couple corporate finance questions.

Discussion in 'Professional Trading' started by hm2684, Oct 11, 2005.

  1. hm2684


    I'm a finance major at penn state, and have a midterm coming up soon. I was wondering if anyone could help me out with a couple questions that have me boggled.

    1) What is the difference between maximizing firm value and maximizing stockholder wealth?
    2) Why do financial instruments differ? How is risk taken into account for a financial instrument?
    3) Interest rates on bank loans exceed rates on commercial paper. Why don't all firms issue commercial paper rather than borrow from banks?

    Sorry if this question doesn't belong, but i'm really confused.
  2. I think you better change your major. If you can't answer these questions, think about switching to politcal science or physical education. You're screwed.
  3. hm2684


    ^can you be helpful and just help me answer the questions?
  4. Good god.. read that thing called Text Book.

    I got this easy question wrong on my Corporate Finance exam.. and I had a 96 or something on it.

    Maximizing stockholder wealth = higher stock prices in expense of the long term value of the firm.

    (I think this is what I wrote on the exam)
  5. 1. Not so sure, assuming firm value is measure by total asset value or non-tangible asset value. Then simply buying assets would increase firm value. Stock/shareholders value doesn't increase until the firm grow and produce return to shareholders.

    2. I'll take bond and stock as example as they are the most common financial instrument. Bondholders has a claim to the firm's asset before shareholders. Therefore, bond generally have less risk, and less return as well. Stockholders has the last claim to the firm's assets, therefore, if the firm went sour, their share price would go worthless. There also short term loans to finance the firm's short term assets and long term loans such as bond to finance the firm long term assets. It is the CFO's job to balance which financial instrument to use to finance the firm's capital and asset.

    3. Refer to my answer on number 2. CFO decides as to how to finance the firm's asset or capital. Its like asking why doesn't a firm sell bonds instead of issuing stocks to cover all its capital needs. Generally, you don't want to finance a long term asset with a short term loan.
  6. hm2684


    ^^^ thanks guys, that really helped. Hopefully I can get an A on this midterm.
  7. Chagi


    As it happens, I'm a finance major too, though my darn degree is taking forever to finish, I work too much hehe...

    Anywho, here are some alternate answers.

    1) The two aren't necessarily directly related. For example, shareholders directly benefit from things like dividends and share buybacks, but don't necessarily benefit from a firm's value. For example, a firm with money could, say, choose to pay off some debt, invest in new assets (such as equipment), raise wages, etc., but a shareholder will only really see benefit if the firm chooses to utilize some of that money to pay a dividend. Maximizing shareholder wealth essentially means focusing on increasing the market value of the firm's equity.

    2) Financial instruments differ in things like term, whether or not they pay interest, structure, and risk. Riskier instruments will tend to offer higher rates of return than lower risk instruments (this is called risk premium by the way).

    3) This one is really, really easy to answer - because not all firms are capable of issuing commercial paper. Small and even medium sized companies are likely incapable of posessing the credit ratings (e.g. S&P, Fitch, Moody) necessary for investors to want to purchase their commercial paper. For additional marks you would probably want to mention that the size of debt needed by smaller firms isn't really appropriate for the commerical paper market, in comparison to, say, GMAC.
  8. risk is taken into account by price. the riskier the deal, the more the firm pays to get it done, either in interest, percentage of equity sold, bid/ask spread, or any other "premium."

    put another way, "risk premium" is a component of price.

  9. RXIS


    um, isn't that what you are supposed to be learning in detail throughout your college career? What class are you taking the midterm for? just wondering
  10. Chagi


    Well, speaking from my own experience, the local university business programs include a mandatory corporate finance class for all business undergrads.

    Exact curriculum would vary, but ours tend to talk about how interest works (e.g. investments and loans, FV, PV), explains risk/reward, bit on the CAPM, capital budgeting (i.e. NPV concepts when deciding whether or not to pursue an investment such as building a new factory), brief focus on financial statements...
    #10     Oct 12, 2005