Introduction Flashcards
What is Corporate finance?
Corporate finance is the area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources.
Corporate finance is the study of the relationship between business decisions and the value of the stock in the business.
Three questions to answer before setting up a business
(1) What long term investments should you take on? This determines the line of business and equipment to be used. (Capital budgeting decision)
(2) Where will you get the long-term financing to pay for your investment? Will you bring in other owners(Equity) or will you borrow the money (debt)? (Capital structure decision)
(3) How will you manage your everyday financial activities? Collecting from customers and payin suppliers?(working capital management decision)
Who is a financial manager?
Financial manager makes business decisions on behalf of the owners (stockholders), and represents the owner’s interests.
Financial manager is anyone who is in charge of making the three financial management decisions: Capital budgeting decision, capital structure decision, and working capital management decision.
Capital budgeting decision
In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire.
The value of the cash flow generated by an asset exceeds the cost of that asset. Evaluation the size,timing, and risk of future cash flows in the essence of capital budgeting.
Foams of business organizations
Sole proprietorship, partnership, and corporation
Sole-Proprietorship
This is a business owned by one person.
Advantages: simple to organize and establish, full ownership and control, full claim on profits, least regulated.
Disadvantages: unlimited liability (no difference between personal income and corporate income), limited life span (by owner’s life span), limited equity (by proprietor’s personal wealth), difficult to transfer ownership (transfer may require the sale of the entire business).
Partnership
A partnership is similar to a proprietorship, except that there are two or more owners (partners).
Advantages: Simple to organize and establish, joint ownership and control, shared claim on profits and loses (based on partnership agreement), limited regulation.
Disadvantages: Unlimited liability for general partners (note limited partners have limited liability), limited life span (by partner’s life span), limited equity (by partner’s wealth), difficult to transfer ownership (transfer may require the sale of the entire business or getting a new partner).
Corporation
The corporation is the most important form (in terms of size) of business organization. It is a legal “person” separate and distinct from it’s owners, and it has many of the rights, duties, and privileges of an actual person.
Corporations can borrow money and own property, can sue and be sued, and can enter into contracts.
A corporation can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation.
A corporation can be called joint stock.
Company (JSC), a public limited company (PLC), or limited liability companies (LLC), depending on the specific nature of the firm and the country of origin.
Advantages and disadvantages of a corporation
Advantages: Limited liability, unlimited life span, unlimited equity, easy transfer of ownership (buying and selling of stocks).
Disadvantages: Complex to organize and establish (need for articles of incorporation and bylaws), high regulation, diversified ownership and control, limited claim on profits or losses, double taxation (income is taxed when earned by the corporation and when paid out to shareholders)
Goals of financial management
The goal of financial management is to maximize the market value of the existing owner’s equity.
Principal agency problem
The relationship between stockholders and management is called an agency relationship.
Such a relationship exists whenever someone (the principle) hires another (the agent) to represent his/her interests.
In all such relationships, there is a possibility of conflict of interest between the principle and the agent, such a conflict is called an agency problem.
Whether infact managers will act in the interests of stockholders depends on two factors: (1) how closely are management goals aligned with stockholders (issues about compensation). (2) can management be replaced if the do not pursue stockholder goals? (An issue about control of the firm).
Agency costs
Refers to the cost of the conflict of interest between stockholders and management.
These costs can be indirect (opportunity cost of missed investment due to management slack).
They can also be direct unprofitable corporate expenditures, costs of supervision like auditing, and board excess-compesation of management.
Principal -agency solutions
The extent to which managers find it optimal to pursue their own interest is limited by internal and external factors.
Internally, managers are limited by monitoring (board of directors:regular board presentations) and incentive contracts(if profits increase to 4% you win a trip to Malaysia).
Externally managers are limited by (1) managerial labour market:good managers get hired by bigger firms with more corporate wealth (2) Market for corporate control: firms which are underperforming are at risk of takeovers or being sold and management would be changed. (3) Bankruptcy: failure to maximize profits can result into bankruptcy and lead to liquidation. (4) Competition in product market: this acts as an indicator for management performance. Those managers who are not competitive would be replaced.
Financial markets
In financial markets, it is debt and equity securities that are bought and sold.
Financial markets differ based on types of securities being traded, how trading is conducted, and who the buyers and seller are.
Primary versus secondary markets
Primary market refers to the original sale of securities by governments and corporations.
Secondary markets are those in which these securities are bought and sold after the original sale.
