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Costs that arise from conflicts of interest between shareholders and managers.

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agency costs

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The conflict of interest between the goals of a firm's owners and its managers.

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agency problems

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Representatives elected by shareholders to be responsible for hiring, firing, and overseeing managers and for setting overall corporate policies.

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board of directors

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The activities involved in selecting the best projects in which to invest the firm's funds based on their expected risk and return. Also called the investment function.

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capital budgeting function

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Top management position charged with developing financial policies and strategies covering all aspects of a firm's financial management and accounting activities.

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chief financial officer (CFO)

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When individual stockholders bear all the costs of monitoring management, but the benefit of such monitoring accrues to all shareholders.

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collective action problem

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When individual stockholders bear all the costs of monitoring management, but the benefit of such monitoring accrues to all shareholders.

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corporate charter

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The activities involved in managing cash (money) that flows through a business.

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corporate finance

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The activities involved in developing company-wide structures and incentives that influence managers to behave ethically and make decisions that benefit shareholders

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corporate governance function

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A legal entity, owned by the shareholders who hold its common stock, with many of the economic rights and responsibilities enjoyed by individuals.

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corporation

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Long-term borrowed money.

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debt capital

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Taxation of corporate income at both company and personal levels—traditionally a significant disadvantage of the corporate form.

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double-taxation problem

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An ownership interest purchased by an investor, usually in the form of common or preferred stock, that is expected to remain permanently invested.

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equity capital

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Owners of a corporation's equity securities.

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equity claimants

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Incentives offered to a manager to encourage her to act in the best interests of the owners.

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executive compensation plans

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A person who invests and manages money on another's behalf.

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fiduciary

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An institution, such as a bank, that raises capital by issuing liabilities against itself, and then uses the capital raised to make either loans to corporations and individuals or to buy various types of investments.

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financial intermediary (FI)

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The activities involved in managing the firm's operating cash flows as efficiently as possible.

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financial management function

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Raising capital to support a company's operations and investment programs.

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financing function

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One or more participants in a limited partnership who operate the business and have unlimited personal liability.

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general partners

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To use complex financial instruments to offset market risks such as interest-rate and currency fluctuations.

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hedge

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The acquisition of one firm (the target) by another (the acquirer) through an open market bid for a majority of the target's shares if the target firm's senior managers do not support (or, more likely, actively resist) the acquisition.

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hostile takeover

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The first public sale of a company's common stock, offered through the sale of shares to outside investors and listed for trade on a stock exchange.

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initial public offering (IPO)

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A legal concept that makes each partner in a partnership legally liable for all the debts of the partnership.

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joint and several liability

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A form of business organization that combines the tax advantages of a partnership with the limited liability protection of a corporation.

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limited liability company (LLC)

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One or more totally passive participants in a limited partnership, who do not take any active role in the operation of the business and who do not face personal liability for the debts of the business.

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limited partners

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A partnership in which most of the participants (the limited partners) have the limited liability of corporate shareholders, but their share of the profits from the business is taxed as partnership income.

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limited partnership (LP)

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A proprietorship with two or more owners who have joined their skills and personal wealth.

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partnership

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The top company manager with overall responsibility and authority for managing daily company affairs and carrying out policies established by the board.

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president or chief executive officer (CEO)

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Cash sales of securities to investors by a corporation to raise capital.

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primary-market transactions

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A corporation, the shares of which can be freely traded among investors without obtaining the permission of other investors and whose shares are listed for trading in a public securities market.

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public company

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Investors (typically common stockholders) who have the right to receive the cash that remains after a firm pays all of its bills and makes necessary new investments in the business.

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residual claimants

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The activities involved in identifying, measuring, and managing the firm's exposure to all types of risk to maintain an optimal risk-return trade-off and therefore maximize share value.

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risk management function

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An ordinary corporation in which the stockholders have elected to allow shareholders to be taxed as partners while still retaining their limited-liability status as corporate stockholders.

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S corporations

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Act of Congress that established new corporate governance standards for U.S. public companies.

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Sarbanes-Oxley Act of 2002 (SOX)

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Trades between investors that generate no new cash flow for the firm.

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secondary-market transactions

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The federal agency, established in 1934, charged with oversight of the fair reporting of financial information to investors in public companies (those whose shares are listed for trading in a public securities market).

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Securities and Exchange Commission (SEC)

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Owner of common or preferred stock in a corporation.

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shareholder

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A business with a single owner.

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sole proprietorship

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Customers, employees, suppliers, and creditors of a corporation.

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stakeholders

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Outright grants of stock to top managers, or, more commonly, giving them the right to purchase stock at a fixed price.

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stock options

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Professional investors who specialize in making high-risk/high-return investments in rapidly growing entrepreneurial businesses.

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venture capitalists

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Does this action create value for the firm's shareholders? By taking actions that generate benefits in excess of costs, firms generate wealth for their investors.

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When contemplating all business decisions, managers should ask:

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Budgeting, financial forecasting, cash management, credit administration, investment analysis, fund procurement

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Corporate Finance

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External Financing Capital Budgeting Financial Management Corporate Governance Risk Management

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Corporate Finance Functions

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Raising capital to support companies' operations and investment programs externally, from either shareholders (equity) or creditors (debt). Corporations can raise equity capital privately, or they may go public by conducting an initial public offering (IPO) of stock.

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External Financing Function

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Capital Budgeting - selecting the best projects in which to invest the resources of the firm, based on each project's perceived risk and expected return. Select investments for which the marginal benefits exceed the marginal costs When r is greater than the coupon interest rate, P0 will be less than par value, and the bond will sell at a discount For Sun, if r >5%, P0 will be less than $1,000 For practice: Value Sun Company, 10-year, 5% coupon rate bond if required return, r =6% and again if r = 4%. Premiums & discounts change systematically as r changes.

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Capital Budgeting Function

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Managing firms' internal cash flows, and its mix of debt and equity financing, to maximize the value of the debt and equity claims on firms, and to ensure that companies can pay off their obligations when they come due. Involves obtaining seasonal financing, managing inventories, paying suppliers, collecting from customers, and investing surplus cash

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Financial Management Function

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-Managing firms' exposures to all types of risk, -both insurable (such as loss caused by fire or flood) and uninsurable, -in order to maintain optimum risk-return trade-offs and thereby maximize shareholder value. -Modern risk management focuses on adverse interest rate movements, commodity price changes, and currency value fluctuations.

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Risk Management Function

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Developing ownership and corporate governance structures for companies that ensure that managers behave ethically and make decisions that benefit shareholders. The takeover market disciplines firms that do not govern themselves. The relationship between nominal (observed) and real (inflation-adjusted) interest rates and expected inflation called the Fisher Effect (or Fisher Equation) Fisher said the nominal rate (r) is approximately equal to the real rate of interest (a) plus a premium for expected inflation (i). If real rate equals 3% (a = 0.03) and expected inflation equals 2% (i = 0.02): r a + i 0.03 + 0.02 0.05 5% The true Fisher Effect is multiplicative, rather than additive: (1+r) = (1+a)(1+i) = (1.03)(1.02) = 1.0506; so r = 5.06%

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Corporate Governance Function

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Boards of directors Compensation packages Auditors Country's legal environment - in U.S., Sarbanes-Oxley Act of 2002

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Dimensions of corporate governance

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Consumer banking Corporate banking

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Commercial Banking

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High income potential Very competitive industry

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Investment Banking

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Opportunities in investment advisory firms, mutual fund companies, pension funds, investment arms of financial departments

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Money Management

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Advise on business practices and strategies of corporate clients

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Consulting

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Borrowed money. The borrower is obliged to pay interest, at a specified annual rate, on the full amount borrowed, as well as to repay the principal amount at the debt's maturity.

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Debt Capital

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An ownership interest usually in the form of common or preferred stock. Common stockholders receive returns on their investments only after creditors and preferred stockholders are paid in full.

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Equity Capital

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An institution that raises capital by issuing liabilities against itself, and then lends that capital to corporate and individual borrowers. Examples: insurance companies, savings and loan institutions, credit unions, commercial banks, pension funds, mutual funds. Pension funds and mutual funds, have surged to prominence as corporate finance shifts towards greater reliance on market-based external funding.

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Financial Intermediary

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Sole Proprietorships Partnerships Limited Partnerships Corporations S Corporations Limited Liability Companies

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Business Organizational Forms in the U.S.

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No distinction between business and person Easy to set up, operate; taxed as personal income Personal liability, limited life, difficult to transfer

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Sole Proprietorships

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Two or more business owners Partners - liable for every partner's actions

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Partnerships

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One or more general partners & many limited partners Limited liability of corporation, tax benefits of partnership

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Limited Partnerships

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Legal entity with all the economic rights and responsibilities of a person Incorporation occurs at state level; based on state law Strengths - limited liability for investors, unlimited business life

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Corporations

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Allow shareholders to be taxed as partners yet retain their limited liability status. Must meet certain criteria like having 75 or fewer shareholders. Can become regular corporations later.

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S Corporations

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Combine partnerships' pass-through taxation with S corporations' limited liability. Popular with professional service firms.

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Limited Liability Companies

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Taxation of corporate income at both the company and the personal levels. This is the single greatest disadvantage of the corporate form The Jobs and Growth Tax Relief Reconciliation Act of 2003 (Tax Relief Act of 2003) dramatically reduced the double taxation problem

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Double Taxation Problem

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What should a financial manager try to maximize? Maximize profit? Earnings reflect past performance, rather than current or future performance. Ignores the timing of the profits. Ignores cash flows. Ignores risk. Maximize shareholder wealth? As measured by the market price of the firm's stock. A firm's stock price reflects the timing, magnitude, and risk of the cash flows that investors expect a firm to generate over time. Shareholders are the residual claimants of a firm. Focus on stakeholders? Many firms seek to preserve the interests of other stakeholders, such as employees, customers, tax authorities, and the communities where the firms operate. Doing so provides long-term benefits to shareholders and is in line with the primary goal of maximizing shareholder wealth.

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Corporate Financial Manager's Goals

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The conflict between the goals of a firm's owners and its managers. To overcome agency problems: Rely on market forces to exert managerial discipline; Incur monitoring and bonding costs to supervise managers; and Structure executive compensation packages to align managers' interests with stockholders' interests The actual workings of many compensation plans have been harshly criticized in recent years.

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Agency Problems

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Today, society in general and the financial community in particular are developing and enforcing higher ethical standards. The U.S. Congress passed the Sarbanes-Oxley Act in 2002 to enforce higher ethical standards and increase penalties for violators.

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Ethics in Corporate Finance

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Financial managers should seek to maximize shareholders' wealth. How? By performing the five basic duties of corporate finance: External financing, capital budgeting, financial management, risk management, corporate governance. Select investments for which the marginal benefits exceed the marginal costs.

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Scope of Corporate Finance

The Scope of Corporate Finance, Financial Management Chapter 1 Notes – Flashcards

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