chapter 1 - key concepts (intro to finance) Flashcards
What is the main goal of the corporation?
is to create value for investors – investors own the company
Who ultimately owns the corporation? What is the relationship between
shareholders, the board of directors, and management?
corporate governance: Rules put in place by the board of directors to ensure managers act in the best interests of shareholders (maximize shareholder value) while balancing the needs of other constituents.
If you own shares of stock, you are an investor/part owner of the company
Rational managers are likely to act in their own best interests instead of shareholders’ best interest
What are the 3 most important management positions?
- stockholders
- the board of directors
- the ceo: chief executive officer
What is the Sarbanes-Oxley legislation? Why was it passed?
- accounting standards against fraud
- Passed in 2012
Aftermath of the accounting scandals of WorldCom and Enron (bankrupted these companies because they lied about their numbers) - Requires the CEO and CFO to certify to the SEC that reports released to stockholders are accurate
- Crucial, can be jailed if fraud occurs
What is the major disadvantages and advantages of corporations compared to
other forms of business organizations?
C-corporations (not S-corporations)
Advantages:
- Unlimited life – never dissolves
- Easy transfer of ownership - sell shares
Unlimited liability - can only lose what you invest (not your personal assets)
- Ease of raising capital issue shared
Disadvantages:
- Double taxation - pay personal and corporate (taxed twice at personal and corp level so less money)
- Greater setup costs (which is why most companies start as proprietorships or partnerships)
- Greater reporting and regulatory costs
What is a stock’s intrinsic value? In an efficient market, will a stock’s price equal
the stock’s intrinsic value?
intrinsic value - the theoretical correct value of the firm, fully rational what should the price be? (long-run value)
Yes, In equilibrium, a stock’s price equals its “true” price or intrinsic value
Why do shareholders have a conflict of interest with managers?
Rational managers are likely to act in their own best interests instead of shareholders’ best interest
Management wants to maximize its wealth, may pay excessive salaries (MORE COMPENSATION)
how to maintain peace:
- Managerial compensation
- Accountability - fire manager (board of directors)
- Hostile takeovers - firm acquired by outside parties
- Shareholder activism: direct intervention by shareholders
What is corporate governance?
Rules put in place by the board of directors to ensure managers act in the best interests of shareholders (maximize shareholder value) while balancing the needs of other constituents.
- Hold managers accountable for poor performance
- Correct type of executive compensation
What are various strategies for aligning the interests of shareholders and
management?
- Managerial compensation
- Accountability - fire manager (board of directors)
- Hostile takeovers - firm acquired by outside parties
- Shareholder activism: direct intervention by shareholders
Change in CEO Compensation starting in the 1980s
- increased exponentially
- when s&p increases so does ceo compensation
- when s&p decreases so does ceo compensation
Why is it a good idea for CEO compensation to track an overall market index like the
S&P 500?
CEOs usually paid by stocks and cash bonus (performance targets) instead of cash only
so if the company is doing well, the ceo is rewarded –> it gives the executive an incentive to increase value for shareholders.
What is the bondholder-stockholder conflict? Do bondholders prefer safer or risky
corporate investments?
Conflict between stockholders and debtholders
Stockholders are more likely to prefer riskier projects because they’ll make more money if it works out, bondholders don’t because they’ll lose their money if it doesn’t work out.
- Stockholders receive more of the upside if the project succeeds
- Bondholders receive fixed payments and are more interested in limiting risk
What is the difference between shareholder theory and stakeholder theory?
Shareholder theory argues that the only responsibility of managers is to serve in the best possible way the interests of shareholders, using the resources of the corporation to increase the wealth of the latter by seeking profits.
Stakeholder theory argues that the firm should consider other objectives such as its impact on employees, suppliers, environment
- Social responsibility, transparency, ESG (environment, social and governance)
