Summary of Learning Objectives

1 Identify the key financial decisions facing the financial manager of

any business firm.
The financial manager faces three basic decisions: (1) which productive assets
the firm should buy (capital budgeting decisions), (2) how the firm should
finance the productive assets purchased (financing decisions), and (3) how the
firm should manage its day-to-day financial activities (working capital
decisions). The financial manager should make these decisions in a way that
maximizes the current value of the firm's stock.

2 Identify the basic forms of business organization in the United States

and their respective strengths and weaknesses.
A business can organize in three basic ways: as a sole proprietorship, a
partnership, or a corporation (public or private). The owners of a firm select the
form of organization that they believe will best allow management to maximize
the value of the firm. Most large firms elect to organize as public corporations
because of the ease of raising money; the major disadvantage is double
taxation. Smaller companies tend to organize as sole proprietorships or
partnerships. The advantages of these forms of organization include ease of
formation and taxation at the personal income tax rate. The major
disadvantage is the owners' unlimited personal liability.

3 Describe the typical organization of the financial function in a large

corporation.
In a large corporation, the financial manager generally has the rank of vice
president and goes by the title of chief financial officer. The CFO reports
directly to the firm's CEO. Positions reporting directly to the CFO generally
include the treasurer, the risk manager, the controller, and the internal auditor.
The audit committee of the board of directors is also important in the financial
function. The committee hires the external auditor for the firm, and the internal
auditor, external auditor, and compliance officer all report to the audit
committee.

4 Explain why maximizing the current value of the firm's stock is the
appropriate goal for management.
Maximizing stock value is an appropriate goal because it forces management
to focus on decisions that will generate the greatest amount of wealth for
stockholders. Since the value of a share of stock (or any asset) is determined
by its cash flows, management's decisions must consider the size of the cash

flow (larger is better), the timing of the cash flow (sooner is better), and the
riskiness of the cash flow (given equal returns, lower risk is better).

5 Discuss how agency conflicts affect the goal of maximizing

stockholder value.
In most large corporations, there is a significant degree of separation between
management and ownership. As a result, stockholders have little control over
corporate managers, and management may thus be tempted to pursue its own
self-interest rather than maximizing the value of the owners' stock. The
resulting conflicts give rise to agency costs. Ways of reducing agency costs
include developing compensation agreements that link employee
compensation to the firm's performance and having independent boards of
directors monitor management.

6 Explain why ethics is an appropriate topic in the study of corporate

finance.
If we lived in a world without ethical norms, we would soon discover that it
would be difficult to do business. As a practical matter, the law and market
forces provide important incentives that foster ethical behavior in the business
community, but they are not enough to ensure ethical behavior. An ethical
culture is also needed. In an ethical culture, people have a set of moral
principlesa moral compassthat helps them identify ethical issues and make
ethical judgments without being told what to do.

Summary of Learning Objectives

1 Describe the role of the financial system in the economy and the two basic ways in
which money flows through the system.
The role of the financial system is to gather money from people and businesses with
surplus funds to invest (lender-savers) and channel that money to businesses and
consumers who need to borrow money (borrower-spenders). If the financial system works
properly, only investment projects with high rates of return and good credit are financed
and all other projects are rejected. Money flows through the financial system in two basic
ways: (1) directly, through financial markets, or (2) indirectly, through financial
institutions.
2 Discuss direct financing and the important role that investment banks play in this
process.
Direct markets are wholesale markets where public corporations transact. These
corporations sell securities, such as stocks and bonds, directly to investors in exchange for
money, which they use to invest in their businesses. Investment banks are important in the
direct markets because they help firms sell their new security issues. The services provided
by investment bankers include origination, underwriting, and distribution.

3 Describe the primary, secondary, and money markets, explaining the special
importance of secondary and money markets to business organizations.
Primary markets are markets in which new securities are sold for the first time. Secondary
markets provide the aftermarket for securities that were previously issued. Not all
securities have secondary markets. Secondary markets are important because they enable
investors to convert securities easily to cash. Business firms whose securities are traded in
secondary markets are able to issue new securities at a lower cost than they otherwise
could because investors are willing to pay a premium price for securities that have
secondary markets.
Large corporations use money markets to adjust their liquidity because cash inflows and
outflows are rarely perfectly synchronized. Thus, on the one hand, if cash expenditures
exceed cash receipts, a firm can borrow short-term in the money markets. If that firm holds
a portfolio of money market instruments, it can sell some of these securities for cash. On
the other hand, if cash receipts exceed expenditures, the firm can temporarily invest the
funds in short-term money market instruments. Businesses are willing to invest large
amounts of idle cash in money market instruments because of their high liquidity and their
low default risk.
4 Explain what an efficient market is and why market efficiency is important to
financial managers.
An efficient market is a market where security prices reflect the knowledge and
expectations of all investors. Public markets, for example, are more efficient than private
markets because issuers of public securities are required to disclose a great deal of
information about these securities to investors and investors are constantly evaluating the
prospects for these securities and acting on the conclusions from their analyses by trading
them. Market efficiency is important to investors because it assures them that the securities
they buy are priced close to their true value.
5 Explain how financial institutions serve the needs of consumers, small businesses, and
corporations.
One problem with direct financing is that it takes place in a wholesale market. Most small
businesses and consumers do not have the expert skills, financing requirements, or the
money to transact in this market. In contrast, a large portion of the indirect market focuses
on providing financial services to consumers and small businesses. For example,
commercial banks collect money from consumers in small dollar amounts by selling them
checking accounts, savings accounts, and consumer CDs. They then aggregate the funds
and make loans in larger amounts to consumers and businesses. The financial services
bought or sold by financial institutions are tailor-made to fit the needs of the markets they
serve. Exhibit 2.3 illustrates how corporations use the financial system.
6 Compute the nominal and the real rates of interest, differentiating between them.
Equations 2.1 and 2.2 are used to compute the nominal (real) rate of interest when you
have the real (nominal) rate and the inflation rate. The real rate of interest is the interest
rate that would exist in the absence of inflation. It is determined by the interaction of (1)
the rate of return that businesses can expect to earn on capital goods and (2) individuals'
time preference for consumption. The interest rate we observe in the marketplace is called
the nominal rate of interest. The nominal rate of interest is composed of two parts: (1) the

real rate of interest and (2) the expected rate of inflation.

Summary of Learning Objectives
1 Discuss generally accepted accounting principles (GAAP) and their importance to the
economy.
GAAP are a set of authoritative guidelines that define accounting practices at a particular
point in time. The principles determine the rules for how a company maintains its
accounting system and how it prepares financial statements. Accounting standards are
important because without them, each firm could develop its own unique accounting
practices, which would make it difficult for anyone to monitor the firm's true performance
or compare the performance of different firms. The result would be a loss of confidence in
the accounting system and the financial reports it produces. Fundamental accounting
principles include that transactions are arms-length, the cost principle, the realization
principle, the matching principle, and the going concern assumption.
2 Explain the balance sheet identity and why a balance sheet must balance.
A balance sheet provides a summary of a firm's financial position at a particular point in
time. It identifies the productive resources (assets) that a firm uses to generate income, as
well as the sources of funding from creditors (liabilities) and owners (stockholders' equity)
that were used to buy the assets. The balance sheet identity is:
. Stockholders'
equity represents ownership in the firm and is the residual claim of the owners after all
other obligations to creditors, employees, and vendors have been paid. The balance sheet
must always balance because the owners get what is left over after all creditors have been
paidthat is
.

3 Describe how market-value balance sheets differ from book-value balance sheets.
Book value is the amount a firm paid for its assets at the time of purchase. The current
market value of an asset is the amount that a firm would receive for the asset if it were sold
on the open market (not in a forced liquidation). Most managers and investors are more
concerned about what a firm's assets can earn in the future than about what the assets cost
in the past. Thus, marked-to-market balance sheets are more helpful in showing a
company's true financial condition than balance sheets based on historical costs. Of course,
the problem with marked-to-market balance sheets is that it is difficult to estimate market
values for some assets and liabilities.
4 Identify the basic equation for the income statement and the information it provides.
An income statement presents a firm's profit or loss for a period of time, usually a month,
quarter, or year. The income statement identifies the major sources of revenues generated
by the firm and the corresponding expenses needed to generate those revenues. The
equation for the income statement is
. If revenues exceed expenses, the firm
generates a net profit for the period. If expenses exceed revenues, the firm generates a net
loss. Net profit or income is the most comprehensive accounting measure of a firm's

performance.
5 Understand the calculation of cash flows from operating, investing, and financing
activities required in the statement of cash flows.
Cash flows from operating activities in the statement of cash flows are the net cash flows
that are related to a firm's principal business activities. The most important items are the
firm's net income, depreciation and amortization expense, and working capital accounts
(other than cash and short-term debt obligations, which are classified elsewhere). Cash
flows from long-term investing activities relate to the buying and selling of long-term
assets. Cash flows from financing occur when cash is obtained from or repaid to creditors
or owners (stockholders). Typical financing activities involve cash received from the
issuance of common or preferred stock, as well as cash from bank loans, notes payable,
and long-term debt. Cash payments of dividends to stockholders and cash purchases of
treasury stock reduce a company's cash position.
6 Explain how the four major financial statements discussed in this chapter are related.
The four financial statements discussed in the chapter are the balance sheet, the income
statement, the statement of cash flows, and the statement of retained earnings. The key
financial statement that ties the other three statements together is the statement of cash
flows, which summarizes changes in the balance sheet from the beginning of the year to
the end. These changes reflect the information in the income statement and in the
statement of retained earnings.
7 Identify the cash flow to a firm's investors using its financial statements.
Cash flow to investors is the cash flow that a firm generates in a given period (cash
receipts less cash payments and investments), excluding cash inflows from new equity
sales or long-term debt issues. Cash flow to investors is the cash flow in a given period
that is used to meet the firm's obligations to its debt holders and that is distributed to its
equity investors, which in turn defines the value of their investments in the firm over time.
The cash flow to investors is calculated as the cash flow to investors from operating
activity, minus the cash flow invested in net working capital, minus the cash flow invested
in long-term assets.
8 Discuss the difference between average and marginal tax rates.
The average tax rate is computed by dividing the total taxes by taxable income. It takes
into account the taxes paid at all levels of income and will normally be lower than the
marginal tax rate, which is the rate that is paid on the last dollar of income earned.
However, for very high income earners, these two rates can be equal. When companies are
making financial investment decisions, they use the marginal tax rate because new projects
are expected to generate additional cash flows, which will be taxed at the firm's marginal
tax rate