Why is corporate finance important to all managers?
Corporate finance helps provide the managers with the skills and knowledge required to identify and analyze the corporate strategies and options possible. The managers can analyze and study how a strategy or a project pr process can help increase value of the firm. They can also run cost benefit analysis, net present value etc of future ventures to understand their suitability in the business. The funding requirement and capital structure of firms can be reviewed and understood, and future funding strategies can also be formulated with the help of knowledge of corporate finance.
So the overall functionality and profitability of the company can be better understood with such skills and knowledge. 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. An organization may undergo various stages in the business life cycle as it grows and expands. A business could start as a start up proprietorship. This form has three advantages, these are: the organization can be formed with ease and in an inexpensive manner.
The government regulations subjected to this form are also lower, also they are not subjected to corporate taxes, but
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A partnership agreement would entail all the details of the terms and conditions, partnership ratio, ownership ratio etc. the advantages and disadvantages of this form are much alike that of a proprietary business. In case of liability both the partners are liable for the debts. However to limit the liability a partner may chose to opt for limited partnership, but this would mean that these partners would have lesser controls than the general ones. Due to the constraint in capital, it is found that organizations turn into corporations to move ahead and grow further.
A corporation is an entity formed by state law and which has distinct existence. So there are three major advantages of this form: firstly the life of such an association is not limited to the decease of the owners, secondly the ownership interest can be easily transferred in the form of shares and stocks and lastly, the liability is limited to the fund invested. While the disadvantages of the forms are that the earnings may be taxed twice, once at the corporate level then again as tax on dividend which is received by the stockholders, as it would be gain to them.
Also setting a charter to form an organization, setting bye laws and filing for all the reports and documentation required by the state and federal government is a complex work. c. How do corporations go public and continue to grow? In the initial phase when a business is set up by a person all the financing is done by him on a personal basis. But as the firm grows it needs larger resources to set up the infrastructure required i. e. factory, machinery, inventory, workforce etc.
most times external funding is required when this phase is arrived at, so external investors such as friends, family, private investors and venture capitalists are approached. If the firm is seen to have a notable growth then they approach banks or raise funds by selling stocks to the general public. This is known as the initial public offering. Post an IPO firms can sell more shares or bonds or raise bank loans to help the firm grow further. Thereby with the help of the financial market the organization can grow provided it has its core capabilities to create a sustainable advantage in the industry. Match each of the international organizations below with one of its functions
What are agency problems? What is corporate governance? Corporations are large entities which have an individual existence; due to complexity of the functions and high volume, they cannot be run single handed by the owner. So there are managers who take care of various functions and business processes. These managers have been hired by the company so they may act in their own best interest rather than consider that of the corporation. This problem which arises between the management and the owners due to difference of interest is the agency problem.
Agency problem can hinder the performance of a company and also its financial decisions. The corporate governance is used by most firms these days to the organizations run with the best interest of all stakeholders in mind. Corporate governance is a set of rules and regulations which steer an organizations control, administration and behavior towards its stakeholders (managers, employees, customers, shareholders, competitors and society at large. d. What should be the primary objective of managers? The management primary objective is wealth maximization for stockholders.
The manager should formulate policies that increase the wealth of shareholders. A manager’s objective is to thereby maximize “fundamental price” of an organization’s stocks and shares. Do firms have any responsibilities to society at large? Organizations have a great responsibility towards the society at large. The society is among the major stakeholders of a company so it is important that a company fulfills its corporate social responsibilities. The firm should provide a safe business environment, to control pollution, and manufacture safe products. Is stock price maximization good or bad for society?
Stock price maximization is a good thing for society as they are also stakeholders of the organization. However if the company is involved in any illegal methods such as accounting frauds, violating rules and regulations or not meeting environmental norms, then it has negative impact on the society. Other than unethical methods stock price maximization proves to be good for the society because of the following reasons: With the growth of pension funds, mutual funds and insurance companies, many people have a stake in the share markets. So they are directly or indirectly related to the price maximization, and benefit from it.
Price maximization is resulted by efficient and low cost processes and high quality inputs at a value price for customers. So the end customers are benefited by the actions taken to bring forth price maximization. Again a management looking forth to a price increase would try and enhance sale and create customer satisfaction so the customer is always benefited through the initiative. Most companies which look at maximizing price retain its employees, and also study shows that these are the companies which treat its human resource well. So the stock price maximization initiative helps the employees as well.
There by it is positive for the society at large. (3) Should firms behave ethically? Yes, firms should behave ethically. Business ethics is the attitude and code of conduct which is followed by an organization. It entails the way a company behaves to all its stakeholders, customers, employees, community, stockholders etc. a firm which makes an initiative to bide by rules and regulations and work keeping in mind all moral standards have been recognized by the society and business arena over the years. These firms create goodwill for themselves and thereby have a sustainable advantage over its competitors.
An ethical company also attracts and retains the talent pool which is essential for every organization’s success. So a firm should behave responsibly. e. What three aspects of cash flows affect the value of any investment? The three basic aspects of a cash flow that affect the value of any investment are: • The financial asset is only as valuable as the cash flow it generates, so a financial asset that generates higher cash flow will be preferable by investors. • The time when the cash flow is generated is important. Any cash flow which takes place sooner is beneficial • Investors are risk averse by nature.
So they will pay a higher amount for a stock whose cash flows are less risky. Thereby more the certainty of the cash flow, the higher the probability that investors would invest in it. f. What are free cash flows? Free cash flows are those cash flows that are available for distribution. If the cash flow is available for disbursement among creditors and stockholders, then it is known as free cash flow. Free cash flow depends on three factors, sales revenue, operating cost and required investment. FCF= sales revenue- operating cost-operating tax- required investment in operating capital g.
What is the weighted average cost of capital? The risk affiliated to a firm’s operation and investors’ attitude towards the risk involved help determine the rate of return which the investors would require. This rate is termed as the weighted average cost of capital, as it is a cost from the investors point of view. WACC depends on various factors such as capital structure, interest rates, firm’s risk etc. h. How do free cash flows and the weighted average cost of capital (WACC) interact to determine a firm’s value? A firm’s value is the present value of its free cash flow, discounted at WACC.
If all relevant information is reflected in the market price, then the intrinsic value is same as the observed value. The relation between weighted average cost of capital and free cash flows is specified through the equation given below: Page 12 I. Who are the providers (savers) and users (borrowers) of capital? Business and firms of any form need funds and capital to run their business successfully. Funds and capital is required for building infrastructure in any country and so capital and funding is required for it as well. Individuals also require funds and loans for the buying homes, cars etc.
so the borrower can be an institution looking for further growth or an individual person seeking to satisfy his personal needs and wants. However, non-financial organizations are the primary borrowers and so are federal, local and state governments. Banks on the other hand raise funds from individuals (savings account) and then invest it with others. Financial organizations also borrow and invest the raise amount itself. Cumulatively speaking household owners are the primary savers and are providers of capital. How is capital transferred between savers and borrowers?
The transfer of capital between the saver and borrowers can occur in three ways. Direct transfer is where the business sells shares or bonds to the saver. The involvement of a financial institution is absent. The savers in return for the stocks provide money to the businesses. The other form is indirect transfer, in which a middleman or an underwriter facilitates the issue of the securities. Here the sale of securities takes place through the middleman. First the shares or bonds are sold to the investment bank or underwriter, who then sells the same securities to savers. This is a primary market transaction.
The third form of transfer is made through a financial intermediary. The intermediary could be a bank or a mutual fund. The funds are collected from the savers by the intermediary, and in exchange he offers the savers shares of his own securities. Later the intermediary purchases shares of the businesses with the money that he received from the saver. Thus a new form of capital is created. j. What do we call the price that a borrower must pay for debt capital? What is the price of equity capital? The price that a borrower must pay for debt capital is the interest rate, while the price of equity capital is called the return on equity capital.
The return on equity is given in form of dividend and capital gains. What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? The four most fundamental factors that affect the cost of money are: production opportunities, time preferences for consumption, risk and inflation. Production opportunities mean the ability to convert capital into benefits. So the expected rate of return that is available from productive assets is known as production opportunities.
The more productive the producer believes the opportunity to be, the higher price he will be willing to pay for the assets. Time preferences for consumption is the inclination a consumer has to the time of consumption that is whether the person wants to invest now or in the future. Those with low preference for current use will lend at lower rate. Inflation is the propensity for the price to increase, the higher the inflation, the more the required rate. Risk refers to the chance that the future inflow may not be as expected; the higher the risk, the higher the rate of return. k.
What are some economic conditions (including international aspects) that affect the cost of money? Economic conditions that that affect the cost of money are: Federal Reserve policy: the money supply of a nation has a great affect on the inflation rate as well as influences all its activities. If the federal policy increases the growth in money supply, then the interest rate would lower. But a long term effect may be an increase in inflation which would cause the interest rates to rise. Federal budget deficit or surplus: if the government spending is greater than the tax collected, then it runs in a deficit.
This deficit has to be covered by increase in money supply or borrowing of funds. If the government borrows then the rate of interest would rise. Business activity: During crisis situation organizations reduce wage inflation and lower hiring, the consumer spending there fore decreases. So inflation falls and so does the interest rate. The cash has more loan able funds which are lend out at lower rates. International trade deficit or surplus: with the advent of globalization countries are found to sell and purchase from various countries across the globe. If the purchase is higher than the sales, then the trade deficit is existent.
This amount again needs to be covered through borrowing, thus the interest rates rise up. International country risk: country risk is the risk associated with conducting a business in a particular country. The social, economic and political environment plays a large role in defining the country risk. The country risk may increase the cost of capital significantly. International exchange rate risk: international funds are subjected to the exchange risk fluctuations, so exchange rate risk is found. Performance of a security and exchange rates thereby derive the value of a security which is being traded internationally.
l. What are financial securities? Financial securities are negotiable instruments and have financial value. The financial securities can be of many forms and will have the ability to generate return on the face value for the holder of the security. A financial security has contractual obligation. Describe some financial instruments. There are various types of financial instruments. The primitive ones claim the cash flow. Common examples of such instruments are stocks and bonds; while derivates value is derived from the value of an underlying security or asset.
Common examples of derivatives are future, forwards, options etc. some short term instruments are treasury bills, commercial paper, CD etc. mortgages, corporate bonds, commercial loans, and municipal bonds are among the many financial instruments. m. List some financial institutions. Some financial institutions are: Investment banking houses, Commercial banks, Financial, services corporations, Savings and loan associations, Mutual savings bank, Credit unions, Life insurance companies, Mutual funds, Traditional pension funds and hedge funds n. What are some different types of markets?
There are different types of markets based on the security type or region served. Some of the financial markets are: physical asset market, spot market, future market, money market, mortgage market, world, national, regional and local market, private market and primary and secondary market. o. How are secondary markets organized? Secondary markets are of different types depending on location (physical and computer/telephone network) and the mechanism for matching offers from buyers and sellers (open outcry auction, dealers and electronic communication network).
(1) List some physical location markets and some computer/ telephone networks. Physical location exchanges are transactions are made on the trading floor by outcry that is verbal bids and offers are entered by traders. This happens in some stock and commodity exchange. The computer/ telephone networks are virtual exchanges where all the trade is done electronically on the computer through traders. Physical location markets aid communication between buyers and sellers of financial instruments. They are physical entity establishes at a particular place and is governed by a board.
A computer/ telephone network help all the transactions take place which are not conducted at a physical location exchange. They facilitate communication between buyer and sellers. Examples of physical location markets or exchanges are CBOT, AMEX, NYSE and computer/ telephone networks are NASDAQ, Foreign exchange markets etc. (2) Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNs). Open outcry auctions have the buyer and seller standing face to face, so they both state their price to buy and sell.
So the matching of trade price takes place. In dealers market, the dealer has the securities as part of his inventories and he offers to sell or buy them. Those who want to trade can see the offers made by the dealer and then transact with the dealer he chooses. In electronic communications networks, the offers from buyers and sellers are matched automatically. The transaction is not manually done; it is completely automatic in nature. Reference: Brigham F. Eugene, Michael C. Ehrhardt, 2008, Financial management: theory and practice, 12th Edition, Thompson South Western, USA