Topic 1 - Chapter 1: Introduction

Question 1

Name the three types of business organisations

Answer 1

Sole proprietorship
Partnership
Corporation

Question 2

What is a sole proprietorship?

Answer 2

A business owned by a single individual
Low cost of setup
The owner keeps all the profits
The owner has unlimited liability and is responsible for the debts
Ownership and management are the same (no separation).
Business and ownership associated, therefore ownership cannot be transferred.
Access to capital very limited
Taxed in personal income tax

Question 3

What are the three primary decisions that financial managers make?

Answer 3

Capital budgeting - the process of planning and managing a firms long term investments
Capital structure - the mix of long term sources of funds used by a firm to finance its operations
Working capital management - managing short term investment in assets and liabilities and ensuring the firm has sufficient resources to maintain operations.

Question 4

What is a partnership?

Answer 4

An association of two or more individuals joining together as co-owners to operate a business for profit, e.g. a legal practice operated by a number of legal practitioners. There can be a limited partnership which shares characteristics of a limited corporation.
Low cost of setup
The owners keep all the profits
The owners have unlimited liability and are responsible for the debts. In limited partnership, limited partners have limited liability
Ownership and management are the same (no separation). In a limited partnership, General partners manage the firm.
Business and ownership associated, therefore ownership cannot be transferred.
Access to capital very limited
Taxed in personal income tax

Question 5

What is a corporation?

Answer 5

An entity that legally functions separately and apart from its owners. eg. Woolworths.
Liability of the owner is limited to the amount of their holding in the company.
Ownership is separate from management
Ownership can be transferred
Capital raising is easy through raising of shares in public companies. Private companies have easier access to capital if they are large
Income taxed at the company rate

Question 6

How does the role of the financial manager change over time?

Answer 6

It is reflective of the economy and business cycles.
During an economic recession, there is a sharper focus on simply surviving (working capital management focus). During good times the focus is on developing ways of controlling these flows, e.g. in investment and budgeting decisions

Question 7

What is the goal of the financial manager?

Answer 7

The goal of the financial manager is to maximise

shareholder wealth, that being to maximise the value of the firm and its shares.

Question 8

What is the agency problem?

Answer 8

Agency theory is the problem that arises out of the separation of ownership and management. The agency theory states that agents (managers) will act in their own interests which may not be aligned with the interests of the shareholder (principals).

Question 9

What is capital budgeting?

Answer 9

The process of planning and managing a firms long term investments.

Question 10

What is capital structure?

Answer 10

The mix of long term sources of funds used by a firm to finance its operations

Question 11

What is working capital management?

Answer 11

Managing short term investment in assets and liabilities and ensuring the firm has sufficient resources to maintain operations.

Question 12

What is equity?

Answer 12

The ownership interest in a corporation. The shareholders investment including the profits accumulated and retained in the business.

Question 13

Why do companies compensate executives with options based on long-term increases in the value of the company’s stock?

Answer 13

This is in response to the agency problem. Share-based compensation plans imply that decisions made to benefit shareholders will also benefit
themselves.

Question 14

What are the five principles of financial management?

Answer 14

Money has a time value
There is a risk return trade-off
Cash flows are the source of value
Market prices reflect information
Individuals respond to incentives

Question 15

Explain Principle 1: Money has a time value.

Answer 15

A dollar earned today is worth more than a dollar earned in the future. Therefore, a dollar earned in the future is worth less in the present.
For example, an amount of $1000 received today could be invested in an opportunity that earns 10% in the 12 months, that would then mean that the organisation has $1100 in 12 months. Therefore, to have received $1000 (although an equivalent amount) in 12 months would have missed the opportunity to earn that interest, hence money invested is worth more over time and has a time value.

Question 16

Explain Principle 2: Risk return trade off

Answer 16

We will not take on additional risk unless we expect to be compensated with additional return
For example, if a business invests in a startup share price with no proven track record and a high potential of bankruptcy or failure within the first three years, it would expect a return to reflect that they may lose their money. Given that the organisation could invest their money into the bank risk free at 4%, they would expect the returns from the startup to well exceed this otherwise they would simply put the money into the bank. Conversely, high returns typically involve an investor taking on additional risk.

Question 17

Explain: Cash flows are the source of value

Answer 17

Accounting profits are a measure of business performance, however only cash can be taken out of the business, therefore is the source of value or wealth.
Only incremental cash flows (the difference) are relevant when making financial decisions. For example, depreciation is an accounting measure and has no benefit on cash flows.

Question 18

Explain: Market prices reflect information

Answer 18

Prices reflect all information available. This translates into an assumption that the markets are quick (efficient) in response to changes in relevant factors and the prices are right,
e.g. there is no such thing as ‘insider trading’.

Question 19

Explain: Individuals respond to incentives

Answer 19

This relates to the agency problem. The theory states that agents work in their own interests, rather than that of the shareholder and therefore must have an incentive to align to the interests of shareholders. Share options are a common incentive in this regard.