Chp 1 Overview Of Financial Management

Question 1

What is Finance

Answer 1

The system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities.
Finance grew out of economics and accounting. Economists developed the notion that an asset’s value is based on the future cash flows the asset will provide, & accountants provided information regarding the likely size of those cash flows.

Question 2

Proprietorship

Answer 2

Unincorporated business owned by one individual. Easy to form, hard to raise capital, unlimited liability, limited life, report via personal income tax & single taxation

Question 3

S Corp or LLC

Answer 3

Fairly easy to form. Like a partnership. Hard to raise capital b/c it is closely held (cannot sell stock). Limited liability. Regulations are limits on shareholders numbers & cannot be non-resident regarding reporting. Taxed at individual.

Question 4

C Corp

Answer 4

Usually requires a lawyer. Takes time & money to form & maintain. Can raise capital by selling stock. Limited liability b/c company is independent legal entity. Life is indefinite, so long as corporate regulations are met. SEC regulations,highly regulated. Double taxation. Easy to transfer ownership by selling stock.

Question 5

What is shareholder wealth typically reflected by?

Answer 5

Share price.

Question 6

Stock price in equilibrium

Answer 6

A stock’s price should equal its “true” or intrinsic value. Intrinsic value is a long-run concept. A stock’s price in the short run may deviate from its intrinsic value.

Question 7

Agency problem

Answer 7

Managers are inclined to act in their own interests. May diverge from owners’ interests. Seek to maximize perks instead of profits.

Question 8

What affects managerial behavior?

Answer 8

Form of compensation
Direct oversight by shareholders & BOD
The threat of firing
The threat of takeover

Question 9

Incentives & payoffs for stockholders

Answer 9

• Residual claimant on cash flows
• Contingent claims
• You get upside
• Downside is limited to losing your entire investment

Question 10

Incentives & payoffs for bond holders

Answer 10

• Receive the same income in good times & bad
• No upside
• No shareholder voters
• May become equity holders if firm goes bankrupt

Solution: Covenants restrict management.

• Limit debt
• Constrain management actions
• Require additional liquidity