Question

Principles of Economics by Taylor - Chapter 19

1. What are the most common ways for start-up firms to raise financial capital?
2. Why can't firms just use their own profits for financial capital, with no need for outside investors?
3. Why are banks more willing to lend to well-established firms?
4. What is a bond? What is a junk bond?
5. What does a share of stock represent?
6. When do firms receive money from the sale of stock in their firm, and when do they not receive money?
7. What is a dividend?
8. What is a capital gain?
9. What's the difference between a private company and a public company?
10. How do the shareholders who own a company choose the actual managers of the company?
11. What are the three main concerns of a financial investor?
12. Why are banks called "financial intermediaries"?
13. Name several different kinds of bank accounts. How are they different?
14. Why are bonds somewhat risky to buy, even though they make predetermined payments based on a fixed rate of interest?
15. What's the difference between fundamentals trading and momentum trading?
16. Why should a financial investor care about diversification?
17. What is a mutual fund?
18. What is an index fund?
19. How is buying a house to live in a type of financial investment?
20. Why is it hard to forecast future movements in stock prices?

Answer 1

Q.1) What are the most common ways for start-up firms to raise financial capital?

Firms can raise the financial capital they need to pay for such projects in four main ways:
(1) from early-stage investors
(2) by reinvesting profits
(3) by borrowing through banks or bonds
(4) by selling stock

Early Stage Financial Capital
Profits as a Source of Financial Capital
Borrowing: Banks and Bonds
Corporate Stock and Public Firms
How Firms Choose between Sources of Financial Capital

* Early Stage Financial Capital
When a firm has a record of at least earning significant revenues, and better still of earning profits, the firm can make a credible promise to pay interest, and so it becomes possible for the firm to borrow money. Firms have two main methods of borrowing: banks and bonds.
A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time. If the firm fails to make its loan payments, the bank (or banks) can often take the firm to court and require it to sell its buildings or equipment to make the loan payments.

* Profits as a Source of Financial Capital
If firms are earning profits (their revenues are greater than costs), they can choose to reinvest some of these profits in equipment, structures, and research and development. For many established companies, reinvesting their own profits is one primary source of financial capital. Companies and firms just getting started may have numerous attractive investment opportunities, but few current profits to invest. Even large firms can experience a year or two of earning low profits or even suffering losses, but unless the firm can find a steady and reliable source of financial capital so that it can continue making real investments in tough times, the firm may not survive until better times arrive. Firms often need to find sources of financial capital other than profits.

* Borrowing: Banks and Bonds
When a firm has a record of at least earning significant revenues, and better still of earning profits, the firm can make a credible promise to pay interest, and so it becomes possible for the firm to borrow money. Firms have two main methods of borrowing: banks and bonds.
A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time. If the firm fails to make its loan payments, the bank (or banks) can often take the firm to court and require it to sell its buildings or equipment to make the loan payments.

* Corporate Stock and Public Firms
A corporation is a business that “incorporates”—that is owned by shareholders that have limited liability for the debt of the company but share in its profits (and losses). Corporations may be private or public, and may or may not have stock that is publicly traded. They may raise funds to finance their operations or new investments by raising capital through the sale of stock or the issuance of bonds.

Q.4)What Is a Bond?
A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower.

Bonds are units of corporate debt issued by companies and securitized as tradeable assets.
A bond is referred to as a fixed income instrument since bonds traditionally paid a fixed interest rate (coupon) to debtholders. Variable or floating interest rates are also now quite common.
Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-versa.
Bonds have maturity dates at which point the principal amount must be paid back in full or risk default.

What Is a Junk Bond?
Junk bonds are bonds that carry a higher risk of default than most bonds issued by corporations and governments. A bond is a debt or promises to pay investors interest payments and the return of invested principal in exchange for buying the bond. Junk bonds represent bonds issued by companies that are struggling financially and have a high risk of defaulting or not paying their interest payments or repaying the principal to investors.
Junk bonds are also called high-yield bonds since the higher yield is needed to help offset any risk of default.

A junk bond is debt that has been given a low credit rating by a ratings agency, below investment grade.
As a result, these bonds are riskier since chances that the issuer will default or experience a credit event are higher.
Because of the higher risk, investors are compensated with higher interest rates, which is why junk bonds are also called high-yield bonds.

Q.5) What does a share of stock mean?
A share is the single smallest denomination of a company's stock. So if you're divvying up stock and referring to specific characteristics, the proper word to use is shares. Technically speaking, shares represent units of stock. Common and preferred refer to different classes of a company's stock.

Q. 6) When do firms receive money from the sale of stock in their firm, and when do they not receive money?
A share of stock is basically small portion of ownership which is sold to public or specific people.Now when the stock is first time sold to public through IPO i.e. initial public offering then the firm receives the money from stock sale, but when stocks are sold by one investor to another then company does not receive any money from this transaction as this is a financial transaction between two parties othan the firm.

Q.7) What Is a Dividend?
A dividend is the distribution of some of a company's earnings to a class of its shareholders, as determined by the company's board of directors. Common shareholders of dividend-paying companies are typically eligible as long as they own the stock before the ex-dividend date.Dividends may be paid out as cash or in the form of additional stock.

Key Points
* A dividend is the distribution of some of a company's earnings to a class of its shareholders, as determined by the company's board of directors.
* Dividends are payments made by publicly-listed companies as a reward to investors for putting their money into the venture.
* Announcements of dividend payouts are generally accompanied by a proportional increase or decrease in a company's stock price.

Q.8) What is a capital gain?
Capital gain is denoted as the net profit that an investor makes after selling a capital asset exceeding the price of purchase. The entire value earned from selling a capital asset is considered as taxable income. To be eligible for taxation during a financial year, the transfer of a capital asset should take place in the previous fiscal year.

Financial gains against a sale of an asset are not applicable to inherited property. It is considered only in case of transfer of ownership. According to The Income Tax Act, assets received as gifts or by inheritance are exempted in the calculation of income for an individual.

Buildings, lands, houses, vehicles, Mutual Funds, and jewelry are a few examples of capital assets. Also, the rights of management or legal rights over any company can be considered as capital assets.

Types of Capital Gain
* Depending on the tenure of holding an asset, gains against an investment can be broadly divided into the following types
* Short term capital gain
* Long term capital gain
* Capital gain on Mutual Funds

Q.9) What's the difference between a private company and a public company?

Private vs. Public Company

Privately held companies are—no surprise here—privately held. This means that, in most cases, the company is owned by its founders, management, or a group of private investors. A public company, on the other hand, is a company that has sold all or a portion of itself to the public via an initial public offering (IPO), meaning shareholders have a claim to part of the company's assets and profits.

* Private Companies
The popular misconception is that privately held companies are small and of little interest. In fact, there are many big-name companies that are also privately held—check out the Forbes list of America's largest private companies, which includes big-name brands like Mars, Cargill, Fidelity Investments, Koch Industries, and Bloomberg. While a privately held company can’t rely on selling stocks or bonds on the public market in order to raise cash to fund its growth, it may still be able to sell a limited number of shares without registering with the SEC, under Regulation D.This way, privately held companies can use shares of equity to attract investors. Of course, privately held companies can also borrow money, either from banks or venture capitalists, or rely on profits to fund growth.The main advantage of private companies is that management doesn't have to answer to stockholders and isn't required to file disclosure statements with the SEC.However, a private company can't dip into the public capital markets and must, therefore, turn to private funding. It has been said often that private companies seek to minimize the tax bite, while public companies seek to increase profits for shareholders.

* Public Companies
The main advantage public companies have is their ability to tap the financial markets by selling stock (equity) or bonds (debt) to raise capital (i.e., cash) for expansion and other projects. Bonds are a form of a loan that a publicly held company can take from an investor. It will have to repay this loan with interest, but it won’t have to surrender any shares of ownership in the company to the investor. Bonds are a good option for public companies seeking to raise money in a depressed stock market. Stocks, however, allow company founders and owners to liquidate some of their equity in the company, and relieve growing companies of the burden of repaying bonds.

Key Differences
One of the biggest differences between the two types of companies is how they deal with public disclosure. If it's a public U.S. company, which means it is trading on a U.S. stock exchange, it is typically required to file quarterly earnings reports (among other things) with the Securities and Exchange Commission (SEC). This information is made available to shareholders and the public. Private companies, however, are not required to disclose their financial information to anyone, since they do not trade stock on a stock exchange.

In most cases, a private company is owned by the company's founders, management, or a group of private investors.
A public company is a company that has sold all or a portion of itself to the public via an initial public offering.
The main advantage public companies have is their ability to tap the financial markets by selling stock (equity) or bonds (debt) to raise capital (i.e., cash) for expansion and other projects.

Q.10) How do the shareholders who own a company choose the actual managers of the company?
The company is owned by shareholders and the shareholders choose the actual managers by voting system conducted at the meeting of the shareholders. The actual managers must be able to keep full eye on tasks such as profits, losses and revenues earned by the company.

Q.11) What are the three main concerns of a financial investor?
Here are the 3 main areas of concern in corporate finance that you must be aware of.
Capital Raising. For any business to flourish they need to invest in themselves. ...
Working Capital. Working capital is simply the money that is used on a day to day basis. ...
Capital Budget.

Q.12) Why are banks called "financial intermediaries"?
Those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Thus, banks act as financial intermediaries—they bring savers and borrowers together. An intermediary is one who stands between two other parties.

Q.13) Name several different kinds of bank accounts. How are they different?
The Ultimate Guide to the Different Types of Bank Accounts
Basic Checking Accounts.
Savings Accounts.
Interest-Bearing Checking Accounts.
Money Market Accounts.
CD's.
IRAs (investment retirement accounts)
Brokerage Accounts.

Q.16) What Is a Mutual Fund?
Types of Mutual Funds
Mutual funds in India are broadly classified into equity funds, debt funds, and balanced mutual funds, depending on their asset allocation and equity exposure. Therefore, the risk assumed and returns provided by a mutual fund plan would depend on its type.
We have broken down the types of mutual funds in detail below:

1. Equity funds, as the name suggests, invest mostly in equity shares of companies across all market capitalisations. A mutual fund is categorised under equity fund if it invests at least 65% of its portfolio in equity instruments.
Equity funds have the potential to offer the highest returns among all classes of mutual funds. The returns provided by equity funds depend on the market movements, which are influenced by several geopolitical and economic factors.
The equity funds are further classified as below:
  
a.Small-Cap Funds
b.Mid-Cap Funds
c.Large-Cap Funds
d.Multi-Cap Funds
e.Sector or Thematic Funds
f.Index Funds
h.ELSS {equity-linked savings scheme}

2. Debt Mutual Funds:
Debt mutual funds invest mostly in debt, money market and other fixed-income instruments such as treasury bills, government bonds, certificates of deposit, and other high-rated securities. A mutual fund is considered a debt fund if it invests a minimum of 65% of its portfolio in debt securities.
Debt funds are ideal for risk-averse investors as the performance of debt funds is not influenced much by the market fluctuations. Therefore, the returns provided by debt funds are very much predictable. The debt funds are further classified as below:

a.Dynamic Bond Funds
b.Income Funds
c.Short-Term and Ultra Short-Term Debt Funds
b.Liquid Funds
e.Gilt Funds
f.Credit Opportunities Funds
g.Fixed Maturity Plans

3. Balanced or Hybrid Mutual Funds:
Balanced or hybrid mutual funds invest across both equity and debt instruments. The main objective of hybrid funds is to balance the risk-reward ratio by diversifying the portfolio.
The fund manager would modify the asset allocation of the fund depending on the market condition, to benefit the investors and reduce the risk levels. Investing in hybrid funds is an excellent way of diversifying your portfolio as you would gain exposure to both equity and debt instruments. The debt funds are further classified as below:

a.Equity-Oriented Hybrid Funds
b.Debt-Oriented Hybrid Funds
c.Monthly Income Plans
d.Arbitrage Funds

Key Points
* A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities.
* Mutual funds give small or individual investors access to diversified, professionally managed portfolios at a low price.
* Mutual funds are divided into several kinds of categories, representing the kinds of securities they invest in, their investment objectives, and the type of returns they seek.
Mutual funds charge annual fees (called expense ratios) and, in some cases, commissions, which can affect their overall returns.
* The overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds.

Q.17) What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses, and low portfolio turnover. These funds follow their benchmark index regardless of the state of the markets. Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs) and 401(k) accounts. Legendary investor Warren Buffett has recommended index funds as a haven for savings for the later years of life. Rather than picking out individual stocks for investment, he has said, it makes more sense for the average investor to buy all of the S&P 500 companies at the low cost an index fund offers.

KEY TAKEAWAYS
An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index.
Index funds have lower expenses and fees than actively managed funds.
Index funds follow a passive investment strategy.
Index funds seek to match the risk and return of the market, on the theory that in the long-term, the market will outperform any single investment.

Q.19) Why is it hard to forecast future movements in stock prices?
Growing firms are always in need of financial capital to fulfill their short-term needs or to finance their long-term needs for expansion plans. Firms raises this capital by borrowing money through bonds, securities, shares, etc. Investors invest their money in these financial instrument having different risk and return structures. The business world is full of uncertainty and the price of shares depends upon the performance of the firm. No one can guarantee the performance of the firm or the industry in the future because uncertainties could sway the business in either direction in future. So, it is very difficult to predict the future price movement of stocks.