Homework 1
Chapter 1
1. What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.
a. Capital budgeting, which is the process of planning and managing a firm’s long term investment. In capital budgeting, financial managers try to identify investment opportunities that are worth more to the firm than they cost to acquire. An example would be for the financial managers to decide to establish a new location in another city. Page 5.
b. Capital structure, which is the specific mixture of long-term debt and equity the firm uses to finance its operations. An example would be for the financial managers to decide to give up some equity and raise money in order to pay an outstanding debt. Page 5.
c. Working capital, which is a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers. An example would be for the financial managers to decide to buy more inventory to be prepared for the holidays. Page 6.
2. What are the four primary disadvantages to the sole proprietorship and partnership forms of business organization? What benefits are there to these types of business organization as opposed to the corporate form?
The four primary disadvantages are unlimited liability, limited life, difficulty in transferring ownership, and hard to raise cash for investment. Some advantages are simpler to form, less regulation, the owners are also the managers, sometimes personal tax rates are better than corporate tax rates. Pages 7-8.
3. What is the primary disadvantage of the corporate form of organization? Name at least two of the advantages of corporate organization.
The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages are limited liability, ease of transferability, ability to raise capital, and unlimited life. Page 8-9.
4. What goal should always motivate the actions of the firm’s financial manager?
The goal of the financial manager is to maximize the current value per share of existing stock. Page 10.
5. Who owns a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise?
The shareholders are the owners of the corporation. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. The reason why an agency relationship exist is for the shareholders and management to align their goals the better they can so both parties can benefit from the corporation. The separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm. Pages 12-13-14-15.
6. You’ve probably noticed coverage in the financial press of an initial public offering (IPO) of a company’s securities. Social networking company Facebook is a relatively recent example. Is an IPO a primary-market transaction or a secondary-market transaction?
It is a primary market transaction. Pages 16-17.
7. What does it mean when we say the New York Stock Exchange is an auction market? How are auction markets different from dealer markets? What king of market is NASDAQ?
In auction markets like the NYSE, brokers and agents meet at a physical location to match buyers and sellers of assets. Dealer markets consist of dealers who buy and sell assets at their own risk, communicating with other dealers either electronically or literally over-the-counter. NASDAQ is a dealer market. Page 17.
8. Suppose you were the financial manager of a not-for-profit business. What kinds of goals do you think would be appropriate?