concepts overview

Topics: Net present value, Investment, Corporate finance Pages: 21 (7122 words) Published: October 20, 2014
Chapter 1
Preliminary concepts
Concepts Overview
The important concepts discussed in Chapter 1 were:
 The main objective underlying corporate financial decisions is to maximise the value of the company, which in turn maximises shareholder wealth. This involves the optimal use of scarce resources. Fisher’s Separation theorem formally links the concepts covered in the chapter to provide a single decision rule for a firm’s investment decisions. This decision rule is that management’s role is to maximise the present value of the firm’s investments in productive assets. Corporate managers face three important decisions in their attempt to maximise shareholder wealth. These decisions are: investment decisions, financing decisions and dividend decisions.

The investment decision relates to the manner in which funds raised in capital markets are employed in productive activities. The objective of such investments is to generate future cash flows, thus providing a ‘return’ to investors. The capital budgeting or project evaluation function is the process by which the investment decision is undertaken.

The financing decision relates to the mix of funding obtained from capital markets; that is, the mix of debt and equity issued by the firm to fund its operations.

The dividend decision relates to the form in which the returns generated by the firm are passed on to equity holders.

The nature of financial assets is simply a claim to a series of cash flows against some economic unit. Only something that produces cash flows, or that you can sell to produce a cash flow in the future, is a financial asset. This is opposed to real assets which are those that can be put to productive use to generate returns; for example, machinery and equipment.

The flow of funds through the capital market and its relationship to corporate finance begins with investors. Investors make consumption and investment decisions. They decide whether, and to what extent, they are willing to trade their present consumption for future consumption. If they decide to forgo present consumption, they may put their money in the bank or buy shares, thereby placing their cash into the capital market

The financing, or capital structure, decision is associated with this flow of funds from the capital market to the company. Individual companies will normally acquire funding through the sale of financial assets; either equity (shares) or debt (bonds). Once a company acquires funds, it will generally purchase real (productive) assets – the investment decision.



Instructor’s Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e © 2009 Pearson Australia


The key corporate objective is to maximise the wealth of the owners of a company. This is measured by market capitalisation, which is found by multiplying the current market price of each share by the number of shares on issue.

There are a number of incentives and mechanisms in place that encourage the directors of a company to make decisions that maximise the wealth of owners: regulation by the Australian Securities and Investments Commission (ASIC), remuneration packages that tie the remuneration of management to company value, and the market for corporate control (i.e. the takeover market).

One of the most important concepts in corporate finance is value – in particular, the value of assets. This chapter describes how to value an asset paying a single cash flow. Valuations of assets that generate cash flows over time involve consideration of the time value of money. For example, consider a simple asset that guarantees the holder a cash flow of $105 in one year’s time, while at the same time a bank is offering a 5% p.a. rate or return. To value the asset offering a cash flow of $105 in one year’s time the 5% p.a. offered by the bank can be used as the opportunity cost or discount rate for the asset to determine its value in...
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