Chapter 1- Introduction to Financial Management

Question 1

What do we need to try and maximize in order to maximize the value of the company?

Answer 1

We need to try and maximize the equity.

Question 2

Why would a firm maximize stock price?

Answer 2

They would do this because stock price is easily observable and constantly updated.

Question 3

Is it possible for a company to have both positive profits and negative cash flow?

Answer 3

Yes, it is possible.

Question 4

What does accounting focus on?

Answer 4

1) Focus on profit.
2) Revenues- Expenses (at book value).

Question 5

What does finance focus on?

Answer 5

1) Focus on cash flow.
2) Inflow and outflow of money (the ability to pay bills).

Question 6

Book Value

Answer 6

How much it costs you. This does not reflect market value. (How much did you purchase something for?)

Question 7

Cash Flow

Answer 7

You care about when money flows in and out.

Question 8

What does the cash flow statement start with?

Answer 8

This statement begins with Earnings. Also note that Cash Flow does NOT equal Earnings.

Question 9

Positive Cash Flow

Answer 9

More money coming in than going out.

Question 10

Negative Cash Flow

Answer 10

More money going out than coming in.

Question 11

What are the three roles shown in the corporate finance decision flow diagram?

Answer 11

The corporation, financial manager, and investors.

Question 12

What is the first decision that a financial manager has to make?

Answer 12

They have to decide how they are going to raise cash/capital.

Question 13

What are two choices that a company can make when they receive cash back/profit?

Answer 13

They can either reinvest the money (plowback) into the company, or they can pay back investors.

Question 14

What is the goal of the firm?

Answer 14

In traditional corporate finance, the objective in decision making is to maximize the value of the company.

Question 15

What does debt and equity allow us to do?

Answer 15

These are how we generate money to purchase and further invest in assets.

Question 16

Growth Assets

Answer 16

How much you can grow your assets based on what you already have.

Question 17

Why is it tricky to maximize assets?

Answer 17

It is tricky to maximize assets because growth assets are estimated/unknown.

Question 18

What is a “narrower” objective for a corporation?

Answer 18

To maximize stockholders’ wealth (equity)

Question 19

Why does the goal of a firm narrow down to stockholders rather than debtholder (e.g., bank, bondholders)?

Answer 19

Shareholders/stockholders have a residual claim. Other claimholders have a contractual claim that they could negotiate contract terms to protect their interests.

Question 20

How does the goal of the firm “narrow down”?

Answer 20

1) Max the value of a firm.
2) Max the shareholders wealth (equity)
3) Max stock price.
- If all three are a choice, #1 is the most correct. #2 and #3 are ways to execute #1.

Question 21

Opportunity Cost

Answer 21

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

Question 22

What are the two types of compensation?

Answer 22

1) Delaying Consumption
2) Compensations on Uncertainty.

Question 23

Risk-Return Trade-Off

Answer 23

The principle that the greater the risk a lender takes in making a loan, the higher the interest rate required. Also, a lender would likely expect a positive return to begin with if consumption is delayed.

Question 24

Agency Problem

Answer 24

The possibility of conflict of interest between the stockholders and management of a firm.
- In theory, the managers maximize stockholders wealth and the stockholders hire and fire managers. (Board, Annual Meeting).
- In practice, managers select the board of directors and sometimes put their interest above stockholders. Stockholders have little control over managers.

Question 25

Sarbanes-Oxley Act

Answer 25

An act passed into law by Congress in 2002 to establish strict accounting and reporting rules in order to make senior managers more accountable and to improve and maintain investor confidence.
- Increased firm’s transparency.
- One way to control agency problem.

Question 26

What are possible solutions to reduce agency costs?

Answer 26

• Increase monitoring (rating agency, stronger board of directors, BIG 4 auditing financial statements)
• Compensation schemes (e.g., stock compensation)
• Market mechanisms (takeovers)

Question 27

Shareholders vs. Bondholders

Answer 27

Equity vs. Debt, essentially.

Question 28

My company accumulated lots of cash and there is no valuable investment now. If you were a stockholder, what do you want? What if you were the bank/bondholder?

Answer 28

If you were the stockholder, you would want the firm to issue dividends. If you were the bank/bondholder, you would want the firm to pay you back.

Question 29

There is a risky project the produces good investment return. If you were the stockholder, what would you want the company to do? If you were the bank/bondholder, what would you want?

Answer 29

If you were the stockholder, you would want the firm to go for the project because it could increase the wealth of the company. If you are the bank/bondholder, you would want the firm to avoid the project. If it flops, they can’t pay you back.

Question 30

Brief on Corporate Social Responsibility

Answer 30

In Theory: All costs and benefits associated with a firm’s decisions can be traced back to the firm.

In Practice: Financial decisions can create unknown social costs and benefits. For example, Environmental Costs, including Pollution and Health Costs, or Quality of Life Costs, including Traffic, Housing, Safety, Etc.

Question 31

Sole Proprietorship

Answer 31

• Owned by an individual.
• Owner determines the whole life cycle of the business and title to assets and profits.
• Unlimited Liability (if the business fails, it is connected to your personal finances or assets).

Question 32

Partnership

Answer 32

• Two or more co-workers
• General Partnerships: Full liabilities for all partners.
• Limited Partnership: Some partners can have limited liability, but at least one owner has to have unlimited liability.

Also note, that if one owner dies, you have to contract and sell their portion. So you don’t lose everything like a sole proprietorship, but still takes organization.

Question 33

Corporation

Answer 33

• It is a separate entity apart form its owners.
• Limited Liability for shareholders.
• Life cycle does not depend on the owners.

Question 34

What are the benefits of a corporation?

Answer 34

• Limited Liability
• Easy to transfer ownership.
• Easier to raise capital.
• Life cycle does not depend on the owners.

Question 35

What are the drawbacks of a corporation?

Answer 35

• No secrecy of information.
• Delays in decision making
• More regulations
• Double taxation

Question 36

What are the benefits of a Limited Liability Company (LLC)?

Answer 36

They have:
- Limited Liability
- Taxed like a partnership.

Question 37

What are the limitations of a Limited Liability Company (LLC)?

Answer 37

• It is more costly to form than sole proprietorship/partnerships
• It is harder to attract capital than a corporation.

Keep in mind that this is a BUSINESS ENTITY

Question 38

What are the benefits of a S-Type (Subchapter Corporation)?

Answer 38

They have:
- Limited liability
- Taxed as partnership

Question 39

What are the limitations of a S-Type (Subchapter Corporation)?

Answer 39

They are:
- More expensive than LLC
- Owners must be people (<100)
- Cannot be used for a joint venture between two corporations.

This is a TAX CLASSIFICATION

Question 40

What is the role of financial markets?

Answer 40

“Saving Surplus” Units- or people (organizations) who have more money than they need (e.g., investors, lenders), help facilitate the growth of “Saving Deficit” Units, which are people (organizations) who need more money than they have (e.g., borrowers).
- “Saving Deficit” Units need someone to lend them money so they can keep growing.

Question 41

Explain the direct transfer of capital.

Answer 41

A firm sells its securities directly to investors (savers) without going through any type of financial institution.
-Mostly used by small firms.
- The business gives an equity share/security to investors in return for capital.

Question 42

Explain the indirect transfer of capital.

Answer 42

Indirect transfer using an investment-banking firm. (They are using some type of agent).
- The firm sells its securities to the investment bank, then the investment bank sells those securities to investors.
- The investment banks bare the risk of being unable to sell the securities. (Banks sell it for a slightly higher price).

Question 43

Primary Markets

Answer 43

Securities are offered for the first time, including both first time issuance and issuance of new batch of stocks.
Note that this is also the only time the issuing company receives money for the securities.

Question 44

What are the two types of offerings in the primary market?

Answer 44

Initial Public Offerings (IPOs) and Seasoned Equity Offerings (SEOs)

Question 45

Initial Public Offering (IPO)

Answer 45

This is the first time a security is coming to the market.

Question 46

Seasoned Equity Offering (SEO)

Answer 46

This is offered by a company that is not new (they are already a publicly traded company), but they are offering a new batch of security.

Question 47

Secondary Market

Answer 47

Currently outstanding securities are traded. (Subsequent trading after the primary market).
- The issuing firm does not get any money during this trading.

Question 48

What role does SEC paly in the markets?

Answer 48

They are both regulated by SEC.
-Firms need to be approved by SEC before they trade their securities to the market.
- Firms must report their financial statements to SEC regularly.

Question 49

Financial Intermediaries

Answer 49

Banks, credit unions, life insurance companies, mutual funds, pension funds, etc.
- These issue securities, which invest in the firm, to the investors.

Key: The securities are NOT the same! The intermediary is selling their own product and using profit to reinvest and build their own portfolio.
- See chart at the end of the class presentation.

Question 50

What is the goal of a firm in traditional corporate finance?

A) Maximize profit.
B) Maximize value.
C) Maximize customer experience.
D) Maximize stock price.

Answer 50

Maximize value.

Question 51

The expected return on a riskless asset is greater than zero due to:

A) An expected return for taxes.
B) An expected return for delaying consumption.
C) An expected return for irrational investors.
D) None of the above.

Answer 51

An expected return for delaying consumption.

Question 52

Which of the following causes conflicts of interest?

A) Separation of management and ownership.
B) Different risk attitudes of investors.
C) Financial decisions at social costs.
D) All of the above.

Answer 52

All of the above.

Question 53

In order to reduce agency problems, managers may be provided compensation that includes:

A) A bonus plan based on the level of profit achieved during the year.
B) A fixed salary so managers’ pay is not at risk, allowing managers to focus on the company’s business.
C) Company’s stock as part of the compensation.
D) Incentive pay for achieving higher sales than last year.

Answer 53

Company’s stock as part of the compensation.

Question 54

Joe is deciding whether to invest $10,000 in a business that has pending lawsuits against it. If Joe invests and the business loses the lawsuit, the most Joe can lose is:

A) $10,000 if Joe is a limited partner.
B) $10,000 if Joe is a general partner.
C) $10,000 if Joe is a sole proprietor.
D) $10,000 plus his share of the lawsuits is Joe is a limited partner.

Answer 54

$10,000 if Joe is a limited partner.