MBA 702 M 1 - 1 Notes (Choi)

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.

1) Capital Budgeting (deciding whether to expand a manufacturing plant) 2) Capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt) 3) Working capital management (modifying the firm's credit collection policy with its customers).

Sole Proprietorship

A business owned by one person

Corporation

A legal "person" is separate and distinct from its owners. They can borrow money and own property, can sue and be sued and can enter into contracts.

A business created as a distinct legal entity and treated as a legal "person" is called a(n): A) corporation. B) sole proprietorship. C) general partnership. D) limited partnership. E) unlimited liability company.

A) corporation.

A firm's short-term assets and its short-term liabilities are referred to as the firm's: A) working capital. B) debt. C) investment capital. D) net capital. E) capital structure.

A) working capital.

General Partnership

All partners share in gains or losses, and all have unlimited liability for all debts

Secondary Markets

Auction Markets: One where buyers and sellers enter competitive bids simultaneously NYSE have more stock total value. Dealer Markets / OTC (Over-the-Counter): Deals in stocks and long-term debt. A financial market where dealers post prices they would be willing to buy and sell specific securities on their own account. NASDAQ tends to be smaller and trade less actively.

One disadvantage of the corporate form of business ownership is the: A) limited liability of its shareholders for the firm's debts. B) double taxation of distributed profits. C) firm's greater ability to raise capital than other forms of ownership. D) firm's potential for an unlimited life. E) firm's ability to issue additional shares of stock.

B) double taxation of distributed profits.

A business owned by a solitary individual who has unlimited liability for the firm's debt is called a: A) corporation. B) sole proprietorship. C) general partnership. D) limited partnership. E) limited liability company.

B) sole proprietorship.

An example of a capital budgeting decision is deciding: A) how many shares of stock to issue. B) whether or not to purchase a new machine for the production Iine. C) how to refinance a debt issue that is maturing. D) how much inventory to keep on hand. E) how much money should be kept in the checking account.

B) whether or not to purchase a new machine for the production Iine.

Which business form is best suited to raising large amounts of capital? A) Sole proprietorship B) Limited liability company C) Corporation D) General partnership E) Limited partnership

C) Corporation

Which one of the following statements is correct? A) The majority of firms in the U.S. are structured as corporations. B) Corporate profits are taxable income to the shareholders when earned. C) Corporations can have an unlimited life. D) Shareholders are protected from all potential losses. E) Shareholders directly elect the corporate president.

C) Corporations can have an unlimited life.

Which one of the following questions is a working capital management decision? A) Should the company issue new shares of stock or borrow money? B) Should the company update or replace its older equipment? C) How much inventory should be on hand for immediate sale? D) Should the company close one of its current stores? E) How much should the company borrow to buy a new building?

C) How much inventory should be on hand for immediate sale?

Which one of the following statements concerning a sole proprietorship is correct? A) A sole proprietorship is designed to protect the personal assets of the owner. B) The profits of a sole proprietorship are subject to double taxation. C) The owner of a sole proprietorship is personally responsible for all of the company's debts. D) There are very few sole proprietorships remaining in the U.S. today. E) A sole proprietorship is structured the same as a limited liability company.

C) The owner of a sole proprietorship is personally responsible for all of the company's debts.

A business formed by two or more individuals who each have unlimited liability for all of the firm's business debts is called a: A) corporation. B) sole proprietorship. C) general partnership. D) limited partnership. E) limited liability company.

C) general partnership.

The growth of both sole proprietorships and partnerships is frequently limited by the firm's: A) double taxation. B) bylaws. C) inability to raise cash. D) limited liability. E) agency problems.

C) inability to raise cash.

A business partner whose potential financial loss in the partnership will not exceed his or her investment in that partnership is called a: A) general partner. B) sole proprietor. C) limited partner. D) corporate shareholder. E) zero partner.

C) limited partner.

Financial Markets

Cash flows to and from the firm

Agency Problem

Conflict of interest between principal and agent

Which one of the following terms is defined as the management of a firm's long-term investments? A) Working capital management B) Financial allocation C) Agency cost analysis D) Capital budgeting E) Capital structure

D) Capital budgeting

Capital structure decisions include determining: A) which one of two projects to accept. B) how to allocate investment funds to multiple projects. C) The amount of funds needed to finance customer purchases of a new product. D) how much debt should be assumed to fund a project. E) how much inventory will be needed to support a project.

D) how much debt should be assumed to fund a project.

Financial managers should primarily focus on the interests of: A) stakeholders. B) the vice president of finance. C) their immediate supervisor. D) shareholders. E) the board of directors.

D) shareholders.

Which one of the following actions by a financial manager is most apt to create an agency problem? A) Refusing to borrow money when doing so will create losses for the firm B) Refusing to lower selling prices if doing so will reduce the net profits C) Refusing to expand the company if doing so will lower the value of the equity D) Agreeing to pay bonuses based on the market value of the company's stock rather than on its level of sales E) Increasing current profits when doing so lowers the value of the company's equity

E) Increasing current profits when doing so lowers the value of the company's equity

The decision to issue additional shares of stock is an example of: A) working capital management. B) a net working capital decision. C) capital budgeting. D) a controller's duties. E) a capital structure decision.

E) a capital structure decision.

Which one of the following terms is defined as the mixture of a firm's debt and equity financing? A) Working capital management B) Cash management C) Cost analysis D) Capital budgeting E) Capital structure

E) capital structure.

The Sarbanes-Oxley Act of2002 is a governmental response to: A) decreasing corporate profits. B) the terrorist attacks on 9/11/200I. C) a weakening economy. D) deregulation of the stock exchanges. E) management greed and abuses.

E) management greed and abuses.

Corporate dividends are: A) tax-free because the income is taxed at the personal level when earned by the firm. B) tax-free because they are distributions of after-tax income. C) tax-free since the corporation pays tax on that income when it is earned. D) taxed at both the corporate and the personal level when the dividends are paid to shareholders. E) taxable income of the recipient even though that income was previously taxed.

E) taxable income of the recipient even though that income was previously taxed.

When is a stock said to be in equilibrium? Why might a stock at any point in time not be in equilibrium?

Equilibrium is when the actual market price equals the intrinsic value, so investors are indifferent between buying and 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. Investor optimism and pessimism, along with imperfect knowledge about the true intrinsic value, leads to deviations between the actual prices and intrinsic values.

Working Capital Management

How will you manage your everyday financial activities, such as collecting from customers and paying suppliers? How do we manage the day-to-day finances of the firm? 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. E.g., How much cash and inventory should we keep on hand?

Goal of Financial Management

Maximize the current value per share of the existing stock

Limited Partnership

One or more partners will run the business and have unlimited liability, but there will also be one or more limited partners who do not actively participate in the business

Treasurer

Oversees cash management, credit management, capital expenditures, and financial planning

Controller

Oversees taxes, cost accounting, financial accounting and data processing

Primary Market

Securities are sold by the company

Secondary Market

Securities that have already been issued are traded between investors

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

The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability ease of transferability ability to raise capital unlimited life

Financial Manager

The top financial manager within a firm is usually the Chief Financial Officer (CFO) or Vice President of Finance Coordinates the activities of the treasurer and the controller.

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: (I) reasonable compensation packages (2) direct intervention by shareholders, including firing managers who don't perform well (3) the threat of takeover. The compensation package should be sufficient to attract and retain able managers but not exceed what is needed. Also, compensation packages should be structured so that managers are rewarded based on 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 managers will be incentivized to keep the stock price high over time. Since intrinsic value is not observable, compensation must be based on the stock's market price-but; the price used should be an average over time rather than on a specific date. Stockholders can intervene directly with managers. Today, most of the stock is owned by institutional investors, and these institutional money managers have the clout to exercise considerable influence over firm's operations. First, they can talk with managers and suggest how the business should be run. In effect, these institutional investors act as lobbyists for the body of stockholders. Second, any shareholder who has owned $2,000 of a company's stock for one year can sponsor a proposal that must be voted on at the annual stockholders' meeting, even if management opposes the proposal. Although shareholder-sponsored proposals are non-binding, the results of such votes are clearly heard by top management. If a firm's stock is undervalued, then corporate raiders will see it to be a bargain and will attempt to capture the firm in a hostile takeover. If the raid is successful, the target's executives will almost certainly be fired. This situation gives managers a strong incentive to take action to maximize their stock's price.

Capital Budgeting

What long-term investments should you take on? What lines of business will you be in, and what sorts of buildings, machinery, and equipment will you need? How much cash do financial managers expect to receive, when they expect to receive it, and how likely they are to receive it? (Size, timing, and risk of future cash flow (FCF)) For example, for a large retailer such as Wal-Mart, deciding whether to open another store would be an important capital budgeting decision

Capital Structure

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? How should we pay for our assets? Should we use debt or equity? A firm's capital structure (or financial structure) is the specific mixture of long-term debt and equity it uses to finance its operations. Regarding the firm's capital structure, the financial manager should answer two questions: 1. How much should the firm borrow? 2. How and where should the firm raise the money?