Week 11 - Managerial Finance Flashcards
What does finance involve?
Finance is forward-looking—it is about making decisions based on expected outcomes.
Finance involves:
Comparing expected costs and benefits before making an investment
Analysing risk vs. reward in financial decisions
Using past data to forecast future performance
What are the two basic principles of finance?
- time value of money (TVM)
- uncertainty (risk and return)
What is time value of money?
A dollar today is worth more than a dollar tomorrow.
Why? Because money today can be invested and earn interest.
What is uncertainty (risk and return)?
A safe dollar is worth more than a risky dollar.
Investors prefer certainty—so risky investments must offer higher potential returns to be attractive.
What are the 4 main areas of finance?
- Corporate finance
- Investments
- Financial institutions
- International finance
What is corporate finance?
Corporate finance is about making financial decisions for businesses to maximise their value.
It focuses on investment, financing, and daily financial management
Explain long term investment decisions (capital budgeting)?
What projects should the firm invest in?
Companies must decide where to allocate capital to generate the highest returns.
Examples:
Expanding into a new market
Purchasing new machinery or technology
Developing new products
Explain financing decisions (capital structure)
Where does the company get the money for investments?
Firms need to decide the right mix of debt (loans, bonds) and equity (stocks, retained earnings).
Key questions:
Should the company issue new stock or borrow money?
How much debt is too much?
How does financing impact profitability and risk?
Explain managing everyday financial activities (working capital management)
How does the company handle day-to-day finances?
Ensures the company has enough cash to cover daily expenses like:
Paying employees and suppliers
Managing inventory
Collecting payments from customers
What do investments focus on?
on managing financial assets such as stocks, bonds, and other securities to maximise returns while managing risk
What are key areas in investments?
- pricing stocks and bonds
- risk and return analysis
- asset allocation
How are stocks and bonds priced?
investors need to determine the fair value of financial assets to make informed decisions.
Stock prices depend on:
Company earnings and growth potential
Market conditions and investor sentiment
Discounted cash flow (DCF) models (predicting future earnings)
Bond prices depend on:
Interest rates (when rates go up, bond prices go down)
Credit risk (the likelihood of default)
How is risk and return analysed?
Risk and return go hand in hand—higher returns usually come with higher risk.
Investors calculate:
Expected return – How much profit they expect to earn.
Standard deviation/volatility – Measures how much the return fluctuates.
Beta (β) – A stock’s sensitivity to overall market movements.
Diversification helps reduce risk by spreading investments across different assets.
What are financial institutions?
companies that specialise in financial services, such as banking, investment, and risk management.
They play a crucial role in the economy by facilitating transactions, lending money, managing risk, and providing investment opportunities
What is involved in asset allocation?
How should money be distributed among stocks, bonds, and other assets?
Common strategies include:
Conservative Portfolio: More bonds, fewer stocks (lower risk).
Aggressive Portfolio: More stocks, fewer bonds (higher risk, higher return).
Balanced Portfolio: A mix of stocks, bonds, and other investments.
What are examples of financial institutions?
banks:
commercial banks - Offer savings accounts, loans, credit cards, and payment services.
Examples: JPMorgan Chase, Wells Fargo, HSBC
investment banks - Help companies raise capital, assist with mergers & acquisitions, and trade financial securities.
Examples: Goldman Sachs, Morgan Stanley
central bank - Regulate the money supply, set interest rates, and ensure financial stability.
Examples: Federal Reserve (U.S.), European Central Bank (ECB), Bank of England
insurance companies - Provide risk management by offering protection against financial losses (e.g., life, health, and property insurance).
They pool premiums from policyholders to pay for claims when needed.
Examples: AIG, Allianz, Prudential
What are 3 career opportunities in financial institutions?
Banker – Works in commercial or investment banking, handling loans, financial transactions, and client relationships.
Actuary – Uses statistics and financial theory to assess risks, primarily in insurance and pension funds.
Underwriter – Evaluates financial risk and decides on issuing insurance policies or loans.
What is international finance?
management of financial resources in a global context, and it’s crucial for businesses with overseas operations or those involved in investing in foreign securities
What are examples of international finance?
overseas operations
investing in foreign securities
What is involved in overseas operations?
Currency Risk: The value of foreign revenues can fluctuate due to changes in exchange rates, potentially impacting profits.
Tax Implications: Different countries have different tax rates and regulations, which can influence financial decisions.
Regulatory Environment: Understanding the legal and regulatory environment in foreign countries is crucial for compliance.
What is involved in investing in foreign securities?
Exchange Rates: The value of a foreign currency affects the return on investment. If the currency depreciates, the investment’s value in the home currency can decrease.
Political Risk: Changes in government policies, instability, or nationalisation can pose a risk to investments
Diversification: International investing can provide portfolio diversification, but it also introduces currency and country risks.
What are the three forms of business organisations within corporate finance?
sole proprietorship, partnership, corporation
What is a sole proprietorship?
it is owned by one person who is the manager
it has unlimited liability (personally responsible for all debts and obligations of the business)
the owner has full control over all decisions
What are advantages and disadvantages of a sole proprietorship?
Advantages: Simple to set up, full control, and the owner keeps all profits.
Disadvantages: Unlimited liability, harder to raise capital, and business ends if the owner dies.
What is a partnership?
owned by two or more owners
can be limited liability (limited partnership) or unlimited liability (general partnership)
ownership is combined with management responsibilities
legal contract of partnership required
examples: many legal and accounting firms
What are the advantages and disadvantages of a partnership?
Advantages: Shared responsibility, more capital can be raised, and different skill sets can be brought to the table.
Disadvantages: Unlimited liability (in general partnerships), potential for conflicts between partners, and shared profits.
What is a corporation/ firm?
owned by many shareholders
limited liability (shareholders are only liable up to the amount of their investment in the company)
ownership and control may be separate, shareholders elect a board of directors who appoint management
the company is managed by a separate team, not the owners
What are advantages and disadvantages of a corporation?
Advantages: Limited liability, easier to raise capital (through stock issuance), and continuity of the business (it doesn’t end if the owner/shareholder dies).
Disadvantages: More complex to set up and maintain, subject to regulations and taxation at both the corporate and shareholder level (double taxation), and less control for individual owners.
What is unlimited liability?
investors are personally responsible for all business debts, even beyond the amount they invested
What is limited liability?
the most an inventor can lose is the amount they initially invested into the business
their personal assets are protected from business debts
What is the risk of unlimited liability?
In the event that the business fails or accrues debts it cannot pay, the owners may have to use their personal assets (like their home, savings, etc.) to cover the liabilities.
What is the risk of limited liability?
If the business goes bankrupt or faces legal claims, shareholders or investors are only at risk for the value of their investment (e.g., the money they spent to purchase shares in a corporation).
How do you payoff to debt holders of a corporation?
Debt holders (creditors) are typically promised a fixed amount, £F, which is the face value of the debt (for example, the principal amount of a bond).
If the value of the firm is less than the debt value (£F), debt holders receive whatever the firm is worth (X), since the firm cannot repay the full debt.
If the value of the firm is greater than or equal to the debt value (£F), debt holders receive the full promised amount, which is £F
algebraically as:
Debt holder’s claim = min(£F, X)
£F is the face value of the debt.
X is the actual value of the firm.
How do you payoff to equity holders of a corporation?
Equity holders (shareholders) are entitled to the remaining value of the firm after debt holders have been paid
If the value of the firm is less than the debt value (£F), there is no remaining value for equity holders, so they receive nothing.
If the value of the firm is more than the debt value (£F), equity holders receive everything above the debt value, i.e., the remaining value after debt is paid off.
algebraically as:
Shareholder’s claim = max(0, X – £F)
£F is the face value of the debt.
X is the actual value of the firm.
How do you payoff to debt holders of a corporation in a diagram?
x axis, Value of the firm (X)
y axis, Payoff to debt holders
line is upward sloping then is horizontal
if the value of the firm is more than £F. debt holders get a maximum of £F
How do you payoff to equity holders in a diagram?
x axis, Value of the firm (X)
y axis, Payoff to shareholders
line is horizontal on the x axis a bit then is upward sloping
if the value of the firm is less than £F, shareholders get nothing
What is the structure of a corporation?
- Hire professional management to run the company (CEO, CFO..)
- This management buys productive assets (property, equipment…)
- They can buy these assets by borrowing money (debt), or by attracting shareholder’s capital (equity) by selling shares essentially
the corporation is a legal entity and is a separate ‘person’ away from owners (shareholders)
- Debt holders provide the corporation with debt financing, lend money to the corporation in exchange for interest payments, talk directly to management about whether their debt is going to be repaid
- Shareholders do not directly have control over management, they invest in the corporation by buying equity (shares of stock), they are last to get money out of the assets, dont have control over a corporation.
They get voting rights and allowed to vote for the directors on the board - Board of directors, an oversight committee, look after the shareholders, can replace bad managers and the course of where the corporation is going
Who is an owner of a corporation?
someone who provides funds, takes the business risk and doesnt have any claim to pre-specified payment like debt holders
shareholders provide the funds necessary to finance the company by buying equity (shares)
debt holders (creditors) provide funds by lending money to the corporation, usually in the form of bonds or loans
Who takes business risk?
Shareholders take the business risk because their returns (if any) depend on the company’s performance. If the company does well, shareholders benefit through dividends and capital gains (increase in stock price). If the company performs poorly or goes bankrupt, shareholders may lose all or part of their investment.
Debt holders face some risk, but they are not exposed to the upside of the business as shareholders are. They are entitled to a fixed payment (interest) and repayment of principal, regardless of the company’s performance, but they do face risk if the company defaults or goes bankrupt.
Who has a financial stake in a corporation?
Shareholders have a direct financial stake in the corporation as owners. They benefit from the corporation’s success (through dividends and capital gains) but are last in line to get paid if the company faces financial difficulty.
Debt holders (creditors) also have a financial stake because they provide loans to the company. They are entitled to receive their principal plus interest. While they don’t benefit from the upside (like shareholders), they are more secure because they are paid before shareholders in the event of liquidation.
those who do not provide finance
- employees, customers, supplies, government (dont own shares)
What is the internal organisational chart for a corporation?
- Board of Directors
- Chairman of the Board and Chief Executive Officer (CEO)
- President and Chief Operations Officer (COO)
3a. Vice President Marketing
3b. Vice President Finance (CFO)
i. Treasurer
ii. Controller
3c. Vice President Production
What does the CEO do?
institutes rules and policies thats set by the board of directors
What does the COO do?
responsible for the day-to-day activity of the company and the person reports back to the CEO
What does the CFO do?
responsible for managing financial risk for a company
has two teams that this person manages, treasurer and controller
What does the controller do?
this person takes care of the accounting function, so record keeping
What does the treasurer do?
manages cash, financial planning and capital expenditure
What is within corporate finance?
financial management decisions including capital budgeting, capital structure, working capital management
and forms of business organisation including sole proprietorship, partnership and corporation
What are 3 financial management decisions within corporate finance?
- Capital budgeting
- Capital structure
- Working capital management
What is capital budgeting?
Capital budgeting is the process of planning and evaluating the long-term investments that a corporation will make.
How to Spend Money: It involves deciding how to spend money to maximise the company’s value. The focus is on evaluating investment opportunities and deciding which projects or assets will provide the best return over time.
What is capital structure?
Capital structure refers to the way a company finances its operations and investments, primarily through a mix of debt (borrowed funds) and equity (ownership funds).
How to Raise Money: One of the primary decisions in financial management is determining the optimal mix of debt and equity. The goal is to balance risk and return while minimising the cost of capital.
What is working capital management?
Working capital management involves managing the company’s short-term assets and liabilities, ensuring that the company has enough liquidity to meet its short-term obligations and operational needs.
How to Manage Day-to-Day Cash Flow: Effective working capital management ensures that the company can maintain optimal liquidity and avoid financial difficulties
How do you think of capital structure in terms of a pie which represents the total value of the firm?
the value of the firm can be compared to a pie (represents everything the company owns, including its assets and its ability to generate future cash flows. This value is the total worth of the firm, and it is what shareholders, debt holders, and other stakeholders are interested in)
the capital structure decision can be viewed as how best to slice up the pie (divide this pie among the different sources of capital—mainly debt and equity)
the goal of the manager is to increase the size of the pie (total value of the firm, through investment, financial decisions, business operations)
if how you slice the pie affects the size of the pie (whether to use more debt or more equity to finance the company affects the firm’s cost of capital and its overall risk profile)
What is the goal of a corporation?
to maximise shareholder value
This goal focuses on increasing the current value per share of the company’s stock, which ultimately reflects the market value of the existing owners’ equity
achieved through: profit maximisation, cost minimisation, increased market share, effective capital allocation, risk management, long term planning…
What is the managers’ incentive?
the financial managers should act in the best interests of the stockholders
What is an agency relationship?
someone (principal) hires another (agent) to represent his or her interests, eg shareholders and management (i.e., maximizing the stock price or the market value of the company’s equity).
However, there is the potential for a conflict of interest between the managers and the shareholders, known as the agency problem
What is an agency problem?
agents’ (manager) interest might be different from the principals’ (shareholders) goal - ‘conflict of interest’
This happens because the agent may pursue their own personal goals or interests, rather than focusing solely on maximising shareholder wealth
What are examples of management goals
to have a luxurious office or private jet
to spend more time with their families (might not work hard to maximise shareholders value)
to build an empire (making a firm as large as possible by raising funds and investing them, even into money-losing businesses)
Example of an agency problem
Eg Own an old car you want to sell
Possible price £1000-£2000
Hire a friend to sell it for you, offer £100 to help you, does she have the incentive to try hard and sell it for £2000 probably not
how to solve this agency problem:
closely monitoring
Change your offer to 10% of the sales price
How do you align managers’ incentive and stockholders’ interests to address the agency problem?
managerial compensation and corporate control
How is managerial compensation used to align managers’ incentive and stockholders interests?
incentives can be used to align management and stockholder interests
incentives need to be carefully structured to ensure that they achieve their goal (use of stock options, bonuses and promotions)
How is corporate control used to align managers’ incentive and stockholders interests?
internal control: replace bad managers, performance reviews of managerial effectiveness
external control: threat of a takeover may result in better management, firms with poor management may be taken over
How do corporations raise money in a financial market?
- the corporation will issue financial securities onto the market to raise funds, and the investors will give cash to the corporation (money flows to the company from the investors)
this money will be used to invest in productive assets (manufacturing, technology) - these productive assets should generate cash, cash flow from assets will flow out of the company
- this cash flow is used to pay taxes to the government, pay stakeholders, salaries. alot of this gets reinvested back into the company.
also can include debt payments - goal is to try get the dividends and debt payments over long period of time to be larger than the cost to the investors initially
What is a financial market?
markets where debt and equity securities are bought and sold
What are 2 examples of a financial market?
- London Stock Exchange (LSE)
- New York Stock Exchange (NYSE)
What is a primary market?
where securities are issued for the first time, raising finance through capital markets (ie equity, bonds) and the money goes directly to the company or government that issued the securities.
The issuer then uses the funds for its intended purpose (e.g., investment in capital projects or business expansion).
What is the purpose of a primary market?
The primary market serves as a means for companies to raise funds by offering new securities (stocks or bonds) to investors. This money raised is used by the company to fund operations, expand, invest in new projects, or reduce debt.
What are examples of a primary market?
Initial Public Offerings (IPOs): A company may issue shares to the public for the first time via an IPO. The company sells shares to investors, and the funds raised go directly to the company.
Bond Issuances: Companies or governments may also issue bonds to raise money. Investors purchase the bonds, and the issuer agrees to pay interest and return the principal at maturity.
What is a secondary market?
once securities have been issued in the primary market, they can be traded traded between investors and the money goes to the ‘owner’ of securities.
The company that issued the securities doesn’t receive any proceeds from these transactions. The exchange of money occurs solely between investors.
What is the purpose of the secondary market?
The secondary market allows investors to buy and sell securities after they have been issued. This provides liquidity to investors, as they can sell their holdings if they need cash or want to adjust their portfolio.
What are examples of a secondary market?
Stock Exchanges: The London Stock Exchange (LSE) and New York Stock Exchange (NYSE) are examples of secondary markets where investors buy and sell stocks and bonds.
Over-the-Counter (OTC): Some securities are traded in decentralised markets, called over-the-counter markets, where dealers negotiate directly.
What does a financial market look like in a diagram?
. Stocks and bonds
Firms————–>Investors
Money securities
<————| A——>B|
{Primary market} <——-
money
{secondary market}
What do financial markets allow?
companies, governments and individuals to increase their investment choices
How do savers use the financial market?
invest in financial assets so they can defer consumption and earn a return to compensate them for doing so
How do borrowers use the financial markets?
raise capital by issuing securities, enabling them to invest in productive assets, fund operations.. since they have better access to the capital
What information do financial markets provide?
information about the returns that are required for various levels of risk
What do financial assets claim on?
future cash flows
What characteristics do financial assets differ in?
- maturity
- frequency of expected payments
- uncertainty of cash flows and/or final price
- ordering of repayment in case of bankruptcy
What are the characteristics of debt: money market instruments (ie Treasury Bills)
short term maturity (usually less than 1 year)
issues by government, financial institutions or corporations
often used to meet short-term funding needs or manage short term liquidity
What are the characteristics of debt: bonds?
maturity usually longer than 1 year,
issues by governments or corporations
eg US treasury bonds (government bonds) or corporate bonds issued by companies like Apple or Microsoft
What are the characteristics of government bonds?
Government Bonds: These are typically long-term instruments with fixed interest (coupon) payments, paid periodically (e.g., semi-annually or annually). They are relatively low-risk, especially if issued by stable governments.
What happens in corporate bonds?
Corporate Bonds: Issued by companies. Bondholders are entitled to cash payments (coupons) before equity holders in case of liquidation. Corporate bonds are riskier than government bonds but often provide higher returns.
What are the characteristics of equity: shares?
no maturity
variable payments: Shareholders may receive dividends, which are not guaranteed and can vary based on the company’s performance and decisions made by its board of directors.
Last to be paid in bankruptcy: In the event of liquidation, equity holders are the last to be paid after debt holders and other creditors have been satisfied. Therefore, equity securities are considered riskier than debt securities.
Example: Shares of Apple, Tesla, or other public companies.
