Chapter 1

Which of the following are defining features of the primary market?

Proceeds from the sale of securities goes to the issuing firm It is the market where initial public offerings are made

Which of these is an important mechanism used by unhappy stockholders to replace current management?

Proxy fight

When one owner or creditor sells to another, the transaction takes place in the _________ market.

Secondary

A bad financial decision is defined as a decision that ______ shareholder wealth.

decreases

The federal government taxes

Corporate earnings and shareholder dividends

Which of the following are considered non-owner stakeholders in a company?

Employees Suppliers Government

How is ownership transferred in a corporation?

Ownership is transferred by gifting or selling shares of stock

Which of the following is NOT one of the basic areas of finance

Personal finance

A corporation borrows money in its own name.

True

A treasurer's responsibilities typically include:

- making financial plans - managing capital expenditure decisions - handling cash flows

Corporations in other countries are often called:

-joint stock companies -public limited companies -limited liability companies

Sole Proprietorship

A business owned by one person simplest type of business to start and is the least regulated form of organization more proprietorships than any other type of business, and many businesses that later become large corporations start out as small proprietorships The owner of a sole proprietorship keeps all the profits The bad news is that the owner has unlimited liability for business debts This means that creditors can look 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, importantly, the amount of equity that can be raised is limited to the proprietor's personal wealth. Ownership of a sole proprietorship may be difficult to transfer because this requires the sale of the entire business to a new owner.

Corporation

A business owned by stockholders who share in its profits but are not personally responsible for its debts a legal "person" separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person. Corporations can borrow money and own property, can sue and be sued, and can enter into contracts. A corporation can even be a general partner or a limited partner in a partnership, and a corporation can own stock in another corporation. n a large corporation, the stockholders and the managers are usually separate groups. The stockholders elect the board of directors, who then select the managers. Management is charged with running the corporation's affairs in the stockholders' interests. In principle, stockholders control the corporation because they elect the directors. advantages: Ownership (represented by shares of stock) can be readily transferred, and the life of the corporation is, therefore, not limited. 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 corporate form has a significant disadvantage. Because a corporation is a legal person, it must pay taxes. Moreover, money paid out to stockholders in the form of dividends is taxed again as income to those stockholders. This is double taxation, meaning that corporate profits are taxed twice: at the corporate level when they are earned and again at the personal level when they are paid out.

Sarbanes-Oxley Act

A law passed by Congress that requires the CEO and CFO to certify that their firm's financial statements are accurate. In response to corporate scandals involving companies such as Enron, WorldCom, Tyco, and Adelphia, Congress enacted the Sarbanes-Oxley Act in 2002. The act, which is better known as "Sarbox," is intended to strengthen protection against corporate accounting fraud and financial malpractice. Since its implementation, hundreds of public firms have chosen to "go dark," meaning that their shares are no longer traded in the major stock markets, 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 had the effect of eliminating public disclosure instead of improving it. Sarbox has also probably affected the number of companies going public in the United States. Recently, many U.S.-based companies have chosen to go public on the London Stock Exchange's Alternative Investment Market (AIM) instead. The cost savings can be enormous, especially for small companies. For example, Protonex Technologies, a fuel cell developer based in Southborough, Massachusetts, estimated that it costs about $1 million per year in compliance costs and mailings to stockholders to be listed on the AIM. In contrast, the annual cost to be listed on the NASDAQ would be about $3 million, with a large part of the increase due to Sarbox compliance costs.

The costs incurred due to a conflict of interest between stockholders and management are called

Agency

If you hire a real estate company to sell your house, you are most apt to encounter which one of the following?

Agency problem

A general partnership has which of the following characteristics?

All the partners share in gains or losses of the partnership. Each partner has unlimited liability for all firm debt.

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. In general, 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.

What is the appropriate goal when the firm has no traded stock?

As long as we are dealing with for-profit businesses, only a slight modification is needed. 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: Maximize the market value of the existing owners' equity.

New York Stock Exchange is an

Auction Market

auction market

Auction markets differ from dealer markets in two ways. First, an auction market, or exchange, has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

the Sarbanes-Oxley Act Requires corporate officers to

Be responsible for errors in the annual report. Confirm the validity of the financial statements.

_____ budgeting is the process of planning and managing a firm's long-term assets

Capital

What three questions are the financial manager concerned with?

Capital budgeting Working capital management Capital structure

Which term applies to the mixture of debt and equity maintained by a firm?

Capital structure

Control of the firm

Control of the firm ultimately rests with stockholders. They elect the board of directors, who, in turn, hires and fires management. The mechanism by which unhappy stockholders can act to replace existing management is called a proxy fight. Another way that management can be replaced is by takeover. Firms that are poorly managed are more attractive as acquisitions than well-managed firms because a greater profit potential exists. Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders' interests.

Which of the following positions generally report to the chief financial officer (CFO)

Controller and Treasurer

The _____ office responsible for corporate tax reporting.

Controller's

Which of the following are reasons that the corporation is the most important form of business?

Corporations are separate legal entities. Corporations can sue and be sued. Corporations can enter contracts.

over-the-counter market (OTC)

Dealer markets in stocks and long-term debt Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically.

Investments

Deals with financial assets such as stocks and bonds. Some of the more important questions include: -What determines the price of a financial asset, such as a share of stock? -What are the potential risks and rewards associated with investing in financial assets? -What is the best mixture of the different types of financial assets to hold? Careers: Portfolio manager, security analyst, stockbroker

Which of the following is a disadvantage of sole proprietorships and partnerships?

Difficulty of transferring ownership.

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

Enron WorldCom Tyco

"Profit Maximization" is the goal for the management of a corporation in the short run only.

False

Profit Maximization is the goal for the management of a corporation in short-run only.

False

The Sarbanes-Oxley Act provides incentives for companies to go public in US markets.

False

One of the important questions in the area of investments includes the potential risks and reward associated with investing in ______ assets.

Financial

Which of the following are true of a sole proprietorship?

Has limited life. It is one of the simplest types of businesses to form.

According to the textbook, which of the following if not one of the three main questions to be addressed if you wanted to start your own business?

How many employees will I need?

What Is Business Finance?

Imagine you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another: 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 investments? 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?

A good financial decision will do which of the following?

Increase market value of shareholders' equity Increase the value of the firm's existing stock

A corporation is a distinct ____ entity and as such can have a name and take advantage of the legal powers of natural persons.

Legal

When a corporation is formed, it is granted which of the following rights?

Legal powers to sue The ability to issue stock

Which of the following are included in a firm's capital structure?

Long-term debt and equity

Since ___________ and ownership are separated, a corporation's life is unlimited.

Management

Managerial Compensation

Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy stock at a fixed price. The more the stock is worth, the more valuable is this option. The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, those managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

In a shareholder-manager relationship, who is the agent?

Managers

_________ ___________ can be used to encourage managers to maximize the value of the stock.

Stock options

Listing

Stocks that trade on an organized exchange (or market) are said to be listed on that exchange. In order to be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ for different exchanges. NYSE has the most stringent requirements of the stock markets in the United States. There are minimums on earnings, assets, and number and market value of shares outstanding.

Cash Flows to and from the Firm

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 (or long-term) assets (B). These assets generate some 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).

The controller is responsible for which of the following tasks?

Tax reporting and payments. Financial accounting.

A Corporation by Another Name . . .

The corporate form has many variations around the world. Exact laws and regulations differ, of course, but the essential features of public ownership and limited liability remain. These firms are often called: joint stock companies, public limited companies, or limited liability companies.

Trading in corporate securities

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), which accounts for more than 85 percent of all the shares traded in auction markets.

profit maximization

The goal of maximizing profits may refer to some sort of "long-run" or "average" profits, but it's unclear exactly what this means. First, do we mean something like accounting net income or earnings per share? As we will see, these numbers may have little to do with what is good or bad for the firm. Second, what do we mean by the long run? As a famous economist once remarked: "In the long run, we're all dead!" More to the point, this goal doesn't tell us the appropriate trade-off between current and future profits. The goal of financial management is to maximize the current value per share of the existing stock. The goal of maximizing the value of the stock avoids the problems associated with the different goals we discussed earlier. There is no ambiguity in the criterion, and there is no short-run versus long-run issue. We explicitly mean that our goal is to maximize the current stock value. Of course, maximizing stock value is the same thing as maximizing the market price per share.

Limited Liability Company (LLC)

The goal of this entity is to operate and be taxed like a partnership but retain limited liability for owners. Thus, an LLC is essentially a hybrid of a partnership and a corporation. The IRS will consider an LLC a corporation, thereby subjecting it to double taxation, unless it meets certain specific criteria. cannot be too corporation-like, or it will be treated as one by the IRS. LLCs have become common.

Agency Relationships

The relationship between stockholders and management Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interest. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. 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 Suppose you hire someone to sell your car and you agree to pay her a flat fee when she sells the car. The agent's incentive in this case is to make the sale, not necessarily to get you the best price. If you paid a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist. This example illustrates that the way an agent is compensated is one factor that affects agency problems.

dealer market

There are two kinds of secondary markets: auction markets and dealer markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses.

What is the main goal of financial management?

To maximize current share value

Management goals

To see how management and stockholder interests might differ, imagine that a corporation is considering a new investment. The new investment is expected to favorably affect the stock price, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the share 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. This is one example of an agency cost. Our discussion indicates that management may tend to overemphasize organizational survival to protect job security. Also, management may dislike outside interference, so independence and corporate self-sufficiency may be important goals.

Do Managers Act in the Stockholders' Interests?

Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely are management goals aligned with stockholder goals? This question relates to the way managers are compensated. Second, can management be replaced if they do not pursue stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of reasons to think that, even in the largest firms, management has a significant incentive to act in the interests of stockholders.

Business finance is broadly concerned with which of the following

Which long-term investments to make. How to finance long-term investments. How to manage day-to-day finances of the firm.

Partnership

a business owned by two or more people 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. This agreement can be an informal oral agreement, such as "let's start a lawn mowing business," or a lengthy, formal written document. 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 do 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. This form of organization is common in real estate ventures, for example. The advantages and disadvantages of a partnership are basically the same as those for a proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to form. General partners have unlimited liability for partnership debts, and the 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 by a general partner is not easily transferred because a new partnership must be formed. A limited partner's interest can be sold without dissolving the partnership, but finding a buyer may be difficult. Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as forms of business organization are (1) unlimited liability for business debts on the part of the owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three disadvantages add up to a single, central problem: The ability of such businesses to grow can be seriously limited by an inability to raise cash for investment.

private placement

a negotiated sale involving a specific buyer. 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).

The threat of _____ motivates managers to make good decisions.

a take over

The conflict of interest between an agent and a principal is called an

agency problem

The relationship between stockholders and management can be best described as an

agency relationship

Financial Institutions

basically businesses that deal primarily in financial matters. Banks and insurance companies would probably be the most familiar. For example, a commercial loan officer at a bank would evaluate whether a particular business has a strong enough financial position to warrant extending a loan. At an insurance company, an analyst would decide whether a particular risk was suitable for insuring and what the premium should be

International Finance

careers in international finance generally involve international aspects of either corporate finance, investments, or financial institutions. For example, some portfolio managers and security analysts specialize in non-U.S. companies. Similarly, many U.S. businesses have extensive overseas operations and need employees familiar with such international topics as exchange rates and political risk. Banks frequently are asked to make loans across country lines, so international specialists are needed there as well.

Working Capital Management

efers 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 the firm has sufficient resources to continue its operations and avoid costly interruptions. Some questions that must be answered are the following: (1) How much cash and inventory should we keep on hand? (2) Should we sell on credit to our customers? (3) How will we obtain any needed short-term financing? (4) If we borrow in the short term, how and where should we do it?

Working capital includes which of the following?

inventory cash short-term assets

Secondary market

involves one owner or creditor selling to another. It is, therefore, the secondary markets that provide the means for transferring ownership of corporate securities. Although a corporation is only directly involved 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.

public offering

involves selling securities to the general public 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.

A sole proprietorship is a business that

is owned by one person

Businesses are motivated to organize as corporations because stockholders in a corporation have ____ liability for corporate debt.

limited

In a limited partnership, a limited partner's liability for business debt is

limited to their cash contribution to the partnership

Capital budgeting is concerned with making and managing expenditures on

long-term assets

primary market

market for selling financial assets that can only be redeemed by the original holder 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.

The goal of a "for profit" business is to _____ the value of shareholder wealth

maximize

A _______ is similar to a proprietorship, except there are two or more owners.

partnership

Capital Structure

refers to 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? Second: What are the least expensive sources of funds for the firm? has to decide exactly how and where to raise the money. Choosing among lenders and among loan types is another job handled by the financial manager.

The owners of a corporation are called:

shareholders

A ______ is someone other than an owner or a creditor who potentially has a claim on the cash flows of the firm.

stake holder

A corporation receives cash from financial markets by selling ________ and _________.

stocks are bonds

Owner's Equity

the amount remaining after the value of all liabilities is subtracted from the value of all assets

The goal of the financial management is to increase the value of ______?

the existing shares of stock

Capital Budgeting

the process of planning and managing a firm's long-term investments 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. must be concerned with how much cash they expect to receive, when they expect to receive it, and how likely they are to receive it.

The officer responsible for managing the firm's cash flows is the

treasurer

Financial Management

usually associated with a top officer of the firm, often called the chief financial officer (CFO) or vice president of finance.

Ensuring that the firm has sufficient funds to continue operations of day-to-day basis comes under the heading of _____ management

working capital