BUS 3710 - Midterm Exam 1

Corporate finance (Business finance)

focuses on determining value and making decisions in a corporation. The finance function allocates resources, including the acquiring, investing, and managing of resource

Investments

deal with financial assets such as stocks and bonds.

Financial institutions

businesses that deal primarily in financial matters, e.g., banks, insurance companies, investment funds, etc.

International finance

generally involve international aspects of either corporate finance, investments, or financial institution

Shareholders (stockholders)

owners of the firm

Stakeholders

managers, employees, suppliers, government, and creditors

Who cares whether the firm succeeds?

• Shareholders (stockholders)

• Stakeholders

What are the 4 basic areas?

• Financial Institution

• International Finance

• Corporate Finance

• Investments

financial manager

top officer of the firm, Chief financial officer (CFO) or vice president (VP) of finance

role of the financial manager

Making decisions that maximize the shareholders’ wealth → maximize the value of the firm’s stock.

CFO coordinates the activities of the treasurer and the controller

treasurer

responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures (which we focus on)

controller

handles cost and financial accounting, tax payments, and management information systems

Capital budgeting

process of planning and managing a firm’s long-term investments

Productive (capital) assets

tangible and intangible assets a firm uses to generate cash flows

When should the financial managers should invest in a capital project?

only if the value of its future cash flows exceeds the cost of the project (benefits > costs

Capital Structure (Financing decisions)

the mixture of long-term debt and equity the firm uses to finance its operations

Debt Financing (Loan)

• Advantage: Interest on debt is tax deductible

• Disadvantage: Increase the bankruptcy risk

Equity Financing

• Advantage: No obligation to pay dividends

• Disadvantage: Dividend payments are not tax deductible

Sole Proprietorships

Characteristics:

• The simplest type of business, owned by one person

• Can have an unlimited number of employees

• Accounts for about 75 percent of all businesses in the U.S.

Sole Proprietorships cont.

Advantages:

• Lower income taxes

• The owner does not have to share decision-making authority

Disadvantages:

• Has unlimited liability for all business debts and obligations, i.e., creditors can look to the proprietor’s personal assets for payment

• Limited equity

• Difficult to transfer ownership

Partnerships

• Two or more owners

• Accounts for about 10 percent of all businesses in the U.S.

• 2 types of partnerships

General partnership

Similar to a sole proprietorship, but with multiple owners

responsible for day-to-day operations and have unlimited liability

Limited partners

cannot actively manage the business and have limited liability

Partnerships cont.

Advantages:

• More sources of equity

• Unlimited liability can be avoided in a limited partnership

Disadvantages:

• Shared control and profit

Corporations

• In a legal sense, it is a “person” distinct from its owners

• Has an indefinite life

• The owners are stockholders

• Accounts for about15 percent of all businesses in the U.S.

• Can be public or private

• Most large firms prefer to go public

• Public companies are listed on NYSE, NASDAQ, London Stock

Exchange, Tokyo Stock Exchange, etc.

• Not all private firms want go public

Corporations cont.

Advantages:

• Stockholders have limited liability

• Greater access to sources of funds

Disadvantages:

• Double taxation on shareholders, i.e., corporate profits are taxed twice

• Costly to start (money and time)

The market considers

• The size of the expected cash flows

• The timing of cash flows

• The riskiness of the cash flows

What is Agency Conflict?

• Separation of ownership and control

• The agents (managers) may make decisions that benefit their own interests than those of the principals (stockholders)

Primary Market

• Wholesale market where firms’ new securities are issued and sold for the first time

• New money goes to the firm

Secondary Market

• Retail market where previously issued securities are resold (traded)

• No new money goes into the firm

• NYSE, NASDAQ, etc.

Liquidity

• The ability to convert an asset to cash quickly without loss of value

• A highly liquid asset is one that can be quickly sold without significant loss of value

financial leverage

more debt a firm has (as a percentage of assets), the greater is its degree of financial leverage

Book value

balance sheet value of the assets, liabilities, and equity, and are not what the assets are actually worth

market value

true value; the price at which the assets, liabilities or equity can actually be bought or sold

GAAP matching principle

costs of producing an item should be recorded when the sale of that item is recorded as revenue.

Operating Cash Flow (OCF):

refers to the CF that results from

the firm’s day-to-day activities of producing and selling

Net Capital spending (NCS)

refers to the net spending on fixed

assets (purchases of fixed assets less sales of fixed assets

Change in net working capital (ΔNWC)

the amount spent on NWC (Δ current assets – Δ current liabilities)

Financial ratios

relationships determined from a firm’s financial information and used for comparison purposes

Inventory

least liquid, least reliable measure of market value, large inventories are short-term trouble

Time-Trend Analysis

Compare with historical information

Peer Group Analysis

• Identify similar firms (markets, assets, operations, etc.)

• Firms with same SIC code (Standard Industrial Classification)