Homework 1 John Slater FIN515 Managerial Accounting Professor Keith Herrick March 8, 2013 Keller School of Management

Greetings Ms. DellaTorre, Welcome to the United States and congratulations on your tennis career and apparel line. As an investment advisor at Balik and Kiefer Inc., it is my pleasure to provide the following explanation of the Unites States financial system in an effort to enhance your understanding of the general terms.

Corporate Finance: Corporate finance is important to all managers because is provides the necessary skills they need to identify value added corporate strategies and to forecast funding requirements and options for acquiring the money. The better they do, they better your return.

Organizational Forms: There are 3 main types of organizational forms of a company and they are a proprietorship, a partnership or a corporation. A proprietorship is an unincorporated business that is generally owned by one individual also known as a sole proprietorship. This is inexpensive and easy to set up, there are not many government regulations and there are no corporate taxes. This type of business may find it hard to attract capital if there is no strong collateral. The proprietor has all of the liability and their personal assets can even be used to satisfy debt if necessary. They are responsible for all company taxes and the life of the company ends with the founder. This is actually best for a small business or a business just getting started with limited funding. If the company has more than one owner, it becomes a partnership. This is when two or more persons or entities start a business for profit that is not incorporated. The variety of agreements range from informal oral to formal agreements filed with the secretary of state where the company resides. The advantages and disadvantages are the same as the proprietorship except the risk is spread out among more players. If a partner wants limited

liability, an LLC or Limited Liability Company can be formed where the general partners have unlimited liability but limited partners will only lose their investment. The caveat is that the limited partners do not have much of a voice in the day to day operations. A corporation on the other hand is a legal entity under the state laws where it was incorporated and it has a charter and bylaws. They are regulated and must file certain documents annually. This type of business form separates the liability from the owners and managers so no personal assets or owners can be demanded to pay corporate debt. As a separate entity, a corporation also gains the advantage of unlimited life as it can continue after the founders are long gone. Ownership interests are also easy to transfer, usually in the form of stocks. Risk is lower as the liability is limited to the actual investment made. This makes it much easier to raise money for a corporation which in turn provides the capital for growth.

IPOs: Corporations can be either private or public and if a firm gets big enough and additional funds are needed to expand, an initial public offering (IPO) may be the way to go. An IPO occurs when a company joins an exchange and offers its stock for sale to the general public. If you want to buy a share in a company, you can easily do so and you are in essence a part owner of that company. After the IPO, growth continues through borrowing from lending institutions, issuing debt or selling more shares of stock.

Agency Problems: In smaller companies, proprietorships and partnerships, chances are the managers are also owners so they have a considerable interest in the success of the company. That is not usually the case in a corporation. There is the possibility that managers in a corporation may act in their own best interest rather than that of the company or stockholders. This is known as an agency problem and corporate governance is the way to combat it.

Corporate Governance: Corporate governance is a set of rules that expresses how the company expects everyone to behave. This includes directors and mangers, sole contributors, shareholders, creditors, customers, the community and even competitors. Managements Primary Objective: The managers primary objective is to maximize stockholder wealth. In other words, they should work to maximize the fundamental stock price. They should also ensure that they are ethical and maintain responsibility to society at large. When it comes to a corporation, it should be responsible to society because its employees, shareholders and all other stakeholders are part of society. The families of employees are part of society, just about anyone the company directly or indirectly touches are part of society so it behooves a corporation to have ethics and not hurt society or the environment. That is not to say that stock price maximization is bad for society though. Companies that work to improve stock price to the maximum point tend to see an increase in employment, its better for the consumer and the companies are perceived to be higher quality with higher employee morale.

Investment Value: There are three aspects that affect investment value and they are the amount of expected cash flow, the timing of the cash flow stream and the risk of the cash flow. Regarding the amount, bigger is better; with timing, sooner is better and with risk, low is better.

Free Cash Flow: Free cash flows are those monies that are at hand for distribution. This includes money for creditors as well as stockholders. It is referred to as FCF and it is generated by subtracting operating costs and operating taxes as well as required investments in operating capital from the sales revenue.

Weighted Average Cost of Capital: The weighted average cost of capital (WACC) is the rate of return requirements of the company investors. It is affected by how the company uses debt and equity, the interest rates and the companys risk aversion.

Value of the Firm: The value of a firm is all of the expected free cash flows in the future converted to current dollars. This is known as the fundamental or intrinsic value. The formula and big picture looks like this; Value = FCF1/(1+WACC)1 + FCF2/(1+WACC)2++ FCF/(1+WACC) .

Fig 1. The Big Picture (Ehrhardt, M. C.and Brigham, E. F., 2011)

Providers, Lenders and Borrowers: The providers or savers of capital are households with savings in the bank. They are the ones that deposit money in a bank account which the bank who are the providers use it to lend to borrowers. This makes the bank a financial intermediary. Capital can also transfer directly from corporations to insurance companies and investment

banking is another way capital transfers. This is where a company might sell a security to an investment bank and they in turn sell it to an investor. Non-financial corporations are considered borrowers and the US government is considered a net borrower. Some governments are net savers, like China and many Arab Countries. Financial corporations are net borrowers but are just about break even.

Interest and Equity: The price borrowers pay for debt capital is called interest and the price of equity capital is the required return. The required return is the dividend yield plus the capital gain. The four most fundamental factors that affect the cost of money are production opportunities or lack thereof, time preferences for consumption, the risk involved and finally expected inflation. The Federal Reserve policies affect the cost of money as they are the ones that set the interest rate between banks. Budget surplus or deficit can also affect the cost of money if we are in surplus rates will go down, in deficit, rates go up. The state of the economy in a depression or boom also affects rates where a depression will see rates drop and boom times see them rise. International trade imbalance also has an effect because if we import more than we export, we borrow to pay the difference. Since we are now in a global economy, exchange rates and a foreign countries political and social stability can also have a great impact. If a country experiences volatility, their currency rates fall and lose value. The two main factors that lead to exchange rate fluctuations are relative inflation rate and increased in country risk.

Financial Securities: Financial securities are either debt, equity or a derivative. They reside in either the money market or the capital market. Money market debt securities include T-Bills, CDs, Eurodollars and Federal Funds. Capital Market debts include T-Bonds, Agency Bonds, Municipal Bonds and Corporate Bonds. The equity securities are in the capital market and they

are Common stock and Preferred stock. Derivatives in the Money Market are Options, Futures and Forward Contracts. The Capital Market derivatives include LEAPS which is a Long term Equity AnticiPation Security.

Financial Institutions: There are many types of financial institutions. Commercial and investment banks, savings & loans, and credit unions, life insurance companies and mutual funds, pension funds, hedge funds and private equity funds to name a few.

Markets: A market is where cash is exchanged for an asset and there are different types of markets. There are spot markets and future markets, and as I mentioned earlier; money markets and capital markets. There are also primary and secondary markets. The primary market is where a new issue of stock might arise and the issuer receives the proceeds. The secondary market is where an existing owner sells to another party and the issuer is no longer directly involved. Secondary markets are organized either by the way buyers and sellers interact or by a location. Physical locations include local stock exchanges like the New York Stock Exchange (NYSE) or the Tokyo Stock Exchange (TSE). Computer and telephone markets are comprised of the National Association of Securities Dealers Automated Quotations (Nasdaq), government bond markets and foreign exchange markets. There are different ways a transaction is completed; open outcry auctions, dealer markets and electronic communications networks or ECNs. Open outcry auctions are where traders meet face to face and shout their intentions at each other. NYSE is the largest of these types of auction houses and it is actually a modified version that has specialists. Dealer markets are where inventory of stock or other assets are held and they are offered at buy and sell prices. A computerized system keeps track of the pricing and this is how Nasdaq works.

ECNs make computerized matches for orders between buyers and sellers and execute the transaction automatically. It is low cost and low overhead.

Mortgage Securitization and the Global Economic Crisis. Savings & Loans (S&L) used to be the go to source for home mortgages. They took in local money from deposits and lent the money back to the people of the neighborhood as fixed rate mortgages. They were limited to a single office to keep them localized which proved to be an important restriction. Once a mass migration to the west in the 1950s created a boom for S&Ls, an imbalance in interest rates developed as it was cheaper to borrow in the east than the west. The other problem was that they lent money on fixed rates for long terms but their liability was that the funds they took in were payable on demand by the savers. This created a big problem because as inflation soared in the 1960s and the regulations of localized and singular branches were removed, it flooded the market with inexperienced bankers which resulted in the entire S&L industry to collapse. Ultimately, this led to a need for mortgage securitization which is where banks and other firms originate mortgages and sell them to an investment bank that bundles them up and uses them as a security to back a bond that is traded in financial markets. This approach resulted in the creation of U.S. government entities that are stockholder owned called Fannie Mae and Freddie Mac which still exist today.

If you have any further questions, please do not hesitate to contact me. I look forward to a long and prosperous teaming.

Regards,

John Slater

Questions (2-6) Statement of Retained Earnings In its most recent financial statements, Newhouse Inc. reported $50 million of net income and $810 million of retained earnings. The previous retained earnings were $780 million. How much in dividends was paid to shareholders during the year? $780M + 50M = $830M $830M 810M = $20M $20M in dividends paid. (2-7) Corporate Tax Liability The Talley Corporation had a taxable income of $365,000 from operations after all operating costs but before (1) interest charges of $50,000, (2) dividends received of $15,000, (3) dividends paid of $25,000, and (4) income taxes. What are the firms income tax liability and its after-tax income? What are the companys marginal and average tax rates on taxable income? Income $365,000 Less: Interest deduction (50,000) Plus: Dividends received 4,500 Taxable income $319,500 70% of dividends received are excluded from taxes for corporations Taxable dividends are $15,000(1 0.70) = $4,500. Taxes = $22,250 + ($319,500 $100,000) x (0.39) = $22,250 + $85,605 = $107,855. After-tax income: Taxable income $319,500 Less: Taxes (107,855) Plus: Non-taxable dividends received 10,500 Net income $222,145 Non-taxable dividends are calculated as $15,000 0.7 = $10,500. The firms marginal tax rate is 39%. The firms average tax rate is $107,855 / 319,500 = 33.76%

(2-9) Corporate After-Tax Yield The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is choosing among AT&T bonds, which yield 7.5%, state of Florida muni bonds, which yield 5% (but are not taxable), and AT&T preferred stock, with a dividend yield of 6%. Shrievess corporate tax rate is 35%, and 70% of the dividends received are tax exempt. Find the after-tax rates of return on all three securities. AT&T Bond = 7.5% x 10,000 = $750 Taxes = 750 x 0.35 = $262.50 $750 - 262.50 = $487.50 After tax rate of return = 487.50/10,000 = 0.04875 x 100% = 4.875% State of Florida Municipal Bond = 5% Municipal Bonds = 10,000 x 0.05 = $500 Nontaxable so no deduction After tax rate of return = 500 / 10,000 = 0.05 x 100% = 5% AT&T Preferred Stock = 6% x 10,000 = 0.06 x 10,000 = $600 Tax exemption 70% = 600 x 0.7 = $420 Taxable = $600 420 = $180 Taxes = $180 x 0.35 = $63 $600 - 63=$537 After tax rate of return = 537 / 10,000 = 0.0537 x 100% = 5.37%

Reference: Ehrhardt, M. C.and Brigham, E. F. (2011). Financial Management: Theory & Practice. 13th ed. Mason, OH: South-Western Cenage Learning.