Chapter 1: An Introduction to the Foundations of Financial Management

Question 1

Incremental Cash Flow

Answer 1

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

Question 2

Opportunity Cost

Answer 2

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

Question 3

Efficient Market

Answer 3

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.

Question 4

Agency Problem

Answer 4

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

Question 5

Capital Budgeting

Answer 5

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

Question 6

Capital Structure Decision

Answer 6

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

Question 7

Working Capital Management

Answer 7

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

Question 8

Financial Markets

Answer 8

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

Question 9

Sole Proprietorship

Answer 9

A business owned by a single individual.

Question 10

Partnership

Answer 10

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

Question 11

General Partnership

Answer 11

A partnership in which all partners are fully liable for the indebtedness incurred by the partnership.

Question 12

Limited Partnership

Answer 12

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.

Question 13

Corporation

Answer 13

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

Question 14

S-Corporation

Answer 14

A corporation that, because of specific qualifications, is taxed as though it were a partnership.

Question 15

Limited Liability Company (LLC)

Answer 15

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

Question 16

Identify the Goal of the Firm

Answer 16

The maintenance and creation of shareholder wealth should be the goal of the firm and its managers. The goal of maximization of shareholder wealth is chosen because it deals well with uncertainty and time in a real-world environment. As a result, the maximization of shareholder wealth is found to be the proper goal for the firm.

Question 17

Five Basic Principles of Finance

Answer 17

1. Cash flow is what matters
2. Money has a time value
3. Risk requires a reward
4. Market prices are generally right
5. Conflicts of interest cause agency problems

Question 18

Principle 1: Cash Flow is What Matters

Answer 18

Incremental cash received and not accounting profits drives value.

Question 19

Principle 2: Money Has a Time Value

Answer 19

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

Question 20

Principle 3: Risk Requires a Reward

Answer 20

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.

Question 21

Principle 4: Market Prices Are Generally Right

Answer 21

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.

Question 22

Principle 5: Conflicts of Interest Cause Agency Problems

Answer 22

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.

Question 23

Ethics and Trust

Answer 23

While not one of the five principles, ethics and trust are also essential elements of the business world, and without them, nothing works.

Question 24

Describe the Role of Finance in Business

Answer 24

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

Question 25

Three Basic Types of Issues that are Addressed by the Study of Finance

Answer 25

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.

Question 26

Sole Proprietorship (Described)

Answer 26

This is a business operation owned and managed by an individual. Initiating this form of business is simple and generally does not involve and substantial organization costs. The proprietorship has complete control of the firm but must be willing to assume full responsibility for its outcomes.

Question 27

General Partnership (Described)

Answer 27

A coming together of two or more individuals, is similar to the sole proprietorship.

Question 28

Limited Partnership (Described)

Answer 28

This is another form of partnership sanctioned by states to permit all but one of the partners to have limited liability if this is agreeable to all partners.

Question 29

Corporation (Described)

Answer 29

The corporation increases the flow of capital from public investors to the business community. Although larger organizational costs and regulations are imposed on this legal entity, the corporation is more conducive to raising large amounts of capital. Limited liability, continuity of life, and ease of transfer in ownership, which increase the marketability of the investment, have contributed greatly in attracting large numbers of investors to the corporate environment. The formal control of the corporation is vested in the parties who own the greatest number of shares. However, day-to-day operations are managed by the corporate officers, who theoretically serve on behalf of the firm’s stockholders.

Question 30

Explain What Has Led to the Era of the Multinational Corporation

Answer 30

With the collapse of communism and the acceptance of the free market system in third-world countries, U.S. firms have been spurred on to look beyond their own boundaries for new business. The end result has been that it is not uncommon for major U.S. companies to earn over half their income from sales abroad. Foreign firms are also increasingly investing in the United States.