INSTRUCTOR’S SOLUTIONS MANUAL
FOUNDATIONS OF FINANCE
10TH EDITION
CHAPTER NO. 01: AN INTRODUCTION TO THE FOUNDATIONS OF FINANCIAL
MANAGEMENT
ANSWERS TO END-OF-CHAPTER REVIEW QUESTIONS
1-1. There are some practical problems implementing the goal of maximization of shareholder
wealth, i.e., maximization of the market value of the firm’s common stock. Many things
affect stock prices, so identifying which changes in stock price are due to management
decisions and which changes are due to external factors such as the state of the economy
may be difficult. There may also be uncertainty about the eventual financial pay-off of
certain business investments. Managers and investors may have different time horizons
and different risk preferences, which can affect their valuation of the firm. In addition,
managers may not always act in the best interest of shareholders, a classic case of an
agency problem.
1-2. No. The goal of shareholder wealth maximization must be viewed as a long-run goal. As
such, the public image of the firm may be of concern inasmuch as it may affect sales and
potential legislation. Thus, while these actions may not directly result in increased profits,
they may affect consumers’ and legislators’ attitudes. In addition, charitable contributions
are a form of marketing for the firm. If people who hear about the donations buy
more products in the future, the expenditure today may lead to increased revenue and
profit in the future.
1-3. Almost all financial decisions involve some sort of risk-return trade-off. The more risk
the firm is willing to accept, the higher the expected return for the given course of action.
For example, in the area of working capital management, the less inventory held, the
higher the expected return, but also the greater the risk of running out of inventory. While
one manager might accept a given level of risk, another more risk-averse manager may
not accept that level of risk. This does not mean that one manager is correct and one is
not; rather, it only means that not all managers will view the risk-return trade-off in the
same manner.
1-4. The corporate agency problem is a result of the separation of ownership from
management, where managers do what is in their own best interests rather than what is in
the best interest of the shareholders. Large firms are typically run by professional
managers who own a small fraction of the firms’ equity. The individual actions of these
managers are often motivated by self-interest, which may result in managers not acting in
the best interests of the firm’s owners. When this happens, the value of the firm
will decrease.
,1-5. a. A sole proprietorship is a business owned by a single individual who maintains
complete title to the assets and is also personally liable for all indebtedness
incurred.
b. A partnership is an association of two or more individuals coming together as co-
owners for the purpose of operating a business. The partnership is similar to the
sole proprietorship, except that the partnership has multiple owners.
c. A corporation is a legal entity functioning separate and apart from its owners. It
can individually sue and be sued, purchase, sell, or own property, and be subject
to criminal punishment for crimes.
1-6. a. The sole proprietor maintains title to the firm’s assets, has unlimited liability, and
is entitled to the profits from the business, but must also absorb any losses
realized. This form of business is easily initiated. Termination of the business
comes by the owner discontinuing the business or upon his or her death.
b. In a partnership, all general partners have unlimited liability. Each partner is liable
for the actions of the other partners. The partnership agreement dictates the basic
relationships among the partners within the firm. As with the sole proprietorship,
the partnership is terminated upon the desires of any partner within the
organization, or upon a partner’s death. Under certain conditions, a partner’s
liability may be restricted to the amount of capital invested in the partnership.
However, at least one general partner must remain in the association for whom the
privilege of limited liability does not apply.
c. The corporation is legally separate from its owners. Ownership of the corporation
is determined by the number of shares of common stock owned by an individual.
Because the shares are transferable, the ownership in a corporation may be easily
transferred. Investors’ liability is limited to the amount of their investment. The
life of the corporation does not depend on the status of the investors. The death or
withdrawal of an investor does not disrupt the corporate life. However, the cost of
forming a corporation is more expensive than a proprietorship or partnership.
,1-7. a. Organizational requirements and costs favor the sole proprietorship or possibly
the general partnership depending upon the approach taken in forming the
partnership.
b. With a corporation, owners have minimum liabilities.
c. Here the corporation is definitely the most favorable form of business
organization because it provides for the continuity of the business regardless of an
owner’s withdrawal or death.
d. If ease of ownership transferability is desired, the corporation is best. However,
because of certain circumstances, the owners may prefer that ownership not be
easily transferred, in which case the partnership would be the most desirable.
e. The sole proprietor is able to maintain complete and ultimate control and
minimize regulations.
f. The corporation is the strongest form of legal entity in terms of the ease of raising
capital from external investors.
g. In regard to income taxes, it is difficult to determine which form of business is the
most advantageous. Such a selection depends on individual circumstances,
including the tax benefits available to a company and an owner’s tax bracket.
1-8. This is an Internet question. Answers will vary.
1-9. This is an Internet question. Answers will vary.
1-10. This is an Internet question. Answers will vary.
, SOLUTION TO MINI CASE
a. The goal of profit maximization is too simplistic in that it assumes away the problems of
uncertainty of returns and the timing of returns. Rather than use this goal, we have chosen
maximization of shareholders’ wealth—that is, maximization of the market value of the firm’s
common stock—because the effects of all financial decisions are included. Shareholders
react to poor investment or dividend decisions by causing the total value of the firm’s stock to
fall and react to good decisions by pushing the price of the stock upward. In this way, all
financial decisions are evaluated, and all financial decisions affect shareholder wealth.
b. Simply put, investors will not put their money in risky investments unless they are
compensated for taking on that additional risk. In effect, the return investors expect is made
up of two parts. First, they receive a return for delaying consumption, which must be greater
than the anticipated rate of inflation. Second, they receive a return for taking on added risk.
Otherwise, both risky and safe investments would have the same expected return associated with
them, and no one would take on the risky investments.
c. The firm receives cash flows and is able to reinvest them, which cannot be done with
accounting profits. In effect, accounting profits are shown when they are earned rather than
when the money is actually in hand. Unfortunately, a firm’s accounting profits and cash flows
may not be timed to occur together. For example, capital expenses, such as the purchase of a
new plant or piece of equipment, are depreciated over several years, with the annual
depreciation subtracted from profits. However, the cash flow associated with these expenses
generally occurs immediately. It is the cash inflows that can be reinvested and cash outflows
that involve paying out money. Therefore, cash flows correctly reflect the true timing of the
benefits and costs of financial decisions.
d. In an efficient market, information is impounded into security prices with such speed that
investors have no opportunities to profit from publicly available information. Actually, what
types of information are immediately reflected in security prices and how quickly that
information is reflected determine how efficient the market actually is. The
implications for us are that stock prices reflect all publicly available information
regarding the value of the company. This means we can implement our goal of
maximization of shareholder wealth by focusing on the effect each decision should have on the
stock price, all else held constant. It also means that earnings manipulations through
accounting changes should not result in price changes. In effect, our preoccupation
with cash flows is validated.
e. An agency problem occurs when an agent (someone acting on behalf of another person) takes
action that is not in the best interest of the principal (the person engaging the agent to perform
some task). For companies where management is separate from ownership, managers may
make decisions that are not in line with the goal of maximization of shareholder wealth.
To control this problem, shareholders monitor managers through oversight by a board of
directors and try to align the interests of shareholders and managers by various contractual
means. The interests of shareholders and managers can be aligned by setting up appropriate
compensation packages with stock options, bonuses,
FOUNDATIONS OF FINANCE
10TH EDITION
CHAPTER NO. 01: AN INTRODUCTION TO THE FOUNDATIONS OF FINANCIAL
MANAGEMENT
ANSWERS TO END-OF-CHAPTER REVIEW QUESTIONS
1-1. There are some practical problems implementing the goal of maximization of shareholder
wealth, i.e., maximization of the market value of the firm’s common stock. Many things
affect stock prices, so identifying which changes in stock price are due to management
decisions and which changes are due to external factors such as the state of the economy
may be difficult. There may also be uncertainty about the eventual financial pay-off of
certain business investments. Managers and investors may have different time horizons
and different risk preferences, which can affect their valuation of the firm. In addition,
managers may not always act in the best interest of shareholders, a classic case of an
agency problem.
1-2. No. The goal of shareholder wealth maximization must be viewed as a long-run goal. As
such, the public image of the firm may be of concern inasmuch as it may affect sales and
potential legislation. Thus, while these actions may not directly result in increased profits,
they may affect consumers’ and legislators’ attitudes. In addition, charitable contributions
are a form of marketing for the firm. If people who hear about the donations buy
more products in the future, the expenditure today may lead to increased revenue and
profit in the future.
1-3. Almost all financial decisions involve some sort of risk-return trade-off. The more risk
the firm is willing to accept, the higher the expected return for the given course of action.
For example, in the area of working capital management, the less inventory held, the
higher the expected return, but also the greater the risk of running out of inventory. While
one manager might accept a given level of risk, another more risk-averse manager may
not accept that level of risk. This does not mean that one manager is correct and one is
not; rather, it only means that not all managers will view the risk-return trade-off in the
same manner.
1-4. The corporate agency problem is a result of the separation of ownership from
management, where managers do what is in their own best interests rather than what is in
the best interest of the shareholders. Large firms are typically run by professional
managers who own a small fraction of the firms’ equity. The individual actions of these
managers are often motivated by self-interest, which may result in managers not acting in
the best interests of the firm’s owners. When this happens, the value of the firm
will decrease.
,1-5. a. A sole proprietorship is a business owned by a single individual who maintains
complete title to the assets and is also personally liable for all indebtedness
incurred.
b. A partnership is an association of two or more individuals coming together as co-
owners for the purpose of operating a business. The partnership is similar to the
sole proprietorship, except that the partnership has multiple owners.
c. A corporation is a legal entity functioning separate and apart from its owners. It
can individually sue and be sued, purchase, sell, or own property, and be subject
to criminal punishment for crimes.
1-6. a. The sole proprietor maintains title to the firm’s assets, has unlimited liability, and
is entitled to the profits from the business, but must also absorb any losses
realized. This form of business is easily initiated. Termination of the business
comes by the owner discontinuing the business or upon his or her death.
b. In a partnership, all general partners have unlimited liability. Each partner is liable
for the actions of the other partners. The partnership agreement dictates the basic
relationships among the partners within the firm. As with the sole proprietorship,
the partnership is terminated upon the desires of any partner within the
organization, or upon a partner’s death. Under certain conditions, a partner’s
liability may be restricted to the amount of capital invested in the partnership.
However, at least one general partner must remain in the association for whom the
privilege of limited liability does not apply.
c. The corporation is legally separate from its owners. Ownership of the corporation
is determined by the number of shares of common stock owned by an individual.
Because the shares are transferable, the ownership in a corporation may be easily
transferred. Investors’ liability is limited to the amount of their investment. The
life of the corporation does not depend on the status of the investors. The death or
withdrawal of an investor does not disrupt the corporate life. However, the cost of
forming a corporation is more expensive than a proprietorship or partnership.
,1-7. a. Organizational requirements and costs favor the sole proprietorship or possibly
the general partnership depending upon the approach taken in forming the
partnership.
b. With a corporation, owners have minimum liabilities.
c. Here the corporation is definitely the most favorable form of business
organization because it provides for the continuity of the business regardless of an
owner’s withdrawal or death.
d. If ease of ownership transferability is desired, the corporation is best. However,
because of certain circumstances, the owners may prefer that ownership not be
easily transferred, in which case the partnership would be the most desirable.
e. The sole proprietor is able to maintain complete and ultimate control and
minimize regulations.
f. The corporation is the strongest form of legal entity in terms of the ease of raising
capital from external investors.
g. In regard to income taxes, it is difficult to determine which form of business is the
most advantageous. Such a selection depends on individual circumstances,
including the tax benefits available to a company and an owner’s tax bracket.
1-8. This is an Internet question. Answers will vary.
1-9. This is an Internet question. Answers will vary.
1-10. This is an Internet question. Answers will vary.
, SOLUTION TO MINI CASE
a. The goal of profit maximization is too simplistic in that it assumes away the problems of
uncertainty of returns and the timing of returns. Rather than use this goal, we have chosen
maximization of shareholders’ wealth—that is, maximization of the market value of the firm’s
common stock—because the effects of all financial decisions are included. Shareholders
react to poor investment or dividend decisions by causing the total value of the firm’s stock to
fall and react to good decisions by pushing the price of the stock upward. In this way, all
financial decisions are evaluated, and all financial decisions affect shareholder wealth.
b. Simply put, investors will not put their money in risky investments unless they are
compensated for taking on that additional risk. In effect, the return investors expect is made
up of two parts. First, they receive a return for delaying consumption, which must be greater
than the anticipated rate of inflation. Second, they receive a return for taking on added risk.
Otherwise, both risky and safe investments would have the same expected return associated with
them, and no one would take on the risky investments.
c. The firm receives cash flows and is able to reinvest them, which cannot be done with
accounting profits. In effect, accounting profits are shown when they are earned rather than
when the money is actually in hand. Unfortunately, a firm’s accounting profits and cash flows
may not be timed to occur together. For example, capital expenses, such as the purchase of a
new plant or piece of equipment, are depreciated over several years, with the annual
depreciation subtracted from profits. However, the cash flow associated with these expenses
generally occurs immediately. It is the cash inflows that can be reinvested and cash outflows
that involve paying out money. Therefore, cash flows correctly reflect the true timing of the
benefits and costs of financial decisions.
d. In an efficient market, information is impounded into security prices with such speed that
investors have no opportunities to profit from publicly available information. Actually, what
types of information are immediately reflected in security prices and how quickly that
information is reflected determine how efficient the market actually is. The
implications for us are that stock prices reflect all publicly available information
regarding the value of the company. This means we can implement our goal of
maximization of shareholder wealth by focusing on the effect each decision should have on the
stock price, all else held constant. It also means that earnings manipulations through
accounting changes should not result in price changes. In effect, our preoccupation
with cash flows is validated.
e. An agency problem occurs when an agent (someone acting on behalf of another person) takes
action that is not in the best interest of the principal (the person engaging the agent to perform
some task). For companies where management is separate from ownership, managers may
make decisions that are not in line with the goal of maximization of shareholder wealth.
To control this problem, shareholders monitor managers through oversight by a board of
directors and try to align the interests of shareholders and managers by various contractual
means. The interests of shareholders and managers can be aligned by setting up appropriate
compensation packages with stock options, bonuses,
