Briefly Explain The Functions Of Finance

briefly Explain The Functions Of Finan

Briefly explain the functions of financial markets. For example, in the case of an electric car project, identify which cash flows should be treated as incremental flows when deciding whether to proceed with the project. Additionally, discuss aspects such as the project's cost of capital, the distribution of returns, the nature of risk, and how stock and bond issuances relate to long-term financing. Provide insights into corporate investment decisions, capital budgeting, valuation principles, and the impact of regulations like the Sarbanes-Oxley Act. Explain how to evaluate project viability using NPV, analyze the market value of a company's equity and debt, and discuss the nature of growth stocks and capital structure. Include the principles behind stock valuation and the functions and limitations of corporate legal entities, referencing credible scholarly and industry sources.

Paper For Above instruction

Financial markets serve as the vital platforms for the exchange of funds between savers and borrowers, facilitating the allocation of resources essential for economic growth and development. They enable the raising of capital through mechanisms such as stocks and bonds, providing liquidity and risk distribution, and fostering efficient investment decisions. The core functions of financial markets include mobilizing savings, allocating capital, facilitating payment systems, and enabling price discovery. These markets also contribute to risk management via derivative products, and they promote economic stability by enabling monetary policy implementation (Mishkin & Eakins, 2018).

In the context of an electric car project, identifying incremental cash flows is crucial for accurate investment appraisal. Incremental cash flows are the additional cash flows that the project will generate above the firm's existing cash flows. For example, the costs associated with research and development undertaken in previous years (Option A) are sunk costs and should not influence the decision, as they are unrecoverable regardless of the project’s outcome. The annual depreciation charge (Option B), while an accounting expense, does not impact the project's cash flow directly but affects tax calculations. Tax savings resulting from depreciation (Option C) are incremental and relevant, as they increase cash flows. Dividend payments (Option D) are distributions to shareholders and are not directly related to the project's cash flows but are important for shareholder wealth reasons.

The cost of capital for a project is dependent on several factors, including the company's overall cost of capital, the specific use of the capital (the project’s risk profile), and industry benchmarks (Brigham & Houston, 2020). The overall required return considers the risk-free rate, market risk premiums, and firm-specific risk, ensuring that projects adequately compensate investors for their risk exposure.

The distribution of returns over short periods, such as daily returns, can often be approximated by a normal distribution, assuming the returns are symmetrically distributed around the mean (Fama & French, 1993). This approximation facilitates risk assessment and portfolio optimization, although real-world return distributions may exhibit skewness or kurtosis, deviating from normality.

Unique risk, also known as unsystematic risk, is specific to individual firms or industries and can be mitigated through diversification. It is also called diversifiable risk (Litterman & Winkelmann, 2020). Unlike systematic risk, which stems from broader market factors, unsystematic risk can be eliminated by holding a diversified portfolio.

Bonds issued to raise long-term finances are typically issued by the federal government, state and local governments, and corporate entities. Individuals usually do not issue bonds directly to raise long-term loans; instead, they may purchase bonds issued by governments or corporations (Bodie, Kane, & Marcus, 2014).

A firm's investment decision, often termed capital budgeting, involves evaluating potential projects to maximize firm value. This process considers factors like net present value (NPV), internal rate of return (IRR), and strategic alignment. Capital budgeting decisions are fundamental to the firm’s long-term planning (Ross, Westerfield, & Jaffe, 2019).

The proposals for capital investments should reflect the capital budgeting process, strategic planning, and managerial insights. While strategic considerations are valuable, the primary basis for investment decisions remains the project's financial viability, assessed through methods like NPV and IRR (Damodaran, 2012).

Given a P/E ratio of 10 and a stock price of $50, earnings per share (EPS) can be calculated as EPS = Price / P/E ratio = $50 / 10 = $5 per share (Berk & DeMarzo, 2017).

The company's weighted average cost of capital (WACC) combines the cost of equity and debt, weighted by their proportions in the firm's capital structure. With the given market values and required returns, the WACC is calculated as: (E / V) Re + (D / V) Rd. Here, E = $60 million, D = $40 million, V = $100 million, Re = 15%, and Rd = 5%. Thus, WACC = (0.6 0.15) + (0.4 0.05) = 0.09 + 0.02 = 11% (Damodaran, 2010).

Maximizing shareholder wealth involves selecting projects that generate positive NPVs, representing value added to the firm. Managers should pursue all projects with NPVs greater than zero, ensuring returns exceed the cost of capital and contribute to growth. Ignoring projects with negative NPVs prevents destruction of value (Brealey, Myers, & Allen, 2019).

The average return over three years for Spill Oil Company is (−8% + 11% + 24%) / 3 = 9%, representing the mean historical return (Elton, Gruber, Brown, & Goetzmann, 2014).

The "rate of return rule" states that an investment should be made if the expected return exceeds the required rate of return or hurdle rate, indicating that the project is expected to generate value (Ross et al., 2019). It is a fundamental decision criterion in capital budgeting.

Using the company's cost of capital to evaluate a project is generally appropriate only if the project's risk profile is similar to the average risk of the company's assets. For projects with different risk levels, adjusting the discount rate accordingly provides a more accurate assessment (Brealey et al., 2019).

The Security Market Line (SML) graphs the relationship between expected return and systematic risk, measured by beta, illustrating the required return for a given level of risk. The SML shows expected return on the y-axis and beta on the x-axis, helping investors assess whether an asset is fairly valued (Sharpe, 1964).

Net Working Capital (NWC) is a key component in project cash flows because it reflects the firm's short-term liquidity requirements. Changes in NWC impact cash flows since additional working capital investments tie up cash, which is recovered when the project winds down. Ignoring NWC would overstate project cash flows (Ross et al., 2019).

The difference between a company's and a project's cost of capital hinges on risk profiles; the company's overall cost averages the risks of its diverse assets, whereas a project-specific cost is tailored to the particular risk of that project. Using the appropriate hurdle rate ensures realistic valuation (Brigham & Houston, 2020).

Calculating the expected return on a portfolio comprising stocks A and B with proportions of 40% and 60% respectively involves weighted averages: Expected Return = (0.4 10%) + (0.6 20%) = 4% + 12% = 16% (Bodie et al., 2014).

The Sarbanes-Oxley Act (SOX) introduced significant regulations to improve corporate governance and financial transparency. Its disadvantages include increased compliance costs and constraints on management's operational flexibility, but its advantages include enhanced investor protection. The disadvantages primarily relate to administrative burdens rather than structural financial limitations (Coates, 2007).

The fundamental principle in stock valuation involves estimating the present value of expected future cash flows, discounted at an appropriate rate reflecting risk and market conditions. This valuation considers earnings prospects, dividend policies, growth opportunities, and risk factors to determine intrinsic value (Damodaran, 2012).

If the last trading day's closing price for a stock is available, and the change in price (Net Chg) is +1.04 from the previous day, the previous day's closing price was $55.14 − $1.04 = $54.10 (investor's data interpretation). This aligns with standard market reporting practices (Financial Times, 2023).

A corporation, as a legal entity, has the ability to borrow and lend money, sue and be sued, and vote in shareholder meetings. These functions enable the corporation to operate and grow within the legal framework, facilitating capital formation and corporate governance (Brealey et al., 2019). However, corporations typically do not lend money on their own; rather, investors or other entities may lend or borrow with the corporation or among themselves.

Stocks classified as growth stocks are characterized by high earnings growth potential and typically reinvest earnings rather than pay dividends. Companies such as Starbucks and Cummins, Inc., exemplify growth stocks, distinguished from value stocks like Unilever, which have stable earnings and dividends (Fama & French, 1993).

The mixture of debt and equity used by a firm to finance its operations is known as its capital structure. The optimal capital structure balances risk and return to minimize the overall cost of capital and maximize firm value (Brealey et al., 2019).

Following the net present value (NPV) rule, a project should be undertaken if its NPV is positive, indicating that expected cash inflows exceed outflows when discounted at the appropriate cost of capital. This ensures the investment adds value to the firm (Ross et al., 2019).

References

• Berk, J., & DeMarzo, P. (2017). Corporate Finance. Pearson.
• Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments. McGraw-Hill Education.
• Brigham, E. F., & Houston, J. F. (2020). Fundamentals of Financial Management. Cengage Learning.
• Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance. McGraw-Hill Education.
• Coates, J. C. (2007). The Goals and promise of the Sarbanes-Oxley Act. Journal of Economic Perspectives, 21(1), 91-116.
• Damodaran, A. (2010). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley.
• Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley.
• Elton, E. J., Gruber, M. J., Brown, S. J., & Goetzmann, W. N. (2014). Modern Portfolio Theory and Investment Analysis. Wiley.
• Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3-56.
• Mishkin, F. S., & Eakins, S. G. (2018). Financial Markets and Institutions. Pearson.
• Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance. McGraw-Hill Education.
• Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425-442.