Financial Management Quiz #1: Chapter 1

What is Finance?
Management of Capital
Professional Finance Examples
Invest oversees?
How should an acquisition of another company be financed?
Which supplier to choose?
Personal Finance Examples
Where to invest savings?
Purchase or lease a car?
Financial Decision Making is Complicated When…
1. Cost and Benefits associates with the decisions DO NOT occur at the same time
2. There is risk: uncertainty regarding the magnitude of these costs and benefits
Public Finance
Decisions made by government
Ex. Which infrastructure projects should the government spend money in?
Investments/ Personal Finance
Decisions made by individuals and institutional investors regarding where to invest their money
-Insurance
-Estate Planning
What is a Firm?
1. Manager Raises Capital from Investors (Debt/Equity)
2. Manager Invests Capital
3. Generates Future Income for Investors
4. Future Income has Value to Investors Today (Expected Amount, Timing, and Risk)
5. Value Created for Investors (Value of Future Income – Capital Provided)
Debt Investment
Promise to pay back principal + interest
Maximum amount
Equity
No promise to pay back a certain amount
Residual Claims: only get paid if company makes profit after debt holders are paid
4 Types of Firms (Table 1.1 pg. 9)
1. Sole Proprietorship
2. Partnership
3. Limited Liability Company (LLC)
4. Corporation
Sole Proprietorship
Business owned and run by one person
-Most common type
-No seperation between business and owner = Unlimited Liability
-Taxation: personal tax rate
-Easy and inexpensive to form
-Life: life of owner
-Access to capital: poor
Partnership
Business owned and run by more than one owner
-Unlimited Liability is shared amongst all partners
-Partnership ends in the event of the death or withdrawal of any partner
-Taxation: shared amongst partners personal rates
-Easy and inexpensive
-Access to capital: better
Limited Liability Company (LLC)
Limited Partnership without a general partner
-All partners have limited liability (limited to their investment)
Corporation
Legally defined, artificial being, separate from its owners
-Has the legal powers of people: can enter contracts, acquire assets, and incur obligations and is protected by US Constitution
– Owned by shareholders
-Controlled by professional managers
-Taxed by Corporate tax rate
-Harder and more expensive to form
-Unlimited life
-Liability is limited to shareholder’s investment
-Easiest to access capital
-Shareholders pay tax twice (double taxation)
How Should a Firm Organize?
Depends…
-Which form has the most advantages and least disadvantages?
-Corporation (C Corp): Able to hire professionals to do job (CEO), have more information available, able to raise more capital
–Must avoid Agency Conflict: interests of agent and principle do not coincide (Moral hazard)
Types of Corporate Decisions
Capital Budgeting
Choice of Financing
Working Capital Management
Risk Management
Capital Restructuring
Corporate Manager
Appointed by the shareholders to run the firm
-Goal= maximize the wealth of the shareholders
1. Make investment decisions
2. Make financing decisions
3. Manage short-term cash needs
Board of Directors
Group of people elected by the shareholders who have the ultimate decision-making authority in the corporation
-Make rules on how the corporation should be run
-Sets policies
-Monitors the performance
Chief Executive Officer (CEO)
In charge of running the corporation by instituting the rules and policies set by the board of directors
Ethics and Incentives in Corporations
How can the owners of a corporation ensure that the management team will implement their goals?
Agency Problems
When managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of those shareholders.
3 Choices to Combat Agency Conflict
1. Monitor the Manager
2. Align managerial and shareholder interests through internal control such as capital structure policy and compensation policy
3. Develop mechanisms (like takeovers) for external controls
Hostile Takeover
An individual or organization (corporate raider) purchases a large fraction of a target corporation’s stock and in doing so gets enough votes to replace the target’s board and CEO
– Stock is a more attractive investment
Other Stakeholders
1. Bondholders
2. Customers
3. Employees
4. Society
Bondholder vs Stockholder
Conflict of Interests, different objectives
Bond: concerned about safety and ensuring they get paid their claims
Stock: concerned with upside potential
ASSUMPTION
Managers will work in the interests of stockholders and that these interests coincide with interests of stakeholders
Stock Markets (exchange or bourse)
Organized markets on which the shares of many corporations are traded
Liquid
An investment that can easily be turned into cash because it can be sold immediately at a competitive market price
Primary Market
Corporation issues new shares of stock and sells them to investors
Secondary Market
NYSE, NASDAQ
Shares of a corporation are traded between investors without the involvement of the corporation
Market Makers
Individuals on a stock exchange who match buyers with sellers (NYSE: specialists)
Bid Price
The price at which a market maker or specialist is willing to buy a security
Ask Price
The price at which a market maker or specialist is willing to sell a security
Bid-Ask Spread
The amount by which the ask price exceeds the bid price
Auction Market
Where share prices are set through direct interaction of buyers and sellers
Transaction Cost
An expense such as a broker commission and the bid-ask spread investors must pay in order to trade securities
Over-the-Counter (OTC) Market
Market without a physical location, in which dealers are connected by computers and telephones
Dealer Market
Market where dealers buy and sell for their own accounts
Listing Standards
Outlines of the requirements a company must meet to be traded on the exchange
Financial Institutions
Entities that provide financial services such as taking deposits, managing investments, brokering financial transactions or making loans
Financial Cycle
1. People invest and save their money
2. That money, through loans and stock, flows to companies who use it to fund growth through new products, generating profits and wages
3. The money, then flows back to the savers and investors
Types of Financial Institutions
Table 1.2 pg 18
Role of Financial Insitutions
1. Move funds from those who have extra to those who need funds
2. Move funds through time
3. Spread out risk-bearing