Chapter 1

What are "Current" items? What are some examples of currents assets and current liabilities?

"Current" items generally liquidate within one year and then cease to exist Cash, Marketable Securities, Accounts Receivable, Inventory, Pre-Paid Assets & Other Current Assets Accounts Payable, Accrued Liabilities, Notes Payable & Other Current Liabilities

What does it mean that stockholders are residual owners? Why is this important?

By this we mean that they are entitled to only what is left after employees, suppliers, and creditors (and anyone else with a legitimate claim) are paid their due. If any of these groups go unpaid, the stockholders get nothing. So, if the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also.

Capital budgeting What is it? What is the goal? What 3 things make up the essence of capital budgeting?

Capital budgeting is the process of deciding which long-term assets we should invest in Financial manager tries to identify investment opportunities that are worth more than they cost to acquire. Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting.

3 main financial questions

Capital budgeting question: Which long- term assets should we invest in? (That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need?) Capital structure question: How should we obtain and manage the long-term financing we need to pay for our investments? (Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money?) Net Working Capital (NWC) question: How should we obtain and manage our short-term assets and liabilities? (How will you manage your everyday financial activities such as collecting from customers and paying suppliers?)

Cash flows in a business

1. Owners (aka stockholders, share holders, or equity holders) invest money in the business 2. Lenders (bondholders, creditors, debt holders) lend cash to the business 3. The firm's managers invest cash in assets. Assets generate cash flows 4. The firm pays money to the government and other stakeholders 5. The firm pays dividends to the shareholders 6. The firm pays interest and principle to the lenders 7. With anything left over, the firm can reinvest in the business

Corporation What is it? What are some actions that corporations can take? How does the state in which the corporation is chartered treat the corporation? Taxes?

A corporation is a separate and distinct legal person, chartered by the state Can acquire property Can sue and be sued Can be a general partner or a limited partner in a partnership Can own stock in another corporation. Is a citizen of the state in which it is formed Pays taxes separately from its owners

Pass-through taxation (sole proprietorship and partnership)

A pass-through business pays no tax itself, but the business owners pay the business tax through their personal tax return each year. This is unlike the "double" taxation of corporations, where income is taxed at the corporation level, and dividends are taxed for each individual as well.

Proxy

A proxy is an agent legally authorized to act on behalf of another party or a format that allows an investor to vote without being physically present at the meeting. Shareholders not attending a company's annual meeting may vote their shares by proxy by allowing someone else to cast votes on their behalf, or they may vote by mail.

Corporate secondary market What is it? Dealer vs auction market

A secondary market transaction involves one owner or creditor selling to another. Therefore, the secondary markets provide the means for transferring ownership of corporate securities. There are two kinds of secondary markets: Dealer markets: Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Auction markets differ from dealer markets in two ways. First, an auction market or exchange has a physical location (like Wall Street). Second, the primary purpose of an auction market is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

S corporation (4)

A unique government creation that looks like a corporation but is taxed like sole proprietorships and partnerships An S-Corp's income is passed to the owners for tax purposes, thereby avoiding potential double taxation of earnings Even undistributed earnings are taxable income for the owners The firm may have no more than 100 stockholders; each must be a US citizen or resident alien—an actual person

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, customers, suppliers, and even the government all have a financial interest in the firm.

Agency relationship (principle and agent) Agency problem

An agency relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests. The relationship between stockholders and management is called an agency relationship. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. Such a conflict is called an agency problem.

When do the advantages of the corporate form of business outweigh the disadvantages?

As a firm gets larger

Capital (or Financial) Structure What is it? internal vs external financing

Capital structure decisions help us determine how to pay for ("finance") our long-term assets We can use internal financing: the net cash we get from selling products and services We can use external financing: Borrow money ("issue debt"), or Sell part of the company ("issue equity")

How does managerial compensation encourage management to act in the best interest of stockholders?

Compensation programs can align managers' self-interest with stockholders' interests Salary and/or bonuses tied to stock performance Stock purchases at discounted prices --Stock option grants --Employee Stock Purchase Programs (ESPP) Promotions for those who increase the stock price

How does control of the firm encourage management to act in the best interest of stockholders? Proxy fight Takeover

Control of the firm ultimately rests with stockholders. They elect the board of directors, who in turn hire and fire managers. A proxy is the authority to vote someone else's stock. A proxy fight is when a group of shareholders join forces and gather enough shareholder proxies to win a corporate vote in order to replace the existing board and thereby replace existing managers. Another way that managers can be replaced is by takeover. Firms that are poorly managed are more attractive as acquisitions because a greater profit potential exists. Thus, avoiding a takeover gives management another incentive to act in the stockholders' interests.

What are 4 examples of companies involved in scandals leading to Sarbanes-Oxley?

Enron, WorldCom, Tyco, and Adelphia

5 things Sarbox tries to do:

Ensure independence of the Board of Directors Maintain accounting controls (checks & balances) Establish compliance programs Establish an ethics program Expand audit committee oversight

Equities and debt security

Equities are issued solely by corporations. Debt securities are issued by both governments and corporations.

What two factors determine whether managers will act in the best interests of stockholders?

First, how closely are management goals aligned with stockholder goals? This question relates, at least in part, to the way managers are compensated. Second, can managers be replaced if they do not pursue stockholder goals? This issue relates to control of the firm.

Long-Term Assets are also called (2) Long-Term Assets are expected to last

Fixed Assets, or Property, Plant & Equipment more than one year

Typical NWC decisions

How much Inventory should we keep on hand? Should we pay for the inventory now or later (thereby creating Accounts Payable)? Should we require our customers to pay cash at the point of sale, or should we allow them to pay us later (creating Accounts Receivable)? Should we pre-pay 6 months of insurance (creating a Pre-Paid Asset), or pay as we go?

Typical capital structure decisions (and who typically makes these decisions?)

How much external financing do we need? When do we need it? Should we issue debt or equity? Should we obtain public or private financing? How much will it cost? Financing decisions are usually made by the Treasury department (within Finance)

In principle, who controls a corporation? Why?Who do stock holders in a corporation elect? Who selects managers?

In principle, stockholders control the corporation because they elect the directors, who then elect managers. Managers are charged with running the corporation's affairs in the stockholders' interests.

Limited partnerships are popular for...

LPs are popular for risky businesses: oil drilling, mining, real estate

What is net working capital? Net working capital (NWC) equation

NWC is the net amount of money the company will have available to work with, to run the firm NWC = Current Assets minus Current Liabilities

What does it mean that owners are residual claimants?

Owners (stockholders) are entitled to cash only after everyone else (lenders, employers, customers, government, etc.) gets paid in full If we focus on ensuring value for owners, by default we are looking out for everyone

PARTNERSHIP What is it? General partnership: To whom do the profits go? Who is liable? Partnership agreement? When does general partnership terminate? How do taxes on income work? What limits the amount of equity that can be raised? How is ownership transferred? Difference between general and limited partnerships: What is it? Liability Ownership

PARTNERSHIP A partnership is similar to a proprietorship except that there are two or more owners (partners). General: all partners share in gains or losses, and all have unlimited liability for all partnership debts. The way gains (and losses) are divided is described in the partnership agreement. This agreement can be an informal oral agreement or a formal written document. General partnership terminates when a general partner wishes to sell out or dies. All income is taxed as personal income to the partners, and the amount of equity that can be raised is limited to the partners' combined wealth. Ownership of a general partnership is not easily transferred because a transfer requires that a new partnership be formed. Limited: One or more general partners will run the business and have unlimited liability, but there will be one or more limited partners who will not actively participate in the business. A limited partner's liability for business debts is limited to the amount that partner contributes to the partnership. A limited partner's interest can be sold without dissolving the partnership, but finding a buyer may be difficult.

3 examples of long-term assets

Real property (real estate): land, buildings Personal property: vehicles, computer systems, etc. Intangible assets: patents, trademarks, goodwill

What are corporate ethics programs really trying to do? (4 goals leading to main goal)

Reduce litigation and judgment costs Maintain a positive corporate image Build shareholder confidence Gain the loyalty & respect of all stakeholders In short, these programs attempt to positively impact the firm's stock price; that is, to maximize value for owners

Pros of partnership (3) Cons of partnership (4)

Pros (same as for sole proprietorship) Easy to create Few regulations Pass-through taxation: income passes to the partners Cons: Unlimited personal liability for partners Difficult to obtain capital Hard to transfer ownership; illiquid The business dies with the partners

Pros of sole proprietorship (3) Cons of sole proprietorship (4)

Pros: Easy to create—just start! Few regulations Pass-through taxation: business income passes to the owner's tax return for tax purposes Cons: Unlimited personal liability Difficult to obtain capital Hard to transfer ownership; illiquid The business dies with the proprietor

Pros & cons of corporations

Pros: Unlimited life Ownership is easily transferred via stock Owners have limited liability Easier to raise large sums of capital Cons: Creating the business can be complex Earnings are subject to double taxation

Are LLCs new concepts or old? What is an LLC? Who can start to tax an LLC as a corporation unless they meet certain criteria? Who can be an owner in an LLC? Taxes? Liability?

Relatively new form of business organization. LLCs will likely replace many partnerships and S-corps goal is to operate and be taxed like a partnership but retain limited liability for owners, so an LLC is essentially a hybrid of partnership and corporation. The IRS. In essence, an LLC cannot be too corporation-like, or it will be treated as one by the IRS. Owners can include foreign investors, corporations, etc. Income is passed to owners for tax purposes, and liability is limited

The Board of Directors has 2 main functions: Management's job

Represent and serve the owners (stockholders) Hire top management ("C" level) The job of financial managers is to make good financial management decisions for the owners in order to increase the current price of the stock

SOLE PROPRIETORSHIP What is it? To whom do the profits go? Who is liable? How do taxes on income work? What is the limit of life span and equity for this form of business? How is ownership transferred?

SOLE PROPRIETORSHIP A sole proprietorship is a business owned by one person. The owner of a sole proprietorship keeps all the profits but the owner has unlimited liability for business debts. This means that creditors can look beyond business assets to the proprietor's personal assets for payment. Similarly, there is no distinction between personal and business income, so all business income is taxed as personal income. The life of a sole proprietorship is limited to the owner's life span, and the amount of equity that can be raised is limited to the amount of the proprietor's personal wealth. Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the sale of the entire business to a new owner.

Typical capital budgeting decisions

Should we launch a new product? Should we expand into a new country? Should we build a new manufacturing plant? Should we install new computer software? With which new equipment should we replace our old equipment?

Unintended effect of Sarbanes-Oxley?

Since its implementation, hundreds of public firms have chosen to "go dark," meaning that their shares are no longer traded on the major stock exchanges, in which case Sarbox does not apply. Most of these companies stated that their reason was to avoid the cost of compliance. Ironically, in such cases, the law has had the effect of eliminating public disclosure instead of improving it.

Possible financial goals (7)

Survive. Avoid financial distress and bankruptcy. Beat the competition. Maximize sales or market share. Minimize costs. Maximize profits. Maintain steady earnings growth. These are too broad and open-ended however.

What are contained in the bylaws? Who can change the bylaws?

The bylaws are rules describing how the corporation regulates its existence. These bylaws may be a simple statement of a few rules and procedures, or they may be quite extensive for a large corporation. The bylaws may be amended or extended from time to time by the stockholders.

Single central problem with sole proprietorships and partnerships

The ability of such businesses to grow can be seriously limited by an inability to raise cash for investment.

SARBANES-OXLEY ACT What is it? Section 404 What does it require of officers? (3) Goal of Sarbox

The act, better known as "Sarbox," is intended to protect investors from corporate abuses. Section 404 requires, among other things, that each company's annual report must have an assessment of the company's internal control structure and financial reporting. An independent auditor must then evaluate and attest to management's assessment of these issues. The officers of the corporation must review and sign the annual reports, report any deficiencies in internal controls, and accept responsibility for material errors in the annual report. In essence, Sarbox makes company management responsible for the accuracy of the company's financial statements.

How does stock price increase?

The cash the firm pays to debtholders, stockholders, and other stakeholders must exceed the cash it received from them In other words, the firm must generate more cash than it consumes

Controller vs Treasurer

The controller's office handles cost and financial accounting, tax payments, and management information systems. The treasurer's office is responsible for managing the firm's cash and credit, its financial planning, and its capital expenditures. These treasury activities are all related to the three general questions raised earlier. Our study thus bears mostly on activities usually associated with the treasurer's office.

Where are large firm equity shares traded in the US? How are OTC shares traded?

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). There is also a large OTC market for stocks: NASDAQ-listed companies tend to be smaller and trade less actively. Total value of NASDAQ stocks is much less than the total value of NYSE stocks.

Goal of Financial Management

The financial manager in a corporation makes decisions for the stockholders of the firm. Given this, instead of listing possible goals for the financial manager, we really need to answer a more fundamental question: From the stockholders' point of view, what is a good financial management decision? If we assume that stockholders buy stock because they seek to gain financially, then the answer is obvious. The goal of financial management is to maximize the current value per share of the existing stock.

Two classes of goals for for-profit companies

The first of these relates to profitability. The goals involving sales, market share, and cost control all relate, at least potentially, to different ways of earning or increasing profits. The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in some way to controlling risk. Unfortunately, these two types of goals are somewhat contradictory.

Agency cost What is it? Indirect Direct (2)

The term agency costs refers to the costs of the conflict of interest between stockholders and management. An indirect agency cost is a lost opportunity, for example imagine that a firm is considering a new investment. The new investment is expected to favorably impact the share value, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the stock 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. Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders. Perhaps the purchase of a luxurious and unneeded corporate jet would fall under this heading. The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.

Primary markets and secondary markets

The term primary market refers to the original sale of securities by governments and corporations. The secondary markets are those in which these securities are bought and sold after the original sale.

What is the appropriate goal (of for-profit businesses) when the firm has no traded stock? Corporations are certainly not the only type of business; and the stock in many corporations rarely changes hands, so it's difficult to say what the value per share is at any given time.

The total value of the stock in a corporation is simply equal to the value of the owners' equity. Therefore, a more general way of stating our goal is as follows: Maximize the market value of the existing owners' equity.

Of which business form are there the most? Why?

There are more sole proprietorships than any other type of business because they are so easy to start.

Why are corporations better at raising cash? (3) What aspect gives them these advantages?

These advantages all make it easier to raise cash: relative ease of transferring ownership [Ownership (shares of stock) can be readily transferred, and the life of the corporation is therefore not limited] unlimited life of the business. limited liability for business debts [The corporation borrows money in its own name. As a result, the stockholders in a corporation have limited liability for corporate debts. The most they can lose is what they have invested], The separation of ownership and management results in these advantages

Clawbacks and deferred compensation

With a clawback, a bonus can be reclaimed by the company for specific reasons, such as fraud. Deferred compensation is money paid to an executive several years after it is earned. With a deferred compensation agreement, if circumstances warrant, the payment can be canceled.

Working Capital What is it? 3 Questions related to working capital

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. (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit? If so, what terms will we offer, and to whom will we extend them? (3) How will we obtain any needed short-term financing? Will we purchase on credit, or will we borrow in the short term and pay cash? If we borrow in the short term, how and where should we do it?

What are contained in the articles of incorporation? To where is this information supplied?

corporation's name its intended life (which can be forever) its business purpose and the number of shares that can be issued. This information must normally be supplied to the state in which the firm will be incorporated. For most legal purposes, the corporation is a "resident" of that state.

A bad financial decision would be one that ____ A good financial decision would be one that ____

decreases owner's equity increases owner's equity

In what way could you argue that management control the firm?

in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm.

Are there more pass-through businesses or corporations in the US? Is more business revenue generated from pass through businesses or corporations?

pass-throughs pass-throughs

What must you do in order to start a corporation?

prepare articles of incorporation (or a charter) and a set of bylaws.

Corporations engage in two types of primary market transactions:

public offerings and private placements. A public offering, as the name suggests, involves selling securities to the general public, whereas a private placement is a negotiated sale involving a specific buyer.

3 forms of business

sole proprietorship, partnership (general and limited), corporation

Definition of corporate finance

the study of the relationship between business decisions and the value of the stock in the business.