dividends. Sole proprietorships and partnerships avoid double taxation but give owners unlimited liability. Separating ownership from control creates agency problems: managers (agents) may pursue perks, job security or empire building instead of shareholder value. Boards, stock-based pay, takeover threats and shareholder activism help keep managers in line.

The balance sheet is a snapshot: assets = liabilities + shareholders' equity. Current assets and current liabilities turn over within a year, and their difference is net working capital (NWC). Balance sheet values are book values based on historical cost. Market values reflect what investors will pay today for the firm's expected cash flows, so the market-to-book ratio is a rough gauge of whether investors think the firm creates value. The income statement covers a period: sales minus costs minus depreciation gives EBIT; subtracting interest gives taxable income, and subtracting taxes gives net income.

Taxes matter for every decision. The average tax rate is total tax divided by taxable income; the marginal tax rate is the rate on the next dollar. Because new projects add income at the margin, decisions use the marginal rate. Under current U.S. law the federal corporate rate is a flat 21%, so the two rates are the same at the federal level, but graduated schedules still appear in problems and in other tax systems. Interest is tax-deductible, while dividends are not, which matters later for capital structure.

Finance cares about cash flow, not accounting income. Cash flow from assets (free cash flow) equals operating cash flow minus net capital spending minus the change in NWC. OCF = EBIT + depreciation − taxes. Net capital spending = ending net fixed assets − beginning net fixed assets + depreciation. The cash flow identity says cash flow from assets equals cash flow to creditors (interest − net new borrowing) plus cash flow to stockholders (dividends − net new equity). A growing firm can show rising profits and negative free cash flow because growth requires investment.

Key ideas

• The financial manager's goal is to maximize the current value per share, which reflects size, timing and risk of cash flows.
• Agency problems arise when managers' goals differ from shareholders', and governance tools try to align them.
• Corporations offer limited liability and easy capital raising but face double taxation.
• Book values are historical; market values reflect expected future cash flows.
• Use the marginal tax rate, not the average rate, for decisions about new income.
• Depreciation is a noncash expense that lowers taxes, so it is added back to find cash flow.
• Cash flow from assets always equals cash flow to creditors plus cash flow to stockholders.

Formulas and rules

Common mistakes

• Using the average tax rate instead of the marginal rate to judge a new project's taxes.
• Forgetting to add depreciation back when computing net capital spending from net fixed assets.
• Treating an increase in NWC as a source of cash instead of a use of cash.
• Subtracting interest expense when computing operating cash flow; interest is a financing flow.
• Assuming rising net income means rising cash flow, when growth investment can make free cash flow negative.

Before the test, make sure you can

• Explain why maximizing share value is a better goal than maximizing profit.
• Identify agency problems and the tools used to control them.
• Compare corporations, sole proprietorships and partnerships on liability, taxes and capital raising.
• Calculate NWC, EBIT and net income from statement data.
• Calculate average and marginal tax rates from a bracket schedule.
• Calculate OCF, net capital spending, change in NWC and cash flow from assets.
• Use the cash flow identity to solve for dividends or new borrowing.
• Explain why book value and market value differ.

Words to know

Goal of financial management

Maximize the current value per share of existing stock, which accounts for the size, timing and risk of cash flows.

Capital budgeting

The process of deciding which long-term investments (projects, assets) the firm should make.

Capital structure

The mix of debt and equity a firm uses to finance its assets.

Working capital management

Managing short-term assets and liabilities such as cash, receivables, inventory and payables.

Agency problem

A conflict of interest between principals (shareholders) and agents (managers) who act for them.

Agency costs

Direct and indirect costs from conflicts between managers and shareholders, including monitoring costs and lost value from poor decisions.

Corporation

A legal entity separate from its owners with limited liability and easy transfer of ownership, but double taxation.

Limited liability

Owners can lose only what they invested; they are not personally liable for the firm's debts.

Net working capital

Current assets minus current liabilities.

Book value

Value of assets or equity on the balance sheet, based on historical cost.

Market value

The price investors will pay today for an asset or the firm's equity, based on expected future cash flows.

Market-to-book ratio

Market value of equity per share divided by book value of equity per share.

Average tax rate

Total taxes paid divided by taxable income.

Marginal tax rate

The tax rate paid on the next dollar of taxable income.

Operating cash flow

Cash generated by the firm's normal operations: EBIT + depreciation − taxes.

Net capital spending

Money spent on fixed assets minus money from selling fixed assets: ending NFA − beginning NFA + depreciation.

Cash flow from assets

OCF minus net capital spending minus the change in NWC; also called free cash flow.

Cash flow identity

Cash flow from assets = cash flow to creditors + cash flow to stockholders.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.