Financial Management Chapters 1 + 2

Corporate finance

It's the area of finance focused on how companies manage money, make investments, and fund their operations.

Chief Financial Officer (CFO)

Oversees all financial activities in a company, including planning, budgeting, and financial reporting.

Capital budgeting

What big investments should we make?

Capital structure

How do we pay for them (debt or equity)?

Working capital management

How do we handle daily cash needs?

Main forms of business organization

1. Sole proprietorship 2. Partnership (general and limited) 3. Corporation 4. Limited Liability Company (LLC)

Pros and cons of a sole proprietorship

✅ Easy to start, owner keeps profits, taxed once ❌ Owner has unlimited liability, hard to raise money, business dies with owner

Pros and cons of a partnership

✅ More owners = more capital, taxed once ❌ Unlimited liability, ends when a partner leaves, hard to transfer ownership

Pros and cons of a corporation

✅ Limited liability, easy to raise capital, ownership is transferable ❌ Double taxation (company and shareholder)

Main goal of financial management

To maximize the current value of the company's stock (maximize shareholder wealth).

Agency relationship

When one person (principal) hires another (agent) to act on their behalf—like shareholders hiring managers.

Agency problem

Conflict of interest between managers and shareholders (managers might not always do what's best for the owners).

Managing agency problems

• Managerial compensation (bonuses tied to performance) • Threat of takeovers if managers underperform

Government as a stakeholder

Because it collects taxes, regulates operations, and is affected by company actions like employment and pollution.

Financial markets

Places where businesses raise money and investors trade securities.

Primary market

Company sells new stock/bonds directly to investors.

Secondary market

Investors trade existing stock/bonds with each other.

Dealer market

Buys and sells for themselves (e.g., NASDAQ).

Auction market

Buyers and sellers meet directly (e.g., NYSE).

What are the 3 main financial management decisions?

1. Capital budgeting – What big investments should we make?

2. Capital structure – How do we pay for them (debt or equity)?

3. Working capital management – How do we handle daily cash needs?

What are the main forms of business organization?

1. Sole proprietorship

2. Partnership (general and limited)

3. Corporation

4. Limited Liability Company (LLC)

What’s the difference between a dealer and an auction market?

• Dealer: Buys and sells for themselves (e.g., NASDAQ)

• Auction: Buyers and sellers meet directly (e.g., NYSE)

What’s the difference between primary and secondary markets?

• Primary market: Company sells new stock/bonds directly to investors

• Secondary market: Investors trade existing stock/bonds with each other

How can agency problems be managed?

• Managerial compensation (bonuses tied to performance)

• Threat of takeovers if managers underperform

A _______ corporation is for profit, and has the legal attributes of accountability, transparency, and

benefit

The possible goal of profit maximization:

can be achieved by cost-cutting.

would probably be the most commonly cited goal for a business.

Corporations in other countries are often called:

public limited companies.

joint stock companies.

It is argued that, left to themselves, managers would tend to ____________.

maximize the amount of resources over which they have control or, more generally, corporate power or wealth.

Examples of stakeholders in a company

Employees

Government

Suppliers

What are the two factors that impact whether managers will act in the best interest of stockholders?

How closely management goals align with stockholder goals

AND

the way managers are compensated

There are five main areas of finance:

Corporate finance

Investments

Financial institutions

International finance

Fintech

The five main areas of finance are corporate finance, investments, financial institutions, international finance, and ______.

Fintech

The five main areas of finance are __________, investments, financial institutions, international finance, and fintech.

corporate finance

The five main areas of finance are corporate finance, investments, _______, international finance, and fintech.

financial institutions

In financial markets, _____ and _____ securities are bought and sold

debt

equity

agency problem

The possibility of conflict of interest between the stockholders and management of a firm.

Most equity shares of large firms in the U.S. trade on:

organized auction markets

Capital budgeting is concerned with planning and managing a firm's Blank______

Long-term investments

A corporation is a distinct legal entity and as such can

have a name and take advantage of the legal powers of natural persons.

What act protects investors from corporate abuse?

SOX

In response to corporate scandals at companies like Enron, WorldCom, Tyco, and Adelphiam Congress passed the:

Sarbanes-Oxley (SOX) Act in 2002.

Because ownership in a corporate is spread over a huge number of shareholders, it can be argued that _______ effectively controls the firm.

management

A benefit corporation has what legal attributes?

Accountability

Transparency

Purpose

The relationship between stockholders and management can best be described as a(n) ______ relationship.

Agency

Organized auction markets include:

The New York Stock Exchange

Some of the cash flow generated by a firm goes back to the financial markets in the form of Blank______

Dividends and debt payments

When a corporation is formed, it is granted which of the following rights? (More than one answer may be correct.)

• The ability to issue stock

• State citizenship for jurisdictional purposes

• Legal powers to sue

A firm’s _________blank balance reflects the firm’s mix of short-term assets and short-term liabilities.

net working capital

Determining the number of shares of stock to issue is an example of a _________blank decision.

capital structure

Explanation:
Determining the number of shares of stock to issue is part of a capital structure decision, which involves deciding the best mix of debt and equity financing (such as issuing stock or taking on loans) to fund a firm’s operations and growth.

Which one of the following questions is a working capital management decision?

Should we offer credit terms to all customers or only certain customers?

Explanation:
Working capital management involves handling day-to-day operations, specifically the management of current assets and current liabilities. This includes managing cash, inventory, accounts receivable, and accounts payable.

Deciding whether to offer credit terms affects accounts receivable, making it a working capital management decision.

Which one of the following statements is generally correct?

Auction markets match buy orders with sell orders.

The ability of both sole proprietorships and partnerships to grow larger is often hindered by their:

inability to raise cash.

Explanation:
Sole proprietorships and partnerships often struggle to grow because they lack access to large amounts of capital. Unlike corporations, they can't issue stock and usually rely on personal funds or loans, making it harder to finance expansion.

Two entrepreneurs, named X and Y, are equal general partners in a business. They are content with their current management and tax situation but are uncomfortable with the idea of unlimited liability. If they wish to remain as the only two owners of the business, which form of business entity should they consider instead of their current arrangement?

Limited liability company

Explanation:
A Limited Liability Company (LLC) offers limited liability protection (like a corporation) while allowing for flexible management and pass-through taxation (like a partnership). Since entrepreneurs X and Y want to avoid unlimited liability but retain their current tax and management structure, an LLC is the most suitable option.

Which one of the following statements regarding corporations is correct?

Corporations can have an unlimited life.

Explanation:
A corporation is a separate legal entity from its owners and can continue to exist independently of its founders or current shareholders, giving it an unlimited life unless it is dissolved.

Which one of the following statements concerning stock exchanges is correct?

Some large companies are listed on Nasdaq.

Explanation:
While Nasdaq is known for tech firms and newer companies, some very large companies—like Apple, Microsoft, and Amazon—are listed on Nasdaq.

An investor sold shares of a firm’s stock to another investor. The stock is listed on the NYSE. The trade occurred in which one of the following types of markets?

Secondary, auction

Explanation:
Since the stock is already listed on the NYSE, and one investor is selling to another, this is a secondary market transaction (not a new issuance).

The NYSE is an auction market, where buyers and sellers are matched directly through a bidding process.

So:

• Secondary = previously issued shares traded

• Auction = NYSE structure

Which one of the following statements is correct concerning the NYSE?

The listing requirements for the NYSE are more stringent than those of Nasdaq.

Explanation:
The New York Stock Exchange (NYSE) has stricter listing standards compared to Nasdaq, including higher requirements for market capitalization, earnings, and number of shareholders.

The articles of incorporation:

describe the purpose of the firm and set forth the number of shares of stock that can be issued.

Explanation:
The articles of incorporation (also known as a corporate charter) is a legal document filed with a state government to legally create a corporation. It typically includes:

• The corporation’s name

• Its purpose

• The number and type of shares it can issue

• The initial registered agent

• The names of the incorporators

A sole proprietorship:

has a limited life.

Explanation:
A sole proprietorship has a limited life because it is legally tied to the owner's life. If the owner dies or stops operating the business, the business legally ceases to exist.

An investor sold 1,000 shares of a firm’s stock on the New York Stock Exchange. This transaction must have:

occurred in the secondary market.

Explanation:
When an investor sells existing shares of stock to another investor — such as on the New York Stock Exchange (NYSE) — the transaction takes place in the secondary market. This is where already-issued securities are bought and sold among investors.

A partnership with four general partners:

distributes profits based on each partner’s percentage of ownership.

Explanation:
In a general partnership, profits and losses are typically distributed according to the partnership agreement, which is often based on each partner’s ownership percentage or investment in the business. If no agreement exists, some states default to equal distribution.

Which one of the following outcomes is an unintended result of the Sarbanes-Oxley Act?

Corporations delisting from major exchanges

Explanation:
An unintended consequence of the Sarbanes-Oxley Act (SOX) was that some companies chose to delist from major exchanges or go private to avoid the high compliance costs and regulatory burdens imposed by SOX. This was not the goal of the legislation, which aimed to improve corporate governance and financial transparency after major scandals like Enron and WorldCom.

Which one of the following actions is least apt to convince managers to work in the best interest of the stockholders? Assume there are no golden parachutes.

Increasing managers' base salaries

Explanation:
Increasing base salaries provides fixed compensation regardless of company performance, which does not align managers' interests with those of shareholders. It gives no incentive to improve stock price or firm value.

Which of the following actions would be considered an agency problem?

A manager in a corporation makes online personal travel arrangements during work hours

Explanation:
This is an example of an agency problem, which occurs when managers (agents) act in their own self-interest rather than in the best interest of the shareholders (principals). Using company time for personal tasks shows misuse of resources and conflicts with shareholder goals.

The Sarbanes-Oxley Act of 2002 is a governmental response to:

management greed and abuses.

Explanation:
The Sarbanes-Oxley Act of 2002 (often called SOX) was enacted in response to major corporate scandals (like Enron, WorldCom, and Tyco) involving fraudulent accounting practices, management misconduct, and misleading financial reporting. Its purpose was to increase transparency, strengthen internal controls, and hold executives accountable for the accuracy of financial statements.

Net Working Capital

The difference between a firm's current assets and current liabilities; reflects short-term financial health and operational efficiency.

Capital Structure Decision

Involves determining the best mix of debt and equity financing, such as issuing stock or taking out loans.

Working Capital Management

Deals with managing short-term assets and liabilities; includes decisions like offering credit terms to customers.

Auction Market

A market like the NYSE where buyers and sellers are matched directly through open bidding.

General Partnerships and Capital Limitations

Sole proprietorships and partnerships often struggle to grow due to limited access to capital.

Limited Liability Company (LLC)

Offers liability protection like a corporation, while maintaining pass-through taxation and management flexibility like a partnership.

Unlimited Life (Corporation)

Corporations can continue to exist independently of their founders or shareholders, giving them unlimited life.

Secondary Market

Where existing securities are traded among investors; does not involve the issuing company.

NYSE as an Auction Market

The NYSE matches buyers and sellers through an open bidding system, not through dealers.

General Partner Liability

Each general partner has unlimited liability for the debts of the business.

Ownership Transfer: Sole Proprietorship vs. Corporation

Ownership in a corporation is easier to transfer than in a sole proprietorship.

Corporations and Stock Trading

Large companies can be listed on Nasdaq; not all public companies are on the NYSE.

Agency Problem Example

Occurs when managers use company time/resources for personal benefit, like booking personal travel during work hours.

Limited Liability Company (LLC)

Offers liability protection like a corporation, while maintaining pass-through taxation and management flexibility like a partnership.

Net Working Capital =

Current Assets - Current Liabilities

The balance sheet provides the _________ of the assets, liabilities, and stockholders equity

Book value

Cirrent assets - current liabilities is what?

Working capital

The balance sheet

is a point in time

The income statement is not a stock number but rather a

time frame

What is the marginal tax rate?

The percentage paid on the next dollar earned

What is the average tax rate?

The tax bill / taxable income

What does the marginal tax rate measure?

It measures how much additional tax you pay for earning one more dollar.

What does the average tax rate measure?

It measures the percentage of total income that is paid in taxes.

Why is the marginal tax rate more relevant for decision-making?

Because it affects how much tax you’ll owe on additional income, which is crucial when evaluating work incentives or investments.

Can the marginal tax rate be higher than the average tax rate?

Yes; in a progressive tax system, the marginal tax rate is usually higher than the average tax rate.

True or False: The marginal tax rate applies to all your income.

False. The marginal rate applies only to income within a specific tax bracket.

If your average tax rate is 18% and your marginal rate is 24%, what does this mean?

You paid an average of 18% on your total income, but your last dollars earned were taxed at 24%.

How does a progressive tax system affect the relationship between marginal and average tax rates?

It creates a situation where the marginal tax rate increases as income increases, often causing it to be higher than the average rate.

Which tax rate is used to calculate how much additional tax you'll owe on a bonus?

The marginal tax rate, since bonuses are taxed as additional income.

What is cash flow not?

It is NOT earnings

Cash Flow From Assets =

Cash Flow to Creditors + Cash Flow to Stockholders

What is Cash Flow From Assets?

Operating Cash Flow - Net Capital Spending - Changes in NWC

Formulas!

OCF =

EBIT + depreciation - taxes

OCF is on what?

The income statement