Algebra review

Capital

A firms’s long term source of financing

Finance

The management of large amounts of money, especially by governments or large companies.

What are the two main financial decisions made by managers

1. capital budgeting or capital expenditure (CAPEX) decisions

2. financing decisions

Capital budgeting or capital expenditure (CAPEX) decisions

which real assets (tangible or intangible) the firm should acquire & invest. Assets needed to generate

expected cash flows that are greater than cash needed to buy.

Financing decisions

How to raise money in firm for investments & operations (internal/external funds)

real assets

Used in production/sale of goods and services (machines, factory, trademarks) – intangible/tangible

Financing assets

Claims to the income generated by real assets (shares, loans, bonds, bank loans)

What is the difference between equity and debt investors?

Equity investors: The investors receive shares of stock and become shareholders, part-owners of the corporation and contribute equity financing

Debt Investors: The investors are lenders and the amount invested must be returned

What is the choice between debt and equity financing called?

capital structure decision

Financing decisions

Raise money for investments & operations of the firm – internally generated funds or externally

generated funds

What is the difference b/w investment and finance decisions?

When a firm invests in real assets (like equipment or property) to produce goods and services, it finances these investments by issuing financial assets (such as stocks or bank loans) to investors.

Investment decisions

Place value on uncertain cash flows generated by capital investment projects.

• Amount

• Timing

• Risk

What are two categories of external investments?

1. Debt financing – selling bonds, must be repaid

2. Equity financing – selling shares of stock (ownership of the firm)

Corporation

A business organized as a separate entity, owned by shareholders – limited liability

o Shareholders sell shares

o Board of directors elected by shareholders

o Taxed twice on company profits

What are some key characteristics of corporations?

• Owned by shareholder (investors who buy shares)

• Considered a separate entity

• Shareholders sell shares

• Board of directors elected by shareholders

• Taxed twice on company profits

• The owners of a corporation are not personally liable for its obligations.

Sole proprietorship

one-person unlimited liability

Hybrid forms (LLP, LLC, PC)

Characteristics of corporations & partnerships

What does limited liability partnerships (LLPs) or limited liability companies (LLCs) mean?

business structures that offer their owners limited liability protection, meaning their personal assets are generally shielded from business debts and lawsuits

Professional corporation (PC)

The business has limited liability, but the professionals can still be sued personally, for example, for malpractice

chief financial officer (CFO)

• Supervises all financial functions and sets overall financial strategy.

• oversee the work of all financial staff

• ex corporate planning, financial policy

Treasurer

Looks after cash, raises capital, relationships with banks & investors

controller

Prepares financial statements – manages budgets, accounts, taxes

Minimum rate of return/opportunity cost of capital/hurdle rate

The minimum return that an investor is expecting to receive for their investment, depends on risk imposed by investment project

• Corporations increase value by accepting all investment projects that earn more than the opportunity cost of capital

what are the goals of the corporation?

maximize market value

• Increasing market value increases shareholder wealth

• Increasing market value is equivalent to maximizing current share price

• Reinvesting in firm may inc. profit but not enough

• Higher profit = higher risk

• Max profits don’t increase overall market value

• Objective should be to max current market value

• Interested in what happens in the future

• Consider risks of investments

• Profit is not the goal – maximize shareholder wealth

Principal

The ones who authorizes agents to act on behalf of them

Agent

The ones who act on behalf of the principal

Agency problems

The owners of firms are principals

Managers are hired as agents of owner

When personal goals of agent’s conflict agency problems

o May shy from attractive risks

o May overindulge

o Managers should act in shareholder interest

o Engage in empire building

agency costs

Value lost from agency problems or from the cost of mitigating agency problems

What are some ways to reduce agency problems?

Executive compensation plans

• Corporate governance

• Threat of takeover

• Specialist monitoring

• Shareholder pressure

• Legal & regulatory requirements

limited partnership