Corporate Finance - Concept Questions

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1.1 (What are the three basic questions of corporate finance? a.Investment decision (capital budgeting): What long-term investment strategy should a firm adopt? b. Financing decision (capital structure): How much cash must be raised for the required investments?

c. Short-term finance decision (working capital): How much short-term cash flow does company need to pay its bills.

(Describe capital structure.
Capital structure is the mix of different securities used to finance a firm's investments.

(How is value created?

(List three reasons why value creation is difficult.
Value creation is difficult because it is not easy to observe cash flows directly. The reasons are: a. Cash flows are sometimes difficult to identify.
b. The timing of cash flows is difficult to determine. c. Cash flows are uncertain and therefore risky.

1.2 (What is a contingent claim?
A contingent claim is a claim whose payoffs are dependent on the value of the firm at the end of the year. In more general terms, contingent claims depend on the value of an underlying asset.

(Describe equity and debt as contingent claims.
Both debt and equity depend on the value of the firm. If the value of the firm is greater than the amount owed to debt holders, they will get what the firm owes them, while stockholders will get the difference. But if the value of the firm is less than equity, bondholders will get the value of the firm and equity holders nothing.

1.3 ( Define a proprietorship, a partnership and a corporation. A proprietorship is a business owned by a single individual with unlimited liability. A partnership is a business owned by two or more individuals with unlimited liability. A corporation is a business which is a "legal person" with many limited liability owners.

( What are the advantages of the corporate form of business organization?
Limited liability, east of ownership transfer and perpetual succession.

1.4 (What are the two types of agency costs?
Monitoring costs of the shareholders and the incentive fees paid to the managers. (How are managers bonded to shareholders?
a. Shareholders determine the membership to the board of directors, which selects management. b. Management contracts and incentives are build into compensation arrangements. c. If a firm is taken over because the firm's price dropped, managers could lose their jobs. d. Competition in the managerial labor market makes managers perform in the best interest of stockholders.

(Can you recall some managerial goals?
Maximization of corporate wealth, growth and company size.

(What is the set-of-contracts perspective?
The view of the corporation as a set of contracting relationships among individuals who have conflicting objectives.

1.5 (Distinguish between money markets and capital markets. Money markets are markets for debt securities that pay off in less than one year, while capital markets are markets for long-term debt and equity shares.

(What is listing?
Listing refers to the procedures by which a company applies and qualifies so that its stock can be traded on the New York Stock Exchange.

(What is the difference between a primary market and a secondary market? The primary market is the market where issuers of securities sell them for the first time to investors, while a secondary market is a market for securities previously issued.


2.1 (What is the balance-sheet equation?
Assets = Liabilities + Stockholders' equity

(What three things should be kept in mind when looking at a balance sheet?
Accounting liquidity, debt vs. equity, and value vs. cost.

2.2 (What is the income statement equation?
Revenue -...
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