Examination One Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s 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 that she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. Dellatorre is also very bright, and, therefore, she would like to understand, in general terms, what will happen to her money.
Your boss has developed the following set of questions which you must ask and answer to explain the U. S financial system to dellatorre. A- Why is corporate finance important to all managers? Corporate strategies and individual projects that add value to their firm; and forecast the funding requirement of of their company, and devise strategies for acquiring those funds. B. (1)- What are the alternative forms of business organization? The three main forms of business organization are (1) sole proprietorships, (2) partner-ships, and (3) corporations.
In addition, several hybrid forms are gaining popularity. These hybrid forms are the limited partnership, the limited liability partnership, the professional corporation, and the s corporation. B. (2) What are their advantages and disadvantages? The proprietorship has three important advantages: (1) it is easily and inexpensively formed, (2) it is subject to few government regulations, and (3) the business pays no corporate income taxes. The proprietorship also has three important limitations: (1) it is difficult for a proprietorship to btain large sums of capital; (2) the proprietor has unlimited personal liability for the business’s debts, and (3) the life of a business organized as a proprietorship is limited to the life of the individual who created it. The major advantage of a partnership is its low cost and ease of formation. The disadvantages are similar to those associated with proprietorships: (1) unlimited liability, (2) limited life of the organization, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital.
The tax treatment of a partnership is similar to that for proprietorships, which is often an advantage. The corporate form of business has three major advantages: (1) unlimited life, (2) easy transferability of ownership interest, and (3) limited liability. While the corporate form offers significant advantages over proprietorships and partnerships, it does have two primary disadvantages: (1) corporate earnings may be subject to double taxation and (2) setting up a corporation and filing the many required state and federal reports is more complex and time-consuming than for a proprietorship or a partnership.
In a limited partnership, the limited partners are liable only for the amount of their investment in the partnership; however, the limited partners typically have no control. The limited liability partnership form of organization combines the limited liability advantage of a corporation with the tax advantages of a partnership. Professional corporations provide most of the benefits of incorporation but do not relieve the participants of professional liability. S corporations are similar in many ways to limited liability partnerships, but LLPS frequently offer more flexibility and benefits to their owners. C.
What should be the primary objective of managers? The corporation’s primary goal is stockholder wealth maximization, which translates to maximizing the price of the firm’s common stock. C. (1) Do firms have any responsibilities to society at large? Firms have an ethical responsibility to provide a safe working environment, to avoid polluting the air or water, and to produce safe products. However, the most significant cost-increasing actions will have to be put on a mandatory rather than a voluntary basis to ensure that the burden falls uniformly on all businesses. C. (2) Is stock price maximization good or bad for society?
The same actions that maximize stock prices also benefit society. Stock price maximization requires efficient, low-cost operations that produce high-quality goods and services at the lowest possible cost. Stock price maximization requires the development of products and services that consumers want and need, so the profit motive leads to new technology, to new products, and to new jobs. Also, stock price maximization necessitates efficient and courteous service, adequate stocks of merchandise, and well-located business establishments–factors that are all necessary to make sales, which are necessary for profits.
C. (3) Should firms behave ethically? Yes. Results of a recent study indicate that the executives of most major firms in the United States believe that firms do try to maintain high ethical standards in all of their business dealings. Furthermore, most executives believe that there is a positive correlation between ethics and long-run profitability. Conflicts often arise between profits and ethics. Companies must deal with these conflicts on a regular basis, and a failure to handle the situation properly can lead to huge product liability suits and even to bankruptcy.
There is no room for unethical behavior in the business world. D. What factors affect stock prices? The price of a firms stock depend on the size of the firms cash flow , the timing of those cash flows, and their risk. The size and risk of the cash flow are affected by the financial environment as well as investment, financing, and dividend policy decisions. E. What factors determine cash flows? Three factors determine cash flows: (1) current level and growth rates of sales; (2) operating expenses; and (3) capital expenses. F. What factors affect the level and risk of cash flows?
The factors are (1) Investment opportunities, (2) risk, (3) how much will inflation reduce the future purchasing power of of our money, (4) The rate-of-return for risk-free investments, (5) a risk premium that reflects the amount of risk in the project. G. What are financial assets? Describe some financial instruments.? Financial assets are pieces of paper with contractual obligations. Some short-term (i. e. , they mature in less than a year) are instruments with low default risk are U. S. treasury bills, banker’s acceptances, commercial paper, negotiable CDs, and eurodollar deposits.
Commercial loans (which have maturities up to seven years) have rates that are usually tied to the prime rate (i. e. , the rate that U. S. banks charge to their best customers) or LIBOR (the London Interbank Offered Rate, which is the rate that banks in the U. K. charge one another. U. S. treasury notes and bonds have maturities from two to thirty years; they are free of default risk. Mortgages have maturities up to thirty years. Municipal bonds have maturities of up to thirty years; their interest is exempt from most taxes. Corporate bonds have maturities up to forty years.
Municipal and corporate bonds are subject to default risk. Some preferred stocks have no maturity date, some do have a specific maturity date. Common stock has no maturity date, and is riskier than preferred stock. H. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers? Households are net savers. Non-financial corporations are net borrowers. Governments are net borrowers, although the U. S. government is a net saver when it runs a surplus. Non-financial corporations (i. e. financial intermediaries) are slightly net borrowers, but they are almost breakeven. Capital is transferred through: (1) direct transfer (e. g. , corporation issues commercial paper to insurance company); (2) an investment banking house (e. g. , IPO, seasoned equity offering, or debt placement); (3) a financial intermediary (e. g. , individual deposits money in bank, bank makes commercial loan to a company). I. List some financial intermediaries? Commercial banks, savings & loans, mutual savings banks, and credit unions, life insurance companies, mutual funds, and pension funds are financial intermediaries.
J. What are some different types of markets? A market is a method of exchanging one asset (usually cash) for another asset. Some types of markets are: physical assets vs. financial assets; spot versus future markets; money versus capital markets; primary versus secondary markets. K. How are secondary markets organized? They are categorized by “location” (physical location exchanges or computer/telephone networks and by the way that orders from buyers and sellers are matched (open outcry auctions, dealers (i. e. , market makers), and electronic communications networks (ECNS). K. 1) List some physical location markets and some computer/telephone networks? Physical location exchanges include the NYSE, AMEX, CBOT, and Tokyo stock exchange. Computer/telephone networks include Nasdaq, government bond markets, and foreign exchange markets. K. (2) Explain the differences between open outcry auctions, dealer markets, and electronic communications networks (ECNs)? The NYSE and AMEX are the two largest auction markets for stocks (NYSE is a modified auction, with a “specialist”). Participants have a seat on the exchange, meet face-to-face, and place orders for themselves or for their clients; e. . , CBOT. Some orders are market orders, which are executed at the current market price, some are limit orders, which specify that the trade should occur only at a certain price within a certain time period (or the trade does not occur at all). In dealer markets, “dealers” keep an inventory of the stock (or other financial asset) and place bid and ask “advertisements,” which are prices at which they are willing to buy and sell. A computerized quotation system keeps track of bid and ask prices, but does not automatically match buyers and sellers.
Some examples of dealer markets are the Nasdaq national market, the Nasdaq small cap market, the London SEAQ, and the German Neuer market. ECNS are computerized systems that match orders from buyers and sellers and automatically execute the trades. Some examples are Instinet (US, stocks), Eurex (Swiss-German, futures contracts), sets (London, stocks). In the old days, securities were kept in a safe behind the counter, and passed “over the counter” when they were sold. Now the OTC market is the equivalent of a computer bulletin board, which allows potential buyers and sellers to post an offer.
However, the OTC has no dealers and very poor liquidity. L. 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 interest rate is the price paid for borrowed capital, while the return on equity capital comes in the form of dividends plus capital gains. The return that investors require on capital depends on (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.
Production opportunities refer to the returns that are available from investment in productive assets: the more productive a producer firm believes its assets will be, the more it will be willing to pay for the capital necessary to acquire those assets. Time preference for consumption refers to consumers’ preferences for current consumption versus savings for future consumption: consumers with low preferences for current consumption will be willing to lend at a lower rate than consumers with a high preference for current consumption.
Inflation refers to the tendency of prices to rise, and the higher the expected rate of inflation, the larger the required rate of return. Risk, in a money and capital market context, refers to the chance that a loan will not be repaid as promised–the higher the perceived default risk, the higher the required rate of return. Risk is also linked to the maturity and liquidity of a security. The longer the maturity and the less liquid (marketable) the security, the higher the required rate of return, other things constant.
The preceding discussion related to the general level of money costs, but the level of interest rates will also be influenced by such things as fed policy, fiscal and foreign trade deficits, and the level of economic activity. Also, individual securities will have higher yields than the risk-free rate because of the addition of various premiums as discussed below. M. What is the real risk-free rate of interest (r*) and the nominal risk-free rate (rRF)? How are these two rates measured? Keep these equations in mind as we discuss interest rates. We will define the terms as we go along: r = r* + IP + DRP + LP + MRP, rRF = r* + IP.
The real risk-free rate, r*, is the rate that would exist on default-free securities in the absence of inflation. The nominal risk-free rate, rrf, is equal to the real risk-free rate plus an inflation premium which is equal to the average rate of inflation expected over the life of the security. There is no truly riskless security, but the closest thing is a short-term U. S. Treasury bill (t-bill), which is free of most risks. The real risk-free rate, r*, is estimate- ed by subtracting the expected rate of inflation from the rate on short-term treasury securities. It is generally assumed that r* is in the range of 1 to 4 percentage points.
The t-bond rate is used as a proxy for the long-term risk-free rate. However, we know that all long-term bonds contain interest rate risk, so the t-bond rate is not really riskless. It is, however, free of default risk. N. Define the terms inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Which of these premiums is included when determining the interest rate on (1) short-term U. S. Treasury securities, (2) long-term U. S. Treasury securities, (3) short-term corporate securities, and (4) long-term corporate securities?
Explain how the premiums would vary over time and among the different securities listed above? The inflation premium (IP) is a premium added to the real risk-free rate of interest to compensate for expected inflation. The default risk premium (DRP) is a premium based on the probability that the issuer will default on the loan, and it is measured by the difference between the interest rate on a U. S. treasury bond and a corporate bond of equal maturity and marketability. A liquid asset is one that can be sold at a predictable price on short notice; a liquidity premium is added to the rate of interest on securities that are not liquid.
The maturity risk premium (MRP) is a premium which reflects interest rate risk; longer-term securities have more interest rate risk (the risk of capital loss due to rising interest rates) than do shorter-term securities, and the MRP is added to reflect this risk. 1. Short-term treasury securities include only an inflation premium. 2. Long-term treasury securities contain an inflation premium plus a maturity risk premium. Note that the inflation premium added to long-term securities will differ from that for short-term securities unless the rate of inflation is expected to remain constant. . The rate on short-term corporate securities is equal to the real risk-free rate plus premiums for inflation, default risk, and liquidity. The size of the default and liquidity premiums will vary depending on the financial strength of the issuing corporation and its degree of liquidity, with larger corporations generally having greater liquidity because of more active trading. 4. The rate for long-term corporate securities also includes a premium for maturity risk. Thus, long-term corporate securities generally carry the highest yields of these four types of securities. O.
What is the term structure of interest rates? What is a yield curve? The term structure of interest rates is the relationship between interest rates, or yields, and maturities of securities. When this relationship is graphed, the resulting curve is called a yield curve. P. Suppose most investors expect the inflation rate to be 5 percent next year, 6 percent the following year, and 8 percent thereafter. The real risk-free rate is 3 percent. The maturity risk premium is zero for securities that mature in 1 year or less, 0. 1 percent for 2-year securities, and then the MRP increases by 0. percent per year thereafter for 20 years, after which it is stable. What is the interest rate on 1-year, 10-year, and 20-year Treasury securities? Draw a yield curve with these data. What factors can explain why this constructed yield curve is upward sloping’step 1:find the average expected inflation rate over years 1 to 20: Yr 1: IP = 5. 0%. Yr 10: IP = (5 + 6 + 8 + 8 + 8 + … + 8)/10 = 7. 5%. Yr 20: IP = (5 + 6 + 8 + 8 + … + 8)/20 = 7. 75%. Step 2:find the maturity premium in each year: Yr 1: MRP = 0. 0%. Yr 10: MRP = 0. 1 ( 9 = 0. 9%. Yr 20: MRP = 0. 1 ( 19 = 1. 9%.
Step 3:sum the IPS and MRPS, and add r* = 3%: Yr 1: rRF = 3% + 5. 0% + 0. 0% = 8. 0%. Yr 10: rRF = 3% + 7. 5% + 0. 9% = 11. 4%. Yr 20: rRF = 3% + 7. 75% + 1. 9% = 12. 65%. The shape of the yield curve depends primarily on two factors: (1) expectations about future inflation and (2) the relative riskiness of securities with different maturities. The constructed yield curve is upward sloping. This is due to increasing expected inflation and an increasing maturity risk premium. Q. At any given time, how would the yield curve facing an AAA-rated company compare with the yield curve for U.
S. Treasury securities? At any given time, how would the yield curve facing a BB-rated company compare with the yield curve for U. S. Treasury securities? Draw a graph to illustrate your answer? The yield curve normally slopes upward, indicating that short-term interest rates are lower than long-term interest rates. Yield curves can be drawn for government securities or for the securities of any corporation, but corporate yield curves will always lie above government yield curves, and the riskier the corporation, the higher its yield curve.
The spread between a corporate yield curve and the treasury curve widens as the corporate bond rating decreases. S. Suppose that you observe the following term structure for Treasury securities: Maturity Yield 1 year 6. 0% 2 years 6. 2 3 years 6. 4 4 years 6. 5 5 years 6. 5 Assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve given above to “back out” the market’s expectations about future interest rates. ) What does the market expect will be the interest rate on 1-year securities one year from now?
What does the market expect will be the interest rate on 3-year securities two years from now? R. What is the pure expectations theory? What does the pure expectations theory imply about the term structure of interest rates? T. Finally, DellaTorre is also interested in investing in countries other than the United States. Describe the various types of risks that arise when investing overseas? Dellatorre should consider country risk, which refers to the risk that arises from investing or doing business in a particular country. This risk depends on the country’s economic, political, and social environment.
Country risk also includes the risk that property will be expropriated without adequate compensation, as well as new host country stipulations about local production, sourcing or hiring practices, and damage or destruction of facilities due to internal strife. Second, Dellatorre should consider exchange rate risk. Dellatorre needs to keep in mind when investing overseas that more often than not the security will be denominated in a currency other than the dollar, which means that the value of the investment will depend on what happens to exchange rates.
Two factors can lead to exchange rate fluctuations. Changes in relative inflation will lead to changes in exchange rates. Also, an increase in country risk will also cause the country’s currency to fall. Consequently, inflation risk, country risk, and exchange rate risk are all interrelated. ———————– [pic] . Hypothetical Treasury and Corporate Yield Curves 0 5 10 15 0 1 5 10 15 20 Years to maturity Interest Rate (%) 5. 2% 5. 9% 6. 0% Treasury yield curve BB-Rated AAA-Rated