Chapter 1

Question 1

What is Finance?

Answer 1

Finance is really about the transfer of capital from investors to companies, and about how companies spend that capital and provide returns to the investors

Question 2

What Drives an Economy?

Answer 2

Production

• Driven by companies that produce goods and services
• Companies need money, or capital
• Acquire capital from investors
• Financial securities that firm sells to obtain capital are called stocks and bonds

Question 3

Why do investors provide capital?

Answer 3

Investors provide capital in exchange for a promise of a return on their investment

Question 4

What is the role of financial managers?

Answer 4

Financial managers are the managers who make the money-related decisions

Question 5

What are typical decisions made by financial managers?

Answer 5

Investing, Financing, and payout (providing a return to investors on that capital)

Question 6

What are the two main characteristics of capital budgeting?

Answer 6

Long-term investments and adding value (cash flows from the project will be worth more than the initial cost of the project)

Question 7

What are the three main forms of business organizations?

Answer 7

Sole proprietorship, partnership, and corporation

Question 8

What is a sole proprietorship?

Answer 8

Business entity that is owned by one person who incurs all of the liability of the business

Question 9

What is a partnership?

Answer 9

Business between two or more people

Question 10

What is a corporation?

Answer 10

Form of business that is a separate legal entity from its owners

Owners share in profits of the company but are not individually liable for its losses

Question 11

What are the advantages of a corporation?

Answer 11

Ability to raise large amounts of capital, limited liability, unlimited life, liquidity of financial securities

Question 12

What are the disadvantages of corporations?

Answer 12

Separation of ownership and control, disclosure/reporting requirements, double taxation of equity income

Question 13

What is the objective function of corporations?

Answer 13

The objective function of a corporation is to maximize shareholder wealth or value.

Question 14

How do you maximize shareholder wealth?

Answer 14

To maximize shareholder wealth, companies must produce something that society wants and is willing to pay for

Question 15

How can consumers respond to a negative impact that a company has on society?

Answer 15

Consumers can contact representatives, join activist groups, boycott the companies products, or engage in investor activism

Note: Governments can also step in and create/uphold antitrust legislation and pass regulations

Question 16

What is an agent? Why do agency problems exist?

Answer 16

An agent is someone who is hired on the behalf of the principal.

Agency problems exist since the interests of the agent are not always aligned with the interests of the principal.

Question 17

How could managers and shareholders better align their interests?

Answer 17

They could institute a performance-based compensation, where managers are paid their salary and bonus but also with shares. This means that managers would become shareholders and in order for the corporation to do well, they would have to perform well.

Question 18

When might there be a shareholder-debtholder conflict?

Answer 18

A debtholder may prefer a safer project that has a higher chance of return, but a shareholder may prefer a riskier project. Risky projects could end poorly, but they have a chance of a larger return compared to the safer projects.