Financial Management Practices ✓ Solved
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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
- Easy and inexpensive startup
- Limited corporate taxes
- Disadvantages
- Unlimited personal liability
- Fewer government regulations
- Difficulty raising capital/finding investors
- Limited life
Partnership
Advantages and disadvantages
- Advantages
- Easy setup
- Low cost to form
- Each partner liable for business debt
- Disadvantages
- Unlimited debt liability
- Difficult to transfer ownership
Corporation
Advantages and disadvantages
- Advantages
- Unlimited life
- Limited liability
- Disadvantages
- Double taxation
- 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 by increasing cash flow and reducing the cost of capital. Agency problems are conflicts of interest between management and stockholders. Management acts as the agent and is supposed to make decisions that maximize shareholder 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 rules ensure the company’s reliability, integrity, and transparency and are designed to motivate managers to act in the best interests 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.
e. Do firms have responsibilities to society at large? Yes, firms do have responsibilities to society at large. Decisions made by firms impact employees, customers, and the community. Practicing corporate responsibility creates positive effects on the community and can drive business. Firms should contribute consistently to community efforts, create employee volunteer programs, and promote sustainability.
f. Is stock price maximization good or bad for society? In general, stock price maximization is beneficial for society unless the firm attempts to monopolize. It improves quality of life, benefits consumers through high-quality, low-cost goods and services, and often results in firm growth and employment expansion. Today, institutional investors hold significant stock shares, aligning corporate success with societal benefits.
g. Should firms behave ethically? Absolutely, firms should behave ethically because ethical behavior enhances reputation, customer trust, and compliance with societal expectations. Modern media amplifies the importance of ethical conduct, and unethical practices can quickly damage a company's reputation and financial standing.
h. What three aspects of cash flows affect the value of any investment?
The three aspects of cash flows that affect the value of any investment are operating, investing, and financing activities.
i. What are free cash flows?
Free cash flows are the cash generated after all expenditures are accounted for. It is typically calculated as operating cash flow minus capital expenditures. It represents the cash available for distribution to investors, debt repayment, or reinvestment.
j. What is the weighted average cost of capital?
The weighted average cost of capital (WACC) is the average after-tax rate of return required by the firm's investors, considering the cost of debt and equity weighted by their proportion in the firm’s capital structure. It reflects the firm's overall cost of capital, affected by factors beyond its control.
k. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?
A firm’s total value equals the present value of its free cash flows discounted at the WACC. Free cash flow provides the cash available to the firm, and WACC serves as the discount rate to calculate the present value of those cash flows, thereby determining the firm's intrinsic value.
l. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers?
Providers of capital include households, pension funds, insurance companies, and non-financial corporations that generate excess cash. Users or borrowers include individuals, startups, and firms seeking expansion. Capital transfer occurs via direct transfers, investment banks, and financial intermediaries such as mutual funds, which facilitate the movement of funds in the economy.
m. 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?
The cost paid by a borrower to use debt capital is the interest rate. The cost of equity capital comprises the expected return demanded by shareholders and dividend expectations.
n. What two components make up the cost of using equity capital?
The two components are the required return for shareholders (cost of equity) and the cost of debt (interest rate). The fundamental factors influencing interest rates include production opportunities, time preference, risk, and inflation.
o. What are some economic conditions that affect the cost of money?
Economic conditions that influence the cost of money include Federal Reserve monetary policy, budget deficits or surpluses, overall business activity levels, and foreign trade balances.
p. What are financial securities? Describe some financial instruments.
Financial securities are contractual obligations representing ownership or debt, such as stocks, bonds, commercial paper, and mutual funds. They are used for raising capital and investment purposes.
q. List some financial institutions.
Financial institutions include commercial banks, savings and loans associations, credit unions, mutual funds, private equity firms, and insurance companies.
r. What are some different types of markets?
Markets can be physical or electronic, dealing with different asset types and maturities, such as spot vs futures markets, primary vs secondary markets, and short-term vs long-term assets.
s. Along what two dimensions can we classify trading procedures?
Trading procedures are classified by location (physical or electronic) and method of order matching (manual or automated).
t. What are the differences between market orders and limit orders?
Market orders execute immediately at the current market price, while limit orders specify a maximum or minimum price at which the investor is willing to buy or sell, with execution only if the limit conditions are met.
u. Explain the differences among broker-dealer networks, alternative trading systems, and registered stock exchanges.
Broker-dealer networks involve human or automated market makers operating under regulation, facilitating trades for clients. Alternative trading systems (ATS) allow direct trading between participants without reporting to consolidated feeds. Registered exchanges like NYSE and NASDAQ are highly regulated venues with strict listing and trading rules.
v. Briefly explain mortgage securitization and how it contributed to the global economic crisis.
Mortgage securitization involves pooling residential loans to create mortgage-backed securities, sold to investors. Excessive risk-taking and over-appraisal of housing assets, combined with high ratings from agencies, contributed to the 2008 financial crisis when housing prices declined, leading to widespread defaults and financial losses.
References
- Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory and Practice. Cengage Learning.
- Investopedia. (n.d.). Capital Markets: What You Should Know.
- Investopedia. (n.d.). What role did securitization play in the global financial crisis?
- Center for Mobile Communication Studies. (2018). From Television to Social Media: The Contemporary Media Revolution.
- Additional scholarly articles and journals relevant to corporate finance, market structures, and financial crises.
- Jorion, P. (2010). Financial Risk Management: Techniques and Applications. McGraw Hill.
- Mishkin, F. S., & Eakins, S. G. (2018). Financial Markets and Institutions. Pearson.
- Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley.
- Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance. McGraw Hill.
- Federal Reserve System. (2020). Monetary Policy and Economic Conditions.