Finance Chapter 1 Review

What kind of market is NASDAQ?

A dealer market

What are the three types of financial management decisions?

Capital Budgeting Capital Structure Working Capital Management

Give an example of Capital Structure.

Deciding whether to issue new equity and use the proceeds to retire outstanding debt.

In this context, what kinds of problems can arise?

Management may act in its own or someone else's best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.

Give an example of Working Capital Management.

Modifying the firm's credit collection policy with its customers.

What benefits are there to these types of business organization as opposed to the corporate form?

Simpler Less regulation The owners are also the managers Sometimes personal tax rates are better than corporate tax rates

Suppose you were the financial manager of a not-for-profit business (a not for profit hospital, perhaps). What kinds of goals do you think would be appropriate?

Since such organizations frequently pursue social or political missions, many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., providing their goods and services to society at the lowest possible cost. Another approach might be to observe that even a not-for-profit business has equity. Thus, an appropriate goal would be to maximize the value of the equity.

What is the primary disadvantage of the corporate form of organization?

The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earning and dividends.

Describe the process whereby the owners control the firm's management.

The shareholders elect the directors of the corporation, who in turn appoint the firm's management.

What is the main reason that an agency relationship exists in the corporate form of organization?

This separation of ownership from control in the corporate form of organization is what causes agency problems to exist.

What goal should always motivate the actions of the firm's financial manager?

To maximize the current market value (share price) of the equity of the firm (whether its publicly traded or not)

What are the four primary disadvantages to the sole proprietorship and partnership forms of business organization?

Unlimited liability Limited life Difficulty in transferring ownership Hard to raise capital funds

You've probably noticed coverage in the financial press of an initial public offering (IPO) of a company's securities. Social networking company Facebook is a relatively recent example. Is an IPO a primary-market transaction or a secondary-market transaction?

A primary market transaction.

Can our goal of maximizing he call of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects such as customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Try to think of some specific scenarios to illustrate your answer.

An argument can be made either way. At one extreme, we could argue that in a market economy, all of these things are priced. This implies an optimal level of ethical and/or illegal behavior and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are non-economic phenomena and are best handled through the political process. The following is a classic (and highly relevant) thought question that illustrates this debate: "A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability planes. What should the firm do?"

How are auction markets different from dealer markets?

Dealer markets like NASDAQ represent dealers operating in dispersed locales who buy and sell assets themselves, usually communicating with other dealers electronically or literally over the counter.

Give an example of Capital Budgeting.

Deciding on whether to expand a manufacturing plant.

Critics have charged that compensation to top management in the US is simply too high and should be cut back. For example, focusing on large corporations, John Hammergren, CEO of McKesson, earned about $131 million in 2011 and about $285 million over the 2007-2011 period. Are such amounts excessive? In answering, it might be helpful to recognize that superstar athletes such as LeBron James, top entertainers such as Oprah Winfrey, and many others at the top of their respective fields earn at least as much, if not more.

How much is too much? Who is worth more, John Hammergren or Tiger Woods? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. having said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argues that much of this reward is simply due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e, stock price increases in excess of general market increases.

What does it mean when we say the New York Stock Exchange is an auction market?

In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to buy and sell their assets.

Who owns a corporation?

In the corporate form of ownership, the shareholders are the owners of the firm.

Name at least 2 advantages of corporate organization.

Limited liability Ease of transferability Ability to raise capital Unlimited life

In response to the Sarbanes-Oxley Act, many small firms in the US have opted to "go dark" and delist their stock. Why might a company choose this route? What are the costs of "going dark"?

The biggest reason that a company would "go dark is because of the increased audit costs associated with Sarbanes-Oxley compliance. A company should always do a cost-benefit analysis, and it may be the case that the costs of complying with Sarbox outweigh the benefits. Of course, the company could always be trying to hide financial issues of the company! This is also one of the costs of going dark: Investors surely believe that some companies are going dark to avoid the increased scrutiny from Sarbox. This taints other companies that go dark just to avoid compliance costs. This is similar to the lemon problem with used automobiles: Buyers tend to underpay because they know a certain percentage of used cars are lemons. So, investors will tend to pay less for the company stock then they otherwise would. It is important to note that even if the company delists, its stock is still likely traded, but on the over-the-counter market pink sheets rather than on an organized exchange. This adds another coast since the stock is likely to be less liquid now. All else the same, investors pay less for an asset with less liquidity. Overall, the cost to the company is likely a reduced market value. Whether delisting is good or bad for investors depends on the individual circumstances of the company. It is also important to remember that there are already many small companies that file only limited financial information.

Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your company's management immediately begins fighting off this hostile bid. Is management acting in the shareholders' best interests? Why or why not?

The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this.

Would our goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country? Why or why not?

The goal will be the same, but the best course of action toward that goal may require adjustments due to different social, political, and economic climates.

In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance?

The treasurer's office and the controller's office are the two primary organizational groups that report directly to the chief financial officer. The controller's office handles cost and financial accounting, tax management, and management information systems. The treasurer's office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is concentrated within the functions of the treasure's office.

Corporate ownership varies around the world. Historically, individuals have owned the majority of shares in public corporations in the US. In Germany and Japan, however, banks, other large financial institutions, and other companies own most of the stock in public corporations. Do you think agency problems are likely to be more or less severe in Germany and Japan than in the US? Why? In recent years, large financial institutions such as mutual funds and pension funds have been becoming the dominant owners of stock in the US, and these institutions are becoming more active in corporate affairs. What are the implications of this trend for agency problems and corporate control?

We would expect agency problems to be less severe in other countries, primarily due to the relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be able to implement more effective monitoring mechanisms that can individual owners, given an institutions' deeper resources and experiences with their own management. The increase in institutional ownership of stock in the US and the growing activism of these large shareholder groups may lead to a reduction in agency problems for US corporations and a more efficient market for corporate control.