Mini Case (p. 45)
Assume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle DellaTorre, a professional tennis player who has just come to the United States from Chile. DellaTorre is a highly ranked tennis player who would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer.
DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to ex- plain the U.S. financial system to DellaTorre.
a. Why is corporate finance important to all managers?
Corporate finance provides the skills managers need to identify and select the corporate strategies and individual projects that add value to their firm and forecast the funding requirements of their company, and devise strategies for acquiring those funds.
b. Describe the organizational forms a company might have as it evolves from a start-up to a major corporation. List the advantages and disadvantages of each form.
Business Organization from Start-up to a Major Corporation: Sole proprietorship, Partnership and Corporation.
Form of Business: Characteristics: Advantages: Disadvantages:
Proprietorships Unincorporated business owned by one individual. • Easily and inexpensively formed
• It is subject to few government regulations
• The business pays not corporate income taxes • It is difficult for a proprietorship to obtain large sums of capital
• The proprietor has unlimited personal liability for the business’s debts.
• The life of a business organized as a proprietorship is limited to the life of the individual who create it.
Partnerships A partnership exists whenever two or more per- sons or entities associate to conduct a non-corporate business for profit.

Similar to those of proprietorships

Similar to those of proprietorships
Corporations A corporation is a legal entity created under state laws, and it is separate and distinct from its owners and managers. • Unlimited life—a corporation can continue after its original owners and managers are deceased;
• Easy transferability of ownership interest—ownership interests are divided into shares of stock, which can be transferred far more easily than can proprietorship or partnership interests; and
• Limited liability—losses are limited to the actual funds invested. • Corporate earnings may be subject to double taxation—the earnings of the corporation are taxed at the corporate level, and then earnings paid out as dividends are taxed again as income to the stockholders.
• Setting up a corporation involves preparing a charter, writing a set of bylaws, and filing the many required state and federal reports, which is more complex and time- consuming than creating a proprietorship or a partnership.
(Brigham/Ehrhardt's Financial Management: T&P, 13th Ed., 13th Edition. South Western Educational Publishing, 3/2010. pgs. 40-42).
c. How do corporations go public and continue to grow? What are agency problems? What is corporate governance?
Corporations go public and continue to grow by Initial Public Offering (IPO) of Stock; raises cash; allowing founders and pre-IPO investors to “harvest” some of their wealth; and subsequent issues of debt and equity.
Some of the know agency problems and corporate governance are: agency problem: managers may act in their own interests and not on behalf of owners (stockholders);
Corporate governance is the set of rules that control a company’s behavior towards its directors, managers, employees, shareholders, creditors, customers, competitors, and community; corporate governance can help control agency problems.
d. What should be the primary objective of managers?
The primary objective should be shareholder wealth maximization, which translates to maximizing the fundamental stock price.
(1) Do firms have any responsibilities to society at large?
Yes, shareholders are also members of society.

(2) Is stock price maximization good or bad for society?
Good, because employment growth is higher in firms that try to maximize stock price. On average, employment goes up in firms that make managers into owners (such as LBO firms), as well, firms that were owned by the government but that have been sold to private investors.

(3) Should firms behave ethically? Yes

e. What three aspects of cash flows affect the value of any investment?
The three aspects of cash flows that affect the value of any investment are: 1) Amount of expected cash flows (bigger is better); 2) timing of the cash flow stream (sooner is better); 3) risk of the cash flows (less risk is better)

f. What are free cash flows?
Free cash flows are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors).
FCF = sales revenues - operating costs - operating taxes - required investments in operating capital.

g. What is the weighted average cost of capital?

WACC is the average rate of return required by all of the company’s investors. WACC is affected by the following:
• Capital structure (the firm’s relative use of debt and equity as sources of financing)
• Interest rates
• Risk of the firm
• Investors’ overall attitude toward risk h. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?

Intrinsic value is the sum of all the future expected free cash flows when converted into today’s dollars: i. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?

The providers (savers) and users (borrowers) of capital are:
• Households: Net savers
• Non-financial corporations: Net users (borrowers)
• Governments: U.S. governments are net borrowers; some foreign governments are net savers
• Financial corporations: Slightly net borrowers, but almost breakeven

Capital is transferred between savers and borrowers by the following methods:
• Direct transfer o Example: A corporation issues commercial paper to an insurance company.
• Through an investment banking house o Example: In an IPO, seasoned equity offering, or debt placement, company sells security to investment banking house, which then sells security to investor.
• Through a financial intermediary o Example: An individual deposits money in bank and gets certificate of deposit, bank makes commercial loan to a company (bank gets note from company).

j. What do we call the price that a borrower must pay for debt capital? What is the price of equity capital? What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy?

We call the price, or cost, of debt capital the interest rate. The price, or cost, of equity capital: Cost of equity = Required return = dividend yield + capital gain

The four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy are 1) production opportunities; 2) time preferences for consumption; 3) Risk; and 4) expected inflation

k. What are some economic conditions (including international aspects) that affect the cost of money?

Some of the economic conditions that affect the cost of money are as follows:
• Federal Reserve policies
• Budget deficits/surpluses
• Level of business activity (recession or boom)
• International trade deficits/surpluses

l. What are financial securities? Describe some financial instruments.
m. List some financial institutions.
• Commercial banks
• Investment banks
• Savings & Loans, mutual savings banks, and credit unions
• Life insurance companies
• Mutual funds
• Exchanged Traded Funds (ETFs)
• Pension funds
• Hedge funds and private equity funds
n. What are some different types of markets?
• A market is a method of exchanging one asset (usually cash) for another asset.
• Physical assets vs. financial assets
• Spot versus future markets
• Money versus capital markets
• Primary versus secondary markets
o. How are secondary markets organized?
• Existing owner sells to another party.
• Issuing firm doesn’t receive proceeds and is not directly involved.

(1) List some physical location markets and some computer/telephone networks.

• Physical location exchanges: e.g., NYSE, AMEX, CBOT, Tokyo Stock Exchange
• Computer/telephone: e.g., Nasdaq, government bond markets, foreign exchange markets

(2) Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNs).

• open outcry auctions: o Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients; e.g., CBOT. o NYSE and AMEX are the two largest auction markets for stocks. o NYSE is a modified auction, with a “specialist.”
• dealer markets: o “Dealers” keep an inventory of the stock (or other financial asset) and place bid and ask “advertisements,” which are prices at which they are willing to buy and sell. o Often many dealers for each stock o Computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers. o Examples: Nasdaq National Market, Nasdaq SmallCap Market, London SEAQ, German Neuer Markt.
• electronic communications networks (ECNs): o Computerized system matches orders from buyers and sellers and automatically executes transaction. o Low cost to transact o Examples: Instinet (US, stocks, owned by Nasdaq); Archipelago (US, stocks, owned by NYSE); Eurex (Swiss-German, futures contracts); SETS (London, stocks).

p. Briefly explain mortgage securitization and how it contributed to the global economic crisis.
Mortgage securitization plays a large role in the U.S. mortgage market. Ehow.com provides details of mortgage securitization results in mortgage backed securities, which allow banks to sell their loans quickly while allowing investors to invest in the mortgage market.

Problems (p. 79)
2-6
In its most recent financial statements, Newhouse Inc. reported $50 million of net income and $810 million of retained earnings. The previous retained earnings were $780 million. How much in dividends was paid to shareholders during the year? $20,000,000

2-7
The Talley Corporation had a taxable income of $365,000 from operations after all operating costs but before (1) interest charges of $50,000, (2) dividends received of $15,000, (3) dividends paid of $25,000, and (4) income taxes. What are the firm’s in- come tax liability and its after-tax income? What are the company’s marginal and average tax rates on taxable income? 2-9
The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is choosing among AT&T bonds, which yield 7.5%, state of Florida muni bonds, which yield 5% (but are not taxable), and AT&T preferred stock, with a dividend yield of 6%. Shrieves’s corporate tax rate is 35%, and 70% of the dividends received are tax exempt. Find the after-tax rates of return on all three securities.

2-11
The Berndt Corporation expects to have sales of $12 million. Costs other than depreciation are expected to be 75% of sales, and depreciation is expected to be $1.5 million. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. Berndt’s federal-plus-state tax rate is 40%. Berndt has no debt.
a. Set up an income statement. What is Berndt’s expected net cash flow?

b. Suppose Congress changed the tax laws so that Berndt’s depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow?
c. Now suppose that Congress, instead of doubling Berndt’s depreciation, reduced it by 50%. How would profit and net cash flow be affected?
d. If this were your company, would you prefer Congress to cause your depreciation expense to be doubled or halved? Why?