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2nd Year - Finance 2 > Lecture 1 - Introduction to Corporate Finance > Flashcards

Lecture 1 - Introduction to Corporate Finance Flashcards

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1
Q

What are capital budgeting or capital expenditure (CAPEX) decisions?

A

Decisions to invest in tangible (e.g. a new factory) or intangible assets (e.g. research and development).

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2
Q

What is the financing decision?

A

Decision on the sources and amounts of financing. Raising the money that the firm requires for its investments and operations.

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3
Q

What are equity investors and what is equity financing?

A

When a company needs to raise money, it can invite investors to put up cash in exchange for a share of future profits. The investors receive shares of stock and become shareholders, part owners of the corporation. The investors in this case are referred to as equity investors, who contribute equity financing.

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4
Q

What are debt investors?

A

When a company needs to raise money, the company can promise to pay back the investors’ cash plus a fixed rate of interest. The investors are lenders, that is debt investors, who one day must be repaid.

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5
Q

What is the choice between debt and equity financing?

A

Capital structure decision. ‘Capital’ refers to the firm’s sources of long term financing. A firm that is seeking to raise long term financing is said to be ‘raising capital’.

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6
Q

What is the difference between the investment and financing decisions?

A

When the firm invests, it acquires real assets, which are then used to produce the firm’s goods and services. The firm finances its investment. in real assets by issuing financial assets to investors.

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7
Q

What are real assets?

A

Assets used to produce goods and services.

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8
Q

Financial assets that can be purchased and traded by investors in public markets are called…

A

Securities.

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9
Q

What is the difference between debt and equity?

A

Debt is repaid before shareholders receive any payment. Equity holders are residual claimants. This means they receive money after debt holders have got their money.

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10
Q

What is corporate financial management?

A

The efficient acquisition and deployment of both short and long term financial resources, to ensure financial objectives achieved.

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11
Q

Investment appraisal considers…

A

The long term plans of the business and identifies the right projects to adopt.

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12
Q

Working capital management is concerned with the…

A

Management of short term liquidity (e.g. short term debts, inventory, cash balances and payables).

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13
Q

There are three different types of investment decisions, what is internal?

A
  • Whether to undertake new projects/plant.
  • Research and development decisions.
  • Investment in a marketing or advertising campaign.
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14
Q

There are three different types of investment decisions, what is external?

A
  • Whether to carry out a takeover or a merger
    involving another business.
  • Whether to engage in a joint venture with another enterprise.
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15
Q

There are three different types of investment decisions, what is disinvestment?

A
  • Whether to sell off unprofitable segments.
  • Whether to sell old or surplus plant and machinery.
  • The sale of subsidiary companies.
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16
Q

What is the investment decision?

A

Purchase of real assets.

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17
Q

What is the financing decision?

A

Sale of financial assets.

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18
Q

What is the dividend decision?

A

The decision on the amount of dividends paid out by the company to its shareholders.

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19
Q

What is payout policy?

A

Payout policy refers to the ways in which firms return capital to their equity investors. Payouts to equity investors take the form of either dividends or share repurchases.

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20
Q

Having invested wisely, a corporation will hopefully be profitable and generate cash. Whether to return any of that cash to the shareholders (in the form of dividends or repurchases) and if so, how much. The alternative is to…

A

Retain some of the cash in the business where it can be invested again to earn further returns.

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21
Q

What is financial management?

A

It is concerned with the short and long term raising of finance and the allocation and control of resources.

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22
Q

What is management accounting?

A

It is concerned with providing information for the more day to day functions of control and decision making.

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23
Q

What is financial accounting?

A

It is concerned with providing information about the historical results of past plans and decisions.

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24
Q

What tasks are carried out by financial managers?

A
  • Establishing dividend policy.

- Evaluating proposed expansion plans.

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25
Q

What tasks are carried out by managing accountants?

A
  • Review of overtime spending.

- Apportioning overheads to cost units.

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26
Q

What tasks are carried out by financial accountants?

A
  • Depreciation of non current assets.

- Identifying accruals and prepayments.

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27
Q

What is a corporation?

A

A business organised as a separate legal entity owned by stockholders.

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28
Q

A corporation’s owners are called…

A

Shareholders or stockholders. The shareholders do not directly own the business’s real assets (factories, oil wells, stores etc). Instead, they have direct ownership via financial assets (the shares of the corporation).

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29
Q

A corporation is legally…

A

Distinct from the shareholders. Therefore, the shareholders have limited liability.

30
Q

What is limited liability?

A

Where the owners of a corporation are not personally liable. For example, when the US corporation Lehman Brothers failed in 2008, no one demanded that its stockholders put up more money to cover Lehman’s massive debts. Shareholders can lose their entire investment in a corporation, but no more.

31
Q

What does it mean for a company to be closely held?

A

This means that the company’s shares may be privately owned by a small group of investors and are not publicly traded.

32
Q

Separation of ownership and control gives…

A

Corporations permanence. Even if managers quit or are dismissed, the corporation survives. Today’s stockholders can sell all their shares to new investors without disrupting the operations of the business.

33
Q

What are the strengths of a corporation?

A

They can, in principle, live forever, and in practice they may survive many human lifetimes.

34
Q

What is a disadvantage of separation of ownership and control?

A

It can open the door for managers and directors to act in their own interests rather than in the stockholders’ interest.

35
Q

What are the drawbacks of a corporation?

A

It is taxed separately. Corporations pay tax on their profits, and shareholders are taxed again when they receive dividends from the company or sell their shares at a profit. By contrast, income generated by businesses that are not incorporated is taxed just once as personal income.

36
Q

What is double taxation?

A

Corporate tax on profits and personal tax on dividends or capital gain.

37
Q

What does the chief financial officer do?

A
  • Oversees the work of all financial staff.
  • Supervises all financial functions and sets overall financial strategy.
  • Deeply involved in financial policy and financial planning.
  • The CFO is the most important financial voice of the corporation and explains earnings results and forecasts to investors and the media.
38
Q

What does the treasurer do?

A
  • Responsible for financing, cash management, and relationships with banks and other financial institutions.
  • Looks after the firm’s cash, raises new capital, and maintains relationships with banks and other investors that hold the firm’s securities.
  • Main function is to obtain and manage the firm’s capital.
39
Q

What does the controller do?

A
  • Responsible for budgeting, accounting, and taxes.
  • Prepares the financial statements, manages the firm’s internal budgets and accounting, and looks after its tax affairs.
  • Main function is to ensure that the money is used efficiently.
40
Q

What do financial managers do?

A
  • Responsible for organising and supervising the capital budgeting process.
  • Refers to anyone responsible for an investment or financing decision.
  • They stand between the firm and outside investors.
  • On one hand, the financial manager is involved in firm’s operations, particularly by helping to make good investment decisions. On the other hand, he or she deals with financial institutions, other investors and with financial markets.
  • The role of the financial manager is to create value and create more cash flow than it uses.
41
Q

What are the common goals of shareholders in a corporation?

A

Maximise the current market value of shareholders’ investment in the firm.

42
Q

When shareholders have access to well functioning financial markets and institutions, this gives them the…

A

Flexibility to manage their own savings and consumption plans, leaving the corporation’s financial managers with only one task, to increase market value.

43
Q

Why is profit maximisation not a well defined corporate objective?

A
  • A corporation may be able to increase current profits by cutting back on outlays for maintenance or staff training, but that will not add value unless the outlays were wasteful in the first place. Shareholders will not welcome higher short term profits if long term profits are damaged.
  • A company may be able to increase future profits by cutting this year’s dividend and investing the freed up cash in the firm. That is not in the shareholder’s best interest if the company earns only a very low rate of return on the extra investment.
44
Q

What is the fundamental principle of financial management?

A

Shareholder wealth maximisation.

45
Q

What is the financial objective for public companies?

A

To maximise share prices and/or dividend payout.

46
Q

What is the financial objective for private companies?

A

To maximise the value of the existing owners’ equity.

47
Q

Why is shareholder wealth maximisation a well defined corporate objective?

A
  • No ambiguity in the criterion.
  • No short run vs long run issue.
  • Shareholder view; anyone with financial interests in the corporation.
  • Shareholders are residual owners in a firm.
48
Q

What is the problem with profit maximisation as a financial objective?

A
  • Share prices bear little relationship to profits figure, for example, biotechnology companies or new economy ventures do not have high earnings or profits but they have the ability and potential to grow in the future.
  • Ambiguous, we do not know what earnings to maximise; before or after tax or earnings per share.
  • Long run vs short run issue.
  • Quality (risk) of earnings; higher quality earnings are likely to be riskier.
  • Accounting profits are just a paper figure, cash flows should be considered. Profits cannot be spent.
49
Q

What is the problem with EPS as a financial objective?

A
  • EPS is widely used as a measure of corporate success; return to equity.
  • A measure of profitability, not wealth generation; the same criticisms as profit maximisation (long run vs short run issue etc).
  • Represents investor’s share of the income generated by the company according to an accounting formula.
  • EPS = (net income - preference dividend) / common shares outstanding. There is no relationship between EPS and share price or EPS and wealth.
50
Q

As long as a corporation’s proposed investments offer higher rates of return than its shareholders can earn for themselves in the stock market, its shareholders will…`

A

Applaud the investments and the market value of the firm will increase.

51
Q

If the company earns an inferior return, shareholders will be unhappy…

A

Market value falls, and stockholders clamour to get their money back so that they can invest on their own.

52
Q

The minimum rate of return is called the…

A

Hurdle rate or opportunity cost of capital.

53
Q

It is called an opportunity cost of capital because…

A

It depends on the alternative investment opportunities available to shareholders in financial markets.

54
Q

Whenever a corporation invests cash in a new project…

A

Its shareholders lose the opportunity to invest the cash on their own.

55
Q

Corporations increase value by…

A

Accepting investment projects that earn more than the opportunity cost of capital.

56
Q

A corporation should direct cash to investments that…

A

Add market value, compared with the investments that shareholders could make on their own.

57
Q

What is opportunity cost of capital?

A

The minimum acceptable rate of return on capital investment set by the investment opportunities available to shareholders in financial markets.

58
Q

Opportunity cost of capital depends on…

A

The risk of the proposed investment project.

59
Q

What are agency problems?

A

Managers are agents for stockholders and are tempted to act in their own interests rather than maximising value.

60
Q

What are agency costs?

A

Value lost from agency problems or from the cost of mitigating agency problems.

61
Q

Examples of how managerial objectives may be different from shareholder goals.

A

Job security, survival, expensive perquisites (benefits), corporate power or wealth, empire building by overaggressive investment, overconfident acquisitions of other companies, takeover bids, high remuneration etc.

62
Q

Explain the agency behaviour.

A

Someone (the principal) hires another (the agent) to represent his or her interests.

63
Q

Agency problems can lead to…

A

Outrageous behaviour. When the former CEO of Tyco, threw a $2million birthday bash for his wife, he charged half the cost to the company. The former boss of Hollinger International, used the company jet for a trip with his wife to Bora Bora. These are extreme examples, the agency problems encountered in the ordinary course of business are often subtle and mundane. However, agency problems do arise whenever managers think just a little less hard about spending money that is not their own and whenever stakeholder’s interests do not coincide.

64
Q

Agency problems arise within many different relationships such as shareholders and debt holders, senior and junior managers etc. They arise when…

A

Stakeholders’ interests do not coincide.

65
Q

Agency problems are controlled in practice in three ways. What are they?

A
  • First, corporations set up internal controls and decision making procedures to prevent wasteful spending and discourage careless investment.
  • Second, corporations try to design compensation schemes that align managers’ and shareholders’ interest.
  • Third, the corporations are constrained by systems of corporate governance.
66
Q

How to create a good executive compensation scheme/package?

A
  • Be clearly defined, impossible to manipulate and easy to monitor.
  • Include a fixed base salary plus an annual award tied to earnings or other measures of financial performance (plus rewards linked to changes in shareholder wealth (e.g. economic value added, EVA)).
  • Match managers’ time horizon to shareholders’ time horizons.
  • Encourage managers to adopt the same attitudes risk as shareholders. Usually managers are more risk averse than shareholders because managers’ wealth is closely linked to the survival and function of the company.
67
Q

The more senior the manager…

A

The smaller the base salary as a fraction of total compensation.

68
Q

Compensation is not all…

A

In cash, but partly in shares.

69
Q

Stock options provide…

A

Incentives to maximise stock price per share. Executives have the right to buy the company’s stock at a specified price for a finite period of time (call options).

70
Q

What is corporate governance?

A

The laws, regulations, institutions, and corporate practices that protect shareholders and other investors.

71
Q

When scandals happen, we say that…

A

Corporate governance has broken down.

72
Q

What are the elements of good corporate governance?

A
  • Legal requirements, for example, insider trading is forbidden/illegal.
  • Board of Directors; there should be independent/non executive directors, as well as a separation of chairman and CEO, otherwise if one person holds and serves both positions they become too powerful.
  • Activist shareholders; institutional shareholders and block holders have more power and ability to actively monitor the performance of a corporation. Monitoring can reduce agency costs and prevent illegal and unethical actions taken by managers.
  • Takeovers; if a manager does a bad job or performs poorly, the company will become a potential target for other investors. The possible threat of a takeover can reduce agency costs and agency problems.
  • Information; transparency for investors, there should be no information asymmetry. Investors should have a high level of, detailed and up to date information for corporate governance to work effectively. This way agency costs can be reduced and controlled.

2nd Year - Finance 2 (10 decks)

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