Corporation – Legal entity authorized under a state charter
- Owners of a corporation are its stockholders
- Stockholders have limited liability for debts and other
obligations of the corporation
- Because the corporation is a legal person it must pay taxes on
the income it earns
- Owners are subject to double taxation because they must also
pay tax on dividends
- Privately held corporations are owned by a small number of
investors and their shares are not traded publicly
Sole Proprietorship – Business owned by one person
- 75% of all businesses in the U.S are sole proprietorships
- Responsible for paying all the firm’s bills and has unlimited
liability for all business debts and other obligations of the firm
- Difficult to transfer ownership
Partnership – Consists of two or more owners who have joined together legally to
manage a business.
- About 10% of U.S businesses
- All partners have unlimited liability in general partnership
Stakeholder – someone other than an owner who has a claim on the cash flows of
the firm
- Managers
- Creditors
- Employees
- Suppliers
Bondholders – holder of bond and is paid before stockholder
Fundamental Decisions in Financial Management
1. Capital Budgeting – identifying the productive assets the firm
should buy
2. Financing decisions – Determining how the firm should finance or
pay for assets.
3. Working capital management decisions – Determining how day-
to-day financial matters should be managed so that the firm can
pay its bills, and how surplus cash should be invested.
Chapter 2
Federal Reserve System – The nation’s central bank, the institution that controls
the money supply.
- Conducts monetary policy
Federal Open Market Committee (FOMC) – the monetary policymaking arm of
the Federal Reserve.
Financial Institutions – Firms such as commercial banks, credit unions, insurance
companies, pension funds, and finance companies that provide financial services to
the economy.
Finance 300 – Exam 1 Notes
- They invest their funds in financial assets such as business
loans, stocks, and bonds, rather than real assets, such as plants
and equipment
CDs – Debt instruments issued by a bank that pay interest and are insured by the
federal government.
- Competition among banks will drive CD rates up and loan rates
down.
Direct financing – In direct transactions the lender-savers and the borrower-
spenders deal directly with one another; borrower-spenders sell securities, such as
stocks and bonds, to lender-savers in exchange for money.
- Funds flow directly through financial market
- In apple example about apple selling bonds to build new facility, for
apple the bonds are a liability and for the insurance companies, the
bonds are assets that earn interest.
-Investment banks specialize in helping companies sell new debt
or equity.
-Money center banks are large commercial banks located in major
financial centers
Tasks banks perform to bring new debt or equity securities to market
1. Origination – the process of preparing a security issue for sale. Banker
helps client determine the feasibility of the project being funded and the
amount of money that needs to be raised
2. Underwriting – process by which the investment banker helps the
company sell its new security issue.
a. First-commitment underwriting – the banker assumes the risk
of buying the new securities from the issuing company and reselling
them to investors.
3. Distribution – the process of marketing and reselling the securities to
investors.
Primary Market – Any market where companies sell new security issues (debt or
equity) directly to investors.
Secondary Market – A financial market in which the owners of outstanding
securities can sell them to other investors.
- These markets are important because they enable investors to buy
and sell securities as frequently as they want.
Marketability – The ease with which a security can be sold and converted into
cash.
- A security’s marketability depends in part on the costs of trading
and searching for information, so called transaction costs.
Liquidity – The ability to convert an asset into cash quickly without loss of value.
- Liquidity implies that when the security is sold, its value will be
preserved; marketability does not carry this implication
Over-the-counter markets (OTC) – Market differs from organized exchanges in
that the “market” has no central trading location. Instead, investors can execute
OTC transactions by visiting or telephoning an OTC dealer or by using a computer-
based electronic trading system linked to the OTC leader.
Money Markets – Global markets where sort-term debt instruments, which have
maturities of less than one year, are sold.
- Money market instruments are lower in risk than other securities
because of their high liquidity and low default risk
- To manage liquidity, a firm can invest idle cash in money market
instruments; then, if the firm has a temporary cash shortfall, it can
raise cash overnight by selling money market instruments from its
portfolio.
- Capital market instruments are less marketable, carry more default
risk, and have longer maturities.
Private market – involves direct transactions between two parties.
Advantages:
- Speed at which funds can be raised
- Low transaction costs
Disadvantages:
- Privately placed securities cannot legally be sold in the markets
because they lack SEC registration
- The dollar amounts that can be raised tend to be smaller.
Stock Market Indexes- used to measure the performance of the stock market.
-Dow Jones Industrial Average – Consists of 30 companies that
represent about 20% of the market value of all U.S. stocks.
-New York Stock Exchange – includes all of the common and
preferred stocks listed on the New York Stock Exchange.
-Standard and Poor’s 500 Index – regarded as the best index for
measuring the performance of the largest companies in the U.S.
economy.
-NASDAQ Composite Index – Consists of all of the common stocks
listed on the NASDAQ stock exchange.
Financial Intermediation – When financial institutions act as intermediaries,
converting financial securities with one set of characteristics with another set of
characteristics.
In the direct market, as securities flow between lender-savers and borrower-
spenders, the form of the securities remains unchanged.
Types of Financial institutions
1. Commercial banks
2. Life and Casualty insurance companies
3. Pension Funds
4. Investment Funds – mutual funds sell shares to investors and use the funds to
Purchase a wide variety of direct and indirect financial instruments
5. Business Finance Companies – obtain the majority of their funds by selling
short-term debt called commercial paper.
Real rate of interest – an interest rate determined in the absence of inflation.
- Measures the inflation-adjusted return earned by lender-savers and
represents the inflation-adjusted cost incurred by borrower-
spenders when they borrow to finance capital goods.
Nominal rate of interest – the rate of interest unadjusted for inflation.
Determinants of the real rate of interest
-Return on Investment
-Time preference for consumption
-Equilibrium condition
Chapter 3
Annual reports are divided into 3 sections
1. Financial tables
2. Corporate public relations piece discussing the firm’s
product lines, its services and its contributions to the
community in which it oprates
3. Audited financial statements: Balance sheet, income
statement, statement of retained earnings, and the
statement of cash flows.
Book Value –the net value of an asset or liability recorded on the financial
statements, normally reflect historical cost
Assumption of arm’s length transactions – assumes that the parties to a
transaction are economically rational and are free to act independently of each
other
Accounting statements are records of past performance; they are based
on historical costs, not on the current market prices values.
Realization Principle – revenue is recognized only when the sale is virtually
completed and the exchange value for the goods or services can be reliably
determined.
Matching principle – Revenue is first recognized (under realization principle) and
then is matched with the costs associated with producing the revenue.
Going Concern Assumption – assumption that a business will remain in operation
for the foreseeable future.
- Allows accountant to record assets at cost rather than their value in
a liquidation sale, which is usually less.
Balance Sheet –reports the firm’s financial position at a particular point in time
- Left hand side identifies the firm’s assets most of which are listed at
book value.
- Right-hand side includes liabilities and stockholder’s equity, which
tells us how the firm has financed its assets.
- Stockholder’s equity represents the residual claim of the owners on
the remaining assets of the firm after all liabilities have been paid.
Current assets are asssets that can reasonably be expected to be
converted into cash within one year
