Week 1

Question 1

What decisions are typically included in corporate finance?

Answer 1

Investment decisions, financing decisions, and Asset management decisions?

Question 2

What does the investment decision primarily consist of?

Answer 2

The capital budgeting decision: what real assets (such as machinery, building, projects or businesses) should the firm invest in?

Question 3

What does the financing decision primarily consist of?

Answer 3

Capital strcuture decision: How will the firm raise funds for the required investments? Use of equity or debt finance or internal profits?

Payout decision: Does the firm retain earnings for investment or pay dividends to shareholders?

Question 4

What does the asset management decision primarily consist of?

Answer 4

How to ensure smooth day-to-day operations.

Question 5

What is the balance sheet model of the firm? What do our investment and financing decisions primarly relate to?

Answer 5

In the balance sheet model of the firm the total value of assets are given by: current assets and fixed assets (both tangible and intangible).
The total firm value to investors consists of the current liabilities, long-term debt, and shareholder equity.

Our investment decisions are mainly related to the fixed assets, while the financing decisions relate to the total firm value to investors components.

Question 6

What is the net working capital?

Answer 6

The net working capital is given by the current assets minus the current liabilities.

Question 7

What is the financial manager’s primary goal?

Answer 7

To increase the value of the firm by: Selecting value creating projects and making wise financing decisions.

They act on behalf of the owners of the firm by making investment decisions, financing decisions, and assets management decisions

Question 8

What are some of the main potential goals for financial management?

Answer 8

To increase the firm’s value by either: Maximizing profits, minimizing costs, maximizing market share, or maximizing shareholders’ wealth(Under shareholder governance orientation).

Question 9

What are the two governance models for a company?

Answer 9

Shareholder governance orientation and stakeholder governance orientation.

Question 10

What is the primary goal of financial management in a shareholder governance orientation? How can we measure this?

Answer 10

Under shareholder governance orientation the goal of financial management is to maximize shareholders’ wealth.

This can be measured as the current value of existing shares, this is the market value of equity, and is the share price of the company * the number of shares.

The share price represents the present value of future cash flows expected to be provided by the firm, it is what the shareholders have a claim to.

Question 11

What are the main challenges with shareholder governance orientation?

Answer 11

The main challenges with shareholder governance orientation are the concerns of other stakeholders, and corporate social responsibility.

Question 12

What is the agency problem?

Answer 12

Stockholders hire an agent to act on their behalf, giving this agent (the manager) decision making power, this is an agency relationship between the stockholders (principal) and the managers (agent) of the company.

The agency problem arises when interests of the principal and agent are not aligned.

Question 13

How can agency problems occur in corporations? How do agency costs relate?

Answer 13

Agency problems are caused by a seperation of ownership from corporate control, this creates a potential conflict of interests between the shareholders and managers.
This occurs due to managerial goals beind different from shareholders’ goals, such as growth and size of the company, which are not necessarily equivalent to increased shareholder wealth.

To limit the divergence shareholders and/or management need to incur costs, these costs are known as agency costs, and represent a loss in the wealth of shareholders.

Question 14

What are two major ways for shareholders to limit agency problems?

Answer 14

Incur monitoring costs, e.g having a greater percentage of management pay linked to company performance targets, use of bonus or option and share ownership plans, threat of takeovers can lead to better management, having financial statements audited by external auditors, appointing independent directors to the firm’s board of directors.

Managers can also incur bonding costs to control their actions, this is things like allocating part of their salary to purchasing shares in the company.

Question 15

What is the present value and future value?

Answer 15

The present value is the value of an investment today, the future value is the value of the investment at some future date.

Question 16

What is the net present value? When should we take an investment on?

Answer 16

The net present value of an investment is the present value of the expected cash flows, less the cost of the investment.

If the net present value is positive we should take on the investment.

Question 17

How do we find the number of periods to get to a future value?

rearrange 10000 = 5000 * (1.10)^T to make T the subject.

Answer 17

Use logs

log(10000/5000) = T * log(1.10).
log(2)/log(1.10) = T

Question 18

What interest rate do we use if the investment compounds more than once a year and we have annual percentage rate?
How does the EAR relate?

Answer 18

(1+(annual percentage rate/number of periods in year))^number of periods in year * number of years.

The effective annual rate (EAR) is the rate that makes (1+ EAR)^number of years = (1+(annual percentage rate/number of periods in year))^number of periods in year * number of years.

Question 19

What is a perpetuity?

Answer 19

A constant stream of cash flows that lasts forever.

Question 20

What is a growing perpetuity?

Answer 20

A stream of cash flows that grows at a constant rate forever.

Question 21

What is an annuity?

Answer 21

A stream of constant cash flows that lasts for a fixed number of periods.

Question 22

What is a growing annuity?

Answer 22

A stream of cash flows that grows at a constant rate for a fixed number of periods.

Question 23

What is the equation for the present value of a perpetuity?

Answer 23

Cash flow divided by discount rate.

Question 24

What is the equation for the present value of a growing perpetuity?

Answer 24

Cash flow divided by ( discount rate - growth rate).

Question 25

What is the equation for the present value of an annuity?

Answer 25

Present value of annuity = (C/R)*(1-(1/(1+r)^T))

Question 26

What is the equation for the present value of a growing annuity?

Answer 26

Present value of growing annuity = (C/(r-g))*(1-((1+g)/(1+r))^T)

Question 27

What is the effective annual rate with discrete compounding? What about continuous?

Answer 27

In discrete compounding the effective annual rate is equal to (1+ annual percentage rate/periods)^periods - 1.

In continuous compounding e^APR = (1+EAR)

Question 28

When does an annuity have it’s first payment? What about an annuity due? What is the difference between the present value and future value of the two assuming the period is the same?

Answer 28

An annuity has its first payment at the end of the year/ the start of the next year. In an annuity due the first payment is at the start of the current year.

The present value of an annuity due is equal to the present value of an annuity * 1+discount rate. The future value of an annuity due = the future value of an annuity * 1+discount rate.