1. Introduction Flashcards
I. The Financial Paradigma of the Firm II. Review of Main Concepts
I. What is the main objective of a firm?
To create Value
I. Name the different kinds of value:
- Equity Value
- Enterprise Value
- Firm Value
I. Name the different measures of Value.
- Accounting/Book Value
- Fundamental/Intrinsic Value
- Market Price (usually, referred as market value)
- Liquidation Value
I. What is a good proxy for the Liquidation Value?
Liquidation value: if we sell all the assets one by one, how much will someone be willing to pay for it
Sometimes as a proxy of this value we tend to use the accounting value.
I. Explain the different measures of Value.
- Market Price: We tend to use market price as a proxy of the Fundamental Value
-Book Value: We tend to use book value as a proxy of liquidation value
I. When financial markets are efficient market price can be used as …
a proxy of the fundamental value (the real market value)
I. If the company is listed, we can calculate Net Debt as …
(Nº of bonds* Bonds price) - MNVOA
Please explain in more detail the liquidation value
Liquidation value is the value which would be obtained if all assets were sold, and debt and all liabilities were paid back.
I. Anytime the liquidation value is persistently higher than the financial value,
the company will be worth more “dead” than staying “alive”, for its shareholders.
I. What is the goal of financial management?
To maximize the value of the owner’s equity.
I. What is the objective in conventional corporate financial theory?
To maximize the value of the firm.
I. Are these objectives compatible?
Yes, but only if debt holders protect themselves from expropriation of value
- Debt holders are not the only stakeholders of a company
I. Concept of stakeholders
All individuals or entities affected by the firm’s actions, objectives and policies.
I. Describe the management shareholders’ agency relationship.
Managers act on the behalf of shareholders. However, they also have their own utility function to maximize.
In other words, they want to keep their job, and receive the higher income possible, this results in a problem: managers have different interests from shareholders.
I. Is it possible to eliminate agency costs?
It is not possible to eliminate agency costs, but it is possible to reduce it.
For instance, Stock options may be a solution for this problem.
I. How is the relationship between managers and creditors?
Creditors cannot control management, therefore, they will be exposed to the risk of wealth expropriation by managers or shareholders.
Managers are on the same side as shareholders. However, for the best interest of shareholders, they have to maintain a good relationship with debt holders.
I. Explain the relationship between managers and Financial Markets.
Managers might manipulate
information in order to misinform
the markets.
I. If debt holders are protected, is there a way to create value for shareholders?
The only way to do so is by increasing the Enterprise Value. Equity Value increase comes from an increase in Enterprise Value.
I. If I look to the increase of share price, can I ensure that the Enterprise value as also increased?
No. EV will only reflect share price if I am able to ensure that:
1. Markets are efficient (share price as a good proxy of share value)
2.Managers are not able to expropriate value from debt holders.
I. Regarding the relationship between managers and society, what is the main problem that needs to be solved?
Firms might jeopardize the interests of society as a whole and those costs might be difficult to allocate to firms (e.g. pollution).
Sometimes companies can increase EV, by expropriating society’s value
- Managers are not responsible to protect society.
- Governments should act in the interest of society, by imposing laws, regulations and implementing fines.
I. What type of value should a firm maximize?
The main objective must be to maximize stock prices.
Even though the main objective of the firm is to maximize firm value, value creation may be measured by changes in stock prices, providing
that agency costs are minimized:
- Creditors are protected against the risk of wealth expropriation by shareholders;
- Management decisions do not impose costs (externalizes) on society;
- Managers do not manipulate information and do not succeed in cheating the markets (efficient markets).
If so, share price can be used to monitoring if managers act in the interest of shareholders.
I. How can a firm create value?
Through 3 types of decisions.
1. Investment Decisions
2. Financing Decisions
3. Dividend Decisions
I. How can a firm create value using investment decisions?
The firm can invest in assets offering a return higher than the required rate of return (hurdle rate).
- The hurdle rate must reflect the investment risk and the financing mix.
- The return on the asset must take into consideration the amount and timing of cash-flows.
I. How can a firm create value using Financing decisions?
By finding the optimal capital mix to finance investments and the nature of debt which better meets the needs of the corporation.
- The optimal mix of equity and debt maximizes enterprise value.
- The nature of debt depends on the characteristics of the enterprise assets.