Bundle: Financial Management: Theory and Practice, Loose-Leaf Version, 16th + MindTap, 1 Term Printed Access Card (16th Edition) Edit edition

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Financial system allows money to transfer from one to another (say from the creditor to borrower). It helps the businesses to have smooth operations in case of deficit conditions.

A financial system allocates the resources more efficiently in the current economic situations. It includes the banks, financial markets, instruments and other finance related services.

a.

Corporate finance mainly deals with the financing sources, capital structure, decisions that increase the value of a firm as well as allocating resources efficiently.

A manager’s primary goal is shareholder’s wealth maximizing. Such goal can be reached only through corporate finance as it helps in selecting the best investment plan that adds value to the respective company. Also helps in forecasting the funds required and the possible sources from which the funds can be acquired.

b.

Following are the three forms of organization:

Sole-Proprietorship

It is a kind of business firm that is operated solely by one individual. Under this type of business there will be no distinction between the business entity and the owner of the business. The sole proprietor will be able to enjoy the total profits and at the same time he will be liable for all the risks.

Partnership firm

A partnership firm is the business established by the association of two or more persons. All the profits and losses will be as per the partnership deed i.e. the partners will agree at the time of partnership agreement to share the profits as well as the risks proportionately.

Corporation

It is a group of persons combined to perform a single act or for the common goal. Under this business the business entity and the owners are considered as separate and distinct.

Advantages of proprietorship and partnership:

• Easy decision making process as both the forms of organization involves simple hierarchy.

• Only few Legal regulations applicable for both the forms.

• Income of the participants is treated as personal income and is not subject to any corporate tax.

Disadvantages of proprietorship and partnership:

• Capital investment for the growth of the business in case of both partnership and proprietorship seems difficult when compared to a corporation.

• Both proprietor and the partner are liable for the company’s liabilities.

• The life of business in case of proprietorship depends on the proprietor or the founder’s life.

• In partnership form there will be always a chance of fallout between the partners.

Advantages of corporation:

• Easy to access capital for the growth of the business.

• Shareholders have a limited liability depending on the amount invested by them.

• Unlimited business life.

• Ownership interest can be transferred to the other interested party.

Disadvantages of corporation:

• Corporation is subject to a set of complex legal regulations.

• Subject to double taxation system i.e. corporate tax on the income of the company and personal tax on the dividends paid to the shareholders.

c.

A firm goes public when it issues its shares to the public through Initial Public Offering (IPO). It may issue additional stocks or debt securities when additional capital is required for the growth plans.

Agency problems generally arise when the company’s decisions serve the personal goals rather than serving the shareholders interest.

Corporation governance refers to a set of internal regulations that are set by the organization to control the agency problems. Also serve as the standards of the firm to be obeyed in the regular business activities.

d.

The primary objective of managers should be stockholders wealth maximization.

(1)

Every firm has some ethical and moral responsibilities to be obeyed to the societal rules and regulations. That means to provide a safe and healthy working environment and produce quality products without harming or polluting the environment.

(2)

Stock price generally increase when the quality of the product or service increases and when producing the products as per the consumer needs. A growing profit margin indicates efficiency in the operations of the organization in reducing cost of products.

Hence, the stock price maximization is good for the society.

(3)

Studies have shown a high correlation between long run profitability of a company and its ethics. If a firm takes back step in following ethics in order to increase the profits by providing poor quality products may lead to legal issues. By all such unethical activities the image of the firm may downslide.

e.

Following are the three aspects of cash flows affecting the value of investment:

• Amount of cash flows expected.

• Timing of the expected cash flows.

• Uncertainty or the risk involved with the materialization of such cash flows.

f.

Free cash flow refers to the cash that is available with a firm after paying all the taxes and acquiring the capital needs for various growth plans.

g.

Weighted average cost of capital is the average rate of return that an investor requires or expects to receive. WACC is used to discount the investment cash flows when the project reflects the average risk involved.

h.

The weighted average cost of capital is used to discount the free cash flows of a project that finally gives the present value of a firm.

i.

Households are treated as net savers whereas financial intermediaries are treated as net borrowers and when the government runs a fiscal surplus is also considered as net borrower.

Capital is transferred from a saver to the user by:

• Direct transfer: Funds are directly place to be used by the users.

• Indirect transfer:

It takes through the following two types of mechanism:

1. Investment banks underwrite the shares of a particular company. It means investment banks buy shares and sell it to other investors in the market.

2. Financial intermediaries issue their own shares or securities and the amount received from the investors is reinvested in the business for further plans.

j.

The price that is paid by the borrower for the debt capital is called as interest rate.

The cost of equity capital is called as return on equity. It is the sum of dividend rate and appreciation in equity capital.

Following are the factors affecting the cost of capital:

• Growth opportunities: A growth opportunity indicates increase in demand for capital.

• Consumption preference with respect to time: Consumers having lower reference of consumption now will be willing to lend the capital at a lower cost.

• Inflation: Increase in the outlook of inflation makes the savers expect a higher rate of return on the investment made.

• Risk: Default in loan payments. Greater the chance of default, higher will be the required rate of return.

k.

Following are some of the economic conditions that affect the cost of money:

• Inflation: Greater the inflation, higher will be the cost of capital.

• Political instability: Greater the instability, higher will be the cost of capital.

• Volatility in foreign exchange rate: Greater the volatility, higher will be the cost of capital.

• Sovereign default risk: Greater the default risk, higher will be the cost of capital.

• Economic outlook: If the economy is positive cost of capital will be low. If the economy is in expansion state, the cost of capital will be lower than the cost of capital in case of contraction.

• Monetary and fiscal policy.

• International trade deficit or surplus.

• Governmental budget deficit or surplus.

l.

Financial securities are the intangible assets. These are negotiable and have a certain financial worth. They are the contractual obligations and most often have an additional payment that is met on the initial advance amount paid for a particular security.

Short term securities such as Treasury bills, commercial paper from the banks have relatively low default risk and are generally for not more than 1 year term.

Similarly US Treasury bonds are long term financial securities having more than three years and are risk free securities.

Corporate bonds have maturities up to forty years and yield a greater interest rate than treasury bonds due to greater default risk.

Municipal bonds are tax free bonds that provide tax exemption.

Bank acceptances makes bank act as guarantors payment of receipt of goods by a buyer is made to the seller. This is mostly in cases of international transactions.

m.

Financial institutions:

• Investment banks

• Deposit taking financial intermediaries – savings and loan associations

• Credit unions

• Commercial banks

• Investment fund houses such as various types of mutual fund houses who invest in varied strategy based financial securities.

• Hedge funds

• Private equity funds

n.

Following are some of the different types of markets:

• Primary and secondary markets

• Spot market and futures markets

• Money markets

• Capital markets

o.

Secondary markets are organized on the following basis:

• On the basis of location weather physical or over the counter (OTC)

• On the basis of how the orders are carried out, weather Auction, Dealer based, through Electronic communication network.

(1)

Physical location based markets:

• NYSE

• AMEX

Computer/telephone based exchange markets:

• NASDAQ

• For-Ex markets

(2)

Open outcry method involves the deals that are made through an auction process and the transaction takes place on the floor of the exchange.

In a dealer market, the dealers maintain an inventory of shares i.e. buying and selling the securities at the bid and ask prices as quoted.

Electronic communication network (ECN) serve as an electronic interface which matches the orders of a trade automatically that the participants post on the ECN.

p.

The mortgages are converted into securities by the financial institutions that buy mortgages from mortgage brokers. This process is called as securitization of mortgages and these securities have their collateral as the expected cash flows from the mortgage.

The securitization of the mortgages leads to a global crisis if the securities are valued as a less risky investment than they actually are. This system clogged to focus on the ability of the buyers to service the payments. In addition to this situation the low interest rates in the US led to a greater demand of mortgages that result a greater degree of securitization.

With an increase in the interest rates became more difficult with the mortgage amount to serve and led to wide spread of defaults triggering a global economic crisis.