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FINA 3770 - Finance > Chapter 1 > Flashcards

Chapter 1 Flashcards

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1
Q

The Goal of the Firm

A

The fundamental goal of a business is to create value for the company’s owners (that is, the shareholders).

This goal is frequently stated as “maximization of shareholder wealth.”

Thus, the goal of the financial manager is to create wealth for the shareholders, by making decisions that will maximize the price of the existing common stock.

Maximizing the market value of the existing shareholders’ common stock. (because all financial decisions ultimately affect the firm’s stock price).

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2
Q

Investors react to poor investment or dividend decisions by casting the total value of the firm’s stock to fall.

A

Investors react to good decisions by pushing up the price of the stock.

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3
Q

Good decisions are those that

A

create wealth for the shareholder.

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4
Q

Principle 1: Cash Flow is What Matters

A

Incremental cash received and not accounting profits drives value.

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5
Q

Incremental Cash Flow

A

The difference between the cash flows a company will produce both with and without the investment it is thinking about making.

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6
Q

Principle 2: Money Has a Time Value

A

A dollar received today is more valuable to the recipient than a dollar received in the future.

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7
Q

Opportunity Cost

A

the cost of making a choice in terms of the next best alternative that must be foregone.

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8
Q

The opportunity cost of any choice you make is

A

the highest-valued alternative that you had to give up when you made the choice.

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9
Q

Principle 3: Risk Requires a Reward

A

The greater the risk of an investment, the higher will be the investor’s required rate of return, and, other things remaining the same, the lower will be its value.

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10
Q

.

A

.

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11
Q

.

A

.

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12
Q

.

A

.

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13
Q

Principle 4: Market Prices are Generally Right

A

For example, product market prices are often slower to react to important news than are prices in financial markets, which tend to be very efficient and quick to respond to news.

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14
Q

Efficient Market

A

a market in which the prices of securities at any instant in time fully reflect all publicly available information about the securities and their actual public values.

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15
Q

An efficient stock market

A

is characterized by a large number of profit-driven individuals who act very quickly by buying (or selling) shares of stock in response to the release of new information.

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16
Q

Principle 5: Conflicts of Interest Cause Agency Problems

A

Large firms are typically run by professional managers who own a small fraction of the firm’s equity. The individual actions of these managers are often motivated by self-interest, which may result in managers not acting in the best interests of the firm’s owners. When this happens, the firm’s owners will lose value.

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17
Q

Agency Problem

A

problems and conflicts resulting from the separation of the management and ownership of the firm.

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18
Q

Finance

A

is the study of how people and businesses evaluate investments and raise capital to fund them.

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19
Q

Three basic types of issues that are addressed by the study of finance

A
  1. What long-term investments should the firm undertake? This area of finance is generally referred to as Capital Budgeting.
  2. How should the firm raise money to fund these investments? The firm’s funding choices are generally referred to as Capital Structure Decisions.
  3. How can the firm best manage its cash flows as they arise in its day-to-day operations? This area of finance is generally referred to as Working Capital Management.
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20
Q

Capital Budgeting

A

the decision-making process with respect to investment in fixed assets.

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21
Q

Capital Structure Decision

A

the decision-making process with funding choices and the mix of long-term sources of funds.

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22
Q

Working Capital Management

A

the management of the firm’s current assets and short-term financing.

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23
Q

Financial Markets

A

those institutions and procedures that facilitate transactions in all types of financial claims.

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24
Q

Chief Financial Officer (CFO)

A

Responsible for overseeing financial planning, strategic planning, and controlling the firm’s cash flow.

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25
Q

Treasurer

A

Responsible for generally handling the firm’s financial activities, including cash and credit management, making capital expenditure decisions, raising capital (funds), financial planning, and managing any foreign currency received by the firm.

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26
Q

Controller

A

Responsible for managing the firm’s accounting duties, including producing financial statements, cost accounting, paying taxes, and gathering and monitoring the data necessary to oversee the firm’s financial well-being.

27
Q

Chief Financial Officer’s (CFO) Duties/Responsibilities

A
  • Oversee financial planning
  • Strategic planning
  • Control Cash flow
28
Q

Treasurer’s Duties/Responsibilities

A
  • –Handles the firm’s financial activities:
  • Cash Management
  • Credit Management
  • Capital Expenditures
  • Raising Capital
  • Financial Planning
  • Management of foreign currencies
29
Q

Controller’s Duties/Responsibilities

A
  • –Managing the firm’s accounting duties:
  • Taxes
  • Financial statements
  • Cost accounting
  • Data Processing
30
Q

Sole Proprietorship

A

a business owned and managed by a single individual.

Initiating this form of business is simple and generally does not involve any substantial organizational costs. The proprietor has complete control of the firm but must be willing to assume full responsibility for its outcomes.

31
Q

Partnership

A

An association of two or more individuals joining together as co-owners to operate a business for profit. Two types.

32
Q

General Partnership

A

a partnership in which all partners are fully liable for the indebtedness incurred by the partnership.
Unlimited liability.

33
Q

Limited Partnership

A

a partnership in which one or more of the partners has limited liability, restricted to the amount of capital he or she invests in the partnership.

34
Q

Several Conditions that must be met to qualify as a limited partner

A
  1. At least one general partner must have unlimited liability.
  2. The names of the limited partners may not appear in the name of the firm.
  3. The limited partners may not participate in the management of the business.

Thus, a limited partnership provides limited liability for a partner who is purely an investor.

35
Q

Corporation

A

An entity that legally functions separate and apart from its owners.

36
Q

S-Corporation

A

a corporation that, because of specific qualifications, is taxed as though it were a partnership.
Provides limited liability while allowing the business’s owners to be taxed as if they were a partnership.

37
Q

Limited Liability Company (LLC)

A

a cross between a partnership and corporation under which the owners retain limited liability but the company is run and is taxed like a partnership.

38
Q

The corporation increases the flow of capital from public investors to the business community.

A

-Limited liability
-Continuity of life
-Ease of transfer in ownership (which increase the marketability of the investment
-
the formal control of the corporation is vested in the parties who own the greatest number of shares.

39
Q

The fundamental goal of a business is to maximize the retained earnings available to the corporation’s shareholders.

True or False

A

False

40
Q

Shareholder wealth maximization means maximizing the price of the existing common stock.

True or False

A

True

41
Q

It is important to evaluate a corporate manager’s financial decision by measuring the effect the decision should have on the corporation’s stock price if everything else were held constant.

True or False

A

True

42
Q

Corporate managers should accept investment projects that maximize profits in the short run because of the time value of money.

True or False

A

False

43
Q

When making financial decisions, managers should always look at marginal or incremental cash flows.

True or False

A

True

44
Q

If two companies have the same net income and the same level of risk, they must also have the same stock price or the market is not in equilibrium.

True or False

A

False

45
Q

The root cause of agency problems is conflicts of interest.

True or False

A

True

46
Q

Investors will be indifferent between two investments if both investments have the same expected return.

True or False

A

False

47
Q

The chief financial officer (CFO) is responsible for overseeing financial planning, corporate strategic planning, and controlling the firm’s cash flow.

True or False

A

True

48
Q

A general partnership, unlike a limited partnership, is an entity that legally functions separate and apart from its owners.

True or False

A

False

49
Q

The primary goal of a publicly owned corporation is to ________.
A) maximize dividends per share
B) maximize shareholder wealth
C) maximize earnings per share after taxes
D) minimize shareholder risk

A

B) maximize shareholder wealth

50
Q 
The five basic principles of finance include all of the following EXCEPT 
A) Cash flow is what matters. 
B) Money has a time value. 
C) Risk requires a reward. 
D) Incremental profits determine value.
A

D) Incremental profits determine value.

51
Q

Suppose XYZ Corporation is traded on the New York Stock Exchange. XYZ’s closing price on Monday is $20 per share. After the market closes on Monday, XYZ makes a surprise announcement that it has obtained a major new customer. XYZ’s stock will likely
A) open at $20 per share on Tuesday and then increase as more investors read the announcement in the Wall Street Journal.
B) remain at $20 per share because in efficient markets the price already reflects all information.
C) open above $20 because the positive news will result in a higher valuation even though the stock has not yet traded.
D) open below $20 because the surprise announcement creates more uncertainty.

A

C) open above $20 because the positive news will result in a higher valuation even though the stock has not yet traded.

52
Q

A corporate manager decides to build a new store on a lot owned by the corporation that could be sold to a local developer for $250,000. The lot was purchased for $50,000 twenty years ago. When determining the value of the new store project
A) the cost of the lot is zero since the corporation already owns it.
B) the opportunity cost of the lot is $250,000 and should be included in calculating the value of the project.
C) the cost of the lot for valuation purposes is $50,000 because land does not depreciate.
D) the incremental cash flow should be the $50,000 original cost less accumulated amortization.

A

B) the opportunity cost of the lot is $250,000 and should be included in calculating the value of the project.

53
Q

The expected return on a riskless asset is greater than zero due to
A) an expected return for delaying consumption.
B) an expected return for opportunity costs.
C) an expected return for taxes.
D) irrational investors who believe risk is always present.

A

A) an expected return for delaying consumption.

54
Q

The principle of risk-return tradeoff means that
A) higher risk investments must earn higher returns.
B) an investor who takes more risk will earn a higher return.
C) a rational investor will only take on higher risk if he expects a higher return.
D) an investor who bought stock in a small corporation five years ago has more money than an investor who bought U.S. Treasury bonds five years ago.

A

C) a rational investor will only take on higher risk if he expects a higher return.

55
Q

Company A reports sales of $100,000 and net income of $15,000. Company B reports sales of $100,000 and net income of $10,000. Therefore
A) Company A’s cash flow may be higher or lower than Company B’s cash flow even though A’s net income is higher.
B) Company A’s cash flow is $5,000 more than Company B’s cash flow.
C) Company B is creating less value for its shareholders than Company A.
D) Company B’s accounts receivable must be higher than Company A’s accounts receivable.

A

A) Company A’s cash flow may be higher or lower than Company B’s cash flow even though A’s net income is higher.

56
Q

In which of the following cases will the agency problem between shareholders and managers be the greatest?
A) 100% of the common stock is owned by the founder of the company who decided to retire and hired a manager to run his business for him.
B) The Johnson family owns 50% of the common stock of the company. The other 50% is owned by 5 mutual funds.
C) The common stock of the company is owned by many diverse shareholders, with no shareholder owning more than 1% of the outstanding stock.
D) All top managers in the company own significant amounts of stock and stock options.

A

C) The common stock of the company is owned by many diverse shareholders, with no shareholder owning more than 1% of the outstanding stock.

57
Q 
A corporate treasurer is typically responsible for each of the following duties EXCEPT 
A) cash management. 
B) credit management. 
C) capital expenditures. 
D) cost accounting.
A

D) cost accounting.

58
Q

The three basic types of issues addressed by the study of finance are
A) capital budgeting, capital structure decisions, and working capital management.
B) capital budgeting, working capital management, and investment analysis.
C) capital structure decisions, working capital management, and sustained profitability.
D) capital budgeting, investment analysis, and cash management.

A

A) capital budgeting, capital structure decisions, and working capital management.

59
Q

A limited partnership provides limited liability to
A) all general partners.
B) only limited partners responsible for day to day management of the firm.
C) only to limited partners who do not participate in the management of the business.
D) all partners.

A

C) only to limited partners who do not participate in the management of the business.

60
Q

S-type corporations have all of the following advantages EXCEPT
A) they are taxed as partnerships.
B) the owners have limited liability.
C) distributions are taxed twice, similar to corporate dividend payments.
D) all owners must be people, no corporations.

A

C) distributions are taxed twice, similar to corporate dividend payments.

61
Q 
All of the following business organizations provide limited liability to their owners EXCEPT 
A) general partnership. 
B) S-type corporation. 
C) corporation. 
D) limited liability company.
A

A) general partnership.

62
Q

Limited partnerships are not as prevalent as corporations because
A) limited partners can lose up to three times the amount they invested in the partnership if the business goes bankrupt.
B) limited partnerships have the disadvantage of double taxation.
C) the general partner has no liability, making it difficult for the partnership to borrow money.
D) it is easier to transfer ownership by selling common stock than it is to sell partnership.

A

D) it is easier to transfer ownership by selling common stock than it is to sell partnership.

63
Q

Which of the following is NOT true for a limited partnership?
A) limited liability for its owners
B) One general partner must exist who has unlimited liability.
C) Only the name of general partners can appear in the name of the firm.
D) Limited partners may sell their interest in the company.

A

A) limited liability for its owners

FINA 3770 - Finance (5 decks)

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