FINC2011 Lec 1 Intro Flashcards
What is finance? What is the function of the financial markets?
- Helps facilitate the movement of funds from the limited providers of funds to the near limitless users of funds.
- Lendors supply funds by acquiring financial products from the financial market. (e.g. household savings, company investments, gov budget surplus).
- Borrowers receive funds by issuing financial products to the financial market. (e.g. household mortgages, companies PPE, gov budget deficit).
What is the overall goal of a public company?
To maximize the wealth of its shareholders (by maximizing the value of the firm)!!!
What are the 3 things that shareholders want when investing in a public company?
- To be as rich as possible / maximize current wealth!!!!
- To transform that wealth into the most desirable time pattern of consumption by borrowing to spend now or investing to spend later.
- To manage the risk characteristics of that consumption plan.
How do public companies help satisfy the shareholder’s desire to transform wealth into the most desirable time pattern of consumption?
Companies cannot satisfy all shareholders - however the existence of secondary financial markets makes it possible for shareholders to control own individual time pattern of consumption.
How do shareholders control their time pattern of consumption?
- Selling stock to spend now but giving up future dividends and capital gains.
- Reinvesting dividends into stock to spend more later.
- Choosing the most suitable stocks (e.g. Telstra is a dividend stock, Apple is a capital gains stock).
MARKET CAPITAL Formula
MARKET CAP = NO. OF ISSUED STOCKS x STOCK PRICE
What is the “market capitalization” of a company?
- Measure of company value: represents the aggregate amount of wealth of ALL the company shareholders.
- Senior managers should focus on maximizing this.
Does maximizing profit = maximizing wealth? Give an example.
NO! Profit is a short term measure whereas wealth is a long term concept.
e. g. firing IT staff:
- ST: save costs.
- LT: things stop working!
In Sunbeam’s case, the stock price massively increased as EPS projections rose under Al Dunlap’s management, but then crashed even harder leading to bankruptcy. What caused this?
- Management Myopia: Excessive focus on increasing ST profits, at the expense of LT wealth.
- ST pressure to beat quarterly forecasts lead to dubious practices and fraud. (e.g. customers encouraged to pre-purchase products at massive discounts leading to inventory buildup and cash short-falls later).
What is the AGENCY PROBLEM and what 2 things that cause it?
Managers act as agents for shareholders (owners). The agency problem occurs as there is a (1) difference in information and (2) difference in objectives.
When are agency costs incurred?
Agency costs are incurred when….
- Managers do not attempt to maximize firm value (shareholder’s interest) but rather act in their own interests. [similar to opportunity cost, wealth is forgone].
- When shareholders incur costs to monitor managers and constrain their actions. [similar to compliance / administration cost]. (e.g. costs for hiring accountants auditors to produce annual financial reports).
What are some factors that incentivize managers to act in their own interests?
- job security
- bonuses
- promotional opportunities
- comfort of a corporate jet
What are the 6 CORPORATE GOVERNANCE solutions to the agency problem?
- BOD (hire / fire management)
- Legal requirements
- Compensation plans (stock options to align interests)
- Monitoring
- Pressure by takeovers (managers lose their job)
- Pressure by shareholders (vote to replace BOD)
Through which 3 categories of decisions do managers maximize firm value with?
- Investment decisions
- Financing decisions
- Dividend decisions
What is the “INVESTMENT DECISION”?
- Considers (1) what types of assets (real / financial) and (2) how many assets the firm should invest in to operate the business and generate cash flows.
