Finance Chapter 1 & 2, Finance Ch 1, Financial Management

Management’s Goal in an Organization To maximize shareholder wealth, which means maximizing the value of the stock.
Maximize the Value of a Stock Maximize the true, long-run value
Finance the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities.
Areas of Finance Financial management, capital markets, investments
Financial management aka corporate finance. Focuses on decisions relating to how much and what types of assets to acquire, how to raise the capital needed to purchase assets, and how to run the firm so as to maximize its value.
Capital markets relate to the markets where interest rates, along with stock and bond prices are determined.
Investments relate to decisions concerning stocks and bonds and include a number of activities: security analysis, portfolio theory and market analysis.
Finance within the organization Board of DirectorsCEOCOO & CFO
Forms of Business Organizations Proprietorship, Partnership, Corporation and LLC & LLP
Proprietorship Unincorporated business owned by one individual.Advantages:-Easy and inexpensive to form-subject to few government regulations-subject to lower income taxes than corporations Limitations:-unlimited personal liability for the business’ debts-can lose more money than they invested -life of the business is limited to the life of the owner-Have difficulty obtaining large sums of capitalBusiness are often started as proprietorships and then converted to corporations when their growth results in the disadvantages outweighing the advantages.Often set up through LLPs and LLCs.
Partnership A legal arrangement between two or more people who decide to do business together.Advantages:-can be established relatively easily and inexpensively-firm’s income is allocated on a pro rata basis to the partners-taxed on an individual basis-avoids corporate income taxLimitations:-partners are subject to unlimited personal liability-partners are responsible for making up for loss of partner’s contribution (if the partner goes bankrupt)-unlimited liability makes it difficult for partnerships to raise large amounts of capital.Often set up through LLPs and LLCs.
Corporation A legal entity created by a state. It is separate and distinct from its owners and managers.Advantages:-seperation that limits stockholders’ losses to the amount they invested in the firm.-unlimited lives.-easier to transfer shares of stock than in an unincorporated business-easier for corporation to raise the capital necessary to operate large businesses.Drawbacks:-Double taxation (corporate & dividends)Corporations are generally referred to as C Corporations
S Corporation Corporation taxed as a proprietorship or partnership (exempt from corporate income tax). Can have no more than 100 shareholders.
S Corporation to C Corporation Once a company decides to sell stocks, they grow into a C Corporation because they exceed 100 shareholders.
Liquidity The ease at which assets can be turned into cash at their fair values
LLCs and LLPs -Provide limited liability protection.-Taxed as partnerships.-Investors have votes in proportion to their ownership -interest.-Growing in popularity recently but people still like C corporations because of the ability to grow.-Idea established by lawyers, so important to have a good lawyer when establishing one.
LLC Limited Liability Company-Hybrid between a partnership and a corporation.-Used by other businesses.
LLP Limited Liability Partnership-Similar to an LLC but used for professional firms in the fields of accounting, law and architecture.
Equilibrium Stock price should equal its “true” or intrinsic value
Intrinsic Value Present Value (PV) of future expected cash flows.A long-run concept.
Manager duty with intrinsic value Managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run
Deviation from Intrinsic Value To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value.
Stock’s Intrinsic Value vs. Market Price Intrinsic Value = “true”Market Price = “Perceived”
Stockholder-Manager Conflicts Managers are naturally inclined to act in their own best interest, which are not always the same as the interest of stockholders
Marginal Investor not all investors agree, so it is the “marginal” investor who determines the actual price
Corporate Raiders See an undervalued stock as a bargain and will attempt to capture the firm
Hostile takeover What happens when people see an undervalued stock as a bargain and attempt to capture the firm
Transfer of capital between savers and borrowers Direct transfers, investment banks, financial intermediaries
Direct Transfers Entity trying to obtain funds goes directly to investors
Financial Intermediaries Commercial Banks
Capital Allocation Process In a well-functioning economy, capital flows efficiently from those who supply capital to those who demand it.
Suppliers of Capital Individuals and institutions with “excess funds.” These groups are saving money and looking for a rate of return on their investment
Demanders or users of Capital individuals and institutions who need to raise funds to finance their investment opportunities. These groups are willing to pay a rate of return on the capital they borrow.
Market A venue where goods and services are exchanged
Types of Financial Markets Physical Assets vs. Financial AssetsSpot vs. FuturesMoney vs. CapitalPrimary vs. SecondaryPublic vs. Private
Physical Assets vs. Financial Assets Physical: for products such as wheat, autos, real estate, computers and machinery.Financial: for stocks, bonds, notes and mortgages. Deal with derivative securities (values are derived from changes in the prices of other assets).A share of Ford stock is a “pure financial asset.”An option to buy Ford shares is a derivative security whose value depends on the price of Ford stock.
Spot Markets vs. Futures Markets Spot: assets are bought or sold for “on the spot” delivery (within a few days)Futures: participants agree today to buy or sell an asset at some future date.
Hedge Reduce
Money markets vs. Capital markets Money: for short-term (less than 1 year) highly liquid debt securities. (New York, London and Tokyo money markets)Capital: for intermediate (1-10 years) or long-term (more than 10 years) debt and corporate stocks (New York stock exchange)
Primary markets vs. secondary markets Primary: markets in which corporations raise new capital. Corporation is involved.Secondary: markets in which existing, already outstanding securities are traded among investors. Corporation is not involved.
Private markets vs. Public markets Private: transactions are negotiated directly between two parties. (Bank loans and private debt placements)Public: standardized contracts are traded on organized exchanges. (Common stock or corporate bonds) Held by a large number of individuals.
IPO Initial public offeringPrimary market transaction
SEO Seasoned equity offering
Stock market efficiency Securities are normally in equilibrium and are “fairly priced”Investors cannot “beat the market” except through good luck or better information.
Well-functioning financial markets facilitate the flow of capital from investors to the users of capital.promote economic growth.perform better than economies with poorly-functioning markets.
derivative security’s value “derived” from the price of another security
Derivatives can Increase risk
Behavioral finance borrows insights from psychology to better understand how irrational behavior can be sustained over time.
Time Value of Money Formula PV x (1 + R)^n = FV
Rule of 72 When doubling an amount, take 72 and divide it by the interest rate, and it will give you the number of years it takes.
According to finance theory, a business firm should attempt to ______ the long-term price of the firm’s ______ . The benefit to this objective is that is provides the best financial outcome for the firm’s shareholders. MaximizeCommon Stock
Two years have passed since Austin purchased his 275 common shares in the Continental Construction Company. The current price of a common share is $16.74 per share. Austin’s wealth has _____. Decreased
Different forms of businesses have different characteristics. Which of the following characteristics belong to a corporation? Easier to transfer ownership in the form of stock.NOTEnds when the owner dies.Limited to 100 owners.
Paradigm media is a company run by a group of new media professionals. The owners of the company do not have any personal liability and file taxes only on their individual tax returns. This is an example of a: LLP/LLC
Roen, the CEO of a juice beverage company, is required to file the company’s quarterly and annual employment, financial and tax reports with the state and federal authorities. This is an example of a Corporation
The intrinsic value of a company’s stock, also known as its ________, refers to the stock’s true value based on expected future cash flows and the risks involved. The value perceived by stock market investors determines the market price of a stock. Fundamental Value
A stock trading at a price below its intrinsic value is considered to be _____ . A stock trading at a price above its intrinsic value is considered to be _____. UndervaluedOvervalued
In a state of market equilibrium, the intrinsic value of the stock will be _____ the market price of the stock. equal to
In an attempt to minimize agency problems in a company, attractive compensation packages are created to retain and encourage managers. In the best interest of shareholders, compensation packages should be structured in a way such that managers have an incentive to maximize the _____ value of the company’s stock price. Long-run
Vision Tech is a software company based out of San Francisco. Its stockholders are mostly individual investors and there is relatively little institutional ownership. If several pension and mutual funds were to take large positions in Vision Tech’s stock, would direct shareholder intervention be more or less likely to motivate the firm’s management? More likely
Vision Tech’s stock price is currently trading at $22 per share. The consensus among analysts is that the intrinsic value of Vision Tech’s stock is $30 per share. Is Vision Tech more or less likely to receive a hostile takeover bid? More likely
A student sells his old computer at a computer hardware store and gets $150 for it. He uses this cash to buy computer accessories. What kind of market is this? Physical Asset Markets
An oil trader buys contracts at the New York Mercantile Exchange, and he locks in the current futures price of heating oil for delivery in the winter season. What market is this in? Futures market
Sheila saves $10,000 and buys a certificate of deposit (CD) that will mature in six months. What kind of market is this? Money markets
An investor holding 3,000 shares of stock of Strata Copr. sells them to another investor. What kind of market is this? Secondary Markets
A bank purchased a credit default swap from another financial institution to protect itself against the default of one of its borrowers. In this example, the bank is _____ . Hedging
These financial conglomerates provide a range of services, such as investment banking, commercial banking and financial advising. Financial Services Corporations
They are owned by members so that members can share funds among themselves. Members who save deposit the funds. These funds are then loans to members who need the funds. Credit Unions
with the use of advanced investment technique, these largely unregulated portfolios are invested in securities. The investment objective is to offset potential losses by investing in counterbalancing securities. They are open to only a select class of investors. Hedge funds
Which of the following characteristics accurately describes the stock market? An active market that determines the price of a firm’s shares.
The difference between the price at which a dealer will sell a certain security and the price at which a dealer will buy a security is called the _____ . bid-ask spread
Water and Power Co.’s stock finished trading at a price of $42.01 for the day. The market price had varied from $41.93 to $42.10 throughout the day as buy and sell orders came in. It would be reasonable to consider the price of $42.01 per share as the firm’s _____ for the day. equilibrium price
Michelle is a top analyst for a prestigious investment bank. She just received a large bonus from her company, and she is looking to invest this money in the stock market. Michelle has identified four stocks that she thinks are undervalued, so she is going to invest her entire bonus in those four stocks. Michelle believes that there is at least some inefficiency in the stock market.
The process for converting present values into future values is called _____ . This process requires knowledge of the values of three of four time-value-of-money variables. Which of the following is not one of these variables? The trend between the present and future values of an investment.
Investments and loans base their interest calculations on one of two possible methods: the _____ interest and the _____ interest methods. SimpleCompound
Compound Interest formula FV = PV x (1 + R)^N
Simple interest formula FV = PV + (PV x R x N)
After the end of the second year and all other factors remaining equal, a future value based on compound interest will exceed a future value based on simple interest. T/F True
All other factors being equal, both the simple interest and the compound interest methods will not generate the amount of earned interest by the end of the first year. T/F False
The process of earning compound interest allows a depositor or investor to earn interest on any interest earned in prior periods. T/F True
_____ is the process of finding the present value of a cash flow or a series of cash flows to be received in the future. Discounting
Other things remaining equal, the present value of a future cash flow increases if the investment time period increases. T/F False
Other things remaining equal, the present value of a future cash flow decreases if the investment time period increases. T/F True
Annuities Characteristics When equal payments are made at the beginning of each period for a certain time period they are treated as an annuity due.An ordinary annuity of equal time earns less interest than an annuity due.Annuities are structured to provide fixed payments for a fixed period of time.
A retirement fund set up to pay a series of regular payments is an ___ Annuity
Shania bought a new dress for her brother’s wedding for $450. She negotiated a deal with the retailer in which she would pay for the dress in three installments of $250, $100, and $100 over the next three months. Uneven Cash Flow or Annuity Payment? Uneven Cash Flows
You signed up to make a monthly payment of $10 for one year for a lifetime subscription to your favorite magazine. Uneven Cash Flow or Annuity Payment? Annuity Payments
British console are British government bonds that promise to make payments of a specified amount at regular intervals to the bearer forever. Uneven Cash Flow or Annuity Payment? Annuity Payments
You receive interest earnings from variable deposits in a regular interest-bearing savings account. Uneven Cash Flow or Annuity Payment? Uneven Cash Flows
Perpetuity characteristics Continues for a fixed time period.The principal amount of a perpetuity is repaid as a lump-sum amount.
Mortgages are examples of amortized loans T/F True
The ending balance of an amortized loan contract will be zero. T/F True
Mortgages always have a fixed nominal interest rate. T/F False
The payment allocated toward principal in an amortized loan is the residual balance – that is, the difference between total payment and the interest due. T/F True
Which groups participate in financial (capital) markets? Financial institutions, households, government, businesses
Sale of stocks and bonds by business to savers without going through a financial institution are referred to as ______ . Direct Transfers
Financial assets can be characterized as claims to future risky cash flows. T/F True
Preferred stock is _____ instrument. Equity
Which class of financial assets has earned the highest average return over 1925-2004? Micro-cap stocks
Which is very short term, highly liquid fixed income securities? Certificates of Deposit
Which financial instrument most typically comes with voting rights? Common Stock
Which of the following instruments has the right to buy financial assets at a future date at the price fixed today? Options
What was the approximate size of all U.S. mutual fund assets as of 2012? $13 Trillion
Domestic equity index funds are always more popular with the investment public than bond and hybrid funds. T/F False
______ are most likely to take high-risk derivative positions, compared to mutual funds. Hedge funds
What can be different between a corporation and a partnership? Taxation, Dividend payout policy, liability, voting rights
The popularity of corporations in the U.S. has been declining recently, compared to that of partnerships. T/F True
The “too big to fail” problem is most generally characterized as _____ . Moral Hazard
Conflict between shareholders and managers can be mitigated through ……. Contractual incentives in executive compensation, CEO turnover mechanism, takeover mechanism, monitoring
One of the major factors that led to the onset of the financial crisis of 2008 was the general underestimation of mortgage default risk. T/F True
Under the Dodd-Frank regulation, the Financial Stability Oversight Council addresses which of the following issues? Systemic risk (financial institutions growing to become “too big to fail”)
Finance addresses how money is raised and used by individuals, businesses, and governments
Corporation state-created entity that is authorized to conduct business and offer its owners an investments with an unlimited life
treasurer in larger organizations, this officeholder supervises the firms credit and inventory managers, as well as the director of capital budgeting, and reports to the firm’s chief financial officer
Limited Liability attribute of the corporate form of an organization limits an owners potential losses to the purchase price of the owners shares
business ethics code of behavior specifies how the firm and its employees will treat employees and stakeholders
limited partner a participant in a partnership, whose personal assets may not be seized to satisfy the debts of the partnership
double taxation of dividends US Internal Revenue Service taxes the taxable income of the corporations as well as the taxable investment income of the firms shareholders
Shareholder wealth maximization primary goal of financial management that is evaluated by the effect of a decision or an action on the value of the firm
stakeholder describes individuals and groups, internal and external, whose support is critical to the success of the organization
value present worth of the future cash flows generated by an asset or firm, discounted at a rate appropriate for the riskiness of the cash flows
Accounting, investments, credit CFOs are responsible for which 3 departments?
Corporate finance focuses on financial decisions that corporations need to make to run the firm; objective of the decisions is to maximize shareholder value
capital market includes the stock & bond markets which are both under supervision of SEC; include entities like stockbrokers, banks, mutual funds, insurance company that deal with capital for different purposes
investments ex: security analysis, market analysis, behavioral finance
annual report required by the SEC and includes the audited document that shows the company’s financial results for the past year and management’s discussion about the future outlook and plans
Income statement divided into two important parts: operating and non operating sections; also known as the profit and loss statement
statement of retained earnings explains the changes in a company’s retained earnings over the accounting year
statement of cash flows provides details about the flow of funds from operating, investing, and financing activities
balance sheet has three segments that when analyzed together give an idea of what the company owns and what it owes
NOPAT (term) Net Operating Profit After Taxes
EBIT (term) Earnings Before Income Taxesor Operating Income
NCF (term) Net Cash Flow
NOPAT = EBIT(1-Taxes)
NCF = NI + Depreciation
NI (term) Net Income
OCF = NOPAT + Depreciation
OCF (term) Operating Cash Flow
Current Ratio = Current Assets/Current Liabilities
Quick Ratio =(Current Assets – Inventory)/Current Liabilities
Inventory Turnover = Sales/Inventory
DSO (term) Days Sales Outstanding
DSO = Accounts Receivable / (Sales/365)
Equity Multiplier to Equity Ratio the inverse of Equity Multiplier
Fixed Asset Turnover = Sales/Fixed Assets
Total Asset Turnover = Sales/Total Assets
Debt Ratio = Total Debt/Total Assets
Equity Ratio = Total Equity/Total Assets
Equity Multiplier = Total Assets/Total Equity
Debt Ratio (from Equity Multiplier) Debt Ratio = 1 – EM
DuPont Equation ROA = Profit Margin x Total Asset Turnover
Extended DuPont Equation ROE = Profit Margin x Total Asset Turnover x Equity Multiplieror ROE = ROA x Equity Multiplier
TIE (term) Times Interest Earned
TIE = EBIT/Interest Expense
Profit Margin = Net Income/Sales
ROA = Net Income/Total Assets
ROE = Net Income/Total Equity
P/E Ratio = Price per Share / Earnings per Share
CF (Cash Flow) per Share = (Net Income + Depreciation) / Shares Outstanding
Price per CF (Cash Flow) = Price per Share / CF per Share
Market to Book (M/B) = Price per Share / Book Value (BV) per Share
BV per Share = Total Equity/# of Shares
It addresses how financial resources are obtained, allocated, and managed by a person, a business organization, or a governmental entity. Finance
This state-created entity is authorized to conduct business and offer its owners an investment with an unlimited life. Corporation
This corporate officer is responsible for managing the firm’s cash and short-term investments, pension fund, and risks. Treasurer
This attribute of the corporate form of organization limits an owner’s potential losses to the purchase price of the owner’s shares. Limited liability
This code of behavior specifies how the firm and its employees will treat employees and stakeholders. Business ethics
This is a participant in a partnership, whose personal assets may not be seized to satisfy the debts of the partnership. Limited partner
This is a disadvantage of the corporate organization since it requires taxes to be levied on both the income of the firm and the dividend income earned by its shareholders. Double taxation of dividends
This goal of financial management is superior to other possible goals, since it considers the timing and risks associated with the cash flows expected from management’s decisions. Shareholder wealth maximization
This term describes individuals and groups, both internal and external to the company, whose support is critical to the success of the organization. Stakeholder
This is the present worth of the future cash flows generated by an asset or firm, discounted at a rate appropriate for the riskiness of the cash flows. Value
Chief Financial Officer (CFO) is responsible for which departments? a) credit b) administrationc) investor relationsd) accounting a) credit, c) investor relations, and d) accounting
Firms should attempt to maximize the long-term price of the firm’s common stock. Finance Theory
The current stock price of a company reflects:a) the top managers best estimate of the true value of the company.b) the amount that the company pays in dividends each year. So a stock price of $5 means you receive a $5 dividend this year.c) the amount that market participants are willing to pay to purchase a share right now. c) the amount that market participants are willing to pay to purchase a share right now.
The primary goal of a financial manager according to our textbook is:a) minimize costsb) maximize earnings per sharec) maximize shareholder wealthd) avoid bankruptcy c) maximize shareholder wealth
The intrinsic value of a company’s stock is defined as: a) the combined wealth of a firm’s board of directors. b) the amount that market participants are willing to pay for one share of the stock. c) the primary goal of the firm.d) an estimation of the stock’s “true” value based on accurate risk and return data. d) an estimation of the stock’s “true” value based on accurate risk and return data.
Is a stock’s “true” long-run value more closely related to its intrinsic value or to its current stock price? a) intrinsic valueb) stock price a) intrinsic value
If you would like to purchase a stock as an investment, which of the following stocks would you rather purchase? a) a stock whose intrinsic value is less than its market priceb) a stock whose intrinsic value is equal to its market price c) a stock whose intrinsic value is greater than its market price c) a stock whose intrinsic value is greater than its market price
Which of the following is NOT one of the principal forms of business organization? a) sole proprietorshipb) partnershipc) strategic business unitd) corporation c) strategic business unit
Which of the following is an advantage of the sole proprietorship as a form of business?a) unlimited liabilityb) unlimited lifec) easy and inexpensive to form d) ease in obtaining large sums of capital c) easy and inexpensive to form
Is stockholder wealth maximization a long-term or short-term goal? a) long-termb) short-term a) long-term
Which of the following is an advantage of the corporation as a form of business? a) unlimited liabilityb) limited lifec) limited liability d) easy and inexpensive to form c) limited liability
Which of the following is NOT one of the more common ways of minimizing agency problems for a publicly traded corporation?a) paying top level managers partially with stock or stock optionsb) the threat of takeover c) the threat of firingd) paying top level managers a large cash salary with no stock or stock options d) paying top level managers a large cash salary with no stock or stock options

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