Corporate finance: key concepts and applications

¶ … self-Serving actions that management may take to decrease the risk to their personal portfolios.

Essentially, this is about the paradigm of risk management, and ways to mitigate such within a template of managerial personal portfolio; another term is, of course, portfolio management. While risk management can be a multi-stage process, there are at least five actions that managers can take to decrease the risks to their own, personal profiles. First, though, we must understand that any risk management philosophy operates off a two-stage template: 1) what risks exist in an investment or grouping of investments and, 2) what are ways that are suited to manage these risks within the paradigm of your own personal objectives. The five steps recommended by most investment professionals are:

Determine a reasonable expectation -- Risk is only a factor if one's portfolio is not in balance. Diversification is usually the first step towards balancing a portfolio; but if there are tactile, reasonable short-term goals, there might be a difference in what is a reasonable expectation.

Identify actual exposure to loss -- There are varying opinions as to loss, usually a what-if scenario. While analysts can often predict long-term market fluctuations, the what-if events (natural disasters, elections, etc.) are usually unpredictable in a given market.

Measure those exposures -- Each part of the portfolio should be objectively measured -- not all parts of the portfolio will share the same risk. The risk measurement can be as simple as high-medium-low; or as complex as a percentile rating.

Select alternatives -- Again, alternatives and diversification are the key to mitigating loss. Time goals are also important, as are choices in domestic or foreign portfolios.

Implement a solution -- All the analysis in the world is for naught if a plan is not put together that will allow for robust solutions. Be in control, at least you will know the decisions were based on analysis (Crouhy, Galai, Mark, et.al., 2005)

Briefly explain the usefulness of each of the following means of mitigating the effects of informational asymmetry in the credit markets: a) Screening; b) Certification; c) Costly Signaling; d) Reputation e) Disclosure rules

Screening -- Screening is based on using a particular criteria or set of criteria to determine the creditworthiness of an individual or organization prior to lending money. Screening can certainly mitigate loss, but is entirely dependent on two factors: quality of information received and screening criteria. Certainly, as an initial step it is almost a requirement of any process involved in lending, as long as basic rules are set regarding consumer, peer-to-peer, and organizational lending with reasonable numeric scales established prior to the project ( Iyer, Khwaja, Luttmer and Shue, 2009).

Certification -- Certification is more of an academic process that one receives in order to understand the multitude of variables that may impact credit decisions. There are several certification agencies, all offering courses that result in the appropriate certification based on an individual methodology. The value that certification brings is a closer look at documents at procedures that have been designed to understand and uncover risks (Credit Risk Certification Processes, 2010).

Costly Signaling -- Costly signaling is a term that initially came from theoretical works on population biology. It has been adopted into economic theory to mean that one party (the agent) conveys meaningful information about itself to the other party (the principal). An employee could signal intentions on promotion by making their acquisition of an advanced degree public. Costly signaling tries to measure the Cost-Benefit relationship between risks in investment areas. One can easily think of this as a simple graph in which the horizontal axis measures the particular variable and the vertical the cost of signaling. Where the two meet is a way to measure vulnerability (Spence, 2002).

Repudiation -- usually refers to the risk that the entity or organization will declare some type of moratorium over the structure of the contract. This becomes especially true when dealing with derivatives -- or the underlying risk on any financial asset. There are costs associated with repudiation; "The pricing of the risk of repudiation or the pricing of restitution costs borne by the depositor shall in general be termed FSLIC risk and shall be defined and measured while controlling for firm risk" (Cooke and Spellman, 1994).

Disclosure Rules -- Like the process of discovery in legal terms, discovery rules are designed to provide a fair and transparent way for parties to understand their potential financial partners prior to any transaction. These vary based on litigation and federal law but are set up to provide an even playing field and force the dissemination of information in a timely and legal manner (Commission, 2010).

Describe various means by which the securities markets themselves mitigate agency and informational asymmetry problems.

Certainly the SEC requires certain amount of information to be passed between buyers, sellers, and interested stakeholders within the market. However, the lack of appropriate information, or asymmetry, has an adverse reaction to all parties within a transaction, and is therefore disadvantageous for all concerned. Therefore, the industry uses some sensical methods to ensure that there is more balance within any given transaction. There are several ways this occurs: screening (investigation of a firm or individual); monitoring (once the loan is made, monitor for any risky action); long-term relationships (more likely to survive and remain honest than short-term or one-shot buys); credit rationing (variable interests rates based on risk and keeping portfolio diverse); and finally, disclosure above and beyond SEC requirements (The Economics of Financial Intermediation, 2007).

The idea behind this is the self-regulation of an industry segment so that more structured and severe regulation becomes unnecessary. Trust is an essential part of security trading -- without trust clients will be unlikely to put fiscal resources into markets. Certainly governmental regulation is important, but exchange incentives are another way that the market self-regulates. As one investment expert indicated: "More trading by customers obviously means more commissions, but more liquid markets also enhance the profitability of broker-dealers' own trading. Exchanges attract trading volume by encouraging companies to list their shares and by encouraging investors to trade in those listed shares. Those two goals are largely consistent, as companies will want to list their shares on exchanges that provide the greatest liquidity because liquidity minimizes their cost of capital" (Pritchard, 2003).

In a world with corporate taxes, explain how the government becomes a stakeholder in each firm. How risky is the government's claim on a firm's earnings?

Corporate taxation has been part of the Federal System since 1861 but had a few decades of Constitutional challenges until ratification of the 16th Amendment. Businesses choose their type and classification (C, S, etc.) based on how they want taxes to flow through to owners or only at the member level. Stakeholder groups have differing interests in a corporation based on their own interests and level of participation. Those with common interests include shareholder and employees, suppliers, and some owners -- all wishing for higher profits which lead to high dividends and job security. Conflicting interests could be management or the government, who see profits and short vs. long-term growth in a different manner. The government exerts stakeholder interest through taxation, government spending, legal action, regulation and changes in the law that affect the organization. It is in the government's best interest that large corporations, for example large Auto Makers, who employee thousands of people and pay millions in taxes (or generate income) remain profitable. Depending on the size and structure of the organization, the government's risk may be higher in some cases than the average investor. We have all heard, for example, that certain firms are "too big to fail," and the recent bail-out of certain financial and auto industry organizations indicates that the government remains concerned about its own interests as well as that of the company. If millions are lost in revenues at the Federal level, millions in State and Local taxes and property taxes, and thousands are laid off (requiring unemployment or social benefits) the costs to the government may be huge. This necessitates the government acting as an interested stakeholder in some organizations (Stakeholders - Interests and Power, 2009).

List and briefly explain the real-world factors that:

a. induces a positive relationship between firm value and leverage; There are a number of market conditions that induce positive relationships between a firm's value and leverage. Numerous studies of the relationship between leverage and value, though, show no complete correlation except for a firm's growth opportunities and market position. If a firm is profitable, market share is growing, and above all has a product or service that is seen as innovative -- and is perceived as optimistic in the market, the effects are correlatively quite positive. Taking growth into account, however, we find that there are a number of factors that influence the organization's ability to appropriately grow. Obviously, product and service are critical, as is the ability to get that product to market (staffing, manufacturing, training and service). A company may be profitable, but not growing, and vice versa, thus affecting leverage (Aggaral and Zhao, 2007).

b. induce a negative relationship between firm value and leverage; conversely, if a firm is perceived with negative or flat growth, leverage is affected. Interestingly enough, new research shows that there are some micro-factors outside of growth that correlate to value and leverage. These include the way a corporation is managed, the size of the Board, the impression of large dividends and lack of focus on shareholder value, and milking of an industry (e.g. yellow pages in the day of the Internet). In addition, certain governmental regulations that are perceived as heavy handed and/or not conducive to growth or -- what is most critical -- perceived growth have considerable negative effects on leverage. Whether this psychological perception is valid or not, the research does not comment -- but it is surprising that an external person would look at board size, perceived growth, and other micro-trends as negative factors in leverage (Ibid and Aivazian, 1980).

How can an incumbent firm in a given industry use leverage to deter entry? Depending on cash flow and market position, firms that exist in say an oligopoly can use debt to commit to a longer-term strategic position that negatively affects rival firms who might want to enter that market. For instance, debt can be managed in a way that commits the organization to such a competitive price or delivery ratio that an entrant's lender would not even think of financing entry because the market is so saturated and the new entrant unable to have any form of positive cash flow. In a way, this is a hyper-sensitive competitive position because it commits the original company into servicing that debt and, therefore, a longer term commitment to the marketplace. In addition, it presupposes both debt as a strategic weapon and the market being able to self-regulate by credit rationing (Showalter, 2009).

Compare and contrast joint ventures and strategic alliances as a means by which a firm can compete more effectively in its industry. Essentially, the difference between joint ventures and strategic alliances comes down to two major factors: length and breadth of proposed arrangement and commitment of principles to each other and the market. A joint venture is more formal, contains more legal responsibilities and results in an independent firm being created by two or more other firms; whereas a strategic alliance is an agreement to cooperate in any value-chain activity from research and development to marketing and sales. In the age of globalism, for instance, many organizations realize that they do not have one or more critical aspect to effectively manage their product in a certain area -- distribution in the Far East, for instance. In this case a manufacturing company might form a strategic alliance with a distribution or warehousing company that specializes in the area needed. Advantages and disadvantages revolve around the resources and expertise a group can bring to the table; strategic alliances can be win-win for a time, but if they are not profitable, easily dissolved. A joint venture is much more serious, and should be thought of as a semi-permanent relationship. For instance, if a company wants to enter certain foreign markets, it might behoove them to form a joint venture with a company in that foreign environment -- limiting export/import, taxation, and/or regulation issues (Waggoner, 2009).

8. List the external governance groups that influence a firm, and explain how they curb self-serving decisions by a public firm's management. Repeat for internal governance groups. External governance is a set of customs, laws, policies, and institutions that affect the way a company is administered and controlled. Essentially, it was put in place to ensure a higher level of accountability within an organization. In effect, one school of thought holds that external governance protects shareholders and the public from unscrupulous practices, something, for instance, that the recent ENRON scandal showed to be of limited value. This, in fact, resulted in the 2002 passing of the Sarbanes-Oxley Act, which intended to restore public belief in corporate governance (Bumiller, 2002). Examples of external governance are all Federal, State and Local taxation agencies; the Securities and Exchange Commission; any governmental agency that participates or requires permits or licenses; large institutional investors, and external legal entities concerned with operations (environment, etc.).

Internal governance, on the other hand, is based on the type of organization and its structure and make-up. In some organizations, for instance, the Board of Directors is very powerful, in others; the CEO and COO control most of the major decisions. Internal stakeholders include employees (union groups or others), lower level management, human resources, the market pool, at times suppliers, consumers and in newer firms, even the very nature and structure of management itself. Internal governance has a two-pronged responsibility: first to avoid external mediation and, second, to ensure that appropriate managerial steps are utilized on a tactical basis to underlay profit and ROI. These are essentially the systems of rule and laws created by the company or the company's board to allow business to occur (Internal Governance, 2009).