Principles of Corporate Finance

Principles of Corporate Finance (1980) is an undergraduate-level textbook edited by Richard Brealey, Stewart Myers, and Franklin Allen. Currently, in its twelfth edition, the textbook, targeted at first-year college students majoring in Finance, is generally taught in classes Finance 101, Finance 102, and Finance 103.

The book opens by refreshing students on general finance topics that exist independently of corporate finance, such as risk and value. As the book progresses, however, the topics become more complicated owing to the fact that corporate finances are generally far more complex than individual or small business finance.

Many of the terms defined going forward involve figures that are calculated using a large number of factors. One such term is Net Present Value or NPV. A business's NPV takes into consideration a company's profits, debts, cash-on-hand, and investments, as well as a number of other market-specific factors to designate a valuation for a firm that can be compared from company to company even across different markets. In calculating a firm's NPV, a finance student must take careful consideration to include what is known as the "time value of money." Determining the time value of money involves making informed predictions based on mathematical formulas and past evidence to discover a company's return on investment or ROI across various sectors of the business over time. For example, just because a company currently makes $10,000 a day selling a certain product, that doesn't mean we can expect the company to continue making that much forever. Before long, consumers may grow tired of the product, the product could become outdated, or the market could become saturated. Alternatively, perhaps the company is currently selling so much because it recently spent millions on a nationwide ad campaign lasting a limited amount of time. That is why students have to take into consideration investment in production, in research and development, and in advertising before being able to compile a reliable return on investment multiple that encapsulates all these factors.



These considerations are further complicated by the fact that a company's cash flow, or the number of liquid assets the company has at its fingertips, fluctuates wildly based on many factors, including de­­bts, loan repayment, and loan availability. For example, it might be easy to say that a company should always pursue every opportunity that has a net positive return on investment. However, that would only be true if the company had an unlimited amount of cash on hand, which isn't usually the case. The student must, therefore, also keep in mind cash flow issues to ensure the corporation can keep up with existing fixed costs, such as payroll for its employees, property taxes, and investment in existing projects. After all, if the company can no longer pay its employees then it can't properly execute projects and investments, thus hobbling the opportunity to make money from even the strongest of investments with a high expected return on investment.

The textbook also dives into details related to corporate mergers, acquisitions, and option valuations. An option valuation, for example, is a contract that gives the buyer the opportunity to buy a particular asset (such as another company or a division of another company) at a certain price as long as the sale is agreed to by a certain date. An option valuation contract does not require the buyer to purchase it, in fact, the buyer is under no obligation at all to go through with the sale, and hence, the contract is referred to as an "option." Other vocabulary terms introduced in this section include "strike price," the fixed price at which the buyer has an option of purchasing the asset; "spot price," a valuation of the asset set by the market, the option is referred to as a "call" to illustrate the contract in which a buyer can purchase the asset, whereas it is known as a "put" when a similar contract is discussed from the seller's perspective.

Another fascinating phenomenon explored is known as the Principal-agent Problem. This arises when just one individual or a very small cabal of individuals disproportionately makes decisions at a business. This can be a problem because what is in the agent's best interest is not always in the best interest of the corporation or entity the agent represents. This can pose a dilemma for both the people who work for the company the principal-agent represents and for third-parties attempting to do business with the company. A very simple and common example would be a lawyer who agrees to take a case for a client. The client may be unsure if the lawyer is truly acting in the client's best interests by taking the case, or if the lawyer simply knows that by taking the case it will generate income for the lawyer.



A mainstay of college-level Finance classes for nearly thirty years, Principles of Corporate Finance offers a valuable primer on the enormously complex world of big business in the United States.