Week 1 – Homework 1

Mini Case

A) I think that corporate finance is important to all managers because it is the basic component of how the business is run. It provides the managers with skills to identify corporate strategies and forecast the funding requirements for their company. It helps them understand how the company is running.

B) There are 3 forms a business :

a. A proprietorship is what most businesses are when then start because they are fairly easy to start. They usually are the only people involved in starting and running the business. A disadvantage is that they are responsible for all of the business’ debt and the government can come after them personally.

b. A partnership is where you may have 2 people invested n a company. This business form is similar to a proprietorship in regards to liability and capital for making the business grow. Both parties are equally responsible for the debt of the business. These limited partnerships are either a LLP, which stands for limited liability partnership or the more common one a limited liability company, also known as LLC.

c. A corporation is the last of the business forms. This is not as easy as the previous two. Corporations have to go through the state and adhere to the guidelines given to them. A corporation can keep living in the business world even once the owners die. They also have shares to sell to the stakeholders. This can help bring in more capital to the company.

C) Once a corporation continues to grow, they can go public, which means that initially the owners have depleted their personal resources and now they approach financial institutions to take on some of the debt. They sell shares to the public to help with the investments of the company. A corporate governance is where the company has a set of rules and regulations that is meant to help control the upper managements behavior, as well as the other stakeholders of the company. An agency problem is where the owners hire managers to ensure that the best interest of the company is met rather than what is going to be the best for the shareholders and the owners.

D) A managers primary objective is to have shareholders wealth maximization in mind. They are to ensure the shareholders value.

a. Yes all firms have a responsibility to society at large because the stakeholders are members of the society.

b. Stock price maximization is good for society.

c. All firms should act ethically when conducting business.

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

Providers of capital in most cases are individuals. Individuals provide most of the funds ultimately used by non-financial corporations. Borrowers of capital are non-financial corporations, banks, and governments. The banks also lend money so in a sense they are providers as well.

Capital is transferred between savers and borrowers in three different ways. The first way is through direct transfers of money and securities. This happens when a business sells it securities directly to savers. The business its securities to savers, who in turn provide the firm with the money it needs. The second way is through indirect transfers, which occur when a company sells it stock or bonds to an investment banking house. The investment bank then sells the same securities to a saver. The last way is indirect transfers through a financial intermediary (bank/mutual fund). The bank/mutual fund obtains the money from the savers for the securities, and uses the money to buy other business’ securities.

j. 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 a borrower pays for debt capital is called the interest rate. The price of equity capital is simply called the cost of equity and it consists of the dividends and capital gains stockholders expect.

The four fundamental factors that affect the cost of money are:

• Production opportunities: the ability to turn capital in to benefits

• Time preferences for consumption: the preferences of consumers for current consumption as opposed to saving for future consumption

• Risk: the chance that an investment will not provide the expected return. The higher the risk of an investment, the higher the expected rate of return for the investor.

• Inflation: tendency of prices to increase over time. The increase in prices leads to an increase in the cost of money.

Financial Management, p. 19

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

The following are economic conditions that affect the cost of money are:

• Federal Reserve policy: The Federal Reserve stimulates the economy mostly by purchasing Treasury securities held by banks. This put more money into the banks so that the banks can loan more money to borrowers, thus putting more money into the economy. The purchases cause the interest rates to decrease, which makes it less expensive for companies to borrow for new growth. The Federal Reserve can slow down the economy by selling securities back to the bank. That increases the interest rates and slows down the borrowing.

• Federal budget deficit or surplus: A federal deficit is when the federal government spends more than it takes in from tax revenues. In order to cover the deficit, the government must be covered either by borrowing or by printing money. Increasing the money supply increases expectations for future inflation, which drives up interest rates.

• Level of business activity: Business activity is the actions taken to respond to the present economic environment. For example during a recession consumer demand slows down. This keeps companies form increasing prices, which reduces price inflation. Companies also cut back on hiring which will reduce wage inflation. The Federal Reserve does what it can to keep low interest rates during recessions to keep the cost of money low.

• Foreign trade balance: Businesses in the United States buy from and sell to people and firms in other countries. If the country buys more than it sells, the company is running a foreign deficit. To correct the deficit, the company must borrow money. If many companies run deficits the companies will have to borrow a lot of money. All of this borrowing causes the interest rate to increase. The government does the same thing, except it borrows from other countries by selling bolds.

• Foreign exchange rates: International securities frequently are denominated in a currency other than the dollar, which means that the value of an investment depends on what happens to exchange rates.

Financial Management, pp. 20 -24

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

a. Financial securities are defined as any form of ownership that can be easily traded on a secondary market, such as stocks, bonds, mutual funds, stock options, and contracts. Financial securities are simply pieces of paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values.

b. Financial Instruments:

• U.S. Treasury bills: Sold by U.S. Treasury. Low risk because it is default free. Treasuries will mature after 3 months to a year.

• Commercial loans: Loans issued by banks to corporations. Risk depends on borrower’s ability to pay the price. Loans can take up to 7 years to mature.

• Common stocks: Stocks issued by corporations to individuals and institution. Riskiest of all the different stocks, very dependent upon the strength of the issue. Has an unlimited maturity level which means it can be cashed in at any time.

Financial Management p. 15-16

http://useconomy.about.com/od/glossary/g/securities.htm

M. List some financial institutions.

Some of the different types of financial institutions range from banks, Savings & Loans, credit unions, to life insurance, investment and pension funds companies. Listed are some examples of financial institutions; Bank of America and CitiBank, NA (National Bank), Bank of New York Mellon (Commercial Bank), JP Morgan Chase & Co. & Merrill Lynch (investment banking house), MetLife (life/investment, insurance), Fairwinds Credit Union and Savings and Loan Associations (S&Ls).

N. What are some different types of markets? Some of the different types of markets may include; money market, private market, primary markets, mortgage markets, and primary markets. The financial markets deal with different types of instrument, customer, or geographic locations (pg. 27). Financial markets consist of primary and secondary markets.

O. How are secondary markets organized? Secondary markets organized in which securities are resold/traded after initially issued in the primary market. The existing, already outstanding securities are then traded among investors in the secondary market (such as New York Stock Exchange) (pg. 28)

1) List some physical location markets and some computer/telephone networks. Physical location markets are the New York Stock Exchange (NYSE), Chicago Board of Trade, NYSE Amex Equities, Hong Kong and London Stock Exchange. Nasdaq and FX Trader are self-regulatory bodies that licenses brokers and oversees trading practices via computer/telephone networking systems.

2) Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNs). With open outcry auctions the traders actually meet face to face. Seller and buyers shout and use hand signals for trading. The Chicago Board of Trade is an example of this type of trading procedure. The dealer market holds inventory of stock. They list bid and quote prices that they are willing to buy or sell the stocks. Nasdaq is an example of this type of trading. The electronic communications network participants post their orders to buy and sell and the ECN automatically matches orders (pg 29). The two largest ECNs for trading in the U.S. are Instinet and Archipelago.

P. Briefly explain mortgage securitization and how it contributed to the global economic. Mortgages are pooled together as securities then sold to investors, who may resell the securities. The securitization creates diversification and liquidity. The pools are then “tranches” (cut into slices), grouped, and packaged with other mortgage pieces of the same types securities called “collateralized debt obligations (CDOs)” (pg. 37). The process does not change the total amount of risk for the original mortgage, making these securities less risky. For the financial instruments of CDO’s yielding greater demand of assets and yields on such securitized subprime mortgages to be higher. During this phase the securities may be making money for the investor. But, if individuals become delinquent on mortgage payments or/and housing prices fall, securitized subprime mortgages start to plummet in value and the investors lose in their investment. This has caused the domino effect in our economical situation through-out the world between mortgages, banking, investors, and homeowners.

2-6: Newhouse Inc. reported: $50 million net income, $810 million retained earnings (current), $780 million retained earnings (prior year). How much in dividends was paid to shareholders during year?

$780million (prior retained earnings) + $50 million (net income) - $810 million (current retained earnings) = $20 million was paid in dividends to shareholders during the year.

$780 million + $50 million = $830 million - $810 million = $20 million.

2-7) The Talley Corporation had a taxable income of $365,000 from operations after all operating costs but before (1) interest charges of $50,000, (2) dividends received of $15,000, (3) dividends paid of $25,000, and (4) income taxes. What are the firm’s income tax liability and its after-tax income? What are the company’s marginal and average tax rates on taxable income?

a. Taxable Income= Operation income + Interest income + Taxable dividend income = 365000 - 50000 + 4500 = 319500 Taxable dividend income = 15000 – (.7 x 15000) = 4500 Amount over base = 319500- 335000 = -15500 Tax liability = 113900 + (.39 x -15500) = 113900 – 6045 = 107855 b. After-tax income = Before-tax income - Taxes = Before-tax income – (Before-tax income) (Effective tax rate) = Before-tax income (1– Effective tax rate) = 319500 - (1 – (.x)) = 319500 – (319500(x) = 319500 – 319500x = 222,145, from the book (In order to get the right answer x=.3047

C. Marginal tax rate 39% because that is where the taxable income falls in the table.

D. Average tax rate = tax liability/ taxable income = 107855/ 319500 = 33.8%
2.9

The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is choosing among AT&T bonds, which yield 7.5%, state of Florida muni bonds, which yield 5% (but are not taxable), and AT&T preferred stock, with a dividend yield of 6%. Shrieves corporate tax rate is 35%, and 70% of the dividends received are tax exempt. Find the after-tax rates of return on all three securities.

FL Muni Bond = 5%
Bond Value = 10,000
Not taxable
After tax rate = $500

AT&T Bonds = 7.5%
Tax Rate = T = 35%
Bond Value = 10,000
* After-tax interest income for AT&T = Amount (1-T) = (.075 * 10,000) (1-.35) = $487.50
After tax rate = $487.50

AT&T Preferred Stock

Dividend Yield = 6%
Bond Value = 10,000
Yield = $600
Tax Rate = 35%
Tax Exempt = 70% of Yield
= 600-0.7(600) = 180 taxable (420 not taxable)
= 180(1-.35) = 117
After tax rate: 420 + 117 = $537