Lessons in Corporate Finance

CHAPTER 1 Introduction

This book is a basic corporate finance text but unique in the way the subject is presented. The book’s format involves asking a series of increasingly detailed questions about corporate finance decisions and then answering them with conceptual insights and specific numerical examples.

The book is structured around real-world decisions that a chief financial officer (CFO) must make: how firms obtain and use capital. The primary functions of corporate finance can be categorized into three main tasks:

1. How to make good investment decisions
2. How to make good financing decisions
3. How to manage the firm’s cash flows while doing the first two

Taking the last point first, cash is essential to a firm’s survival. In fact, cash flow is much more important than earnings. A firm can survive bad products, ineffective marketing, and weak or even negative earnings and stay in business as long as it has cash flow. Not running out of cash is an essential part of corporate finance. It requires understanding and forecasting the nature and timing of a firm’s cash flows. For example, at the turn of the century, dot-coms were almost all losing large sums of money. However, financial analysts covering these firms focused primarily not on earnings but on what is called “burn rates” (i.e., the rate at which a firm uses up or “burns” cash). There is an old saying in finance: “You buy champagne with your earnings, and you buy beer with your cash.” Cash is the day-to-day lifeblood ...