NAVARRO, Bea Czarina B.

17-334
International Corporate Finance
Atty. Cochingyan III

MIDTERM EXAMINATIONS

1. The theory of the firm being a nexus of contracts describes the firm as a set of explicit
and implicit contracts. The firm is neither an entity nor a thing capable of being owned. It is a
legal fiction representing the complex set of contractual relationships between these inputs. The
Wealth Maximization theory, on the other hand, seeks to increase social wealth, as measured by
the dollar equivalents of everything in society. I would subscribe to the contractarian theory of
the firm. I find the wealth maximization theory as unrealistic because it does not take into
account that different players in the firm have different goals other than wealth maximization. As
compared to the contractarian theory, all the interests of the parties are represented in bargaining
for the contract terms.

2. No. An enterprise in the informal sector is not 100% in the underground economy.

According to Martha Alther Chen in “Rethinking the Informal Economy” (2005), the
informal sector includes microenterpreneurs, own account operators, informal wage workers, and
industrial workers. This large share of economic units and workers remain outside the world of
regulated economic activities and protected employment relationships. For these entities,
registration may not benefit them as much and may be too costly for them, hence, they opt to
remain informal. It may be classified into two broad groups: self-employed, who run small
unregistered and wage workers. Examples of informal entities are the vegetable vendors on the
street, taho vendors, and sari-sari store vendors.

Compared to informal sector which involves unregistered and unregulated entities

(meaning they don’t pay taxes and are not subject to the law) but deals with business that is
otherwise legal, underground economy, on the other hand, is outright criminal. Entities in the
underground economy deal with selling illegal products or offering illegal services. An example
of which is illegal drug dealers. The underground economy since they are selling illegal products
is 100% informal. However, the informal sector may not belong to the underground economy.

3. Yes, there is a relationship between corporate governance and corporate finance in an

emerging economy such as the Philippines. According to the New International Financial
Architecture, Corporate Governance and Competition in Emerging Markets by Ajit Singh,
corporate governance means ensuring the external investors and creditors in a company can get
their money back. Corporate finance, on the other hand, refers to how corporations finance
themselves. In the case of developing countries such as the Philippines, businesses in these
countries would depend largely on self-financing due to the underdevelopment of its capital
markets. It is relevant to us because if we are going to compare it with trading markets in
developed countries, emerging markets make a sizable contribution to financing corporate
investment.

4. No, finance is not simply a matter of cash inflow and outflows. The role that finance
plays in enhancing the capability of the firm is that finance helps in investing in opportunities
that would bring possible income or benefit to it. It does not only concern cash inflow and
outflows. Corporations, in order to thrive, need to invest in human capital, skills, creativity,
training, and others. Valuation plays a part in this milieu because these investments have value,
even though there are problems as to ascertaining such in the balance sheet as they are elusive in
practice. Some asset doesn’t even appear therein because it has not been involved in a
transaction.

5. According to William Klein in the Business Organization and Finance, the advantage of
separating ownership from control is that some shareholders choose to be hands-off and not
bother running the business themselves (or are not comfortable in doing so). However, the
downsides of separating ownership from control are that first, there could be conflicts of interest
or incompetent business decisions since ownership is with the shareholders while control is with
board of directors who are driven by different incentives. A second disadvantage would be in
terms of negligence. For example, Morris, Pamela’s manager negligently injures a pedestrian.
Morris is personally liable because it was his negligence that caused the harm. However, Pamela
is also liable because of the doctrine of respondeat superior. Lastly, there could be irreducible
divergencies of interest since the parties have different objectives and both parties are better off
other than alone, even if they failed to reach their optimal goal.

6. The Economics of Organizational Structure by Brickley presented the Barings Bank case
where its Singaporean star trader was able to do risky trades resulting in the fall of the bank
which was sold in the end for one pound. Its organizational structure is flawed which allowed
such employee to abuse its decision making powers as to making trades. This contributed to its
failure. A poorly designed structure may result in loss of profits and even failure of such. A
company that clings to an inefficient high-cost organizational design is eventually forced to
either adapt or close. Thus, Brickley proposed that the three factors to consider in making the
organizational structure of a company which are: decision making rights, performance evaluation
and rewards system.

7. According to Equity and Debt Financings: Documentation and Regulatory Compliance

with Securities Laws, Equity is defined as an ownership interest in an entity that permits a holder
of the equity instrument to participate in growth and success of the company. On the other hand,
debt is a liability or obligation of a company that is evidenced by a note or written obligation of a
company to repay the obligation with interest at some future point in time, on a specified
schedule and by a specified maturity date. The distinction between debt and equity blurs when
each of these types of securities is granted hybrid rights. For example, preferred stock may bear a
dividend payable on a regular basis that looks similar to an interest payment. In addition,
preferred stock agreement provisions may contain a requirement that the company must redeem
or pay back consideration paid for the preferred stock at a specified time in the future. Another
example would be when a debt instrument contains a provision that permits the holder to pay
interest by issuing additional notes, the effect is to cause the debt instrument to closely resemble
a preferred stock with a redemption feature. Those dealing with the four bargaining elements
may seek debt with equity attributes because they are subject to varying risks of default, and they
may condition their loan on the business owner’s acceptance on certain constraints on power to
manage (control) as well as a higher interest rate (rate of return).

8.   According to Marks, Robbins, Fernandez and Funkhouser, there is no standard optimum

structure for all companies. Defining capital structure is a critical decision for any business
organization. Capital structure is the amount of debt and equity, and the types of debt and equity
used to fund the operations of the company. The factors shaping company capital structure are:
(1) Shareholder’s objectives and preferences, (2) Company characteristic, (3) company stage, (4)
use of funds, (5) capital markets’ favor of the industry, (6) base assumptions, (7) industry
leverage norms and (8) industry dynamics. Barro Corporation may consider outside financing in
order to balance its debt-to-equity ratio and enjoy the advantages and benefits of external
financing.

9.   The change in the view on corporate finance brought about by ENRON is that it urged
the state to give at least basic standards for all corporations. Before the ENRON bankruptcy, the
government had deregulated the oil and gas industry to allow more competition, but deregulation
also made it easier for companies to act fraudulently. Enron, among other companies, took
advantage of this situation. The various misdeeds and crimes that Enron's officers and employees
committed were extensive and ongoing. Particularly damaging misrepresentations produced
inflated earnings reports for shareholders, many of whom eventually suffered devastating losses
when the company failed. Many other instances of dishonesty and fraud also occurred, including
embezzlement of corporate funds by Enron executives and illegal manipulations of the energy
market. To minimize corporate fraud, U.S. Senator Paul Sarbanes and U.S. Representative
Michael Oxley drafted legislation known as the Sarbanes-Oxley Act (SOX). The intent of SOX
was to protect investors by improving the accuracy and reliability of corporate disclosures in
financial statements and other documents by: closing loopholes in accounting practices and
strengthening corporate governance rules.

10. The purpose of a balance sheet is to list all the assets of a business and all of its financial
resources at a given point in time. The main items on a balance sheet are Assets, Liabilities and
Equity. The balance sheet measures accurately the historical cost of the company’s assets and
liabilities. The balance sheet must balance as portrayed by the equation Assets = Liabilities +
Equity. According to Fridson, however, the balance sheet does not really give us an accurate
picture of the value of an enterprise. There is a value problem. It is difficult to value assets
accurately such as intangible assets or specialized machinery. Also, some assets which have
value are not listed in the balance sheet because there is no transaction. An example would be
goodwill, human capital, which is the skill and creativity of the employees.