Financial Management Chapter 1

Is the stock's "true" long-run value more closely related to its intrinsic value or to its current price?

"true" long-run value is more closely related to intrinsic value.

Which of the following actions are likely to reduce the agency problem between stockholders and managers?

- A manager receives a lower salary but receives additional shares of the company's stock. - The board of directors has become more vigilant in its oversight of the company's management.

Financial Management

- Another word for corporate finance. - How much assets do we need - What type of assets do we need - How do we raise capital - How do we make profit

Investments

- Deals with stock and bonds - Portfolio theory - Includes the market analysis of stock and bond markets - Includes Behavioral Finance meaning how behaviors change the prices of like stocks and bonds.

Which of the following is likely to encourage a firm's managers to make decisions that are in the best interest of shareholders?

- Executive compensation comes primarily in the form of stock options. -Institutional investors such as mutual funds and pension funds hold large amounts of the firm's stock.

Difference between LLC and LLP?

- LLC is for businesses that offer products. - LLP is for services like professional firms in the fields of accounting, law, and architecture.

Capital Markets

- Relate to the markets where interest rates, along with stock and bond prices, are determined. - The study of financial institutions that supply capital to businesses. Banks, investment banks, stockbrokers, mutual funds, insurance companies, and people who have money to invest and businesses, individuals, and other entities that need capital for various purposes. - Governmental organizations such as the Federal Reserve System, which regulates banks and controls the supply of money, and the Securities and Exchange Commission (SEC), which regulates the trading of stocks and bonds in public markets, are also studied as part of capital markets.

The future value of a lump sum at the end of five years is $1,000. The nominal interest rate is 10 percent and interest is compounded semiannually. Which of the following statements is most correct?

- The effective annual rate is greater than 10 percent. - The periodic interest rate is 5 percent.

What are factors that will affect managerial behavior?

-Managerial compensation packages -Direct intervention by shareholders -The threat of firing -The threat of takeover

Organization Flow Chart of who's in charge

1. Board of Directors - the top people governing the business. Chairperson has the most power in the board of directors. The Chairperson is usually the CEO too. 2. CEO (Chief Executive Officer) - usually the chairperson in the board of directors. 3. COO (Chief Operating Officer) aka the "president" of the firm. They direct the firms operations. They deal with marketing, production, human resources, and operations department. 4. CFO (Chief Financial Officer) aka "senior vice president" - In charge of the financial stuff like accounting, treasury, credit, legal, capital budgeting, investor relations, investing opportunities, and they communicate with the press and shareholders.

What are the 3 areas of finance?

1. financial management 2. capital markets 3. investments

Propriertorship

A business owned by one person. Advantages - 1. Easy to form 2. Not expensive 3. Few government regulations 4. Subject to no or low income taxes. Disadvantages - 1. Unlimited Liability meaning if you invest $10,000 for your business, then it is possible that you could be personally sued or liable for $1 million dollars if something happens. 2. Difficult to raise money/capital because small businesses can't get anybody to invest cause they small and speak broke lmfao.

Corporation

A legal entity separate from its owners. Advantages - 1. Unlimited lives 2. Easy to transfer shares of a stock 3. Easy to raise money/capital 4. If the company loses all their money, the owners just lose what they invested in. The owners are not liable to pay out of pocket for anything if shit hits the fan. 5. A lot of growth opportunities. 6. corporate investment is relatively liquid. This too enhances the value of a corporation. This means you can cash out easily and get money back. Disadvantages - 1. Corporation Taxes are a lot of money bruh. Double taxation... There is a loophole for this though. There are C - Corporations meaning the corporation is big and have to pay the corporation taxes. BUT there are also S - Corporations meaning small corporations. They are taxed as if they were a propriership or partnership, so they pay low taxes. In order to be seen as a S - Corporations (a small corporation) you have to have less than 100 shareholders. 2. There are a lot of bylaws and regulations for a corporation. 3. Cost of set up and report filing.

Stock Market Price (stock' current price)

A stock's current price is its market price—the value based on perceived but possibly incorrect information as seen by the marginal investor. - Basically is the market price or the current price of the stock. It is perceived so it means the stock is seen as that price. Doesn't mean that's how much its actually worth.

Until this year, Cheers Inc. was organized as a partnership. This year, the partners have decided to organize the business as a corporation. As a result of this change in organizational form...

Cheers' shareholders (the ex-partners) will now have limited liability.

The president of Southern Semiconductor Corporation (SSC) made this statement in the company's annual report: "SSC's primary goal is to increase the value of our common stockholders' equity." Later in the report, the following announcements were made: The company contributed $1.5 million to the symphony orchestra in Birmingham, Alabama, its headquarters city. The company is spending $500 million to open a new plant and expand operations in China. No profits will be produced by the Chinese operation for 4 years, so earnings will be depressed during this period versus what they would have been had the decision been made not to expand in China. The company holds about half of its assets in the form of U.S. Treasury bonds, and it keeps these funds available for use in emergencies. In the future, though, SSC plans to shift its emergency funds from Treasury bonds to common stocks. Discuss how SSC's stockholders might view each of these actions and how the actions might affect the stock price

Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to create a more attractive community that will make it easier to hire a productive work force. This corporate philanthropy could be received by stockholders negatively, especially those stockholders not living in its headquarters city. Stockholders are interested in actions that maximize share price, and if competing firms are not making similar contributions, the "cost" of this philanthropy has to be borne by someone—the stockholders. Thus, stock price could decrease. b. Companies must make investments in the current period in order to generate future cash flows. Stockholders should be aware of this, and assuming a correct analysis has been performed, they should react positively to the decision. The Chinese plant is in this category. Capital budgeting is covered in depth in Part 4 of the text. Assuming that the correct capital budgeting analysis has been made, the stock price should increase in the future. c. U.S. Treasury bonds are considered safe investments, while common stocks are far more risky. If the company were to switch the emergency funds from Treasury bonds to stocks, stockholders should see this as increasing the firm's risk because stock returns are not guaranteed—sometimes they increase and sometimes they decline. The firm might need the funds when the prices of their investments were low and not have the needed emergency funds. Consequently, the firm's stock price would probably fall.

Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership?

Corporations generally find it easier to raise large amounts of capital.

Frank Lewis has a 30-year, $100,000 mortgage with a nominal interest rate of 10 percent and monthly compounding. Which of the following statements regarding his mortgage is most correct? a. The monthly payments will decline over time. b. The proportion of the monthly payment that represents interest will be lower for the last payment than for the first payment on the loan. c. The total dollar amount of principal being paid off each month gets larger as the loan approaches maturity. d. Statements a and c are correct. e. Statements b and c are correct.

E. Statements b and c are correct. b. The proportion of the monthly payment that represents interest will be lower for the last payment than for the first payment on the loan. c. The total dollar amount of principal being paid off each month gets larger as the loan approaches maturity. - Statements b and c are correct; therefore, statement e is the correct choice. Monthly payments will remain the same over the life of the loan.

Edmund Enterprises recently made a large investment to upgrade its technology. Although these improvements won't have much effect on performance in the short run, they are expected to reduce future costs significantly. What effect will this investment have on Edmund Enterprises' earnings per share this year? What effect might this investment have on the company's intrinsic value and stock price?

Earnings per share in the current year will decline due to the cost of the investment made in the current year and no significant performance impact in the short run. However, the company's stock price should increase due to the significant cost savings expected in the future.

When is a stock said to be in equilibrium?

Equilibrium is the situation where the actual market price equals the intrinsic value. - Investors are indifferent between buying and selling a stock. -If a stock is in equilibrium then there is no fundamental imbalance, hence no pressure for a change in the stock's price.

Is it better for a firm's actual stock price in the market to be under, over, or equal to its intrinsic value? Would your answer be the same from the standpoints of stockholders in general and a CEO who is about to exercise a million dollars in options and then retire? Explain.

If a stock's market price and intrinsic value are equal, then the stock is in equilibrium and there is no pressure (buying/selling) to change the stock's price. So, theoretically, it is better that the two be equal; however, intrinsic value is a long-run concept. Management's goal should be to maximize the firm's intrinsic value, not its current price. So, maximizing the intrinsic value will maximize the average price over the long run but not necessarily the current price at each point in time. So, stockholders in general would probably expect the firm's market price to be under the intrinsic value—realizing that if management is doing its job that current price at any point in time would not necessarily be maximized. However, the CEO would prefer that the market price be high—since it is the current price that he will receive when exercising his stock options. In addition, he will be retiring after exercising those options, so there will be no repercussions to him (with respect to his job) if the market price drops—unless he did something illegal during his tenure as CEO.

Suppose three honest individuals gave you their estimates of Stock X's intrinsic value. One person is your current roommate, the second person is a professional security analyst with an excellent reputation on Wall Street, and the third person is Company X's CFO. If the three estimates differed, in which one would you have the most confidence? Why?

If the three intrinsic value estimates for Stock X were different, you would have the most confidence in Company X's CFO's estimate. - Intrinsic values are strictly estimates, and different analysts with different data and different views of the future will form different estimates of the intrinsic value for any given stock. However, a firm's managers have the best information about the company's future prospects, so managers' estimates of intrinsic value are generally better than the estimates of outside investors.

Which of the following works to reduce agency conflicts between stockholders and bondholders?

Including restrictive covenants in the company's bond contract.

Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders?

Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.

Corporate Raiders

Individuals who target corporations for takeover because they are undervalued. If a firm's stock is undervalued, corporate raiders will see it as a bargain and will attempt to capture the firm in a hostile takeover. If the raid is successful, the target's executives will almost certainly be fired. This situation gives managers a strong incentive to take actions to maximize their stock's price. It's bad for stockholders and managers when the intrinsic value is high but the actual price is low. In that situation, a raider may swoop in, buy the company at a bargain price, and fire the managers.

Limited and Unlimited Liability is what?

Limited Liability = Good. Corporations have this. It means that they are not responsible if shit goes down. Unlimited Liability = Bad. Sole Proprietorships and Partnerships have this. This means that the owners are liable if shit goes down.

Stockholder-Manager Conflicts

Managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders). - They might try to do short term fixes and stuff to benefit short term but that will decrease the stock in the long run later on. That would mess things up for stockholders.

Market Equilibrium

Market equilibrium is when the Intrinsic Value (or the real actual true price of the stock) equals the stock price. Things are good when there is market equilibrium cause the stock is worth how much it actually is. No one's trippin. When equilibrium exists, there is no pressure for a change in the stock's price. Market prices can—and do—differ from intrinsic values; eventually, however, as the future unfolds, the two values tend to converge. Managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run. Ex - Volkswagon made their cars shitty but for a super cheap price. People started buying a lot of Volkswagon cars and that increased the stock price a lot. Then when people's cars were breaking down cause it was made so cheap, the stock prices went down and Volkswagon lost the trust of the investors, the public and shareholders.

The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to

Maximize shareholder wealth, which is equivalent to maximizing the firm's stock price per share.

The primary goal of a publicly-owned firm interested in serving its stockholders should be to

Maximize the stock price per share.

Investors generally can make one vote for each share of stock they hold. TIAA-CREF is the largest institutional shareholder in the United States; therefore, it holds many shares and has more votes than any other organization. Traditionally, this fund has acted as a passive investor, just going along with management. However, in 1993, it mailed a notice to all 1,500 companies whose stocks it held that henceforth it planned to actively intervene if, in its opinion, management was not performing well. Its goal was to improve corporate performance to boost the prices of the stocks it held. It also wanted to encourage corporate boards to appoint a majority of independent (outside) directors, and it stated that it would vote against any directors of firms that "don't have an effective, independent board that can challenge the CEO." In the past, TIAA-CREF responded to poor performance by "voting with its feet," which means selling stocks that were not doing well. However, by 1993, that position had become difficult to maintain for two reasons. First, the fund invested a large part of its assets in "index funds," which hold stocks in accordance with their percentage value in the broad stock market. Furthermore, TIAA-CREF owns such large blocks of stocks in many companies that if it tried to sell out, doing so would severely depress the prices of those stocks. Thus, TIAA-CREF is locked in to a large extent, which led to its decision to become a more active investor. Is TIAA-CREF an ordinary shareholder? Explain. Due to its asset size, TIAA-CREF owns many shares in a number of companies. The fund's management plans to vote those shares. However, TIAA-CREF is owned by many thousands of investors. Should the fund's managers vote its shares, or should it pass those votes, on a pro rata basis, back to its own shareholders? Explain

No, TIAA-CREF is not an ordinary shareholder. Because it is one of the largest institutional shareholders in the United States and it controls more than 900 billion in pension funds, its voice carries a lot of weight. This "shareholder" in effect consists of many individual shareholders whose pensions are invested with this group. b. For TIAA-CREF to be effective in wielding its weight, it must act as a coordinated unit. In order to do this, the fund's managers should solicit from the individual shareholders their "votes" on the fund's practices, and from those "votes" act on the majority's wishes. In so doing, the individual teachers whose pensions are invested in the fund have, in effect, determined the fund's voting practices.

Suppose you are a director of an energy company that has three divisions—natural gas, oil, and retail (gas stations). These divisions operate independently from one another, but all division managers report to the firm's CEO. If you were on the compensation committee, as discussed in Question 1-12, and your committee was asked to set the compensation for the three division managers, would you use the same criteria as that used for the firm's CEO? Explain your reasoning

Setting the compensation policy for three division managers would be different than setting the compensation policy for a CEO because performance of each of these managers could be more easily observed. For a CEO an award based on stock price performance makes sense, while basing the compensation for division managers on stock price performance doesn't make sense. Each of the managers could still be given stock awards; however, rather than the award being based on stock price it could be determined from some observable measure like increased gas output, oil output, etc.

Stockholder-Debtholder Conflicts

Stockholders are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds. By contrast, bondholders receive fixed payments and are more interested in limiting risk. Bondholders are particularly concerned about the use of additional debt. Bondholders attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers' actions.

stockholder

The owner of one or more shares of stock stockholders do better when the company does better. they get leftovers of whatever is left, but they can make a lot of money if the business and the market is good. So they tend to take more risks. Debtholders are creditors that sometimes loan money to the stockholder. But they want to be paid every month at a fixed cost. Whatever is left over after the debtholder is paid, then the stockholder gets whatever that's leftover.

Shareholder Wealth Maximization

The primary financial goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm's common stock.

Finance

The system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities.

Corporate Governance

This involves putting in place a set of rules and practices to ensure that managers act in shareholders' interests while also balancing the needs of other key constituencies such as customers, employees, and affected citizens.

True or false? One of the disadvantages of the sole proprietorship form of organization is that there is unlimited liability.

True

True or false? Agency problems exist between stockholders and managers, and between stockholders and creditors.

True

True or false? Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.

True

True or false? Bond covenants are designed to reduce potential conflicts between stockholders and bondholders.

True

True or false? In part due to limited liability and ease of ownership transfer, corporations have less trouble raising money in financial markets than other organizational forms.

True

True or false? LLCs and LLPs have been gaining in popularity in recent years, but large companies still find it advantageous to be C corporations because of the advantages in raising capital to support growth.

True

True or false? Managers do not always attempt to maximize the long-run value of their firms' stocks, or the stocks' intrinsic values. Thus, conflicts between stockholders and managers can exist. Additionally, there can be conflicts between stockholders and bondholders.

True

True or false? One disadvantage of operating a business as a corporation is that the firm is subject to double taxation, because taxes are levied at both the firm level and the individual shareholder level.

True

True or false? Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

True

True or false? If the firm is publicly owned, the CEO and the CFO must both certify to the SEC that reports released to stockholders, and especially the annual report, are accurate. If inaccuracies later emerge, the CEO and the CFO could be fined or even jailed. This requirement was instituted in 2002 as a part of the Sarbanes-Oxley Act. The act was passed by Congress in the wake of a series of corporate scandals involving now-defunct companies such as Enron and WorldCom, where investors, workers, and suppliers lost billions of dollars due to false information released by those companies.

True

True or false? intrinsic values are estimates, and different analysts with different data and different views about the future form different estimates of a stock's intrinsic value.

True

True or false? Intrinsic value is a long-run concept. Management's goal should be to take actions designed to maximize the firm's intrinsic value, not its current market price. Note, though, that maximizing the intrinsic value will maximize the average price over the long run, but not necessarily the current price at each point in time.

True. For example, management might make an investment that lowers profits for the current year but raises expected future profits. If investors are not aware of the true situation, the stock price will be held down by the low current profit even though the intrinsic value was actually raised. Management should provide information that helps investors make better estimates of the firm's intrinsic value, which will keep the stock price closer to its equilibrium level. However, there are times when management cannot divulge the true situation because doing so would provide information that helps its competitors

What are some actions that stockholders can take to ensure that management's and stockholders' interests are aligned?

Useful motivational tools that will aid in aligning stockholders' and management's interests include... (1) Reasonable compensation packages. (2) Direct intervention by shareholders including firing managers who don't perform well. (3) The threat of takeover.

Partnership

a business owned by two or more people. Advantages - 1. Similar to Propriertorships because they are easy and inexpensive. Disadvantages - 1. Its on a pro rata basis meaning all the partners are individually taxed. (but if one partner fails to pay up, the other partners are responsible for covering them.) 2. Hard to raise money/capital because the partners are liable for each other and that is super risky.

LLC (Limited Liability Company) and LLP (Limited Liability Partnership)

a popular type of organization that is a hybrid between a partnership and a corporation. They are taxed as if they are a partnership. Advantages - 1. Provides limited liability protection meaning the owners won't be completely liable if bad stuff happens. 2. When the general partner has full control of the business, the investors in an LLC or LLP have votes in proportion to their ownership interest. Disadvantages - 1. LLCs/LLPs are often structured in very complicated ways, and their legal protections often vary by state. So, it is necessary to hire a good lawyer when establishing one.

Intrinistic Value

an estimate of a stock's "true" value based on accurate risk and return data. It can be estimated but not measured precisely. basically means the actual value a stock has. Analysts determine this themselves and it's based on the true cash flows, the true risk, the economic environment, political climate, managerial actions of the company or taxes.

Why might a stock at any point in time not be in equilibrium?

at times stock prices and equilibrium values are different, so stocks can be temporarily undervalued or overvalued. - Investor optimism and pessimism, along with imperfect knowledge about the true intrinsic value, leads to deviations between the actual prices and intrinsic values.

You are interested in investing your money in a bank account. Which of the following banks provides you with the highest effective rate of interest? a. Bank 1; 8 percent with monthly compounding. b. Bank 2; 8 percent with annual compounding. c. Bank 3; 8 percent with quarterly compounding. d. Bank 4; 8 percent with daily (365-day) compounding. e. Bank 5; 7.8 percent with annual compounding.

d. Bank 4; 8 percent with daily (365-day) compounding. Statement d is correct; the other statements are false. Looking at responses a through d, you should realize the choice with the greatest frequency of compounding will give you the highest EAR. This is statement d. Now, compare choices d and e. We know EARd > 7.8%; therefore, statement d is the correct choice. The EAR of each of the statements is shown below. EARa = 8.30%; EARb = 8%; EARc = 8.24%; EARd = 8.328%; EARe = 7.8%.

Debtholders (Creditors)

include the company's bankers and its bondholders, generally receive fixed payments regardless of how well the company does