Download Introduction to Corporate Finance: Financial Management Decisions and Strategies and more Exams Business Finance in PDF only on Docsity!
Financial Management Decisions
and Strategies
Introduction to Corporate Finance
Forms of Business Organization
Sole Proprietorship : A business owned by an individual who has unlimited personal liability. Partnership : A business formed by two or more individuals. The partners have unlimited personal liability. Corporation : A separate legal body formed by an individual or group of individuals. Shareholders have limited personal liability.
Financial Management Decisions
Capital Budgeting : The process of identifying investment opportunities that are worth more to the firm than they cost to acquire. The size, timing, and risk of cash flows are important factors. Capital Structure : Determines the appropriate mix of debt and equity financing for the firm. This affects the firm's cost of capital and risk. Working Capital Management : Addresses the firm's appropriate level of current assets and current liabilities, such as inventory, accounts receivable, and accounts payable.
Goal of Financial Management
The primary goal of financial management is to maximize the value of the firm for its shareholders. This does not imply that illegal or unethical actions should be taken.
Agency Problem and Corporate Governance
Agency Problem : Potential conflicts of interest between managers and shareholders. Managers may pursue their own interests rather than those of the shareholders. Corporate Governance : The system by which companies are directed and controlled. The board of directors is responsible for overseeing the management of the firm on behalf of the shareholders.
Corporate Social Responsibility (CSR) and Ethical
Investing
CSR : Also known as corporate sustainability, the triple bottom line, or stakeholder theory. Suggests that firms should consider the interests of employees, customers, suppliers, and various levels of government, in addition to shareholders.
Ethical Investing : Investing in companies that demonstrate a commitment to CSR and ethical behavior. Research on the relationship between CSR and corporate performance has been mixed.
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Objective: 01-05 The roles of financial
institutions and markets.
Topic: 01-23 Primary versus Secondary Markets
A secondary market is a market where previously issued securities are bought and sold. In a secondary market, investors trade securities among themselves, without the involvement of the issuing company. The secondary market provides liquidity to investors, allowing them to buy and sell securities easily.
The primary market, on the other hand, is where new securities are issued and sold to investors for the first time. In the primary market, the issuing company raises capital by selling its securities directly to investors.
Some key differences between primary and secondary markets:
Participants : In the primary market, the participants are the issuing company and investors. In the secondary market, the participants are investors trading securities among themselves. Timing : The primary market involves the initial sale of securities, while the secondary market involves the subsequent trading of previously issued securities. Purpose : The primary market allows companies to raise capital, while the secondary market provides liquidity for investors. Pricing : Prices in the primary market are determined by the issuing company and investors, while prices in the secondary market are determined by supply and demand.
The key features of a limited partnership are:
Only the general partners are involved in the daily management of the firm. Limited partners are liable only for the amount they contributed to the partnership. General partners are liable for the full amount of the firm's debts and obligations.
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 01-04 The conflicts of interest that can
arise between managers and owners.
Topic: 01-18 Do Managers Act in the Shareholders'
Interests?
A shareholder is any person or entity that owns shares of stock in a corporation. Shareholders have voting rights based on their stock ownership and a claim on the cash flows of the firm.
A founding stockholder is a person who initially started a firm and currently has management control over the cash flows of the firm due to their current ownership of company stock.
A creditor is a person or entity to whom the firm currently owes money and who consequently has a claim on the cash flows of the firm.
A stakeholder is any person or entity who potentially has a claim on the cash flows of the firm, including shareholders and creditors.
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 01-04 The conflicts of interest that can
arise between managers and owners.
Topic: 01-16 Agency Relationships
An agency problem exists when there is a conflict of interest between a principal and their agent. In the context of corporate finance, the principal-
agent relationship exists between shareholders (the principals) and managers (the agents).
Shareholders, as the owners of the firm, hire managers to run the day-to-day operations of the company. However, managers may not always act in the best interests of the shareholders, as they may pursue their own personal goals, such as increasing their compensation or job security, even if these goals conflict with maximizing shareholder wealth.
This conflict of interest between managers and shareholders is known as an agency problem, and it can lead to agency costs, which are the costs incurred by shareholders to monitor and control the actions of managers.
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Objective: 01-02 The financial implications of the
different forms of business organization.
Topic: 01-06 Sole Proprietorship
A sole proprietorship is a business owned and operated by a single individual. Some key features of a sole proprietorship include:
Income from the proprietorship is taxed as part of the owner's personal income, rather than as a separate entity. The proprietor is personally responsible for 100% of the firm's liabilities, meaning the owner's personal assets can be used to pay the firm's debts. Transferring ownership of a sole proprietorship is generally easier than transferring ownership of a corporation. Income from a sole proprietorship is not taxed at a lower rate than other personal income.
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Hard
Learning Objective: 01-05 The roles of financial
institutions and markets.
Topic: 01-23 Primary versus Secondary Markets
The main difference between the third and fourth markets is:
The third market involves trading exchange-listed securities in over- the-counter (OTC) markets, while the fourth market involves institution- to-institution trading without using the services of brokers or dealers.
In the third market, securities listed on an exchange are traded in the OTC market, often at prices better than those available on the exchange. The fourth market, on the other hand, involves direct trading between large institutional investors, such as mutual funds and pension funds, without the involvement of brokers or dealers.
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 01-01 The basic types of financial
management decisions and the role of the financial
manager.
Topic: 01-04 Financial Management Decisions
The best definition of capital structure is how a firm is financed through different proportions of debt and equity. Capital structure decisions involve determining the optimal mix of debt and equity financing for the firm.
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 01-05 The roles of financial
institutions and markets.
Topic: 01-22 Money versus Capital Markets
The best definition of capital markets is a venue where long-term debt and equity securities are bought and sold. Capital markets are financial markets that facilitate the trading of long-term financial instruments, such as stocks and bonds.
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Hard
Learning Objective: 01-04 The conflicts of interest that can
arise between managers and owners.
Topics: 01-16 Agency Relationships, 01-17 Management
Goals
One way to address the agency problem between managers and shareholders is to align the interests of managers with those of shareholders. This can be done by basing management bonuses on the attainment of specific financial goals, such as increasing the market value of the firm's stock or achieving certain profitability targets.
Paying management bonuses based on the current market value of the firm's stock can help to align the interests of managers and shareholders, as managers will be incentivized to make decisions that increase the firm's stock price and, consequently, shareholder wealth.
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 01-01 The basic types of financial
management decisions and the role of the financial
manager.
Topic: 01-04 Financial Management Decisions
The mixture of debt and equity used by the firm to finance its operations is called the capital structure. Capital structure decisions involve determining the optimal mix of debt and equity financing for the firm.
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 01-04 The conflicts of interest that can
arise between managers and owners.
Topic: 01-16 Agency Relationships
The agency problem exists between agents and principals. In the context of corporate finance, the agents are the managers, and the principals are the shareholders and bondholders.
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 01-04 The conflicts of interest that can
arise between managers and owners.
Topics: 01-16 Agency Relationships, 01-17 Management
Goals
One action by a financial manager that can create an agency problem is agreeing to expand the company at the expense of stockholders' value. This decision may benefit the manager, as it can increase the size of the firm and the manager's power and compensation, but it may not be in the best
interests of the shareholders, who are primarily concerned with maximizing the value of their investment.
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 01-05 The roles of financial
institutions and markets.
Topic: 01-23 Primary versus Secondary Markets
The statement that is correct concerning the listing of stock on an exchange is that the TSX has the most stringent listing requirements of any Canadian stock exchange. The listing requirements for each exchange are established by the exchange itself, and they can vary in terms of the minimum number of shareholders, minimum market capitalization, and other criteria that a company must meet to be listed.
Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 01-05 The roles of financial
institutions and markets.
Topic: 01-23 Primary versus Secondary Markets
The statement that is correct concerning auction markets is that a market where buyers specify the lowest price they are willing to pay and sellers indicate the highest price they are willing to accept is an auction market. In an auction market, the price of a security is determined by the interaction of buyers and sellers, rather than by a dealer.
market, but it also has characteristics of an auction market, as prices are determined by the interaction of buyers and sellers.
Accessibility: Keyboard Navigation
Agency Costs
An agency problem exists when there is a conflict of interest between the stockholders and management of a firm. An agency problem exists when there is a conflict of interest between a principal and an agent. A corporate expenditure that benefits stockholders but harms management is an agency cost. If agency costs get too high in the eyes of shareholders, they can begin a proxy fight to replace existing management.
Primary versus Secondary Markets
A primary market transaction involves the sale of newly issued securities by a corporation to investors. A secondary market transaction involves the trading of existing securities between investors. Examples of primary market transactions include: A corporation selling new shares of stock to a financial institution. A corporation issuing new bonds to investors. Examples of secondary market transactions include: An individual investor selling shares of stock to another individual investor. A financial institution selling shares of stock to another financial institution.
Financial Management Decisions
The key elements evaluated in the capital budgeting process are the size, risk, and timing of future cash flows. Ensuring that a firm has sufficient cash available on a daily basis is part of working capital management. A firm's capital structure is defined as the combination of debt and equity used to finance the firm's operations.
Goal of Financial Management
The primary goal of financial management in a publicly traded corporation is to maximize the current value per share of the existing stock. This goal aligns the interests of the financial manager with the interests of the shareholders, who own the firm.
Financial Institutions and Markets
Dealer markets, also known as over-the-counter (OTC) markets, include NASDAQ and the New York Stock Exchange. An individual who buys and sells stocks for his/her own account is a dealer. Buy or sell orders to a broker for shares listed on a stock exchange would be considered a secondary market transaction.
Primary versus Secondary Markets
Primary Market Transactions
A primary market transaction refers to the initial sale of a security by the issuing company. This is when a firm sells stock to the public for the first time in an initial public offering (IPO). In this case, the firm is raising capital by issuing new securities directly to investors.
Secondary Market Transactions
Secondary market transactions involve the trading of securities that have already been issued. For example, when an investor buys stock in Chrysler Canada from their buddy, or when Chrysler Canada's stockholders sell some of their shares to an activist investor, these are secondary market transactions. The securities are simply being traded between investors, not issued by the company.
On September 25, 1995, 30.8 million shares of stock changed hands on the Toronto Stock Exchange (TSX). This is an example of a secondary market transaction, as the shares were being traded between investors rather than issued by the companies.
In summary, primary market transactions involve the initial issuance of securities by a company, while secondary market transactions involve the trading of securities that have already been issued.
Introduction to Corporate Finance
The Role of Financial Institutions and Markets
The original sale of securities by governments and corporations occurs in the primary market. The purchase and sale of securities after the original issuance occurs in the secondary market. A market where trading takes place directly between buyers and sellers is called an over-the-counter (OTC) market. A market where dealers buy and sell securities for themselves, at their own risk, is called a dealer market.
Partnership
General Partnership: Each partner has unlimited personal liability for the firm's debts Limited Partnership: General partners have unlimited liability, while limited partners have limited liability up to their investment amount Disadvantages: Personal liability Limited firm life
Corporation
Advantages: Ease of ownership transfer Ability to raise capital Disadvantages: Double taxation
Financial Management Decisions
Capital Budgeting
The process of planning and managing a firm's long-term investments
Working Capital Management
Ensuring sufficient funds to operate the business on a daily basis
Financial Planning
Overseeing the financial planning and management of a firm
Financial Institutions and Markets
Primary and Secondary Markets
Primary markets: Where new issues of securities occur Secondary markets: Where existing securities are bought and sold
Money Markets vs. Capital Markets
Money markets: Where short-term debt securities are bought and sold Capital markets: Where long-term debt and equity securities are bought and sold
Derivative Securities
Investment products whose value derives from the price of another, underlying, asset
Trends in Financial Markets and Financial Management
Hedge Funds
Largely unregulated and privately managed investment funds catering to sophisticated investors, which look to earn high returns using aggressive financial strategies prohibited by mutual funds.
Agency Problem
The possibility of conflicts between shareholders and management in a large corporation
Hedge Funds
Hedge funds are largely unregulated and privately managed investment funds catering to sophisticated investors. These funds aim to earn high returns using aggressive financial strategies similar to mutual funds.
Characteristics of Hedge Funds
Hedge funds are secondary market sources of raising capital for startup companies. They are largely unregulated and privately managed investment funds. They cater to sophisticated investors, who are typically high-net-worth individuals or institutional investors. Hedge funds employ aggressive financial strategies to generate high returns, similar to mutual funds.
Limited Partnerships
Features of Limited Partnerships
Limited partners are not responsible for all debts of the partnership. Limited partners generally do not manage the partnership. Limited partnerships can bring in more partners. Limited partnerships have limited liability (to the extent of their investment).
Differences between Limited and General Partnerships
In a general partnership, only the key partner is personally liable for the business debts.
Raising Capital
It is easiest to raise capital for a project under the corporate form of business organization.
Agency Problems
The form of business structure that faces the greatest agency problems is the corporation.
Advantages of the Corporate Form
The corporate form of ownership provides advantages such as limited personal liability, the ability to raise capital, and limited firm life.
Conflicts of Interest between Managers and
Owners
Agency Problems
Conflicts that arise between the interests of managers and stockholders are referred to as agency problems.
Examples of Agency Problems
Managers rewarding themselves with bonuses when the stock price rises Managers rejecting a merger desired by shareholders Managers expanding operations overseas, which is favorably received by the financial markets Managers reducing the risk level of the firm while maintaining a steady stock price
Aligning Interests
The decisions made by financial managers should all be ones which increase the market value of the existing owners' equity.
Corporate Social Responsibility and Ethical
Investing
Corporate social responsibility (CSR) measures a company's performance within its three financial statements.
The Primary Market
The primary market is defined as the market:
A. Wherein the original sale of securities by the issuer to the general public occurs. B. Where stocks and bonds are exchanged between dealers. C. Mechanism by which a sale of a financial instrument between two shareholders is conducted. D. Operated by brokers for the benefit of shareholders.
Partnership
A partnership is a business organization that can take the following forms:
A. A single individual who desires limited liability for the firm's debts. B. One or more individuals who are each totally responsible for the debts of the entity. C. Multiple individuals, 80 percent of whom enjoy limited liability. D. Two or more individuals, each of whom has limited liability for the firm's debts. E. Two or more individuals, only one of whom has unlimited liability for the firm's debts.
The Financial Manager
The Treasurer:
A. Is responsible for overseeing the data processing functions within a firm. B. Has the responsibility for managing the cash for an organization. C. Must keep current on tax laws since he/she is responsible for managing the taxes for a firm. D. Must file quarterly financial statements in a timely manner. E. Reports directly to the Chief Executive Officer of a corporation.
Financial Institutions
Which of the following is not a Canadian financial institution?
A. Trust companies. B. Provincial governments. C. Mutual funds. D. Investment dealers. E. Chartered banks.
Primary versus Secondary Markets
A. NASDAQ is an auction market. B. Most smaller firms are listed on NASDAQ rather than on the NYSE. C. NASDAQ is an electronic market. D. NASDAQ is an OTC market. E. NASDAQ stands for National Association of Securities Dealers Automated Quotations system.
Partnership
A. Entitlement to a larger portion of the partnership's income. B. Ability to manage the day-to-day affairs of the business. C. No potential financial loss. D. Greater management responsibility. E. Liability for firm debts limited to the capital invested.
