½ essay questions:

Question 1: Analyze the benefits and the costs of a company when it raises capital
by issuing bond.
Advantages of issuing bonds and notes:

● Raising finance: With the help of issuing bonds and notes company is able to
raise finance for meeting the cash requirement of the organization. By issuing
bonds, you get money from investors without making them part owner of the
company. You only need to pay interest for letting them use their money and even
if they have invested money in your organization, they are still not part of
decision-making.
● Avoid decrease in assets: To meet the financial requirement of the organization
management sales the asset of the organization, with the issuance of bonds and
notes organization can avoid such activity.
● Deduction from tax: Company issuing bonds gets a deduction from tax
regarding the interest paid to bondholders. The payment of interest is subjected
to tax deductions and is considered an expense to the company. While this
makes it possible to have money for business operations, it also reduces the
taxes that need to be paid.
● Access to Funds: People who prefer issuing bonds over selling stocks say that
this lets the company to borrow money only when at a time it is needed. Instead
of borrowing from banking institutions, companies can borrow from investors and
only pay lower interest rates. Moreover, the issuing company can decide the
period of maturity of the bond from 3 years or 30 years, depending on their
preference. This also gives them control of their debts.

Costs of company issuing bonds: The value of any financial asset—a stock, a bond, a
lease, or even a physical asset such as an apartment building or a piece of
machinery—is the present value of the cash flows the asset is expected to produce. The
cash flows for a standard coupon bearing bond, like those of Allied Food, consist of
interest payments during the bond’s 15-year life plus the amount borrowed (generally the
par value) when the bond matures.

INT = dollars of interest paid each year = Coupon rate × Par value
Bond issue costs are the fees associated with the issuance of bonds by an issuer to
investors. The accounting for these costs involves initially capitalizing them and then
charging them to expense over the life of the bonds. Bond issue costs may include
accounting fees, commissions, legal fees, printing costs, registration fees, and
underwriting fees.

These costs are recorded as a deduction from the bond liability on the balance sheet.
The costs are then charged to expense over the life of the associated bond, using the
straight-line method. Under this amortization method, you charge the same amount to
expense in each period over the life of the bonds. The full period over which bond issue
costs should be charged to expense is from the date of bond issuance to the bond
maturity date.

Question 2: Analyze the benefits and the costs of a company when it raises capital
by issuing stock.
** The benefits of issuing stock:

● Debt Reduction: The funds a company receives from its sale of common stock
does not have to be repaid, and there is no interest expense associated with it.
Thus, if a company currently has a high debt load, it can issue common stock and
use the proceeds to pay down its debt. By doing so, the company reduces its
fixed costs (since interest expense has been reduced or eliminated), which
makes it easier to earn a profit at lower sales levels.
● Enhanced Liquidity: If company management believes that the business requires
cash to see it through future down cycles in the economy, or other issues that will
constrain its cash flow, issuing common stock is one potential source of the
needed cash.
● Attract investors: Issuing stock is a great way to attract investors, as opposed to
funding your company with debt, which could turn investors away. Investors
typically compare the proportion of your company owned by shareholders to the
amount owned by lenders. The more that’s owned by investors, the less risky
your company is presumed to be.
** Costs of a company when issuing stock:
The value of a share of common stock depends on the cash flows it is expected to
provide, and those flows consist of two elements: (1) the dividends the investor receives
each year while he or she holds the stock and (2) the price received when the stock is
sold. The final price includes the original price paid plus an expected capital gain.
Horizon (Continuing) Value The value at the

horizon date of all dividends expected thereafter

Question 3: Compare bond and stock.
● Stocks and bonds are the two main classes of assets investors use in their
portfolios. Stocks offer an ownership stake in a company, while bonds are akin to
loans made to a company (a corporate bond) or other organization (like the U.S.
Treasury). In general, stocks are considered riskier and more volatile than bonds.
However, there are many different kinds of stocks and bonds, with varying levels of
volatility, risk and return.

● A stock represents a collection of shares in a company entitled to receive a fixed

dividend at the end of the relevant financial year, mostly called the company’s equity.
In contrast, the bond term is associated with debt raised by the company from
outsiders, which carries a fixed return ratio each year and can be earned as they are
generally for a fixed period.

● A company issues stocks and bonds as a way of raising capital for short-term needs
or future investment. Stocks represent a company's equity, while bonds represent a
company's debt which must legally be paid back. Both stocks and bonds can be
traded by investors in the secondary market after a company has issued them.
Question 4: How can a company raise capital?
Businesses typically have two options for financing to consider when they want to raise
capital for business needs: equity financing and debt financing. Debt financing involves
borrowing money; equity financing involves selling a portion of equity in the company. In
a free economy, capital, like other items, is allocated through a market system, where
funds are transferred and prices are established. The interest rate is the price that
lenders receive and borrowers pay for debt capital. Similarly, equity investors expect to
receive dividends and capital gains, the sum of which represents the cost of equity.
Debt holders = lenders
Equity holders = investors.
Debt financing requires borrowing money from a bank or other lender or issuing
corporate bonds. The full amount of the loan has to be paid back, plus interest, which is
the cost of borrowing. The other option is to issue corporate bonds. These bonds are
sold to investors—also known as bondholders or lenders—and mature after a certain
date. Before reaching maturity, the company is responsible for issuing interest payments
on the bond to investors

Equity financing: is the process of raising capital through the sale of shares.
Companies raise money because they might have a short-term need to pay bills or have
a long-term goal and require funds to invest in their growth. By selling shares, a
company is effectively selling ownership in its company in return for cash. Equity
financing involves the sale of common equity and the sale of other equity or quasi-equity
instruments such as preferred stock, convertible preferred stock, and equity units that
include common shares and warrants.

Question 5: What is the goal and the role of corporate financial management?
- The goal of corporate FM: maximize the shareholder value which means the
amount of money that u will have when you sell the company. Management’s
primary goal should be to maximize the long-run value of the stock, which means
the intrinsic value as measured by the stock’s price over time. If firms are
successful at maximizing the stock’s value, they will also be contributing to social
welfare and citizens’ well-being.
- The role of corporate FM:
+ Capital Structure Management: have enough capital to invest in fixed
assets and raise capital at a reasonable cost
+ Working Capital Management: enough cash to pay due debt and operate
the company continuosly
+ Fixed Assets Management: increase profit ability of the company
Question 7: What is time value of money? Why does a financial manager of a
company need to understand the time value of money?
Time value analysis has many applications, including planning for retirement, valuing
stocks and bonds, setting up loan payment schedules, and making corporate decisions
regarding investing in new plants and equipment. In fact, of all financial concepts, time
value of money is the single most important concept. Indeed, time value analysis is used

The time value of money (TVM) is a core financial principle that states a sum of money
is worth more now than in the future. The time value of money (TVM) is the concept that
the money you have in your pocket today is worth more than the same amount would be
if you received it in the future because of the profit it can earn during the interim.

TMV is a fundamental concept that provides the foundation for virtually every financial
and investing decision. From taking out a loan to negotiating a salary, or making a
purchase decision, use the time value of money to evaluate the best financial course of
action. Time value of money is important because it helps investors and people saving
for retirement determine how to get the most out of their dollars. This concept is
fundamental to financial literacy and applies to your savings, investments and
purchasing power. Having money right now is more valuable than getting the same
amount in the future. From a business perspective, the money can be used for the
expansion of the business, which can generate more money.

Question 8: How can the change of the market interest rate affect the price of
bonds with different maturities.

We have the negative relationship between the discount rate and the bond price
We have the positive/negative relationship between the time to maturity and bond price
● Par value bond: Bond price = FV
● Discount bond: Discount rate > Coupon rate - Bond price < Face value
● Premium bond: Discount rate < Coupon rate - Bond price > Face value

● If the market interest rate reduces, bond price increase, you would like to buy bond
with longterm maturity and a lower coupon rate. The price of longterm bond and the
bond with a lower coupon rate will be more sensitive to the change of the market
interest rate. Short-term bond prices are less sensitive than long-term bond prices to
interest rate changes because funds invested in short-term bonds can be reinvested
at the new interest rate sooner than funds tied up in long-term bonds.

● If the market interest rate increases, bond price falls, you should not buy any bond. If
you have to buy bond with market interest rate increases, buy bond with a higher
coupon rate and buy short-term bond as the increase of short term bond is less
When there is an increase in interest rate in an economy, the bondholders would
required more return to hold the bonds. An increase in interest rate is an indication of
increase in riskiness of the economy and therefore the increase in riskiness of the
bonds. Therefore, as yield to maturity on a bond rise, the discount rate used to calculate
the bond value shall increase and therefore there would be more effect of discounting.
This leads to a decreased price of bonds.

Now since the discount rates have increased, the longer maturity bonds would see a
higher percentage decrease in prices because for them the discounting effect shall be
compounded due to presence of more discounting periods. This leads to an increased
interest rate risk for longer maturity bonds. A good (but not very accurate) measure of
this risk is duration of a bond.

The price of the bond will fall and its YTM will rise if interest rates rise. If the bond still
has a long term to maturity, its YTM will reflect long-term rates. Of course, the bond's
price will be less affected by a change in interest rates if it has been outstanding a long
time and matures soon. While this is true, it should be noted that the YTM will increase
only for buyers who purchase the bond after the change in interest rates and not for
buyers who purchased previous to the change. If the bond is purchased and held to
maturity, the bondholder's YTM will not change, regardless of what happens to interest
rates. For example, consider two bonds with an 8% annual coupon and a $1,000 par
value. One bond has a 5-year maturity, while the other has a 20-year maturity. If interest
rates rise to 15% immediately after issue the value of the 5-year bond would be $765.35,
while the value of the 20-year bond would be $561.85.

a. If a bond's price increases, its YTM decreases.

b. If a company's bonds are downgraded by the rating agencies, its YTM

increases.

c. If a change in the bankruptcy code made it more difficult for bondholders to

receive payments in the event a firm declared bankruptcy, then the bond's YTM
would increase.

d. If the economy entered a recession, then the possibility of a firm defaulting

on its bond would increase; consequently, its YTM would increase.

e. If a bond were to become subordinated to another debt issue, then the

bond's YTM would increase
Question 9: Describe three main forms of an organization
There are four main forms of business organizations: (1) proprietorships, (2)
partnerships, (3) corporations, and (4) limited liability companies (LLCs) and limited
liability partnerships (LLPs).
a. A proprietorship is an unincorporated business owned by one individual. Going
into business as a sole proprietor is easy—a person begins business operations.
Proprietorships have three important advantages: (1) They are easy and
inexpensive to form. (2) They are subject to few government regulations. (3) They
are subject to lower income taxes than corporations.
b. A partnership is a legal arrangement between two or more people who decide to do
business together. Partnerships are similar to proprietorships in that they can be
established relatively easily and inexpensively.
+ General member is unlimited member, famous, lots of skills to manage
company: Law firms, medical office
+ Limited member: contribute the capital (money) to the company
c. A corporation is a legal entity created by a state, separate and distinct from its
owners and managers, having unlimited life, easy transferability of ownership, and
limited liability. Corporations also have unlimited lives, and it is easier to transfer
shares of stock in a corporation than one’s interest in an unincorporated business.
These factors make it much easier for corporations to raise the capital necessary to
operate large businesses. A major drawback to corporations is taxes. Most
corporations’ earnings are subject to double taxation—the corporation’s earnings
are taxed, and then when its after-tax earnings are paid out as dividends, those
earnings are taxed again as personal income to the stockholders.
d. A limited liability company (LLC) is a popular type of organization that is a hybrid
between a partnership and a corporation. A limited liability partnership (LLP) is
similar to an LLC. LLPs are used for professional firms in the fields of accounting,
law, and architecture, while LLCs are used by other businesses. Similar to
corporations, LLCs and LLPs provide limited liability protection, but they are taxed
as partnerships.

Question 10: What is capital budgeting? How can a company make capital
budgeting decision?
Capital refers to long-term assets used in production, while a budget is a plan that
outlines projected expenditures during some future period. The capital budget is a
summary of planned investments in long-term assets, and capital budgeting is the whole
process of analyzing projects and deciding which ones to include in the capital budget.

Capital budgeting is the planning process used to determine whether a firm’s long term
investment such as new machinery, replacement machinery, new plants, new products
or research development projects would provide the desired return (profit).

When a firm is dealing/faced with a capital budgeting decision, one of its first tasks is to
determine whether or not the project will prove to be profitable. The most common
approaches for choosing projects are the payback period (PB), internal rate of return
(IRR), and net present value (NPV) methodologies.

The NPV is the best method, primarily because it addresses directly the central goal of
financial management—maximizing shareholder wealth. NPV is the present value of the
project’s free cash flows discounted at the cost of capital. The NPV tells us how much a
project contributes to shareholder wealth; the larger the NPV, the more value the project
adds—and added value means a higher stock price.
NPV= CF0 + CF1/(1+r) + CF2/(1+r)^2 + … + CFn/ (1+r)^n

Question 11: What is agency cost? How can a company deal with this cost?
Agency cost is commonly referred to as the company’s disagreements between
shareholders and managers and the expenses incurred to resolve this disagreement and
maintain a harmonious relationship. This form of dispute becomes obvious as the
principals or the shareholders want the company’s managers to run it to maximize the
shareholders’ value. On the other hand, the managers want to operate to maximize the
wealth. This might even affect the market value of the company. Therefore, the
expenses to handle these opposing interests are termed agency costs.

Agency cost refers to a typical corporate situation due to disagreements between

shareholders and managers; the cost incurred to resolve the conflict and maintain a
cordial relationship is known as agency cost. It intends to harmonize the interests and
benefits of management and shareholders. On the other hand, if a debt is involved in
agency costs, it may affect the share price of the company’s stock.
 ● Agency cost of equity refers to the conflict of interest that arises between
management and shareholders. When management makes decisions that might
not be in the best interest of the firm and that shareholders view as an action that
will not increase the value of their shares, an agency cost of equity has arisen.
● Agency costs of debt arise when debtholders place limits on the use of their
capital if they believe that management will take actions that favor shareholders
instead of debtholders.

The company can provide manager very good compensation package such as:
+ Monthly salary
+ Bonus (pay at the end of the year)
+ Pay manager the rights to buy the stock in the future with a fixed price (stock
option) => the most important one as it makes the benefit of 2 parties the same
However, stock options would align management with shareholders rather than
bondholders, which would reduce the agency cost of equity but increase the agency cost
of debt.

Some ways to ensure that both agency costs of equity and debt are reduced include the
following: ensuring that management and the business adhere to budget planning,
performing accurate accounting, implementing limits on business expenses, such as
when traveling, and programs to increase employee satisfaction, which would reduce
costs related to employee turnover.

Question 6: Describe the relationship between the financial statements of a

company.