Michelle Dellatorre Financial Case Essay Example For Students

Michelle Dellatorre Financial Case Essay 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) difficul ty 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 establishmentsfactors 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. Mary Shelley's Worldview EssayExplain 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: I P = (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 â€Å"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. . 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