A Guide to Financial Management: Key Concepts and Applications
1. Business Structures: Advantages and Disadvantages
Proprietorship
Advantages:
- Easy and inexpensive to form
- Subject to few government regulations
- Low income taxes
Disadvantages:
- Unlimited personal liability
- Life of the business is limited to the life of the creator
- Difficult to obtain large sums of capital
Partnership
Shares the same advantages and disadvantages as a proprietorship, but with more than one owner.
Corporation
Advantages:
- Separate and distinct legal entity from its owners and managers
- Limited liability for stockholders
- Easier to transfer shares of stock
Disadvantages:
- Double taxation
Which of the following is an advantage of a corporation? It is easier for investors to transfer ownership.
2. Reducing Stockholder and Manager Conflicts
- Increase the proportion of compensation that comes from shares of stock and decrease the proportion paid as cash salaries.
- Implement agency problem compensation packages.
- Encourage direct stockholder intervention.
- Address the threat of hostile takeovers.
By aligning the interests of managers with those of stockholders, conflicts can be minimized.
3. Reducing Stockholder and Bondholder Conflicts
Bondholders often protect themselves by including covenants in bond agreements that limit a firm’s use of additional debt and constrain managers’ actions.
4. The Goal of a Firm
The primary goal of a firm is to maximize the wealth of its stockholders. This is typically achieved by maximizing stock price per share over the long run.
5. Money Markets vs. Capital Markets, Spot Markets vs. Futures Markets
Money Market
A market for short-term, liquid debt securities with maturities of less than one year. Example: Treasury bills
Capital Market
A market for intermediate- or long-term debt and corporate stocks. Intermediate-term securities have maturities of 1-10 years, while long-term securities have maturities exceeding 10 years.
Spot Market
A market where securities are traded for immediate delivery.
Futures Market
A market where contracts are made to buy or sell securities at a future date and price.
6. Types of Financial Institutions
Investment Banks
Underwrite and distribute new investment securities and assist businesses in obtaining financing.
Commercial Banks
Provide a wide range of financial services to savers and borrowers, acting as traditional “department stores” of finance.
Financial Services Corporations
Offer a comprehensive range of financial services, including investment banking, brokerage operations, insurance, and commercial banking.
7. Auction Markets vs. Dealer Markets
Dealer Market
Dealers buy securities from investors looking to sell and sell from their inventory to investors looking to buy. These transactions typically occur in non-physical spaces, such as the internet. Example: NASDAQ
Auction Market
Buyers and sellers are matched by a specialist in a physical location. Example: NYSE
8. NYSE vs. NASDAQ
The NYSE is a physical auction market, while the NASDAQ is a virtual dealer market.
9. Primary Market Transactions vs. Secondary Market Transactions
Primary Market
Corporations raise new capital by issuing new securities. Example: IBM issues 200,000 shares of new stock and sells them to the public through an investment banker.
Secondary Market
Existing, already outstanding securities are traded among investors. Example: Selling 200 shares of Facebook stock through a broker.
10. Stock Market Efficiency
Market efficiency refers to the degree to which stock prices and other securities prices reflect all available, relevant information.
- Market Price: The current price of a stock.
- Intrinsic Value: The price at which the stock would sell if all investors had all knowable information.
- Equilibrium Price: The price that balances buy and sell orders at any given time.
- Efficient Market: A market in which prices are close to intrinsic values and stocks seem to be in equilibrium.
11. The Usefulness of Ratios
Ratios are useful for:
- Evaluating financial statements.
- Improving understanding of financial results and trends over time.
- Providing key indicators of organizational performance.
12. Limitations and Problems with Ratios
- Difficulty in finding comparable firms.
- Limited usefulness for multidivisional firms.
- Distortions caused by seasonal factors.
- Potential for manipulation through “window dressing” techniques.
13. Time Value of Money
A dollar today is worth more than a dollar tomorrow due to factors like inflation and interest rates. Inflation erodes the purchasing power of money over time.
14. Future Value of Annuities
The future value of an annuity due will be higher than the future value of an ordinary annuity, all else being equal.
15. Impact of Decreasing Days Sales Outstanding (DSO)
Decreasing DSO frees up cash for the firm, improving its liquidity.
16. Fixed-Rate Mortgages
Which of the following statements about fixed-rate mortgages is NOT correct? The amount of the payments applied to principal and interest is fixed over time. (This statement is incorrect because while the total payment remains fixed, the proportion allocated to principal and interest changes over the life of the loan.)