Chapter 1: The Firm Flashcards
Bond Market
A marketplace where investors buy bonds from government entities or corporations
Types of Bonds
- Corporate Bond
- Government Bond
- Municipal Bonds (Muni Bonds)
- Mortgage-Backed Bonds (MBS)
- Emerging Market Bonds
- Junk Bonds
Corporate Bonds
- Used for financing current operations or opening new facilities
- Maturity of at least one year
Government Bonds
- Used to finance infrastructural improvements and pay down debts
- Issued by national governments
- Pay out face value on the agreed maturity date with periodic interest payments
Municipal Bonds (Muni Bonds)
- Issued by states, cities and other local government entities
- Fund various local projects
Mortgage-backed Bonds (MBS)
- Consist of pooled mortgages on real estate properties
- Investors lend money to home buyers through their lenders
Emerging Market Bonds
- Issued by governments and companies in emerging market economies
Junk Bonds
- Offer the highest return but also present the greatest risks of fault
Primary Bond Market
Where bonds are initially issued and sold to investors
Secondary Bond Market
Where bonds are traded among investors after they have been issued in the primary market
Advantages of the Bond Market
- Wide variety of issuers and bond types
- Bondholders have preference over shareholders in the event of bankruptcy
- Corporate and government bond markets are highly liquid and active
Disadvantages of the Bond Market
- Less accessible for ordinary investors
- Exposure to credit and interest rate risk
- Lower expected rate of return compared to stocks, despite being less volatile and more conservative
Types of Financing
- Debt Financing
- Equity Financing
Debt Financing
Taking a loan and promising to repay it over time with interest
Equity Financing
Raising money by selling ownership shares in the business
- Used by startups to raise initial capital
- Highly regulated in the US at both state and federal levels
What is a reason to choose Equity Financing for Entrepeneurs?
It is often the only option as startups have a high failure rate, making banks reluctant to offer loans
What is a reason to choose Equity Financing for Large Corporations?
Chosen when it is less expensive to sell stock than to pay interest on debt
Equity options for investors in Equity Financing
- Convertible Preferred Shares
- Common Stock with Warrants
Commercial Paper
A short-term debt security issued by financial companies and large corporations, promising the buyer ** a return typically stated as an interest rate
Purpose and Usage of Commercial Paper
Companies use commercial paper for short-term loans to cover expenses such as accounts payable and inventories
Maturity of Commercial Paper
Most commercial papers mature within 1-6 months, but some can mature up to 9 months
C-Corporation (C-Corp)
A legal structure for a corporation in which the owners, or shareholders are taxed separately from the entity
C-Corporation (C-Corp): Taxation
Double Taxation
- Corporate profits are taxed
- Shareholder dividends are taxed
C-Corporation (C-Corp): Liability
Limited liability for shareholders
- Shareholders’ personal assets are protected from business liabilities
C-Corporation (C-Corp): Regulation
More regulatory requirements and formalities
C-Corporation (C-Corp): Capital Raising
Can issues unlimited shares and multiple classes of stock, making it easier to attract a wide range of investors, including venture capitalists and institutional investors; can also issue bonds
S-Corporation (S-Corp)
A special type of corporation that allows income to be passed through directly to the owners or shareholders, thereby avoiding double taxation that typically affects C-corporations
S-Corporation (S-Corp): Taxation
Pass-through taxation
- Income is only taxed at the shareholder level
S-Corporation (S-Corp): Liability
Limited liability for shareholders
S-Corporation (S-Corp): Regulation
Limited to 100 shareholders, all must be U.S. citizens or residents and only once class of stock allowed
S-Corporation (S-Corp): Capital Raising
Limited by the restrictions on the number and type of shareholders; primarily raises capital through selling shares and taking out loans
Partnership
A business owned by more than one person and of which one or more of them are financially responsible for the actions and obligations of the business
Partnership: Taxation
Pass-through taxation
- Profits and losses are reported on partners’ personal tax returns
Partnership: Liability
General partners have unlimited liability; limited partners have liability up to their investment
Partnership: Regulation
Fewer regulatory requirements and formalities
Partnership: ** Capital Raising**
Primarily through contributions from partners; limited partnerships can attract investors as limited partners who have limited liability to their investment can also take out loans
Limited Liability Company (LLC)
A flexible business structure that combines a limited partnership and a corporation
Limited Liability Company (LLC): Taxation
Flexible
- Can opt for either pass-through or double-taxation
Limited Liability Company (LLC): Liability
Limited Liability for members
Limited Liability Company (LLC): Regulation
Fewer formalities than a corporation, with flexible management structures
Limited Liability Company (LLC): Capital Raising
- Members can contribute capital
- Possibility to bring in additional investors through flexible membership interests
- Loans
What type of company must be owned by a single person?
Sole Proprietorship
What type of business is the least expensive to start?
Sole Proprietorship
What type of business can have unlimited number of stockholders?
C-Corporations
What are the Three Fundamental Decisions in Financial Management?
- Capital Budgeting
- Financing
- Working Capital
Financial Management: Capital Budgeting
Deciding on which long-term assets to acquire to maximise net benefits for the firm
Financial Management: Financing
Deciding on how to pay for short term and long-term assets by finding the best combination of short-term debt, long-term debt, and equity
Financial Management: Working Capital
Decide on how to manage short-term resources and obligations by adjusting current assets and current liabilities to promote growth in cash flow
The value of a stock is a benchmark for:
- SIZE: future cash flows of the firm are considered
- TIMING: When the future cash flows will come are considered
- RISK: Risks associated with wait for cash flow are considered
Why should a business not solely focus on maximising market share?
Giving away goods or services for free is a short-term solution, the firm will not be able to pay its bills and stay in business
Why should a business not solely focus on maximising profits?
- Accounting profit does not equal economic profit
- Profit earned may not equal cash received
- Depreciation
What should the goal of a firm be?
The larger the positive residual cash flow, the greater the value of a firm
Formula Residual Cash Flow
Income - (Expenses + Debts + Investments)
Main reasons for Businesses failing
- Lack of acceptance of the products by customers
- Poor strategy
- Poor management skills to properly execute a good strategy
- Underestimating how much money it will take to get their business up and running
What is used to estimate how much financing a new business will require?
- Cash flow (EBITDA) break-even
- Cash budget
Key Elements of a Financial Plan
- Income Statement
- Cash Flow Statement
- Balance Sheet
- Sales Forecast
- Business Ratios
- Break Even Analysis
- Pricing Strategies
- Budgeting
Key Elements of a Business Plan
- Executive Summary
- Company Overview
- Description of product(s) and services the company will sell
- Market Analysis
- Marketing and Sales activities
- Management team and ownership
Venture Capitalist
Professional investor in privately held startup companies
Angel Investor
Very wealthy investor (1 mill+) that predominantly invests in startup businesses
