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Mini Case

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 firms 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. a. Why is corporate finance important to all managers? The number one goal of managers is to increase the wealth of owners or shareholders. By understanding corporate finance, managers gain the skills they need to know what strategies or tools would be best for adding value to the organization. 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. Sole Proprietorship -Advantages: 1. Easily and Inexpensively Formed 2. Few government regulations 3. Not subject to corporate tax code -Disadvantages: 1. Difficult to obtain large amounts of capital 2. Unlimited personal liability for the proprietor 3. The life of the business may be limited to the life of the proprietor. Partnerships -Advantages: Same advantages as Sole-Proprietorships -Disadvantages: 1. Unlimited liability 2. Limited life of the organization 3. Difficulty transferring ownership 4. Difficult to obtain large amounts of capital Corporations -Advantages: 1. Unlimited life 2. Easy to transfer ownership 3. Limited liability of those who invest -Disadvantages 1. Double taxation 2. Difficult to initially establish c. How do corporations go public and continue to grow? A company goes public through an IPO, this is the initial sale of their stock. The company may issue

additional stock as they grow. What are agency problems? An agency problem is when a manager puts their own interests in front the companys interests. What is corporate governance? The set of rules that control a companys behavior toward its directors, managers, employees, shareholders, creditors, customers, competitors, and community d. What should be the primary objective of managers? To increase the wealth of owners or stockholders (1) Do firms have any responsibilities to society at large? Companies should function in an ethical manner, including providing a safe environment for employees, abide by labor laws and respect the environment (2) Is stock price maximization good or bad for society? Stock price maximization requires companies to be as efficient as possible while producing quality goods and staying price competitive. I think its good for society as it requires companies to do whats best for their consumers in an effort to maintain or increase market share. (3) Should firms behave ethically? There is no question that firms should behave ethically. However sometimes the ethical choice is not always clear, especially when tied to profits e. What three aspects of cash flows affect the value of any investment? 1. Expected amount 2. Cash flow timing 2. Level of risk f. What are free cash flows? The cash flow actually available for distribution to all investors after the company has made all investments in fixed assets and working capital necessary to sustain ongoing operations g. What is the weighted average cost of capital? The weighted average of the after-tax component costs of capitaldebt, preferred stock, and common equity Each weighting factor is the proportion of that type of capital in the optimal, or target, capital structure. h. How do free cash flows and the weighted average cost of capital interact to determine a firms value? value is the present value of the firms expected free cash flows, discounted at the weighted average cost of capital. Value = FCF1/(1+WACC)1 + FCF2/(1+WACC)2 + FCF3/(1+WACC)3 i. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers? 1. Households Net Savers 2. Non-financial corporations Net-users 3. Governments Net borrowers 4. Financial Corporations almost net borrowers Capital is transferred by 1. Direct Transfer 2. Indirect transfers through a banking house 3. Indirect transfers through a financial intermediary

j. What do we call the price that a borrower must pay for debt capital? The Interest Rate What is the price of equity capital? Dividends plus capital gains What are the four most fundamental factors that affect the cost of money, or the general level of interest rates, in the economy? 1. Production Opportunities 2. Time preferences 3.Risk 4.Expected Inflation k. What are some economic conditions (including international aspects) that affect the cost of money? The cost of money can be influenced by federal policy, fiscal and foreign trade deficits and a specific countrys risk. l. What are financial securities? Describe some financial instruments. Financial securities are pieces of paper with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values. These may include T-Bills, negotiable CDs, Municipal Bonds, Corporate Bonds and preferred and common stocks.

m. List some financial institutions. Credit Unions, pension funds, commercial banks, mutual savings, savings & loans, insurance companies n. What are some different types of markets? Capital Markets including stock markets and bond markets, commodity markets, money markets, futures markets, insurance markets, foreign exchange markets. o. How are secondary markets organized? The secondary market is the financial market where previously issued securities and instruments such as stocks, bonds and options are bought and sold. (1) List some physical location markets and some computer/telephone networks. Physical Location NYSE and CBOT; Computer/Telephone NASDAQ, foreign exchange markets (2) Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNs). Open outcry auctions method verbal bids and offers are used on the trading floor. Dealer Markets transactions occur between principles buying and selling for their own accounts. ECN an attempt to eliminate third parties in order execution p. Briefly explain mortgage securitization and how it contributed to the global economic crisis. The market started soaring, the economy started shivering and the homeowners were left holding the torch with unaffordable mortgages. The dream lasted a short period until they started defaulting on their mortgages. Originating institutions (like Countrywide) quickly sold the mortgages to investment banks and other institutions. Investment banks created CDOs and got rating agencies to help design and then rate the new CDOs, with rating agencies making big profits despite conflicts of interest. Financial engineers used unrealistic inputs to generate high values for the CDOs. Investment banks sold the CDOs to investors and made big

profits. Investors bought the CDOs but either didnt understand or care about the risk. Some investors bought insurance via credit default swaps. When mortgages reset and borrowers defaulted, the values of CDOs plummeted. Many of the credit default swaps failed to provide insurance because the counterparty failed. Many originators and securitizes still owned sub-prime securities, which led to many bankruptcies, government takeovers, and fire sales, including New Century, Countrywide, Indy Mac, Northern Rock, Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, and Merrill Lynch (2-6)Statement of Retained Earnings In its most recent financial statements, Newhouse Inc. reported $50 million of net income and $810 million of retained earnings. The previous retained earnings were $780 million. How much in dividends was paid to shareholders during the year Dividend paid = Retained Earnings of Previous year + Net Income of Current Year - Retained earnings of Current Year = 780+50-810 = 830-810 = $20M

(2-7) Corporate Tax Liability 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 firms income tax liability and its after-tax income? What are the companys marginal and average tax rates on taxable income? Income $365,000 Less Interest deduction (50,000) Plus: Dividends received 4,500 Taxable income $319,500 70% of dividends received are excluded from taxes = $15,000(1 - 0.70) = $4,500. Tax = $22,250 + ($319,500 - $100,000)*0.39 Tax= $22,250 + $85,605 = $107,855. After-tax income: Taxable income $319,500 Taxes (107,855) Plus Non-taxable dividends received 10,500

Net income $222,145 Non-taxable dividends: $15,000 x 0.7 = $10,500. Marginal tax rate is 39 percent Average tax rate is $107,855/$319,500 = 33.76%.

(2-9)Corporate After-Tax Yield 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%. Shrievess corporate tax rate is 35%, and 70% of the dividends received are tax exempt. Find the after-tax rates of return on all thre

A-T yield on FLA bond = 5%. A-T yield on AT&T bond = 7.5% - Taxes = 7.5% - 7.5%(0.35) = 4.875%. Check: Invest $10,000 @ 7.5% = $750 interest. Pay 35% tax, so A-T income = $750(1 - T) = $750(0.65) = $487.50. A-T rate of return = $487.50/$10,000 = 4.875%. A-T yield on AT&T preferred stock: A-T yield = 6% - Taxes = 6% - 0.3(6%)(0.35) = 6% - 0.63% = 5.37%. Therefore, invest in AT&T preferred stock.