Part 1 - Introduction Flashcards
Define a corporation
A corporation (selskap) is a collection of companies that act as a single entity, and is recognized as such by law.
What is the aim of the book?
The aim of the book is to understand how people in corporations make financial decisions.
Name a key factor of why corporations are useful
The ability to easily exchange ownership shares
Name the major types of firms
There are 4 major types of firms:
1) The sole proprietorships
2) Partnerships
3) Limited liability companies
4) Corporations
the most important one, and our focus, is the corporations.
Elaborate on sole proprietorships
Run and owned by a single individual.
Usually very small, typically a single person. Can have employees.
They are technically the most common type of organizational form, but they (obviously) do not account for the same majority share in regards to revenue.
Sole proprietorships have a couple of characteristics:
1) They are straightforward to set up.
2) No separation between the firm and the owner. Can only have a single owner. Only one dude can hold ownership.
3) the owner has unlimited personal liability for any of the debts of the firm. Personal bankruptcy awaits any owner of a sole proprietorship if he fails to repay his loans.
4) The life of a sole proprietorship follow the life of the owner. it is difficult to transfer the ownership
Elaborate on the partnership
Partnerships are one of the big four.
THey are the same as the sole proprietorships, but they have multiple owners.
Thus:
1) All owners are fully liable for the firms debt. The lender can force any of the loaners to repay.
2) The partnership will end on the death of a single individual, however there are ways to avoid it.
What is a limited partnership?
A limited partnership is a partnership where some of the individuals that are listed as partners/owners are so-called “limited”. Being limited holds the advantage of only being liable for the investment he made. This is called limited liability.
Also, the death of a limited partner does not force a partnership to liquidate.
A limited partner has no management autohority.
Name examples of limited partnerships
private equity funds and venture capital funds are dominated by limited partnerships.
What is the name of the partner with authority in a limited partnership?
General partner.
why is the limited partnership good for PE and VC funds?
Multiple reasons. Firstly, it avoids double taxation.
Secondly, the roles are very clearly defined between the general partners and the limited partners.
and of course: Limited partners (people who allocate money for saving) obviously do not want to be liable. Can be easy to miss this one, as it is so obvious. Yet it is a cornerstone of the firm structure.
What are LLC?
Limited Liability Companies.
these are limited partnerships, but completely without general partners.
This means that all of the partners are unliable. Can be beneficial.
Can have different structures. Can be member-managed, manager-managed etc.
What is the main distinguishable fact about corporations?
They are legally, considered as a separate entity that is not legally tied to the owners. It is a judical person.
The owners are not liable for the actions of the corp, and the corp is not liable for the actions of the owners. sort of.
Define the equity of the corporation
The collection of outstanding shares
A stockowner is entitled to ….
Dividend payouts.
What is perhaps the most important difference between the types of organizational forms? What is the major dealbreaker in terms of what you’d select?
Their tax rules.
The corporation is defiend as a separate legal entity (from its shareowners). THerefore it is also subject to taxation.
Because of this, shareholders pay taxes twice. First, the corporaiton pays taxes on its profits. Then the shareowners pay taxes on the dividends.
What is the primary advantage of corporations?
The extreme power of funding
The 3 tasks of the financial managers in a corporaiton is..?
Making investment decisions
Managing financing decisions
Managing cash flows
What are agency problems?
Agency problems refer to problems when the different types of actors in an organization have differing opinions/goals.
The agency problem is rypically used to describe the situation where a manager/managers act in their own self-interest, despite being hired by the shareholders to act according to the shareholders.
How is the agency problem typically handled in practice?
Recall agency problem is the problem if managers acting in their own self interest rather than in the interest of the shareholders.
Typically, the shareholders want to ensure that the number of decisions that the manager has to make that can cause confliction is limited. This is most likely done through compensation packages that align the goals of all actors.
elaborate on “hostile takeover”
Hostile takeover is a situation where a group of investors, commonly referred to as a “corporate raider”, purchase a large fraction of the corporation which gives them enough votes to replace the board of directors and the CEO. With a new superior management team, the stock is likely to rise. The important point is that the management team is not involved, and thus the raider is going directly to the shareholders.
Hostile takeovers are usually considered bad etiquette, as they usually happen under the radar and with the goal of taking over the corporation.
However, the hostile takeovers happen, and they usually occur because of a number of reasons.
1) The stock is severely undervalued. Maybe the current board of directors and CEO is close friends with the shareholders and have become enthreched with bad results. The new hostile acquirer can see upside potential.
2) The corporation may hold valuable technology or other assets that the acquierer want to possess.
Hostile takeovers are typically initiated in two ways:
1) Tender offer: Raider gives a tender offer to purchase the shares at a premium.
2) Proxy fight, where the raider persuade the shareholders to vote out the board of directors and CEO, and vote in the raider so that the takeover can be accepted.
What exactly makes a takeover “hostile”?
Whether the current board of directors approve or not.
What is the role of lenders in the corporation?
Lenders are the ones of lend out money. They do not receive control, but if the corp is unable to repay its debt, the lenders will have the right to acquire assets. Then they possess these assets, and may use them as they want.
bankruptcy need not result in liquidation of the firm. In some cases, it will be in the interest of the lenders to run the corporation
it is important to recognize the two parts of owners of corporations. Debt holders and equity holders. Both are investors.
Corporate bankruptcy is a change in ownership, not necessarily a failure of operation.
Elaborate on how investments in a firm is typically valued, and how investors look at their investment
Investors want to see their investments appreciate in value. This is done through the price of the shares.
the share price is difficult to measure if the corporation is private.
If the corporation is public, it is easy to measure, as the shares are traded publicly and commonly (typically).
Define a liquid investment
An investment is said to be liquid if it is easy to buy and sell the investment QUICKLY at approximately the same price.
Liquidity is attractive.
Name the different types of stock market
Primary and secondary.
The primary market is a market where the corporation itself is the issuer/seller of the stock.
The secondary market is where the majority of transactions occur, and these transactions occur without the involvement of the corporation.
What is the role/effect of the limit order?
the limit order create the bid-ask spread in the modern age of technological “market makers”. The list of limit buy orders compete against the list of limit sell orders. The difference between the highest limit buy order and the lowest limit sell order makes up the bid-ask spread.
So, in essence, it is the limit orders that crteate the spread.
the collection of all limit orders is known as …
The limit order book
What is the role of liquidity in regards to limit orders?
Limit orders provide liquidity.
Market orders, on the other hand, are said to be takers of liquidity.
Define “book value of equity”
book value of equity is the same as shareholder/stockholder equity, and refer to the total assets less the totla liabilities.
Does the book value of equity supply us with accurate informaiton?
No. We want it to be, but it usually is not.
The most important why this is the case, is because proptery and other assets are likely to be valued based on historical cost net of depreciation. All assets are that are subject to “depreciation” is likely undervalued to some degree.
Also, there are a lot of assets that never show on the balance sheet. for instance, expertise.
We have to add that the book value of equity will be correct from an accounting view. It is just not an accurate representaiton of the true value of the corporation.
What is market value of equity?
Same as market capitalization. Shares outstnading times market share price.
This is the value that the equity is “worth”. it is not based on historical cost of assets, but rather based on future expectation.
how do we calcualte the present value of a cash flow stream?
We use the formula that goes like the picutre:
Basically take all the different cash flows at the various time points and calculate the present value.
elaborate on term structure
Term structure refers to the relationship between interest rate and time horizon of the investment.
Term structure is a term that is used in conjunction with interest rates. For instance: “The relationship between the investment term and the interest rate is called the term structure of interest rates”.
In informal words, it is about how a long term investment will usually yield a different interest rate from investments with a shorter term. the relationship is called “yield curve”.
This is a crucial concept. The interest we will get is time dependent. When chosen, the interest rate remain the same (for bonds). Therefore, one must be aware of high the rate will change with various times to maturity.
This logic is appleid backwards to compute the present value of the investments of varying times to maturity. We already know the formula for discounting one cash flow. We generalize it to create the following formula to compute the present value of a stream of cash flows: (image).
Why do we use different interest rates? is it not a locked one?
the reason the interest is changing is because we are discounting the flow to find the present value. And the yield curve represent sort of the current rate we’d get for various time horizons. So since what we are actually doing is comparing the specific investment cash flow against the risk-free option, we need to use those rates in our discounting procedure.
Always remember what present value represent.
