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Case Study 1. Why is Corporate Finance important to all managers? Corporate Finance talks about how to effectively deliver products or services to the customers that will bring the best and most out of the investment. As a financial manager, corporate finance is a critical aspect of the job. The primary motive of all financial managers is to maximize shareholder’s wealth. Besides the company performance, a financial manager always needs to consider how his or her decisions are affecting the company as well as the investors of the company. To help managers understand those decisions, corporate finance helps them in understanding the different investment and financing decisions, financing tools, intrinsic value, ratios, etc.

2. Describe the organizational forms a company might have as it evolves from a startup to a major corporation. List the advantages and disadvantages of each form. A company can go through three phases or forms during its journey from start-up to a major. First, as a startup, majority of the companies form as a single owner entity or Sole Proprietorship. This is the stage where the business has only one owner. The advantages of Sole Proprietorship are first of all, it is easy and inexpensive to form, secondly, it is subject to less government regulations, and thirdly, income tax is applicable to only the owner’s personal income and not subject to corporate taxation. The disadvantages of sole proprietorship are firstly, it can be difficult for one single owner to arrange the capital to start the business, secondly the owner bears unlimited liability that holds his or her personal property liable as well, and thirdly, the life of the ownership is limited to the life of the owner himself or herself.

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Case Study Second, the business can evolve to more than one owner which is known as Partnership. This is usually formed when there are two or more people (approximately up to 20) comes together to do business. Partnership is formed through agreements that states how the profit or losses are to be shared, how much salary each partner will get (if any), etc. The advantages of partnership are firstly, the higher number of owners makes it easier to accumulate capital for the business, secondly, they are also subject to less governmental regulations like a sole proprietorship, thirdly, income tax is applicable to the earnings of the partners and not corporate taxation, and fourthly, different owners bring in different expertise in the business. The disadvantages of partnership are firstly, like sole proprietorship, partnership’s partners are also liable to unlimited liability, secondly, if one partner is unable to meet liabilities then the other partners have to share his liabilities, and thirdly, ownership is divided which can often lead to conflict of interests.

Third, the business can evolve to a Corporation. A corporation is where there are lots of owners, usually more than 20. A corporation is a legal entity and it is separated by law from its owners and managers. The advantages of corporation are firstly, it has unlimited life, that is, it will run if some owners are deceased, secondly, it is easy to transfer ownership usually in the form of stocks, and thirdly, the owners have limited liability, therefore, in case of default, their personal assets are not to be touched to fulfill the claims from the corporation. The disadvantages of corporation are firstly, corporate earnings are subject to double taxation, once by the earnings of the corporation and second by the dividends that are paid out are taxed again as personal income, and secondly, setting up a corporation is more complex and time consuming.

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Case Study 3. How do corporations go public and continue to grow? What are agency problems? What is corporate governance? When a corporation is formed, the entrepreneurs provide the initial fund from their personal sources. As the corporation grows, it is likely to need more capital to sustain, and that is when the corporation goes public through initial public offering (IPO). This is the first time the corporation sells its stock to the public at large. This attracts and brings in huge capital for the corporation. After that the corporation can support its growth through borrowing from banks, issuing debt, or selling more stocks to the public. Agency Problems arise when managers focus on their best interest instead of the best interest of the shareholders or owners. For example, a manager whose salary depends on the income that the company makes, may be more focused in increasing the income of the company instead of focusing on increasing the owner’s wealth. Corporate governance addresses agency problems. It is the set of rules that control the company’s behavior towards its stakeholders.

4. What should be the primary objective of managers? (a) Do firms have any responsibilities to society at large? (b) Is stock price maximization good or bad for society? (c) Should firms behave ethically? The primary objective of managers as discussed before is maximizing shareholder’s wealth. One way to increase shareholder’s wealth is to increase the market price of the stocks. Firms do have responsibilities towards the society at large. Aside from the primary

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Case Study objective, the managers have interest in their own personal satisfaction, in the employee’s welfare, and in the good of their communities and society at large. It is good to increase the intrinsic value of the firm for society. The reasons are firstly, most individuals have a stake in the stock market, thus increasing the share price will benefit the individuals, secondly, it provides consumer benefits as firms strive towards efficiency to reduce costs and produce higher quality products or services, and thirdly, it benefits the employees as increasing the stock price usually puts the company in growth and hire more people. A firm should behave ethically because as history is evident that unethical practice led to major crash of the financial system. A firm should be ethically responsible towards its stakeholders.

5. What three aspects of cash flows affect the value of any investment? A company’s value is determined by its ability to generate cash flows now and in the future. The three aspects of cash flows that affect the value of any investment are first, any financial asset, including a company’s stock, is valuable only to the extent that it generates cash flows, secondly, the timing of the cash flows matter, that is, whether it is received sooner or later, where sooner is better, and thirdly, investors are risk averse, so with everything else constant, they will pay more when cash flows are more certain than risky.

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Case Study 6. What are free cash flows? The cash flows that available for distribution to all the company’s investors, including creditors and stockholders are known as free cash flows (FCF). It is calculated by subtracting operating costs, operating taxes, and required investments in new operating capital from sales revenue.

7. What is the weighted average cost of capital? A firm usually chooses a mix of financing sources to fund the business. The sources are debts and equity. Each of these have a cost associated with them. Weighted Average Cost of Capital (WACC) is the required rate of return by the investors who have invested or financed the business. It is calculated by multiplying the weight of each source with their cost and adding them all.

8. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value? Using the free cash flows and the weighted average cost of capital (WACC), a firm’s value can be determined. To do that, free cash flows of forecasted years are discounted back to the present year using the WACC as the discounting factor. In other words, a firm’s value is equal to the summation of the present value of all future free cash flows discounted by the WACC.

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Case Study 9. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers? Most individuals and firms are both borrowers and lenders of capital. Government too can be a lender and borrower of capital. Transfer of capital between savers and borrowers can take place in three different ways and they are direct transfer of money and securities, transfer through investment banking house, who is known as the underwriter and serves the purpose of a middle-man between savers and borrowers, and thirdly, through a financial intermediary such as bank or mutual fund.

10. 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 that a borrower must pay for debt capital is the principal payment. For example, if a bond is issued whose face value is $1,000 and 8% interest, then the bond issuer (borrower) must pay the principal amount of $1,000. The price of equity capital is the residual value. The stockholders are entitled to the cash flows generated by the issuer.

The four most fundamental factors that affect the cost of money or the general level of interests in the economy are first, production opportunities, second, time preferences for consumption, third, risk, and fourth, inflation. Production opportunities means the ability to turn capital into benefits. Time preferences for consumption is when an individual is willing to consume products or services. One might choose to spend as earned whereas others may choose to spend less and save more for future consumption. If an investment is 6

Case Study risky then investors require a higher rate of return. Inflation leads to increase in the cost of money as it reduces consumption power. One cannot buy the same product with the same amount of dollars if inflation occurs.

11. What are some economic conditions (including international aspects) that affect the cost of money? The economic conditions that affect the of money are: a. Federal Reserve Policy – Federal Reserve board can purchase Treasury securities held by banks. b. The Federal budget deficit or surplus – If a government spends more than it earns then it suffers a deficit which must be covered either by borrowing or by printing money (increasing the supply of money) c. The level of business activity – Based on the economic situation, recession, normal, or boom, the level of business activity also changes. For example, during recession, consumer demand is slow thus prices cannot be increased. d. international factors, including the foreign trade balance, the international business climate, and exchange rates – Other international factors such as international trade deficits or surplus, country risk that can arise from investing in a particular country, and exchange rate risk that can arise due to fluctuations in the exchange rates.

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Case Study 12. What are financial securities? Describe some financial instruments. Financial securities are instruments that represents an ownership position in a publicly-traded corporation (stock), a creditor relationship with governmental body or corporation (bond), or rights to ownership as represented by an option. It represents some type of financial value. Stock – Stocks are the most common form of financial instruments. All the publicly-traded corporation issues stocks to the general public who purchase those stocks with the hope of some capital gain and dividends. Bonds – Bonds are another form of financial instrument that governments or corporations issue to raise capital. It does not give ownership right to the bondholder but ensures interest payment and principal payment. Options – Options are the position where the option holder has the right to exercise the option to buy or sell if he or she wishes to.

13. List some financial institutions Some Financial Institutions are investment banks, Deposit-Taking financial intermediaries, Brokerage Houses.

14. What are some different types of markets? The different types of markets are: a. Physical asset markets – Markets where tangible products are sold. In a financial asset market, stocks, bonds, notes, etc. are sold.

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Case Study b. Spot markets and future markets – Markets where assets are sold or bought on the spot or for some future date. c. Money Markets and Capital Markets – Money Markets where short-term, highly liquid debt securities are sold. Capital Markets are for long-term securities. d. Mortgage Markets – Markets that deal with loans on residential, agricultural, commercial, and industrial real estate. Consumer credit markets involve loans for autos, appliances, etc. e. World, national, regional, and local markets – Markets depending on the size. f. Primary Markets – Markets where securities are traded for the first time. g. Private Markets – Markets where the transaction works directly between two parties without third party.

15. How are secondary markets organized? (a) List some physical location markets and some computer/telephone networks. (b) Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNs). Secondary markets are markets where existing and outstanding securities are traded among investors. Physical Location Markets examples are New York Stock Exchange, the American Stock Exchange (AMEX), the Dhaka Stock Exchange (DSE), Bangladesh. Computer/telephone networks examples are NASDAQ, U.S. Treasury Bonds. Open outcry auctions are where traders meet in a pit and sellers and buyers communicate with one another through shouts and hand signals and trade securities. 9

Case Study Dealer markets are markets where there are market makers who keep an inventory of stock. The dealers list bid quotes and ask quotes, that is the prices they are willing to buy or sell. Electronic Communications Network (ECNs) are the third method of matching orders through online medium. Participants post their orders for buy or sell and it is matched automatically with other orders online.

16. Briefly explain mortgage securitization and how it contributed to the global economic crisis. Mortgage securitization is about collecting bundle of mortgages into pools and then create new securities that had claims on the pool’s cash flows. The securitizing firms sold the newly created securities to individual investors, hedge funds, college endowments, insurance companies, and other financial institutions. It was meant to return the cash to the original cash provider but due to some mortgage defaults the chain was broken. When the sub-prime market mortgages began defaulting, mortgage companies were the first to fall. Many originating firms fell due to not selling of all their sub-prime mortgages and was bankrupt. The securitizing firms also crashed, because they kept the new securities that they created. With commercial banks cutting on lending and causing difficulties for nonfinancial business and consumers, the U.S. suffered the worst recession in history since 1929.

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