Finance Topic 2 Flashcards
7 Components of the business finance environments
- Different types of business entity
- Stakeholders
- Corporate objectives
- Sources of finance available to firm
- Firm value and capital structure
- Shareholders and directors, agency theory
- Governance
Business entities
National economy (profit = ST, Partnership, company) & (non profit = local/central gov, social org)
Sole tradership/ proprietorship
Owned by single individual
Not legally separate from owner
Unlimited liability
Limited access to capital
Partnership
2 or more owners
All share in risk and profit
Partners liable for debts
Limited access to capital
Company
Business incorporated under company law
Own separate legal identity
Own rights and obligations
Wider sources/access to new capital
Transfer ownership without affects
Public access to financial info
Public vs private
Limited liability of SHs
3 Factors influencing a business entity
- Liability/obligations
- Info given out
- Funding availability and options
Stakeholders
Person/org to some extent relies on business and apron whom business decides to rely on
E.g.
Primary objective
Maximise the wealth or its SHs or maximise firm value (neo classical objective)
-needs of SHs or needs of other stakeholders
-fair treated workforce = productive (less leaving = reduces recruitment)
-env = avoid legislation/penalties
-social contribution = +ve rep/image
-corp gov mechanism = considers stakeholder more generally
Wealth vs profits
Max profit = ST obj, no focus on cash generation, don’t consider timing or risk
Max wealth = LT overriding obj, focus on cash flow, consider timing and risk
Timing & Risk 5 considerations
1-last how long
2-profile of cash flows over time
3-residual value
4-maintenance costs
5-interest fixed or variable
Alternative corporate objectives
-max profit or profit satisficing
-max sales
-target MS
-minimise employee turnover & provide gainful employment
-tech innovation
-max managerial income
-limit env damage & contribute to society
Pursue in isolation without wealth max obj = value destroying
Sources of financing
3 categories
- Long term
-ordinary and preference share capital
-reserves (retained profit & others)
-LT loans/bonds (secured/unsecured, fixed/variable interest) - Medium term
-bank loans
-lease/hire purchase - Short term
-overdraft
-factoring/invoice discounting
-trade creditors
Ordinary vs Preference shares
Preference shareholders are paid a fixed percentage of yearly dividends, which is decided during the signing of the share certificates,
ordinary shareholders are compensated varying amounts of dividends each year
Debt vs Equity
Equity: residual right to participate beyond any pre-defined limit in distribution
Debt - investing as a lender e.g. Bank (recevie interest)
Equity = investing as a SH
Lending = form of inv
8 Factors differing debt and equity
- Regular servicing
- Repayment
- Position in ‘queue’ for cash flows
- Ownership interest
- Sanction for non-performance
- Variety
- Commonly used by
- Public trading
Value of the firm
View balance sheet as:
Non CA + CA (exlclude cash) - CL (exclude overdraft/st loan/st leasing obligation/other debt) - Non CL (exclude loans/leasing obligations/other debt)
Balanced by (financed by) SH equity + all debt - cash
Total value = value of equity + value of other shares + value of debt (of all types)
V = S + B
Value not as numbers in financial accounting balance sheet but mkt (true) value
Establishment and operation of the firm vs financing of the firm
Shareholders and directors 3 key points
1-separation of ownership and control (public comp with diverse SHs)
2-SHs = owners of company (accrue profit and gains through dividend and capital gain, lossses are borne by them up to amount invested
3-mngment delegated to directors (appoint/removed by SHs, may be SHs themselves, board of directors = comprise both executive and non (independent outside)
Agency theory
1 or more persons (principals) engage another person (agent) to perform some service on their behalf involving delegating some decision making authority to agent
Company directors/managers = agents
SHs = principles as own company
Conflict of interest (self interested behaviour & redistribution and or loss of wealth)
3 characteristics of the agency problem
- Asymmetric info
- Bounded rationality (no unlimited resource can’t optimise everything to perfection
- Moral hazard (unmonitored decisions)
4 Agency costs
- Contracting (logistics/constraints/incentives) - contracts/schemes
- Monitoring (audits, analyst reports, general meetings)
- Bonding (SH briefings. Easy share trading agreements)
- Residual loss
4 shareholder control mechanisms
- Calling for & voting on corp resolutions
-SHs = resolve to appoint/remove directors, directors select mngment team, competition = force performance - Director/Manager contract and compensation arrangements
-restrictions/compulsions & incentive schemes - Market mechanism
-poor mngment = drop in share price, firm acquired by another in takeover = mgmnemt out of job - Other corporate governance mechanisms
-non executive directors, remuneration and audit committee
Corporate governance
Way in which companies are directed and controlled
Narrow view - relationship of company & SHs, traditional finance paradigm
Broader view - inclusive, web of relationships between company and range of stakeholders, attract more attention as issues of accountability and CSR come to fore
Traditional finance paradigm
seeks to understand financial decisions by making a few normative assumptions about individual behavior.
