Topic 1 - Introduction, Corporate Finance, Corporate Governance

Question 1

What is the purpose of Corporate Finance?

Answer 1

The purpose for the firm is to create value for the owner

Question 2

Value of the firm =

Answer 2

V = D + E

Question 3

When thinking in terms of value creation, what is the financial managers’ main goal?

Answer 3

The goal of the financial manager is to choose the ratio of debt to equity that makes the value of the firm as large as it can be

Question 4

What are the 3 considerations of cash flows?

Answer 4

1. Identification of cash flows
2. Timing of cash inflows
3. Risk of cash flows

Question 5

Explain the ‘Identification of Cash Flows’ as a consideration of cash flows

Answer 5

Corporate finance is interested in whether cash flows are being created

This compares to the accounting perspective, which looks at profit being made in terms of sales and costs

Question 6

Explain the ‘Timing of Cash Inflows’ as a consideration of cash flows

Answer 6

The value of an investment made by a firm depends on the timing of cash flows

Individuals prefer to receive cash flows earlier rather than later as this allows for reinvestment

Question 7

Explain the ‘Risk of Cash Flows’ as a consideration of cash flows

Answer 7

The firm must consider the risk of cash flows since their amount and timing arent usually known with certainty

most investors have an aversion to risk

Question 8

Define risk aversion in the context of investors

Answer 8

Investors are described as being risk averse because they are more inclined to avoid or minimise risk in their investment decisions

Question 9

List 5 possible goals of financial management

Answer 9

1. Avoid financial distress
2. Beat the competition
3. Maximise sales or market share
4. Minimise costs
5. Maximise profits

Question 10

Describe how firms raise money to invest in new projects

Answer 10

They could either
1. borrow money
2. give up a fraction of ownership in their firm

if they borrow money, the firm takes out a loan and agrees to pay it back PLUS interest.
They can issue debt securities in the financial markets.

If they sell part of their company for a set amount of cash, they can do this through private negotiation or a public sale.

Question 11

What are debt securities?

Answer 11

Debt securities are contractual obligations to repay corporate borrowing

Question 12

What are equity securities?

Answer 12

Equity securities are shares that represent non-contractual claims to the residual cash flow of the firm

Question 13

What are Agency Problems?

Answer 13

Agency problems arise in situations where one party (the principal) delegates decision-making authority or control to another party (the agent) to act on their behalf. These problems arise due to conflicts of interest between the principal and the agent.

Question 14

What causes Agency Problems?

Answer 14

1. Differing Objectives e.g. Shareholders seek to maximise the value of their investment but managers may have different objectives like job security and personal wealth.
2. Information Asymmetry e.g. managers posses more information about day-to-day operations and financial health of the company than shareholders. Managers may choose to not disclose relevant information to shareholders, making it difficult for shareholders to assess the performance of the firm
3. Short-Termism e.g. managers may be motivated to focus on short-term results to maximize their performance-based compensation. This short-term focus may not align with the long-term interests of shareholders who seek sustainable, long-term value creation.

Question 15

What is Corporate Governance?

Answer 15

The system by which companies are directed and controlled. Corporate governance is aligning the incentives of managers so that they can act the interest of shareholders

Question 16

What corporate governance mechanisms are put in place to mitigate agency problems?

Answer 16

1. Stakeholder Engagement: Maintaining open communication with shareholders helps build trust.
2. Transparency and Disclosure:
   Timely and transparent financial reporting helps shareholders assess the company’s performance and financial health.
3. Executive Compensation:
   Tying executive compensation to the company’s performance aligns the interests of managers with those of shareholders. Stock options, bonuses, and other incentives should be linked to long-term value creation rather than short-term gains.