Mini Case: Corporate Finance And Financial Securities

MINI CASE a. Why is corporate finance important to all managers? Corporate finance is important to all managers because it provides managers the skills needed 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.

The organizational forms a company might have as it evolves from a start-up to a major corporation are proprietorship, partnership, or corporation. The advantages of a proprietorship are: •Easy and inexpensive to form, •Subject to few government regulations, and •Income not subject to corporate taxation. The disadvantages of a proprietorship are: •May be difficult to obtain the capital needed for growth, •Unlimited personal liability for the businesses’ debts, and •Limited to the life of its founder. The advantages of a partnership are: •Relatively easy to establish, •Increased ability to raise funds, Prospective employees become attracted to the business if given the incentive to become a partner, •May benefit from the combination of complementary skills of two or more people, •Can be cost effective, and •Provide moral support and will allow for more creative brainstorming. The disadvantages of a partnership are: •Partners are jointly and individually liable for the actions of the other partners, •Profits must be shared, •Disagreements can occur, •May have limited life, •Has limitations that keeps it from becoming a large business, •Partners have to consult with each other before making decisions, and •Unlimited liability.

The advantages of a corporation are: •Unlimited life, •Easy transferability of ownership interest, and •Limited liability. The disadvantages of a corporation are: •Earnings may be subject to double taxation, and •Complex and time-consuming set up. 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 selling stock to outsiders or venture capitalists, attracting lending from banks or raising additional funds through an initial public offering (IPO) by selling stock to the public at large.

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Agency problems are conflicts of interest arising between creditors, shareholders and managers because of differing goals. Corporate governance is the relationship between all the stakeholders in the company. d. What should be the primary objective of managers? The primary objective of managers is stockholder wealth maximization, which means to maximize the fundamental price of the firm’s common stock and not just the current market price. 1)Do firms have any responsibilities to society at large? Yes, firms have responsibilities to society at large.

Corporate social responsibility is operating a business in a manner that accounts for the social and environmental impact created by the business. This means a commitment to developing policies that integrate responsible practices into daily business operations and to reporting on progress made toward implementing these practices. 2)Is stock price maximization good or bad for society? Stock price maximization is good for society. Shareholders are members of society. Consumers benefit when companies develop products and services that consumers want and need, which leads to new technology and new products.

Employees benefit generally when companies successfully increase stock prices, it opens up growth and addition for more employees. 3)Should firms behave ethically? Yes, firms should behave ethically. There is no room for unethical behavior in the business world. 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. Failure to handle these situations properly can lead to huge product liability suits and even bankruptcy. e.

What three aspects of cash flows affect the value of any investment? The three aspects of cash flows the affect the value of any investment are the amount of expected cash flows, the timing of the cash flow stream, and the risk of the cash flows. f. What are free cash flows? Free cash flows are the monies available for distribution to all investors after paying current expenses, taxes, and making the investments necessary for growth. g. What is the weighted average cost of capital? The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets. . How do free cash flows and the weighted average cost of capital interact to determine a firm’s value? Free Cash Flow = Sales Revenues – Operating Costs and Taxes – Required Investments in Operating Capital. Weighted Average Cost of Capital (WACC) is affected by market interest rates, market risk aversion, cost of debt, cost of equity, firm’s debt/equity mix, and firm’s business risk. Therefore, free cash flows and the weighted average cost of capital interact to determine a firm’s value by the following equation: Value=FCF1+FCF2+ … +FCF00 (1 + WACC)1(1 + WACC)2(1 + WACC)00 i.

Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers? Households and some foreign governments are the providers (savers) of capital. Non-financial corporation’s net users and U. S. governments are users (borrowers) of capital. Financial corporations are slight users (borrowers), but almost breakeven. Capital is transferred between savers and borrowers by direct transfer, through an investment banking house, or through 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 price that a borrower must pay for debt capital is called the interest rate. The price of equity capital is the cost of equity equals required return equals dividend yield plus capital gains. The four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy are production opportunities, time preferences for consumption, risk, and expected inflation. k. What are some economic conditions (including international aspects) that affect the cost of money?

Some economic conditions (including international aspects) that affect the cost of money are country risk and exchange rate risk. Country risk depends on the country’s economic, political, and social environment. Exchange rate risk is dependent on the non-dollar denominated investment’s value. l. What are financial securities? Describe some financial instruments. Financial securities are pieces of paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values. Some financial instruments are: •U. S. Treasury Bills ­Sold by U. S.

Treasury ­Default-free risk ­91 days to one year – original maturity •Money Market Mutual Funds ­Invest in short-term debt; held by businesses and individuals ­Low degree of risk ­No specific maturity (instant liquidity) •Consumer Credit Loans ­Loans by banks/credit unions/finance companies ­Risk is variable ­Original maturity is variable •U. S. Treasury Notes and Bonds ­Issued by U,S, government ­No default risk, but price falls if interest rate rises ­2-30 years – original maturity •Municipal Bonds ­Issued by state and local government to individuals and institutions ­Riskier than U. S. overnment guides, but exempt from most taxes ­Up to 30 years – original maturity m. List some financial institutions. Some financial institutions are commercial banks, investment banks, savings and loan, mutual savings bands, credit unions, life insurance companies, mutual funds, pension funds, and hedge funds and private equity funds. n. What are some different types of markets? Some different types of markets are physical asset markets, financial asset markets, spot markets, future markets, money markets, capital markets, mortgage markets, consumer credit markets, and world, national, regional and local markets. . How are secondary markets organized? Secondary markets are organized by location and the way that orders from buyers and sellers are matched. 1)List some physical location markets and some computer/telephone networks. Some physical locations markets are New York Stock Exchange, the American Stock Exchange (AMEX), the Chicago Board of Trade (CBOT), and the Tokyo Stock Exchange. Some computer/telephone networks are NASDAQ, government bond markets, and foreign exchange markets. 2)Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNs).

Auction markets are markets where participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients. The two largest auction markets for stocks are the New York Stock Exchange and the American Stock Exchange. The New York Stock Exchange is a modified auction with a “specialist. ” Dealer markets are markets where “dealers” keep an inventory of the stock (or other financial assets) and place bids and ask “advertisements”, which are prices at which they are willing to buy and sell. There are often many dealers for each stock.

A computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers. Examples of dealer markets are the NASDAQ National Market, NASDAQ Small Cap Market, London SEAQ, and German Neuer Market. Electronic communication networks (ECNs) are computerized systems that match orders from buyers and sellers and automatically execute the transaction. It is a low cost to transact. Examples of ECNs are Instinet (U. S. stocks owned by NASDAQ), Archipelago (U. S. stocks owned by NYSE), Eurex (Swiss-German futures contracts), and 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. This process allows the originator of the mortgage loans to restructure its balance sheet by reducing the receivables and using the funds received from the sale of securities to invest elsewhere. 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 face some difficulty in trading. http://www. economywatch. com/finance/high-finance/mortgage-securitization. html) Mortgage securitization contributed to the global economic crisis in many ways. •Homeowners wanted better homes than they could afford. •Mortgage brokers encourage homeowners to take mortgages even though they would reset the payments to amounts that the borrowers might not have been able to afford because the brokers got a commission for closing the deal. •Appraisers were over-appraising house values and getting paid at the time of the appraisal. •Originating institutions (e. . , Countrywide) were quickly selling the mortgages to investment banks and other institutions. •Investment banks created CDOs and got rating agencies to help design and then rate the new CDOs with rating agencies making big profits despite the conflicts of interest. •Financial engineers used unrealistic inputs to generate high values for the CDOs. •Investment banks sold the CDOs to investors and made big profits. •Investors bought the CDOs but either didn’t understand or didn’t care about the risk. •Some investors bought “insurance” via credit default swap. When the mortgages were reset and the borrowers defaulted on them, the values of the CDOs plummeted. •Many of the credit default swaps failed to provide insurance because the counterparty failed. •Many originators and securitizers still owned sub-prime securities, which led to many bankruptcies, government takeovers, and fire sales including New Century, Countrywide, Fannie Mae, Freddie Mac, and many more. PROBLEMS (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? Dividends Paid= (Previous Retained Earnings + Net Income) – Recent Retained Earnings = ($780 million + $50 million) - $810 million = $830 million - $810 million = $20 million (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 income tax liability and its after-tax income? What are the company’s marginal and average tax rates on taxable income? Taxable Income$365,000 Less: Interest Charges(50,000) Plus: Dividends Received4,500? $15,000(1 – 0. 70) = $4,500 Total Taxable Income$319,500 Tax Liability= $22,250 + ($319,500 - $100,000)(0. 39) = $22,250 + ($219,500)(0. 39) = $22,250 + $85,605 = $107,855 After-Tax Income: Total Taxable Income$319,500 Less: Tax Liability(107,855) Plus: Non-taxable Dividends Received10,500? 15,000(0. 70) = $10,500 Net Income$222,145 Marginal Tax Rate = 39% Average Tax Rate= Tax Interest Income/Taxable Operating Income = $107,855/$319,500 = 0. 33757 or 33. 76% (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%. Shrieve’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. AT&T Bonds - $10,000 x 7. 5% = $750 Taxes = $750 x 35% = $262. 50 $750 - $262. 50 = $487. 50 AT&T Bond Yield = $487. 50/$10,000 = 0. 04875 or 4. 875% AT&T Preferred Stock - $10,000 x 6% = $600 Tax Exemption = $600 x 70% = $420 Taxable Income = $600 - $420 = $180 Taxes = $180 x 35% = $63 $600 - $63 = $537 AT&T Preferred Stock Yield = $537/$10,000 = 0. 0537 or 5. 37% Florida Muni Bonds - $10,000 x 5% = $500 Not taxable, so no tax deductions Florida Muni Bonds Yield = $500/$10,000 = 0. 05 or 5%

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