Financial Management

Question 1

What is the goal of management within a business?

Answer 1

To manage the business within the owners’ best interests, including when management’s interests might conflict with the owners’

Question 2

How might diversification provide a conflict of interest for management?

Answer 2

Stockholders in a corporation will usually have more diversified investments, whereas management stakes their income as coming from that one business, so management might be unwilling to enter risky ventures that stockholders would like

Question 3

What sort of incentives do companies offer management to help align their interests with the owners’?

Answer 3

Giving compensation based on stock performance

This can backfire if management is concerned with only the appearance of stock success

Question 4

What are some reasons for an investor to prefer a company that pursues non-profit-motivated social projects?

Answer 4

(1) the company’s stress on integrity would reduce the risk of future problems (e.g. fraud, laziness)
(2) possible lawsuits against the company might be deterred if customers believe the errors occurred in good faith

Question 5

What are some reasons for an investor NOT to prefer a company that pursues non-profit-motivated social projects?

Answer 5

(1) the projects don’t make a profit (obviously)
(2) certain social causes have hardly any benefit if only a small number of firms support it, and thus the cost would not be worth it until it’s legally required across all firms
(3) maximizing owner wealth (legally) itself benefits society, since it makes customers happy and gives the owners wealth with which to benefit society

Question 6

For maximizing shareholder wealth, what financial measure should management focus on?

Answer 6

Total return per share

Focusing solely on dividends or EPS would not present the whole picture (e.g. stock prices could rise due to undistributed dividends and not performance)

Question 7

How does a view to profit maximization not properly maximize shareholder wealth?

Answer 7

Profit could increase partly because of an influx of new stock – thus additional profit would be diluted by the additional shares, and not necessarily increase the total return per share

Question 8

How does a view to EPS maximization not properly maximize shareholder wealth?

Answer 8

EPS can sometimes be increased temporarily at the expense of long-term performance, and thus at the expense of stock value

Since total return per share takes into account the change in stock value (as well as dividends), it would account for an EPS that is artificially or temporarily high

Question 9

What are the main determinants of stock prices?

Answer 9

(1) laws and regulations
(2) management’s policy decisions, including dividends, debt financing, and production choices
(3) the health of the overall economy, including taxes
(4) the health of the stock market overall

Question 10

What is the first stage of the product life cycle?

Answer 10

Infancy – the product must earn customer loyalty to make a name for itself, especially through advertising and sometimes free samples

Also called the experimentation stage

Question 11

What is the second stage of the product life cycle?

Answer 11

Growth – sales heavily increase and attract competitors; thus profits in this stage may also need to be partly reinvested to distinguish the product from competitors

Question 12

What is the third stage of the product life cycle?

Answer 12

Maturity – the sales increase slows due to competition; profits are usually not reinvested in the product (which cannot be improved much more), but tend to be aimed more towards a new or replacement product

If products were not very profitable before this stage, they might generate losses at this stage

Question 13

What is the fourth stage of the product life cycle?

Answer 13

Decline – sales decrease as the product dies out and other products take its place

Question 14

To what else does the product life cycle apply?

Answer 14

It can also apply to firms and industries, not just to products

Question 15

What are the two main ways for companies to raise capital?

Answer 15

Debt (e.g. bonds, notes, loans) and equity (e.g. stock)

Question 16

How do physical asset markets differ from financial asset markets?

Answer 16

Physical asset markets include equipment, computers, crops, land, and so on

Financial asset markets include claims to assets, such as stocks, bonds, options, mortgages, warrants, and so on

Question 17

How do money markets differ from capital markets?

Answer 17

Money markets include short-term debt instruments (under one year)

Capital markets include long-term debt and equity instruments

Question 18

How do mortgage markets differ from consumer credit markets?

Answer 18

Mortgage markets involve all loans on (and usually secured by) real estate, including non-residential real estate

Consumer credit markets involve loans on consumer goods, including intangible goods (e.g. student loans) and durable goods (e.g. laundry machines)

Question 19

What are different ways for financial transfers of capital to occur?

Answer 19

(1) direct transfers
(2) facilitated transfers
(3) repackaged transfers
(4) securities markets

Question 20

As regards the transfer of capital, what are direct transfers?

Answer 20

Simply the transfer of capital between the capital-provider and the capital-seeker – often done with stock for closely-held corporations, employee stock plans, and dividend reinvestment plans (DRIPs)

Question 21

As regards the transfer of capital, what are facilitated transfers?

Answer 21

Transfers of capital done through some middleman, such as a mortgage broker or investment bank – investment banks usually buy and re-sell securities

Question 22

As regards the transfer of capital, what are repackaged transfers?

Answer 22

Similar to facilitated transfers, they involve buyers and resellers of securities who help buyers to purchase the stock in a way that fits them (e.g. getting diversification through a mutual fund)

Question 23

What are mutual funds?

Answer 23

Corporations that use money from many investors in order to purchase a large variety of securities – thus giving investors in the mutual funds wide diversification for a small investment

There are many different kinds of mutual funds, depending on what they invest in (e.g. equity funds) and what they aim to raise money for (e.g. pension funds)

Question 24

Besides mutual funds, what institutions engage in repackaged transfers?

Answer 24

(1) banks
(2) insurance companies
(3) financial service companies (e.g. investment companies)

Question 25

What are different kinds of banks?

Answer 25

Banks are often not strictly distinguished in these ways, but the distinctions are still helpful:

(1) commercial banks
(2) savings and loan associations (S&Ls) – open savings accounts and make various loans, usually in competition with commercial banks’ interest rates
(3) mutual savings banks – similar to S&Ls, but geared more towards low-income persons and mortgages
(4) credit unions – act like banks but solely for members; all who deposit in them are effectively owners

Question 26

What are two different kinds of securities markets?

Answer 26

(1) organized exchanges, such as the New York Stock Exchange (NYSE)
(2) over-the-counter (OTC) markets

Question 27

What are some characteristics of organized securities exchanges?

Answer 27

Companies must gain membership (a “seat”) on the exchanges in order to have their stock traded there, and the exchanges are overseen by a governing body

Question 28

How do organized securities exchanges generally function?

Answer 28

A number of stocks are available to be bought or sold in the exchange (called listed stocks), such that investors can place buy orders or sell orders to registered specialists for those stocks

Sometimes, if the buy order or sell order does not refer to a stock which another person is willing to sell or buy at that price, the specialists can buy or sell it using an independent inventory of stocks – for this, specialists set bid or ask prices stating at what price they will buy or sell securities from others

Question 29

How do OTC markets generally function?

Answer 29

The overall structure is similar to organized exchanges, in that investors can place buy or sell orders, and dealers hold inventories to buy or sell stocks for which other investors have not stated a willingness to sell or buy

Since OTC markets deal with less ordinary or common securities, these inventories are more crucial for dealers to have

Question 30

What does it mean to “make a market” for some stock or other security?

Answer 30

To “make a market” refers to a dealer who holds an inventory of securities traded OTC

Question 31

How is the real interest rate, as a benchmark, generally measured?

Answer 31

As the interest rate on a (“risk-free”) U.S. Treasury bond, adjusted for any inflation

Question 32

What is default risk?

Answer 32

The risk that a debtor will not pay back his debt, either interest or principal

This risk affects interest rate; lenders will demand a higher interest rate to account for a higher default risk

Question 33

What is a default risk premium?

Answer 33

The amount of interest added beyond the risk-free interest rate paid on U.S. Treasury bonds, since those are deemed to have zero risk of default

Question 34

How does inflation affect interest rates?

Answer 34

Since lenders want a real return on their lent money, their interest rates will try to account for inflation, adding a premium according to the expected average inflation rate for the duration of the loan (i.e. not past inflation rates, except as they bear on the future)

Question 35

What is a yield curve?

Answer 35

A curve representing the different interest rates on a class of bonds with an equal default risk but different maturity dates (e.g. maturing in one year, maturing in three years, or maturing in thirty years) – with the yield curve for U.S. Treasury bonds being the default curve

Can be called a yield-to-maturity (YTM) curve

Question 36

What are the three different shapes of a YTM curve, and what do they represent?

Answer 36

(1) normal = has a positive (but decreasing) slope, showing that interest rates are higher for bonds with longer maturities
(2) inverted = has a negative (but increasing) slope, showing that interest rates are lower for bonds with longer maturities
(3) flat = has basically no slope, showing that interest rates are about the same for bonds of any maturity

Question 37

What are the causes for normal, inverted, or flat yield curves?

Answer 37

Ordinarily yield curves have a normal shape, since the longer-duration investment of a longer-maturity bond, being less liquid, must offer a higher interest rate

Yet interest rates can be raised or lowered depending on the expected inflation rates in the future (with higher interest rates offsetting higher inflation)
-Further, interest rates can be lower for the future if economic recession is expected (i.e. investors will settle for lower long-term interest rates if they think the economy as a whole will not offer much)

Question 38

What is maturity risk premium?

Answer 38

The premium given to bond interest rates simply because their maturities are longer – while investors’ money is in the bonds, there is the risk that higher interest rates could be available, and the risk of such an opportunity gives rise to the maturity risk premium

Question 39

What is the risk premium?

Answer 39

The total increase in interest rates on bonds due to risk – and thus the sum of the default risk premium and the maturity risk premium

Question 40

How does Fed intervention affect bond interest rates?

Answer 40

Generally, it causes yield curves to be distorted

Specifically, if the Fed increases the money supply, interest rates will initially lower, but inflation will rise and thus increase interest rates nominally – or the opposite can happen if the money supply is contracted

Question 41

How do interest rates affect stock prices?

Answer 41

Interest rates affect corporations that rely on debt, and thus affect the stock value (and price) for such firms – moreover, bonds and stocks tend to compete for investors’ money, which means that rising interest rates make bonds more attractive, causing stock prices to lower in response

Overall, then, higher interest rates lead to lower stock prices

Question 42

How do interest rate risks affect financial management?

Answer 42

Due to the volatility of interest rates, it is prudent to have both short- and long-term debt (in addition to stock), so that a business is not harmed too much by unfavorable interest rates

Question 43

What is the general rule concerning how much short-term debt should be used by a company?

Answer 43

The more liquidity the company has, the more short-term debt they could use – since the company could then, without much loss, in a bad scenario pay back the short-term debt with their liquid assets

Question 44

How do changes in market interest rates affect the prices of bonds with different maturity dates?

Answer 44

A change in market interest rates more powerfully affects the price of a longer-duration bond than for a shorter-duration one

Increase in market interest rates –> decrease in bond price, since the bonds would then be less valuable than other available interest rates