Introduction To Corporate Finance Exam
Questions and Answers
What categories can real assets be divided into?
- tangible assets (we can see these)
- intangible assets (we can't see these)
What basic forms do investment decisions come in?
- capital expenditure
- research and development (developing a patent, generating a real asset)
How can firms purchase real assets?
- they need to raise funding by issuing financial assets
Are bonds similar to a loan?
- yes
- bonds are offered to several investors who buy a small proportion of the debt
How can firms get their financing?
- borrowing (issue loans or bonds)
- equity financing (issuing shares)
- internally generated earnings
Characteristics of a sole proprietorship
- owned and managed by one person
- very easy to form
- profits taxed as personal income (up to 40%)
- unlimited liability
- life of company linked to life of owner
- amount of funding is limited by owner's personal wealth
Characteristics of a partnership
- easy to form
- requires a partnership agreement
- limited and unlimited partners
- partnership is terminated when a partner dies/leaves the firm
- difficult to raise cash
- profits taxed as personal income
- controlled by general partners - sometimes votes are required on major business decisions
- higher partner share out dividend, lower partners don't and have less of a say
Characteristics of limited (public) corporation
- articles and memorandum of incorporation required
- limited liability
- profits taxed at corporate tax rate (19%)
- board of directors
- life of company hypothetically unlimited
- shareholder will pay dividend tax for ownership of shares
- 20-30% of the cost of the share is paid by shareholders
,What is the advantage of limited liability
- a company is considered a 'legal' entity that can borrow in its own name
- liability is restricted to the assets of the firm
- limited liability can help investors manage risk and encourage investment
Disadvantages of corporations
- must create articles of incorporation or bylaws
- double taxation: corporate tax rate + dividend tax
- going public can attract more investors but this decision also entails higher disclosure requirements
and significant costs
Characteristics of a public corporation
- liquidity and marketability (traded easily on stock exchanges)
- voting rights (different share structure, but generally each share gives a voting right)
- taxation of profits (taxed at corporate tax rate)
- reinvestment and dividend payout (freedom of financing decisions)
- liability (shareholders have limited liability)
- continuity of existence (unlimited life)
Principal-agent theory
- information asymmetries: management and shareholders
- principals cannot effectively monitor the agent's behaviour due to information asymmetries
- managers will have more information as they are running the business on a daily basis
- monitoring costs and free-loaded problem; principals have weakened incentive to monitor
- conflicting objectives and moral hazard
- defining objectives can be complex
- balancing short-term vs long-term objectives
- imperfect contracts (difficult to design a contract that perfectly control behaviour)
- difficult to define single objective goal to align incentives with long-term goals
Self-interest of principals
- they want to have the highest possible return
Self-interest of agents
- they want a higher salary
What do shareholders aim to do?
- maximise the current market value of the firm
- seek to achieve the highest possible return on their investments
- pay-off can be used for charitable purposes or luxuries
- target is straightforward
- they want to be as rich as possible
- manage the timing of consumption
- manage the risk associated with the consumption plan
What type of market is essential for achieving the shareholder's goal?
- a well-functioning market
- good investment attract buyers, driving up share prices and increasing shareholder value
- investors can adjust their internal portfolio to match their desired risk profile
,Is market value maximisation the same as profit maximisation?
- no
- profits can vary significantly over time, making the goal less well-defined
- profit maximisation does not adequately account for risk
Disadvantages of achieving shareholder's objectives
- maximising current shareholder wealth may lead to myopic corporate behaviours
- maximising shareholder wealth may harm the interests of stakeholders, including customers,
employees, suppliers, the environment, and the public
What does the shareholder theory suggest?
- corporations are owned by their shareholders
- directors and executives should do what the company's owners/shareholders want them to do
- what shareholders generally wanted managers to do was to maximise 'shareholder value' measured
by share price
What does stakeholder theory suggest?
- suggests that a company must be run in a manner that creates stakeholder, and not just
shareholder, value
- stakeholders can be internal (employees and managers), connected (shareholders, creditors, and
customers), and external (local communities, government)
Examples of internal stakeholders
- anyone who work within the company
- employees
- managers
- owner managers
Examples of external stakeholders
- anyone who do not work within the company, but affect and are affected by firms
- shareholder
- customers
- suppliers
- creditors
- government
- society
How can companies become socially responsible?
- integrating social, environmental, ethical, consumer, and human rights concerns into their business
strategy and operations
- following the law
- should encompass, at a minimum, areas such as human rights, labour and employment practices,
environmental issues, and the fight against bribery and corruption
- community involvement and development, the integration of disabled people, consumer interests,
including privacy, are also included
Why should firms engage in CSR?
, - firms with high CSR ratings had stock returns that were 4-7% higher than firms with low CSR during
the 2007-2008 financial crisis
- when shareholders engage more extensively on the environmental social and governance (ESG),
firms' valuation is significantly higher, while the downside risk is significantly lower
- firms with higher CSR performance enjoy lower cost of capital
- firms have a stronger preference for CSR when their investors have a stronger preference for CSR
- investors will support managers when they make a 'green investment', even if the cost exceed the
benefits
Issues with stakeholderism
- stakerholdism leaves the definition of stakeholders to corporate leaders, making its impact depend
on their discretion
- it doesn't resolve conflicts among stakeholders or with long-term shareholder value
- acceptance of stakeholderism may reduce corporate leaders' accountability
- discussions of stakerholderism raising false hopes can weaken calls for policy reforms
- stakeholderism may not benefit stakeholders, shareholders, or society
Difference between ESG and CSR
- ESG includes governance explicitly
- CSR includes governance issues indirectly as they relate to environmental and social considerations
- ESG tends to be a more expansive terminology than CSR
Essential role of financial managers
- helps money flow from investors to the corporation, back to the investor again
- flow starts when cash is raised from investors (eg banks)
- cash is used to pay for the real assets needed for the corporations' business
- as the business operates, the assets produce cash inflows
- cash is either reinvested or returned fo the investor who furnished the money in the first place
- they help to managed the firm's operations
- deal with investors
When do agency costs occur?
- managers do not attempt to maximise firm value
- shareholders incur costs to monitor the managers and constrain their actions
Five themes of corporate finance
- corporate finance is all about maximising value
- opportunity cost of capita sets the standard for investment decisions
- a safe dollar is worth more than a risky dollar
- smart investment decision creates more value than smart financing decisions
- good governance matters
Lemons problem in used cars
- information asymmetry
- if we can't distinguish between 'good' and 'bad' (lemons) used cars, we are willing to pay only an
average of good and bad car values (rational choice)
- sellers can tell the difference and they want to make profit
- at average price, only bads could generate profit so they will push for bad cars to be bought
- result is that good cars won't be sold and the used car market will function inefficiently
Questions and Answers
What categories can real assets be divided into?
- tangible assets (we can see these)
- intangible assets (we can't see these)
What basic forms do investment decisions come in?
- capital expenditure
- research and development (developing a patent, generating a real asset)
How can firms purchase real assets?
- they need to raise funding by issuing financial assets
Are bonds similar to a loan?
- yes
- bonds are offered to several investors who buy a small proportion of the debt
How can firms get their financing?
- borrowing (issue loans or bonds)
- equity financing (issuing shares)
- internally generated earnings
Characteristics of a sole proprietorship
- owned and managed by one person
- very easy to form
- profits taxed as personal income (up to 40%)
- unlimited liability
- life of company linked to life of owner
- amount of funding is limited by owner's personal wealth
Characteristics of a partnership
- easy to form
- requires a partnership agreement
- limited and unlimited partners
- partnership is terminated when a partner dies/leaves the firm
- difficult to raise cash
- profits taxed as personal income
- controlled by general partners - sometimes votes are required on major business decisions
- higher partner share out dividend, lower partners don't and have less of a say
Characteristics of limited (public) corporation
- articles and memorandum of incorporation required
- limited liability
- profits taxed at corporate tax rate (19%)
- board of directors
- life of company hypothetically unlimited
- shareholder will pay dividend tax for ownership of shares
- 20-30% of the cost of the share is paid by shareholders
,What is the advantage of limited liability
- a company is considered a 'legal' entity that can borrow in its own name
- liability is restricted to the assets of the firm
- limited liability can help investors manage risk and encourage investment
Disadvantages of corporations
- must create articles of incorporation or bylaws
- double taxation: corporate tax rate + dividend tax
- going public can attract more investors but this decision also entails higher disclosure requirements
and significant costs
Characteristics of a public corporation
- liquidity and marketability (traded easily on stock exchanges)
- voting rights (different share structure, but generally each share gives a voting right)
- taxation of profits (taxed at corporate tax rate)
- reinvestment and dividend payout (freedom of financing decisions)
- liability (shareholders have limited liability)
- continuity of existence (unlimited life)
Principal-agent theory
- information asymmetries: management and shareholders
- principals cannot effectively monitor the agent's behaviour due to information asymmetries
- managers will have more information as they are running the business on a daily basis
- monitoring costs and free-loaded problem; principals have weakened incentive to monitor
- conflicting objectives and moral hazard
- defining objectives can be complex
- balancing short-term vs long-term objectives
- imperfect contracts (difficult to design a contract that perfectly control behaviour)
- difficult to define single objective goal to align incentives with long-term goals
Self-interest of principals
- they want to have the highest possible return
Self-interest of agents
- they want a higher salary
What do shareholders aim to do?
- maximise the current market value of the firm
- seek to achieve the highest possible return on their investments
- pay-off can be used for charitable purposes or luxuries
- target is straightforward
- they want to be as rich as possible
- manage the timing of consumption
- manage the risk associated with the consumption plan
What type of market is essential for achieving the shareholder's goal?
- a well-functioning market
- good investment attract buyers, driving up share prices and increasing shareholder value
- investors can adjust their internal portfolio to match their desired risk profile
,Is market value maximisation the same as profit maximisation?
- no
- profits can vary significantly over time, making the goal less well-defined
- profit maximisation does not adequately account for risk
Disadvantages of achieving shareholder's objectives
- maximising current shareholder wealth may lead to myopic corporate behaviours
- maximising shareholder wealth may harm the interests of stakeholders, including customers,
employees, suppliers, the environment, and the public
What does the shareholder theory suggest?
- corporations are owned by their shareholders
- directors and executives should do what the company's owners/shareholders want them to do
- what shareholders generally wanted managers to do was to maximise 'shareholder value' measured
by share price
What does stakeholder theory suggest?
- suggests that a company must be run in a manner that creates stakeholder, and not just
shareholder, value
- stakeholders can be internal (employees and managers), connected (shareholders, creditors, and
customers), and external (local communities, government)
Examples of internal stakeholders
- anyone who work within the company
- employees
- managers
- owner managers
Examples of external stakeholders
- anyone who do not work within the company, but affect and are affected by firms
- shareholder
- customers
- suppliers
- creditors
- government
- society
How can companies become socially responsible?
- integrating social, environmental, ethical, consumer, and human rights concerns into their business
strategy and operations
- following the law
- should encompass, at a minimum, areas such as human rights, labour and employment practices,
environmental issues, and the fight against bribery and corruption
- community involvement and development, the integration of disabled people, consumer interests,
including privacy, are also included
Why should firms engage in CSR?
, - firms with high CSR ratings had stock returns that were 4-7% higher than firms with low CSR during
the 2007-2008 financial crisis
- when shareholders engage more extensively on the environmental social and governance (ESG),
firms' valuation is significantly higher, while the downside risk is significantly lower
- firms with higher CSR performance enjoy lower cost of capital
- firms have a stronger preference for CSR when their investors have a stronger preference for CSR
- investors will support managers when they make a 'green investment', even if the cost exceed the
benefits
Issues with stakeholderism
- stakerholdism leaves the definition of stakeholders to corporate leaders, making its impact depend
on their discretion
- it doesn't resolve conflicts among stakeholders or with long-term shareholder value
- acceptance of stakeholderism may reduce corporate leaders' accountability
- discussions of stakerholderism raising false hopes can weaken calls for policy reforms
- stakeholderism may not benefit stakeholders, shareholders, or society
Difference between ESG and CSR
- ESG includes governance explicitly
- CSR includes governance issues indirectly as they relate to environmental and social considerations
- ESG tends to be a more expansive terminology than CSR
Essential role of financial managers
- helps money flow from investors to the corporation, back to the investor again
- flow starts when cash is raised from investors (eg banks)
- cash is used to pay for the real assets needed for the corporations' business
- as the business operates, the assets produce cash inflows
- cash is either reinvested or returned fo the investor who furnished the money in the first place
- they help to managed the firm's operations
- deal with investors
When do agency costs occur?
- managers do not attempt to maximise firm value
- shareholders incur costs to monitor the managers and constrain their actions
Five themes of corporate finance
- corporate finance is all about maximising value
- opportunity cost of capita sets the standard for investment decisions
- a safe dollar is worth more than a risky dollar
- smart investment decision creates more value than smart financing decisions
- good governance matters
Lemons problem in used cars
- information asymmetry
- if we can't distinguish between 'good' and 'bad' (lemons) used cars, we are willing to pay only an
average of good and bad car values (rational choice)
- sellers can tell the difference and they want to make profit
- at average price, only bads could generate profit so they will push for bad cars to be bought
- result is that good cars won't be sold and the used car market will function inefficiently
