Question

1. What are the two primary instruments corporations issue to raise money? Explain the primary characteristics of each.

2. What is the goal of financial management? What three elements are essential to meeting the goal?

3. One of the key assumptions in finance is that people are risk averse. What do we mean by risk aversion? Does this seem to be a valid assumption? Explain.

4. Explain what is meant by social responsibility and ethics. Discuss how these issues relate to the primary goal of the firm.

Answer 1

1.

The two primary sources of financing for corporations are stocks (equity) and bonds (debt).
STOCKS

Stocks Represent Ownership

Shares of common stocks represent ownership in the company. One share represents a fractional ownership depending on the number of shares outstanding. In simplified terms, if a company issues 100 shares of stock and an investor purchases 10 shares, she would own 10 percent of the company. Real-world corporations issue millions, often billions of shares. However, each one represents a proportional share of the equity in the company.

Voting Rights

Attached voting privileges are a characteristic of most common stocks. Shareholders elect directors, who in turn choose managers who are responsible for the direction of the business. Often, if a corporation is involved in a merger or acquisition, shareholders express opinions on the deals by exercising voting privileges.

Common Stock Value

Hypothetically, the value of stocks has no ceiling. Conversely, the value of a company's stock shares can fall to zero, making the shares worthless. One attractive characteristic of common stocks is the dividend payment. Many companies pay earnings to stockholders in regular dividends. This represents the owner's share of profits earned. In the event a company must liquidate or file bankruptcy, the owners receive only what is left over, if anything, after the company pays creditors and bondholders.

Common Bond Characteristics

Corporations, government agencies, and municipalities issue common bonds that represent loans the bondholders make to a company or organization. The contract accompanying a bond issue details the obligations of the issuer to bondholders and outlines the particular characteristics of the issue, such as the rate of interest.

Convertible and Callable

Some corporate bonds may have a conversion provision that permits the bondholder to exchange the bond for a specified number of shares of the company's stock. A bond may also be callable, meaning the issuer can force the bondholder to redeem before the maturity date.

Bond Rates, Maturity and Value

Bond investors do not receive dividends in the form of company earnings, but instead earn a fixed return, called the coupon rate. Bonds have an expiration date, in investor words, a maturity date when the principal is returned to the investor. The principal is based on the par, or face value of the bond. Bond values are generally known beforehand when calculating future interest rate payments. However, bond values are subject to credit risk based on the financial condition of the issuer and affected by inflation and market interest rates.

2.

The goal of the Financial Manager is to Maximize the Shareholder Wealth (side note — sometimes this is referred to as Maximizing Firm Value since increasing the value of the firm increases shareholder wealth.)

Note that in the 3 factors impacting firm value listed above we use cash flows NOT earnings (net income). While there are many similarities between earnings and cash flows, they are not the same. We should always focus our attention on cash flows instead of earnings. Cash flows are considered more important than earnings for three basic reasons:

• The accrual-based approach of net income accounting can distort the timing of when cash is received or spent. Time value of money recognizes that money spent today is more costly than the same money spread out over years. Therefore, something like depreciation may understate the financial cost of owning assets.
• Generally Accepted Accounting Principles (GAAP) or International Accounting Standards (IAS) allow corporations some flexibility in how they account for revenues and expenses. Firms that choose to aggressively apply GAAP/IAS may mislead shareholders by reporting artificially high earnings. Cash flows are harder to manipulate than net income (earnings).
• Cash is the life-blood of a business. Ultimately, it doesn’t matter if the firm is profitable on an EARNINGS basis if it isn’t generating enough cash to pay its employees, suppliers, creditors, etc. The firm needs to generate positive cash flows in order to maintain its operations.

3.

Risk aversion refers to the idea that investors don’t like risk. All else equal, if two investments have the same expected return investors will choose the one with the least risk. However, risk aversion does not mean investors avoid risk at all costs…only that they need to be paid to take on extra risk. If investors were risk minimizers instead of merely risk averse, the stock market would not exist as investors would not take the risk associated with investing in stocks, regardless of the higher expected return. Investors will take on extra risk, assuming they receive ADEQUATE compensation for doing so.

Does adequate seem like a vague word? It should, because it is intentionally vague.The reason for this is because people have different levels of risk aversion depending on their personality, their age, their income, and several other factors. Some people are highly risk averse (needing significantly higher expected return to take on a little more risk) while others are only mildly risk averse (needing only slightly higher expected return to take on significantly more risk). To summarize:

• We will assume all investors are risk averse
• Risk aversion implies investors do not like risk
• If two investments have the same expected return, investors will choose the one with the least risk
• Risk aversion is NOT risk minimization, investors will take on more risk if they are adequately compensated for that risk
• The level of risk aversion varies from individual to individual

4.

SOCIAL RESPONSIBILITY AND ETHICS

SOCIAL RESPONSIBILITY

Social Responsibility refers to the concept that businesses should be actively concerned with the welfare of society. Examples may include establishing scholarship funds, contributing to the arts, or “matching” employee’s contributions to charities.

ETHICS

Ethics refers to standards of conduct or moral behavior. Examples may include exceeding minimum safety requirements for employees, abiding by (or exceeding) regulations regarding environmental issues, honoring not just the letter, but the spirit of contracts or verbal agreements with customers and suppliers.

Social Responsibility and Ethics are NOT inconsistent with the maximization of firm value. While there is a cost to engaging in ethical and socially responsible behavior, there are often benefits in goodwill and public relations that may more than offset those costs. There is substantial evidence that engaging in Social Responsibility and Ethics is highly consistent with maximizing shareholder wealth. This implies that the overwhelming evidence suggests that corporations behaving in a manner consistent with social responsibility and ethical behavior are likely to either benefit financially or not experience any noticeable financial downside to doing so. In other words, companies that do the right thing will either generate additional financial rewards to shareholders or, at the worst, not cost their shareholders.

However, we must remember that while social responsibility is consistent with our primary goal (maximizing shareholder wealth) it is not the primary goal in and of itself. While it seems wrong to say that a corporation can spend too much money on trying to improve the welfare of society, keep in mind that the owners of the corporation are the stockholders. When a corporation writes a large check to a charitable organization, essentially the managers of the corporation are deciding where and how to spend the stockholders’ money. It would be fairer to let those stockholders decide how to allocate their money.