fundamentals of corporate finance 13th edition - Chapter 1+2

Agency Cost

Refer to the costs of the conflict of interest between stockholders and management • Indirect agency costs are lost opportunities • Direct agency costs come in two forms: 1. Corporate expenditures that benefits management but costs the stockholder 2. Expense that arises from the need to monitor management actions

capital spending

Refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets)

(7) Possible Financial Goals

Risk Control: • Survive • Avoid financial distress and bankruptcy Profitability: • Beat the competition • Maximize sales or market share • Minimize costs • Maximize profits • Maintain steady earnings growth These two things are difficult to do at the same time! You usually have to take some risks in order to increase profitability.

In addition to the importance of finance for marketing, accounting, and management careers, finance is also now considered a ______ discipline, especially at the graduate level.

STEM

Taxes

Same rate for every corporation

Net Working Capital

current assets - current liabilities

Assets are listed on a balance sheet in order of

decreasing liquidity. This means that the most liquid assets are listed first.

What positions report to the CFO?

Treasurer and Controller

Operating Cash Flow

refers to the cash flow that results from the firm's day-to-day activities of producing and selling

What are some shortcomings of the goal of profit maximization?

"Profit maximization" is a vague goal. Do we mean profits this year? If so, we should note that actions such as deferring maintenance, letting inventories run down, and taking other short-run cost-cutting measures will tend to increase profits now, but these activities aren't necessarily desirable. The goal of maximizing profits may refer to some sort of "long-run" or "average" profits, but it's still unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? Second, what do we mean by the long run? Also, the pursuit of profit normally involves some element of risk, so it isn't really possible to maximize both safety and profit. What we need, therefore, is a goal that encompasses both factors.

Finance: The Five Main Areas

1. Corporate finance 2. Investments 3. Financial institutions 4. International finance 5. Fintech

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

1. Managerial compensation is usually tied to financial performance in general and often to share value in particular 2. Managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries

Benefit Corporation

A benefit corporation is for profit, but it has three additional legal attributes: 1. Accountability - must consider how an action will affect shareholders, employees, customers, the community, and the environment 2. Transparency - in addition to standard corporate reports, a benefit corporation must provide an annual report detailing how the company pursued a public benefit during the year, or any factors that inhibited the pursuit of this goal 3. Purpose - must provide a public benefit, either to society as a whole or the environment

Sole Proprietorship

A business owned by one person. This is the simplest type of business to start and is the least regulated form of organization. Depending on where you live, you might be able to start a proprietorship by doing little more than getting a business license and opening your doors. For this reason, there are more proprietorships than any other type of business, and many businesses that later become large corporations start out as small proprietorships.

Corporation

A corporation is a business created as a distinct legal entity composed of one or more individuals or entities • Legal "person," separate and distinct from its owners with many of the rights, duties, and privileges of an actual person • Stockholders and managers are usually separate groups • May be referred to as joint stock companies, public limited companies, or limited liability companies

Working Capital

A firm's short-term assets and liabilities. 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 that 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. Some questions about working capital that must be answered are the following: (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? These are just a small sample of the issues that arise in managing a firm's working capital.

Partnership

A partnership is a business formed by two or more individuals or entities. There are two types of partnerships: • General partnership • Limited partnership

Stakeholders

A stakeholder is someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm • Such groups will also attempt to exert control over the firm, perhaps to the detriment of the owners

Liabilities:

Accounts payable, notes payable,

What are the advantages / disadvantages of a Corporation?

Advantages: • Ownership can be readily transferred • Life of corporation is unlimited • Limited liability for stockholders Disadvantages: • Double taxation - first profits are taxed at the corporate level when they are earned and then again at the personal level when they are paid out (as dividends)

What are the advantages / disadvantages of a Sole Proprietorship?

Advantages: • Simplest to start • Least regulated • Owner keeps all the profits Disadvantages: • All business income is taxed as personal income • Amount of equity that can be raised is limited to the amount of the proprietor's personal wealth • Owner has unlimited liability for business debts • Life of sole proprietorship is limited to owner's life span • Ownership may be difficult to transfer

Product Costs

All costs that include things such as raw materials, direct labor expense, and manufacturing overhead.

Shareholders' Equity

Assets - Liabilities

What are the advantages / disadvantages of a Partnership?

Basically same as sole proprietorship - Advantages: • Simplest to start • Least regulated • Owners keeps all the profits Disadvantages: • All business income is taxed as personal income • Amount of equity that can be raised is limited to the amount of the proprietor's personal wealth • Owners (depending on whether limited or general partner) has unlimited liability for business debts • Life of sole proprietorship is limited to owner's life span • Ownership may be difficult to transfer

cash flow from assets

Cash flow to creditors + Cash flow to stockholders

Assets

Cash, accounts receivable, inventory, fixed assets

In large firms, financial activity is usually associated with which top officer?

Chief Financial Officer (CFO)

How to make management behave:

Compensate and have the power to replace

Can you give a definition of corporate finance?

Corporate finance, broadly speaking, is the study of ways to answer these three questions: 1. What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need? 2. 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? 3. How will you manage your everyday financial activities, such as collecting from customers and paying suppliers?

Period Costs

Costs that are incurred during a particular time period and might be reported as selling, general, and administrative expenses.

cash flow to stockholders

Dividends paid-Net new equity raised

Operating Cash Flow Calculation

EBIT + Depreciation - Taxes

Sarbanes-Oxley Act (SOX)

Enacted in 2002, SOX is intended to protect investors from corporate abuses Key requirements of SOX include the following: • Section 404 requires each company's annual report to have an assessment of the company's internal control structure and financial reporting • Officers of corporation must review and sign annual reports • Annual report must list any deficient in internal controls

Change in NWC

Ending NWC-Beginning NWC

Net Capital Spending calculation

Ending net fixed assets-Beginning net fixed assets +Depreciation

Which of the following companies were involved in corporate scandals that led to Sarbanes-Oxley?

Enron Tyco WorldCom

noncash items

Expenses charged against revenues that do not directly affect cash flow such as depreciation

T/F It is sometimes argued that, left to themselves, managers tend to minimize the amount of resources over which they have control.

False - maximize

Financial Market

Financial markets function as both primary and secondary markets for debt and equity securities. 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. Equities are, of course, issued solely by corporations. Debt securities are issued by both governments and corporations.

Goal of Financial Management

In a for-profit business, the goal of financial management is to make money or add value for the owners. • In general, the goal is to maximize the current value per share of the existing stock. When a firm has no traded stock, the goal is to maximize the market value of the existing owners' equity. • Goal does not imply the financial manager should take illegal or unethical actions to increase the value of equity in the firm

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

In a general partnership, all the partners share in gains or losses, and all have unlimited liability for all partnership debts, not just some particular share. The way partnership gains (and losses) are divided is described in the partnership agreement. In a limited partnership, 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.

Primary Markets

In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation. 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. By law, public offerings of debt and equity must be registered with the Securities and Exchange Commission (SEC). Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal, and selling costs of public offerings can be considerable. Partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the SEC and do not require the involvement of underwriters (investment banks that specialize in selling securities to the public).

cash flow to creditors

Interest paid-Net new borrowing

Which tax rate is relevant for financial decision making?

Marginal tax rate

Change in Net Working Capital

Measured as the net change in current assets relative to current liabilities

Income Statement

Measures performance over some period of time like a quarter or a year. The income statement equation is: Revenues-Expenses=Income.

Cash Flow from assets Calculation

Operating Cash Flow-Net Capital Spending-Change in net working capital

Secondary Markets

Secondary market transaction involves one owner or creditor selling to another. Therefore, the secondary markets provide the means for transferring ownership of corporate securities. Although a corporation is directly involved only in a primary market transaction (when it sells securities to raise cash), the secondary markets are still critical to large corporations. The reason is that investors are much more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired.

Balance Sheet

Snapshot of the firm. Financial statements showing a firm's accounting value on a particular date.

Cash Flows between the Firm and the Financial Markets

Suppose we start with the firm selling shares of stock and borrowing money to raise cash. Cash flows to the firm from the financial markets (A). The firm invests the cash in current and fixed assets (B). These assets generate cash (C), some of which goes to pay corporate taxes (D). After taxes are paid, some of this cash flow is reinvested in the firm (E). The rest goes back to the financial markets as cash paid to creditors and shareholders (F).

average tax rate

Tax bill divided by taxable income-percentage of income that goes to pay taxes

Capital Structure

The mixture of debt and equity maintained by a firm. A firm's capital structure (or financial structure) is 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? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm. Second, what are the least expensive sources of funds for the firm?

Agency Problem

The possibility of conflict of interest between the stockholders and management of a firm. Occurs when: Stockholder self-interest =/= management's self-interest

Capital Budgeting

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

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 why the corporate form is superior for raising cash. If a corporation needs new equity, for example, it can sell new shares of stock and attract new investors. Apple is an example. The company was a pioneer in the personal computer business. As demand for its products exploded, it had to convert to the corporate form of organization to raise the capital needed to fund growth and new product development. The number of owners can be huge; larger corporations have many thousands or even millions of stockholders. For example, in 2020, General Electric Company (better known as GE) had about 440,000 stockholders and about 8.7 billion shares outstanding. In such cases, ownership can change continuously without affecting the continuity of the business

Liquidity

The speed and ease with which an asset can be converted to cash.

The relationship between stockholders and management is called an ______ relationship

agency (stockholders hire someone else, i.e. an agent, to represent their interests)

Assets=

liabilities + stockholders equity

Since ownership in a corporation can be dispersed over a huge number of stockholders, it can be argued that ______ effectively controls the firm.

management

Cash flow from assets involves three components

operating cash flow, capital spending, and change in net working capital

Book Value

the difference between the cost of a depreciable asset and its related accumulated depreciation

marginal tax rate

the rate of the extra tax you would pay if you earned one more dollar

financial leverage

the use of debt in a firm's capital structure

What is a Proxy? and what is a Proxy Fight?

• proxy - the authority to vote someone else's stock • proxy fight - when a group solicits proxies in order to replace the existing board and thereby replace existing managers • Existing management may be replaced by stockholders via proxy fights and takeovers