Finance ch 1

Which of the following more accurately describe the treasurer than the controller a. monitors capital expenditures to make sure they are not misappropriated b. Responsible for investing the firms spare cash c. responsible for arranging any issues of common stock d. responsible fr companies tax affairs

B. Responsible for investing the firm's spare cash AND C. Responsible for arranging any issue of common stock

Agency Costs

the costs of the conflict of interest between stockholders and management

corporate governance

laws, regulations, institutions, and corporate practices that protect shareholders and other investors

Stockholders

people or entities that own stock in a corporation and therefore are its owners

Treasuerer

responsible for: cash management, Raising of capital, and banking relationships

two major decisions made by financial managers

Which real assets to invest in (capital budgeting decision) and how to raise the funds (financial decision)

Expenditure on research and development (Financial decision or Investment decision)

investment decision

Read the following passage and and fit each of the following terms into the most appropriate space: financing, real, bonds, investment, executive airplanes, financial, capital budgeting, brand names. Companies usually buy_____ assets. These include both tangible assets such as_____ and intangible assets such as_____. To pay for these assets, they sell_____ assets such as_____. The decision about which assets to buy is usually termed the _____ or _____ decision. The decision about how to raise the money is usually termed the _____ decision.

"Companies usually buy REAL assets. These include both tangible assets such as EXECUTIVE AIRPLANES and intangible assets such as BRAND NAMES. To pay for these assets, they sell FINANCIAL assets such as BONDS. The decision about which assets to buy is usually termed the CAPITAL BUDGETING or INVESTMENT decision. The decision about how to raise the money is usually termed the FINANCING decision."

Fixed salary

A fixed salary means that compensation is (at least in the short run) independent of the firm's success.

Why is underpricing any competitors not an appropriate corporate goal?

A policy of underpricing any competitor can lead the firm to sell goods at a price lower than the price that would maximize market value. Again, in some situations, this strategy might make sense, but it should not be the ultimate goal of the firm. It should be evaluated with respect to its effect on firm value.

A salary linked to Company profits

A salary linked to profits ties the employee's compensation to this measure of the success of the firm. However, profits are not a wholly reliable way to measure the success of the firm. The text points out that profits are subject to differing accounting rules and reflect only the current year's situation rather than the long-run prospects of the firm.

A salary that is paid partly in the form of the company's shares

A salary that is paid partly in the form of the company's shares means that the manager earns the most when the shareholders' wealth is maximized. This is therefore most likely to align the interests of managers and shareholders.

What is agency cost? What are easy agency costs can be mitigated

Agency costs are caused by conflicts of interest between managers and shareholders, who are the owners of the firm. In most large corporations, the principals (i.e., the stockholders) hire the agents (i.e., managers) to act on behalf of the principals in making many of the major decisions affecting the corporation and its owners. However, it is unrealistic to believe that the agents' actions will always be consistent with the objectives that the stockholders would like to achieve. Managers may choose not to work hard enough, to overcompensate themselves, to engage in empire building, to overconsume perquisites, and so on. Corporations use numerous arrangements in an attempt to ensure that managers' actions are consistent with stockholders' objectives. Agency costs can be mitigated by "carrots," linking the manager's compensation to the success of the firm, or by "sticks," creating an environment in which poorly performing managers can be removed

We claim that the goal of a firm is to maximize current market value. Could the following action be considered with that goal? firm drills for oil in a remote jungle. The chance of finding oil is only 1 in 5

Although the drilling appears to be a bad bet, with a low probability of success, the project may be value-maximizing if a successful outcome (although unlikely) is potentially sufficiently profitable. A one-in-five chance of success is acceptable if the payoff conditional on finding an oil field is 10 times the costs of exploration.

Which of the following are correct descriptions of large corporations a. Managers no longer have the incentive to act in their own interest b. The corporation survives even if managers are dismissed c. Shareholders can sell their holdings without disrupting the business d. Corporations, unlike sole proprietorships, do not pay tax; instead, shareholders are taxed on any divided they receive

B. The corporation survives even if managers are dismissed AND C. Shareholders can sell their holdings without disrupting the business.

What is the difference between capital budgeting decisions and capital structure decisions?

Both capital budgeting decisions and capital structure decisions are long-term financial decisions. However, capital budgeting decisions are long-term investment decisions, while capital structure decisions are long-term financing decisions. Capital structure decisions essentially involve selecting between equity financing and long-term debt financing

Which of the following always apply to corporations? a. managers no longer have the incentive to act in their own interest b. limited life c. ownership can be transferred without effecting operations d. managers can be fired with no effect on ownership

C. Ownership can be transferred without affecting operations AND D. Managers can be fired with no effect on ownership.

How do clear and comprehensive financial reports promote effective corporate governance?

Clear and comprehensive financial reports provide essential information to the numerous shareholders of large corporations, allowing the shareholders to monitor the performance of the corporation and its board of directors and management. The debacles at WorldCom and Enron were directly related to a lack of clear and comprehensive financial reports

Company A pays its managers a fixed salary. Company B ties compensation to the performance of the stock. Which companies compensation package would most effectively mitigate conflicts of interest between managers and shareholders?

Company B: Paying managers according to the performance of the firm's stock aligns their interest with those of the owners. Since managers are likely to seek to maximize their own income, linking their compensation to share price, effectively turning them into shareholders, is likely to cause them to focus on increasing firm value. Long- term decisions may not produce short- term profits, thus managers may shy away from making good long- term decisions. Therefore, stock compensation plans may induce better long- term decisions if share grants are restricted stock, which the manager is required to hold onto while employed by the corporation.

Chief Financial Officer (CFO)

Corporate officer who is responsible financial policy and corporate planning

Has limited liability (Partnership or Corporation)

Corporation

What do we mean when we say that corporate income is subject to double taxation?

Double taxation means that a corporation's income is taxed first at the corporate tax rate, and then, when the income is distributed to shareholders as dividends, the income is taxed again at each shareholder's personal tax rate.

Who gets paid first? Common shareholders or employees

Employees get paid first. common share holders get paid last

Why is expanding profits not and appropriate corporate goal

Expanding profits is a poorly defined goal of the firm. The text gives three reasons: (i) There may be a trade-off between accounting profits in one year and accounting profits in another year. For example, writing off a bad investment may reduce this year's profits but increase profits in future years. Which year's profits should be maximized? (ii) Investing more in the firm can increase profits, even if the increase in profits is insufficient to justify the additional investment. In this case the increased investment increases profits but can reduce shareholder wealth. (iii) Profits can be affected by accounting rules, so a decision that increases profits using one set of rules may reduce profits using another.

A bank loan (Real asset or Financial asset)

Financial Asset

With the savings we make from our new inventory system, it may be possible to increase our dividend. (investing decision or financial decision)

Financial Decision

A bank loan agreement (real asset or financial asset)

Financial asset

A share of stock (real asset or financial asset)

Financial asset

Personal IOU (real asset or financial asset)

Financial asset

The balance in the firm's checking account (real asset or financial asset)

Financial asset

Alternatively, we can use the savings to repay some of our long-term debt. (investment decision or financial decision)

Financial decision

Do we need a bank loan to help buy the inventory? (Investment decision or Financial decision)

Financial decision

Why do financial managers refer to the opportunity cost of capital? How would you find opportunity cost of capital for a safe investment?

Financial managers refer to the opportunity cost of capital because corporations increase value for their shareholders only by accepting all investment projects that earn more than this rate. If the company earns below this rate, the market value of the company's stock falls and stockholders look for other places to invest. To find the opportunity cost of capital for a safe investment, managers and investors look at current interest rates on safe debt securities, such as U.S. Treasury debt.

Fritz is a risk-averse and is content with a relatively low but safe return on his investment. Frieda is a risk tolerant and seeks a very high rate of return on her invested savings. Yet both shareholders will applaud a high-risk capital investment if it offers an attractive rate of return. why?

In this situation, a "superior" rate of return is a rate greater than the rate of return investors could earn elsewhere in the financial markets from alternative investments with risk equal to that of the "high-risk capital investment" described in the problem. Fritz (who is risk-averse) will likely sell the investment since he is risk averse. Frieda (who is risk-tolerant) will likely keep her shares since it matches her risk tolerance.

Why is increasing market share not an appropriate corporate goal?

Increased market share can be an inappropriate goal if it requires reducing prices to such an extent that the firm is harmed financially. Increasing market share can be part of a well-reasoned strategy, but one should always remember that market share is not a goal in itself. The owners of the firm want managers to maximize the value of their investment in the firm.

Should we develop a new software package to manage inventory? (Investment or Financial decision)

Investment decision

Should we stock up with inventory ahead of the holiday season? (Investment decision or financial decision)

Investment decision

With a new automated inventory management system, it may be possible to sell off our Birdlip warehouse. (investment decision or financial decision)

Investment decision

mutual fund

fund that pools the savings of many individuals and invests this money in a variety of stocks, bonds, and other financial assets

Is limited liability always an advantage for a corporation and its shareholders? (hint: could limited liability reduce a corporations access to financing?)

Limited liability is generally advantageous to large corporations. Large corporations would not be able to obtain financing from thousands or even millions of shareholders if those shareholders were not protected by the fact that the corporation is a distinct legal entity, conferring the benefit of limited liability on its shareholders. On the other hand, lenders do not view limited liability as advantageous to them. In some situations, lenders are not willing to lend to a corporation without personal guarantees from shareholders, promising repayment of a loan in the event that the corporation does not have the financial resources to repay the loan. Typically, these situations involve small corporations, with only a few shareholders; often these corporations can obtain debt financing only if the shareholders provide these personal guarantees.

Why is minimizing cost not an appropriate corporate goal?

Minimizing costs can also conflict with the goal of value maximization. For example, suppose a firm receives a large order for a product. The firm should be willing to pay overtime wages and to incur other costs in order to fulfill the order, as long as it can sell the additional product at a price greater than those costs. Even though costs per unit of output increase, the firm still comes out ahead if it agrees to fill the order.

The business does not pay income tax (private corporation or partnership)

Partnership

The business is owned by a small group of investors (private corporation or public corporation)

Private corporation

Listed on a stock exchange (Closely held corporation or Public corporation)

Public Corporation

The business has limited liability (sole proprietorship or public corporation)

Public corporation

The business is owned by its shareholders (partnership or public corporation)

Public corporation

A trademark (real asset or financial asset)

Real asset

A truck (real asset or financial asset)

Real asset

An experienced and hardworking sales force (real asset or financial asset)

Real asset

Undeveloped land (real asset or financial asset)

Real asset

controller

Responsible for: preparing financial statements, accounting, and taxes

Read the following passage and and fit each of the following terms into the most appropriate space: expected return, financial assets, Lowe, market value, higher, opportunity cost of capital, real assets, dividend, shareholders Shareholders want managers to maximize the _____ of their investments. The firm faces a trade-off. Either it can invest its cash in ____ or it can give cash back to ____ in the form of a(n) _____ and they can invest it in _____. Shareholders want the company to invest in ____ only if the ____ is ____ than they could earn for themselves in equivalent risk investments. The return that shareholders could earn for themselves is therefor the ____ for the firm.

Shareholders want managers to maximize the MARKET VALUE of their investments. The firm faces a trade-off. It can either invest its cash in REAL ASSETS or it can give the cash back to SHAREHOLDERS in the form of a DIVIDEND and they can invest it in FINANCIAL ASSETS. Shareholders want the company to invest in REAL ASSETS only if the EXPECTED RETURN is HIGHER than they could earn for themselves. The return that shareholders could earn for themselves is therefore the OPPORTUNITY COST OF CAPITAL for the firm.

Many firms have devised defense that make it much more costly or difficult for other firms to take them over. How might such takeover defense affect the firms agency problems? Are managers of firms with formidable takeover defense more or less likely to act in the firms interest rather than their own?

Takeover defenses increase the target firm's agency problems. One of the mechanisms that stockholders rely on to mitigate agency problems is the threat that an underperforming company (with an underperforming management) will be taken over by another company, and the new owners will replace the management team. If management is protected against takeovers by takeover defenses, it is more likely that managers will act in their own best interest, rather than in the interests of the firm and its stockholders.

Sometimes lawyers work on contingency basis. They collect a percentage of their clients settlements instead of receiving fixed fees. Why might cleats prefer this arrangement? Would the arrangement mitigate an agency problem?

The contingency arrangement aligns the interests of the lawyer with those of the client. Neither makes any money unless the case is won. If a client is unsure about the skill or integrity of the lawyer, this arrangement can make sense. First, the lawyer has an incentive to work hard. Second, if the lawyer turns out to be incompetent and loses the case, the client will not have to pay a bill. Third, the lawyer will not be tempted to accept a very weak case simply to generate bills. Fourth, there is no incentive for the lawyer to charge for hours not really worked. Once a client is more comfortable with the lawyer, and is less concerned with potential agency problems, a fee-for-service arrangement might make more sense.

We claim that the goal of a firm is to maximize current market value. Could the following action be considered with that goal? firm buys a corporate jet for its executives

The corporate jet would have to generate benefits in excess of its costs in order to be considered stock-price enhancing. Such benefits might include time savings for executives and greater convenience and flexibility in travel.

Agency cost (The cost resulting from conflicts of interest between managers and shareholders or The amount charged by a company's agents such as the auditors and lawyers)

The cost resulting in conflicts of interest between managers and shareholders

British Quince comes across an average risk investment project that offers a rate of return of 9.5%. This is less than the companies normal rate of return, but one of Quince's directors notes that the company can easily borrow the required investment at 7%. "It's simple" he says "If the bank lends us money at 7%, then cost of capital must be 7%. The projects return is higher than the cost of capital so lets move ahead" How would you respond?

The director is mistaken. The risk of the project is not determined by the borrowing rate from the bank. The opportunity cost of capital is the rate of return available from investments in the financial markets at the same level of risk as Quince's average-risk investments. Therefore, the opportunity cost of capital is also the minimum acceptable rate of return for a firm's capital investments. The rate of return on the average-risk investment project must be compared to the firm's cost of capital in order to determine whether to move ahead with the project

What is limited liability and who benefits from it

The individual stockholders of a corporation (i.e., the owners) are legally distinct from the corporation itself, which is a separate legal entity. Consequently, the stockholders are not personally liable for the debts of the corporation; the stockholders' liability for the debts of the corporation is limited to the investment each stockholder has made in the shares of the corporation.

Your company has uncovered an opportunity to invest for 10 years at a guaranteed 6% rate of return. How would you determine the opportunity cost of capital for this investment?

The opportunity cost of capital for this investment is the rate of return that investors can earn in the financial markets from safe investments, such as U.S. Treasury securities. The best estimate of the opportunity cost of capital would rely on interest rates on U.S. Treasuries with the same maturity as that of the proposed investment, i.e., 1-year Treasury bills.

We claim that the goal of a firm is to maximize current market value. Could the following action be considered with that goal? firm reduces its divided payment, closing ti reinvest more earnings in the business

The reduction in dividends, in order to allow increased reinvestment, can be consistent with maximization of current market value. If the firm has attractive investment opportunities, and wants to save the expenses associated with issuing new shares to the public, then it could make sense to reduce the dividend in order to free up capital for the additional investments.

Explain the difference between a CFO's responsibilities and the treasurer and controllers responsibilities

The responsibilities of the treasurer include the following: supervising cash management, raising capital, and banking relationships. The controller's responsibilities include supervision of accounting, preparation of financial statements, and tax matters. The CFO of a large corporation supervises both the treasurer and the controller. The CFO is responsible for large-scale corporate planning and financial policy

Explain why a firm that strives to maximize stock price should be less subject to an overemphasis on short-term results than one that simply maximizes profits

The stock price reflects the value of both current and future dividends that the shareholders expect to receive. In contrast, profits reflect performance in the current year only. Profit maximizers may try to improve this year's profits at the expense of future profits. But stock-price maximizers will take account of the entire stream of cash flows that the firm can generate. They are more apt to be forward-looking

We claim that the goal of a firm is to maximize current market value. Could the following action be considered with that goal? firm adds cost-of-living adjustment to the pensions of its retired employees

This action might appear, superficially, to be a grant to former employees and thus not consistent with value maximization. However, such "benevolent" actions might enhance the firm's reputation as a good place to work, might result in greater loyalty on the part of current employees, and might contribute to the firm's recruiting efforts. Therefore, from a broader perspective, the action may be value-maximizing..

Responsible for bank relationships (the treasurer or the controller)

Treasurer

It is sometimes suggested that instead of seeking to maximize shareholders value, and in the process, pursuing profit, the firm should seek to maximize the welfare of all its stockholders, such as its employees, its customers, and the community. How far would this object conflict with one of maximizing shareholder value?

While these other objectives are important, only by having Shareholder Value maximized do we have a clear, unambiguous goal. The risks and liability from ambiguity of multiple "Primary" goals would in the end mean little would be accomplished. Instead, we set one goal as the legal obligation of the board and officers of the company, and if they are prudent they will accomplish that in part through working productively with all stakeholders, including employees, the larger community, etc. Failure to act ethically might occasionally provide short-term gains, but in the long term is likely to damage the firm's reputation, alienate employees and customers, and reduce shareholder value (even aside from the intrinsic rewards of ethical behavior). Shareholder value is the one measure that is legally paramount, is measurable, and in the end is most productive overall for all stakeholders.

A manager might do which of the following a. Make shareholders as wealthy as possible by investing in real assets b. modify the firms investment plan to help shareholders achieve a particular time pattern of consumption c. choose high or low risk assets to match shareholders risk preferences d. help balance shareholders checkbooks

a. Make shareholders as wealthy as possible by investing in real assets

Real Assets

assets used to produce goods and services

financial asset

claim on the property or income of a borrower

agency problems

conflicts of interest between managers and stockholders

Corporation

distinct permanent legal entity owned by stockholders