Financial Management Overview and Business Structures
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Questions and Answers

What is the primary role of investment banks in relation to corporate actions?

Investment banks advise companies on executing corporate actions, such as acquiring other companies.

How do savings and loan associations (S&Ls) operate financially?

S&Ls take deposits from individuals and loan that money out in the form of mortgages, car loans, and business loans.

In what way do credit unions differ from savings and loan associations?

Credit unions are structured as non-profit organizations and serve a specific group of people.

What are the main characteristics that differentiate hedge funds from mutual funds?

<p>Hedge funds can hold more complicated investments, are less regulated, and are only open to certain educated investors.</p> Signup and view all the answers

What type of investments do private equity and private debt funds target?

<p>Private funds invest in holdings that are not listed on public markets, focusing on long-term, high-risk, high-reward opportunities.</p> Signup and view all the answers

How do commercial banks finance their operations compared to savings and loan associations?

<p>Commercial banks often utilize a greater amount of debt than equity to fund their operations.</p> Signup and view all the answers

Explain the role of insurance companies in the financial landscape.

<p>Insurance companies collect premiums from individuals and provide payouts in case of certain events, like accidents.</p> Signup and view all the answers

What effect did investor demand have on banks during the run-up to the 2007 crisis?

<p>It drove banks to write more mortgages to have something to securitize.</p> Signup and view all the answers

How did low interest rates impact homeowners during the housing boom?

<p>Low interest rates allowed homeowners to make their mortgage payments despite the risks.</p> Signup and view all the answers

What is the primary function of pension funds?

<p>Pension funds are investment funds managed by companies for the benefit of their employees.</p> Signup and view all the answers

What happened when mortgage interest rates began to rise?

<p>Defaults on mortgages increased, leading to a decline in property values.</p> Signup and view all the answers

What are the primary roles and liabilities of a General Partner (GP) in a Limited Liability Partnership (LLP)?

<p>A General Partner (GP) has a managerial role and holds unlimited liability for the business.</p> Signup and view all the answers

List two financial institutions that went bankrupt or were rescued during the 2007 crisis.

<p>Lehman Brothers went bankrupt; Bear Stearns was acquired in a rescue.</p> Signup and view all the answers

How does a Limited Partner (LP) differ from a General Partner (GP) in terms of liability?

<p>A Limited Partner (LP) is not personally liable for the business's debts, whereas a General Partner (GP) has unlimited liability.</p> Signup and view all the answers

List two advantages of structuring a business as a corporation.

<p>Unlimited lifespan and limited liability for owners are two advantages of a corporate structure.</p> Signup and view all the answers

What type of bonds were issued against risky mortgages?

<p>Mortgage-backed securities (MBS) were issued against these mortgages.</p> Signup and view all the answers

What was the outcome for property values during the financial crisis?

<p>Property values dropped sharply during the crisis.</p> Signup and view all the answers

What is an Initial Public Offering (IPO) and what does it entail?

<p>An IPO is when a company sells its equity to the public for the first time, involving extensive regulatory paperwork.</p> Signup and view all the answers

What potential problem arises when a manager has no vested interest in a company's success?

<p>The manager may misuse company funds for personal benefit.</p> Signup and view all the answers

What is one major disadvantage of a corporate structure regarding taxation?

<p>Profits are taxed twice: once at the corporate level and again as personal income for shareholders.</p> Signup and view all the answers

What role did Uncle Al play in the development of the soda fountain industry?

<p>Uncle Al was a patent holder and a founder of one of the largest soda fountain manufacturers.</p> Signup and view all the answers

How did Uncle Al's career reflect his success in business?

<p>He filed over 100 patents and retired wealthy from managing real estate investments.</p> Signup and view all the answers

What is the agency problem in corporations?

<p>The agency problem arises when owners hire managers, leading to potential conflicts of interest in managing the business.</p> Signup and view all the answers

How can a company align a manager's compensation with the company's success?

<p>By structuring compensation to increase when the company gains value, often through stock options.</p> Signup and view all the answers

Name the two types of corporations mentioned and highlight a key difference between them.

<p>C-Corp and S-Corp; a key difference is that S-Corps are taxed only once while C-Corps are taxed twice.</p> Signup and view all the answers

What is the formula for calculating free cash flow (FCF)?

<p>FCF = revenue - operating costs - taxes - business investments.</p> Signup and view all the answers

Why might ownership of a corporation be described as 'highly fragmented'?

<p>Ownership can be highly fragmented due to numerous shareholders holding small stakes, making management complex.</p> Signup and view all the answers

Why is ethical conduct important for a company in the long term?

<p>Ethical failures can cause reputational, legal, and other damages that harm growth and income.</p> Signup and view all the answers

What is the primary purpose of securitization for banks?

<p>To liquidate assets and free up cash for more business activity.</p> Signup and view all the answers

What role do financial intermediaries like banks play in the financial system?

<p>They facilitate the connection between entities with excess funds and those wanting to invest those funds.</p> Signup and view all the answers

Explain how a shell company like Loan Bucket operates in the context of securitization.

<p>It purchases loans off the bank's balance sheet and pays in cash, using the proceeds from selling bonds backed by those loans.</p> Signup and view all the answers

What is the difference between direct and indirect investment in a business?

<p>Direct investment involves a relationship with the capital provider, while indirect investment uses discreet units sold in a financial market.</p> Signup and view all the answers

What is meant by the 'weighted average cost of capital' in cash flow analysis?

<p>It is used to discount future cash flows to account for the cost of securing capital.</p> Signup and view all the answers

In the event of default, which tranche of bonds bears the first loss?

<p>The lowest tranche.</p> Signup and view all the answers

How does securitization relate to the financial crisis of 2007?

<p>It was a significant factor that contributed to the crisis due to the high rates of defaults on mortgage-backed securities.</p> Signup and view all the answers

What is a bond categorized as in the context of securities?

<p>A bond is considered a unit of debt.</p> Signup and view all the answers

What happens to the loans held by banks when securitization occurs?

<p>The loans are sold to a shell company and removed from the bank's balance sheet.</p> Signup and view all the answers

What role do investors play in the securitization process?

<p>They buy bonds issued by the shell company, which are backed by the loans.</p> Signup and view all the answers

Describe what kind of protection the highest tranche of a securitized bond enjoys.

<p>It has protection from defaults on the underlying assets and is typically rated as investment grade.</p> Signup and view all the answers

Why might ABC Credit Union 'run out of money' despite having significant loan assets?

<p>If more people want loans than deposits are received, the credit union may not have enough liquid cash to meet demands.</p> Signup and view all the answers

What is the main role of a portfolio in providing retirement income?

<p>A portfolio generates investment returns that enable the company to provide lifetime income to retirees.</p> Signup and view all the answers

Differentiate between physical and financial assets.

<p>Physical assets are tangible items like property, while financial assets are stocks and bonds that can be used to acquire physical assets.</p> Signup and view all the answers

What is the difference between spot price and future price?

<p>The spot price is the current price for immediate purchase, while the future price is the agreed price for a transaction that will occur later.</p> Signup and view all the answers

Define the term 'bid' in the context of financial markets.

<p>The bid is the highest price a dealer is willing to pay to buy shares from a seller.</p> Signup and view all the answers

Explain the term 'market order' as it relates to trading.

<p>A market order is executed immediately at the current market price when the trader submits it.</p> Signup and view all the answers

What does the bid-ask spread indicate in a financial market?

<p>The bid-ask spread represents the dealer's profit margin between the highest price they will pay and the lowest price they will accept.</p> Signup and view all the answers

How does a limit order differ from a market order?

<p>A limit order is executed only if the price meets a specified threshold, while a market order is executed at the current market price.</p> Signup and view all the answers

What type of market is represented by the NYSE, and how does it operate?

<p>The NYSE is an auction market where buyers and sellers submit bids and offers simultaneously, and transactions occur at the most favorable prices.</p> Signup and view all the answers

Study Notes

Financial Management Overview

  • This chapter introduces financial management and the financial environment, likely for a business or economics course.
  • It details the life and business ventures of Alvin Davis Puffer, seemingly as a case study or example.
  • Puffer was a 19th-century engineer who developed and patented soda fountain technology.
  • In 1842, he established a plumbing company.
  • In 1871, he secured a patent related to soda fountains.
  • He founded a company to manufacture and sell his patented soda fountains.

Business Structure Options

  • Companies often take different legal structures depending on their stages of growth.
  • During initial start-up, a sole proprietorship is a common structure.
  • Advantages of a sole proprietorship include ease and low cost of creation, low government intervention, and low taxes (individual, not corporate).
  • Disadvantages are difficulties acquiring funding, unlimited liability (owner personally responsible if business fails), and no transfer of ownership if the owner is not able to transfer the business to others.

Additional Business Structures

  • As the company grows, it may switch to a partnership structure, which allows for additional sources of equity (funding), and expertise and connections from partners.
  • Partnerships can also have downsides similar to a sole proprietorship structure - shared control and shared profit, along with the need to come to agreement which can also be hard to solve.

Limited Liability Partnerships (LLPs)

  • A LLP provides a way for partners to avoid the unlimited liability typically associated with a business operation.
  • General Partners (GPs) have a managerial role and larger stakes to be considered liable for venture.
  • Limited Partners (LPs) have funded the business but do not have day-to-day management rights and liability is limited.

Corporations

  • As a business grows to maturity, it may be considered as a corporation. The ownership is formalized and potentially sold to the public.
  • Advantages of a corporation include potentially unlimited lifespan (the company's life is not dependent on the life of the people involved), transferable ownership, and limited liability for the owners of the company.
  • Disadvantages are the difficulties in establishing and maintaining a company and potentially double taxation of profits (once at the company level and then again when dividends are paid to investors).
  • A public corporation sells shares of ownership to investors through an Initial Public Offering (IPO) on the market. This process can be expensive. Public corporations are subject to high standards of transparency.

Increasing Company Value

  • The overarching goal of a business is to maximize value over time, which typically means maximizing profit within the restrictions of regulations.
  • Business value is determined by the predicted future earnings.
  • A primary measure to estimate future income streams is free cash flow (FCF).
  • FCF is calculated by subtracting operating costs and taxes from revenue, and subtracting capital investments as well.

Ethical Considerations

  • Companies have to have responsibility toward the public, encompassing considerations of ethical behaviour as well.
  • Companies should maintain ethical behaviour as this can affect reputation, legal issues, and the long-term value of the company.

Financial Intermediaries

  • Financial institutions, such as banks, act as intermediaries to match investors with companies seeking funding.
  • There are various types of intermediaries, including investment banks which structure offerings to investors; and banks and credit unions which manage individual and business deposits as well as loan activities for mortgages or other kinds of debt funding. The intermediaries usually receive a fee for handling these operations.

Securities

  • Securities are claims against the assets of an entity, often representing value and traded on financial markets.
  • Debt securities, such as bonds, provide a series of payments (often regular interest payments and a return of the principal at a date in the future) to holders over a set time frame. Risk levels are often linked to the length of time until the payout (risk is generally higher for longer time horizons), but can also be impacted by other factors.
  • Equity securities represent ownership and residual value; they have significant and permanent participation in the company.

Other Instruments

  • Derivative securities (options or futures contracts) enable traders to make trades on the value of underlying securities at specific prices.
  • Securitization is a process of packaging and selling securities, which might be collections of otherwise hard-to-sell assets (e.g., mortgages).

Cost of Money

  • Companies need to consider returns from investments, a required rate of return the investors will seek.
  • The cost of funds (borrowed money) depends on prevailing interest rates, risk assessment of the investment project, and macroeconomic factors (such as projected inflation).

Financial Markets

  • Different types of secondary markets exist, such as the NYSE and NASDAQ. These markets have distinct structures (physical vs. digital information exchange).
  • Common orders include market orders (executed upon immediate entry) or limit orders (executed when an order matches a price previously entered). A bid-ask spread represents the difference between these two limits.
  • High Frequency Trading (HFT) is an aggressive type of electronic trading in the market by computers.

Securitization

  • Securitization is a process that transfers assets (for example, mortgages) to a separate entity. The entity then issues bonds, essentially pooling the assets into a package sold on the market.
  • This can help companies in cash flow management.
  • A risk is that the structured bonds can create risk, e.g., if mortgages default. Credit risk associated with assets underlying the instrument is transferred to investors.

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Chapter 1: Financial Management Overview PDF

Description

This quiz covers the fundamentals of financial management and explores various business structures, including sole proprietorships. It highlights the case study of Alvin Davis Puffer, an innovator in soda fountain technology, and discusses the advantages and disadvantages of owning a sole proprietorship. Test your knowledge on these key concepts in business and finance.

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