Table of Contents

Corporate business 2

Performance Evaluation 5

The Capital allocation Process

Economic Conditions and Policies that Affect the Cost of Money

8

Financial Securities8
References

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1. Corporate business:

Many

companies

start

as

an

unincorporated

business

(proprietorship

or

partnership), which is easy and inexpensive. Unincorporated business usually

subjects to a few government regulations and its income is not subject to corporate
taxation. On the other hand, it has limited access to capital needed for growth,
unlimited personal liability, and the business is limited to the life of the founders.
Unincorporated business account only to 13% of sales so its clear that corporate
business has a better chance to scale and expand the business. A corporation is a
legal entity under the state laws, and its separate and distinct from its owners and
managers. Corporation has unlimited life, easy access to capital, limited liability,
and easy transferability of ownership interest. On the other hand, corporation is
subjected to more taxes and requires set of bylaws. A corporate usually starts by
the owners money and resources. Other resources for a startup corporate are
friends, family, and private investors. If the corporation continues to grow, it may
attract lending from banks or through an initial public offering (IPO) by selling stock.
Shareholders in a corporation elect directors, who then hire managers to run the
business on behalf of shareholders. Corporation mangers are a serious problem for
the shareholders if they use the corporate resources for their best interests.
Corporate governance is the set of rules that control the companys behavior
towards its directors, managers, employees, shareholders, creditors, customers,
competitors, and community. The managements objective should be to maximize
fundamental price of the firms common stock, not just the current market price.
Firms do, of course, have other objectives; in particular, the managers who make
the actual decisions are interested in their own personal satisfaction, in their
employees welfare, and in the good of their communities and of society at large.
Still, maximizing intrinsic stock value is the most important objective for most

corporations. Unfortunately, some managers deliberately mislead investors by

taking actions to make their companies appear more valuable than they truly are.
Sometimes

the

actions

are legal but

are

taken

to

push the current

market

price above its fundamental price in the short term. Managers convey information
honestly and truthfully to financial markets, and financial markets make reasoned
judgments of 'true value' so stock price performance is a good measure of
management performance.
Figure 1 shows the relationship between managers, stockholders, bondholders,
society and financial markets. Firms have responsibilities toward the society at large
and financial decisions can create social costs and benefits. Examples of the costs
are (1) environmental problems such as pollution or heath issues and (2) quality of
life such as traffic, housing, and safety. Figure 2 shows what can go wrong between
the managers and the rest of the group in a firm.

Figure 1: relationship between the corporate managers and the

stockholders, bondholders, society and financial markets. 1

Figure 2: what can go wrong in a corporation. 1

2. Performance Evaluation:
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The companys performance is measured by the free cash flow (FCF). FCF is a
measure of financial performance calculated as operating cash flow minus capital
expenditures. Free cash flow represents the cash that a company is able to generate
after laying out the money required to maintain or expand its asset base. It is
important

because

it

allows

company

to

pursue

opportunities

that

enhance shareholder value. Without cash, it's tough to develop new products,
make acquisitions, pay dividends and reduce debt. The rate used to discount future
unlevered free cash flows and the terminal value to their present values should
reflect the blended after-tax returns expected by the various providers of capital.
The discount rate is a weighted-average of the returns expected by the different
classes of capital providers (holders of different types of equity and debt), and must
reflect the long-term targeted capital structure as opposed to the current capital
structure. While a separate discount rate can be developed for each projection
interval to reflect the changing capital structure, the discount rate is usually
assumed to remain constant throughout the projection period. While choosing the
discount rate is a matter of judgment, it is common practice to use the weightedaverage cost of capital (WACC) as a starting point. WACC is the discount rate that
should be used for cash flows to reflect the firms value in the future converted into
todays dollars. The mathematical formula relating the cash flow to WASS is:

WACC can serve as a useful reality check for investors; however, the average
investor would rarely go to the trouble of calculating WACC because it is a

complicated measure that requires a lot of detailed company information.

Nonetheless, being able to calculate WACC can help investors understand WACC
and its significance when they see it in brokerage analysts' reports. In reality
however, there is uncertainty associated with these inputs. Some of the parameters
in the WACC, such as the unlevered beta and market risk premium, are not known
with certainty due to their stochastic nature or because they are not under the
firm's control. These variable inputs can add to the variability of WACC results.
3. The Capital allocation Process:
In a well-functioning economy, capital flows efficiently from those who supply
capital to those who demand it. Suppliers of capital are individuals and institutions
with excess funds. These groups are saving money and looking for a rate of return
on their investment. Demanders or users of capital are individuals and institutions
that need to raise funds to finance their investment opportunities. These groups are
willing to pay a rate of return on the capital they borrow. The capital transferred
between savers and borrowers through (a) direct transfers (b) investment banking
house (3) financial intermediaries.
Figure 3: Direct Transfer from saver-to-borrower

Figure 4: Indirect Transfer through Investment Banking House

Figure 5: Indirect Transfer through Financial Intermediary

The price that a borrower must pay for debt capital is the interest rate. The price of
equity capital is called the cost of equity, and it consists of the dividends and
capital gains stockholders expect. (pg 29) The four most fundamental factors that
affect the cost of money or the general level of interest rates in the economy are (1)
Investment Opportunities: the higher the profitability of the business is, the higher
the interest rate the investor can afford to pay lenders for use of their savings (2)
time preferences for consumption: the interest rate lenders will charge depends in
large part on their time preferences for consumption. If the entire population of an
economy were living at the subsistence level, time preferences for current
consumption would necessarily be high, aggregate savings would be low, interest
rates would be high, and capital formation would be difficult (3) risk: the higher the
risk, the higher the interest rate so investors would be unwilling to lend to high-risk
businesses unless the interest rate were higher than the rate on loans to low-risk
businesses and (4) inflation: because the value of money in the future is affected by
inflation, the higher the expected rate of inflation is, the higher the interest rate
demanded by savers. Debt suppliers must demand higher interest rates when
inflation is high to offset the resulting loss of purchasing power.

4. Economic Conditions and Policies that Affect the Cost of Money:

The cost of money will be influenced by such things as federal policy, fiscal deficits,
business activity, and foreign trade deficits. The Federal Reserve exerts major
influence on interest rates. It can push rates upward or downward by adjusting the
federal funds rate, which is the interest rate at which banks lend money to each
other to meet overnight reserve requirements, and by buying or selling Treasury
bonds (T-bonds). When a recession hits, the Federal Reserve prefers rates to be low.
The prevailing logic is that low interest rates encourage borrowing and spending,
which stimulates the economy (Table: 1).

To Fight Recession:

To Fight Inflation:

Lower interest rates

Lower reserve requirements
Buy securities

Raise interest rate

Raise reserve requirements
Sell securities

Table 1: Monetary Policy Options

5. Financial Securities:
A security is a financial instrument that represents an ownership position in a
publicly-traded corporation (stock), a creditor relationship with governmental body
or a corporation (bond), or rights to ownership as represented by an option. The
company or entity that issues the security is known as the issuer. In the United
States, the U.S. Securities and Exchange Commission (SEC) and other selfregulatory organizations (such as the Financial Industry Regulatory Authority
(FINRA)) regulate the public offer and sale of securities.
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Money for securities in the primary market is typically received from investors
during an initial public offering (IPO) by the issuer of the securities.
In the secondary market, securities are simply transferred as assets from one
investor to another. In this aftermarket, shareholders can sell their securities to
other investors for cash or other profit. The secondary market thus supplements the
primary by allowing the purchase of primary market securities to result in profits
and capital gains at a later time. The national exchanges - such as the New York
Stock Exchange and the NASDAQ are secondary markets. The secondary markets
are organized by location (physical or computer/telephone exchanges), or by the
way that orders from buyers and sellers are matched (open outcry auction, dealers,
electronic communications network (ECNs). Some examples are shown in table 2
and the differences between markets are listed in table 3.

Physical Location Exchanges

NYSE
AMEX
CBOT
Tokyo Stock

Computer/Telephone Exchanges
Nasdaq
Government Bond Markets
Foreign Exchange Markets

Table 2: Examples of Secondary Markets Exchanges

Auction Markets
NYSE and AMEX are
the two largest
auction markets for
stocks

Dealer Market
Dealers keep the
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.

ECNs
Computerized
system matches
orders from buyers
and sellers and
automatically
executes
transaction.

NYSE is a modified
auction, with a
specialist

Computerized
system keeps track
of bid and ask
prices, but does not
automatically
match buyers and
sellers.

Examples: Instinet
(US, stocks), Eurex
(Swiss-German,
futures contracts),
SETS (London,
Stocks)

Participants have a
seat on the
exchange, meet
face-to-face, and
place orders for
themselves or for
clients; e.g., CBOT
Market orders vs.
limit orders

Examples: Nasdaq
National Market,
Nasdaq SmallCap
Market, London
SEAQ, German
Neuer Market.

OTC
Equivalent of a
computer bulletin
buyers and sellers
to post an offer.
No dealers
Very poor
liquidity

Table 3: Differences between Markets

Securitization of mortgages has its own named, mortgage asset-back securities

(ABS). Unfortunately, the securitization of mortgages led to the U.S. housing bubble
between 2000 and 2007. Even in 2013, banks held $1.3 trillion in asset-back
securities.5
A problem of the U.S. housing bubble was the banks relaxed their loan
requirements. Before 2000, banks would grant home loans only to borrowers with a
stable work history and good credit history. Furthermore, the borrowers documented
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their incomes completely. During the housing bubble, several large U.S. banks
relaxed their lending standards. Homebuyers could state their incomes without
verifying them. Furthermore, banks granted mortgages to people with poor credit or
poor work history, called subprime loans. After the U.S. economy had entered the
2007 Great Recession, the subprime loans turned into toxic loans as the subprime
borrowers began defaulting on their loans in record numbers.

6. References:
1. http://people.stern.nyu.edu/adamodar/pdfiles/cfovhds/
2. http://www.investopedia.com/
3. Corporate Finance: A Focused Approach By Michael C. Ehrhardt, Eugene F.
Brigham
4. http://www.federalreserve.gov
5. Source: Ken Szulczyk. Securitization and the 2008 Financial Crisis.
Money, Banking, and International Finance. Boundless, 21 Jul. 2015.
Retrieved 07 Mar. 2016

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