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This compendium provides a comprehensive overview of the most important topics covered in a corporate finance course at the Bachelor, Master or MBA level. The intension is to supplement renowned corporate finance textbooks such as Brealey, Myers and Allen's "Corporate Finance", Damodaran's "Corporate Finance - Theory and Practice", and Ross, Westerfield and Jordan's "Corporate Finance Fundamentals".
The compendium is designed such that it follows the structure of a typical corporate finance course. Throughout the compendium theory is supplemented with examples and illustrations.
The objective of the firm
Corporate Finance is about decisions made by corporations. Not all businesses are organized as corporations. Corporations have three distinct characteristics:
1. Corporations are legal entities, i.e. legally distinct from it owners and pay their own taxes
2. Corporations have limited liability, which means that shareholders can only loose their initial investment in case of bankruptcy
3. Corporations have separated ownership and control as owners are rarely managing the firm
The objective of the firm is to maximize shareholder value by increasing the value of the company's stock. Although other potential objectives (survive, maximize market share, maximize profits, etc.) exist these are consistent with maximizing shareholder value.
Most large corporations are characterized by separation of ownership and control. Separation of ownership and control occurs when shareholders not actively are involved in the management. The separation of ownership and control has the advantage that it allows share ownership to change without influencing with the day-to-day business. The disadvantage of separation of ownership and control is the agency problem, which incurs agency costs.
Agency costs are incurred when:
1. Managers do not maximize shareholder value
2. Shareholders monitor the management
In firms without separation of ownership and control (i.e. when shareholders are managers) no agency costs are incurred.
In a corporation the financial manager is responsible for two basic decisions:
1. The investment decision
2. The financing decision
The investment decision is what real assets to invest in, whereas the financing decision deals with how these investments should be financed. The job of the financial manager is therefore to decide on both such that shareholder value is maximized.
Present value and opportunity cost of capital
Present and future value calculations rely on the principle of time value of money.
Time value of money
One dollar today is worth more than one dollar tomorrow.
The intuition behind the time value of money principle is that one dollar today can start earning interest immediately and therefore will be worth more than one dollar tomorrow. Time value of money demonstrates that, all things being equal, it is better to have money now than later.
Compounded versus simple interest
When money is moved through time the concept of compounded interest is applied. Compounded interest occurs when interest paid on the investment during the first period is added to the principal. In the following period interest is paid on the new principal. This contrasts simple interest where the principal is constant throughout the investment period. To illustrate the difference between simple and compounded interest consider the return to a bank account with principal balance of €100 and an yearly interest rate of 5%. After 5 years the balance on the bank account would be:
- €125.0 with simple interest: €100 + 5 • 0.05 • €100 = €125.0
- €127.6 with compounded interest: €100 • 1.055 = €127.6
Thus, the difference between simple and compounded interest is the interest earned on interests. This difference is increasing over time, with the interest rate and in the number of sub-periods with interest payments.