Ch 1 Flashcards
(17 cards)
How does finance build on economics and accounting?
Economics: Provides theories about economic systems and decision-making.
Accounting: Supplies financial data and analysis tools for decision-making in finance.
Other Disciplines: Finance also connects to mathematics (risk modeling), statistics (data analysis), and psychology (behavioral finance).
What is the risk-return trade-off in finance?
Increased profitability = Increased risk
Decreased profitability = Decreased risk
Financial decisions involve balancing potential returns with risk. The goal is to find an optimal combination for the firm.
What is the primary goal of finance?
The primary goal is shareholder wealth maximization, which is measured by share price.
Why not profit? Profit doesn’t consider risk or timing and is hard to measure accurately. Share price reflects market expectations.
What are alternative goals of a firm beyond shareholder wealth maximization?
Social Responsibility: Goals like pollution control and fair business practices.
Management Goals: Priorities like job security, company growth, or corporate social responsibility.
There can be a conflict of interests between management and shareholders.
What are the key activities of a financial manager?
Raising Funds: Deciding between equity (stocks) or debt (bonds) for the company’s capital structure.
Investing Funds: Allocating funds to profitable projects to achieve long-term goals.
Cash Management: Ensuring the firm has enough liquidity for daily operations and obligations.
What role do financial markets play in allocating capital and establishing yields?
Capital Allocation: Markets direct funds from investors to firms for productive uses.
Determining Value: Financial markets establish security prices, reflecting risk, return, and future prospects.
Establishing Yields: Interest rates or yields reflect the risk associated with investments, with higher risk leading to higher yields.
What’s the difference between the primary and secondary markets?
Primary Market: Where new securities (stocks/bonds) are issued for the first time to raise capital.
Secondary Market: Where existing securities are traded between investors (e.g., stock exchanges).
What’s the difference between common stock and bonds?
Common Stock: Represents ownership (equity) in a company. Shareholders benefit from capital gains and dividends.
Bonds: Represent debt. Bondholders receive fixed interest payments and have priority in case of liquidation, but don’t share in company profits.
What’s the difference between money markets and capital markets?
Money Markets: Deal with short-term securities (less than 1 year) like Treasury bills or commercial paper. Low risk, low return.
Capital Markets: Deal with long-term securities (more than 1 year) like stocks, bonds, and government securities. Higher risk, higher return.
How does debt impact a firm’s capital structure?
Too much debt: Can erode cash flow and increase financial risk due to the need for debt repayment.
Interest rates/yields: Help determine the cost of debt, influencing capital allocation decisions.
Risk-Return: More debt typically increases the cost of capital and potential return, but also adds financial risk.
How does a financial manager decide on investments given risk and return?
The manager must choose a balance between high returns (which often come with higher risk) and safer, lower returns.
This involves capital budgeting (which projects to invest in), fundraising (equity vs. debt), and risk management (mitigating risk while maximizing returns).
How does social responsibility fit with financial goals?
Social Responsibility can align with the goal of shareholder wealth maximization if it enhances the company’s reputation, brand value, and long-term success.
Companies should consider pollution control, ethical business practices, and avoiding issues like insider trading.
How do financial markets play a role in risk management?
Financial markets allow firms to hedge and manage risks through instruments like derivatives (options, futures, etc.).
Markets establish prices for these instruments based on perceived risks, helping businesses manage exposure to changes in factors like interest rates, commodity prices, or currency fluctuations.
Why is cash flow more important than profit for a firm’s financial health?
Cash flow is crucial for day-to-day operations, paying bills, and investing in opportunities.
Profit can be misleading because it doesn’t account for timing or liquidity, whereas cash flow reflects actual cash available.
What is Agency Theory and how does it relate to financial management?
Agency Theory explores the conflict of interest between shareholders (owners) and managers (who run the firm).
Managers may prioritize their own interests (e.g., compensation, job security) over maximizing shareholder wealth.
Solutions: Incentive-based compensation and performance-based measures can help align manager and shareholder goals.
What is the Efficient Market Hypothesis (EMH)?
The EMH states that security prices fully reflect all available information, meaning investors can’t consistently outperform the market by using this information.
Implication: Active management (picking stocks) is less likely to outperform the market compared to a passive strategy (e.g., index funds).
