FIN 300-01, Chapter 1, Introduction to Financial Management

1.5b: What are agency problems, and how do they arise? What are agency costs?

Agency problems are the possibility of conflict of interest between the owners and management of a firm. They arise when management goals do not align with the owners' goals. To see how management and stockholder interests might differ, imagine that a corporation is considering a new investment. The new investment is expected to favorably affect the stock price, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the share value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost.

1.1 a: What are the major areas in finance?

Corporate finance, investments, financial institutions, & international finance

1.6c What does OTC stand for? What is the large OTC market for stocks called?

Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically. In addition to the stock exchanges, there is a large OTC market for stocks. In 1971, the National Association of Securities Dealers (NASD) made available to dealers and brokers an electronic quotation system called NASDAQ (NASD Automated Quotations system, pronounced "naz-dak"). There are more companies listed on NASDAQ than there are on NYSE, but they tend to be much smaller in size and trade less actively. There are exceptions, of course. Both Microsoft and Intel trade OTC, for example. Nonetheless, the total value of NASDAQ stocks is significantly less than the total value of NYSE stocks.

1.5c: What incentives do managers in large corporations have to maximize share value?

First, managerial compensation, particularly at the top, is usually tied to financial performance in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy stock at a fixed price. The more the stock is worth, the more valuable is this option. The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, those managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

1.4b: What are some shortcomings of the goal of profit maximization?

It's not a precise objective in terms of the short- or long-term profits. More to the point, this goal doesn't tell us the appropriate trade-off between current and future profits.

1.1b: Besides want to pass this class, why do you need to understand finance?

Other than a career in finance, knowledge of finance when faced when financial decisions is also critical in marketing, accounting, management, and in your own life.

1.6b: What is the largest auction market in the United States?

The equity shares of most of the large firms in the United States trade in organized auction markets. The largest such market is the New York Stock Exchange (NYSE), which accounts for more than 85 percent of all the shares traded in auction markets.

1.4a: What is the goal of financial management?

The goal of financial management is to maximize the current value per share of the existing stock or to maximize the market value of the existing owners' equity.

1.2a: What is the capital budgeting decision?

The process of planning and managing a firm's long-term investments is called capital budgeting. In capital budgeting, the financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow generated by an asset exceeds the cost of that asset.

1.5a: What is an agency relationship?

The relationship between stockholders and management is called an agency relationship.

1.3d: Why is the corporate form superior when it comes to raising cash?

The relative ease of transferring ownership, the limited liability for business debts, and the unlimited life of the business are the reasons the corporate form is superior when it comes to raising cash. If a corporation needs new equity, it can sell new shares of stock and attract new investors. The number of owners can be huge; larger corporations have many thousands or even millions of stockholders.

1.2c: Into what category of financial management does cash management fall?

The term working capital refers to a firm's short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. Managing the firm's working capital is a day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm's receipt and disbursement of cash.

1.6a: What is a dealer market? How do dealer and auction markets differ?

There are two kinds of secondary markets: auction markets and dealer markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses. Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically. Auction markets differ from dealer markets in two ways. First, an auction market, or exchange, has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

corporation

a business created as a distinct legal entity owned by one or more individuals or entities

sole proprietorship

a business owned by a single individual

working capital

a firm's short-term assets and liabilities

1.3c: What is the difference between a general and a limited partnership?

general partners are involved in business decisions and have unlimited liability limited partners are not involved in business decisions and have limited liability (what they invested)

1.3a: What are the three forms of business organization?

sole proprietorship, partnership, & corporation

stakeholder

someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm

capital structure

the mixture of debt and equity maintained by a firm

agency problem

the possibility of conflict of interest between the owners and management of a firm

capital budgeting

the process of planning and managing a firm's long-term investments

1.3b: What are the primary advantages and disadvantages of sole proprietorships and partnerships?

- owners/partners keep all profits - owners/partners responsible for any losses (unlimited liability) - all business income is taxed as personal income - life of company limited to owners'/partners' lifespan - limited to owners'/partners' wealth for raising equity - difficult to transfer ownership

1.2b: What do you call the specific mixture of long-term debt and equity that a firm chooses to use?

A firm's capital structure (or financial structure) refers to the specific mixture of long-term debt and equity the firm uses to finance its operations. The financial manager has two concerns in this area. First: How much should the firm borrow? Second: What are the least expensive sources of funds for the firm?

partnership

a business formed by two or more individuals or entities