Chapter 1-3 Flashcards
What are the two major decisions made by financial managers?
Financial management can be broken down into (1) the investment or capital budgeting decision and (2) the financing decision. The firm has to decide (1) which real assets to invest in and (2) how to raise the funds necessary to pay for those investments.
What does “real asset” mean?
Real assets include all assets used in the production or sale of the firms’ products or services. They can be tangible (plant and equipment, for example) or intangible (patents or trademarks, for example). In contrast, financial assets (such as stocks or bonds) are claims on the income generated by real assets.
What are the advantages and disadvantages of forming a corporation?
Corporations are distinct, permanent legal entities. They allow for separation of owner- ship and control, and they can continue operating without disruption even as management or ownership changes. They provide limited liability to their owners. On the other hand, managing the corporation’s legal machinery is costly. Also, corporations are subject to double taxation, because they pay taxes on their profits and the shareholders are taxed again when they receive dividends or sell their shares at a profit.
Who are the principal financial managers in a corporation?
Almost all managers are involved to some degree in investment decisions, but some man- agers specialize in finance, for example, the treasurer, controller, and CFO. The treasurer is most directly responsible for raising capital and maintaining relationships with banks and investors that hold the firm’s securities. The controller is responsible for preparing financial statements and managing budgets. In large firms, a chief financial officer oversees both the treasurer and the controller and is involved in financial policymaking and corporate planning.
Why does it make sense for corporations to maximize shareholder wealth?
Value maximization is the natural financial goal of the firm. Shareholders can invest or consume the increased wealth as they wish, provided that they have access to well-functioning financial markets.
What is the fundamental trade-off in investment decisions?
Companies either can invest in real assets or can return the cash to shareholders, who can invest it for themselves. The return that shareholders can earn for themselves is called the opportunity cost of capital. Companies create value for shareholders whenever they can earn a higher return on their investments than the opportunity cost of capital.
How do corporations ensure that managers act in the interest of stockholders?
Conflicts of interest between managers and stockholders can lead to agency problems and agency costs. Agency problems are kept in check by financial controls, by well- designed compensation packages for managers, and by effective corporate governance.
Is value maximization ethical?
Shareholders do not want the maximum possible stock price; they want the maximum honest price. But there need be no conflict between value maximization and ethical behav- ior. The surest route to maximum value starts with products and services that satisfy customers. A good reputation with customers, employees, and other stakeholders is important for the firm’s long-run profitability and value.
Where does the financing for corporations come from?
The ultimate source of financing is individuals’ savings. The savings may flow through financial markets and intermediaries. The intermediaries include mutual funds, pension funds, and financial institutions, such as banks and insurance companies.
Why do nonfinancial corporations need modern financial markets and institutions?
It’s simple: Corporations need access to financing in order to innovate and grow. A modern financial system offers different types of financing, depending on a corporation’s age and the nature of its business. A high-tech start-up will seek venture capital financing, for example. A mature firm will rely more on bond markets.
What if a corporation finances investment by retaining and reinvesting cash generated from its operations?
In that case, the corporation is saving on behalf of its shareholders.
What are the key advantages of mutual funds and pension funds?
Mutual and pension funds allow investors to diversify in professionally managed portfo- lios. Pension funds offer an additional tax advantage, because the returns on pension investments are not taxed until withdrawn from the plan.
What are the functions of financial markets?
Financial markets help channel savings to corporate investment, and they help match up borrowers and lenders. They provide liquidity and diversification opportunities for inves- tors. Trading in financial markets provides a wealth of useful information for the financial manager.
Do financial institutions have different functions?
Financial institutions carry out a number of similar functions to financial markets but in different ways. They channel savings to corporate investment, and they serve as financial intermediaries between borrowers and lenders. Banks also provide liquidity for deposi- tors and, of course, play a special role in the economy’s payment systems. Insurance com- panies allow policyholders to pool risks.
What happens when financial markets and institutions no longer function well?
The financial crisis of 2007–2009 provided a dramatic illustration. The huge expansion in subprime mortgage lending in the United States led to a collapse of the banking system. The government was forced into costly bailouts of banks and other financial institutions. As the credit markets seized up, the country suffered a deep recession. In much of Europe, the financial crisis did not end in 2009. As governments struggled to reduce their debt mountains and to strengthen their banking systems, many countries suffered sharp falls in economic activity and severe unemployment.
