Managerial Finance - Chapter 1

Is an IPO a primary market transaction or a secondary market transaction?

An IPO is a primary market transaction.

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.

What does it mean when we say the New York Stock Exchange is an auction market? How are auction markets different from dealer markets? What kind of market is NASDAQ?

In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to buy and sell their assets. Dealer markets like NASDAQ represent dealers operating in dispersed locales who buy and sell assets themselves, usually communicating with other dealers electronically or literally over the counter. NASDAQ is a dealer market.

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

Management will frequently have a significant economic incentive to increase share value for two reasons. 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.

What is the capital budgeting decision?

Planning and managing a firm's long-term investments

Stakeholder

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

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

The four primary disadvantages to the sole proprietorship and partnership forms of business organization are: Unlimited Liability Limited Life Difficulty in transferring ownership Hard to raise capital funds

Into what category of financial management does cash management fall?

Working Capital Management

What is an agency relationship?

relationship between stockholders and management

What are the three forms of business organization?

sole proprietorship, partnership, corporation

Can the goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Think of some specific scenarios to illustrate your answer.

- An argument can be made either way. - At the one extreme, we could argue that in a market economy, all of these things are priced. - There is thus an optimal level of, for example, ethical and/or illegal behavior, and the framework of stock valuation explicitly includes these. - At the other extreme, we could argue that these are non-economic phenomena and are best handled through the political process.

Suppose you were the financial manager of a not-for-profit business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be appropriate?

- Such organizations frequently pursue social or political missions, so many different goals are conceivable. - One goal that is often cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society. - A better approach might be to observe that even a not-for-profit business has equity. - Thus, one answer is that the appropriate goal is to maximize the value of the equity.

What are the major areas in finance?

1. corporate finance 2. investments 3. financial institutions 4. international finance

Corporation

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

Partnership

A business formed by two or more individuals or entities.

Sole Propietorship

A business owned by a single individual.

Working Capital

A firm's short-term assets and liabilities.

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

Capital Structure

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

for the relative ease of transferring ownership, the limited liability for business debts, and the unlimited life of the business are why the corporate form is superior for raising cash. Ex: a corp. needs new equity, it can then sell new shares of stock and attract new investors.

What is the difference between a general and a limited partnership?

The difference between a general partnership and a limited partnership, a general partnership means the same for everyone meaning they share the business profits, debts, running business. Limited partnership is like an investor. Invests money in the business but down not have any management responsibilities. Limits liability.

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. Other auction exchanges include the American Stock Exchange (AMEX) and regional exchanges such as the Chicago Stock Exchange.

What are the four primary disadvantages to the sole proprietorship and partnership forms of business organization? What benefits are there to these types of business organizations as opposed to the corporate form?

The four primary disadvantages to the sole proprietorship and partnership forms of business organization are: Unlimited Liability Limited Life Difficulty in transferring ownership Hard to raise capital funds Benefits are: Simpler Less regulation Owners are managers Personal tax rates are sometimes better than corporate tax rates

What goal should always motivate the actions of the firm's financial manager?

The goal that should always motivate the actions of the firm's financial manager is to maximize the current market value (share price) of the equity of the firm (whether its publicly traded or not).

Capital Structure

The mixture of debt and equity maintained by a firm.

What is the goal of financial management?

the goal of financial management is to maximize the current value per share of the existing stock. The financial manager acts in the shareholders' best interests by making decisions that increase the value of the stock.

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. 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 impact 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.

Agency Problem

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

What is the primary disadvantage of the corporate form of organization? Name at least two of the advantages of corporate organization.

The primary disadvantage of the corporate form of organization is the double taxation to shareholders of distributed earning and dividends. Advantages of the corporate organization are: Limited liability Ease of transfer-ability Ability to raise capital Unlimited life

Capital Budgeting

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

What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.

The three types of financial management decisions are capital budgeting, capital structure, and working capital management. An example of capital budgeting is deciding on whether to expand a manufacturing plant. An example of capital structure is deciding whether to issue new equity and use the proceeds to retire outstanding debt. An example of working capital management is modifying the firm's credit collection policy with its customers.

In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance?

The two distinct groups that report directly to the chief financial officer are treasurer's office and the controller's office. The controller's office handles cost and financial accounting, tax management, and management information systems. The treasurer's office is responsible for cash and credit management, capital budgeting, and financial planning. The focus of corporate finance is concentrated within the functions of the treasure's office.

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

There are two kinds of secondary markets: auction markets and dealer markets. 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.

Who owns a corporation? Describe the process whereby the owners control the firm's management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise?

he shareholders are the owners of a corporation. The shareholders elect the directors of the corporation, who in turn appoint the firm's management. Agency relationships exist because of the separation of ownership from control in the corporate form of organization. Problems can arise because management may act in its own or someone else's best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.

What are some shortcomings of the goal of profit maximization?

shareholders are entitled to what is left over after employees, suppliers, and creditors are paid their due. If none is left then shareholders are left w/ nothing.