Chapter 1 Study Guide
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This 5 page Study Guide was uploaded by Matthew Maniscalco on Tuesday December 8, 2015. The Study Guide belongs to 311 at Clemson University taught by in Fall 2015. Since its upload, it has received 26 views. For similar materials see Financial Management I in Finance at Clemson University.
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Date Created: 12/08/15
Fin 311 Ch.1 Study Guide What is the primary responsibility of financial managers? o Acquiring funds needed by a firm and directing those funds into projects that will maximize the value of the firm for its owners What should be management’s goal for the firm/owners be? o To maximize shareholder wealth Represented by the market price of a firm’s common stock Market price encaptures the present value of the expected future returns to owners Stock prices reflect the magnitude, timing, and risk associated with these future benefits How does one calculate shareholder wealth? o Shareholder wealth is measured by market value o Market value – price at which stock trades on NYSE o Formula Shareholder wealth = number of shares outstanding x market price per share What are 3 advantages of shareholder wealth maximization? o Considers timing and risk expected to be received from stock ownership o Possible to determine if a particular financial decision is consistent with objective If stock price goes up -> good decision If appears it won’t shouldn’t take action o Impersonal objective Stockholders free to sell shares if they object with firm’s policies If they do they are selling at more favorable terms (higher price) than any other strategy What is the primary reason managements actual goals often diverge with shareholder wealth maximization? o Separation of ownership and control Managers can often look after self-interest more as long as they satisfy stockholders just enough “acceptable level of performance” Ex. Managers often benefit from job security which might lead them to minimize risk What are agency relationships? o When one or more individuals (the principals) hire another individual (the agent) to perform a service on behalf of the principals o Agency problems are inefficiencies that arise because of agency relationships How do agency problems arise between stockholders and creditors? o Creditors have fixed claim on company’s resources o Stockholder’s returns are variable based on performance (residual claim – what’s left over) Have much more upside when the company takes risks o Bondholders often insist on protective covenants to protect selves from this Do we need to know what they are? Limits on dividends payments Limits on issuance of new debt Limits on types of investments How do agency problems arise between stockholders and managers? o Ex. If management likes job security rather than shareholder wealth maximization o Ex. Consumption of on the job perquisites (company planes) by managers without a large amount of ownership interest in firm Economics - they don’t own it why care What are agency costs? Give examples o Costs incurred to minimize agency problems o Aka what it takes to ensure alignment of interests Ex. Costs to organize management structure in way to align interests Ex. Cost of audits and other actions to monitor managerial performance How can agency problems be reduced? o Incentive systems that help align interests of managers and stockholders Stock options Entitle managers to buy shares of a company at a set price (exercise price) Often exercise price is higher than current one and can only be exercised after a certain period of time has elapsed o Prevents managers from cashing out, taking the money and running o Monitor agent options Performance reviews Audits Threat of takeover If managers act in self interest, share values depressed, providing incentive for someone to take over company at depressed level because they could institute shareholder wealth maximizing principals and benefit Almost always current manager loses job What determines value of a company’s shares? o Note value here means market value not book/accounting value per share o 3 major factors cash flow relates to actual cash generated or paid by firm only cash can be used to acquire assets (says book) and make valuable distributions to investors “amount of cash flow expected to be generated for the benefit of stockholders” timing of cash flows ex. 100 bucks today is worth more than 100 a year from now risk in general, the greater the perceived risk associated with an expected cash flow, the greater the rate of return required by investors in mangers o reward has to be worth risk How should managers maximize value? o Make correct investment decisions Choose opportunities that generate most NPV (Net Present Value) o Make correct financing decisions Must balance risk/cost Ex. o Public vs private o Debt vs equity o Short-term vs long-term What are the forms of business organization? Pro’s/con’s of each? o Sole proprietorship Owned by 1 person Easy to set up Unlimited liability Difficult to access capital Only one level of taxes (pro) Ownership is not transferable really Ex. Owner dies its done o Partnerships Owned by two or more Still limited access to capital Still only taxed at personal level Partnerships can be either general or limited General o Each partner has unlimited liability Limited o Usually involves one or more general partners and one or more limited partners General partners have unlimited liability Limited partners have liability limited by partnership agreement Partnership dissolved when general partner dies or leaves o Corporation Separate legal entity More difficult/expensive to start. Need paperwork and such (articles of incorporation) Can raise lots of capital Loans Selling stock in company Limited liability Why stock prices can’t fall below 0 Double taxation (main drawback) Corporation pays income tax Stockholders pay income taxes on dividends and capital gains Ownership is separate from management/control Ownership exchange easy giving company permanence o Hybrid forms Subchapter S Limited liability of corporation No corporation taxation, earnings flow through to owners Must have less than 100 shareholders o One of many restrictions Limited Liability Corporation (LLC) Like subchapter S but with fewer restriction o No corporation taxation, earnings flow through to owners o Kind of replacing subchapter S Limited Liability Partnership (LLP) All partners have limited liability Special form – Professional LLP (PLLP) Ex. PriceWaterhouseCoopers LLP What to consider when deciding how to organize my business o Capital needed o Size o Liability What do investors get from corporations in exchange for use of their funds? o Corporate securities Represent claims against future assets and earnings Types Debt securities o When investors lend o expect periodic interest payments as well as eventual return of principal Equity securities o Partial ownership of company o Types Common stock “true owners” get there claims met after all other claims Preferred stock have priority over other stockholders on firms earnings/assets also paid cash dividends before common second in line behind creditors
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