Finance Ch 1-5

What is a firm’s intrinsic value? An estimate of a stock’s “true” value based on accurate risk and return data. It can be estimated but not measured precisely.
What is a firm’s current stock price? It’s market price – the value based on perceived but possibly incorrect information seen by the marginal investor.
What is more closely related to the stock’s “true” long run value? (intrinsic value/current price) A stock’s “true” long-run value is more closely related to its intrinsic value than its current price (market price)
When is a stock said to be equilibrium? Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are indifferent between buying and selling stock. If the stock is at equilibrium, there is no pressure to change the stock price. At any given point, most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium
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 under/overvalued.
If 3 people gave estimates on Stock X’s intrinsic value, who would you have more confidence in – roommate, professional security analyst, CFO of Company X? Have the most confidence in the CFO. Since intrinsic values are strictly estimates, different analysts with different data and different views of the future will form different estimates of intrinsic value for any given stock. But, a firms managers have the best information about the company/future prospects, so managers’ estimates of intrinsic values are generally better than the estimates of outside investors
Is it better for a firm’s actual stock price in the market to be under, over, or equal to its intrinsic value? It is better that the actual stock price and intrinsic value to be equal, however intrinsic value is a long run concept. If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium, and there is no pressure (for buying/selling) to change the stock’s price.
Would the answer be the same of wanting actual stock price and intrinsic value to be equal from the stand points of stockholders in general and a CEO who is about to exercise a million dollars in options and then retire? Explain. No. 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. Stockholders in general, would 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 need to be maximized. However, the CEO would prefer the market (current) price to be high since it is the current price that they will receive when exercising the stock options.
If a company’s board of directors wants management to maximize shareholder wealth, should the CEO’s compensation be set as a fixed dollar amount, or should the compensation depend on how well the firm preforms? Should be dependent on how well the firm performs.
If the CEO’s compensation is based on performance, how should performance be measured? Would it be easier to measure performance by growth rate in reported profits or the growth rate in the stocks intrinsic value? Which would be a better performance measure? Why? Compensation should be structured so that the CEO is rewarded on the basis of the stock’s performance over the long-run, not the stock’s price on an option (expiration date) of the stock. This means that the options (direct stock awards) should be phased in over a number of years so that the CEO will have an incentive to keep the stock price high over time. It is easier to measure the growth rate in reported profits than the intrinsic value even though reported profits can be manipulated through aggressive accounting procedures and that intrinsic values cannot be manipulated. Since intrinsic value is not observable, compensation must be based on a stock’s market price – but the price used should be an average over time rather than on a specific date.
What are the various forms of business organization? Sole proprietorships, partnerships, corporations and limited liability corporations and partnerships.
What are the advantages and disadvantages of sole proprietorships? (a) ease of low cost of formation. (d) difficulty in obtaining large sums of capital, unlimited personal liability for business debts, limited life
What are the advantages and disadvantages of partnerships? (a) ease and low cost of formation. (d) unlimited liability, limited life, difficulty of transferring ownership, difficulty of raising large amount of capital.
What are the advantages and disadvantages of corporations? (a) limited liability, indefinite life, ease of ownership transfer, access to capital markets. (d) double taxation of earnings, setting up a corporation and filing required state and federal reports which are complex and time consuming.
What are the advantages and disadvantages of limited liability corporations/partnerships? (a) limited liability. (d) difficulty in raising capital and the complexity of setting them up.
Should stockholder wealth maximization be a long-term or short-term goal? For example: if one action increases a firm’s stock price from a current level of $20 to $25 in 6 months, and then to $30 in 5 years but another action keeps the stock at $20 for several years but then increase it to $40 in 5 ears, which action would be better? Think of specific corporate actions that have these general tendencies. Stockholder wealth maximization is a long-run goal. Companies and consequently stockholders prosper by management making decisions that will produce long-term earnings increases. Actions that are continually shortsighted often “catch up” with a firm and, as a result, it may find itself unable to compete effectively against its competitors. There has been much criticism in recent years that US firms are too short-run profit-oriented. An example is the US auto industry, which has been accused of continuing to build large gas guzzler automobiles because they had higher profit margins rather than retooling for smaller, more fuel efficient cars.
What are some actions that stockholders can take to ensure that management’s and stockholder’s interests are aligned? Reasonable compensation packages, Direct intervention by shareholders (including firing managers who don’t perform well) and the threat of takeover.
Reasonable Compensation Packages The compensation package should be sufficient to attract and retain able managers but not go beyond what is needed. Also, compensation packages should be structured so that managers are rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so managers will have an incentive to keep the stock price high over time. Since intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a specific date.
Direct Intervention of Shareholders Stockholders can intervene directly with managers. Today, the majority of stock is owned by institutional investors and these institutional money managers have the clout to exercise considerable influence over firms’ operations. First, they can talk with managers and make suggestions about how the business should be run. In effect, these institutional investors act as lobbyists for the body of stockholders. Second, any shareholder who has owned $2,000 of a company’s stock for one year can sponsor a proposal that must be voted on at the annual stockholders’ meeting, even if management opposes the proposal. Although shareholder-sponsored pro.
The threat of takeover If a firm’s stock is undervalued, then corporate raiders will see it to be 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.

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