Chapter 1

Question 1

Define investment decisions. What do they typically involve?

Answer 1

Involve spending money to acquire real assets that will generate future cash flows, such as machinery, buildings, or technology

Question 2

What are financing decisions, and what are some common methods to raise funds?

Answer 2

Financing decisions involve raising money to fund investments.
Some methods include: borrowing (debt financing), issuing new shares (equity financing), & reinvesting profits back into the business.

Question 3

Explain the difference between real assets and financial assets. Provide examples.

Answer 3

Real assets are tangible or intangible assets used to produce goods and services (machinery, patents).
Financial assets are claims on the income generated by real assets (stocks, bonds).

Question 4

What does it mean to maximize market value, and why is it considered the natural financial goal of a corporation?

Answer 4

Maximizing market value means increasing the current value of shareholders’ investments, which is considered the natural financial goal because it aligns with shareholders’ interests.

Question 5

What is a corporation?

Answer 5

A distinct, permanent legal entity separate from its owners (shareholders)

Question 6

What does limited liability mean for shareholders?

Answer 6

They are not personally liable for the corporation’s debts, they can only lose their investment.

Question 7

How does the separation of ownership and control affect corporate governance?

Answer 7

It can lead to agency problems, where managers may act in their own interests rather than those of the shareholders.

Question 8

What is double taxation in the context of corporations?

Answer 8

Corporations pay taxes on their profits, and shareholders are texed again on dividends or capital gains.

Question 9

What is the difference between public and private corporations?

Answer 9

Public corporations have shares traded on stock exchanges, while private corporations are owned by a small group of investors and do not trade shares publicly.

Question 10

What are the advantages and disadvantages of incorporation?

Answer 10

Advantages are limited liability and continuous existence.
Disadvantages are double taxation and potential agency problems.

Question 11

What is a corporation?

Answer 11

A business organized as a separate, permanent legal entity, owned by shareholders who have a limited liability.

Question 12

What are some pros and cons of a corporation?

Answer 12

Pros:
- limited liability
- continuity, infinite life
Cons:
- double taxation
- highly regulated, cumbersome governance and administration

Question 13

Name different types of business organisations

Answer 13

1) Sole proprietorship
2) Partnership
3) Corporation
4) Limited liability companies -> hybrid of partnerships and corporations

Question 14

Who is the financial manager and what is his function?

Answer 14

A financial manager is anyone that’s responsible for an investment/financial decision. He stands between the firm and outside investors.

Question 15

What is the main goal of a corporation?

Answer 15

To maximize market value!

Question 16

Why is maximizing profit not a well-defined objective?

Answer 16

1) Maximizing profit won’t add value and shareholders will not welcome a higher ST profit if the LT profit is damaged.
2) Firm could increase future profits by cutting dividends and investing, however shareholders won’t be pleased.

Question 17

How can managers maximize shareholder wealth/market value?

Answer 17

Corporations can increase value by accepting investment projects that earn more than the Opportunity Cost of Capital.
So when the expected rate of return from an investment in real assets > expected rate of return from the stock market.

Question 18

What is a stakeholder?

Answer 18

Anyone with a financial interest in the corporation such as lenders, government, shareholders, etc.

Question 19

What are Agency problems?

Answer 19

Managers are tempted to act in their own interests rather than maximizing market value.

Question 20

What are Agency costs?

Answer 20

It’s the value lost because of agency problems and the cost from dealing with them.

Question 21

How can Agency costs be reduced?

Answer 21

Agency costs can be reduced by implementing a Corporate governance mechanism.

Question 22

What are the components of a good Corporate governance?

Answer 22

1) Legal framework
2) Board of directors
3) Incentives/Compensation package
4) Activist shareholders
5) Takeovers
6) Information for investors