L1 Introduction Flashcards
What is corporate finance and its objective function?
A subfield of finance that studies all major decisions to be taken by firms, because all business decisions have financial implications.
Objective function: maximize the value of the corporation.
Which are the 4 types of firms?
- Sole Proprietorship
- Partnership
- Limited Liability Company (LLC)
- Corporation
Which are the main characteristics of a Sole Proprietorship?
- Owned by 1 person (full control)
- Few (if any) employees
- Easy to create (most common)
- No (legal) separation between the firm and the owner
- Unlimited personal liability
- Limited life ( = life of the owner)
Which are the main characteristics of a Partnership?
- More than one owner: General partner (GPs) and Limited partner (LPs)
- Limited life (it may end with the death/withdrawal of any partner)
- Managerial and creative synergies, but more room for conflict
What is the difference between General Partners and Limited Partners?
- General Partners (GPs): unlimited liability, management of the firm
- Limited Partners (LPs): limited liability (to their initial investment), no control or management authority
Which are the main characteristics of a Limited Liability Company (LLC)?
- All owners have limited liability and management authority
- Ownership and control are not separated
- No information disclosure requirement
Which are the main characteristics of a corporation?
- Legal entity separate from its owners
- Has a “person legal powers” such as the ability to enter into contracts, own assets, or borrow money
- It is liable for its own obligations, not the owners
- Ownership is represented by shares of stock
- Sum of all ownership values = equity
- Owners = shareholders / stockholders / equity holders (entitled to dividend payments)
- No limited number of shareholders (funds can be raised by selling stock)
- Separation of ownership and control
Explain the legal formation process of a corporation (in the US).
- The corporation files a charter* in the state it wants to be incorporated.
- Possibility to hire a lawyer to create the corporate charter with all the formal articles of incorporation and set of bylaws (i.e., initial rules that govern the corporation) - The state “charters” the corporation and formally approves its incorporation.
* acta constitutiva
Ownership and direct control are separated in corporations.
If shareholders are the owners of the corporation, who is in direct control?
The Corporate Management Team, formed by:
- Board of Directors: elected by shareholders, ultimate decision-making authority
- Chief Executive Officer (CEO): elected by the Board of Directors, which delegates day-to-day decision making to the CEO
What is the organizational chart of a typical corporation?
- Board of Directors
- CEO
- Chief Operating Officer
- Chief Financial Officer
- 2.1. Controller
- Accounting
- Tax Department - 2.2. Treasurer
- Capital Budgeting
- Risk Management
- Credit Management
What is the main goal of a firm (or corporation)?
Shareholders agree that they are better off if management makes decisions that maximize the value of their shares.
Maximizing the value of a firm’s shares always supposes a problem for society and stakeholders.
True / False
False.
As long as nobody else is made worse off by a corporation’s decisions, increasing the value fo the firm’s equity is good for society.
It becomes a problem only when increasing the firm’s equity comes at the expenses of other stakeholders.
Which are the main stakeholders of a firm?
- Shareholders
- Creditors/Bendors
- Management team
- Government (taxes)/Society
- Employees
- Suppliers/Customers
- Competitors
Which are the main corporate finance decisions?
- Investment decisions (good investment project? NPV positive?)
- Financing decisions (debt vs. equity)
- Payout decisions (dividend? or repurchase?)
Why is 1€ worth more today than 1€ next year? (time value of money)
- Opportunity cost (1€ could have been used for consumption or investment)
- Inflation (purchasing power of 1€ will be generally lower due to increasing price levels)
- Risk-based explanations
What is the Net Present Value (NPV)? And the NPV-Rule?
The NPV is our main decision criteria to evaluate investment projects (or value projects and entire firms)
NPV > 0 = take the project
NPV < 0 = reject the project
- Always choose the project with highest NPV
What is Arbitrage?
Arbitrage consists on buying and selling equivalent goods in different markets to exploit a price difference.
If prices in two markets differ, you can make a profit by buying cheap and selling expensive.
Arbitrage opportunity: make a profit without taking any risk or making any investment (prices do not differ for long)
What is the Law of One Price?
If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in all markets (there must be no arbitrage opportunities).
What is a sensible discount rate?
It should be their risk-free rate + an adjustment for additional risk taken in the investment project.
What is a risk-free rate (rf)?
A rate in which you can enjoy an interest payment on your investment without taking any risk.
For what types of risk do investors require compensation?
For project-specific risk and systematic risk.
What is the Capital Asset Pricing Model (CAPM)?
Investors hold well-diversified investment portfolios, therefore Idiosyncratic (firm-specific) risk should be wiped out and there are only systematic (economy-wide) risk left that is priced according the required return of the stock (ri).
Why is the risk-free interest rate important?
Because to discount a cash flow, we want to use the risk-free rate that matures on the date when cash flow accrues.
We do not have many alternatives because we don’t know what assets are totaly risk-free, therefore what can we use?
Interest rates of long-term government debt (sovereign bond), because yield curve is often less volatile (less variation) in the long-term than in the short-term.
What is the Market Risk Premium? (or the common shortcut to calculate it)
The difference between the return of a common market index (rM) and risk-free rate (rf).
It provides a quantitative measure of the extra return demanded by market participants for the increased risk.
