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Summary Finance 1 for Business (mid-term and final)
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SUMMARY FINANCE 1 FOR BUSINESSTable of Contents
Chapter 1 – The corporation and financial markets............................................................1
Chapter 2 – Financial Statement Analysis...........................................................................4
Chapter 3 – Financial decision making and the Law of One Price......................................10
Chapter 4 – Time value of money.....................................................................................12
Chapter 5 – Interest rates.................................................................................................13
Chapter 6 – Bonds............................................................................................................16
Chapter 7 – Investment Decision Rules.............................................................................18
Chapter 8 – Fundamentals of Capital Budgeting...............................................................19
Chapter 9 – Valuing Stocks (9.1-9.4).................................................................................20
Chapter 10 – Capital markets and the Pricing of Risk........................................................24
Chapter 11 – Optimal Portfolio Choice and the CAPM.......................................................26
Chapter 12 – Estimating the CAPM (12.1-12.3).................................................................29
Chapter 9.5 – Efficient market hypothesis (EMH)..............................................................30
Chapter 13 – Behavioral Finance (13.1-13.4).....................................................................31
Chapter 26 – Working Capital Management.....................................................................32
Chapter 27 – Short-term financial planning (27.1, 27.2, 27.4)...........................................34
Chapter 1 – The corporation and financial markets
,Learning objectives
Reproduce the organizational chart of a corporation and the financial functions
Evaluate the objective of shareholder value maximization including limits: principal agent
problems and externalities.
Understand the implications and remedies of separation of ownership and control in
corporations: agency problems like excessive risk, partial solutions like executive compensation
Understand bankruptcy and ownership claims of debt and equity holders
Describe how stocks are traded, bid ask spread, role of market makers
1. What is a Corporation?
Sole Partnership Limited liability Corporation
Proprietorship Company (LLC)
Ownership 1 person = More than one Shareholders Shareholders
manager + owner person (not traders) (traded at
organized
exchange)
Liablility of the Personal liability All partners are Shareholders not Shareholders nog
firm’s debt of owner personally liable liable for firm’s liable for firm’s
debts debts
Separation No No Yes Yes
ownership and
control
Legal entity No No Yes Yes
Taxation Income tax Income tax Corporate tax + Corporate taks +
income tax income tax
Legal entity = an individual, company, or organization that has legal rights and obligations.
Sole proprietorship extra information:
- If there are other investors, they cannot hold an ownership stake in the firm.
- An owner hoe cannot afford to repay the loan must declare personal bankruptcy.
- The life of a sole proprietorship is limited to the life of the owner. It is also difficult to transfer
ownership of a sole proprietorship.
Partnership extra information:
- Businesses where the owner’s personal reputation are the basis for the business (law firms,
accounting firms, groups of doctors) stay as a partnership.
- Limited partnership = 2 kinds of owners. General partners and limited partners. General
partners have the same as a normal partnership, limited partners are limited to their
investment. Their private property cannot be held for the debt. Their death doesn’t end the
company and their interest is transferrable. They also have no management authority and
cannot legally be involved in the managerial decision making for the business. “The outside
investors play no active role in the partnership other than monitoring how their investments
are performing”.
Limited liability extra information:
- All owners have limited liability, but unlike limited partners, they can also run the business.
,Corporation extra information:
- Equity of the corporation = all the outstanding shares of a corporation
2. What is the objective of a Corporation?
Maximizing shareholder value (SV)
- Advantages:
a) Clear objective (clearly defined number available in stock market)
b) Smart price: share price determined in comepetitive market using a lot of information
and provides a clear trade-off between different moments in time (as it is all about the
effect on current value).
- Disadvantages:
a) Rules and regulation often do not sufficiently protect interests of all stakeholders (eg
employees).
b) SV does not take into account impact on future generations (eg CO2 emissions, depletion
of natural resources)
c) Externalities are not sufficiently internalized when not or insufficiently priced
Without frictions and externalities, maximizing shareholder value makes sense as an objective.
With frictions and externalities (like agency problems or pollution), this objective introduces new
problems shareholder value vs stakeholder value. Regulation of corporations is needed.
A propose is to maximize shareholder welfare instead, which is about the “happiness” to choose
for a company.
Shareholder = residual claimant
Maximizing shareholder value means you take other stakeholders (like employees) into account.
Maximizing shareholder value can be interpreted as: doing anything within the law to
maximize profits. = False
- You don’t have to stay into the law.
- Profit is not the same as value.
3. Who owns/runs the Corporation?
- Shareholders are called ‘owners’, but don’t have full ownership rights. Only some economic
and voting rights.
- CEO/managers run the firm (make day to day decisions)
- Corporation is the owner of its assets
Most important jobs of a financial manager:
1. Investment decisions
2. Financial decisions – how to pay for the investments
3. Cash management – ensure that the firm has enough cash to pay it’s day-to-day expenses
(managing working capital).
4. Does the Corporation generate problems?
Agency problem = conflicts that occur when an agent (manager) who is entrusted with following the
interests of the principal (shareholder or owner) of an organization abuses their position to further
their own personal goals.
How to firms minimize the agency problem?
- Board of directors overlooking CEO
, - Tie management’s compensation to firm performance
- Poor performance investor’s sell shares share price drops hostile takeovers (new
management team tries to fix the company)
- Competition on product markets (more competition gives less leeway from managerialism
otherwise firm should go bankrupt)
- Debt. Debt disciplines management to do everything to pay it back, otherwise the firm would
default and the CEO loses his job.
Shareholder wealth is more about the “happiness” and “feeling” a person has with a company,
instead of the money.
Corporate Bankruptcy
When a firm fails to repay its debts, the end result is a change in ownership of the firm, with control
passing from equity holders to debt holders. Debt holders has priority and equity holders is the
residual claimant.
Importantly, bankruptcy need not result in liquidation of the firm (=shutting down the business and
selling the assets), for instance in cases where keeping the firm alive and in business results in a
higher value for the claimants.
The Stock Market
- Private companies have limited shareholders and their shares are not regularly traded. The
value of their shares can be difficult to determine.
- Many corporations are public companies, whose shares are traded on stock markets.
Stock markets provide liquidity and determine a market price for the company’s shares.
An investment is said to be liquid if it is possible to sell it quickly and easily for a price very close to
the price at which you could contemporaneously buy it.
- The liquidity is attractive to outside investors, as it provides flexibility regarding the timing and
duration of their investment in the firm.
- The research and trading of participants in these markets give rise to share prices that provide
constant feedback to managers regarding investor’s views of their decisions.
Primary vs secondary stock markets
- New shares of stock are issued on the primary market. After this, the shares continue to trade
in a secondary market without the involvement of the corporation.
Market makers = match buyers and sellers. They provide liquidity by ensuring that market
participants always have somebody to trade with. They post 2 prices for every stock:
1. The price at which they were willing to buy the stock = the bid price.
2. The price at which they were willing to sell the stock = the ask price.
Bid ask spread = the difference between the bid and ask price.
Investors always buy at the ask price and sell at the bid price. Since ask prices
always exceed bid prices, investors "lose" this difference. It is one of the
transaction costs. Since the market makers take the other side of the trade, they
make this difference.
The price in red is the market maker's ask price while the price in green is the
market maker's bid price.
Chapter 2 – Financial Statement Analysis
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