Finance Textbook Notes – Chapter 1: The Firm and Its Environment


Notes from various chapters in the core finance textbook, Financial Management, by Ramesh Rao.
Subject: Finance
Source: Financial Management by Ramesh Rao
  1. Freedom of choice is the driving force behind a capitalistic society. This influences our production and distribution decisions because we will channel our resources (because we are free to do so) into activities that benefit us most. In turn, society generally benefits overall.
  2. Competition in the capitalistic marketplace encourages parties to act in the best interest of society as a whole. That is, if a good is perceived as beneficial to society, it will we purchased by the public. However, when this becomes opportunistic, society can actually be worse off. To address this, regulations, policies, standards, ethics, etc. discourage opportunistic behavior. In general, capitalism promotes the pursuit of self-interest and discourages opportunism.
  3. See above. Opportunism can lead to deception, unfair business practices, exploitation, expropriation, lying, deceit, stealing, etc. Eventually, this behavior leads to a worsening of societal welfare and firms that pursue opportunism are worse off.
  4. Society is held together with contracts. Firms exist when the costs of writing contracts and conducting operations through them are less than the cost of making individual market transactions.
  5. Proprietorships are generally limited to the capital of the individual owner and the limited amount of funds that can be obtained given the creditworthiness of a single individual. Partnerships have greater access to capital, but only because there are more individuals in the firm. Corporations have virtually unlimited access to capital because of their nature as a separate legal entity, owned by many individuals who can freely and easily transfer their ownership in organized markets. A corporation has access to all the forms of capital that are available in the economy through organized public exchanges.
  6. Financial markets provide a source of capital to corporations in that firms can access this capital through organized public exchanges and other sources within the financial market.
  7. Firms are in fact very interested in secondary markets because (1) the wealth of their stockholders’ is measured through the price of company stock as traded on the secondary markets, and (2) the secondary market determines, to a large extent, a firms cost of funds in the primary market.
  8. Debt securities (bonds) create creditors of a corporation whereby the creditors have a claim to interest payments and principle (or collateralized assets) from the firm. No ownership is involved. Equity securities (stocks) create owners of a corporation who have a residual claim to the earnings (or losses) of the firm according to the percentage ownership.
  9. Yes, because if a firm declares bankruptcy, bondholders may be residual claimants to assets or funds in the bankruptcy distribution. However, their claims are superior to that of equity holders.
  10. The goal of financial management is to maximize the welfare of its residual claimants (stockholders). This can be at odds with a benefit to society as a whole in that the pursuit of this narrow goal may come at a detriment to employees, customers, etc. However, in general this goal is viewed as proper because, given a competitive environment, the maximization of stockholder welfare will generally lead to a benefit to society.
  11. A Firm’s management might take a “stakeholder” view whereby it attempts not only to maximize stockholder welfare, but also the welfare of customers, employees, suppliers, and the world communities in which the firm operates. The effect of the stakeholder view is difficult to analyze. If a firm chooses to maximize the wealth to society at the detriment of its own stockholders, the end result (bankruptcy for instance) may actually hamper the efficient allocation of resources and ultimately retard economic growth and increase unemployment.
  12. Stockholders play the most important role in regulating the activities of a corporation because they, unlike other stakeholders, have much more power to influence the firm through their ownership and voting rights.
  13. Stakeholders should expect to gain wealth, as measured by metrics other than stock value, such as improved standards of living, greater access to goods and services, etc.
  14. Society, through its government representatives, makes decisions regarding the relative trade-offs between desirable social goals and reduced efficiency from reallocating those scarce resources necessary to realize those goals. A certain amount of government regulation is necessary for the general good, and therefore constraints should be imposed on a firm’s value-maximizing behavior. Otherwise, the pursuit of this goal in an of itself might become opportunistic. The firm should therefore be allowed to maximize the shareholders’ wealth, subject to the mandatory constraints imposed by society on all firms.
  15. The vast potential for added revenues and reduced costs motivates American firms to pursue lucrative overseas business. If a comparative advantage exists, firms will want to exploit that advantage. The same is true for imperfect markets (the Imperfect Market Theory), such as those where labor costs are low (Taiwan) Also, international business can circumvent certain domestic constraints like tariffs and taxes.
  16. Firms competing internationally can be exposes to exchange rate risk when operating in countries with different currencies that fluctuate in value relative to the firm’s reporting currency. Firms also face political risk internationally in that other countries may enforce or enact certain restrictions on foreign companies that only effect those companies.
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