Introduction

Question 1

Firms purchase of real assets is called

Answer 1

capital investment decision

Question 2

Sale of financial assets by a corporation is called

Answer 2

financing decision

Question 3

What is a corporation

Answer 3

large/medium sized business owned by several people - pay corporate income tax - ownership divided by shares

Question 4

What is a partnership

Answer 4

small businesses owned and managed by a group of people - only pay personal income tax

Question 5

Sole proprietorships

Answer 5

small businesses owned and managed by a single individual

Question 6

Characteristics of a corporation

Answer 6

Limited liability - stockholders not responsible for firms debts
Distinct Entity - can borrow etc but cannot vote
Separation of ownership & management - shareholders vote to elect management

Question 7

Disadvantages of a corporation

Answer 7

Complex structure - communication with shareholders is costly and time consuming
Double taxation problem - tax on firms profits and shareholders dividends
Moral hazard due to asymmetric information - managers may act in personal interest

Question 8

Role of the financial manager

Answer 8

Firm pays for real assets by selling financial assets in financial markets e.g. stock market
Decide on what real assets the firm should invest in
How the cash should be raised to finance investments
Dividend decision
Risk management and hedging

Question 9

Role of financial institutions

Answer 9

provide choice between short, long term borrowing and assist with M&A, provide financial managers with a source of information on interest rates

Question 10

Shareholders want the FM to

Answer 10

Increase value of the corporation
Increase stock price
maximise market value & wealth

Question 11

Corporation maximise value by accepting projects that…

Answer 11

earn more than the opportunity cost of capital

Question 12

Principal agent problem

Answer 12

agents (managers) may not act in best interest of principles (firm owners) and may avoid attractive but risky projects with fear of losing job. Work to maximise bonuses

Question 13

Agency costs

Answer 13

firms potential value is not achieved as owners incur costs of monitoring the behaviour and actions of management team

Question 14

Mechanisms to alleviate principal agent problem

Answer 14

Incentive schemes - bonuses if shareholders make a gain
Managers face losing job - board of directors may replace them
Governance rules - legal frameworks that protect shareholders interests

Question 15

Explain the advantages of a corporation as a form of business organisation

Answer 15

Infinite life
Many owners so can raise funds more easily
easy to transfer ownership
limited liability

Question 16

Take home ideas

Answer 16

Corporate finance is about maximising value
Opportunity cost of capital sets standard for investment decisions
Smart investment decisions create more value than smart financing decisions