Question

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 explain the U.S. financial system to DellaTorre.

1. Why is corporate finance important to all managers?

2. 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.

3. How do corporations go public and continue to grow? What are agency problems? What is corporate governance?

4. What should be the primary objective of managers?

   1. Do firms have any responsibilities to society at large?

   2. Is stock price maximization good or bad for society?

   3. Should firms behave ethically?

5. What three aspects of cash flows affect the value of any investment?

6. What are free cash flows?

7. What is the weighted average cost of capital?

8. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?

9. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?

10. What do we call the cost that a borrower must pay to use debt capital? What two components make up the cost of using 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?

11. What are some economic conditions that affect the cost of money?

12. What are financial securities? Describe some financial instruments.

13. List some financial institutions.

14. What are some different types of markets?

15. Along what two dimensions can we classify trading procedures?

16. What are the differences between market orders and limit orders?

17. Explain the differences among dealer-broker networks, alternative trading systems, and registered stock exchanges.

18. Briefly explain mortgage securitization and how it contributed to the global economic crisis

Answer 1

Why is corporate finance important to all managers?

Corporate finance is important to all managers because it allows a manager to be able to predict the funds the company will need for their upcoming projects and think about ways to organize and acquire those funds.

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:

sole proprietorships, partnerships and corporations.

Sole Proprietorship

The simplest and most common form of business ownership, sole proprietorship is a business owned and run by someone for their own benefit. The business’ existence is entirely dependent on the owner’s decisions, so when the owner dies, so does the business.

Advantages of sole proprietorship:

• All profits are subject to the owner
• There is very little regulation for proprietorships
• Owners have total flexibility when running the business
• Very few requirements for starting—often only a business license

Disadvantages:

• Owner is 100% liable for business debts
• Equity is limited to the owner’s personal resources
• Ownership of proprietorship is difficult to transfer
• No distinction between personal and business income

Partnership

These come in two types: general and limited. In general partnerships, both owners invest their money, property, labor, etc. to the business and are both 100% liable for business debts. In other words, even if you invest a little into a general partnership, you are still potentially responsible for all its debt. General partnerships do not require a formal agreement—partnerships can be verbal or even implied between the two business owners.

Limited partnerships require a formal agreement between the partners. They must also file a certificate of partnership with the state. Limited partnerships allow partners to limit their own liability for business debts according to their portion of ownership or investment.

Advantages of partnerships:

• Shared resources provides more capital for the business
• Each partner shares the total profits of the company
• Similar flexibility and simple design of a proprietorship
• Inexpensive to establish a business partnership, formal or informal

Disadvantages:

• Each partner is 100% responsible for debts and losses
• Selling the business is difficult—requires finding new partner
• Partnership ends when any partner decides to end it

Corporation

Corporations are, for tax purposes, separate entities and are considered a legal person. This means, among other things, that the profits generated by a corporation are taxed as the “personal income” of the company. Then, any income distributed to the shareholders as dividends or profits are taxed again as the personal income of the owners.

Advantages of a corporation:

• Limits liability of the owner to debts or losses
• Profits and losses belong to the corporation
• Can be transferred to new owners fairly easily
• Personal assets cannot be seized to pay for business debts

Disadvantages:

• Corporate operations are costly
• Establishing a corporation is costly
• Start a corporate business requires complex paperwork
• With some exceptions, corporate income is taxed twice

Limited Liability Company (LLC)

Similar to a limited partnership, an LLC provides owners with limited liability while providing some of the income advantages of a partnership. Essentially, the advantages of partnerships and corporations are combined in an LLC, mitigating some of the disadvantages of each.

Advantages of an LLC:

• Limits liability to the company owners for debts or losses
• The profits of the LLC are shared by the owners without double-taxation

Disadvantages:

• Ownership is limited by certain state laws
• Agreements must be comprehensive and complex
• Beginning an LLC has high costs due to legal and filing fees

How do corporations go public and continue to grow?What are agency problems? What is corporate governance?

A corporation can go public through an initial public offering (IPO) allowing anyone to purchase shares ofthe company on open stock exchanges. A company continues to grow by demonstrating increasing value.Value is continued generation of cash flows and/orconsistently decreasing the cost of capital.

Agency problem is the plausible conflict of interest that might exist between management andstakeholders. Meaning there must be measures in place to prevent management from acting on behalf oftheir own interests, and not on behalf of the owners. Some methods can consist of offering stock optionsto management incentivizing growth.

Corporate governance is the “set of rules that control the company’s behavior towards its directors,managers, employees, shareholders, creditors, customers, competitors, and community.”

What should be the primary objective of managers?

The primary objective of the manager is to please the stockholder by maximizing stockholder wealth.

Is stock price maximization good or bad for society?

Stock price maximization is the goal to increase publicly traded stock prices as high as possible. The increase of a stock price itself has no moral groun The decisions that management might make in the effort to achieve stock price maximization could be bad or good for society. An economist would argue increasing stock prices can increase the purchasingpower of a nation as well as standards of living effectively benefiting society. Or the economist could be smart and not argue this and keep it to himself.“The actions that maximize intrinsic stock value also benefit society by (1) To a large extent, the owners of stock are society. (2) Consumer benefits. (3) Employee benefits.

Should firms behave ethically?

Yes, it is in a corporation’s best interests to behave ethically. In a global economy where corporations areanswerable to the court of public opinion acting unethically can easily result in bankruptcy, or the lesserdamaging of brand equity.

What three aspects of cash flows affect the value of any investment?

(1) Sales revenues, (2) operating costs and taxes,and (3) required new investments in operating capital.

What are free cash flows?

“Free cash flows (FCFs) are the cash flows available for distribution to all of a firm’s investors(shareholders and creditors) after the firm has paid all expenses (including taxes) and has made therequired investments in operations to support growth.”

What is the weighted average cost of capital?

The weighted average cost of capital is the rate of return required by investors. The lower the weighted average cost of capital is, potentially, the more valuable a company is.

How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?

The greater the free cash flows, and the lower the weighted average cost of capital is the more acompany is valued. Free cash flows are divided by the WACC to determine a company’s value. Who are the providers (savers) and users (borrowers)of capital? How is capital transferred between savers and borrowers?

“In aggregate, individuals are net savers... non financial corporations are net borrowers in the aggregate.” There are three ways savers transfer money to borrowers:

Direct transfers of money and securities. Indirect transfers often times throughinvestment banks underwrite financial instruments on behalf of borrowers and sell them to savers. Lastly, financial intermediaries, such as banks or mutual funds transfer money from savers to borrowers simply by performing profitable business.

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

The price that a borrower must pay for debt capital is the interest rate. The price of equity capitalis calledthe cost of equity, “and it consists of the dividends and capital gains stockholders expect.”

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

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

The economic conditions (including international aspects) that affect the cost of money are: “(1)Federal Reserve policy; (2) the federal budget deficit or surplus; (3) the level of business activity;and (4) international factors, including the foreign trade balance, the international business climate, and exchange rates.”

What are financial securities? Describe some financial instruments.

Financial securities are instruments that are sold by financial institutions to variety of clients, institutional,retail, private, and otherwise. Financial securities can be generalized into three different types (1)debt,(2) equity, (3) derivatives.

Some financial instruments are: Treasury bills, certificates of deposits (cd’s), and money market accounts are all lower interest (rate of return) instrumentswhich are low risk and can be FDIC insured guaranteeingno loss of principal.Mortgages, Muni Bonds, Corporate bonds, consumer credit cards, and commercial loansAnd the most common type of equity is common stocks

List some financial institutions

Some U.S. financial institutions: Bank of America,Citibank, JP Morgan Chase, Goldman Sachs, FannieMae, Freddie Mac, Fidelity, Janus, Vanguard, E-trade, Calpers, Federal reserve, AIG, and AmericanExpressSome international financial institutions: Barclays, Banco Santander, DeutchBank,ScotiaBank,Westpac,BNPParibas, BNL Italia, and China Construction Bank.

Financial institution types: Investment banks and brokerages, Savings and Loans Associations, Credit Unions, Commercial banks, Mutual Funds, Hedge Funds, Private equity funds, Life Insurance and Pension funds, and Regulatory Agencies. What are some different types of markets?Physical asset markets, spot markets and futures markets, money and capital markets, mortgage marketsand consumer credit markets, world, national, regional, and local markets, primary markets, secondary markets, and private markets and public markets.

How are secondary markets organized?

Secondary markets are either physical locations like the New York Stock Exchange, and the CBOT(Chicago Board of Trade) or computer/telephone networks like the Nasdaq. Secondary markets are open out cry or auction systems where buyers and sellersare matched together to create deals at agreed upon prices. Additionally dealer markets, and electronic communications networks (ECN) are secondary markets where market orders are fulfilled electronically.

List some physical location markets and some computer/telephone networks.

Some physical location markets are: the New York Stock Exchange, the American Stock Exchange(AMEX), and the Chicago Board of Trade (the CBOT).Some computer/telephone networks are: Instinet, Archipelago, and Eurex.

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

Open outcry auctions are physical location exchanges where traders actually meet in a pit and sellers and buyers communicate with one another through shouts and hand signals.Dealer markets are run by “market makers” who keep inventory of stock (or other financial instruments) by listing bids and ask quotes given a spread given the speed at which the market is moving (wider the spread, the faster the market is moving); however,computerized systems keep trade of traders the“market maker” matches traders.Electronic communications networks are automatic trading networks where buyers and sellers are marched immediately.

Briefly explain mortgage securitization and how it contributed to the global economic crisis.

The global economic crisis can be broken into threeparts just like anything: (1) beginning, (2) middle, and(3) end. First sub-prime standards were established in the mid-1990s allowing for less than credit worthy borrows to start purchasing homes. With lower fundamental loan standards in lending risk exposure in mortgage securitization became prevalent.Mortgage securitization is when investment bank packages a group of loans together and sells them asinvestments. Unfortunately institutional investors did not perform due diligence and even retail investors invested in products they did not understand. The most common form of mortgage securitization and theform which had the most meaningful part in the global crisis were CDO’s.CDO’s or collateralized debt obligations began to flourish in all shapes, sizes, and risk tolerances.This provided the framework for the failure to cause global ramifications. Lastly, the end, with six factors (1)low rates, (2) high risk, (3) incentives to drive short-sided business, (4) over-valued appraisals, (5)conflicts of interest in regulatory bodies, and (6)insurance companies not appropriately hedging risk all contributed to the global economic crisis.