Week 1 assignments FI515

Mini case
A-Why is corporate finance important to all managers?
Corporate finance provides managers with the skills to identify and select the corporate strategies and individual projects that add value to the company. It helps them to forecast the funding requirements of their company and the necessary strategies to acquire 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.
The three main forms of business organizations are: Sole proprietorship, Partnerships and corporations. The main advantages of a Proprietorship are: it is easily and inexpensively formed, it is subject to few government regulations, and the business pays no corporate income taxes. Its disadvantages are: it is difficult for a proprietorship to obtain large sums of capital, the proprietor has unlimited personal liability for the business debts, and the life of the business is limited to the life of the owner.
The major advantage of a partnership is its low cost and ease of formation. The disadvantages are similar to those associated with proprietorships: unlimited liability, limited life of the organization, difficulty of transferring ownership, and difficulty of raising large amounts of capital. The tax treatment of a partnership is similar to that for proprietorships, which is often an advantage. The corporate form of business has three major advantages: unlimited life, easy transferability of ownership interest, and limited liability. While the corporate form offers significant advantages over proprietorships and partnerships, it does have two primary disadvantages: corporate earnings may be subject to double taxation and setting up a corporation and filing the many required state and federal reports is more complex and time-consuming than for a proprietorship or a partnership. In a limited partnership, the limited partners are liable only for the amount of their investment in the partnership; however, the limited partners typically have no control. The limited liability partnership form of organization combines the limited liability advantage of a corporation with the tax advantages of a partnership. Professional corporations provide most of the benefits of incorporation but do not relieve the participants of professional liability.
C. How do corporations go public and continue to grow? What are agency problems? What is corporate governance?
As a firm grows, it needs more capital. The firm finds out that it’s advantageous to raise funds directly from investors. This is when the firm is ready to sell new financial assets, such as share of stocks, to the public.
Agency problems are the conflict of interest between the firm’s owner and the managers.
Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation is directed, administered or controlled. There is a separation between ownership and management in corporations, so corporate governance includes the relationships among the stakeholders and the goals for which the corporation is governed.

D. What should be the primary objective of managers?
The managers will act to maximize the value of the firm to its stockholders. The primary objective of managers is to maximize the current value of the investment of the shareholders.

D. (1) Do firms have any responsibilities to society at large?
Firms have an ethical responsibility to provide a safe working environment, to avoid polluting the air or water, and to produce safe products. However, the most significant cost-increasing actions will have to be put on a mandatory rather than a voluntary basis to ensure that the burden falls uniformly on all businesses.

D. (2) Is stock price maximization good or bad for society?
The same actions that maximize stock prices also benefit society. Stock price maximization requires efficient, low-cost operations that produce high-quality goods and services at the lowest possible cost. Stock price maximization requires the development of products and services that consumers want and need, so the profit motive leads to new technology, to new products, and to new jobs. Also, stock price maximization necessitates efficient and courteous service, adequate stocks of merchandise, and well-located business establishments--factors that are all necessary to make sales, which are necessary for profits.

D. (3) Should firms behave ethically?
Yes. Most executives believe that there is a positive correlation between ethics and long-run profitability. Conflicts often arise between profits and ethics. Companies must deal with these conflicts on a regular basis, and a failure to handle the situation properly can lead to huge product liability suits and even to bankruptcy. There is no room for unethical behavior in the business world.

E. What three factors of cash flow affects the value of any investment?
The price of a firms stock depends on the size of the firm’s cash flow, the timing of those cash flows, and their risk. The size and risk of the cash flow are affected by the financial environment as well as investment, financing, and dividend policy decisions.

F- What are free cash flows?
Cash flows generated by the operation of the corporation on a defined period, after taxes, after changes in working capital and fixed assets.

G- What is the weighted average cost of capital?
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.

H. How free cash flows and WACC interact to determine a firm’s value?
It has to do with the calculation. Firm’s value is the present value at market price. A firm’s fundamental or intrinsic value is determined by:
Value= FCF11+WACC1+FCF21+WACC2+FCF31+WACC3+…+FCF∞1+WACC∞

I. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?
Households are net savers. Non-financial corporations are net borrowers. Governments are net borrowers, although the U.S. government is a net saver when it runs a surplus. Non-financial corporations are slightly net borrowers, but they are almost breakeven. Capital is transferred through: direct transfer e.g. corporation issues commercial paper to insurance company; an investment banking house e.g. debt placement; or a financial intermediary.
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?
The interest rate is the price paid for borrowed capital, while the return on equity capital comes in the form of dividends plus capital gains. The return that investors require on capital depends on production opportunities, time preferences for consumption, risk, and inflation.
Production opportunities refer to the returns that are available from investment in productive assets: the more productive a producer firm believes its assets will be, the more it will be willing to pay for the capital necessary to acquire those assets.
Time preference for consumption refers to consumers’ preferences for current consumption versus savings for future consumption: consumers with low preferences for current consumption will be willing to lend at a lower rate than consumers with a high preference for current consumption.
Inflation refers to the tendency of prices to rise, and the higher the expected rate of inflation, the larger the required rate of return.
Risk, in a money and capital market context, refers to the chance that a loan will not be repaid as promised, the higher the perceived default risk the higher the required rate of return. Risk is also linked to the maturity and liquidity of a security.

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

The cost of money will be influenced by: Federal policy, Fiscal deficits, Business activity, foreign trade deficits. The cost of money for an international investment is also affected by: Fisher Effect, Country risks that is the risk that arises from investing in a particular country. It depends on the country’s economic, political, and social environment.
When investing in other country, the security usually will be denominated in a currency, so the value of the investment will depend on what happens to exchange rates. Changes in relative inflation or interest rates will lead to changes in exchange rates. International trade deficits/surpluses affect exchange rates. An increase in country risk will also cause the country’s currency to fall.
L. What are some financial securities? Define some financial instruments.
A security is a negotiable instrument representing financial value. Securities are categorized into debt securities like banknotes and bonds; and equity securities. Securities may be represented by a certificate or an electronic form. They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, and stock options.
m. List some financial institutions.
Banks, building societies, credit unions, mortgage loan companies, insurances companies, pension funds, Brokers, investment funds.

n. What are some different types of markets?
Capital Markets: Markets for long term financing.
Money Markets: Markets for short term financing.
Foreign Exchange Market: Markets for trading foreign exchange
Insurance Markets: Markets for distribution of risk.
Commodity Markets: Market for trading commodities
Primary Market: Market for the sale of new securities by corporations.
Secondary Market: Market in which already issued securities are traded among investors.

O. How are secondary markets organized?
The secondary market is the financial market where previously issued securities and financial instruments such as stock, bonds, options are bought and sold. After the initial issuance, investors can purchase from other investors in the secondary market.

(1) List some physical location markets and some computer/telephone networks?
Physical location exchanges include the NYSE, AMEX, CBOT, and Tokyo stock exchange. Computer/telephone networks include Nasdaq, government bond markets, and foreign exchange markets.

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

The NYSE and AMEX are the two largest auction markets for stocks (NYSE is a modified auction, with a “specialist”). Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients; e.g., CBOT. Some orders are market orders, which are executed at the current market price, some are limit orders, which specify that the trade should occur only at a certain price within a certain time period (or the trade does not occur at all). In dealer markets, “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. A computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers. Some examples of dealer markets are the Nasdaq national market, the Nasdaq small cap market, the London SEAQ, and the German Neuer market. ECNS are computerized systems that match orders from buyers and sellers and automatically execute the trades. Some examples are Instinet (US, stocks), Eurex (Swiss-German, futures contracts), sets (London, stocks).

P. Briefly explain mortgage securitization and how it contributed to the global economic crisis?
Mortgage securitization is the pooling of various mortgage loans and their usage as collateral to issue securities. Mortgage securitization allows the originators of the loans to diversify their risk besides enabling them to secure immediate liquidity for assets which would otherwise have faced some difficulty in trading.
The securitization of mortgage loans has emerged as the leading cause of the subprime mortgage crisis.
The problem with securitization stems from the fact that it does not provide protection against systematic risk. And unfortunately, such a systematic risk was also not priced into the subprime mortgage pools. Because investors considered such securities low risk, they leveraged them. In other words they invested more than they actually had capital for. in mid-2007, the losses in the subprime mortgage markets triggered surprising turmoil throughout the international financial system, given the presumed small size of the US subprime market compared to the global financial markets. The crisis spread with amazing speed to other markets and even to financial institutions that had no direct exposure to the subprime mortgage market.

Problems

2-6 Statement of retained earnings

Dividends=780 million+ 50 million- 810 million
Dividends=20 million

2-7 Corporate Tax Liability (calculate tax liability and AT income)

Taxable income: $365,000 - $50,000 + ($15,000 * 0.3) = $319,500

Tax liability: $22,250 + ($319,500 – $100,000) * 0.39 = $107,855

After-tax income: $365,000 - $50,000 + $15,000 - $107,855 = $222,145 Marginal tax rates: 39%

Average tax rates: $107,855 / ($319,000) * 100 = 33.75%

2-9 Corporate After-Tax Yield (muni, corp, PS)
A-T yield on FLA bond = 5%.

A-T yield on AT&T bond = 7.5% - Taxes = 7.5% - 7.5%(0.35) = 4.875%.

Check: Invest $10,000 @ 7.5% = $750 interest.
Pay 35% tax, so A-T income = $750(1 - T) = $750(0.65) = $487.50.

A-T rate of return = $487.50/$10,000 = 4.875%.

A-T yield on AT&T preferred stock:

A-T yield = 6% - Taxes = 6% - 0.3(6%)(0.35) = 6% - 0.63% = 5.37%.