MGT 181 Chapter 1 Notes PDF

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Chapter 1.1 -

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Three questions for starting own business - What long-term investments should you take on? What lines of business will you be in and what materials are needed? - Where will you get the long-term financing to pay for your investment? - How will you manage everyday financial activities like collecting from customers and paying suppliers? Corporate Finance- The study of ways to answer the above questions The owners (stockholders) in large corporations are not directly involved in making business decisions, but rather they employ managers to do so on their behalf (financial manager would answer the above questions) In a large firm, the vice president of finance coordinates activities of the treasurer and controller. Controller’s office handles cost and financial accounting, tax payments, management information systems, etc. Treasurer’s office manages the cash and credit of the firm, financial planning, and capital expenditures Capital Budgeting- The process of planning and managing a firm’s long-term investments (first question) - Financial manager tries to identify investment opportunities worth more to the firm than the acquisition cost (value of cash flow from asset exceeds asset’s cost) - Ex. Deciding to open another store is an important capital budgeting decision for Walmart; Deciding to develop and market a new spreadsheet program is an important capital budgeting decision for software companies like Microsoft Financial managers must be concerned with the amount of cash expected to be received as well as the likelihood of them receiving the particular cash stream and when it will be received The essence of capital budgeting lies in evaluation of the size, timing, and risk of future cash flows Capital Structure (Financial Structure)- The specific mixture of long-term debt and equity the firm uses to finance its operations (second question) - Concerns include how much the firm should borrow (determine best mixture of debt and equity) and what the least expensive sources of funds are for the firm - The firm’s capital structure determines what percentage of the firm goes to creditors and what percentage goes to shareholders - The heart of the capital structure issue is whether one structure is better than another for a particular firm Financial managers must also be concerned with how and where to raise the money - Expenses with long-term financing are considerable, so different possibilities must be evaluated, and corporations borrow money from various lenders, so choosing among lenders and loans types is also handled by financial managers Working Capital- A firm’s short-term assets, such as inventory, and short-term liabilities, such as money owed to suppliers (third question) - Managing working capital is a daily operation ensuring that the firm has enough resources to continue its work and avoid costly interruptions

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Involves activities relating to receipt and disbursement of cash Questions about working capital include how much cash and inventory can be kept on hand, whether to sell on credit and the terms and parties if selling on credit, and how short-term financing will be obtained

Chapter 1.2 -

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Three different forms of legal organization - Sole Proprietorship - Partnership - Corporation As a firm grows, advantages of corporate forms may outweigh their disadvantages Sole Proprietorship- A business owned by one person; Simplest type of business to start and least regulated form of organization - To start a proprietorship, you may need to do little more than getting a business license and opening your doors, which justifies the vast amount of proprietorships than any other type of business - Many corporations start out as small proprietorships - The owner gets to keep all the profits, but he or she has unlimited liability for business debts, meaning that creditors can look beyond business assets for payments. There is also no distinction between personal and business income, so all business income is taxed as personal income - The lifetime of a sole proprietorship is limited to the owner’s life span, and the amount of equity raised is limited to the amount of personal wealth. This means that the business cannot exploit new opportunities due to lack of capital - Transfer of a sole proprietorship is difficult because it requires the sale of the entire business to a new owner Partnership- Similar to a proprietorship, but there are two or more owners - General Partnership- All partners share in gains or losses and have unlimited liability for all partnership debts - Partnership Agreement- The way partnership gains and losses are divided; Informal agreement like “let’s start a cooking business” or lengthy formal document - Limited Partnership- One or more general partners run the business and have unlimited liability, but there exists one or more limited partners that do not actively participate in the business; Liability for debts are limited to the amount that partner contributes to the partnership (Common in real estate ventures) - Advantages and disadvantages of a partnership are the same as those of a proprietorship - A written agreement is very important because a partner in a general partnership can be held responsible for all partnership debts - If you are a limited partner, you must not be deeply involved in business decisions because you may be deemed a general partner in the event that things go south for the partnership

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The three main disadvantages of sole proprietorships and partnerships, which include unlimited liability for debts, limited business lifetime, and difficulty of ownership transferability, create the single problem that the ability of a business to grow is limited by an inability to raise cash for investment Corporation- Most important form (size) of business organization in the US; A legal “person”, separate and distinct from its owners, and it has many of the rights, duties, and privileges of an actual person - Can borrow money and own property, can sue or be sued, can enter into contracts, and can be part of limited or general partnerships and/or own stocks - Forming a corporation involves preparing articles of incorporation (includes corporation’s name, lifetime, purpose, and number of issued shares) and a set of bylaws (rules describing how the corporation regulates its existence, like for example how directors are elected) - In large corporations, stockholders and managers are separate groups! - Stockholders elect board of directors, who then select managers in charge of running corporation’s affairs in the interest of stockholders - Ownership (shares of stock) are readily transferable and the life of the corporation is unlimited - Corporations borrow money in its own name, so stockholders have limited liability - If corporations need, for example, new equity, it can sell new shares of stock and attract new investors - Since a corporation is a legal person, it must pay taxes, and money paid out to stockholders via dividends is taxed again as income to those stockholders, which all describes double taxation - Double Taxation- Corporate profits are taxed twice (corporate level when earned and personal level when paid out) Limited Liability Company (LLC)- An entity that operates and is taxed like a partnership but retains limited liability for owners (hybrid of partnership and corporation) - The Internal Revenue Service considers LLC a corporation and subjects it to double taxation, so an LLC can’t be too corporation-like

Chapter 1.3 -

The goal of financial management is to make money or add value for owners The most commonly cited goal out of all the possibilities is profit maximization, but this even then creates problems such as figuring out what year’s profits are being dealt with The goal of maximizing profits refers to “long-run” or “average” profits, but this doesn’t tell us the trade-offs between current and future profits Goals of sales, market share, and cost control all relate to ways of earning or increasing profits (Profitability) Goals of bankruptcy avoidance, stability, and safety relate to controlling risk (Risk Control) Financial managers in a corporation make decisions for the stockholders of the firm, so it is better to answer the question “what is a good financial management decision?”

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Financial managers acts in the shareholder’s best interests by making decisions which increase the value of the stock The goal of financial management is to maximize the current value per share of the existing stock Stockholders in a firm are residual owners, so they are entitled to only what remains after employees and other workers are paid their due. They get nothing if any worker is not paid their fair share Corporate Finance can also be defined as the study of the relationship between business decisions and the value of the stock in the business A general way of stating our goal for financial management is that it requires maximizing the market value of the existing owners’ equity This goal does not imply that financial managers should behave in illegal and unethical ways in order to increase the value of equity in the firm, but rather the financial manager best serves the owners of the business by identifying goods and services which add value to the firm since they are valued in the marketplace Sarbanes-Oxley Act (Sarbox)- Intended to protect investors from corporate abuses; - Section 404 requires that a company’s annual report must assess internal control structure and financial reporting, which then must be evaluated by independent auditors - Officers of corporation must review and sign annual reports and declare that no false information exists and no information is omitted Since Sarbox has been implemented, public firms have chosen to “go dark”, meaning that their shares are no longer traded on major stock exchanges

Chapter 1.4 -

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The dispersion of ownership by the corporation to the stockholders ultimately means that management effectively controls the firm Agency Relationship- The relationship between stockholders and management that exists whenever someone (principal) hires another (agent) to represent his or her interests Agency Problem- A possibility of a conflict of interest between the principal and the agent - An example demonstrating this concept is compensating an agent with a 5% flat fee as opposed to 10% commission because there is motivation to do one thing rather than another, which may not be beneficial to the opposing party Agency Costs- The costs of the conflicts of interest between stockholders and management (Ex. not taking on a risky investment because it may not work well in the end and cause lost jobs) - Indirect agency cost is a lost opportunity, like not taking the risk for a potential high-return investment - Direct agency costs consist of corporate expenditures benefiting management but costing the stockholders, and expenses arising from the need to monitor management actions Managers arguably would tend to maximize resources which they have control,

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corporate power, or wealth over, but this could lead to overemphasizing corporate size or growth Reasons that management will have an economic incentive to increase share value include the notion that managerial compensation is tied to financial performance and share value (managers given option to buy stocks at bargain price, but stocks are worth more at a higher purchase price) and job prospects (better performers in firms will likely get promoted and managers successful in pursuing stockholder goals are more marketable for jobs with higher salaries) Proxy Fight- An important mechanism that unhappy stockholders can use to replace existing management - A proxy is the authority to vote someone else’s stock, so a proxy fight develops when a group solicits proxies in order to replace the existing board of directors Takeover is another method by which managers can be replaced! - Poorly managed firms are more attractive since they have higher profit potential, so avoiding a takeover gives management a new incentive to act in the interests of its shareholders Stakeholder- Someone other than a stockholder or creditor who potentially has a claim on a firm’s cash flows

Chapter 1.5 -

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Like any market, a financial market is merely a way of bringing buyers and sellers together Debt and equity securities are bought and sold in a financial market, and other important differences concerns the types of securities traded, how trading is conducted, and who buyers and sellers are Primary Market- Original sales of securities by governments and corporations Secondary Market- Securities are bought and sold after the original sale In primary market transactions, the corporation is the seller, and transactions, in forms of public offerings and private placements, raise money for the corporation Public Offering- Involves selling securities to the general public Private Placement- Negotiated sale involving a specific buyer According to the law, public offerings of debt and equity must be registered with the SEC, and registration requires the firm to disclose information before selling any securities To avoid such regulations, debt and equity securities are often sold privately to large financial institutions such as life insurance companies or mutual funds (private placements do not need to be registered with the SEC) In secondary market transactions, one owner or creditor sells to another owner or creditor, and secondary markets provide the means of transferring ownership of corporate securities Secondary markets are still critical to large corporations because investors are much more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired

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The two types of secondary markets are dealer markets and auction markets Dealers buy and sell for themselves at their own risk (car dealer buys and sells automobiles, but real estate agents don’t buy and sell houses) Over-the-Counter Markets (OTC)- Dealer markets in stocks and long-term debt; the expression “over-the-counter” describes old days when securities were bought and sold at counters in offices nationwide Auction markets have physical locations and their purpose is mainly to match those who wish to buy with those who wish to sell...