Lecture 1: Corporate Finance & Financial Manager (Chapter 1)

Question 1

What are the 4 types of firms that financial managers run?

Answer 1

1. Sole Proprietorship
2. Partnership
3. Limited Liability Companies (LLC)
4. Corporations

Question 2

What is sole proprietorship?

Answer 2

It is a business owned & run by one person. The firm can only have one owner who runs the business.

Question 3

What are some of the key features of a sole proprietorship?

Answer 3

• straightforward & easy to set up
• owner has unlimited personal liability for the firms’ debts (if owner cannot repay loan, he’ll be personally liable & must declare personal bankruptcy)
• the life of business is limited to the life of the owner himself (diff to transfer ownership of sole proprietorship)
• prinncipal limitation: no separation between firm and owner

Question 4

What is the principal limitation of a sole proprietorship?

Answer 4

There isn’t any separation between the firm and owner. Only one owner can run the business. Nobody else can hold an ownership stake besides the owner himself.

Question 5

What is a partnership?

Answer 5

It is a business owned & run by more than one owner.

Question 6

What are some of the key features of a partnership?

Answer 6

• all partners are liable for the firms’ debts (lender can command any partner to repay all the firms’ debts)
• partnership ends in the event of death or withdrawal of any partner unless there is an upfront agreement being made
• partners may avoid liquidation if partnership agreement provides alternatives such as buyout of a deceased or withdrawn partner

Question 7

In a partnership agreement, can a partner still continue the partnership after one of the partners passed away?

Answer 7

Yes, he can still continue if the partners had made an agreement regarding this matter.

Question 8

What is a buyout?

Answer 8

It is the purchase of a controlling share in the co.

Question 9

What is a limited partnership?

Answer 9

It is a partnership w/ 2 kinds of owners:
1. General partners: has the same rights & privileges as partners in any general partnership (personally liable for the firms’ debts obligations)

2. Limited partners: have limited liability based on the amount they invest, their ownership interest is transferrable and they have no management authority which means they cannot legally be involved in the managerial decision making of the business

Note: In a limited partnership, the death or withdrawal of either partner DOES NOT dissolve the partnership since the ownership interest is transferrable.

Question 10

What is the drawback of limited partners?

Answer 10

They have no management authority & cannot legally be involved in the managerial decision making for the business.

Question 11

What is limited liability company (LLC)?

Answer 11

It is a limited partnership but w/o general partner. All owners have limited liability up to the amount that they invested in the company unlike unlimited partners. However, these limited liability owners have the rights to the run the business

Question 12

What is Corporations?

Answer 12

It is a legal entity separate & distinct from its owners, and is solely responsible for its own obligations. (Owners of the corporation are not liable for any obligations the corporation enters into and vice versa)
Similarly, the corporation isn’t liable for any personal obligations of its owners.

Question 13

How is a corporation formed?

Answer 13

A corporation must be legally formed, it must formally give its consent to the incorporation by chartering it in the state which it is incorporated. Hence, the cost of setting up a corporation is more costly than setting up a sole proprietorship.

Note: A corporate charter specifies the initial rules that govern how the corporation is run.

Question 14

Ownership of a Corporation:

Answer 14

• there is no limit in the no. of owners (each owner owns a fraction of the corp. stocks)
• collection of all outstanding shares in a corporation is known as the equity
• owner of a share of stock is called “shareholder, stockholder or equity holder”.
• shareholders are entitled to dividend payment based on their proportion of stocks owned
• corporation can raise substantial capital as they can sell ownership shares to anonymous outside investors (open to the public)

Question 15

In essence, do shareholders in a corporation pay double taxation?

Answer 15

Yes, firstly the corporation pays tax on profits, then once the remaining profits after tax are distributed to shareholders as dividend, then they pay their own personal income tax on dividends. (in a way paying tax twice).

Note: A corporation is a separate legal entity.

Question 16

What are the 2 types of corporation?

Answer 16

1. S Corporation

2. C Corporation

Question 17

What is S Corporations?

Answer 17

They are corporations in the US that elect subchapter S tax treatment. The US Internal Revenue Code exempts S Corporations from double taxation. This is only applicable to US residents or citizens. This means that the firms’ profit & losses are not subject to any corporate taxes, instead they are allocated directly to shareholders income based on their ownership stake. Shareholders must include these profits as income on the personal income tax returns even if no money is distributed to them as dividends. In essence, shareholders only pay tax once since at the corporation level, no tax is paid.

Note: In S Corporations, shareholders MUST pay tax on income immediately regardless whether the corporation pays them any dividend.

Question 18

What is C Corporations?

Answer 18

Corporations that have no restrictions on who owns their shares or the no. of shareholders. Thus, they cannot qualify for subchapter S tax treatment (only restricted to US citizen). Most corporations are C corporations since there isn’t restrictions oon who can own their shares, which means the corporation itself is subject to paying taxes. The remaining profits distributed to shareholders as dividend will once again be taxed as a part of their personal income tax return. (Double taxation exists)

Note: In C Corporations, shareholders are only taxed once they received dividend payments. Otherwise, income is only taxed at the corporation level, not on the shareholders.

Question 19

What are the 3 main roles of a financial manager?

Answer 19

1. making investment decisions
2. making financing decisions
3. manage short-term cash needs

Question 20

How do financial managers make investment decisions?

Answer 20

They must weigh the costs and benefits of each investment/ project and then decide which ones qualify as good uses of the money shareholders have invested in the co.
Investment decisions shape what the firm does and whether it’ll add value for its owners.

Question 21

How do financial managers make financing decisions?

Answer 21

They must decide how to pay for those investments that they’ve decided on. Large investments may req. the corp. to raise additional money. Money can be raised either through selling more stocks to existing shareholders (equity) or borrowing money (bond/ debt).

Question 22

What is a bond?

Answer 22

It is a security sold by gov. & corp. to raise money from investors today in exchange for a promised future payment. (viewed as a loan from investors to issuer)

Question 23

How do financial managers manage short-term cash needs?

Answer 23

They must ensure that the firm has enough cash on hand to meet its obligations day to day. (aka managing working capital)
They must ensure that limited access to cash does not hinder(affect) the firms’ success.

Question 24

What are the ultimate goal of a financial manager?

Answer 24

It is to maximize shareholders’ wealth. Since stockholders have invested in the corp. by putting their money at risk to become the owners of the corp., the financial manager has to take good care of the stockholders’ money by making decisions in their interests.

Question 25

Stockholders or shareholders are owners of the firm. Do they make decisions on behalf of the firm?

Answer 25

No. Shareholders own the corporation but rely on the financial managers to actively manage the corporation. Financial managers are the caretaker of the shareholders’ money, making decisions in their interest.

Question 26

Who possess direct control of the corp.?

Answer 26

It is the board of directors (BOD) and the management team headed by the CEO

Question 27

How do shareholders of a corp. exercise their control?

Answer 27

They do so by electing a board of directors, who has ultimate decision-making authority in the corp. Normally, one share represents one vote in the election of BODs. Investors w/ more shares will have more influence.

Question 28

Who are the Board of Directors (BOD)?

Answer 28

They are a group of people elected by the shsareholders who have the ultimate decision-making authority in the corporation.

Question 29

What are the roles of the BODs?

Answer 29

• make rules on how the corp. should run
• sets policy of the corp.
• monitors the performance of the co.
• delegates most decisions involving day-to-day operation to the management
• hires the top management team

Question 30

Who is the Chief Executive Officer (CEO)?

Answer 30

He is the person charged w/ running the corporation by instituting the rules and policies set by the board of directors.

Question 31

What are the roles of the Chief Executive Officer (CEO)?

Answer 31

• run the corp. by instituting the rules & policies set out by the BODs
• separation of powers between the BODs and the CEO is not distinct as CEO can sometimes be the chairman of the BOD
• CFO often reports directly to the CEO

Question 32

What is Agency Problem?

Answer 32

When managers are hired as agents of shareholders, they put their self-interest ahead of the interest of those shareholders. Managers tend to face the ethical dilemma of whether to adhere to their responsibility towards the corp. (to put the interest of shareholders first) or to do what is in their personal best interests.

Question 33

What is the cause of Agency Problem in a corp.?

Answer 33

It is due to the separation of ownership & control in a corp., managers have little incentive to work in the interests of the shareholders when it means working against their self-interest.

Question 34

What is the advantage of a corp. providing managers’ compensation contracts to managers?

Answer 34

It ensures that most decisions in the shareholders’ interest are also in the managers’ interest. Avoids agency problem.

Question 35

What is the disadvantage of providing managers’ compensation contracts?

Answer 35

By typing compensation too closely to performance, shareholders might be asking managers to take on more risks. Thus, managers might not make decisions that shareholders want them to.

Question 36

What other reasons why potential conflicts of interest & ethical considerations arise?

Answer 36

It arise when some stakeholders in the corp. benefit while others lose from a decision. In this case, managers may decide to take interests of other stakeholders into account in their decision depending on their priorities.

Question 37

What can shareholders do if they’re unhappy w/ the CEO’s performance?

Answer 37

They can pressure the BOD to fire the CEO and rehire a better CEO who performs well in the best interest of the shareholders.

Question 38

In what situation would the BOD be reluctant to fire the CEO?

Answer 38

When the BOD comprised of people who are close friends of the CEO and lack objectivity.

Question 39

What causes a corporate raider to perform a hostile takeover?

Answer 39

The expectation of continued poor performance will cause stock price to be low and thus these corporate raiders sees this as an opportunity for a hostile takeover.

Question 40

What is a hostile takeover or a corporate raider?

Answer 40

It is when an org. or individual purchase a large fraction of a co.’s stock & doing so to get enough votes to replace the BODs and the CEO. Thus, a new superior management team is formed which enhances the firms’ performance, leading to a rise in share price and profit for the corporate raider & other shareholders.

Question 41

How do we determine the value of owners’ investment?

Answer 41

It is determined by the price of a share of the corp.’s stock.

Question 42

What is the difference between a public and private corporation?

Answer 42

Private corporation: limited no. of owners & there is no organised market for its shares. It’s difficult to determine the market price of shares

Public corporation: has many owners & its shares trade on an organised market aka the stock market, which provides liquidity for a co.’s shares & determine the market price for those shares easily.
Investors in a public co. values the ability to turn investment into cash easily and quickly by simply selling the shares in the market (high liquidity)

Question 43

What is a primary market?

Answer 43

It refers to a corp. issuing new shares of stock & selling them to investors.

Question 44

What is a secondary market?

Answer 44

It involves selling or buying of old shares between investors only. It does not involve any corp.
Eg: buying shares from someone who has already held the shares instead of purchasing it newly from the corp. itself.

Question 45

What is the difference between NYSE and NASDAQ?

Answer 45

NYSE always has a trading floor and has only one market maker, whereas NASDAQ doesn’t have a trading floor and has multiple market maker.

Question 46

How do market makers make money?

Answer 46

They make money when the asking price > bid price. (the diff is known as the bid-ask spread)
Bid-ask spread refers to the transaction costs that investors pay in order to trade.

Question 47

What is a limit order?

Answer 47

It is an order to buy or sell at a set amount at a fixed price.
The limit sell order w/ the lowest price is the ask price.
The limit buy order w/ the highest price is the bid price.
Trader who post limit orders provide liquidity to the market.
The limit order book is a collection of all limit orders.

Question 48

What is market orders?

Answer 48

It is orders that trade immediately at the best outstanding limit order. They are said to be takers of liquidity.

Question 49

Who are high-frequency traders (HFT)?

Answer 49

They are a class of traders who, w/ the aid of computers, place, update, cancel & execute trades many times per second in response to new info and other orders which are profiting by both provider liquidity & taking advantage of stale limit order.

Question 50

What is dark pools?

Answer 50

Dark pools don’t make their limit order books visible. They offer investors the ability to trade at a better price w/ the tradeoff that their order might not be filled if an excess of either buy or sell orders is received.

Question 51

Who will most likely be attracted to dark pools?

Answer 51

Traders who don’t wanna reveal their demand and are willing to sacrifice the guarantee of immediacy for potential price improvement.

Question 52

What is listing standards?

Answer 52

It refers to the outlines of req. a co. must meet to be traded on the exchange. This normally req. that the co. has enough shares outstanding for shareholders to have a liquid market & to be of interest to a broad set of investors.

Question 53

Who are the 2 largest financial markets in the world?

Answer 53

1. Bond market
2. Foreign exchange market
   They are the networks of dealers connected by phone & computer.

Question 54

What are financial institutions?

Answer 54

They are entities that provide financial services, such as taking deposits, managing investments, brokering financial transactions or making loans.

Question 55

The 3 steps in financial cycle

Answer 55

1. People invest & save their money
2. The money flows to co. who use it to fund growth through new products, generating profits & wages
3. Money then flows back to the savers & investors.
   NOTE: All financial institutions play a role at some point in the cycle of connecting money w/ ideas and returning the profits back to the savers & investors.

Question 56

What are the types of financial institutions?

Answer 56

• banks and credit unions
• insurance companies
• mutual and pension funds
• hedge funds
• venture capital funds (big co. assists small start-up co.)
• private equity funds

Question 57

What do financial conglomerates (aka financial services firm) do?

Answer 57

They combine more than 1 type of institution, which engage in commercial banking and investment banking.
Investment banking = the business of advising co. in major financial transactions

Question 58

What is the role of financial institutions?

Answer 58

They move funds from those who have extra funds (savers) to those who are in need (borrowers/ firms). They move funds through time.
They also help spread out risk-bearing to limit the exposure of risk.

Question 59

What is the Valuation Principle?

Answer 59

It refers to how to make the costs and benefits of a decision comparable so that we can weigh them properly.