FINANCE 450 CH 1

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 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.

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.

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.

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.

Your 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 and disadvantages of organizing a firm as a corporation?

Advantages: 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. Disadvantages: 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.

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.

Which organization forms give their owners limited liability?

Limited partnership for limited partners only. Corporation.

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.

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.

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.

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.