Corporate Finance


The Video Product Company designs and manufactures very popular software forvideo game consoles. The company was started in 1999, and soon thereafter its game“Gadfly” appeared on the cover of Billboardmagazine. Company sales in 2000 wereover $20 million. Video Product’s initial financing of $2 million came from Seed Ltd., aventure-capital firm, in exchange for a 15-percent equity stake in the company. Now the fi-nancial management of Video Product realizes that its initial financing was too small. In thelong run Video Product would like to expand its design activity to the education and busi-ness areas. It would also like to significantly enhance its website for future Internet sales.However, at present the company has a short-run cash flow problem and cannot even buy$200,000 of materials to fill its holiday orders.
Video Product’s experience illustrates the basic concerns of corporate finance:
1. What long-term investment strategy should a company take on?
2. How can cash be raised for the required investments?
3. How much short-term cash flow does a company need to pay its bills?

These are not the only questions of corporate finance. They are, however, among the mostimportant questions and, taken in order, they provide a rough outline of our book.

One way that companies raise cash to finance their investment activities is by sellingor“issuing” securities. The securities, sometimes called financial instruments or claims,may be roughly classified as equity or debt, loosely called stocks or bonds. The differencebetween equity and debt is a basic distinction in the modern theory of finance. All securi-ties of a firm are claims that depend on or are contingent on the value of the firm.1In Section1.2 we show how debt and equity securities depend on the firm’s value, and we describethem as different contingent claims.
In Section 1.3 we discuss different organizational forms and the pros and cons of thedecision to become a corporation.
In Section 1.4 we take a close look at the goals of the corporation and discuss why max-imizing shareholder wealth is likely to be the primary goal of the corporation. Throughoutthe rest of the book, we assume that the firm’s performance depends on the value it createsfor its shareholders. Shareholders are better off when the value of their shares is increasedby the firm’s decisions.
A company raises cash by issuing securities to the financial markets. The market valueof outstanding long-term corporate debt and equity securities traded in the U.S. financialmarkets is in excess of $25 trillion. In Section 1.5 we describe some of the basic features ofthe financial markets. Roughly speaking, there are two basic types of financial markets: themoney markets and the capital markets. The last section of the chapter provides an outlineof the rest of the book.

We tend to use the words firm, company, and business interchangeably. However, there is a difference betweena firm and a corporation.

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