Finance HW

define sole proprietorship, partnership and corporation

(1) A sole proprietorship is a business owned by a single individual who maintains complete title to the assets, but who is also personally liable for all indebtedness incurred. (2) A partnership is an association of two or more individuals coming together as co-owners for the purpose of operating a business for profit. The partnership is equivalent to the sole proprietorship, except that the partnership has multiple owners. (3) A corporation is a legal entity functioning separate and apart from its owners. It can individually sue and be sued, purchase, sell, or own property, and be subject to criminal punishment for crimes.

3. What is the relationship between financial decision making and risk and returns? Would all financial managers view risk-return trade off similarly?

Almost all financial decisions involve some sort of risk-return trade-off. The more risk the firm is willing to accept, the higher the expected return for the given course of action. In the area of working capital management, the less inventory held, the higher the expected return, but also the greater the risk of running out of inventory. While one manager might accept a given level of risk, another more risk-averse manager may not accept that level of risk. Not all managers will view the risk-return trade-off in the same manner.

explain the term opportunity cost with respect to the cost of funds to the firm

As a net user of funds, a firm must raise funds in the financial markets, either in the form of debt or of equity. Also, since there will be other entities in need of funds, including both businesses and governments, the firm must offer the investor a return that is attractive, given the investor's next best opportunity. Thus, the cost of money to the firm will invariably be determined by the investor's next best opportunity for the given level of risk being assumed—that is, the investor's opportunity cost. Otherwise, the investor will not be interested in purchasing the company's bonds or stocks. We should never base our decisions on past or historical costs, even when they represent the actual out-of-pocket costs to the firm. Maximizing shareholder wealth means that we make decisions based upon our understanding of the investor's best alternative opportunities. In the case of investment and financing decisions, the opportunity cost for the firm's investors is captured in the rates of return available in the financial markets.

As a recent business school graduate, you work directly for the corporate treasurer. Your corporation is going to issue a new security and is concerned with the probable flotation costs. What tendencies about flotation costs can you relate to the treasurer.

As a percent of gross proceeds, flotation costs are inversely related to the dollar size of the new issue. Additionally, common stock is more expensive to issue than preferred stock, which is more expensive to issue than debt.

what do ethics and ethical behavior have to do with finance

Ethical errors are not forgiven in the business world. Business interaction is based upon trust, and there is no way that trust can be eliminated quicker than through an ethical violation. As a result, acting in an ethical manner is not only morally correct, but it is congruent with our goal of maximization of shareholder wealth.

Identify three distinct ways that savings are ultimately transferred to business firms in need of cash

First, there may be a direct transfer of savings from the investor to the borrower. Second, there may be an indirect transfer that uses the services provided by an investment banker. Third, there may be an indirect transfer that uses the services of a financial intermediary. Private pension funds and life insurance companies are prominent examples of the latter case.

compare and explain the historical rates of return for different types of securities

Historically, returns of different types of securities have followed the risk-return relationship with securities, with higher levels of risk producing higher returns.

What is the major difference between a negotiated purchase and a competitive bid purchase

In a negotiated purchase, the corporate security-issuer and the managing investment banker negotiate the price that the investment banker will pay the issuer for the new offering of securities. In a competitive-bid situation, the price paid to the corporate security-issuer is determined by competitive (sealed) bids, which are submitted by several investment banking syndicates, each hoping to win the right to underwrite the offering.

what is an efficient market and what are the implications of efficient markets for us

In an efficient market, information is impounded into security prices with such speed that there are no opportunities for investors to profit from publicly available information. Actually, what types of information are immediately reflected in security prices and how quickly that information is reflected determine how efficient the market actually is. The implications for us are that stock prices reflect all publicly available information regarding the value of the company. This means we can implement our goal of maximization of shareholder wealth by focusing on the effect each decision should have on the stock price, all else held constant. It also means that earnings manipulations through accounting changes should not result in price changes.

Why is an investment banking syndicate formed

Investment banking syndicates are established for three key reasons: (1) the investment banker who originates the business probably cannot afford to purchase the entire new issue himself; (2) to spread the risk of loss among several underwriters; (3) to widen the distribution network.

what does the risk return trade off mean

Investors will not put their money in risky investments unless they are compensated for taking on that additional risk. In effect, the return investors expect is composed of two parts. First, they receive a return for delaying consumption, which must be greater than the anticipated rate of inflation. Second, they receive a return for taking on added risk. Otherwise, both risky and safe investments would have the same expected return associated with them, and no one would take on the risky investments.

why do you think most secondary-market trading in bonds takes place over the counter

Most bonds are traded among very large financial institutions. Life insurance companies and pension funds are typical examples. These institutions deal in large quantities (blocks) of securities. An over-the-counter bond dealer can easily bring together a few buyers and sellers of these large quantities of bonds. By comparison, common stocks are owned by millions of investors. Organized exchanges are necessary to accomplish the "fragmented" trading in equities.

what major benefits do corporations and investors enjoy because of the existence of organized security exchanges

Organized stock exchanges provide for: (1) A continuous market. This means a series of continuous security prices is generated. Price changes between trades are dampened, reducing price volatility, and enhancing the liquidity of securities. (2) Establishing and publicizing fair security prices. Prices on an organized exchange are determined in the manner of an auction. Moreover, the prices are published in widely available media like newspapers. (3) An aftermarket to aid businesses in the flotation of new security issues. The continuous pricing mechanism provided by the exchanges facilitates the determination of offering prices in new flotations. The initial buyer of the new issue has a ready market in which he can sell the security should he need liquidity rather than a financial asset.

Why might a large corporation want to raise long-term capital through a private placement rather than a public offering?

Several positive benefits are associated with private placements. The first is speed. Funds can be obtained quickly, primarily due to the absence of a required registration with the SEC. Second, flotation costs are lower compared to public offerings of the same dollar size. Third, greater financing flexibility is associated with the private placement. All of the funds, for example, need not be borrowed at once. They can be taken down over a period of time. Also, elements of the debt contract can be renegotiated during the life of the loan.

4. What is the agency problem and how much it impact the goal of maximization of shareholder wealth

The agency problem is a result of the separation of owners and managers, where managers do what's in their own best interests rather than what is in the best interest of the shareholders. Large firms are typically run by professional managers who own a small fraction of the firms' equity. The individual actions of these managers are often motivated by self-interest, which may result in managers not acting in the best interests of the firm's owners. When this happens the firm's owners will lose value.

what is the cause of the agency problem and how do we try to solve it

The agency problem is the result of the separation of management and the ownership of the firm. As a result, managers may make decisions that are not in line with the goal of maximization of shareholder wealth. To control this problem, we monitor managers and try to align the interests of shareholders and managers. The interests of shareholders and managers can be aligned by setting up stock options, bonuses, and perquisites that are tied directly to how closely management decisions coincide with the interest of shareholders.

what general criteria does an organized exchange examine to determine whether a firm's securities can be listed on the exchange?

The criteria for listing can be labeled as follows: (1) profitability; (2) size; (3) market value; (4) public ownership.

why are we interested in cash flows rather than accounting profits in determining the value of an asset

The firm receives cash flows and is able to reinvest them, which cannot be done with accounting profits. In effect, accounting profits are shown when they are earned rather than when the money is actually in hand. Unfortunately, a firm's accounting profits and cash flows may not be timed to occur together. For example, capital expenses, such as the purchase of a new plant or piece of equipment, are depreciated over several years, with the annual depreciation subtracted from profits. However, the cash flow associated with these expenses generally occurs immediately. It is the cash inflows that can be reinvested and cash outflows that involve paying out money. Therefore, cash flows correctly reflect the true timing of the benefits and costs.

what is the appropriate goal for the firm and why

The goal of profit maximization is too simplistic in that it assumes away the problems of uncertainty of returns and the timing of returns. Rather than use this goal, we have chosen maximization of shareholders' wealth—that is, maximization of the market value of the firm's common stock—. The shareholders react to poor investment or dividend decisions by causing the total value of the firm's stock to fall and react to good decisions by pushing the price of the stock upward. In this way, all financial decisions are evaluated, and all financial decisions affect shareholder wealth.

1.What are some of the problems involved in implementing the goal of maximization of shareholder wealth?

The goal of profit maximization is too simplistic since it assumes away the problems of uncertainty of returns and the timing of returns. -Rather than use this goal, we have chosen maximization of shareholders' wealth—that is, maximization of the market value of the firm's common stock—because the effects of all financial decisions are included. -The shareholders react to poor investment by causing the total value of the firm's stock to fall and react to good decisions by pushing the price of the stock upward

2. Firms often involve themselves in projects that do not result directly in profits. For example, Apple, which featured in the chapter introduction, donated $50 million to Stanford University hospitals and another $50 million to African aid organization. A charity against Aids. Do these projects contradict the goal of maximization of shareholder wealth

The goal of shareholder wealth maximization must be looked at as a long-run goal. -As such, the public image of the firm may be of concern inasmuch as it may affect sales and legislation. Thus, while these actions may not directly result in increased profits, they may affect consumers' and legislators' attitudes.

what is an investment banker and what major functions does he or she perforrm

The investment banker is a middleman involved in the channeling of savings into long-term investment. He performs the functions of: (1) underwriting; (2) distributing; (3) advising. By assuming underwriting risk, the investment banker and his syndicate purchase the securities from the issuer and hope to sell them at a higher price. Distributing the securities means getting those financial claims into the hands of the ultimate investor. This is accomplished through the syndicate's selling group. Finally, the investment banker can provide the corporate client with sound advice on which type of security to issue, when to issue it, and how to price it.

Distinguish between the money and capital markets

The money market consists of all institutions and procedures that accomplish transactions in short-term debt instruments issued by borrowers with (typically) high credit ratings. Examples of securities traded in the money market include U.S. Treasury bills, bankers acceptances, and commercial paper. Notice that all of these are debt instruments. Equities are not traded in the money market. The money market is entirely an over-the-counter market. On the other hand, the capital market provides for transactions in long-term financial claims (those claims with maturity periods extending beyond one year). Trades in the capital market can take place on organized exchanges or over-the-counter.

6. Identify the primary characteristics of each form of legal organization

The sole proprietor maintains title to the firm's assets, has unlimited liability, is entitled to the profits from the business, but must also absorb any losses realized. This form of business is easily initiated. Termination- owner discontinuing the business or upon his death. b. In a partnership, all general partners have unlimited liability. Each partner is liable for the actions of the other partners. The partnership agreement dictates the basic relationships among the partners within the firm. As with the sole proprietorship, the partnership is terminated upon the desires of any partner within the organization, or upon a partner's death. Under certain conditions a partner's liability may be restricted to the amount of capital invested in the partnership. However, at least one general partner must remain in the association for whom the privilege of limited liability does not apply. c. The corporation is legally separate from its owners. Ownership of the corporation is determined by the number of shares of common stock owned by an individual. Shares are transferable, the ownership in a corporation may be easily transferred. Investors' liability is limited to the amount of their investment. The life of the corporation is not dependent upon the status of the investors. The death or withdrawal of an investor does not disrupt the corporate life. Cost of forming a corporation is more expensive than a proprietorship or partnership.

Define the term structure of interest rates

The term structure of interest rates represents the relationship between a debt security's rate of return and the length of time until the debt matures. For the relationship to be meaningful to us, all other factors than maturity, such as the chance of the bond defaulting, must be held constant.

explain the popular theories for the rationale of the term structure of interest rates.

Three theories were given in the chapter for explaining the term structure of interest rates, (1) the unbiased expectations theory, (2) the liquidity preference theory, and (3) the market segmentation theory. (1) The unbiased expectations theory states that the term structure is determined by an investor's expectations about future interest rates. Looking at the current term structure of interest rates we can estimate what investors should expect future interest rates to be. If we know the current interest rates for securities maturing one and two years, we can estimate what rate investors expect on a similar security issued one year from now with a one-year maturity date. (2) According to the liquidity preference theory, investors require a liquidity premium to compensate for buying securities that expose them to the risks of fluctuating future interest rates. (3) The market segmentation theory is built on the notion that legal restrictions and personal preferences limit investment choices to certain ranges of maturities. For example, commercial banks prefer short- to medium-term maturities as a result of their short-term deposit liabilities. They simply do not like to invest in long-term securities. Life insurance companies, have longer-term liabilities, so they prefer longer maturities when they invest. The market segmentation theory implies that the rate of interest for a particular maturity is determined solely by demand and supply conditions for a given maturity!!, and is independent of the demand and supply for securities having different maturities.

explain the impact of inflation on rates of return

We may think of the difference in the nominal rate and real rate of return as the "inflation premium." As the expected rate of inflation increases, investors will demand a higher rate of return (a higher inflation premium) to compensate for the potential loss of purchasing power.

5. Define sole proprietorship, partnership and corporation

a. A sole proprietorship is a business owned by a single individual who maintains complete title to the assets and is also personally liable for all indebtedness incurred. b. A partnership is an association of two or more individuals coming together as co-owners for the purpose of operating a business for profits. The partnership is equivalent to the sole proprietorship, except that the partnership has multiple owners. c. A corporation is a legal entity functioning separate and apart from its owners. It can individually sue and be sued, purchase, sell, or own property, and be subject to criminal punishment for crimes.

Using the following criteria, specify the legal forms of business that is favored a. organizational requirements and costs. b. liability of the owners c. the continuity of the business d. transferability of ownership e. management control and regulations f. the ability to raise capital b. income taxes.

a. Organizational requirements and costs favor the sole proprietorship or possibly the general partnership depending upon the approach taken in forming the partnership. b. Under corporation, owners have minimum liabilities. c. The corporation is most favorable form of business because it provides the continuity of the business regardless of an owner's withdrawal or death. d. If ease of ownership transferability is desired, the corporation is best. But owners may prefer that ownership not be easily transferred, in which partnership would be the most desirable. e. The sole proprietor is able to maintain complete and ultimate control and minimize regulations. f. The corporation is the strongest form of legal entity in terms of the ease of raising capital from external investors. g. In regard to income taxes, it is difficult to determine which form of business is the most advantageous. Such a selection is dependent upon individual circumstances.

Liquidity preference theory:

— This theory buys into the idea that investors have a preference toward more liquid investments, and that borrowers like to lock in interest rates so that they don't suffer if interest rates go up and the debt has to be refinanced at a higher interest rates. — Therefore, any yield curve is a combination of expected future rates and a "liquidity premium" for longer investment. Thus, we cannot say what the shape of the yield curve means; an upward-sloping yield curve is consistent with expectations for rising, falling, or unchanged future short rates.

Unbiased expectation theory:

— This theory proposes that the slope of the yield curve is based solely on expected future rates. The rise in the yield curve over the next five years is based on expectations by investors that prevailing interest rates in the market will rise.