SOLUTION MANUAL for Foundations of Financial Management,
18th Edition by Stanley Block, Geoffrey Hirt,
Chapters 1 – 21, Complete
,
, Chapter 1
The Goals and Functions of Financial Management
Discussion Questions
1-1 What effect did the recession of 2007-2009 have on government regulation?
It was greatly increased.
1-2 What advantages does a sole proprietorship offer? What is a major drawback of this type of
organization?
A sole proprietorship offers the advantage of simplicity of decision making and low organizational
and operating costs. A major drawback is that there is unlimited liability to the owner.
1-3 What form of partnership allows some of the investors to limit their liability? Explain briefly.
A limited partnership allows some of the partners to limit their liability. Under this arrangement,
one or more partners are designated general partners and have unlimited liability for the debts of
the firm; other partners are designated limited partners and are liable only for their initial
contribution. The limited partners are normally prohibited from being active in the management of
the firm.
1-4 In a corporation, what group has the ultimate responsibility for protecting and managing the
stockholders’ interests?
The board of directors.
1-5 What document is necessary to form a corporation?
The articles of incorporation.
1-6 What issue does agency theory examine? Why is it important in a public corporation rather
than in a private corporation?
, Agency theory examines the relationship between the owners of the firm and the managers of the
firm. In privately owned firms, management and the owners are usually the same people.
Management operates the firm to satisfy its own goals, needs, financial requirements and the like.
As a company moves from private to public ownership, management now represents all owners.
This places management in the agency position of making decisions in the best interest of all
shareholders.
1-7 What are institutional investors important in today’s business world?
Because institutional investors such as pension funds and mutual funds own a large percentage of
major U.S. companies, they are having more to say about the way publicly owned companies are
managed. As a group, they have the ability to vote large blocks of shares for the election of a board of
directors, which is supposed to run the company in an efficient, competitive manner. The threat of
being able to replace poor performing boards of directors makes institutional investors quite
influential. Since these institutions, like pension funds and mutual funds, represent individual
workers and investors, they have a responsibility to see that the firm is managed in an efficient and
ethical way.
1-8 Why is profit maximization, by itself, an inappropriate goal? What is meant by the goal of
maximization of shareholder wealth?
The problem with a profit maximization goal is that it fails to take account of risk, the timing of the
benefits is not considered, and profit measurement is a very inexact process. The goal of
shareholders’ wealth maximization implies that the firm will attempt to achieve the highest possible
total valuation in the marketplace. It is the one overriding objective of the firm and should
influence every decision.
1-9 When does insider trading occur? What government agency is responsible for protecting against
the unethical practice of insider trading?
Insider trading occurs when anyone with non-public information buys or sells securities to take
advantage of that private information. The Securities and Exchange Commission is responsible for
protecting markets against insider trading. In the past, people have gone to jail for trading on non-
public information. This has included company officers, investment bankers, printers who have
information before it is published, and even truck drivers who deliver business magazines and read
positive or negative articles about a company before the magazine is on the newsstands and then
place trades or have friends place trades based on that information. The SEC has prosecuted anyone
who profits from inside information.
1-10 In terms of the life of the securities offered, what is the difference between money and capital
markets?
Money markets refer to those markets dealing with short-term securities that have a life of one
year or less. Capital markets refer to securities with a life of more than one year.
1-11 What is the difference between a primary and a secondary market?
, A primary market refers to the use of the financial markets to raise new funds for the corporation.
After the securities are sold to the public (institutions and individuals), they trade in the secondary
market between investors. It is in the secondary market that prices are continually changing as
investors buy and sell securities based on the expectations of corporate prospects.
1-12 Assume you are looking at many companies with equal risk. Which ones will have the highest
stock prices?
Given companies with equal risk, those companies with expectations of high return will have
higher common stock prices relative to those companies with expectations of poor returns.
1-13 How is the time value of money concept related to the valuation of stocks?
The value of an investment that is expected to earn money in the future can be calculated using
time-value of money principles. Corporations are expected to pay dividends to their shareholders.
The current value of these future dividends is the present value. The present value of a stock’s
future dividends should be the same as the stock’s current price.
Chapter 2
Review of Accounting
Discussion Questions
2-1. Discuss some financial variables that affect the price-earnings ratio.
The price-earnings ratio will be influenced by the earnings and sales growth of the firm, the risk
or volatility in performance, the debt-equity structure of the firm, the dividend payment policy,
the quality of management, and a number of other factors. The ratio tends to be future-oriented,
and the more positive the outlook, the higher it will be.
2-2. What is the difference between book value per share of common stock and market value per
share? Why does this disparity occur?
Book value per share is arrived at by taking the cost of the assets and subtracting out liabilities and
preferred stock and dividing by the number of common shares
, outstanding. It is based on the historical cost of the assets. Market value per share is
based on the current assessed value of the firm in the marketplace and may bear little relationship
to original cost. Besides the disparity between book and market value caused by the historical cost
approach, other contributing factors are the growth prospects for the firm, the quality of
management, and the industry outlook. To the extent these are quite negative or positive; market
value may differ widely from book value.
2-3. Explain how depreciation generates actual cash flows for the company.
The only way depreciation generates cash flows for the company is by serving as a tax shield
against reported income. This non-cash deduction may provide cash flow equal to the tax rate
times the depreciation charged. This much in taxes will be saved, while no cash payments occur.
2-4. What is the difference between accumulated depreciation and depreciation expense? How are they
related?
Accumulated depreciation is the sum of all past and present depreciation charges, while
depreciation expense is the current year’s charge. They are related in that the sum of all prior
depreciation expense should be equal to accumulated depreciation (subject to some differential
related to asset
write-offs).
2-5. How is the income statement related to the balance sheet?
The earnings (less dividends) reported in the income statement is transferred to the ownership
section of the balance sheet as retained earnings. Thus, what we earn in the income statement
becomes part of the ownership interest in the balance sheet.
2-6. Comment on why inflation may restrict the usefulness of the balance sheet as normally
presented.
The balance sheet is based on historical costs. When prices are rising rapidly, historical cost data
may lose much of their meaning—particularly for plant and equipment and
, inventory.
2-7. Explain why the statement of cash flows provides useful information that goes beyond income
statement and balance sheet data.
The income statement and balance sheet are based on the accrual method of accounting, which
attempts to match revenues and expenses in the period in which they occur. However, accrual
accounting does not attempt to properly assess the cash flow position of the firm. The statement
of cash flows fulfills this need.
2-8. What are the three primary sections of the statement of cash flows? In what section would the
payment of a cash dividend be shown?
The sections of the statement of cash flows are:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
The payment of cash dividends falls into the financing activities category.
2-9. What is free cash flow? Why is it important to leveraged buyouts?
Free cash flow is equal to cash flow from operating activities:
Minus: Capital expenditures required to maintain the productive capacity of the firm.
Minus: Dividends (required to maintain the payout on common stock and to cover
any preferred stock obligation).
, The analyst or banker normally looks at free cash flow to determine whether there are
sufficient excess funds to pay back the loan associated with the leveraged buyout.
2-10. Why is interest expense said to cost the firm substantially less than the actual expense, while
dividends cost it 100 percent of the outlay?
Interest expense is a tax-deductible item to the corporation, while dividend payments are not. The
net cost to the corporation of interest expense is the amount paid multiplied by the difference of
one minus the applicable tax rate.
For example, $100 of interest expense costs the company $65 after taxes when the corporate tax
rate is 35 percent—for example, $100 × (1 – 0.35) = $65.
Problems
1. Income Statement (LO1) Frantic Fast Foods had earnings after taxes of $410,000 in the year 20X1 with
301,000 shares outstanding. On January 1, 20X2, the firm issued 30,000 new shares. Because of the proceeds
from these new shares and other operating improvements, earnings after taxes increased by 25 percent.
a. Compute earnings per share for the year 20X1.
b. Compute earnings per share for the year 20X2.
2-1. Solution:
18th Edition by Stanley Block, Geoffrey Hirt,
Chapters 1 – 21, Complete
,
, Chapter 1
The Goals and Functions of Financial Management
Discussion Questions
1-1 What effect did the recession of 2007-2009 have on government regulation?
It was greatly increased.
1-2 What advantages does a sole proprietorship offer? What is a major drawback of this type of
organization?
A sole proprietorship offers the advantage of simplicity of decision making and low organizational
and operating costs. A major drawback is that there is unlimited liability to the owner.
1-3 What form of partnership allows some of the investors to limit their liability? Explain briefly.
A limited partnership allows some of the partners to limit their liability. Under this arrangement,
one or more partners are designated general partners and have unlimited liability for the debts of
the firm; other partners are designated limited partners and are liable only for their initial
contribution. The limited partners are normally prohibited from being active in the management of
the firm.
1-4 In a corporation, what group has the ultimate responsibility for protecting and managing the
stockholders’ interests?
The board of directors.
1-5 What document is necessary to form a corporation?
The articles of incorporation.
1-6 What issue does agency theory examine? Why is it important in a public corporation rather
than in a private corporation?
, Agency theory examines the relationship between the owners of the firm and the managers of the
firm. In privately owned firms, management and the owners are usually the same people.
Management operates the firm to satisfy its own goals, needs, financial requirements and the like.
As a company moves from private to public ownership, management now represents all owners.
This places management in the agency position of making decisions in the best interest of all
shareholders.
1-7 What are institutional investors important in today’s business world?
Because institutional investors such as pension funds and mutual funds own a large percentage of
major U.S. companies, they are having more to say about the way publicly owned companies are
managed. As a group, they have the ability to vote large blocks of shares for the election of a board of
directors, which is supposed to run the company in an efficient, competitive manner. The threat of
being able to replace poor performing boards of directors makes institutional investors quite
influential. Since these institutions, like pension funds and mutual funds, represent individual
workers and investors, they have a responsibility to see that the firm is managed in an efficient and
ethical way.
1-8 Why is profit maximization, by itself, an inappropriate goal? What is meant by the goal of
maximization of shareholder wealth?
The problem with a profit maximization goal is that it fails to take account of risk, the timing of the
benefits is not considered, and profit measurement is a very inexact process. The goal of
shareholders’ wealth maximization implies that the firm will attempt to achieve the highest possible
total valuation in the marketplace. It is the one overriding objective of the firm and should
influence every decision.
1-9 When does insider trading occur? What government agency is responsible for protecting against
the unethical practice of insider trading?
Insider trading occurs when anyone with non-public information buys or sells securities to take
advantage of that private information. The Securities and Exchange Commission is responsible for
protecting markets against insider trading. In the past, people have gone to jail for trading on non-
public information. This has included company officers, investment bankers, printers who have
information before it is published, and even truck drivers who deliver business magazines and read
positive or negative articles about a company before the magazine is on the newsstands and then
place trades or have friends place trades based on that information. The SEC has prosecuted anyone
who profits from inside information.
1-10 In terms of the life of the securities offered, what is the difference between money and capital
markets?
Money markets refer to those markets dealing with short-term securities that have a life of one
year or less. Capital markets refer to securities with a life of more than one year.
1-11 What is the difference between a primary and a secondary market?
, A primary market refers to the use of the financial markets to raise new funds for the corporation.
After the securities are sold to the public (institutions and individuals), they trade in the secondary
market between investors. It is in the secondary market that prices are continually changing as
investors buy and sell securities based on the expectations of corporate prospects.
1-12 Assume you are looking at many companies with equal risk. Which ones will have the highest
stock prices?
Given companies with equal risk, those companies with expectations of high return will have
higher common stock prices relative to those companies with expectations of poor returns.
1-13 How is the time value of money concept related to the valuation of stocks?
The value of an investment that is expected to earn money in the future can be calculated using
time-value of money principles. Corporations are expected to pay dividends to their shareholders.
The current value of these future dividends is the present value. The present value of a stock’s
future dividends should be the same as the stock’s current price.
Chapter 2
Review of Accounting
Discussion Questions
2-1. Discuss some financial variables that affect the price-earnings ratio.
The price-earnings ratio will be influenced by the earnings and sales growth of the firm, the risk
or volatility in performance, the debt-equity structure of the firm, the dividend payment policy,
the quality of management, and a number of other factors. The ratio tends to be future-oriented,
and the more positive the outlook, the higher it will be.
2-2. What is the difference between book value per share of common stock and market value per
share? Why does this disparity occur?
Book value per share is arrived at by taking the cost of the assets and subtracting out liabilities and
preferred stock and dividing by the number of common shares
, outstanding. It is based on the historical cost of the assets. Market value per share is
based on the current assessed value of the firm in the marketplace and may bear little relationship
to original cost. Besides the disparity between book and market value caused by the historical cost
approach, other contributing factors are the growth prospects for the firm, the quality of
management, and the industry outlook. To the extent these are quite negative or positive; market
value may differ widely from book value.
2-3. Explain how depreciation generates actual cash flows for the company.
The only way depreciation generates cash flows for the company is by serving as a tax shield
against reported income. This non-cash deduction may provide cash flow equal to the tax rate
times the depreciation charged. This much in taxes will be saved, while no cash payments occur.
2-4. What is the difference between accumulated depreciation and depreciation expense? How are they
related?
Accumulated depreciation is the sum of all past and present depreciation charges, while
depreciation expense is the current year’s charge. They are related in that the sum of all prior
depreciation expense should be equal to accumulated depreciation (subject to some differential
related to asset
write-offs).
2-5. How is the income statement related to the balance sheet?
The earnings (less dividends) reported in the income statement is transferred to the ownership
section of the balance sheet as retained earnings. Thus, what we earn in the income statement
becomes part of the ownership interest in the balance sheet.
2-6. Comment on why inflation may restrict the usefulness of the balance sheet as normally
presented.
The balance sheet is based on historical costs. When prices are rising rapidly, historical cost data
may lose much of their meaning—particularly for plant and equipment and
, inventory.
2-7. Explain why the statement of cash flows provides useful information that goes beyond income
statement and balance sheet data.
The income statement and balance sheet are based on the accrual method of accounting, which
attempts to match revenues and expenses in the period in which they occur. However, accrual
accounting does not attempt to properly assess the cash flow position of the firm. The statement
of cash flows fulfills this need.
2-8. What are the three primary sections of the statement of cash flows? In what section would the
payment of a cash dividend be shown?
The sections of the statement of cash flows are:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
The payment of cash dividends falls into the financing activities category.
2-9. What is free cash flow? Why is it important to leveraged buyouts?
Free cash flow is equal to cash flow from operating activities:
Minus: Capital expenditures required to maintain the productive capacity of the firm.
Minus: Dividends (required to maintain the payout on common stock and to cover
any preferred stock obligation).
, The analyst or banker normally looks at free cash flow to determine whether there are
sufficient excess funds to pay back the loan associated with the leveraged buyout.
2-10. Why is interest expense said to cost the firm substantially less than the actual expense, while
dividends cost it 100 percent of the outlay?
Interest expense is a tax-deductible item to the corporation, while dividend payments are not. The
net cost to the corporation of interest expense is the amount paid multiplied by the difference of
one minus the applicable tax rate.
For example, $100 of interest expense costs the company $65 after taxes when the corporate tax
rate is 35 percent—for example, $100 × (1 – 0.35) = $65.
Problems
1. Income Statement (LO1) Frantic Fast Foods had earnings after taxes of $410,000 in the year 20X1 with
301,000 shares outstanding. On January 1, 20X2, the firm issued 30,000 new shares. Because of the proceeds
from these new shares and other operating improvements, earnings after taxes increased by 25 percent.
a. Compute earnings per share for the year 20X1.
b. Compute earnings per share for the year 20X2.
2-1. Solution:
