Chapter 1

Question 1

Types of decisions financial managers make

Answer 1

• Capital Budgeting
• Capital Structure
• Working Capital Management

Question 2

Capital Budgeting Decision

Answer 2

The process of planning and managing a firm’s long-term investments (Loosely speaking, this means that the
value of the cash flow generated by an asset exceeds the cost of that asset.)
-> What longterm investments should the firm choose?

Question 3

Capital Structure Decision

Answer 3

The mixture of debt and equity maintained by a firm. The financial manager has also to decide exactly how and where to raise the money.
-> How should the firm raise funds for the selected investments?

Question 4

Working Capital Management

Answer 4

A firm’s short-term assets and liabilities. Managing the firm’s working capital is a day-to-day activity that ensures that the firm has sufficient resources to continue its operations and avoid costly interruption.
-> How should short-term assets be managed and financed?

Question 5

Most important things when considering a buisness decision

Answer 5

size, timing, and risk of cash flow

Question 6

3 different types of organizations

Answer 6

• sole proprietorship
• partnership (general and limited)
• corporations

Question 7

Pro and Contra: Sole proprietorship

Answer 7

Advantages
– Easiest to start
– Least regulated (from a structural standpoint)
– Single owner keeps all the profits
– Taxed once as personal income

Disadvantages
– Limited to life of owner
– Equity capital limited to owner’s personal wealth
– Unlimited liability
– Usually difficult to sell ownership interest

Question 8

Pro and Contra: Partnership

Answer 8

Advantages
– Two or more owners
– More capital available
– Relatively easy to start
– Income taxed once as personal income

Disadvantages
– Unlimited liability
• General partnership
• Limited partnership
– Partnership dissolves
– Often difficult to transfer ownership

Question 9

Pro and Contra: Corporation

Answer 9

Advantages
– Limited liability
– Unlimited life
– Transfer of ownership is usually relatively easy (stocks)
– Often easier to raise capital, due to unlimited life and option to sell new shares of stocks

Disadvantages
– More paperwork
– corporation acts as a legal person, must pay tax
–> Double taxation (company and person level)

Question 10

sole proprietorship

Answer 10

• one person, the simplest type, the least regulated
• owner keeps all the profit
• owner is liable for all debts

Question 11

partnership: general

Answer 11

A business formed by two or more individuals or entities

• all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share
• The way partnership gains (and losses) are divided is described in the partnership agreement, which is important to avoid miscommunications (oral or written)

Question 12

partnership: limited

Answer 12

A business formed by two or more individuals or entities

• one or more general partners will have unlimited liability
• one or more limited partners do not participate at business and are limited liable
• common for real estate ventures
• in bad times, you may be deemed to be a general partner even if you are a limited partners

Question 13

corporation

Answer 13

A business created as a distinct legal entity composed of one or more individuals or entities
- most important, much effort to start one
- for most legal purposes, the corporation is a “resident” of the state
- bylaws and normal laws which regulate the action of a corporation
- The stockholders elect the board of directors, who then
select the managers, which are charged with running the corporation’s affairs in the stockholders’ interests.
Stockholders are only liable for the amount they invested in the corporation

Question 14

LLC

Answer 14

limited liability company:
The goal of this entity is to operate and be taxed like a partnership but retain limited liability for owners, so an LLC is essentially a hybrid of partnership and corporation.

Question 15

Goal of financial management

Answer 15

• different ways of earning or increasing profit
• controlling risk
  Unfortunately, these two types of goals are somewhat
  contradictory. The pursuit of profit normally involves some element of risk, so it isn’t really possible to maximize both safety and profit
  therefore: goal of financial mgmt. is to maximize the current market value of the existing stock or owner’s equity

Question 16

agency relationship

Answer 16

The relationship between stockholders and management. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests

Question 17

agency problem

Answer 17

The possibility of conflict of interest between the stockholders and management of a firm

Question 18

Example of agency problem/costs

Answer 18

imagine that the firm is considering a new investment. The new investment is expected to favorably impact the share value, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the stock value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost.

Question 19

agency costs

Answer 19

the term agency costs refers to the costs of the conflict of
interest between stockholders and management
- indirect and direct agency costs

Question 20

indirect agency costs

Answer 20

An indirect agency cost is a lost opportunity, such as the example with the management and the firm’s investment

Question 21

direct agency costs (two forms)

Answer 21

• a corporate expenditure that benefits management but costs the stockholders (like an unneeded corporate jet etc.)
• an expense that arises from the need to monitor management actions (e.g. Paying outside auditors to assess the accuracy of financial statement information)

Question 22

Managerial Compensation

Answer 22

Management will frequently have a significant economic incentive to increase share value for two reasons

1. ) is usually tied to financial performance in general and often to share value in particular. For example, managers are frequently given the option to buy stock at a bargain price. The more the stock is worth, the more valuable is this option
2. ) managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

Question 23

Control of the firm

Answer 23

Control of the firm ultimately rests with stockholders. They elect the board of directors, who in turn hire and fire managers. Abundantly clear with Steve Job and Apple. He got fired and then rehired again, by the time apple did not go well.

Question 24

stakeholder

Answer 24

Someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm.
-> Employees, customers, suppliers, and even
the government all have a financial interest in the firm