COMM 121 Study Guide - Final Guide: Cash Flow, Net Present Value, Preferred Stock

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8 Feb 2014
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Chapter 1
 Goal of firm is to maximize value of SH wealth
Firm must create wealth:
1) Buy assets that generate more money than they cost
2) Sell securities that generate more money than they cost
Three objectives of Finance
1) What should we invest in?  Capital Budgeting
2) How should we make these investments?  Capital Structure
3) How should we manage short term operational cash flows?
 Net working capital = current assets – current liabilities
Balance Sheet Model of Firm
Total Value of Assets Total Value of Firm to Investors
Current Assets Current Liabilities
Assets with short lives Short-term debt that must be repaid within a
year
Long-Lived Assets Long-Term Debt
Assets with long lives Long-term debt that does not have to be
Tangible or intangible repaid within a year
*In order to purchase long-lived Shareholders’ Equity
assets, firm must obtain financing Difference between assets and debt
Capital Structure
Creditor: person/institution that buys debt from firm (B)
Shareholder: holder of equity shares (S)
The size of the firm is value of firm as determined by financial markets  V = B + S
Capital Budgeting
Process of making and managing expenditures of long-lived assets
Important variable: cash flow to firm, NOT shareholders
Two Important Considerations in Finance
1) Timing of cash flows
-The value of investment depends on timing of cash flows
-Prefer to receive sooner
2) Risk of cash flows
-Important to consider
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Debt and Equity as Contingent Claims
If value of firm is greater than or equal to F, debtholders get F
If value of firm is less than F, debtholders get X
Shareholders’ claim on value of firm is residual amount after debtholders have been
paid  if value of firm is less than amount promised to debtholders, SH get nothing
If value of firm is greater than amount promised to debtholders, SH get residual amount
If value of firm is less than amount promised to debtholders, SH get nothing and
debtholders get value of firm
Corporation
-Distinct legal entity
-Three sets of distinct interests: SH, Board of Directors, corporate officers
-Agency costs  cost of resolving conflicts of interest between SH and management
-Set-of-contracts perspective  firm can be seen as nothing more than set of contracts
-Principle-agent relationship  management (agent) is responsible for managing firm in
best interest of principles (SH)
-Advantages:
1) Ownership through shares  easily transferable
2) Unlimited lives  corporation separate from owners
3) Limited liabilities  liability limited to amount invested
4) Easy to raise cash
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-Disadvantages: costly (start-up, taxes)
Money vs. Capital Markets
Money Market Short-term debt securities
Actually own commodity
”Dealer market”
Capital Market Long-term debt and equity
Don’t own commodity
NYSE, TSX
Primary vs. Secondary Capital Markets
Primary: original sale of securities
1) Public offering  selling to public
2) Private placement  negotiated sale
Secondary: selling or buying after original sale
1) Auction market  physical location, limited use of dealers, NYSE
2) Dealer market  connected electronically, use of dealers, “over-the-counter
market”, NASDAQ
Chapter 4
Fisher Separation Theorem
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