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Summary for the course 'finance 1'. This summary was written in order to study for the midterm as well as for the final. Everything you need to know is available in this summary. Advice: this summary alone will not be enough, the tutorials are as ...
,Finance summary
Chapter 1
Sole proprietorship: (eenmanszaak)
- Owned and run by one person
- Typically, few if any, employees
- Advantage: Easy to set up
- Disadvantage: - no separation between the firm and the owner
- unlimited personal liability
- limited life
- Majority of all businesses are sole proprietorships, but they generate the lowest
amount of revenue out of all the firms.
Partnership: (VOF)
- More than one owner
- All partners are personally liable for all the debts
- The partnership ends with the death or withdrawal of any single partner
- General partners: personally, liable for debt and runs the firm on a day-to-day basis
Limited partners: limited liability, transferable in case of death/withdrawal, no
management authority or legal involvement.
- Small part of all businesses are partnerships, and they generate a low amount of
revenue out of all the firms.
Limited liability companies: (NV)
- All owners have limited liability, without a general partner.
- European invention (relatively new in the US)
Corporations:
- Has legal power like human being
- Responsible from its own action
- Artificial legal entity, separated from owner
- Formation:
* legally formed
* costly to establish
- Ownership:
* owners receive dividends
* owners share / equity holders
* Equity → total sum of shareholders
* no limit in shares → company can issue equity and raise money fairly easy
→ free trade in the shares of a corporation
→raise capital because they can sell ownership shares to anonymous investors
1. Pay debtholder 3. Pay returns to equity holders
2. Pay tax to ‘state’
3
,Total effective tax rate: tax payed / total earnings
C-corporation: double taxation
S-corporation: only taxation to the shareholders
Corporate management team:
In a corporation, ownership and direct control are typically separate
* Board of directors: - elected by shareholders
- have ultimate decision-making authority
* Chief Executive Officer (CEO) - board delegates daily decision making to the CEO
* Chief Financial Officer (CFO) - Investment dec. where to invest? Which project?
- Financing dec. how to raise money?
- Cash management. Managing day to day business
Goal of the firm: - Maximizing shareholders value (maximizing stock prices)
- Maximizing utility / welfare
- Maximizing the value of the firm
- Minimizing risk vs maximizing return
Shareholder:
Stockholder: - customers, employees, creditors, government, unions, communities etc.
Principal agent problem (agency problem:
- Owner/shareholder (principal)
- CEO (agent)
- Conflict between principal and agent. The act of the agent might not be the best interest
of the principal
- Contract → how to mitigate the agency problem
Moral hazard: - not enough effort - extravagant investment
- lack of transparency - accounting manipulations
CEO performance: stock prices are good indicator for CEOs performance.
CEO performing poorly → shareholders dissatisfied → sell shares →
drive the stock price down
Hostile takeover: low stock prices may entice a corporate raider
Corporate raider: gets control by buying the stocks and replace current management
Market for corporate control: puts pressure on managers
Corporate bankruptcy: reorganization → liquidation (gives pressure to CEO’s)
Private firms: no shares → no liquid
Public firms: listed on stock markets → liquid
the stock market provides liquidity. Easy to transfer company to others.
Liquid: fast and easy stock buying
4
,Primary markets: when a corporation itself issues new shares of stock and sells them to inv.
Secondary markets: after the primary market. The shares continue to trade between inv. In
the secondary market.
Traditional trading venues:
New York Stock exchange and Nasdaq
Bid price: the price at which the market makers were willing to buy the stock
Ask price: the price at which the market makers were willing to Sell the stock
ASK > BID
Bid ask spread: transaction cost investors pay in order to trade
market makers have largely disappeared, everything is elec. Everyone is a market maker.
Limit order: an order to buy or sell a set amount at a fixed price
limit order book: the collection of all limit orders
Market orders: orders that trade immediately at the best outstanding limit order
High frequency traders: traders who, execute trades many times per second.
Dark pools: do not make limit order books visible.
instead, they offer investors the ability to trade at a better price.
5
, Chapter 3
Competitive market: a market in which goods can be bought and sold at the same price
→but the price determines the cash value of goods
Interest rate: the rate at which we can exchange money today for money in the future
suppose current interest rate is 7%. 1 euro will become 1.07 in 1 year.
Risk-free (rf) interest rate / discount rate
Interest rate factor = 1 + rf
Discount factor = 1 / (1 + rf)
Present value:
* 7% interest rate on a 1000 project will be 1070 euro. 1070 is the FV
if the benefit is 1050, you will not accept the project. (-20 net value)
→ you could’ve earned 20 more if you had put it on the bank
* If you know the benefit is 105 and the rf is 7% → 1/1.07 = 98.13 PV
if the cost is 100, you shouldn’t invest. You lose 1.87
→ this is what the bank would lend to us if we promised to pay 105 in one year
When we express the value in terms of dollars today, we call it the PV of the investment.
If we express it in terms of dollars in the future, we call it the FV of the investment.
PV = FV * 1/(1+r) 1/(1+r) = discount factor
Check slide no.17 for example
Net present value (NPV) = PV(benefits) – PV(costs)
= PV (all project cash flows)
Accept those projects with positive NPV, because accepting them = receiving their NPV cash
today
Reject those projects with negative NPV, because accepting them would reduce the wealth
of investors
NVP-rule: always choose the project with the highest NPV. If both negative → avoid both
Arbitrage opportunity: when it is possible to make profit without taking any risk or invest.
Normal market: a competitive market in which there are no arbitrage opportunities.
Law of One price: if equal investment opportunities trade in different competitive markets,
then they must trade for the same price in both markets.
→ if prices are different, they will converge to each other over time
Bond: risk free security
interest goes up → bond price goes down
interest goes down → bond prices goes up
Price(security) = PV (all cash flows paid by the security)
E.G. Bond costs 952
6
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