LeTourneau University

Financial Risk Management

FINC 3203 - 01

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Submitted to: Dr. Juan Castro

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Title of Assignment: Chapter 1 Mini-case

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Submitted by: Nick Nguyen
NickNguyen@letu.edu
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Glen Frank
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GlenFrank@letu.edu
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Jonathan Norman
JonathanNorman@letu.edu
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Date Due: September 5, 2012

Date of Submission: September 5, 2012

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a. Why is corporate finance important to all managers?

Corporate finance is important for all managers to understand because it describes the
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production, distribution, and implementation of economic resources such as money, stock,

bonds, and other economic instruments affecting the company.
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.

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 Most companies begin as sole proprietors or small partnerships and later evolve into
corporations. The advantages of a sole proprietorship or partnership are that it is easily and
inexpensively formed. The disadvantages of a sole proprietorship are that the liability rests
directly on the owner of the company. It is also a challenge to get enough capital as a sole
proprietorship to expand and compete in the general market. Partnerships have much of the
same characteristics as do sole proprietorships; however the liability for the company now
rests on all of the partners. This means that if your partner sinks the company, you would
still be held responsible for paying back the debts as much as your partner. A partnership
can gain more capital than a sole proprietorship because there are simply more people
invested in the company. The major advantages of a corporation are that they can raise large
amounts of capital fairly easily as well as the fact that they provide protection for the

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investors from liability. They can only lose what they invest. The disadvantages of a

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corporation are loss of control in many cases as well as many complications that are required

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to become a corporation.
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c. How do corporations go public and continue to grow? What are agency problems? What is
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corporate governance?
A corporation goes public by selling a large percentage of its stock to the public as its
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initial public offering (IPO). They continue to grow by borrowing from banks and selling
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additional shares of stock. Agency problems come about when managers are hired as agents
to act on behalf of the owners. Company governance is the set of rules that control the
company’s behavior towards those in and around the company.
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d. What should be the primary objectives of managers?

The primary objective of managers is to enhance stockholder value, otherwise known as
stockholder wealth maximization.
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(1) Do firms have any responsibilities to society at large?

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Yes, firms do have a responsibility to society at large because their stockholders are
a part of society. Their employees and customers benefit when the company looks
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out for society in general.

(2) Is stock price maximization good or bad for society?
The textbook says that the same actions that maximize intrinsic stock values also
benefit society.

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 (3) Should firms behave ethically?
Yes, as members of society, they are expected to behave in an ethical manner.
e. What three aspects of cash flows affect the value of any instrument?
(1) Any financial asset, including a company’s stock, is valuable only to the extent that it
generates cash flows;
(2) the timing of cash flows matters- cash received sooner is better;
(3) investors are averse to risk, so all else equal, they will pay more for a stock whose cash
flows are relatively certain than for one whose cash flows are more risky.
f. What are free cash flows?
Free cash flows are cash flows that are available (or free) for distribution to all of the
company’s investors.

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g. What is the weighted average of cost of capital?

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The weighted average cost of capital is the rate of return required by investors to invest.

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h. How do free cash flows and weighted average cost of capital interact to determine a firm’s
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The interact to form this equation for getting a firm’s value:
Value = FCF1 + FCF2 + FCF3
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(1+WACC)^1 (1+WACC)^2 (1+WACC)^3

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i. Who are the providers (savers) and users (borrowers) of capital? How is capital transferred
between savers and borrowers?
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Households: Net savers

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Non-financial corporations: Net users (borrowers)

Governments: Net borrowers
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Financial corporations: Slightly net borrowers, but almost breakeven

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There are three ways that capital is transferred between savers and borrowers:
• Direct transfer (e.g., corporation issues commercial paper to insurance company)
• Through an investment banking house (e.g., IPO, seasoned equity offering, or debt
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placement)
• Through a financial intermediary (e.g., individual deposits money in bank, bank makes
commercial loan to a company)

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 j. 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.
Four most fundamental factors that affect the cost of money, or the general level of
interest rates, in the economy is:
• Production opportunities
• Time preferences for consumption

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• Risk

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• Expected inflation

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k. What are some economic conditions(including international aspects) that affect the cost of
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money?
The cost of money will be influenced by such things as fed policy, fiscal deficits,
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business activity, and foreign trade deficits.

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The cost of money for an international investment is also affected by country risk,which
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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
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includes the risk that property will be expropriated without adequate compensation, as well
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as new host country stipulations about local production, sourcing or hiring practices, and
damage or destruction of facilities due to internal strife.
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The cost of money for an international investment is also affected by exchange rate risk.
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When investing overseas the security usually 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. Changes in relative inflation or interest rates will lead to changes in exchange
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rates. International trade deficits/surpluses affect exchange rates. Also, an increase in country
risk will also cause the country’s currency to fall.

l. What are financial securities? Describe some financial instruments.

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 Financial securities are contractual agreements that entitle someone to future rights and
claims of value in which the owner of the security usually makes a profit through an interest
based on a Capital that the owner decided to buy.
Some financial instruments are: US Treasury Bills, Commercial Loans, Common Stocks,
Preferred Stocks, Consumer Credit Loans, Certificates of Deposit (CD’s), among many
others.

m. List some financial institutions.

Savings and Loan Associations, Credit Unions, Commercial Banks, Mutual Funds (and
the companies that establish them), among a few other types of financial institutions.

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n. What are some different types of markets?

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Physical Asset markets, Futures markets, Mortgage markets, Primary markets (and

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secondary markets), Private markets.
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o. How are secondary markets organized?
Primary markets are where the companies directly sell their primary stock (IPOs and
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such). This market where stock and other types of securities that have remained are sold to
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individual investors is called the Secondary Market. The secondary market is organized by
different procedures through which securities can be traded(Physical Location markets,
Dealer markets, and Electronic communications network).
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(1) List some physical location markets and some computer/telephone networks.
Physical Location markets: New York Stock Exchange, AMEX, Chicago Board of Trade,
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and the Tokyo Stock Exchange are examples physical location markets.
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Computer/Telephone Networks: Nasdaq, London SEAQ, and the Neuer Market are
examples of computer/telephone Networks.
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(2) Explain the differences between open outcry auctions, dealer markets, and electronic
communications networks (ECNs).
In open outcry auctions is described as when traders meet in a pit in which buyers and
sellers communicate with one another through loud signals and signals. In a dealer market,

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 buyers and sellers post prices at which they are willing to buy and sell and then they get in
contact with the buyer or seller to which they are matched. Electronic communications
networks is the procedure through which buyers and sellers put in orders and quotes
electronically and are matched with each other.
p. Briefly explain mortgage securitization and how it contributed to the global economic crisis.
Mortgage securitization contributed to a global economic crisis because while here in the
US, many people were getting mortgages easily and the housing market was growing it
attracted foreign investors. These foreign investors put lots of money into these investments
which all of the sudden failed. Hereby, not only was the US was affected, but also anyone
who had any stake in the housing market including people from all around the world.

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