Mini Case (p. 45)

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.

  • Why is corporate finance important to all managers?Corporate finance helps in making long-term investments or long term financing for investment by a company. It directs the company towards profits and shareholder profit maximization. It helps in addressing question related to the firm’s long-term investments, long-term financing to support its long-term investments and working capital management. It enables the financial manager to control the financial situation in their companies.


  • 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.


Many companies begin as a proprietorship, which is an unincorporated business owned by one individual. Some companies start with more than one owner, and some proprietors decide to add a partner as the business grows. A partnership exists whenever two or more persons or entities associate to conduct a non-corporate business for profit. The proprietorship has three important advantages: (1) it is easily and inexpensively formed, (2) it is subject to few government regulations, and (3) its income is not subject to corporate taxation but is taxed as part of the proprietor’s personal income. Proprietorship firm have difficulty procuring funds, and the owner has an unlimited liability if the company fail. In that situation, partnerships can ease the burden if the business should fail. A partnership’s advantages and disadvantages are generally similar to those of a proprietorship. Although the liability is still unlimited with this type of business, it may be split amongst the owners. Most partnerships have difficulty attracting substantial amounts of capital. Thus, many companies begin as a proprietorship or partnership, but at some point they decide to convert to a corporation. Corporations have a very long life and are easy to transfer over to new owners. One of the big advantages is that they have limited liability. On the downside, there are more government regulations and taxes on corporations. A corporation can continue after its original owners and managers are deceased. There is an easy transferability of ownership interest and there is limited liability as losses are limited to the actual funds invested.

How do corporations go public and continue to grow? What are agency problems? What is corporate governance?Going public helps the companies to diversify. By selling some of their stock in a public offering, founders can diversify their holdings, thereby reducing the riskiness of their personal portfolios. A company can go public by offering an IPO (initial public offer). Stocks are a way it can raise capital, but it usually must pay dividends back. Sometimes, managers act in their own best interests, rather than in the best interests of the stockholder/owners. This situation is called an agency problem. Agency problems can be addressed by a company’s corporate governance, which is the set of rules that control the company’s behaviour towards its directors, managers, employees, shareholders, creditors, customers, competitors, and community.


  • What should be the primary objective of managers?


  1. Do firms have any responsibilities to society at large?Firms are responsible to stockholders of the company and the firm has to meet the objective of shareholder’s wealth maximization. Companies are also responsible to other stakeholder’s e.g. public, society at large, environment. There are government rules and regulations which require business to be environmentally conscious, to be ethical in business practices, to ensure equal employment opportunity and fair wages to its employees, to be socially responsible and carry out employee welfare.
  2. Ans:    Is stock price maximization good or bad for society?The owners of stock are people in the society. Most members of society now have an important stake in the stock market, either directly or indirectly. Therefore, when a manager takes actions to maximize the stock price, this improves the quality of life for millions of ordinary citizens. Stock price maximization requires efficient, low-cost businesses that produce high-quality goods and services at the lowest possible cost. This means that companies must develop products and services that consumers want and need, which leads to new technology and new products. Also, companies that maximize their stock price must generate growth in sales by creating value for customers in the form of efficient service, adequate stocks of merchandise, and well-located business establishments. Companies that successfully increase stock prices also grow and add more employees, thus benefiting society.
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  4. Should firms behave ethically?Illegal and unethical practices can lead to bankruptcy for the company. This is one of the main reasons why firms should behave ethically. When conflicts arise between profits and ethics, sometimes legal and ethical considerations make the choice obvious. It is true that the focus must be stockholder wealth maximization, but Companies should look after the interests of society and other stakeholders of the society at large. Proper ethical practices, corporate governance and stockholder wealth maximization go hand in hand in the long run.
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  • What three aspects of cash flows affect the value of any investment?Three aspects of cash flow that affect the value of any investment are:


  1. (1) Amount of cash – any financial asset, including a company’s stock, is valuable only to the extent that it generates cash flows; (2) the timing of cash flows matters—cash received sooner is better; and (3) Risk – investors are averse to risk, so all else equal, they will pay more for a stock whose cash flows are relatively certain than for one whose cash flows are more risky. Because of these three facts, managers can enhance their firm’s value by increasing the size of the expected cash flows, by speeding up their receipt, and by reducing their risk.
  2. Ans:   
  • 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 the required investments in operations to support growth.


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  • What is the weighted average cost of capital?The weighted average cost of capital (WACC) is the average return required by all of the firm’s investors. It is determined by the firm’s capital structure (the firm’s relative amounts of debt and equity), interest rates, the firm’s risk, and the market’s attitude toward risk.
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  • How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?


  1. Ans:   

The value of a firm depends on the size of the firm’s free cash flows, the timing of those flows, and their risk. A firm’s fundamental, or intrinsic, value is defined by


Firm’s Value = FCF1/(1 + WACC) + FCF2/(1 + WACC)^2 + … + FCFn/(1 + WACC)^n + …, where WACC is the weighted average cost of capital and FCFi for i = 1, 2, 3, … is the expected free cash flow i years from the present.


  • Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?The net providers in an economy are households, who are net savers, and corporations are net borrowers (users). Capital is transferred through direct transfers, investment banking houses, financial intermediaries and others.


  • 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 the interest rate. The return on equity capital is the dividends and capital gains. The four most fundamental factors are production opportunities, time preferences for consumption, risk, and inflation.


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


  1. Ans:   

Economic conditions and policies 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. If the expected rate of return on an investment is risky, then providers require a higher expected return to induce them to take the extra risk, which drives up the cost of money. Inflation also leads to a higher cost of money.


  • What are financial securities? Describe some financial instruments.


  1. Ans:   

Securities are financial instruments which are backed up by physical assets. Some types of financial securities are debt securities, such as paper money and bonds; equity securities such as stocks, and derivative contracts – forwards, futures, options, swap etc.


  • List some financial institutions.


  1. Ans:   

Life Insurance Companies, Pension Funds, Savings and Loan Institutions, investment banking houses, insurance companies, pension plan operations, mutual funds and Banks.

 What are some different types of markets?


  1. Ans:   

Different types of markets are:

(1) physical asset markets and financial asset markets, (2) spot and futures markets, (3) money and capital markets, (4) primary and secondary markets, and (5) private and public markets.

 How are secondary markets organized?

Secondary markets are organized by their location, such as the physical spot where exchanges and telephone networks are, and also in terms of how buyers and sellers are paired, as well as ECNS (Electronic communications networks)

Assume that you recently graduated and have just reported to work as an investment advisor Answer