,CHAPTER 1: INTRODUCTION TO CORPORATE FINANCE
The values shown in the solutions may be rounded for display purposes. However, the answers
were derived using a spreadsheet without any intermediate rounding.
Answers to Problem Sets
1. a. real
b. executive airplanes
c. brand names
d. financial
e. bonds
f. investment or capital expenditure
*g. capital budgeting or investment
h. financing
*Note that f and g are interchangeable in the question.
Est time: 01-05
2. A trademark, a factory, undeveloped land, and a work force (c, d, e, and g) are all real
assets. Real assets are identifiable as items with intrinsic value. The others in the list are
financial assets, that is, these assets derive value because of a contractual claim.
Est time: 01-05
3. a. Financial assets, such as stocks or bank loans, are claims held by investors.
Companies sell financial assets to raise the cash to invest in real assets such as
plant and equipment. Some real assets are intangible.
b. Capital expenditure means investment in real assets. Financing means raising the
cash for this investment.
c. The shares of public companies are traded on stock exchanges and can be
purchased by a wide range of investors. The shares of closely held companies are
not publicly traded and are held by a small group of private investors.
d. Unlimited liability: Investors are responsible for all the firm’s debts. A sole proprietor
has unlimited liability. Investors in companies have limited liability. They can lose
their investment, but no more.
Est time: 01-05
4. Items c and d apply to companies. Because companies have perpetual life, ownership can
be transferred without affecting operations, and managers can be fired with no effect on
ownership. Other forms of business may have unlimited liability and limited life.
Est time: 01-05
,5. Separation of ownership facilitates the key attributes of a corporation, including limited
liability for investors, transferability of ownership, a separate legal personality of the
corporation, and delegated centralized management. These four attributes provide
substantial benefit for investors, including the ability to diversify their investment among
many uncorrelated returns—a very valuable tool explored in later chapters. Also, these
attributes allow investors to quickly exit, enter, or short sell an investment, thereby
generating an active liquid market for companies.
However, these positive aspects also introduce substantial negative externalities as well.
The separation of ownership from management typically leads to agency problems, where
managers prefer to consume private perks or make other decisions for their private benefit—
rather than maximize shareholder wealth. Shareholders tend to exercise less oversight of
each individual investment as their diversification increases. Finally, the corporation’s
separate legal personality makes it difficult to enforce accountability if they externalize costs
onto society.
Est time: 01-05
6. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their
pattern of consumption through borrowing and lending, match risk preferences, and hopefully
balance their own checkbooks (or hire a qualified professional to help them with these tasks).
Est time: 01-05
7. If the investment increases the firm’s wealth, it increases the firm’s share value. Ms.
Espinoza could then sell some or all these more valuable shares to provide for her retirement
income.
Est time: 01-05
8. a. Assuming that the encabulator market is risky, an 8% expected return on
the F&H encabulator investments may be inferior to a 4% return on U.S.
government securities, depending on the relative risk between the two assets.
b. Unless the financial assets are as safe as U.S. government securities, their cost of
capital would be higher. The CFO could consider expected returns on assets with
similar risk.
Est time: 06-10
9. Managers would act in shareholders’ interests because they have a legal duty to act in their
interests. Managers may also receive compensation— bonuses, stock, and option payouts
with value tied (roughly) to firm performance. Managers may fear personal reputational
damage from not acting in shareholders’ interests. And managers can be fired by the board
of directors (elected by shareholders). If managers still fail to act in shareholders’ interests,
shareholders may sell their shares, lowering the stock price and potentially creating the
possibility of a takeover, which can again lead to changes in the board of directors and
senior management.
Est time: 01-05
10. Managers that are insulated from takeovers may be more prone to agency problems and
therefore more likely to act in their own interests rather than in shareholders’. If a firm
instituted a new takeover defense, we might expect to see the value of its shares decline as
, agency problems increase and less shareholder value maximization occurs. The
counterargument is that defensive measures allow managers to negotiate for a higher
purchase price in the face of a takeover bid—to the benefit of shareholder value.
Est time: 01-05
Appendix Questions:
1. Both would still invest in their friend’s business. O invests and receives $121,000 for his
investment at the end of the year—which is greater than the $120,000 that would be
received from lending at 20% ($100,000 × 1.20 = $120,000). Y also invests, but borrows
against the $121,000 payment, and thus receives $100,833 ($121,.20) today.
Est time: 01-05
2. a. He could consume up to $200,000 now (forgoing all future consumption) or up to
$216,000 next year ($200,000 × 1.08, forgoing all consumption this year). He should invest
all of his wealth to earn $216,000 next year. To choose the same consumption (C) in both
years, C = ($200,000 – C) × 1.08 = $103,846.
b. He should invest all of his wealth to earn $220,000 ($200,000 × 1.10) next year. If he
consumes all this year, he can now have a total of $203,703.70 ($200,000 × 1.10/1.08) this
year or $220,000 next year. If he consumes C this year, the amount available for next year’s
consumption is ($203,703.70 – C) × 1.08. To get equal consumption in both years, set the
amount consumed today equal to the amount next year:
C = ($203,703.70 – C) × 1.08
C = $105,769.20
Est time: 06-10
The values shown in the solutions may be rounded for display purposes. However, the answers
were derived using a spreadsheet without any intermediate rounding.
Answers to Problem Sets
1. a. real
b. executive airplanes
c. brand names
d. financial
e. bonds
f. investment or capital expenditure
*g. capital budgeting or investment
h. financing
*Note that f and g are interchangeable in the question.
Est time: 01-05
2. A trademark, a factory, undeveloped land, and a work force (c, d, e, and g) are all real
assets. Real assets are identifiable as items with intrinsic value. The others in the list are
financial assets, that is, these assets derive value because of a contractual claim.
Est time: 01-05
3. a. Financial assets, such as stocks or bank loans, are claims held by investors.
Companies sell financial assets to raise the cash to invest in real assets such as
plant and equipment. Some real assets are intangible.
b. Capital expenditure means investment in real assets. Financing means raising the
cash for this investment.
c. The shares of public companies are traded on stock exchanges and can be
purchased by a wide range of investors. The shares of closely held companies are
not publicly traded and are held by a small group of private investors.
d. Unlimited liability: Investors are responsible for all the firm’s debts. A sole proprietor
has unlimited liability. Investors in companies have limited liability. They can lose
their investment, but no more.
Est time: 01-05
4. Items c and d apply to companies. Because companies have perpetual life, ownership can
be transferred without affecting operations, and managers can be fired with no effect on
ownership. Other forms of business may have unlimited liability and limited life.
Est time: 01-05
,5. Separation of ownership facilitates the key attributes of a corporation, including limited
liability for investors, transferability of ownership, a separate legal personality of the
corporation, and delegated centralized management. These four attributes provide
substantial benefit for investors, including the ability to diversify their investment among
many uncorrelated returns—a very valuable tool explored in later chapters. Also, these
attributes allow investors to quickly exit, enter, or short sell an investment, thereby
generating an active liquid market for companies.
However, these positive aspects also introduce substantial negative externalities as well.
The separation of ownership from management typically leads to agency problems, where
managers prefer to consume private perks or make other decisions for their private benefit—
rather than maximize shareholder wealth. Shareholders tend to exercise less oversight of
each individual investment as their diversification increases. Finally, the corporation’s
separate legal personality makes it difficult to enforce accountability if they externalize costs
onto society.
Est time: 01-05
6. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their
pattern of consumption through borrowing and lending, match risk preferences, and hopefully
balance their own checkbooks (or hire a qualified professional to help them with these tasks).
Est time: 01-05
7. If the investment increases the firm’s wealth, it increases the firm’s share value. Ms.
Espinoza could then sell some or all these more valuable shares to provide for her retirement
income.
Est time: 01-05
8. a. Assuming that the encabulator market is risky, an 8% expected return on
the F&H encabulator investments may be inferior to a 4% return on U.S.
government securities, depending on the relative risk between the two assets.
b. Unless the financial assets are as safe as U.S. government securities, their cost of
capital would be higher. The CFO could consider expected returns on assets with
similar risk.
Est time: 06-10
9. Managers would act in shareholders’ interests because they have a legal duty to act in their
interests. Managers may also receive compensation— bonuses, stock, and option payouts
with value tied (roughly) to firm performance. Managers may fear personal reputational
damage from not acting in shareholders’ interests. And managers can be fired by the board
of directors (elected by shareholders). If managers still fail to act in shareholders’ interests,
shareholders may sell their shares, lowering the stock price and potentially creating the
possibility of a takeover, which can again lead to changes in the board of directors and
senior management.
Est time: 01-05
10. Managers that are insulated from takeovers may be more prone to agency problems and
therefore more likely to act in their own interests rather than in shareholders’. If a firm
instituted a new takeover defense, we might expect to see the value of its shares decline as
, agency problems increase and less shareholder value maximization occurs. The
counterargument is that defensive measures allow managers to negotiate for a higher
purchase price in the face of a takeover bid—to the benefit of shareholder value.
Est time: 01-05
Appendix Questions:
1. Both would still invest in their friend’s business. O invests and receives $121,000 for his
investment at the end of the year—which is greater than the $120,000 that would be
received from lending at 20% ($100,000 × 1.20 = $120,000). Y also invests, but borrows
against the $121,000 payment, and thus receives $100,833 ($121,.20) today.
Est time: 01-05
2. a. He could consume up to $200,000 now (forgoing all future consumption) or up to
$216,000 next year ($200,000 × 1.08, forgoing all consumption this year). He should invest
all of his wealth to earn $216,000 next year. To choose the same consumption (C) in both
years, C = ($200,000 – C) × 1.08 = $103,846.
b. He should invest all of his wealth to earn $220,000 ($200,000 × 1.10) next year. If he
consumes all this year, he can now have a total of $203,703.70 ($200,000 × 1.10/1.08) this
year or $220,000 next year. If he consumes C this year, the amount available for next year’s
consumption is ($203,703.70 – C) × 1.08. To get equal consumption in both years, set the
amount consumed today equal to the amount next year:
C = ($203,703.70 – C) × 1.08
C = $105,769.20
Est time: 06-10
