Introduction

Question 1

Corporations pay for real assets by selling claims on:

Answer 1

• those real assets

- the cash flow that they will generate

Question 2

Is undeveloped land a real or a financial asset?

Answer 2

Real

Question 3

Is a share of stock a real or a financial asset?

Answer 3

Financial

Question 4

Is an experienced and hardworking sales force a real or a financial asset?

Answer 4

Real

Question 5

Corporations:
(What are they?)
limited liability
distinct entity

Answer 5

• Comprise of large and medium-sized businesses owned by several people
  e. g. Microsoft, Google, IBM
• Limited Liability: stockholders are not personally responsible for the firm’s debts
• Distinct entity: the corporation is considered as a distinct legal entity or legal person. This means it can make contracts, borrow/lend, sue/be sued but it CANNOT VOTE

Question 6

Partnerships:

Answer 6

• Small businesses owned and managed by a group of people

Question 7

Sole proprietorships:

Answer 7

• Small businesses owned and managed by a single individual

Question 8

Disadvantages of corporations

Answer 8

Complex structure:
- management of complicated structure and communication with shareholders, which is costly and time consuming

Double taxation problem:
- tax on both firms’ profits and on shareholders’ dividends/capital gains

Moral hazard issues due to asymmetric information:
- managers may act at their best personal interests and not those of the shareholders

Question 9

The role of the Financial Manager

Answer 9

They decide on:

• What real assets the firm should invest in
• How the cash needed to finance the investments should be raised

So the financial managers

• Helps manage the firm’s operations (making investment decisions)
• Deals with investors: shareholders, financial institutions (banks), and financial markets (stock markets)

Question 10

Importance of Financial institutions

Answer 10

• Provide choice between short-term borrowing, long-term borrowing and issuing of shares
• Assist and and provide advice in mergers and acquisitions
• Provide financial managers with a source of information on interest rates, market value of firms, prices of raw materials

Question 11

Shareholders want the Financial Manager to:

Answer 11

• Increase the value of the corporation
• Increase its current stock price
• Maximise its market value

Question 12

How do corporations increase market value

Answer 12

Accepting all investment projects that earn more than the opportunity costs of capital

Question 13

Role of financial manager (4 parts)

Answer 13

• Valuation and investment decisions
• Financing decisions
• Dividend decisions
• Risk management and hedging

Question 14

Principle agent problem

Answer 14

• The ‘agents’ (managers) may not act to the best interest of their ‘principles’ (firm owners) although they claim or promise to do so
• They may avoid attractive but risky projects (fear of losing their job); they may work just to maximise their own business

Question 15

Agency costs (costs of the principal agent problem)

Answer 15

• Firms potential is not achieved

- Owners incur costs of monitoring the behaviour and actions of management team

Question 16

Mechanisms to alleviate the Principal-agent problem

Answer 16

• Incentive schemes
  
  • Managers get additional, high bonuses if shareholders/owners make a gain, otherwise they get no bonuses at all
• Governance rules
  
  • Legal frameworks and reforms to corporate governance that protect shareholders’ interests against the possibility of fraudulent behaviour by managers