The cost of money is affected by many economic conditions

Executive Memorandum
September 20, 2019
Teaching Net Present Value
September 20, 2019

The cost of money is affected by many economic conditions

A) Corporate finance is important to all managers because it provides the skills managers need to identify and select corporate strategies and individual projects that add value to a firm.

B) As a company develops into a major corporation, a few of the forms it takes along the way are:

-Proprietorship, advantages are that they can easily be formed and come with few government regulations, disadvantages are there can be difficulty raising funds initially and there is unlimited liability for the business.

-Partnership, generally has the same advantages as a proprietorship.

-Limited Liability Company, (LLC), advantages are that it allows all partners involved to enjoy limited liabilities with regards to their business, and that their potential losses are limited to their investment in LLC.

C) As corporations evolve and become successful they will start to attract lending from banks or even raise additional funds through and initial public offering (IPO) by selling stock to the public. A corporation’s ability to grow depends on its interactions with the financial markets. Agency problems develop from the idea that a corporations owners are not also its managers. A corporation’s managers may choose to act in their own self-interest opposed to the best interests of the owners or stockholders. Agency problems can be eliminated by corporate governance, which is a set of rules that control the companies and mangers behavior towards everyone that is associated with the firm.

D) The primary objective of managers should be maximizing shareholders wealth

1- Firms have responsibilities to present any relevant information that would reflect the price of the stock to the public, as well as avoiding any illegal actions.

2- Generally it is good, to a large extent the owners of stock are society, therefore when a manager attempts to maximize the stock price this improves the quality of life for millions of citizens.

3- Ethical dilemmas certainly arise whenever there are conflicts between ethics and profits, but usually when the conflict is considered the best decision is usually the most obvious and will typically protect the firm from harm or backlash from investors.

E) The amount of how much is generate from the cash flows, more is always better. The timing of when cash is received, sooner is always better. Risk, investors will pay more for a stock whose cash flows are more certain compared to a stock that has more risk, so less risk is better.

F) Free cash flows are called free cash flows because they are available or (free) for distribution to all investors, including creditors and stockholders. FCF = sales revenues – operating costs-operating taxes – required investments in operating capital

G) The weighted average cost of capital is the rate of return that is required by investors.

H) A firm’s value is the sum of all future expected free cash flows, converted into today’s dollars.

I) For debt we call the price the interest rate, for equity we call this cost of equity. The four most fundamental factors that affect the cost of money are production opportunities, time preferences for consumption, risk and expected inflation.

J) The cost of money is affected by many economic conditions, such as Federal Reserve policies, budget deficits or surpluses, the level of business activity such as a recession or boom, and also international trade surplus and deficits. International country risk also affects the cost of money, which is the risk that is associated with investing or doing business in other countries.

K) Financial securities are pieces of paper with contractual rights and claims to their owners on specific cash flows or values. Some instruments are focused more on short term, such as U.S. Treasury bills, bankers’ acceptance, and commercial paper. Others are more long term or have no such maturity date such as common stock and preferred stock.

L) Mortgage securitization is just banks combining mortgages into pools, and then selling the pools to other organizations, once they were sold they would have the funds to give out more loans. The organizations who bought the mortgages can take them put them in an even larger pool and sell bonds backed by the pool to other investors. This process shifts the risks from the organizations such as Fannie Mae, now to the investors. The most common form of securitization came in the form of collateralized debt obligations or CDO’s, and contributed heavily to the global economic crisis.

 

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