Financial Management Theory and Practice Chapter 1

Proprietorship

An unincorporated business owned by one individual

Easily and inexpensively formed, few government regulations, not subject to corporate taxation

Advantages of a proprietorship

Difficult to obtain capital, unlimited personal liability, limited to life of its founder

Limitations of a proprietorship

Partnership

Exists whenever two or more persons or entities associate to conduct a noncorporate business for profit

Limited Partnership

wherein certain partners are designated general partners and other limited partners

Limited Partners

In a limited partnership, can lose only the amount of their investment in the partnership, but typically have no control

General Partners

In a limited partnership, have unlimited liability and typically control rests solely with

Limited Liability Partnership (or limited liability company)

All partners enjoy limited liability with regard to the business's liabilities, and their potential losses are limited to their investments in the business

Corporation

A legal entity created under state laws, and it is separate and distinct from its owners and managers.

Unlimited life, easy transferability of ownership inters, limited liability

Advantages of a corporation

Double taxation, complex to set up

Disadvantages of a corporation

Charter

Includes information such as the name of the proposed corporation, types of activities it will pursue, amount of capital stock, number of directors, and names and addresses of directors

Bylaws

A set of rules drawn up by the founders of the corporation

Professional Corporation (or professional association)

Has most of the benefits of incorporation but the participants are not relieved of professional (malpractice) liability

S Corporations

A small corporation that, under Subchapter S of the Internal Revenue Code, elects to be taxed as a proprietorship or a partnership yet retains limited liability and other benefits of the corporate form of organization

Initial Public Offering

Occurs when a closely held corporation or its principal stockholders sell stock to the public at large

Agency Problem

Occurs when mangers act in their own best interests, rather than in the best interests of the stockholder/owners

Corporate Governance

The set of rules that control a company's behavior toward its directors, managers, employees, shareholders, creditors, customers, competitors, and community

Market Price

The stock price that we observe in the financial markets

Intrinsic/Fundamental Price

The market price when it reflects all relevant information

Free Cash Flows (FCF)

The cash flow actually available for distribution to all investors after the company has made all investments in fixed assets and working capital necessary to sustain ongoing operations

Weighted Average Cost of Capital

The rate of return required by investors

Investment Banking House

Organization in which indirect transfers of securities may go through, these organizations underwrite the issue and basically serves as a middleman and facilitates the issuance of securities

Financial Intermediary

Middle Man that buys securities with funds that it obtains by issuing its own securities. An example is a common stock mutual fund that buys common stocks with funds obtained by issuing shares in the mutual fund

Capital Market Security

Debt that matures in more than a year

Money Market Security

Debt that matures in less than a year

Equity Instruments

A claim upon a residual value

Derivatives

Claims whose value depends on what happens to the value of some other asset. Futures and option are two important types, and their values depend on what happens to the prices of other assets. Therefore, the value of these securities comes from the value o

Securitization

A process in which some securities are created from packages of other securities

Savings and Loan Associations (S&Ls)

Organization that at one time made most mortgages, took in the vast majority of their deposits from individuals in nearby neighborhoods, pooled these deposits and then lent money to others in the neighborhood in the form of fixed-rate mortgages

Interest Rate

The rate users pay providers for debt

Cost of Equity

The rate users pay providers for equity

Production Opportunities, Time Preferences For Consumption, Risk, Inflation

Four most fundamental factors affecting the cost of money

Country Risk

The risk that arises from investing or doing business in a particular country and it depends on the country's economic , political, and social environment

Exchange Rate Risk

Risk associated with the value of an investment depending on what happens to exchange rates

Mutual Savings Banks (MSBs)

Operate similiar to S&Ls, mostly in northeastern states

Credit unions

Cooperative associations whose members have a common bond, which loans members' savings only to other members

Commercial Banks

raise funds from depositors and issue stock and bonds to investors

Mutual Funds

Corporations that accept money from savers and then use these funds to buy financial instruments, they pool funds which allows them to reduce risks by diversification and achieve economies of scale in analyzing securities, managing portfolios, and buying/

Money Market Funds

Invest in short term, low risk securities, such as Treasury bills and commercial paper

Exchange Traded Fund (ETF)

Allows investors to sell their share in a mutual fund at any time during normal trading hours, usually have very low management expenses and are rapidly gaining in popularity

Hedge Funds

Raise money from investors and engage in a variety of investment activities, limited to institutional investors and a relatively small number of high net worth individuals

Private Equity Funds

Similar to hedge finds in that they are limited to a relatively small number of large investors, but they differ in that they own stock in other companies and often control those companies, whereas hedge funds usually own many different types of securitie

Life Insurance Companies

Take premiums, invest these funds in stocks, bonds, real estate, and mortgages, and them make payments to beneficiaries

Pension Funds

Retirement plans funded by corporations or government agencies, invest primarily in bonds, stocks, mortgages, hedge funds, private equity, and real estate

Financial Markets

Bring together people and organizations needing money with those having surplus funds

Physical Asset Market

markets for such products as wheat, autos, real estate and machinery

Financial Asset Markets

markets that deal with stocks, bonds, notes, and other financial instruments

Spot Markets

markets where assets are being bought or sold for "on-the-spot

Future Markets

Markets where assets are bought and sold and delivered on some future date

Money Markets

Markets for short term highly liquid debt securities

Capital Markets

Markets for corporate stocks and debt maturing more than a year in the future

Mortgage Markets

Markets dealing with loans on residential agricultural commercial and industrial real estate

Consumer Credit Markets

Markets involving loans for autos, appliances, education, vacation, etc

Primary Markets

Markets in which corporations raise new capital

Secondary Markets

Markets in which existing, already outstanding securities are traded among investors

Private Markets

Markets where transactions are worked out directly between two parties

Public Markets

Markets where standardized contracts are traded on organized exchanges

auction

example is the CBOT where traders meet in a pit and sellers and buyers communicate with one another through shouts and hand signals

Dealer markets

Markets where market makers keep an inventory of the stock in much the same way that any merchant keeps and inventory, they then list bid and ask quotes which are the prices at which they are willing to buy or sell

Electronic Communications Network (ECN)

participants post their orders to buy and sell and this automatically matches orders

Seasoned Equity Offering

when a company decides to sell additional shares to raise new equity after the IPO, this is still a primary market

National Association of Securities Dealers (NASD)

a self regulatory body that licenses brokers and oversees trading practices