California State University, San Bernardino FIN 602 FIN 602 EXAM 1.

SAMPLE QUESTIONS
• What is Finance?
Finance is a discipline covering financial activities of Corporation. Specifically, it covers Corporate Finance, Investment,
International Finance and Institutional Finance.
• What is Corporate Finance?
It is about financial activities within Corporation.
It covers topics of understanding financial statements and valuation (time value of money) to handle capital budgeting,
capital structure, and working capital management and to maximize the firm value.
• Capital budgeting: allocation of resources to profitable projects.
• Capital structure: long term financing decision.
• Working capital management: short term financing decision.
To deal with these functions, we need to know how to read financial statement and how to calculate time value of money.
1) Types of Business Organization:
• Sole proprietorship
• Partnership
• Corporation
• Hybrid
(1) Sole proprietorship: an owner is a manager.
Advantages:
- Easily and inexpensively formed
- Subject to few government regulations
- Avoid corporate income tax
Limits:
- Unlimited personal liability
- Limited to the life of the individual who create
- Difficult to obtain large sums of capital
(2) Partnership – more than one owner who involves management too.
Advantages:
- Easy and inexpensive to set up
Limits:
- Unlimited liability
- Limited life
- Difficult to transfer ownership
• Limited partnership has limited partners and general partners. Limited partners do not involve in management
and can lose only his or her investment whereas general partners involve in management and have unlimited
liabilities. In both regular and limited partnerships, at least, one partner is liable for debts of the partnership.
However, in a Limited Liability Company or Limited Liability Partnership, all partners enjoy limited liability
regard to the business liabilities and their potential losses.
(3) Corporation
Separation of owners from management.
Advantages:
- Unlimited life
- Easy transferability of ownership
- Limited liabilities
Limits:
- Double taxations: corporate and individual levels
- More time consuming documentation and reports: charter and a set of bylaws
Charter includes; (1) name of proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4)
number of directors, (5) names and addresses of directors. This charter is filed with the secretary of the state in which the
firm will be incorporated.
- Bylaw includes; (1) how directors are elected, (2) whether the existing stockholders will have the first right to buy
any new shares the firm issues, (3) procedure for changing the bylaws.
- Different types:
• Professional Corporation (PC) or Professional Association (PA). Though Corporation, it does not allow to relieve
professional liability (e.g. malpractice of doctors, lawyers, etc).
• S Corporation: small size business and 100 owners. Taxed like a proprietorship.
3. Growing and managing a Corporation
• Agency problem: conflict of interest between management and shareholders
• Corporate governance in order to address agency problem. Here corporate governance is a set of rules that
control company’s behavior towards its directors, managers, employees, shareholders, creditors, customers,
competitors, and community.
Primary Objective of Corporation
• Stock holders elect directors who then hire managers to run a corporation
• Goal of management is to maximize the fundamental or intrinsic price of common stock rather than the market
price.
• Maximizing stock price also benefit social welfare: (1) owners of stock are society, (2) Consumer benefit resulting
from high quality and low cost, and (3) employees benefit, .etc
Managerial Actions to Maximize Shareholder Wealth
• Firm value is determined by a company’s ability to generate free cash flows (FCF) now and in the future. The
improvement of FCF will improve the intrinsic value of a firm.
• FCF = sale revenue – operating costs – operating taxes – required new investments in operating capital.
• Value (intrinsic or fundamental value) ¿∑
n=1
∞
FCFn
(1+WACC)n
• Here WACC is weighted average cost of capital
How to improve free cash flows (FCF)?
• Improvement of free cash flow affects ordinary citizen, consumers and employee
• Improvement of free cash flow relates to ethics.
(2) Regulations
• SOX (Sarbanes-Oxley 2002)
• Dodd Frank Reform and Consumer Protection (2010)
• Both protect whistleblowers reporting wrong doing. E.g.) Occupational Safety and Health Administration
(OSHA).
Capital Allocation Process
1) Direct Transfers
2) Indirect Transfers though Investment Bankers underwriting the security issues.
3) Indirect Transfer through a Financial Intermediary such as banks and funds.
Financial Securities/Instruments
Def: claim on a future cash flow
- Debts: papers entitling owners to specific rights and claims.
- Equity: a claim upon a residual value after debts.
- Derivatives: securities whose value is deriven by underlying assets.
- Hybrids: mixture of characters in debts, equity, and derivatives.
3) The process of securitization – mortgage securitization:
• S&L, banks or specialized mortgage originating firms originate mortgage and sell them to investment banks.
The investment bundle them into packages and then use these package as collateral for bonds sold to pension
funds, insurance and other investors.
• Congress facilitated this process by creating two stockholder-owned but government sponsored entities – Federal
National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac)
which have a small amount of equity and a huge amounts of debt.
• Since then, S&L and banks originate and pool mortgage and then sell them to Fannie Mae which uses them as
collateral in order to sell bonds. E.g) Collateralized debt obligation (CDO,
https://www.investopedia.com/terms/c/cdo.asp).
• This process (1) increases lendable funds, (2) transfer of risk of mortgage to Fannie Mae, and (3) increases
liquidity for holders of the debts.
• This process benefit investors (lenders) through diversification – bundled mortgage and an improved return.
4) Crypto currency:
• A cryptocurrency is a digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult
to counterfeit because of this security feature. A defining feature of a cryptocurrency; it is not issued by any
central authority, rendering it theoretically immune to government interference or manipulation.
Financial Institutions
1) Investment banks: an organization that underwrites and distributes new investment securities and helps businesses
obtain financing. It also provides consulting and advisory services and brokerage services.
2) Deposit-taking financial intermediates
• Savings and Loan Association (S&Ls): accepted deposits from many small savers and then loaned this money to
home buyers and consumers.
• Credit union: cooperative association whose members’ savings are loaned only to other members.
• Commercial bank: raising money from deposits or by issuing stock or bonds to investors. Some one with a bank
account can write checks, use debit cards, etc. And investors can receive dividends or interests.
Investment Funds
• Mutual funds: organizations that pool investor funds to purchase financial instruments and thus reduce risk
through diversification.
- Money market funds: investment in low-risk securities and allow investors to write checks against their
accounts.
• Exchange Traded Funds (ETFs): similar to mutual funds. ETFs funds buy a portfolio of stocks of certain type
and then sell their own shares to the public.
• Hedge funds: similar to mutual funds.
- Limited to institution investors and small number of net worth individuals.
- Mutual funds are registered and regulated by SEC but hedge funds are less regulated.
- Minimum investment requirement ( $1 million).
• Private Equity Companies: they buy and then manage entire firms.
- Limited to a small number of large investors.
- Tend to privatize public firms and then sell them later at premium.
Insurance and Pension funds