Why is corporate finance important to all managers

Financial Management Practices

Financial Management Practices

Evaluate the impact of financial management practices on organizational decision-making.

GB550

Module 1

Purdue University Global

Michelle Freeman

October 16, 2020

a. Why is corporate finance important to all managers?

Corporate finance is important to all managers because it helps them to do the following:

i. Make decisions on hiring, firing, and promoting

ii. Set price levels

iii. Establish production schedules

iv. Explain company decisions and motivate employees

v. Maximize shareholder value

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.

A company may start out as a proprietorship then may move to a partnership by adding more than one owner and ultimately convert to a corporation in anticipation of growth.

Sole proprietorship: Advantages and disadvantages

Advantages

Disadvantages

Easy and inexpensive startup

Unlimited personal liability

Fewer government regulations

Difficulty raising capital/finding investors

No corporate taxes

Limited life

Partnership: Advantages and disadvantages

Advantages

Disadvantages

Easy setup

Unlimited debt liability

Low cost to form

Each partner liable for business debt

Difficult to transfer ownership

Corporation: Advantages and disadvantages

Advantages

Disadvantages

Unlimited life

Double taxation

Limited liability

Complicated and time-consuming setup

Easy to transfer ownership

c. How do corporations go public and continue to grow? What are agency problems? What is corporate governance?

Companies go public by offering an initial IPO (initially public offering) which makes them a publicly traded and owned entity. The company would contact an investment bank to make decisions on things such as the price of shares that will be issued. The investment bank employs brokers who help sell the stock to investors. The way the corporation can continue to grow is to increase its share value is by an increased cash flow and the reduction of the cost of capital.

Agency problems is the conflict of interest between management and stockholders. Management acts as the agent and is supposed to make decision that maximize the shareholder’s wealth. These problems occur when the agent is motivated to act not in their own best interest and not those of the stockholders. Agency problems can be addressed through corporate governance rules.

Corporate governance is a set of rules, practices and processes enforced by the company’s board of directors. These if followed ensures the company’s reliability, integrity, and transparency. These rules are used to reciprocate managers behavior that are in the best interest of shareholders.

d. What should be the primary objective of managers?

A measure of a publicly owned corporation is determined by the share price of its stock. Therefore, the primary objective of managers is to maximize the intrinsic value of the firm.

1. Do firms have any responsibilities to society at large?

Yes, firms do have responsibilities to society at large. Irrespective to the size of a firm, they are not on an island alone therefore decisions they make do impact their employees, customers, and the community at large where they operate. When companies practice corporate responsibility, it creates a positive effect on the community which also aids in driving business. It is not sufficient for firms to only be responsive during natural disasters or crisis, they need to be contributing to the community all year long. Company’s should create an employee corporate committee and provide paid time off so that the employees can volunteer in the community.

2. Is stock price maximization good or bad for society?

In general. stock price maximization is good for society unless the firm attempts to form a monopoly. It improves the quality of life for people in society and benefits consumers. Maximizing stock prices benefits society because the owners of stock is society. Today institutions such as pension funds, life insurance companies and mutual funds own more than 57 percent of all stock. Consumers benefit because maximization require companies to produce high quality goods and services at the lowest possible cost. This suggests that companies need to develop products and services that consumers want and need. Lastly there is an employee benefit. Companies who are successful in increasing stock prices, generally grow and add employees.

3. Should firms behave ethically?

Absolutely, firms should behave ethically because customers chose to patronize businesses when they have a good reputation. Businesses today are also open to adverse customer feedback due to the innovation of contemporary media. In addition to audio, video and image television and media plays streamlines people’s decisions (From Television to Social Media: The Contemporary Media Revolution History | Center for Mobile Communication Studies, 2018).

e. What three aspects of cash flows affect the value of any investment?

The three aspects of cash flows that the value of any investment would be operating, investing, and financing activities.

f. What are free cash flows?

Free cash flows are the cash generated after all expenditures are accounted for. It is usually calculated as the operating cash flow minus the operating capital. Free cash flow is calculated using the sales revenue subtracting the operating cost and taxes minus the new operating capital.

g. What is the weighted average cost of capital?

The weighted average cost of capital (WACC) is affected by various factors which are beyond the firms’ control. It is the average after-tax cost of the firm’s capital sources such as common and preferred stock, bonds, and other long-term debt. Essentially it is the rate of return a company generates on its capital.

h. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?

A firm’s total value is a combination of the operations value plus the value of its financial assets. The free cash flow is the cash generated after all expenditures are accounted for and the WACC is used as the discount rate to determine the intrinsic value of the firm.

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

Providers or savers are made up of households, pension funds, life insurance companies, charitable foundations and non-financial companies who generate cash beyond their investment needs. Users or borrowers will include persons wishing to borrow money, entrepreneurs with startup ideas and corporations looking to expand. The capital is allocated between savers and borrowers through direct transfers from providers to users, indirect transfers through investment banks and through a financial intermediary such as a mutual fund. These are important aspect of a functioning economy because they move money from people who have it to those who need it.

j. What do we call the cost that a borrower must pay to use debt capital? What two components make up the cost of using equity capital? What two components make up the cost of using equity capital?

The cost paid by a borrower to use debt capital is the interest rate. The cost of capital is calculated using two components, the cost of equity and the cost of debt.

The four fundamental factors that affect the cost of money or the level of interest rates are production opportunities, time preference for consumption, risk and inflation.

k. What are some economic conditions that affect the cost of money?

Federal reserve policy, federal budget deficits or surpluses, level of business activity and the deficit or surplus of foreign trade balance are the economic conditions that affect the cost of money.

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

Financial securities can also be referred to as financial assets or instruments, representing a short- or long-term contractual obligation. Some financial instruments include but are not limited to commercial paper, money market mutual funds, bonds, commercial loans, and others.

m. List some financial institutions.

Some of the financial institutions include savings & loans, credit unions, commercial banks, mutual funds, private equity funds, life insurance companies and others.

n. What are some different types of markets?

A market is used to connect providers with users with a means for trading securities after they have been issued. Some of the different types of markets are physical assets vs financial assets, spot vs future, short vs long, long term asset vs shorter term spending, primary vs secondary market and others.

o. Along what two dimensions can we classify trading procedures?

A trading venue consist of either a geographical or electronic site by which secondary market trading occurs. There are two dimensions that classify the trading procedures these are location and method of matching orders. With a location dimension trader physically meet and trade, for example the NYSE conducts stock trading at a specific location. On the electronic traders use computers as a meeting place, for example most stock markets do not participate in face to face trading.

p. What are the differences between market orders and limit orders?

Market orders are transacted at the current market price, while with limit orders the buyer indicates specific limits relative to the price and duration of the order.

q. Explain the differences among broker-dealer networks, alternative trading systems, and registered stock exchanges.

Both brokers and dealers must establish brokerage account to place orders. These can include human stockbrokers or computer systems. The investor places the order, and the broker chooses where it is sent. Two of the trading venues are standard broker-dealer networks and alternate trading systems.

A broker-dealer network can buy and sell for itself when acting as a market maker. Broker-dealers must follow state, industry, and registration requirements. On the other hand, with an alternate trading system, buyers can trade directly with sellers. As with other trading venues, an ATS must also comply with regulatory systems as well but are not required to report quotes to the consolidated quote system.

Finally, there is the registered stock exchange that requires more regulations due to the higher volume of security trading. The two registered exchanges are the New York and Chicago Stock Exchange. The SEC which is the governing body for registered stock exchanges helps to ensure that orderly trading and fair dissemination of information such as price and number of shares.

r. Briefly explain mortgage securitization and how it contributed to the global economic crisis.

Mortgage securitization is when the originator of a homeowner’s mortgage such as Loan Depot, sells the loan to an investment banking firm such as Merrill Lynch in exchange for cash. The investment firm then pools the mortgages to create new collateralized debt obligation (CDO). This was one of the major causes of the financial housing crisis because it fostered excessive risk-taking behavior throughout the financial sector. When the housing prices began falling, homeowners could not afford to continue maintaining mortgage payments and so the delinquency level rose leaving banks with immeasurable losses on mortgage backed securities. During the market boom home values were being over-appraised They then get agencies to design favorable rating that envelops big profits despite the conflicts of interest (What Role Did Securitization Play in the Global Financial Crisis?, n.d.).

Reference

Brigham, E. F., & Ehrhardt, M. C. (2019). Bundle: Financial Management: Theory and Practice, Loose-Leaf Version, 16th + MindTap, 2 terms Printed Access Card (16th ed.). Cengage Learning.

Capital Markets: What You Should Know. (n.d.). Investopedia. https://www.investopedia.com/terms/c/capitalmarkets.asp#:%7E:text=Capital%20markets%20are%20composed%20of%20the%20suppliers%20and%20users%20of,beyond%20their%20needs%20for%20investment.

What role did securitization play in the global financial crisis? (n.d.). Investopedia. https://www.investopedia.com/ask/answers/041515/what-role-did-securitization-play-us-subprime-mortgage-crisis.asp#:%7E:text=Securitization%20of%20mortgage%20debt%20in,originators%20to%