Principals of Finance Exam 1

What is the goal of the firm or financial managers?

Maximize shareholders’ (owners) wealth, or equivalently, the stock price or market value of the firm.

Should the firm or financial managers set the goal to maximize Profit?

No. Maximization of Accounting Profit (earnings, or EPS) does not lead to highest possible share price.

Why is profit maximization not the right goal for financial managers? First factor - 

Timing

Why is profit maximization not the right goal for financial managers? Second factor - 

Cash Flows

Why is profit maximization not the right goal for financial managers? Third factor -

Risk

Should the firm or financial manager maximize stakeholders’ welfare (employees, customers, suppliers, creditors, and communities)?

No

Why can’t stakeholders’ financial welfare be maximized simultaneously?

Stakeholders are difficult to rank, so their interests cannot all be maximized at once.

What happens if the firm maximizes shareholders’ wealth?

It indirectly takes care of stakeholders’ benefits in a competitive market environment.

How are stakeholders’ interests protected in the U.S.?

A healthy legal system ensures their interests are well protected.

What are the four key decisions financial managers make?

Financing, Investment, Capital Budgeting, and Working Capital decisions.

What are financing decisions?

How to raise funds, both short-term and long-term.

What are investment decisions?

How to allocate funds/capital in long-term projects.

What are capital budgeting decisions?

How to select projects that create the most value for shareholders.

What are working capital decisions?

How to manage short-term resources to run daily business operations.

What are the principles of managerial decisions?

Time Value of Money, Risk-Return Tradeoff, Cash is King, Competitive Financial Market, Incentives.

What does the principle “Time Value of Money” mean?

Timing matters—money today is worth more than money in the future.

What does the principle “Risk-Return Tradeoff” mean?

Higher risk is linked with higher potential return; lower risk with lower return.

What does the principle “Cash is King” mean?

Focus on cash flows, not just accounting profits.

What does the principle “Competitive Financial Market” mean?

Managers must follow market demand/supply and respond to market signals.

What does the principle “Incentive” mean?

Provide proper incentives to both employees and managers.

What principle did Finance adopt from Economics?

Marginal cost–marginal benefit analysis.

How should financial decisions be evaluated using this principle?

A decision is wise if marginal benefit (MB) > marginal cost (MC).

What is the goal of applying MB > MC in finance?

To ensure resources are allocated to create value.

What do financial managers emphasize in business transactions?

Actual cash flows (inflows, outflows, and net flows).

What do accountants emphasize in business transactions?

Accrual basis—recognizing revenue when earned and expenses when incurred, regardless of cash.

Example: Firm A sells goods worth $10,000 (cost $8,000), pays for the goods, but has not collected from the customer. What is the net profit (accrual basis)?

$2,000.

Firm A sells goods worth $10,000 (cost $8,000), pays for the goods, but has not collected from the customer. What is the cash flow (financial managers’ focus)?

–$8,000 (cash outflow with no inflow yet).

What is the Principal–Agent problem?

When owners (principals) and managers (agents) are not the same, managers may act in their own interests rather than in owners’ interests.

What are agent costs?

Extra costs that arise when managers (agents) do not act in the best interest of owners (principals).

Who bears the agent costs in a firm?

The firm’s owners (stockholders).

How can the Principal–Agent problem be solved through corporate governance?

By using rules, processes, and laws that align managers’ actions with owners’ interests.

What are internal solutions firms use to reduce the Principal–Agent problem?

Stock options or restricted stock compensation that tie managers’ benefits to the firm’s stock price.

What is the role of the Board of Directors?

Make strategic decisions.

What is the role of the President/CEO?

Fully in charge of overall business operations.

What is the role of the CFO?

In charge of overall financial management (reports to the CEO).

What is the role of the Treasurer?

Manages cash, pension plans, and key risks (reports to the CFO).

What is the role of the Controller?

Chief accountant—responsible for accounting activities, tax management, and cost control (reports to the CFO).

What are the three main organizational forms of business?

Sole proprietorship, Partnership, and Corporation.

What are the key features of a Sole Proprietorship?

Unlimited liability; taxed on proprietor’s personal tax return.

What are the key features of a Partnership?

Unlimited liability for owners; may have to cover debts of other partners; taxed on partners’ personal tax return.

What are the key features of a Corporation?

Limited liability; double taxation (firm and individual). 

What is the major liability difference between proprietorships/partnerships and corporations?

Proprietors/partners have unlimited liability; corporations provide limited liability.

What is the major taxation difference between proprietorships/partnerships and corporations?

Proprietorships/partnerships are taxed once (personal returns); corporations face double taxation.

How do you calculate marginal tax in a progressive taxation framework?

Apply the marginal tax rate to the last dollar earned within the taxable income bracket. 

How do you calculate total tax payment due in a progressive taxation framework?

Calculate tax for each income bracket at its marginal rate, then add them all together.

What’s the difference between marginal tax and total tax payment?

Marginal tax = tax rate on the next dollar earned.

Total tax payment = sum of taxes owed across all applicable brackets.

Does ethical behavior of a firm affect its share prices?

Yes

What law established ethical guidelines for firms in 2002?

The Sarbanes–Oxley Act of 2002.

Why does ethical behavior matter for share prices?

It builds investor trust, reduces risk of scandals, and supports long-term value.

Who are the main fund suppliers in the economy?

Individuals (net fund suppliers).

Who are the main fund demanders in the economy?

Firms (net fund demanders).

What are financial institutions?

Intermediaries that channel savings of individuals, businesses, and governments into loans or investments for fund demanders

Why are financial institutions important?

They connect savers with borrowers, making capital flow efficiently in the economy.

What are the three main types of financial institutions?

Commercial banks, Investment banks, and the Shadow banking system (non-bank financial institutions).

What do Commercial Banks do?

Receive deposits and make commercial loans.

What do Investment Banks do?

Assist companies in raising capital, advise on major transactions/business issues, and engage in security trading and market-making.

What is the Shadow Banking System?

Non-bank financial institutions (insurance companies, mutual funds, pension funds, etc.) that lend money but do not accept deposits.

Why are shadow banks regulated differently from commercial banks?

Because they do not take deposits, they are not subject to traditional depository regulations.

What is the Money Market?

A short-term financial market where highly liquid, marketable securities with maturities of one year or less are traded.

What are typical Money Market instruments?

Treasury bills (T-bills), Commercial paper, Negotiable certificates of deposit (CDs).

What is the Capital Market?

A long-term financial market where securities with maturities over one year or without maturity are traded.

What are typical Capital Market instruments?

Treasury notes (T-notes), Treasury bonds (T-bonds), Corporate bonds, Preferred stocks, Common stocks, Financial derivatives.

What is the main difference between the Money Market and Capital Market?

Money Market = short-term (≤ 1 year); Capital Market = long-term (> 1 year or no maturity).

What is the Primary Market?

A market where a firm issues and sells new securities (often common stock) to raise long-term funds.

What is the key process in the Primary Market?

Initial Public Offering (IPO), when investors purchase stocks for the first time.

What is the Secondary Market?

A market where investors trade pre-owned (already issued) securities.

What are examples of Secondary Markets?

The New York Stock Exchange (NYSE) and Nasdaq.

What is the main difference between the Primary and Secondary Market?

Primary = firms raise funds by issuing new securities; Secondary = investors trade existing securities with each other.

What are the two major forms of firm owners’ income?

Ordinary income and Capital gains.

What is Ordinary Income?

Income from business operations, such as wages, salaries, and dividend distributions.

What is a Capital Gain?

Income from selling the firm’s assets, including physical assets and financial securities.

What do Broker and Dealer markets have in common?

Both are secondary markets that trade pre-owned securities.

What is a Broker Market?

A market with a trading floor (e.g., NYSE) where brokers match buyers and sellers but do not trade themselves.

How do brokers earn revenue?

They charge transaction fees (commissions).

What is a Dealer Market?

A market without a physical trading floor (e.g., Nasdaq) where dealers act as “market makers” by buying and selling securities themselves.

How do dealers earn revenue?

From the bid/ask spread plus transaction fees.

Which market usually has higher transaction costs—Broker or Dealer?

Dealer market (because of the bid/ask spread + commission).

What is the Over-the-Counter (OTC) market?

A financial market where smaller, unlisted securities are traded.

How does trading volume in the OTC market compare to major exchanges?

Trading volumes are relatively small.

What types of securities are usually traded in the OTC market?

Smaller or unlisted securities that are not on major exchanges.

What does the Efficient Market Hypothesis (EMH) claim about security prices?

Security prices fully reflect all available information (historical, public, and inside).

According to EMH, how are securities generally priced?

Securities are in equilibrium and fairly priced.

What does EMH imply about finding undervalued or overvalued securities?

Investors cannot easily identify mispriced securities.

What does EMH suggest about investors’ ability to make systematic gains?

Systematic gains are not possible because markets quickly adjust to new information.

What does Behavioral Finance claim about stock prices?

Stock prices can deviate from their true values for extended periods.

What can these deviations in stock prices create?

Predictable patterns in stock prices.

What specific pattern has evidence in Behavioral Finance?

Stocks that performed poorly in the past often rebound, creating profit opportunities.

How does Behavioral Finance oppose the Efficient Market Hypothesis?

It suggests markets are not always perfectly efficient, so investors may exploit predictable patterns.

What was the main restriction placed by the Glass–Steagall Act of 1933?

It prohibited deposit-taking institutions from engaging in high-risk activities like securities underwriting and trading, separating commercial banks from investment banks.

What major organization did the Glass–Steagall Act establish?

The Federal Deposit Insurance Corporation (FDIC).

What is the primary role of the FDIC regarding deposits?

Provides deposit insurance to individuals if their bank fails.

Besides deposit insurance, what else does the FDIC do?

Examines banks regularly to ensure operations are “safe and sound.”

What was the main purpose of the Gramm–Leach–Bliley Act of 1999?

To promote competition in the U.S. banking industry.

What did the Gramm–Leach–Bliley Act allow?

Business combinations between commercial banks, investment banks, and insurance companies.

What was the impact of the Gramm–Leach–Bliley Act?

It permitted financial institutions to compete in a wider range of activities. 

What are the two major ways a firm can raise capital?

Private placement and Public offering.

What is a Private Placement?

Raising funds by selling the firm’s new securities directly to an investor or group of investors through its own business network.

What is a Public Offering?

Sale of bonds or stocks to the general public, conducted by investment banks in the capital market (typically the primary market).

Which capital-raising method usually involves investment banks?

Public offering.

What is Venture Capital?

Equity financing provided to young, rapidly growing firms.