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B.
Business finance or corporate finance = branch of finance dealing with financial decisions of
firms
C.
D.
Typical financial decisions by firms: (i) strategic planning, (ii) capital budgeting, (iii)
determining the firms capital structure, and (iv) working capital management
1.
1st financial decision firm makes:
a.
What business it wants to be in = strategic planning
b.
Strategic planning involves evaluation of cost and benefits spread over time
financial-decision making process
2.
2nd financial decision firm makes:
a.
Capital budgeting process = preparing plan to acquire factories, machinery,
research laboratories, showrooms, warehouses, and other long-lived assets
b.
Prepare plan to train personnel who will operate this physical capital
c.
Investment project = basic unit of analysis in capital budgeting
i.
Identify new investment projects
ii. Evaluate competing projects
iii. Decide which projects to undertake
iv. Implement new project
3.
3rd major financial decision
a.
Decide how to finance new project
b.
Determine capital structure = percentage of loans, bonds, common stock and
preferred stock that minimizes the cost of capital
An Overview of Financial Management
Page 1
c.
4.
II.
Cost of capital = minimum rate of return an investment project must earn in order
not to diminish stockholder wealth = interest rate used to discount a projects
future cash flows in computing its present value
d.
Unit of analysis is the firm as a whole
th
4 major financial decision:
a.
Working capital management = day-to-day financial affairs of firm
b.
Cash flow: collecting from consumers, paying bills as they come due
c.
Need to finance cash-flow deficits and invest cash-flow surpluses
B.
C.
Sole proprietorship
1.
Advantages
a.
Ease of formation: easily and inexpensively formed
b.
Subject to few government regulations
c.
Pays no corporate income tax
2.
Disadvantages
a.
Difficult to obtain large sums of capital
b.
Unlimited liability = no legal distinction is made between personal and business
activities or assets and liabilities
c.
Limited life: limited to life of individual who created it
D.
Partnership: has roughly the same advantages and disadvantages as a sole proprietorship
1.
Advantages
a.
Low cost and ease of formation
b.
Pays no corporate income tax
2.
Disadvantages
a.
Unlimited liability
c.
Difficulty in transferring ownership
b.
Limited life
d.
Difficulty in raising large amounts of capital
An Overview of Financial Management
Page 2
E.
Corporation
1.
Advantages
a.
Unlimited life
b.
Limited liability = liability of owners limited to the amount of capital they have
invested in the business
c.
Easy transfer of ownership
d.
Ease of raising capital: sell additional shares of stock to current or new
stockholders
2.
Disadvantages
a.
Double taxation: corporate earnings taxed at corporate tax rate, dividends taxed as
income to stockholders
b.
More complex and time consuming to set up. Cost of report filing.
F.
Deciding upon form of organization? Firms must trade off the advantages of incorporation
against disadvantages of possible higher tax disadvantage. Book argues corporate structure
usually maximizes value of business. Why?
1.
Limited liability risk borne by investors. firms risk firms value
2.
Corporations attract capital more easily than unincorporated business firms ability
to take advantage of growth opportunities firms value
3.
Because corporate stock is easier to sell than interests in sole proprietorship or
partnership corporate stock is more liquid than ownership in other forms of business
(Liquidity = ease of selling asset and converting it to cash at fair market value)
stock liquidity price of stock firms value
Assume managements primary goal =maximize stockholder wealth maximize the price of
the firms common stock
B.
C.
Market price of stock = present value of cash flows it provides to its owners over time
D.
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C.
D.
V.
2.
True value based on accurate risk and return data
3.
Intrinsic value can be estimated but not measured precisely
Stocks market price
1.
Based on marginal investors estimates of perceived investor returns and perceived
risk
2.
Based on perceived but possibly incorrect data
Stock prices: Disequilibrium and equilibrium values
1.
Disequilibrium: in short run stock price may deviate from its intrinsic value
a.
If actual market price > intrinsic value stock overvalued
b.
If actual market price < intrinsic value stock undervalued
2.
Equilibrium
a.
Situation where actual market price = intrinsic value
b.
Investors indifferent between buying or selling stock
3.
Management should take actions designed to maximize firms intrinsic value, not its
current price
a.
Maximizing intrinsic value will maximize average price over the long run
b.
Ideally managers should avoid actions that reduce intrinsic value, even if those
decisions increase stock price in short run
Recent corporate scandals have reinforced importance of business ethics Have spurred
additional regulations and corporate oversight
B.
C.
Changing information technology has profound effect on all aspects of business finance
VI. Separation of ownership and management: Common practice for owners of large firm to
delegate management responsibilities to professional managers
A.
Page 4
b.
If former owner wasnt the manager, new owners hire existing management
and work continues in place
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6.
c.
Managerial compensation plans based on performance
d.
Direct intervention by shareholders
Shareholders vs. creditors
a.
Shareholders (through management) could take actions to maximize stock
price that are detrimental to creditors
b.
In the long run, such actions will raise the cost of debt and ultimately lower
the stock price.
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