Chapter 1

Three important business Trends

1) Increased globalization of business 2) The improvement of Information Technology IT 3) Corporate Governance - The way top managers operate and interface with stockholders.

1-1:What is a firm's intrinsic value? Its current stock price? Is the stock's "true" long-run value more closely related to its intrinsic value or to its current price?

A firm's intrinsic value is an estimate of a stock's "true" value based on accurate risk and return data. It can be estimated but not measured precisely. A stock's current price is its market price—the value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions, you can see that a stock's "true" long-run value is more closely related to its intrinsic value rather than its current price.

Sarbanes-Oxley Act

A law passed by Congress that requires the CEO and CFO to certify that their firm's financial statements are accurate. Eg: Bernie Madoff & Enron

Corporation

A legal entity created by a state , and it is separate and distinct from its owners and mangers, having unlimited life, easy transferability of ownership, and limited liability.

Limited Liability Corporation LLC

A relatively new type of organization that is a hybrid between a partnership and a corporation.

S Corporation

A special designation that allows small business that meet qualifications to be taxed as if they were a proprietorship or partnership rather than a corporation.

Intrinsic Value

An estimate of a stocks "true" value based on accurate risk and return data. The intrinsic value can be estimated but not measured precisely

Corporate Raider

An individual who targets a corporation for takeover because it is undervalued.

Marginal Investor

An investor whose views determine the actual stock price

Proprietorship

An unincorporated business owned by one individual. They have three important advantages: 1) They are easily and inexpensively formed 2) They are subject to few government regulations 3) They are subject to lower income taxes that are corporations They also have three important limitations 1) Proprietors have unlimited personal liability for the business debts, so they can lose more than the amount they invested in the company. 2) The life of the business is limited to life of the individual. 3) because of the first two points they have a difficult time obtaining large amounts of capital. Proprietorships are generally used in small business.

Partnership

An unincorporated business owned by two or more persons.

1-2:When is a stock said to be in equilibrium? At any given time, would you guess that most stocks are in equilibrium as you defined it? Explain.

Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are indifferent between buying or selling a stock. If a stock is in equilibrium then there is no fundamental imbalance, hence no pressure for a change in the stock's price. At any given time, most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium. However, at times stock prices and equilibrium values are different, so stocks can be temporarily undervalued or overvalued.

1-3:Suppose three honest individuals gave you their estimates of Stock X's intrinsic value. One person is your current roommate, the second person is a professional security analyst with an excellent reputation on Wall Street, and the third person is Company X's CFO. If the three estimates differed, in which one would you have the most confidence? Why?

If the three intrinsic value estimates for Stock X were different, you would have the most confidence in Company X's CFO's estimate. Intrinsic values are strictly estimates, and different analysts with different data and different views of the future will form different estimates of the intrinsic value for any given stock. However, a firm's managers have the best information about the company's future prospects, so managers' estimates of intrinsic value are generally better than the estimates of outside investors.

The primary goal of a corporation should be to:

Maximize its owners' value.

Limited Liability Partnership LLP

Similiar to LLC but used for professional firms such as accounting, law, and architecture. It has limited liability like corporations but it is taxed like a partnership.

1-11:Edmund Enterprises recently made a large investment to upgrade its technology. Although these improvements won't have much of an impact on performance in the short run, they are expected to reduce the future cost significantly. What impact will this investment have on Edmund Enterprise's earnings per share this year? What impact might this have on company's intrinsic value and stock price?

Since firm has recently invested large capital to upgrade their technology, earning per share of the firm will go down. The reason why firms earning per share go down is that the firm has less money (as expenses goes up, profit decreases due to capital investment) to distribute dividends to the shareholders. The intrinsic value of firm may increase due to positive future perception of investor towards firm that firms future cash flow will increase due to the change in technology. Since investors have positive perception towards firm , the demand of stock goes up as a result intrinsic value and stock price go up.

1-7:Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For example, if one action increases a firm's stock price from a current level of $20 to $25 in 6 months and then to $30 in 5 years but another action keeps the stock at $20 for several years but then increases it to $40 in 5 years, which action would be better? Think of some specific corporate actions that have these general tendencies.

Stockholder wealth maximization is a long-run goal. Companies, and consequently the stockholders, prosper by management making decisions that will produce long-term earnings increases. Actions that are continually shortsighted often "catch up" with a firm and, as a result, it may find itself unable to compete effectively against its competitors. There has been much criticism in recent years that U.S. firms are too short-run profit-oriented. A prime example is the U.S. auto industry, which has been accused of continuing to build large "gas guzzler" automobiles because they had higher profit margins rather than retooling for smaller, more fuel-efficient models.

Hostile Takeover

The acquisition of a company over the opposition of its management.

1-5:If a company's board of directors wants management to maximize shareholder wealth, should the CEO's compensation be set as a fixed dollar amount, or should the compensation depend on how well the firm performs? If it is to be based on performance, how should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock's intrinsic value? Which would be the better performance measure? Why?

The board of directors should set CEO compensation dependent on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock's performance over the long run, not the stock's price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the growth rate in reported profits than the intrinsic value, although reported profits can be manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must be based on the stock's market price—b ut the price used should be an average over time rather than on a specific date.

What is Finance?

The management of large amounts of money by the government or by large coporations.

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 or selling a stock.

Ethics

The standards of conduct or moral behavior

Market Price

The stock value based on perceived but possibly incorrect information as seen by the marginal investor

1-8:What are some actions that stockholders can take to ensure that management's and stockholders' interests are aligned?

Useful motivational tools that will aid in aligning stockholders' and management's interests include: (1) reasonable compensation packages, (2) direct intervention by shareholders, including firing managers who don't perform well, and (3) the threat of takeover.

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.

Investments

relate to decisions concerning stocks and bonds and include a number of activities, such as: 1) Security Analysis, dealing with finding the proper values of individual securities 2) Portfolio Theory deals with the best way to structure portfolios, or "baskets", of stocks and bonds. 3) Market Analysis deals with the issue of whether stock and bond markets at any given time are "too high", "too low" or about right"

Capital markets

relate to the markets where interest rates, along with stock and bond prices, are determined.