Tuesday, February 2, 2010

CHAPTER 1 − INTRODUCTION TO FINANCIAL MANAGEMENT

1. Describe the type of people who use the financial markets.

The financial markets are used by people who have extra money now and want it to grow for their future. They offer this capital through the financial markets to others who have good ideas and opportunities, but need the capital to implement them. These types of people are denoted as Type 2 and 3 people in Figure 1.1.

2. What is the purpose of financial management? Describe the kinds of activities that financial management involves.

Financial management is the process of making decisions for the acquisition, use, and repayment of capital. Decisions for the acquisition of capital can include how the business is organized, what type of capital should be obtained, and how much capital should be obtained. Decisions for the uses of capital include what new business projects to invest in, what capital to retain to fund ongoing projects, and to reduce taxation. Decisions for the repayment of capital involve paying capital back to its providers.

3. What is the difference in perspective between finance and accounting?

Accounting focuses on recording and presenting the past business activities. This information is good for evaluating past performance. The finance function uses this past data along with current information to make decisions on what business activities to do now and in the future. Decisions about the future involve much uncertainty, so risk evaluation is part of the finance job.

4. What personal decisions can you think of that will benefit from learning finance?

Learning finance will help the student build wealth and reduce costs in their personal life. After taking this class, the student should be able to make good decisions about funding their future retirement and investment allocations. People with finance knowledge can also reduce costs by making good decisions in borrowing while buying cars, homes, and using credit cards.

5. What are the three basic forms of business ownership? What are the advantages and disadvantages to each?

The three basic business forms are the sole proprietorship (SP), the partnership (Part), and the corporation (Corp). Advantages and disadvantages can be determined along several dimensions: control, risks, access to capital, and taxation. The SP owner has total control of business decisions. Control decreases for owners of Part and then Corp. The owner has high risk to their personal wealth in a SP and Part, but low risk in a Corp. Access to capital is addressed in the next question. Lastly, SP and Part owners are taxed as if the business was personal income. The Corp owner is taxed twice, once at the corporation level and then again at the personal level.

6. Between the three basic forms of business ownership, describe the ability of each form to access capital.

The corporation has the highest access to capital. It can acquire new equity capital from the public market. Also, banks are more willing to lend to corporations. Debt investors are also more likely to buy the bonds of a corporation. Partnerships have the next best access to capital. With larger numbers of partners involved with the business, the more likely banks will lend and debt investors will buy its bonds. Partnerships do not have access to the public equity market. Lastly, sole proprietorships have poor access to capital. Generally speaking, the sole proprietor cannot borrow as much money from banks or debt investors.

7. Explain how the founder of a business can eventually lose control of the firm. How can the founder ensure this will not happen?

When the founder wants the business to grow quickly, more capital is required. In the early stages of a small fast growing company, it is equity capital that is available. In other words, the founder must give up a portion of his/her ownership to other investors. As this process continues over time, the founder may find that he/she no longer owns a majority of the firm. There may come a time when enough of these other owners that own a combined 50+% of the firm come together and change the leadership of the firm.

8. Explain the shareholder wealth maximization goal of the firm and how it can be measured. Make an argument for why it is a better goal than maximizing profit.

The shareholder wealth maximization goal of the firm states that managers should run the company in such a way that maximizes the wealth of the stockholders. Progress for this goal can be measured using the stock price. The stock price contains what investors know about the current profitability of the firm and expectations about future profits and opportunities. Maximizing profit is a similar goal, but quite as good. A manager could maximize this year’s profit at the detriment of future profits. This would not be good for long-term investors.

9. Name and describe as many corporate stakeholders as you can.

Stockholders, managers, and employees are all stakeholders with a very close relationship to the firm. Customers, suppliers, banks, and bondholders have a close relationship to the firm. Local government, local community people, and people who enjoy the environment are also stakeholders.

10. What conflicts of interest can arise between managers and stockholders?

Stockholders own the firm and hire managers to run the firm. Managers, therefore, control the day to day operations of the firm. Since the stockholders can’t see these decisions, it is possible that the managers will manage the firm in such a way that it benefits themselves more than the shareholders. This conflict of interest can manifest as higher costs to the firm for things that benefit the managers. It can also show up in decisions to make poor acquisitions of other firms in order to make the company bigger and then argue for higher managerial pay.

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