Chapter 1: The key principles of finance

Question 1

What are the 4 main business structures?

Answer 1

• sole trader
• partnership
• private limited company
• public limited company

Question 2

What is a sole trader?

Answer 2

• A business owned by one person, that is not a limited company
• Typically this business is small, perhaps with just a few employees
• It is quick and easy to set up (no documentation needed) however, they do need to fill out tax returns
• Unlimited liability: the sole trader is liable for any losses made by the business (all personal wealth is at risk

The owner’s personal wealth is at risk, if the business fails, their assets might be seized

Question 3

What is a partnership?

Ordinary vs LL

Answer 3

• Set up by more than one person, not as a limited company
• The owners are partners, they may own equal or unequal proportions of the business.
• Profits can be taken out of the partnership and shared amongst the business.

1. An ordinary partnership, each partner has unlimited liability.
2. A limited liability partnership, enables partners to have limited liability (typically to the amount invested) and is a separate legal entity. There is a defualt agreement if a bespoke one isn’t made

There is usually a partnership agreement in place which governs how the partnership operates. But it is not a legal requirement

Question 4

What might be included in a partnership agreement?

Answer 4

• The rules for making decisions
• The roles and responsibilities of partners
• The percentage share of profits to which each partner is entitled
• What happens if a partner decides to leave the business

Question 5

What is a company?

Answer 5

A company has its own distinct legal identity. this means for example:
* it can enter into contracts, such as loan arrangements in its own right
* it can own property, for example a factory
In addition it can sue other parties or be sued and subject to fines.

Owners liability is limited to the fully paid value of their shares

Question 6

What is a shareholder?

Answer 6

• Almost all limited companies are set up by the issue of shares. Investors who own shares in the company are called shareholders.
• The size of the shareholding can vary.
• They have limited liability, meaning they can only lose the money they invested in the company if the company becomes bankrupt.
• They often have no direct involvement in the day-to-day running of the business.
• However, they normally get the right to vote on certain matters at company meetings and hence at a high level they exert some control on the direction of the company.
• They can also appoint directors who are responsible for the control of the company on their behalf
• They may recieve a return on their investment through dividend payments.

Question 7

What are dividend payments?

How often are they paid?

Answer 7

A share of a company profits.
They are normally paid half-yearly

Question 8

What are the two types of company structure?

Answer 8

• Public limited companies where they offer their shares publicly. Most times they are listed on the stock exchange so it is easy for investors to buy/sell. In the UK they have PLC at the end of their name. Most say so in their documentationa and have issued share capital >=£50,000. Name ends in plc (or public limited company)
• Private limited companies, where shares must be bought/sold privately. Generally they are smaller than public ones. Name ends in limited

Question 9

What is the main aim of shareholders and management? How is this achieved?

Answer 9

• Shareholders - maximise their own wealth
• Management - maximise shareholder wealth

This is achieved by undertaking profitable projects and raising the money to invest in those projects in the most efficient way.

max shareholder wealth is also a goal of other workers who are responsible for making financial decisions

Question 10

Who runs a company?

Answer 10

Normally shareholders elect a Board of Directors to govern a company on their behalf. Sometimes the directors run the company, sometimes they hire managers, who are experts in their fields to run the company on a day-to-day basis.
The CEO (Chief Executive Officer) normally manages the company and is responsible for the strategic direction of the business and for hiring the rest of the management team.
The CFO (Chief Financial Officer) is responsible for deciding on the resources the company needs and the projects the company should invest in.
The company Treasurer is responsible for raising the money to pay for these resources and projects.

Question 11

What are the pros and cons of the separation of ownership and management?

Answer 11

Pros:
* Gives management the freedom for the owners to change (i.e. if shares are sold) without day-to-day activites of the company being affected
* Gives managers the freedom to hire/fire personnel to run the business

Cons:
* Different shareholders might have different needs
* Shareholders and managers may have different views on how the company should be run.

Question 12

How might needs and objectives vary by shareholder?

Answer 12

• Different attitudes towards risk - individuals may be much more risk averse than a large pension scheme.
• Different preferences for receiving the return on shares - some may prefer a regular income stream, others may prefer their shares increasing in value (and making more when they sell it) [This is called a capital gain]
  This may be influenced by tax treatment. I.e. shareholders that are taxed more heavily on income will prefer capital gains
• Time horizon of their investment - Some want a quick profit, others care more for the long-term fortunes of the company

Question 13

How does a CFO meet the needs of shareholders?

Answer 13

It is difficult for a CFO to even know the needs of shareholders so they focus on maximising wealth given the following assumptions
* shareholders can pick from a wide range of appropriately priced shares in the market (the market for shares is accesible and competitive)
* they desire to be as rich as possible
* they will choose whichever shares meet their own risk appetite and cashflow needs.
In order to do this, they need to make decisions on what assets to buy, what projects to invest in and how to raise the finance to pay for that.

Question 14

What are real assets?

Answer 14

Real assets are items owned by a company needed to run its day to day business.
Tangible assets are ones that physically exist (i.e. a factory or machines), intangible assets do not (i.e. brand name or a good relationship with the workforce).

Question 15

What is an investment budgeting decision?

Answer 15

AKA capital budgeting decision. The choice of real assets or projects to invest in.
It is very important and the choices made will impact the future of the company.
It is normally the concern of the CFO, but managers are often consulted

Question 16

What are financial assets?

Answer 16

Investments, i.e. shares held in other companies.

Question 17

Why is a capital budgeting decision difficult to make?

Answer 17

It involves estimating the cashflows, i.e.
* likely income arising
* likely outgo (e.g. initial setup costs, ongoing costs)
These can be very difficult to estimate, particularly if they occur far in the future.

Question 18

An insurance company is thinking of launching a new car insurance policy. Which department managers should the CFO consult?

Answer 18

• Sales and marketing manager (as the sales team would need to provide the resources to bring the product to the market and ensure a sufficient volume is sold)
• Pricing manager (as the product will need to be priced appropriately)
• IT manager (as the insurance company’s systems will need to be updated to be able to manage this new product)
• Administration manager (as policies sold will need to be entered onto the data system and maintained there)
• Investment managers (as the premiums received when policies are sold will need to be invested)
• Claims manager (as the claims team will need to deal with the additional work resulting from claims arising from the new policies)

Question 19

What is a financing decision?

Answer 19

Deciding how a company raises finance (money) to pay for its assets.
It needs to do this to buy the resources needed to invest in new assets.
Money can be raised from shareholders or by approaching the capital markets. This will be long-term finance (more than a year).
The two sources of long-term finance are:
* equity (selling shares, privately or through the stock market)
* bonds (i.e. raising debt finance by borrowing from banks or other lenders)

Question 20

What is the treasurer responsible for?

Answer 20

The financing decision:
* managing the company’s cash
* raising new cash when needed
* keeping good relations with those who are already lending the company money

Question 21

What is a stakeholder and who are the key stakeholders in a company?

Answer 21

A stakeholder is any party with an interest in the company’s operations.
* Providers of finance:
* * Shareholders
* * Lenders (eg banks)
* Workers
* * Management
* * Employees
* Trade Partners
* * Suppliers
* * Customers
* Government/tax authorites

Question 22

What are the stakeholder objectives of shareholders?

Answer 22

Maximise overall return on their investment, through the company undertaking successful projects and therefore maximising the long-term value of the company

Question 23

What are the stakeholder objectives of lenders?

Answer 23

That the company remains in business to service any loan and to receive a market rate of interest on the money loaned

Question 24

What are the stakeholder objectives of management?

Answer 24

Job security and possibly to pursue projects of interest to them, prestige and power, good pay and perks, eg, a company car

Question 25

What are the stakeholder objectives of employees?

Answer 25

Job security, market rate of pay, job training, safe working conditions, other benefits eg a good pension

Question 26

What are the stakeholder objectives of suppliers?

Answer 26

The company remains in business and pays promptly for the goods and services provided

Question 27

What are the stakeholder objectives of customers?

Answer 27

The company remains in business and provides quality goods at reasonable prices and maybe that the company produces goods in an ethical manner

Question 28

What are the stakeholder objectives of government/tax authority?

Answer 28

The company performs well so employs many citizens. The company operates within the legal framework. The company performs well and so pays more taxes

Question 29

Describe why there may be conflict between the objectives of shareholders and management

Answer 29

Shareholders are primarily interested in achieving a higher return on their invested money. Management may be attracted to
* Taking over other companies to maximise control (may not max profits)
* Undertaking projects of a particular interest to them (rather than the most profitable projects)
* A leisurely pace of working life, so may not run the business in a way so as to maximise return
It can be difficult for management to satisfy the competing objectives of all stakeholders who have an interest in the company

Question 30

What is agency theory?

Answer 30

Agency theory looks at the complex relationships and conflicting objectives between a principal and an agent of that principal. Where the interests of the principal and agents diverge, then principal-agent problems arise.

The primary example of agency theory is between shareholders (the principal) and management (their agents).
Other examples are employee-management (mangement are the principal). Or between parties who provide finance

Agency costs arise due to conflicts, and costs arise in monitoring and trying to reduce the principal-agent problems.

Question 31

Describe the agency costs that may be incurred by the shareholders in their relationship with the company’s management

Answer 31

• The cost due to management not acting in the best interests of shareholders eg choosing projects which do not max shareholder return
• the costs of monitoring management, eg audits
• the costs of trying to influence the actions of mangement eg through providing bonuses for good performance, or costs of replacing mangement if they underperform

Question 32

Why might agency problems arise between shareholders and other providers of finance to the company?

Answer 32

Shareholders want to max returns, lenders want to receive their promised interest/capital payments and ensure the company does not take too much risk and jeapordise the chance of these payments being made.
Ex: a project might be potentially risky but could lead to a high rate of return.

Question 33

How can agency problems arise between a company and society as a whole?

Answer 33

A company needs to ensure it manages its operations in a way that is ethical, meets the needs of workers, customers and wider society
For example, care needs to be taken to:
* avoid polluting the environment
* ensure that any goods sold are safe for customers to use
* ensure that employment contracts are fair to workers
Regulations may impose controls on these areas. There is also reputational risk to a company if it ignores its wider social respoonsibilities
companies and the government will need to co-operate to ensure that companies are in a position to max shareholder wealth, but within the constraints of acting legally and ethically.

Question 34

What is informational asymmetry? How might it exist between shareholders and management?

Answer 34

If all stakeholders have access to the same information about a company, then principal-agent problems would be easier to resolve. In practice, different stakeholders have access to differing amounts of information about the company, this is informational asymmetry.

Management have detailed info on current and likely future company performance. Shareholders will have access only to the information published by the company, eg, annual company reports.
Providing full information to all stakeholders would be problematic since some info may be commercially sensitive (eg, regarding new products the company is planning to develop). Management may not want this in the public domain.

Question 35

What are incomplete contracts?

Answer 35

Written agreements can be put in place to set out the key aspects of relationships between stakeholders and help ensure all stakeholders understand their roles and responsiblities.

However, they cannot cover every possible scenario that might arise and so are known as incomplete contracts.

In addition to the formal arrangements, there will need to be less formal understanding and arrangements in place.

Question 36

What documentation does a company need?

Answer 36

• A memorandom of association - a short document recording the intention to form a company
• Articles of association - lays down the internal rules by which the directors run the company and sets out the rights of shareholders
• Must also produce auditted accounts each year