Financial Management Flashcards
What is the goal of management within a business?
To manage the business within the owners’ best interests, including when management’s interests might conflict with the owners’
How might diversification provide a conflict of interest for management?
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
What sort of incentives do companies offer management to help align their interests with the owners’?
Giving compensation based on stock performance
This can backfire if management is concerned with only the appearance of stock success
What are some reasons for an investor to prefer a company that pursues non-profit-motivated social projects?
(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
What are some reasons for an investor NOT to prefer a company that pursues non-profit-motivated social projects?
(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
For maximizing shareholder wealth, what financial measure should management focus on?
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)
How does a view to profit maximization not properly maximize shareholder wealth?
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
How does a view to EPS maximization not properly maximize shareholder wealth?
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
What are the main determinants of stock prices?
(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
What is the first stage of the product life cycle?
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
What is the second stage of the product life cycle?
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
What is the third stage of the product life cycle?
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
What is the fourth stage of the product life cycle?
Decline – sales decrease as the product dies out and other products take its place
To what else does the product life cycle apply?
It can also apply to firms and industries, not just to products
What are the two main ways for companies to raise capital?
Debt (e.g. bonds, notes, loans) and equity (e.g. stock)
How do physical asset markets differ from financial asset markets?
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
How do money markets differ from capital markets?
Money markets include short-term debt instruments (under one year)
Capital markets include long-term debt and equity instruments
How do mortgage markets differ from consumer credit markets?
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)
What are different ways for financial transfers of capital to occur?
(1) direct transfers
(2) facilitated transfers
(3) repackaged transfers
(4) securities markets
As regards the transfer of capital, what are direct transfers?
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)
As regards the transfer of capital, what are facilitated transfers?
Transfers of capital done through some middleman, such as a mortgage broker or investment bank – investment banks usually buy and re-sell securities
As regards the transfer of capital, what are repackaged transfers?
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)
What are mutual funds?
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)
Besides mutual funds, what institutions engage in repackaged transfers?
(1) banks
(2) insurance companies
(3) financial service companies (e.g. investment companies)
What are different kinds of banks?
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
What are two different kinds of securities markets?
(1) organized exchanges, such as the New York Stock Exchange (NYSE)
(2) over-the-counter (OTC) markets
What are some characteristics of organized securities exchanges?
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
How do organized securities exchanges generally function?
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
How do OTC markets generally function?
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
What does it mean to “make a market” for some stock or other security?
To “make a market” refers to a dealer who holds an inventory of securities traded OTC
How is the real interest rate, as a benchmark, generally measured?
As the interest rate on a (“risk-free”) U.S. Treasury bond, adjusted for any inflation
What is default risk?
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
What is a default risk premium?
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
How does inflation affect interest rates?
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)
What is a yield curve?
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
What are the three different shapes of a YTM curve, and what do they represent?
(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
What are the causes for normal, inverted, or flat yield curves?
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)
What is maturity risk premium?
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
What is the risk premium?
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
How does Fed intervention affect bond interest rates?
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
How do interest rates affect stock prices?
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
How do interest rate risks affect financial management?
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
What is the general rule concerning how much short-term debt should be used by a company?
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
How do changes in market interest rates affect the prices of bonds with different maturity dates?
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
