FINA 3332 Exam 1
Stock market indexes
-Dow jones industrial average (DJIA) -Standard & poor's 500 (S&P 500)
Which of the following features of a corporation is LEAST accurate?
-Earnings from a corporation are taxed only once
Advantages of sole proprietorship
-Easy formation (because of that many new business uses this organizational form
Shareholders can:
-Ensure that employees are paid with company stock and/or stock options -Endure that underperforming managers are fired -Mount hostile takeovers
The collection of all the outstanding shares of a corporation is known as the _________
-Equity of the corporation
The _____ the risk of recieving future cash flows, the _____ will be the present value of those cash flows
-Greater -Lower
The primary reason for the divergence between the shareholder wealth maximization goal and the actual goals pursued by management has been attributed to
-Separation of ownership and control
Four types of firms
-Sole proprietorships -Partnerships (General and limited) -Limited liability companies -Corporations
Explain double taxation
-The corporation pays tax on its profits. When the remaining profits are distributed to the shareholders, the shareholders pay their own personal income tax on this income
A major disadvantage of a sole propriertorship is the fact that:
-The owner has unlimited personal liability
Shareholders of a corporation have limited liability?
-They are not liable Bc: A corporation is solely responsible for its own obligations .The corporation is not liable for any personal obligations of its owners.
in corporations, shareholders are entitled to
-dividend payments
general partners
-have same rights and privileges as partners in any general partnership -are personally liable for the firms debt obligations -LIABLE FOR DEBTS -have management authority
Partnership
-more than one owner -Each partner is liable for the entire amount -Partnership ends on the death or withdrawal of any single partner -Personal Taxation
S corporations
-100 or less shareholders -Limited liabilty -Profits/Loses are allocated directly to shareholders based on their ownership share -ALL INCOME IS TREATED AS PERSONAL INCOME TO YOU -you pay taxes on the income immediately regardless of whether the corporation distributes it as a dividend or reinvests it in the company. -Personal Taxation
Financial management draws heavily on the following related disciplines:
-Accounting -Macroeconomics -Microeconomics
Valuing decisions for a corporation
-Acquisition of another company -Expansion to a different market -Development of a new product
Dow Jones Industrial Average (DJIA)
-Includes 30 large and well-established U.S corps that covers most important sectors in the economy -It is calculated by adding the prices of 30 stocks and dividing by an adjustment factor (accounts for stock dividends and splits)
Standard & Poor's 500 (S&P 500)
-Includes 500 of highest-valued U.S companies -Market value-weighed index
Valuing decisions for an individual
-Investing in stocks? Which stocks? -Saving for retirement? How much?
Competitive market
A market in which goods can be bought and sold at the same price
perpetuity
A stream of equal cashflows that occur at regular intervals and last forever
Quantifying costs and benefits
Any decision in which the value of the benefits exceeds the costs will increase the value of the firm
Arbitrage Opportunity
Any situation in which it is possible to make profit without taking any risk or making any investment
Why can their be only one competitive price of a good?
Arbitrage
example of agency problem
Relationship between a landlord and a renter
Bid-ask spread
Ask price-Bid price. -It represents the cost of trading and the profit for the market makers
Transaction cost
Bid-ask spread+ broker commission
Banks and credit unions source of money:
Deposits
Shareholders of a corporation pay taxes twice
Double taxation
A ________ is when a rich individual or organization purchases a large fraction of the stock of a poorly performing firm and in doing so gets enough votes to replace the board of directors and the CEO.
Hostile take-over
Law of one price
In competitive markets, securities with the same cash flows must have the same price
Explain why the bid-ask spread is a transaction cost.
Investors always buy at the ask and sell at the bid. Since ask prices always exceed bid prices, investors "lose" this difference. It is one of the transaction costs. Since the market makers take the other side of the trade, they make this difference.
Rule #1 for moving cash flows across time
It is only possible to compare or combine values at the same point in time
Joe is a general partner in a limited partnership firm, while Jane is a limited partner in the same firm. Which of the following statements regarding their respective relationships to the firm is correct?
Jane's liability for the firm's debt consists solely of her investment in the firm.
Which organization forms give their owners limited liability? ****
Limited partnership for limited partners only. Corporation.
Banks and credit unions use of money:
Loans to people and business
A corporation is a legal entity separate from its owners
None of the other organizational forms share this characteristic
The same share of stock CANNOT trade for two different prices
Otherwise there would be an arbitrage opportunity
What does the phrase limited liability mean in a corporate context?
Owners' liability IS limited to the amount they invested in the firm. Stockholders ARE NOT responsible for any encumbrances of the firm; in particular, they CANNOT be required to pay back any debts incurred by the firm.
Mutual funds source of money:
Peoples investments
Bid price
Price the Market Maker is willing to BUY a security
Ask price
Price the Market Maker is willing to SELL a security
The primary objective of the firm is:
Profit maximization
The primary objective of the financial manager is:
Shareholder wealth maximization
What are some of the differences between the NYSE and the NASDAQ?
The NYSE is an example of a physical market. It is located at 11 Wall Street in New York City. On the floor of the NYSE, market makers (known on the NYSE as specialists) match buyers and sellers. Nevertheless, in today's technology-driven economy, a stock market does not need to have a physical location. Consequently, stock markets such as NASDAQ, which are called OTC market. An important difference between the NYSE and NASDAQ is that on the NYSE, each stock has only one market maker. The NYSE standards are more stringent than those of NASDAQ; traditionally, there has been a certain pride in being listed on the NYSE. Many companies would start on the NASDAQ and then move to the NYSE as they grew. However, NASDAQ has retained many big, successful companies such as Starbucks, Apple, and Microsoft.
mmanaging work capital
The financial manager must ensure that the firm has enough cash on hand to meet its obligations at each point in time
What is the most important type of decision that the financial manager makes?
The financial manager's most important job is to make the firm's investment decisions.
Arbitrage
The practice of buying and selling equivalent to take advantage of a price difference
In a competitive market
The price of a good determines its cash value
interest rate is
The price of money
What is the difference between a primary and a secondary market?
The primary market refers to a corporation issuing new shares of stock and selling them to investors. After this initial transaction between the corporation and investors, the shares continues to trade in a secondary market between investors without the involvement of the corporation.
Interest rate factor
The rate of exchange between dollars today and dollars in the future
Valuation principal
The value of an asset to the firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using these market prices, and when the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm.
Discount factor
The value today of a dollar received in the future, expressed as: 1/1+r
Rule #2 for moving cash flows across time
To calculate a cash flow's future value, you MUST COMPOUND IT
Rule #3 for moving cash flows across time
To calculate the value of a future cash flow at an earlier point in time, we must discount it
arbitrage opportunity
You would buy it on the exchange with the lower price and immediately sell it on the exchange with the higher price
Mutual funds use of money:
buys stocks, bonds, and other financial instruments on behalf of its investors
How to measure shareholder wealth
by the market value of the firm Number of shares outstanding x Market price per share
Agency problems
conflict of interest in which AGENTS entrusted to look after the interest of the PRINCIPAL, use this power for THEIR OWN BENEFIT.
investor buys at the ask
investor sells at the bid
Shareholder wealth is defined as the
present value of the expected future returns to the shareholders of the firm.
Board of directors are elected by
shareholders
Corporations
-Separate from its owners -owners are NOT LIABLE -not liable for any personal obligations of its owners
Corporate securities represent claims agains the
-Assets and future earnings of the firm
Limited partnership
-Atleast 1 GP -No limit on LP -GP are liable for firms debts LP are NOT liable Personal Taxation
A financial manager makes two types of decisions and one task
-Financing decision -Investment decision -Manage cash flow
Disadvantages of corporations
-High cost and longer process to establish -"double" taxation -Agency problems due to the seperation of ownership and management
Questions faced by Financial managers?
-Investment can be successful -Where do funds come from -Does firm have adequate cash -Merger or acquisition -how are Cash flows used
Insurance companies use of money
-Invests mostly in bonds and some stocks, using the investment income to pay claims
Financial decisions often faced in a typical career in business?
-Launching new product -Choosing suppliers -Deciding to outsource or not -Issue new stock or borrow money -Raise money
A major advantage of the corporate form of business over both sole proprietorships and partnerships is the
-Limited liability
Advantages of corporations
-Limited liability of shareholders -Permanency -Flexibility -Higher ability to raise capital: due to the limited liability and easy marketability of corporation's shares
Private corporation
-Limited number of owners and there is no organized market for its shares -More difficult to determine the market value
Three mechanisms to minimize agency problems
-Managerial compensation -The CEO's performance: Replacing the CEO Hostile takeover
Public corporation
-Many owners and its shares trade on an organized market, called a stock market
Primary market
-Market for the sale of NEW SECURITIES issued by corporations -Issuing firm recieves the proceeds from the sale
Secondary market
-Market in which PREVIOUSLY ISSUED securities are traded among investors -Issuing firm doesn't recieve proceeds and it is not directly involved
C corporations
-Most corporations are "c" corporations -Must pay corporate taxes on its profits -Shareholders effectivley pay taxes twice -you are only taxed when you receive the income as a dividend -Double taxation
Limited partners
-NOT LIABLE -ownership interest is transferable -They have NO management authority
What are the most important exchanges in the U.S?
-NYSE -Nasdaq
Limited liability companies (LLC)
-No general partner -Owners run the business -Unlimited owners -No liability for firms debts -Personal Taxation -Require approval of members to transfer ownership
ownership of a corporation
-No limit on number of owners -Divided into shares known as STOCK
Listing standards
-Outlines of the requirements a company must meet to be traded on the exchange -The NYSE's listing standards are more strick than NASDAQ
sole proprietorship
-Owned & run by one person -Represent 71.8% of all business in the U.S -Account for 3% of total. usiness revenues in the U.S -Liability for firls debts -Personal Taxation
Insurance companies source of money:
-Premiums and investments
The shareholder wealth maximization goal states that management should seek to maximize the ______ of the expected future returns to the owners of the firm.
-Present value
Disadvantages of sole proprietorship
-Principal limitation that there is NO SEPERATION between the firm and the owner -Unlimited personal liability -Difficulty raising funds -Permanence of the business -The life of the business is limited to the life of the owner -It is difficult to transfer ownership
The objective of maximizing shareholder wealth, as measured by the market value of the firm's stock
-Provides a way to consider the risk of the returns being offered
When do individuals face financial decisons?
-Retirement -Car loan or lease -Partuclar stock -Home mortgage
The major factors that determine the market value of a company's shares of stock include the
-Risk of its cash flows and the timing of its cash flows
Why do all shareholders agree on the same goal for the financial manager?
1. All of the decisions by the financial manager are made within the context of the overriding goal of financial management - to maximize the wealth of the owners, the stockholders. 2. The stockholders have invested in the corporation, putting their money at risk to become the owners of the corporation.
What is the most important difference between a corporation and all other organizational forms?
1. An important difference amount the types of corporate organizational forms is the way they are taxed. Shareholders of a corporation pay taxes twice. 2. This system is sometimes referred to as double taxation
What is the financial cycle?
1. In the financial cycle, money flows from savers and investors to companies who use that money to fund growth through new products. 2. Financial institutions connect the money with ideas and assist in returning the profits back to the investors. 3. In the financial cycle, companies generate profits and wages and interest which then flow back to the savers and investors.
What are the main disadvantages of organizing a firm as a corporation?
1. Income to a corporation is subject to double taxation, once at the corporate level and again when received by the owners in the form of a dividend. 2. The corporation is more complicated and more expensive to set up than other business entities.
How do financial institutions help with risk-bearing?
1. Insurance companies spread out risk by pooling premiums together from policy holders and pay the claims of those who have an accident, fire, medical need or die. This process spreads the financial risk of these events out across a large pool of policyholders and the investors in the insurance company. 2. Mutual funds and pension funds take your savings and spread them out among the stocks and bonds of many different companies, limiting your exposure to any one company. 3. Financial institutions not only assist with risk-bearing of savers and investors, but must also be concerned about their own risk, spreading their loans out among a variety of clientele.
What role do investment banks play in the economy?
1. Investment banks advise companies in major financial transactions such as buying or selling companies or divisions. 2. Investment banks assist companies in raising capital by issue of stocks and bonds on behalf of corporate clients.
Corporate managers work for the owners of the corporation. Consequently, they should make decisions that are in the interests of the owners,rather than in their own interests. What strategies are available to shareholders to help ensure that managers are motivated to act this way?
1. Mount hostile takeovers. 2. Write contracts that ensure that the interests of the managers and shareholders are closely aligned. 3. Ensure that employees are paid with company stock and/or stock options. 4. Ensure that underperforming managers are fired.
What are some of the similarities and differences among mutual funds, pension funds, and hedge funds?
1. Mutual funds, pension funds and hedge funds are all financial institutions involved with helping savers and investors reach their financial goals. 2. Unlike mutual funds and pension funds which serve investors of all means, hedge funds are primarily designed for wealthy investors and endowments. 3. Pension funds, which are similar to mutual funds in that they buy stocks, bonds and other financial instruments on behalf of its investors, is primarily concerned with providing retirement income. Mutual funds allow investments to be accumulated and withdrawn for a variety of financial goals.
Recall the last time you ate at an expensive restaurant where you paid the bill. Now think about the last time you ate at a similar restaurant, but your parents paid the bill. Did you order more food (or more expensive food) when your parents paid? Explain how this relates to the agency problem in corporations.
1. The agency problem leads an individual (in your case) and corporate managers (in the corporate setting) to put their own self-interest ahead of the interests of the shareholders (your parents in your case). 2. In both situations there may be a lack of interest in controlling costs if those costs are not borne directly by the person making the decision.
You're are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too high, but you will be the CEO of the combined, much larger company. You know that when the company gets bigger, your pay and prestige will increase. What is the nature of the agency conflict here and how is it related to ethical considerations?
1. There is an ethical dilemma when the CEO of a firm has incentives that are opposite to those of the shareholders. 2. In this case, you (as the CEO) have an incentive to potentially overpay for another company (which would be damaging to your shareholders) because your pay and prestige will improve.
What are the main advantages of organizing a firm as a corporation?
1. There is no limit on the number of owners a corporation may have, thus allowing the corporation to raise substantial amounts of capital. 2. The life of the business can continue beyond the death of any of the owners. 3. The liability of the owners is limited to the amount of their investments in the firm.
The financial cycle
1.People invest and save their money 2.Through loans and stock, that money flows to companies who use it to fund growth through new products, generating profits and wages 3.The money then flows back to the savers and investors
Time value of money
A dollar today is worth more than a dollar tomorrow
about 19% of us businesses, 84% of business revenues are:
Corporations
Suppose you are considering renting an apartment. You, the renter, can be viewed as an agent while the company that owns the apartment can be viewed as the principal. What agency conflicts do you anticipate? Suppose, instead, that you work for the apartment company. What features would you put into the lease that would give the renter incentives to take good care of the apartment?
The agent (renter) will not take the same care of the apartment as the principal (owner), because the renter does not share in the costs of fixing damages to the apartment. To mitigate this problem, having the renter pay a deposit should motivate the renter to keep damages to a minimum. The deposit forces the renter to share in the costs of fixing any problems that are caused by the renter. In addition, the provision in the lease for annual renewals allows an incentive for a long-term renter* to maintain the leased apartment.
Explain the difference between an S and a C corporation.
The profits and losses of the S corporation are passed directly to shareholders and are not subject to corporate taxes, while the C corporation must first pay taxes on any profits before passing the after-tax profits on to shareholders. In addition, the S corporation can have no more than 100 shareholders, all of whom must be US citizens or residents. The C corporation does not have any such restrictions on its shareholders.
What is the difference between a public and private corporation?
The shares of a public corporation are traded on an exchange (or "over the counter" in an electronic trading system) while the shares of a private corporation are not traded on a public exchange.
On August 19, 2004 Google IPO offered 19,605,052 shares at a price of U.S. $85 per share, which were sold in an online auction in a bid to make the shares more widely available. Which of the following statements best describes why these are considered primary market transactions?
The transactions were between the corporation and investors.
Dollars today are different than dollars in the future
Use the price of money to evaluate
The secondary market is:
Where investors can buy and/or sell the company's shares with other investors (but not the company itself)
A primary market is:
Where the company sells shares of itself to investors.
