Principles of Finance Module 2

dividend

1. a pro rata payment of money by a company to its shareholders, usually made periodically

defining agency conflict

1. agency conflicts can occur when the incentives of the agent do not align with those of the principal

defining conflicts between managers and shareholders

1. agency costs mainly occur when ownership is separated, or when managers have objectives other than shareholder value maximization

limited partnerships

1. allow limited liability for some partners who have management authority

fundamental analysis

1. an analysis of a business with the goal of financial projections in terms of income statement, financial statements and health, management and competitive advantages, and competitors and markets

partnership

1. an association of two or more people to conduct a business

proprietor

1. an owner

valuations are usually done on

1. assets or liabilities -assets: stocks, options, business enterprises, and intangible assets -liabilities: bonds issued by a company

business structures

1. business organizations can be structures in two major ways: in terms of their structures as legal entities, and in terms of the internal structure and management processes 2. sole proprietor, partnership, corporation, and LLC

limited liability company

1. business structure in the US in where by the owner's are not personally liable for the company's debts or liabilities 2. combine the characteristics of a corporation with those of a partnership or sole proprietorship 3. LLC owners are generally called members 4. many states don't restrict ownership, meaning anyone can be a member including individuals, corporations, foreigners, and foreign entities 5. an LLC is a more formal partnership arrangement that requires articles of organization to be filed with the state 6. may file taxes as personal or as a corporation 7. articles of organization establish the rights, powers, duties, liabilities, and other obligations of each member of the LLC 8. limits liability; can be dissolved upon the death or bankruptcy of a member 9. LLC separates the business assets of the company from the personal assets of the owners

"Goals of Financial Management"

1. can differ from company to company and sector and industry 2. managing a company's finances with the intention to succeed 3. creating profit and ensuring an acceptable ROI 4. accomplished through business financial plans, setting up financial controls, and financial decision-making 5. long-term success includes: -planning, budgeting, managing and assessing risk, establishing ongoing procedures

maturity

1. date when payment is due

financial management

1. financial management focuses on the practical significance of financial numbers (what do the figures mean?) 2. sound financial management creates value and organizational agility through the allocation of scarce resources among competing business opportunities 3. it is an aid to the implementation and monitoring of business strategies and helps achieve business objectives 4. there are several goals of financial management, one of which is valuation

financial management is concerned with

1. financial matters for the practical significance of the numbers, asking "what do the figures mean?" 2. many goals of financial management, one of which is maximizing shareholder and market value

valuation often relies on

1. fundamental analysis (of financial statements) of the project, business, or firm, using tools such as discounted cash flow or net present value

managers

1. managers control the corporation and make strategic decisions, while shareholders are owners, and bondholders are creditors 2. while all three parties have a direct or indirect interest in the financial performance of the corporation, each of the three parties has different rights and rewards

managers conflicts of interest

1. managers might also purchase other companies to expand individual power, or spend money on wasteful pet projects, instead of working to maximize the value of corporation stock -venturing onto fraud, they may even manipulate financial figures to optimize bonuses and stock-price-related benefits

bondholders

1. may create ex-ante contracts prohibiting management from taking on very risky projects that may arise, or they may raise the interest rate demanded, increasing the cost of capital for the company 2. this can negatively impact the shareholders 3. conversely, shareholder's preferences can adversely impact bondholders

conflicts of interest (COI)

1. occurs when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in another

sole proprietorship disadvantages

1. one main disadvantage is there is not separation between the entrepreneur and the business 2. with sole proprietorships, like some forms of partnerships, owners can be personally liable for business losses, meaning their personal assets are not protected against the claims of creditors 3. the sole proprietorship is not a separate entity from the owner/ entrepreneur, unlike a corporation -as a result, if the proprietor dies, the business ceases toe xit 4. because the enterprise rests exclusively on one person, it often has difficulty raising long-term capital

entrepreneur

1. a person who organizes and operates a business venture and assumes much of the associated risk

S corporation

1. S corporations are corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes 2. S status combines the legal environment of standard corporations with US federal income taxation similar to that of partnerships 3. as with partnerships, the income, deductions, and tax credits of an S corporation flow through to shareholders annually, regardless of whether distributions are made -thus, income is taxed at the shareholder level and not at the corporate level 4. payments to S shareholders level and not at the corporate level 5. payments to S shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were previously taxed 6. also, certain corporate penalty taxes accumulated earnings tax, personal holding company (tax) and the alternative minimum tax do not apply to an S corporation

board of directors

1. a body of elected or appointed members who jointly oversee the activities of a company or organization

bond

1. a documentary obligation to pay a sum or to perform a contract; a debenture

financial statement

1. a formal record of all relevant financial information of a business, person, or other entity, presented in a structured and standardized manner to allow easy understanding

defining the goal of shareholder welath

1. a goal of financial management can be to maximize shareholder wealth by paying dividends and causing the market value to increase

partnership advantages

1. a large advantage of the partnership structure is tis ease in filing and tax treatment 2. with a general partnership, two or more people can start a business as co owners with no special formalities, directly controlling the partnership and making binding decisions with a simple majority vote 3. the partners are taxed individually on their share of the partnership's profits -profits are shared equally -however, partnership agreement will express the manner in which profits and losses are to be shared

stakeholder vs. shareholders

1. a major debate is currently occurring about whether a firm or company should make decisions chiefly to maximize value for shareholders, or if a company has obligations to other types of stakeholders 2. some European countries formally recognize other stakeholders in corporate governance decisions 3. some people who argue that businesses should consider other stakeholders, like the government or the environment, argue that an attention to these types of stakeholders is intimately entwined with market value -they can also enhance general outcomes for all the stakeholders that are involved (holistic view)

stakeholder

1. a person or organization with a legitimate interest in a given situation, action, or enterprise 2. stakeholders are those who are affected by an organization's activities -internal: like owners or employees -external: customers, suppliers, the government, local communities, and the environment 3. some are involved directly in economic transactions with the business 4. others are either affected by, or able to affect, an organizations actions without directly engaging in an economic exchange with the business (activist groups) 5. because of the breadth of the term stakeholder, there are different views as to who should be included in stakeholder considerations

corporation advantages

1. one of the most favorable advantages of the corporate structure is the protection of personal assets -stockholders, directors, and officers of a corporation are typically not liable for the company's debts and obligations -they're limited to the amount they have invested in the corporation 2. ownership is easily transferable 3. corporation does not cease to exist with the death of shareholders directors, or officers of the corporation 4. in the US, corps are generally taxed at a lower rate than are individuals

agent

1. one who acts for, or in the place of, another (the principal), by authority from him; one entrusted with the business of another; a substitute; a deputy; a factor there's a difference in status between the agent and principal

principal

1. one who directs another (the agent) to act on one's behalf

stakeholders

1. people or organizations with legitimate interest in a given situation, action or enterprise

limited liability partnerships

1. provide for limited liability for all partners

shareholders and bondholders

1. shareholders are individuals or institutions that legally own shares of stock in the corporation, while the bondholders are the firm's creditors

sole proprietor advantages

1. simplest and easiest to start 2. a large advantage of the sole proprietorship structure is its ease of filing incorporation and tax documents as well as having uninterrupted control of the business -does not require formal incorporation (does not need formally filed articles of incorporation, hold regular meetings, or elect an advising or directing board 3. tax treatment: files taxes as personal income 4. sole proprietors also have control over the aspects of their businesses without involvement of elected board members

defining the goal of financial management for stakeholders

1. stakeholders are typically a diverse set of parties who can be affected by the business 2. a goal of financial management can be to maximize value without harming stakeholders

three parties have different objectives (managers, shareholders, and bondholders)

1. stockholders have an incentive to take riskier projects than bondholders do, as bondholders are more interested in strategies that will increase the chances of getting their money/investment back 2. shareholders also prefer that the company pay more out in dividends than bondholders would like 3. managers may also be shareholders; they might reap the profits of riskier strategies, or they may prefer risk-averse, empire-building projects

principal-agent problem

1. the agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders' (and other parties') interests -corporate governance mechanisms include a system of controls intended to help align managers' incentives with those of shareholders and other stakeholders 2. the principal-agent problem or agency dilemma: concerns the difficulties in motivating one party (the "agent") to act on behalf of another (the principal) -the two parties have different interests and asymmetric information (the agent having more information) -the principal cannot directly ensure that the agents are always acting in its best interest 3. particularly true when activities that are useful to the principal are costly to the agent, and where element of what the agent does are costly for the principal to observe -moral hazard and conflict of interest (COI) may arise

shareholders conflict of interest with one another

1. the chief goal of current corporate governance is to eliminate instances when shareholders have conflicts of interest with one another 2. another important goal is to evaluate whether a corporate governance system hampers or improves the efficiency of an organization 3. research of this type focuses on how corporate governance impacts the welfare of shareholders -advocates of governance typically encourage corporations to respect shareholder rights, and to help shareholders learn how and where to exercise those rights 4. disclosure and transparency are intertwined with these goals

defining the pros and cons of a corporate structure

1. the corporate structure is less simple to found and maintain but has the advantages of limited liability and perpetual life

corporation disadvantages

1. the corporation is less simple to found and maintain 2. the incorporation must file articles of incorporation with the secretary of state's office in the state where it will be incorporated, as well as hold an organizational meeting to elect a board of directors 3. the structure also generally requires the maintenance of at least annual reporting -in many jurisdictions, corporations whose shareholders benefit from limited liability are required to publish annual financial statements and other data -this is so that any creditors can assess credit worthiness of the corporation and cannot enforce claims against shareholders 4. shareholders, therefore, experience some loss of privacy in return for limited liability 5. there is also the issue of double taxation, wherein the corporation is taxed on its profits and shareholders are also taxed on their earnings

agency cost

1. the deviation from the principal's interest by the agent is called "agency cost" 2. mainly arise due to contracting costs and the divergence of control, separation fo ownership and control, and the different objectives (rather than shareholder maximization) of the managers

maximizing market value

1. the idea of maximizing market value is related to the idea of maximizing shareholder value, as market value is the price at which an asset would trade in a competitive auction setting 2. different models of corporate governance around the world -differ according to the variety of capitalism in which they are embedded -US/UK emphasize the Interest of shareholders 3. criticism for sole focus on shareholder value since a management decision can maximize shareholder value while lowering the welfare of other stakeholders -additionally, short-term focus on shareholder value can be detrimental to long-term shareholder value

corporate governance: maximizing shareholder value

1. the idea of maximizing shareholder value comes from interpretations of the role of corporate governance 2. corporate governance involves regulatory and market mechanisms and the roles and relationships between a company's management, it board, its shareholders, other stakeholders, and the goals by which the corporation is governed 3. in large firms where there is a separation of ownership and management and no controlling shareholder, the principal-agent issue arises between upper-management and shareholders 4. thus, one interpretation of proper financial management is that the agents are oriented toward the benefit of the principals--shareholders--in increasing their wealth by paying dividends and/or causing the stock price or market value to increase

business organization: partnership

1. the partnership is the simplest business structure after the sole proprietorship 2. open to collaborative ownership

defining a partnership

1. the partnership is the simplest structure open to collaborative ownership 2. the benefit of simplicity and control, but the drawback of personal liability for the partnership's activities

valuation

1. the process of estimating what something is worth 2. used to determine the price financial market participants are willing to pay or receive to buy or sell a business 3. used by business appraisers to resolve disputes related to estate and gift taxations, divorce litigation, allocate business purchase price among business assets, establishing a formula for estimating the value of partner's ownership interest for buy-sell agreements, and many other business and legal purposes 4. therefore, managers want to keep reliable financial statements, and also want to manage finances well to enhance the value of their businesses to potential buyers, creditors, or investors

moral hazard

1. the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk you act more reckless with car insurance than if you didn't have car insurance

an accurate valuation depends on

1. the reliability of the firm's historical financial information

defining conflict between shareholders and bondholders

1. the shareholders and bondholders have different rights and returns, leading to potential conflicts of interest

defining the pros and cons of sole proprietorship

1. the sole proprietorship structure has the benefit of simplicity and control but the drawback of unlimited liability 2. the sole proprietorship is one type of business structure from a legal status perspective -it is a structure open to any business run and owned by one entrepreneur

corporate governance: stakeholder concept

1. the stakeholder concept is associated with the concept of corporate governance 2. corporate governance involves regulatory and market mechanisms and the relationships that exist between a company's management, its board, its shareholders, other stakeholders, and the goals for which the corporation is governed

partnership main disadvantage

1. the structure's main disadvantage is similar to the sole proprietorship -owners can be personally liable for business losses in some forms of partnerships, meaning their personal assets are not protected against the claims of creditors -a partnership is not a separate entity from the owners/entrepreneurs, unlike a corporation 2. partnerships are the aggregate of their partners, not a separate entity -if the relationship breaks down between the partners, the partnership breaks down 3. types of partnerships beyond the general partnership have developed to mitigate some of the disadvantages of the structure

manager and shareholder agency cost

1. the term "agency costs" refers to instances when the agent's behavior has deviated from a principal's interest 2. they arise when managers have personal objectives that are different form the goal of maximizing shareholder profit 3. typically the CEO and other top executives are responsible for making decisions about high-level policy and strategy 4. shareholders (those who own shares) typically have the right to sell those shares, to vote on directors nominated by various boards, and many other privileges -usually give their control rights to managers 5. managers while attempting to benefit shareholders, may encounter conflicts of interest

market value

1. the total value of the company as traded in the market, calculated by multiplying the number of shares outstanding by the price per share

shareholders and bondholders relationship to the company

1. the two parties have different relationships to the company, accompanied by different rights and financial returns 2. shareholders (owners): -get ownership -take riskier projects -want more payouts of dividends -shareholders have voting rights at general meetings -stocks can be outstanding indefinitely and sold at any point -no dividend if no profit 3. bondholder (lenders): -reduce risk (want to get their investment back) -want less dividends paid out -do not have voting rights -interest is paid to debenture-holders regardless of whether a profit has been made -bonds have a defined term, or maturity, after which the bond is redeemed

defining managers, shareholders, and bondholders

1. three parties key to the corporate's functioning are managers, shareholders, and bondholders, each of which can have different interests

incorporate

1. to form into a legal company

defining valuation

1. valuation is the goal of financial management; it often relies on fundamental analysis of financial statements 2. the process of estimating market value of a financial asset or liability

conflict of interest

1. when a firm has debt, COI can arise between stockholders and bondholders, leading to agency costs on the firm 2. examples: -cost on shareholders (principals) when the corporate management (the agent) wants to expand its power instead of maximize value -when politicians act on their own instead of for the constituents 3. much of the contemporary interest in corporate governance is concerned with mitigation of the COI between stakeholders -can also occur among other stakeholders of a company, board of directors, employees, government, suppliers, and customers -can also be referred to as "competition of interest" -COI are sometimes confused with cases that might be better termed "corruption"

Module 2

Relating Finance to Business