chapter 1 - introduction to corporate finance Flashcards
capital budgeting
describes the process of making and managing expenditures on long-lived assets.
this answers the question, “what longterm assets should the firm invest in?”
capital structure
represents the proportions of the firm’s financing from current and long-term debt and equity.
answers the question, “how can the firm raise capital for its capital expenditures?”
net working capital
There is often a mismatch between the timing of cash inflows and cash outflows during operating activities. Furthermore, the amount and timing of operating cash
flows are not known with certainty. Financial managers must attempt to manage the gaps in cash flow.
Net working capital is defined as current assets minus current
liabilities. From a financial perspective, short-term cash flow problems come from the mismatching of cash inflows and outflows. This is the subject of short-term finance.
answers the question, “how should short-term operating cash flows be managed?”
most organizations start as proprietorships or partnerships and then later become corporations. why?
It is difficult for large business organizations to exist as sole proprietorships or partnerships. The
main advantage to a sole proprietorship or partnership is the cost of getting started. Afterward, the
disadvantages, which may become severe, are (1) unlimited liability, (2) limited life of the enterprise, and
(3) difficulty of transferring ownership. These three disadvantages lead to (4) difficulty in raising cash.
corporations as legal entities
can have a name and enjoy many of the legal powers of natural
persons. For example, corporations can acquire and exchange property. Corporations can enter contracts
and may sue and be sued. For jurisdictional purposes the corporation is a citizen of its state of
incorporation (it cannot vote, however).
much harder to establish than proprietorships or partnerships. must have articles of incorporation that include bylaws of how the firm is to operate. bylaws must address the interests of owners (i.e. shareholders), directors and corporate officers (top management)
shareholders elect board of directors
directors select management
benefits of corporations over proprietorships and partnerships
separation of ownership from management gives the corporation several advantages
Because ownership in a corporation is represented by shares of stock, ownership can be readily
transferred. Also, because the corporation exists independently of those who own its
shares, there is no limit to the transferability of shares as there is in partnerships.
Because the corporation is separate from its owners, the death or withdrawal of an owner does not affect the corporation’s legal existence.
The shareholders’ liability is limited to the amount invested in the ownership shares. In a partnership, a general partner with a $1,000 contribution could lose the $1,000 plus any other indebtedness of the partnership.
the big disadvantage = federal government taxes corporate income (the states do as well). This tax is in addition to the personal income tax that shareholders pay on dividend income they receive. This is double taxation for shareholders when compared to taxation on proprietorships and partnerships.
timing of cash flows matters
The Midland Company refines and trades gold. At the end of the year, it sold 2,500 ounces of gold for
$1 million. The company had acquired the gold for $900,000 at the beginning of the year. The company
paid cash for the gold when it was purchased. Unfortunately it has yet to collect from the customer to
whom the gold was sold. By generally accepted accounting principles (GAAP), the sale is recorded even though the customer
has yet to pay. It is assumed that the customer will pay soon. From the accounting perspective, Midland
seems to be profitable.
However, the perspective of corporate finance is different. It focuses on cash flows. The perspective of corporate finance is interested in whether cash flows are being created by the gold trading operations of Midland. For Midland, value creation depends on whether and when it actually receives $1 million.
timing of cash flows
One of the most
important principles of finance is that individuals prefer to receive cash flows earlier rather than later.
One dollar received today is worth more than one dollar received next year
difficulty financial managers of companies face
what are the goals? there are so many to list. plus achieving each goal might not actually have any benefit
For example, it’s easy to increase market share or unit sales: All we have to do is lower our prices or
relax our credit terms. Similarly, we can always cut costs simply by doing away with things such as
research and development. We can avoid bankruptcy by never borrowing any money or never taking any
risks, and so on. It’s not clear that any of these actions are in the stockholders’ best interests.
Profit maximization would probably be the most commonly cited goal, but even this is not a precise
objective. Do we mean profits this year? If so, then we should note that actions such as deferring
maintenance, letting inventories run down, and taking other short-run cost-cutting measures will tend to
increase profits now, but these activities aren’t necessarily desirable.
generally, the goals fall into two groups = profitability (sales, market share, cost control) and reducing risk (bankruptcy avoidance, stability); these goals are often contradictory because pursuit of profits entails risk
what goals of a financial manager should be with regard to shareholders
since financial managers should act to benefit shareholders, The goal of financial management is to maximize the current value per share of the
existing stock
if the company is not publicly traded, then financial manager should seek to maximize owner’s (or owners’) equity
agency problem
in large corporations ownership can be spread over a
huge number of stockholders.1 This dispersion of ownership arguably means that management
effectively controls the firm. In this case, will management necessarily act in the best interests of the
stockholders? Put another way, might not management pursue its own goals at the stockholders’
expense?
agency relationship
relationship between stockholders and management. exists whenever someone (the principal) hires another (the agent) to represent his or her interests
agency cost
refers to the costs of the conflict of interest between
stockholders and management.
can be direct or indirect
example of indirect = management decides against a risky investment/opportunity because if it doesn’t work out they’ll lose their jobs; in this case, owners/shareholders lost out on potential gains
example of direct = come in two forms. The first type is a corporate expenditure that benefits
management but costs the stockholders. Perhaps the purchase of a luxurious and unneeded corporate jet
would fall under this heading. The second type of direct agency cost is an expense that arises from the
need to monitor management actions. Paying outside auditors to assess the accuracy of financial
statement information could be one example
do managers act in interest of shareholders?
Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First,
how closely are management goals aligned with stockholder goals? This question relates, at least in part,
to the way managers are compensated (if they get a lot of their comp as stock, they will act accordingly). Second, can managers be replaced if they do not pursue
stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of
reasons to think that, even in the largest firms, management has a significant incentive to act in the
interests of stockholders. even then, there are periods of time where management pursues its own goals at expense of shareholders.
proxy fight
portant mechanism by which unhappy stockholders can replace existing management is called
a proxy fight. A proxy is the authority to vote someone else’s stock. A proxy fight develops when a group
solicits proxies in order to replace the existing board and thereby replace existing management. In 2002,
the proposed merger between HP and Compaq triggered one of the most widely followed, bitterly
contested, and expensive proxy fights in history, with an estimated price tag of well over $100 million.
