Chapter 1
3 limitations of sole proprietorship
(1) Proprietors have unlimited personal liability for the business' debts, so they can lose more than the amount of money they invested in the company. (2) The life of the business is limited to the life of the individual who created it; and to bring in new equity, investors require a change in the structure of the business. (3) Because of the first two points, proprietorships have difficulty obtaining large sums of capital;
3 advantages of sole proprietorship
(1) They are easy and inexpensive to form. (2) They are subject to few government regulations. (3) They are subject to lower income taxes than are corporations.
Useful motivational tools include
(1) reasonable compensation packages, (2) firing of managers who don't perform well, and (3) the threat of hostile takeovers.
Compensation packages
--should be sufficient to attract and retain able managers, but they should not go beyond what is needed. --should be structured so that managers are rewarded on the basis of the stock's performance over the long run, not the stock's price on an option exercise date.
Finance within the Organization
1. Board of Directors 2. CEO 3. COO, CFO COO - Marketing, production, HR, and other operating Departments CFO - Accounting, Treasury, Credit, Legal. Capital Budgeting, and Investor Relations
Investments breakdown
1. Security analysis 2. Portfolio theory 3. Market analysis
Which of the following statements is CORRECT? a. A corporation is a legal entity created by a state, and it has a life and existence that is separate from the lives and existence of its owners and managers. b. Unlimited liability and limited life are two key advantages of the corporate form over other forms of business organization. c. A hostile takeover is the main method of transferring ownership interest in a corporation. d. Although the stockholders of the corporation are insulated by limited legal liability, the legal status of the corporation does not protect the firm's managers in the same way, i.e., bondholders can sue the firm's managers if the firm defaults on its debt. e. Limited liability is an advantage of the corporate form of organization to its owners (stockholders), but corporations have more trouble raising money in financial markets because of the complexity of this form of organization.
A corporation is a legal entity created by a state, and it has a life and existence that is separate from the lives and existence of its owners and managers.
Shareholder
A person who invests in a corporation by buying stock and is a partial owner
Which of the following statements about business organizations is CORRECT? a. It is generally easier to transfer one's ownership interest in a partnership than in a corporation. b. Tax advantages of incorporation offset the corporate shareholders' exposure to unlimited liability. c. It's unlikely for a firm to be organized as a corporation when it requires a lot of capital. d. If a corporation elects to be taxed as a P corporation, then both it and its stockholders can avoid all federal taxes. This provision was put into the Federal Tax Code in order to encourage the formation of small businesses. e. A significant risk in starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt. This problem would be avoided if you formed a corporation to operate the business.
A significant risk in starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt. This problem would be avoided if you formed a corporation to operate the business.
Which of the following factors tend to encourage management to act in their stockholders' best interests? Threat of a hostile takeover. Direct intervention by shareholders. A reasonable compensation package sufficient to attract and retain able managers. Firing managers who do not perform well. All of the above encourage management to act in stockholders' best interests.
All of the above encourage management to act in stockholders' best interests.
Stakeholders
All the people who stand to gain or lose by the policies and activities of a business and whose concerns the business needs to address. --Employees and families, Vendors and Suppliers, customers, environment
intrinsic value
An estimate of a stock's "true" value based on accurate risk and return data. The intrinsic value can be estimated but not measured precisely.
Of the following actions, which one is most likely to reduce conflicts of interest between managers and stockholders?
Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.
Which of the following could explain why a business might choose to operate as a corporation rather than as a proprietorship or a partnership?
Corporations generally find it easier to raise large amounts of capital.
Which of the following helps ensure that managers operate in their stockholders' interests rather than their own personal interests? a. The threat of firing by the board of directors. b. The threat of a hostile takeover possibly resulting in top managers losing their jobs. If the stock price is below its intrinsic value, this threat is magnified. c. Compensation packages designed to provide incentives for management to maximize the long-run stock price. d. All of these help keep management focused on stockholders' interests as reflected in maximizing the long-run stock price.
D. All of these help keep management focused on stockholders' interests as reflected in maximizing the long-run stock price.
Which is TRUE about business organizations? a. Most businesses (by number and total dollar sales) are organized as proprietorships or partnerships because it is easier to set up and operate one of these forms rather than as a corporation. However, if the business gets very large, it becomes advantageous to convert to a corporation, primarily because corporations have important tax advantages over proprietorships and partnerships. b. Corporate stockholders are exposed to unlimited liability. c. Due to legal considerations related to ownership transfers and limited liability, which affect the ability to attract capital, most business (measured by dollar sales) is conducted by corporations in spite of large corporations' less favorable tax treatment. d. Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority of international businesses (in terms of the number of businesses) are organized as corporations, all governed by the same legal statutes. e. Large corporations are taxed more favorably than proprietorships.
Due to legal considerations related to ownership transfers and limited liability, which affect the ability to attract capital, most business (measured by dollar sales) is conducted by corporations in spite of large corporations' less favorable tax treatment.
Intrinsic value is equal to market value when markets are:
Efficient
Conflicts between stockholders and debtholders arise because stockholders are less willing than debtholders to take on risky projects because stockholders are more "at risk" of losing their investment. True or false?
False
Maximizing expected EPS will maximize shareholder value. True/False
False
Maximizing the stock price on a specific target date will maximize shareholder value. True/False
False
One advantage of the corporate form of organization is that it avoids double taxation. True/False
False
Stocks have market prices, and they also have intrinsic values. If the market price is below the intrinsic value as estimated by marginal investors, and if the intrinsic value remains stable in the future, then there will be a tendency for the stock's price to fall over time. True or false?
False
The chairperson of the board and the CEO are one and the same. True/False
False
The primary financial objective of the firm is to maximize EPS. True/False
False
Marginal investor
Investors at the margin are the ones who actually set stock prices. Some stockholders think that a stock at its current price is a good deal, and they would buy more if they had more money. Others think that the stock is priced too high, so they would not buy it unless the price dropped sharply. Still others think that the current stock price is about where it should be; so they would buy more if the price fell slightly, sell it if the price rose slightly, and maintain their current holdings unless something were to change. These are the marginal investors, and it is their view that determines the current stock price. We discuss this point in more depth in Chapter 9, where we discuss the stock market in detail.
C corporations
Larger corporations with more than 100 stockholders --The vast majority of small corporations elect S status and retain that status until they decide to sell stock to the public, at which time they become C corporations.
Primary Financal goal of most financial corporation
Maximize shareholder value
Which of the following statements accurately describes business organizations? a. In a typical partnership, liability for other partners' misdeeds is limited to the amount of a particular partner's investment in the business. b. A major disadvantage of a partnership relative to a corporation is the fact that federal income taxes must be paid by the partners rather than by the firm itself. c. In a limited partnership, the limited partners have voting control, while the general partner has operating control over the business, and the limited partners are individually responsible, on a pro rata basis, for the firm's debts in the event of bankruptcy. d. A slow-growth company, with little need for new capital, would be more likely to organize as a corporation than would a faster growing company. e. Partnerships have more difficulty attracting large amounts of capital than corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying and selling) of partnership interests.
Partnerships have more difficulty attracting large amounts of capital than corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying and selling) of partnership interests.
Of the following policy changes, which would be the most likely to REDUCE potential conflicts of interest between stockholders and managers? a. The company's outside marketing firm is given a lucrative year-by-year consulting contract with the company. b. The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash. c. A firm's compensation system is changed so that managers receive larger cash salaries and no long-term options to buy stock. d. Congress passes a law that severely restricts hostile takeovers. e. The company changes the way executive stock options are handled, with all options vesting after one year rather than having 20% of the options awarded vest every two years over a 10-year period.
The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash.
shareholder wealth maximization
The primary goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm's common stock.
Equilibrium
The situation in which the actual market price equals the intrinsic value, so investors are indifferent between buying and selling a stock.
Business Ethics
The use of ethics in making business decisions A firm's commitment to business ethics can be measured by the tendency of its employees, from the top down, to adhere to laws, regulations, and moral standards relating to product safety and quality, fair employment practices, fair marketing and selling practices, the use of confidential information for personal gain, community involvement, and the use of illegal payments to obtain business.
Finance prepares students for jobs in banking, investments, insurance, corporations, and government. It is important for all business students, no matter what their major is, to understand finance concepts. In addition, finance is useful to all individuals regardless of their jobs as we encounter finance in our everyday lives, such as decisions regarding consumer loans and mortgages. True or false?
True
If a company practices "good business ethics," then it will treat its customers, employees, and stockholders "fairly," and this will cause it to have a good reputation. Such behavior may increase costs and thus hurt profits in the short run, but this is often offset by long-run benefits in the form of customer loyalty, more dedicated employees, and stockholders who will support management in the event of a downturn in the business. True or false?
True
If a firm's board of directors wants to maximize value for its stockholders in general (as opposed to some specific stockholders), it should design an executive compensation system whose focus is on the firm's long-term value. True/False
True
If a firm's managers narrowly focused on creating shareholder value, but in the process the company was unresponsive to its employees and customers, hostile to its local community, and indifferent to the effects its actions had on the environment; then in all likelihood society would impose a wide range of costs on the company, and this would ultimately lead to a reduction in shareholder value. True or false?
True
Imagine that a firm's board of directors wants to maximize value for all of its stockholders in general, as opposed to some specific stockholders. A smart solution would be to design an executive compensation system that aims to build the firm's long-term value. True/False
True
In most corporations, the CFO is outranked by the CEO. True/False
True
It is generally harder to transfer one's ownership interest in a partnership than in a corporation. True/False
True
Managers should try to forecast the effects of different decisions on the firm's intrinsic value and then take actions designed to maximize this value. Management should provide information that helps investors make better estimates of the firm's intrinsic value, which will keep the stock price closer to the equilibrium level. However, there are times when management cannot divulge the true situation because doing so would provide information that helps its competitors. True or false?
True
Managers should try to maximize their stock's intrinsic value and then communicate effectively with stockholders. That will cause the intrinsic value to be high and the actual stock price to remain close to the intrinsic value over time. True/False
True
Maximizing the firm's expected profits for the current year does not necessarily maximize the stockholders' wealth for the current year. True/False
True
The board of directors is the highest ranking body in a corporation. The members of the board are elected by the shareholders, and the chairperson of the board is the highest ranking member of the board. The CEO generally reports to the board and its chairperson, and the board generally has the authority to remove the CEO. True/False
True
The chief executive officer (or CEO) is the top executive officer, and he or she reports to the board. The chairperson of the board often also serves as the CEO. Most firms also have a chief operating officer (COO) and a chief financial officer (CFO). The COO is often designated as the firm's president and directs the firm's operations. The CFO is in charge of accounting, financing, credit policy, decisions regarding asset acquisitions, and investor relations. True or false?
True
The more capital a firm is likely to require, the greater the probability that it will be organized as a corporation. True/False
True
There are factors that influence stock price over which managers have virtually no control. True/False
True
Another word for intrinsic value is:
True value
Calistoga Combines is a publicly-owned firm. In order to best serve shareholders, its' primary operating goal should be to:
Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers.
B Corporation
a business that explicitly seeks to blend its social objectives with its financial goals
If you sat on the board of directors of Tyng Corporation, which of the following actions would you recommend to reduce potential conflicts of interest between Tyng's stockholders and bondholders?
a. The use of covenants in bond agreements that limit the firm's use of additional debt and constrain managers' actions.
Financial Management
also called corporate finance, focuses on decisions about acquiring assets, raising capital, and running the firm so as to maximize its value.
Financial management
also called corporate finance, focuses on decisions relating to how much and what types of assets to acquire, how to raise the capital needed to purchase assets, and how to run the firm so as to maximize its value.
S corporations
are taxed as if they were proprietorships or partnerships --can have no more than 100 stockholders, which limits their use to relatively small, privately owned firms. --The vast majority of small corporations elect S status and retain that status until they decide to sell stock to the public, at which time they become C corporations.
Which of the following statements reflects the position of most people in business? a. Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees. b. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. c. A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation. d. It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior. e. Whistleblowers are generally promoted more rapidly than other employees because of the courage it takes to blow the whistle.
b. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.
Which of the following represents a significant disadvantage to the corporate form of organization? a. Difficulty in transferring ownership. b. Exposure to taxation of corporate earnings and stockholder dividend income. c. Degree of liability to which corporate owners and managers are exposed. d. Level of difficulty corporations' face in obtaining large amounts of capital in financial markets. e. All of the above are disadvantages to the corporate form of organization.
b. Exposure to taxation of corporate earnings and stockholder dividend income.
Which of the following is NOT an advantage of the corporate form of organization versus partnerships and proprietorships? a. Limited liability. b. More favorable tax treatment. c. Ease of transferring ownership among investors. d. Ability to attract large amounts of capital. e. Liquidity of investors' holdings in the business.
b. More favorable tax treatment.
Which of the following situations would most likely encourage a firm's managers to make decisions that are in the best interests of stockholders? a. The percentage of executive compensation that comes in the form of cash is increased and the percentage coming from long-term stock options is reduced. b. The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds, rather than by small individual investors, rises from 10% to 80%. c. The state legislature passes a law that makes it more difficult to successfully complete a hostile takeover. d. The firm's founder, who is also the president and chairperson of the board, sells 85% of her shares. e. The firm's board of directors gives the firm's managers greater freedom to take whatever actions they think best without obtaining board approval.
b. The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds, rather than by small individual investors, rises from 10% to 80%.
With which of the following statements would most people in business agree? a. A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation. b. It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior. c. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. d. "Whistle blowers," because of the courage it takes to blow the whistle, are generally promoted more rapidly than other employees. e. Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees.
c. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.
Bethany is planning to start a business. Why might she choose to operate her business as a corporation rather than as a proprietorship or a partnership?
d. Corporations generally find it easier to raise large amounts of capital.
Which of the following statements about legal and ethical issues is CORRECT? a. If a lower level person in a firm does something illegal, like "cooking the books," to understate costs and thereby artificially increase profits because he or she was ordered to do so by a superior, the lower level person cannot be prosecuted but the superior can be prosecuted. b. Ethical behavior is not influenced by training and auditing procedures. People are either ethical or they are not, and this is what determines ethical behavior in business. c. There are many types of unethical business behavior. One example is when executives provide information that they know is incorrect to outsiders. It is illegal to provide such information to federally regulated banks, but it is not illegal to provide it to stockholders. d. If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted. e. Ethics is not an important consideration in business and in business schools.
d. If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted.
Imagine that you are the chairman of the board of a large corporation. Which of the following mechanisms do you think the board should choose to adopt to motivate top-level managers to act in the best interests of stockholders? a. Decrease the use of restrictive covenants in bond agreements. b. Take actions that reduce the possibility of a hostile takeover. c. Elect a board of directors that allows managers greater freedom of action. d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries. e. Eliminate a requirement that members of the board of directors have a substantial investment in the firm's stock.
d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.
Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders? a. Elect a board of directors that allows managers greater freedom of action. b. Eliminate a requirement that members of the board of directors have a substantial investment in the firm's stock. c. Decrease the use of restrictive covenants in bond agreements. d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries. e. Take actions that reduce the possibility of a hostile takeover.
d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.
Which of the following statements is CORRECT? a. Corporations face fewer regulations than proprietorships. b. If a partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business. c. One disadvantage of operating a business as a proprietor is that the firm is subject to double taxation, because taxes are levied at both the firm level and the owner level. d. One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership. e. It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents are required.
d. One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership.
Security analysis
deals with finding the proper values of individual securities (Stocks and bonds)
Portfolio Theory
deals with the best way to structure portfolios, or "baskets," of stocks and bonds. Rational investors want to hold diversified portfolios in order to limit risks, so choosing a properly balanced portfolio is an important issue for any investor.
Market analysis
deals with the issue of whether stock and bond markets at any given time are "too high," "too low," or "about right."
Which of the following are stakeholders in a corporation? a. A corporation's shareholders b. A corporation's employees c. A corporation's customers d. A corporation's vendors e. All the above are stakeholders in a corporation
e. All the above are stakeholders in a corporation
The Gabriel Corporation has asked you, a consultant, to recommend an action that is likely to reduce potential conflicts between stockholders and bondholders. Which action do you propose?
e. Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders).
Which of the following statements is CORRECT? a. Managerial compensation plans cannot be used to reduce potential conflicts between stockholders and managers. b. The creation of the Securities and Exchange Commission (SEC) has eliminated conflicts between managers and stockholders. c. One of the ways in which firms can mitigate or reduce potential conflicts between bondholders and stockholders is by increasing the amount of debt in the firm's capital structure. d. The threat of takeover generally increases potential conflicts between stockholders and managers. e. The threat of takeovers tends to reduce potential conflicts between stockholders and managers.
e. The threat of takeovers tends to reduce potential conflicts between stockholders and managers.
limited liability company (LLC)
hybrid between a partnership and a corporation. --LLCs are used by other businesses. --provide limited liability protection, but they are taxed as partnerships. --investors in an LLC or LLP have votes in proportion to their ownership interest.
limited liability partnership (LLP)
hybrid between a partnership and a corporation. --used for professional firms in the fields of accounting, law, and architecture --provide limited liability protection, but they are taxed as partnerships. --investors in an LLC or LLP have votes in proportion to their ownership interest.
Debtholders
include the company's bankers and its bondholders, generally receive fixed payments regardless of how well the company does, while stockholders do better when the company does better.
corporate raiders
individuals who target corporations for takeover because they are undervalued
Investments
involve decisions concerning stocks and bonds and include security analysis, portfolio theory, and market analysis. These areas are closely interconnected.
Partnership
is a legal arrangement between two or more people who decide to do business together. --the firm's income is allocated on a pro rata basis to the partners and is taxed on an individual basis. --all of the partners are generally subject to unlimited personal liability
Corporation
is a legal entity created by a state, and it is separate and distinct from its owners and managers. --the corporation can lose all of its money, but its owners can lose only the funds that they invested in the company. --have unlimited lives, and it is easier to transfer shares of stock in a corporation than one's interest in an unincorporated business. --Most corporations' earnings are subject to double taxation—the corporation's earnings are taxed; and then when its after-tax earnings are paid out as dividends, those earnings are taxed again as personal income to the stockholders.
Proprietorship
is an unincorporated business owned by one individual.
Capital Markets
relate to the markets where interest rates and stock and bond prices are determined.
Capital markets
relate to the markets where interest rates, along with stock and bond prices, are determined. Also studied here are the financial institutions that supply capital to businesses. Banks, investment banks, stockbrokers, mutual funds, insurance companies, and the like bring together "savers" who have money to invest and businesses, individuals, and other entities that need capital for various purposes.
hostile takeover
the acquisition of a company over the opposition of its management
Market Price
the actual market price based on perceived but possibly incorrect information as seen by the marginal investor.
Behavioral Finance
where investor psychology is examined in an effort to determine whether stock prices have been bid up to unreasonable heights in a speculative bubble or driven down to unreasonable lows in a fit of irrational pessimism.