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Questions and Answers
What is one of the primary roles of a financial manager within an organization?
What is one of the primary roles of a financial manager within an organization?
Which of the following is NOT a common legal form of business organization?
Which of the following is NOT a common legal form of business organization?
What is a key benefit of forming a Limited Liability Company (LLC)?
What is a key benefit of forming a Limited Liability Company (LLC)?
In an LLC, what is meant by 'pass-through taxation'?
In an LLC, what is meant by 'pass-through taxation'?
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What is a potential responsibility of financial managers when making business decisions?
What is a potential responsibility of financial managers when making business decisions?
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What does opportunity cost represent in financial decisions?
What does opportunity cost represent in financial decisions?
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What encourages investors to take on additional risk?
What encourages investors to take on additional risk?
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What is the equity risk premium?
What is the equity risk premium?
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Why might an investor opt for delayed consumption?
Why might an investor opt for delayed consumption?
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How are market prices viewed in an efficient market?
How are market prices viewed in an efficient market?
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What fundamental principle guides financial managers in maximizing shareholder wealth?
What fundamental principle guides financial managers in maximizing shareholder wealth?
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What can distort market prices from their true value?
What can distort market prices from their true value?
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What is a primary reason for the interdependence between risk and reward in investments?
What is a primary reason for the interdependence between risk and reward in investments?
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What is one potential benefit of global expansion for a company?
What is one potential benefit of global expansion for a company?
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Which risk involves fluctuations in exchange rates impacting financial forecasts?
Which risk involves fluctuations in exchange rates impacting financial forecasts?
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What challenge might a company experience due to cultural differences when expanding abroad?
What challenge might a company experience due to cultural differences when expanding abroad?
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Which factor is NOT considered a risk when expanding a business abroad?
Which factor is NOT considered a risk when expanding a business abroad?
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How can companies potentially gain a competitive advantage internationally?
How can companies potentially gain a competitive advantage internationally?
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Why is a dollar today worth more than a dollar in the future?
Why is a dollar today worth more than a dollar in the future?
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What should financial decisions focus on when evaluating projects?
What should financial decisions focus on when evaluating projects?
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Which of the following statements best describes opportunity cost?
Which of the following statements best describes opportunity cost?
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What is the significance of timing in investment returns?
What is the significance of timing in investment returns?
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What can lead to a company showing accounting profits but lacking cash?
What can lead to a company showing accounting profits but lacking cash?
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Which principle highlights the importance of cash flows over accounting profits?
Which principle highlights the importance of cash flows over accounting profits?
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Which example best illustrates the concept of opportunity cost?
Which example best illustrates the concept of opportunity cost?
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What effect does the time value of money have on future earnings?
What effect does the time value of money have on future earnings?
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What is a primary benefit of incorporating as a corporation?
What is a primary benefit of incorporating as a corporation?
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What happens to ownership in a corporation when shares are sold?
What happens to ownership in a corporation when shares are sold?
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Which statement accurately describes double taxation in corporations?
Which statement accurately describes double taxation in corporations?
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What is NOT a drawback of the corporate form?
What is NOT a drawback of the corporate form?
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How does the lifespan of a corporation typically compare to other business forms?
How does the lifespan of a corporation typically compare to other business forms?
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What is the combined effective tax burden on original profits when a corporation distributes dividends?
What is the combined effective tax burden on original profits when a corporation distributes dividends?
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Which of the following is a characteristic of a corporation's ownership?
Which of the following is a characteristic of a corporation's ownership?
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What is a common misconception about corporations concerning their ability to operate after ownership changes?
What is a common misconception about corporations concerning their ability to operate after ownership changes?
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What is a key advantage of forming an LLC for entrepreneurs?
What is a key advantage of forming an LLC for entrepreneurs?
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Which statement accurately describes a sole proprietorship?
Which statement accurately describes a sole proprietorship?
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What differentiates a limited partnership from a general partnership?
What differentiates a limited partnership from a general partnership?
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Which of the following describes a unique characteristic of a corporation?
Which of the following describes a unique characteristic of a corporation?
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What happens to a sole proprietorship upon the owner's death?
What happens to a sole proprietorship upon the owner's death?
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In a general partnership, what level of liability do all partners share?
In a general partnership, what level of liability do all partners share?
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Which option correctly describes the ownership structure of an LLC?
Which option correctly describes the ownership structure of an LLC?
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How is the ownership of a corporation typically structured?
How is the ownership of a corporation typically structured?
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Study Notes
Financial Management and the Firm
- Financial management is a critical aspect of running a successful business.
- It involves planning, organizing, and controlling a company's financial resources to achieve strategic objectives.
- This study explores fundamental principles and practices of financial management.
- Students will gain knowledge for informed decisions driving growth and profitability.
Learning Objectives
- Identify the Goal of the Firm: Understand the primary objective guiding business decisions and operations, typically maximizing shareholder wealth or value.
- Understand Financial Principles: Understand core finance principles including cash flow, time value of money, risk and reward, and the role of ethics in financial decision-making.
- Describe Finance's Role in Business: Recognize the crucial function of finance in supporting a company's operations, strategy, and decision-making processes across various functional areas.
The Goal of the Firm
- The primary objective of a firm is to maximize shareholder wealth,
- This involves making well-informed strategic decisions that increase the market value of the company's stock over the long term.
- Achieving this goal requires careful financial management, effective operations, and a focus on creating value for customers and stakeholders.
- Maximizing shareholder wealth is done by effectively increasing the price of the existing common stock.
- Good decisions increase profitability and prospects thus increasing the stock price benefiting shareholders.
- Conversely poor decisions harm a firm's operations and outlook reducing the stock price thus harming shareholders.
Foundations of Finance
- Principle 1: Cash Flow Matters: The real value of a business lies in its ability to generate positive cash flows, not just accounting profits. Decisions must focus on maximizing long-term free cash flow.
- Principle 2: Time Value of Money: A dollar today is worth more than a dollar in the future due to the opportunity to invest and earn a return. Financial analysis must account for time value of money by using tools like present value & future value calculations.
Principle 1: Cash Flow Is What Matters
- Accounting profits are not equal to cash flows.
- Companies can generate accounting profits without having available cash.
- Positive cash flows can exist without necessarily reporting accounting profits
- Decisions should focus on cash flows
- Financial decisions should be based on predicted cash flow instead of simply reported earnings to demonstrate driving business value.
- Focusing on marginal cash flows (difference between projected cash flows if a project is or isn't selected) is important to demonstrate the impact on company cash position.
Principle 2: Time Value of Money
- A dollar today is worth more than a dollar in the future due to its investment and earning potential.
- Understanding timing is crucial to earning returns
- Calculating the time value of money is vital in financial analysis.
Opportunity Cost
- Opportunity cost is the cost of choosing one option over other alternatives.
- It represents the potential benefits missed from choosing a different option.
- Opportunity costs highlight trade-offs in financial decisions.
- Understanding and evaluating the gains and losses of different options is crucial in financial decisions.
Principle 3: Risk Requires a Reward
- Investors will not take on more risk unless there is a higher potential return.
- This highlights the relationship between risk and reward in investment decisions.
- Investors expect a higher rate of return on stocks compared to bank accounts due to increased risk to their investments.
- Delaying consumption (depositing in a bank) can earn interest, but there is risk.
Principle 4: Market Prices Are Generally Right
- In an efficient market, market prices accurately reflect available information.
- Stock prices often reflect expected future cash flows and are a useful tool in assessing a company's value.
- Inefficiencies can exist in the market and distort prices, leading to errors in investment decisions.
Principle 5: Conflicts of Interest Cause Agency Problems
- Separation of management and ownership creates agency problems.
- Managers may make decisions not aligned with maximizing shareholder wealth.
- Agency conflicts can be reduced through monitoring mechanisms (like annual reports), compensation schemes (like stock options), and market forces (like the threat of takeovers).
- Aligning the interests of managers and shareholders can mitigate agency problems.
The Current Global Financial Crisis
- The 2007-2008 crisis stemmed from the subprime mortgage crisis.
- High-risk mortgages, packaged as complex financial products, spread risk throughout the financial system.
- Five finance principles explain the crisis:
- Cash flow issues- inability to make mortgage payments led to a breakdown in cash flow
- Time value of money- distorted by short-term funding for long-term obligations
- Risk and reward- misjudged risk and reward in subprime mortgages
- Market prices- inflated market prices of mortgage-backed securities
- Agency problems between institutions, regulators, and investors contributed to the crisis
Ethics & Trust in Business
- Ethical behavior involves doing the right thing, though right and wrong is subjective depending on personal preferences and beliefs.
- Ethical dilemmas arise when personal judgments clash requiring careful consideration of principles and consequences.
- Sound ethical conduct is essential for both personal and business success.
- Unethical decisions can have severe consequences.
The Role of Finance in Business
- Finance provides tools and strategies for informed decision-making, resource management, and achieving long-term growth and profitability.
- Finance professionals work with other departments to achieve overarching business goals
- Finance is critical for managing capital budgeting and investment decisions, financial reporting, and risk management.
Basic Issues in Finance
- Capital Budgeting Decisions: Assessing long-term investments alignment with firm's strategic objectives to maximize shareholder wealth. This includes evaluating costs and expected returns of potential projects.
- Capital Structure Decisions: Determining funding through debt, equity, or a combination of both to optimize the firm's risk, cost of capital, and value.
- Working Capital Decisions: Managing daily cash flows and working capital to meet short-term obligations and ensuring sufficient liquidity for operations.
Financial Tools in Decision Making
- Financial tools are applicable across various business functions including marketing, production, and personal finance.
- Understanding these tools is key to decision-making
- Adjusting financial decisions regarding time, risk, and uncertainty is often critical for sound decisions.
- Assessing financial decisions for viability and long-term sustainability is necessary for informed decisions.
The Role of the Financial Manager
- Financial managers are crucial decision-makers in ensuring financial health and success.
- Their responsibilities include capital budgeting, investment, cash flow management and financing activities.
- They need to balance various stakeholder interests (shareholders, creditors, etc) to maximize firm value.
- The role requires analyzing financial data, assessing risks, and optimizing strategies for the firm within its competitive landscape.
The Legal Forms of Business Organization
- Choosing the legal structure for a new business is crucial.
- Options include sole proprietorships, partnerships, corporations, and limited liability companies (LLCs).
- Each form has advantages and disadvantages, including, but not limited to, liability issues, taxation, control, and the ease of operation.
LLC Overview
- LLCs combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation.
- LLCs offer flexible management, pass-through taxation (profits and losses passed directly to owners) and limited liability (protects personal assets of owners from business liabilities).
- LLCs are relatively easy to form and maintain compared to corporations.
Sole Proprietorship
- A business owned and operated by a single individual.
- The owner has unlimited liability.
- There is no legal separation between the owner and the business.
- The sole proprietorship can be dissolved at the owner's discretion or upon the owner's death.
Partnership
- Two or more people co-own a business.
- All partners share in the firm's liabilities in general partnerships.
- Liability in limited partnerships is limited to the amount invested in the partnership.
- Limited partners do not participate in business management and their names cannot appear in the firm name.
Corporation
- A separate legal entity distinct from its owners.
- Owners (shareholders) have limited liability (only risk the amount invested in the company).
- Shareholders elect a board of directors to manage the corporation.
- Corporations can continue operating even if owners sell shares or leave the firm.
The Trade-offs: Corporate Form
- Benefits of incorporating include limited liability, ease of ownership transferability, enhanced capital raising, and unlimited lifespan.
- Disadvantages include lack of secrecy, potential delays in decision-making, greater regulation, and double taxation.
Double Taxation Example
- Corporations are often taxed twice on profits, once at the corporate tax rate, and again at the individual shareholder level by dividends.
- Dividends are subject to additional withholding tax.
S-Corporations and Limited Liability Companies (LLCs)
- S-Corporations pass income, losses, deductions, and credits directly to shareholders (avoiding double taxation).
- They are suitable for smaller businesses.
- LLCs provide the liability protection of a corporation while also offering the flexibility and tax benefits of a partnership or sole proprietorship.
Limited Liability Companies (LLCs)
- LLCs provide limited liability protection shielding personal assets of the owners..
- LLCs are taxed similar to partnerships, meaning profits and losses pass directly to owners.
- State laws regulate LLCs
Finance and the Multinational Firm: The New Role
- Finance in multinational firms is incredibly complex and crucial for success.
- Issues like foreign markets, managing various currencies, and optimizing tax strategies are major challenges.
Why Companies Go Abroad
- Increase Revenues: Companies seek new markets.
- Reduce Expenses: Businesses can access opportunities with cheaper costs globally.
- Reduce Regulations Countries may have relaxed regulations such as environmental protection standards or worker conditions.
- Increase Exposure: Expansion improves brand recognition & facilitates wider reach for potential success in global markets.
Risks/Challenges of Going Abroad
- Country Risk: Unexpected changes in government or other similar policies can greatly impact operations and profitability.
- Currency Risk: Fluctuation in Forex (foreign exchange) rates impact cost and revenue estimations.
- Cultural Risk: Cultural differences, languages and traditions can create communications breakdowns.
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