FIN 3290 EXAM 1 SEPT. 25TH

1.1 Identify three fundamental types of decisions that financial managers make and identify which part of the balance sheet each of these decisions affects.

1. Capital Budgeting Decisions - identifying the productive assets the firm should buy. These decisions affect long-term assets on the balance sheet. 2. Financing Decisions - determining how the firm should finance or pay for assets. These decisions affect long-term debt and stockholders' equity on the balance sheet. 3. Working Capital Management Decisions - determining how day-to-day financial matters should be managed. These decisions affect current assets and current liabilities on the balance sheet.

1.5 Cash flows: What is the appropriate decision rule for a firm considering undertaking a capital project? Give a real-life example.

A firm should undertake a capital project only if the value of its future cash flows exceeds the cost of the project. For example, a financial manager would not invest $10,000,000 in a new production line if the net present value of future cash flows from that line are expected to be only $9,000,000. That would be like throwing $1,000,000 away.

1.23 Business ethics: How can a lack of business ethics negatively affect the performance of an economy? Give an example.

A lack of business ethics can lead to corruption, which, in turn, creates inefficiencies in an economy, inhibits the growth of capital markets, and slows the rate of overall economic growth. For example, the Russian economy has had a relatively difficult time attracting foreign investment since the fall of the Soviet Union due, in part, to weak ethics and corruption in the business community and local and national governments. Lower foreign investment has led to slower overall economic growth than the country might otherwise have enjoyed.

1.10 Organizational form: What is a partnership, and what is the biggest disadvantage of this form of business organization? How can this disadvantage be avoided?

A partnership consists of two or more owners legally joined together to manage a business. The major disadvantage to partnerships is that all partners have unlimited liability for the organization's debts and legal obligations no matter what stake they have in the business. One way to avoid this is to form a limited partnership in which only general partners have unlimited liability and limited partners are only responsible for business obligations up to the amount of capital they have invested in the partnership.

1.3 Cash flows: Explain the difference between profitable and unprofitable firms.

A profitable firm is able to generate enough cash flows from productive assets to cover its operating expenses, taxes, and payments to creditors. Unprofitable firms fail to do this, and therefore they may be forced to declare bankruptcy.

1.9 Organizational form: What are the advantages and disadvantages of a sole proprietorship?

Advantages: • It is the easiest business organization to start. • It is the least regulated. • Owners keep all the profits and do not have to share the decision-making authority with anyone. • All income is taxed as personal income, which is usually in a lower tax bracket than corporate income. Disadvantages: • The proprietor has an unlimited liability for all business debt and financial obligations of the firm. • The amount of capital that can be invested in the firm is limited by the proprietor's wealth. • It is difficult to transfer ownership (requires sale of the business).

1.4 What are agency costs? Explain.

Agency costs are costs that result from an agency relationship in which there is a conflict of interest between a principal and an agent. An agency relationship exists in a business when a firm's managers (agents) are not also its owners (principals). Agency costs are incurred when managers act in ways that harm owners' interests. The cost of mechanisms, such as audits, that help control agency conflicts are also agency costs.

1.8 Identify the sources of agency costs. What are some ways these costs can be controlled in a company?

Agency costs are the costs that result from conflicts of interest between the agent and the principal. They can either be direct, such as lavish dinners or trips, or indirect, which are usually missed investment opportunities. A company can control these costs by tying management compensation to company's performance and by establishing an independent board of directors. Outside factors that contribute to the minimization of agency costs are the threat of corporate raiders that can take over a company not performing up to expectations and the competitive nature of the managerial labor market

1.20 Agency conflicts: What is an agency relationship, and what is an agency conflict? How can agency conflicts be reduced in a corporation?

Agency relationships develop when a principal hires an agent to perform some service or represent the firm. An agency conflict arises when the agent's interests and behaviors are at odds with those of the principal. Agency conflicts can be reduced through the following three mechanisms: management compensation, control of the firm, and the board of directors.

1.6 Explain why profit maximization is not the best goal for a company. What is a better goal?

Although profit maximization appears to be the logical goal for any company, it has many drawbacks. First, profit can be defined in a number of different ways, and variations in net income for similar firms can vary widely. Second, accounting profits do not exactly equal cash flows. Third, profit maximization does not account for timing and ignores risk associated with cash flows. An appropriate goal for financial managers who do not have these objections is to maximize the value of the firm's current stock price. In order to achieve this goal, management must make financial decisions so that the total value of cash inflows exceeds the total value of cash outflows.

1.16 Finance function: All public companies must hire a certified public accounting firm to perform an independent audit of their financial statements. What exactly does the term audit mean?

An independent CPA firm that performs an audit of a firm ensures that the financial numbers are reasonably accurate, that accounting principles have been adhered to year after year and not in a manner that distorts the firm's performance, and that the accounting principles used are in accordance with generally accepted accounting principles (GAAP).

Information asymmetry: Describe what an information asymmetry is in a business transaction. Explain how the inequity associated with an information asymmetry might be, at least partially, solved through the market for goods or services.

An information asymmetry exists when one party to a business transaction possesses information that is not available to the other parties in the transaction. If the parties with less information understand their relative disadvantage, they are likely to pay lower prices for the goods and services they purchase, or charge higher prices for the goods and services they sell.

1.5 Why would the owners of a business choose to form a corporation even though they will face double taxation?

Because the benefits, such as limited liability and access to large amounts of capital at relatively low cost in the public markets, outweigh the cost of double taxation (as well as the higher costs associated with forming a corporation).

1.6 Management role: What is a firm's capital structure, and why is it important?

Capital structure shows how a company is financed; it is the mix of debt and equity on the liability side of the balance sheet. It is important as it affects the risk and the value of the company. In general, companies with higher debt-to-equity proportions are riskier because debt comes with legal obligations to pay periodic payments to creditors and to repay the principal at the end.

1.1 Describe the cash flows between a firm and its stakeholders.

Cash flows are generated by a firm's productive assets that were purchased through either issuing debt or raising equity. These assets generate revenues through the sale of goods and services. A portion of this revenue is then used to pay wages and salaries to employees, pay suppliers, pay taxes, and pay interest on the borrowed money. The leftover money, residual cash, is then either reinvested back in the business or is paid out to stockholders in the form of dividends.

1.13 Organizational form: What is double taxation?

Double taxation occurs when earnings are taxed twice. The owners of a C-corporation are subject to double taxation—first at the corporate level when the firm's earnings are taxed and then again at a personal level when they receive dividends.

1.7 What are some of the major external and internal factors that affect a firm's stock price? What is the difference between the two general types of factors?

External factors that affect the firm's stock price are: (1) economic shocks, such as natural disasters or wars, (2) the state of the economy, such as the level of interest rates, and (3) the business environment, such as taxes or regulations. On one hand, external factors are variables over which the management has no control. On the other hand, internal factors that affect the stock price can be controlled by management to some degree, because they are firm specific, such as financial management decisions, product quality and cost, and the line of business, the management has selected to enter. Finally, perhaps the most important internal variable that determines the stock price is the expected cash flow stream: its magnitude, timing, and riskiness.

1.4 Management role: What three major decisions are of most concern to financial managers?

Financial managers are most concerned with the capital budgeting decisions, the financing decisions, and the working capital management decisions.

1.10 Give an example of a conflict of interest in a business setting, other than the one involving the real estate agent discussed in the chapter text.

For example, imagine a situation in which you are a financial officer at a growing software company and your firm has decided to hire outside consultants to formulate a global expansion strategy. Coincidentally, your wife works for one of the major consulting firms that your company is considering hiring. In this scenario, you have a conflict of interest, because instinctively, you might be inclined to give the business to your wife's firm, because it will benefit your family's financial situation if she lands the contract, regardless of whether or not it makes the best sense for your firm.

1.21 Firm's goal: What can happen if a firm is poorly managed and its stock price falls substantially below its maximum potential price?

If the stock price falls below its maximum potential price, it attracts corporate raiders, who look for fundamentally sound but poorly managed companies they can buy, turn around, and sell for a handsome profit.

Business ethics: What ethical conflict does insider trading present?

Insider trading is an example of information asymmetry. The main idea is that investment decisions should be made on an even playing field. Insider trading is illegal because it puts one party at a significant disadvantage in trading. If insider trading were allowed, capital transfers would be much more difficult.

1.12 Organizational form: Explain what is meant by stockholders' limited liability.

Limited liability for a stockholder means that the stockholder's legal liability extends only to the capital contributed or the amount invested.

1.5 Identify seven mechanisms that can help better align the goals of managers with those of stockholders.

Mechanisms that can help align the goals of managers with those of stockholders are as follows: (1) the board of directors, (2) management compensation, (3) the managerial labor market, (4) competition among managers, (5) large stockholders, (6) the takeover market, and (7) the legal and regulatory environment. Boards of directors that are independent from managers can help limit the extent to which managers are able to act solely in their own interest. Firms design compensation plans that are tied to firm performance in order to provide managers with incentives to make decisions consistent with the goal of stockholder value maximization. A third mechanism that helps align the goals of managers is the managerial labor market. It is difficult for poorly performing managers to find a good job elsewhere, and it is difficult for a poorly performing firm to hire good managers, which a firm's current managers typically want to do. Competition among managers within a firm is a fourth mechanism that helps align the goals of managers with those of stockholders. This is because managers who act in the interest of stockholders are more likely to advance within the firm. Because large stockholders have a lot to gain from aligning the goals of managers with their own, they are likely to expend resources to encourage managers to maximize stock value. Sixth, the threat of a takeover, which leads to firing of poor managers, can provide current managers with incentives to perform well. Finally, laws and regulations limit the ability of managers to make decisions that harm stockholders.

1.14 Organizational form: What is the form of business organization taken by most large companies and why?

Most large companies prefer to operate as public corporations because large amounts of capital can be raised in public markets at a relatively low cost.

1.4 Suppose that a group of accountants wants to start an accounting business. What organizational form would they most likely choose, and why?

Most lawyers, accountants, and doctors form what are known as limited liability partnerships. This formation combines the tax advantages of partnerships with the limited liability of corporations.

1.2 Management role: What is net working capital?

Net working capital is the difference between a firm's total current assets and its total current liabilities.

1.24 Agency conflicts: What are some ways to resolve a conflict of interest?

One way to resolve a conflict of interest is by complete disclosure. As long as both parties are aware of the fact that, for example, both parties in a contract negotiation are represented by the same firm, disclosure is sufficient. Another way to avoid a conflict of interest is for the company to remove itself from serving the interest of one of the parties. This is, for example, the case with accounting firms not being allowed to serve as consultants to companies for whom they perform audits.

1.22 Agency conflicts: What are some of the regulations that pertain to boards of directors that were put in place to reduce agency conflicts?

Some of the regulations include: • The majority of board members must be outsiders. • A separation of the CEO and chairman of the board positions is recommended. • Firm is required to have a code of ethics approved by the board.

1.3 What is the difference between stockholders and stakeholders?

Stockholders, also referred to as shareholders, are the owners of the company. A stakeholder, on the other hand, is anyone with a claim on the assets of the firm, including, but not limited to, shareholders. Stakeholders include the firm's employees, suppliers, creditors, and the government.

1.9 What is the Sarbanes-Oxley Act, and what does it focus on? Why does it focus in these areas?

The Sarbanes-Oxley Act is an act of Congress that was passed in 2002. This act was passed in the aftermath of several corporate scandals that occurred at the turn of the century. The act focuses on (1) reducing agency costs in corporations, (2) restoring ethical conduct within the business sector, and (3) improving the integrity of accounting reporting system within firms. Failures in these areas led to the corporate scandals that preceded passage of Sarbanes-Oxley.

1.4 Which one of the following characteristics does not pertain to corporations? a. Can enter into contracts b. Can borrow money c. Are the easiest type of business to form d. Can be sued e. Can own stock in other companies

The answer that does not pertain to corporations is: c. Are the easiest type of business to form.

1.18 Firm's goal: What is the appropriate goal of financial managers? How do managers' decisions affect how successful the firm is in achieving this goal?

The appropriate goal of financial managers should be to maximize the current value of the firm's stock price. Managers' decisions affect the stock price in many ways as the value of the stock is determined by the future cash flows the firm can generate. Managers can affect the cash flows by, for example, selecting what products or services to produce, what type of assets to purchase, or what advertising campaign to undertake.

1.15 Finance function: What is the primary responsibility of the board of directors in a corporation?

The board of directors of a corporation is responsible for serving the interests of stockholders in managing the corporation. It is possible that the interest of managers may deviate from those of the stockholders. The board's objective is to monitor and correct any management decisions that might not be in the best interest of the stockholders. For example, board duties include hiring and firing the CEO, setting CEO pay, and monitoring the investment decisions of managers.

1.8 Organizational form: What are the common forms of business organization discussed in this chapter?

The common forms of business organization discussed are sole proprietorship, partnership, corporation, and limited liability company and partnership.

1.19 Firm's goal: What are the major factors that affect a firm's stock price?

The factors affecting the stock price include: the characteristics of the firm, the economy, economic shocks, the business environment, expected cash flows, and current market conditions.

1.7 Management role: What are some of the working capital decisions that a financial manager faces?

The financial manager must make working capital decisions regarding the level of inventory to hold, the terms of granting credit (accounts receivable), and the firm's policy on paying accounts payable.

1.11 Organizational form: Who are the owners in a corporation, and how is their ownership represented?

The owners of a corporation are its stockholders or shareholders, and the evidence of their ownership is represented by shares of common stock. Other types of ownership do exist and include preferred stock.

1.2 What are the three fundamental decisions the financial manager is concerned with, and how do they affect the firm's balance sheet?

The primary financial management decisions every company faces are capital budgeting decisions, financing decisions, and working capital management decisions. Capital budgeting addresses the question of which productive assets to buy; thus, it affects the asset side of the balance sheet. Financing decisions focus on raising the money the firm needs to buy productive assets. This is typically accomplished by selling long-term debt and equity. Finally, working capital decisions involve how firms manage their current assets and liabilities. The focus here is seeing that a firm has enough money to pay its bills and that any spare money is invested to earn a return.

1.5 What are typically the main components of an executive compensation package?

The three main components of a typical executive compensation package are: base salary, bonus based on accounting performance, and compensation tied to the firm's stock price.

1.1 Capital: What are the two basic sources of funds for all businesses?

The two basic sources of funds for all businesses are debt and equity.

1.3 Why is stock value maximization superior to profit maximization as a goal for management?

While profit maximization appears to be a logical goal at first glance, it has some serious drawbacks. First, since accounting profit is the difference between revenues and expenses, it can be distorted by accounting decisions. Second, accounting profits are quite different from cash flows. Since cash flows are the focus of investors, they should also be the focus of managers. Third, profit maximization does not account for when cash flows actually occur. Finally, profit maximization as a goal ignores the risk involved in generating the cash flows. Stock value maximization is superior to profit maximization because it overcomes all of the listed shortcomings of profit maximization. This is because the value of a firm's stock is determined by the cash flows that the firm is expected to produce. It accounts for (1) the size of the expected cash flows, (2) the timing of the expected cash flows, and (3) the riskiness of the expected cash flows.

1.2 Which of the following is/are advantages of the corporate form of organization? a. Reduced start-up costs b. Greater access to capital markets c. Unlimited liability d. Single taxation

b. (Shares in a corporation can be sold to raise capital from investors who are not involved in the business. This greatly increases the amount of capital that can be raised to fund the business.)

1.17 Firm's goal: What are some of the drawbacks to setting profit maximization as the main goal of a company?

• It is difficult to determine what is meant by "profit". • It does not address the size and timing of cash flows—it does not account for the time value of money. • It ignores the uncertainty or risk of cash flows.