SOLUTIONS MANUAL
CORPORATE
TH
FINANCE13 EDITION
BY ROSS,
WESTERFIELD, JAFFE,
AND JORDAN LATEST
UPDATE
, 1
CHAPTER
INTRODUCTION TO CORPORATE
FINANCE
Answers to Concept Questions
1. In the corporate form of ownership, the shareholders are the owners of the firm. The
shareholders elect the directors of the corporation, who in turn appoint the firm’s
management. This separation of ownership from control in the corporate form of
organization is what causes agency problems to exist. Management may act in its o wn or
someone else’s best interests, rather than those of the shareholders. If such events
occur, they may contradict the goal of maximizing the share price of the equity of the
firm.
2. Such organizations frequently pursue social or political missions, so many different
goals are conceivable. One goal that is often cited is revenue minimization; i.e., provide
whatever goods and services are offered at the lowest possible cost to society. A better
approach might be to observe that even a not-for-profit business has equity. Thus, one
answer is that the appropriate goal is to maximize the value of the equity.
3. Presumably, the current stock value reflects the risk, timing, and magnitude of all future
cash flows, both short-term and long-term. If this is correct, then the statement is false.
4. An argument can be made either way. At the one extreme, we could argue that in a
market economy, all of these things are priced. There is thus an optimal level of, for
example, ethical and/or illegal behavior, and the framework of stock valuation explicitly
includes these. At the other extreme, we could argue that these are non-economic
phenomena and are best handled through the political process. A classic (and highly
relevant) thought question that illustrates this debate goes something like this: “A firm
has estimated that the cost of improving the safety of one of its products is $30 million.
However, the firm believes that improving the safety of the product will only save $20
million in product liability claims. What should the firm do?”
5. The goal will be the same, but the best course of action toward that goal may be different
because of differing social, political, and economic institutions.
6. The goal of management should be to maximize the share price for the current
shareholders. If management believes that it can improve the profitability of the firm so
that the share price will exceed $35, then they should fight the offer from the outside
company. If management believes that this bidder or other unidentified bidders will
actually pay more than $35 per share to acquire the company, then they should still fight
the offer. However, if the current management cannot increase the value of the firm
beyond the bid price, and no other higher bids come in, then management is not acting
in the interests of the shareholders by fighting the offer. Since current managers often
, CHAPTER 2 - 3
lose their jobs when the corporation is acquired, poorly monitored managers have an
incentive to fight corporate takeovers in situations such as this.
7. We would expect agency problems to be less severe in other countries, primarily due to
the relatively small percentage of individual ownership. Fewer individual owners
should reduce the number of diverse opinions concerning corporate goals. The high
percentage of institutional ownership might lead to a higher degree of agreement
between owners and managers on decisions concerning risky projects. In addition,
institutions may be better able to implement effective monitoring mechanisms on
managers than can individual owners, based on the institutions’ deeper resources and
experiences with their own management.
8. The increase in institutional ownership of stock in the United States and the growing
activism of these large shareholder groups may lead to a reduction in agency problems
for U.S. corporations and a more efficient market for corporate control. However, this
may not always be the case. If the managers of the mutual fund or pension plan are not
concerned with the interests of the investors, the agency problem could potentially
remain the same, or even increase since there is the possibility of agency problems
between the fund and its investors.
9. How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest
answer is that there is a market for executives just as there is for all types of labor.
Executive compensation is the price that clears the market. The same is true for athletes
and performers. Having said that, one aspect of executive compensation deserves
comment. A primary reason executive compensation has grown so dramatically is that
companies have increasingly moved to stock-based compensation. Such movement is
obviously consistent with the attempt to better align stockholder and management
interests. In recent years, stock prices have soared, so management has cleaned up. It is
sometimes argued that much of this reward is due to rising stock prices in general, not
managerial performance. Perhaps in the future, executive compensation will be
designed to reward only differential performance, i.e., stock price increases in excess of
general market increases.
10. Maximizing the current share price is the same as maximizing the future share price at
any future period. The value of a share of stock depends on all of the future cash flows of
company. Another way to look at this is that, barring large cash payments to
shareholders, the expected price of the stock must be higher in the future than it is
today. Who would buy a stock for $100 today when the share price in one year is
expected to be $80?
, 2
CHAPTER
ACCOUNTING STATEMENTS, TAXES, AND
CASH FLOW
Answers to Concepts Review and Critical Thinking Questions
1. True. Every asset can be converted to cash at some price. However, when we are
referring to a liquid asset, the added assumption that the asset can be quickly converted
to cash at or near market value is important.
2. The recognition and matching principles in financial accounting call for revenues, and
the costs associated with producing those revenues, to be “booked” when the revenue
process is essentially complete, not necessarily when the cash is collected or bills are
paid. Note that this way is not necessarily correct; it’s the way accountants have chosen
to do it.
3. The bottom line number shows the change in the cash balance on the balance sheet. As
such, it is not a useful number for analyzing a company.
4. The major difference is the treatment of interest expense. The accounting statement of
cash flows treats interest as an operating cash flow, while the financial cash flows treat
interest as a financing cash flow. The logic of the accounting statement of cash flows is
that since interest appears on the income statement, which shows the operations for the
period, it is an operating cash flow. In reality, interest is a financing expense, which
results from the company’s choice of debt and equity. We will have more to say about
this in a later CHAPTER. When comparing the two cash flow statements, the financial
statement of cash flows is a more appropriate measure of the company’s performance
because of its treatment of interest.
5. Market values can never be negative. Imagine a share of stock selling for –$20. This
would mean that if you placed an order for 100 shares, you would get the stock al ong
with a check for $2,000. How many shares do you want to buy? More generally, because
of corporate and individual bankruptcy laws, net worth for a person or a corporation
cannot be negative, implying that liabilities cannot exceed assets in market value.
6. For a successful company that is rapidly expanding, for example, capital outlays will be
large, possibly leading to negative cash flow from assets. In general, what matters is
whether the money is spent wisely, not whether cash flow from assets is po sitive or
negative.
7. It’s probably not a good sign for an established company to have negative cash flow from
operations, but it would be fairly ordinary for a start-up, so it depends.
CORPORATE
TH
FINANCE13 EDITION
BY ROSS,
WESTERFIELD, JAFFE,
AND JORDAN LATEST
UPDATE
, 1
CHAPTER
INTRODUCTION TO CORPORATE
FINANCE
Answers to Concept Questions
1. In the corporate form of ownership, the shareholders are the owners of the firm. The
shareholders elect the directors of the corporation, who in turn appoint the firm’s
management. This separation of ownership from control in the corporate form of
organization is what causes agency problems to exist. Management may act in its o wn or
someone else’s best interests, rather than those of the shareholders. If such events
occur, they may contradict the goal of maximizing the share price of the equity of the
firm.
2. Such organizations frequently pursue social or political missions, so many different
goals are conceivable. One goal that is often cited is revenue minimization; i.e., provide
whatever goods and services are offered at the lowest possible cost to society. A better
approach might be to observe that even a not-for-profit business has equity. Thus, one
answer is that the appropriate goal is to maximize the value of the equity.
3. Presumably, the current stock value reflects the risk, timing, and magnitude of all future
cash flows, both short-term and long-term. If this is correct, then the statement is false.
4. An argument can be made either way. At the one extreme, we could argue that in a
market economy, all of these things are priced. There is thus an optimal level of, for
example, ethical and/or illegal behavior, and the framework of stock valuation explicitly
includes these. At the other extreme, we could argue that these are non-economic
phenomena and are best handled through the political process. A classic (and highly
relevant) thought question that illustrates this debate goes something like this: “A firm
has estimated that the cost of improving the safety of one of its products is $30 million.
However, the firm believes that improving the safety of the product will only save $20
million in product liability claims. What should the firm do?”
5. The goal will be the same, but the best course of action toward that goal may be different
because of differing social, political, and economic institutions.
6. The goal of management should be to maximize the share price for the current
shareholders. If management believes that it can improve the profitability of the firm so
that the share price will exceed $35, then they should fight the offer from the outside
company. If management believes that this bidder or other unidentified bidders will
actually pay more than $35 per share to acquire the company, then they should still fight
the offer. However, if the current management cannot increase the value of the firm
beyond the bid price, and no other higher bids come in, then management is not acting
in the interests of the shareholders by fighting the offer. Since current managers often
, CHAPTER 2 - 3
lose their jobs when the corporation is acquired, poorly monitored managers have an
incentive to fight corporate takeovers in situations such as this.
7. We would expect agency problems to be less severe in other countries, primarily due to
the relatively small percentage of individual ownership. Fewer individual owners
should reduce the number of diverse opinions concerning corporate goals. The high
percentage of institutional ownership might lead to a higher degree of agreement
between owners and managers on decisions concerning risky projects. In addition,
institutions may be better able to implement effective monitoring mechanisms on
managers than can individual owners, based on the institutions’ deeper resources and
experiences with their own management.
8. The increase in institutional ownership of stock in the United States and the growing
activism of these large shareholder groups may lead to a reduction in agency problems
for U.S. corporations and a more efficient market for corporate control. However, this
may not always be the case. If the managers of the mutual fund or pension plan are not
concerned with the interests of the investors, the agency problem could potentially
remain the same, or even increase since there is the possibility of agency problems
between the fund and its investors.
9. How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest
answer is that there is a market for executives just as there is for all types of labor.
Executive compensation is the price that clears the market. The same is true for athletes
and performers. Having said that, one aspect of executive compensation deserves
comment. A primary reason executive compensation has grown so dramatically is that
companies have increasingly moved to stock-based compensation. Such movement is
obviously consistent with the attempt to better align stockholder and management
interests. In recent years, stock prices have soared, so management has cleaned up. It is
sometimes argued that much of this reward is due to rising stock prices in general, not
managerial performance. Perhaps in the future, executive compensation will be
designed to reward only differential performance, i.e., stock price increases in excess of
general market increases.
10. Maximizing the current share price is the same as maximizing the future share price at
any future period. The value of a share of stock depends on all of the future cash flows of
company. Another way to look at this is that, barring large cash payments to
shareholders, the expected price of the stock must be higher in the future than it is
today. Who would buy a stock for $100 today when the share price in one year is
expected to be $80?
, 2
CHAPTER
ACCOUNTING STATEMENTS, TAXES, AND
CASH FLOW
Answers to Concepts Review and Critical Thinking Questions
1. True. Every asset can be converted to cash at some price. However, when we are
referring to a liquid asset, the added assumption that the asset can be quickly converted
to cash at or near market value is important.
2. The recognition and matching principles in financial accounting call for revenues, and
the costs associated with producing those revenues, to be “booked” when the revenue
process is essentially complete, not necessarily when the cash is collected or bills are
paid. Note that this way is not necessarily correct; it’s the way accountants have chosen
to do it.
3. The bottom line number shows the change in the cash balance on the balance sheet. As
such, it is not a useful number for analyzing a company.
4. The major difference is the treatment of interest expense. The accounting statement of
cash flows treats interest as an operating cash flow, while the financial cash flows treat
interest as a financing cash flow. The logic of the accounting statement of cash flows is
that since interest appears on the income statement, which shows the operations for the
period, it is an operating cash flow. In reality, interest is a financing expense, which
results from the company’s choice of debt and equity. We will have more to say about
this in a later CHAPTER. When comparing the two cash flow statements, the financial
statement of cash flows is a more appropriate measure of the company’s performance
because of its treatment of interest.
5. Market values can never be negative. Imagine a share of stock selling for –$20. This
would mean that if you placed an order for 100 shares, you would get the stock al ong
with a check for $2,000. How many shares do you want to buy? More generally, because
of corporate and individual bankruptcy laws, net worth for a person or a corporation
cannot be negative, implying that liabilities cannot exceed assets in market value.
6. For a successful company that is rapidly expanding, for example, capital outlays will be
large, possibly leading to negative cash flow from assets. In general, what matters is
whether the money is spent wisely, not whether cash flow from assets is po sitive or
negative.
7. It’s probably not a good sign for an established company to have negative cash flow from
operations, but it would be fairly ordinary for a start-up, so it depends.
