@PROFDOCDIGITALLIBRARIES
Solution Manual for
Fundamentals of Corporate Finance, 5th Edition by Robert Parrino, David
Kidwell, Bates & Gillan
Chapter 1-21
Chapter 1
The Financial Manager and the Firm
Before You Go on Questions and Answers
Section 1.1
1. What are the three basic types of financial decisions managers must make?
The three basic decisions each business must make are the capital budgeting decision, the
financing decision, and the working capital management decision. These decisions determine
which productive assets to buy, how to pay for or finance these purchases, and how to
manage the day-to-day financial matters so the company can pay its bills.
2. Explain why you would make an investment if the value of the expected cash flows
exceeds the cost of the project.
You would accept an investment project whose cash flows exceed the cost of the project
because such projects will increase the value of the firm, making the owners wealthier. Most
people start a business to increase their wealth. Remember that the cost of capital (time value
of money) will affect the decision about whether to invest.
3. Why are capital budgeting decisions among the most important decisions in the life of a
firm?
The capital budgeting decisions are considered the most important in the life of the firm
because these decisions determine which productive assets the firm purchases, and which
assets generate most of the firm’s cash flows. Furthermore, capital budgeting decisions are
,@PROFDOCDIGITALLIBRARIES
long-term decisions and if you make a mistake in selecting a productive asset, you are stuck
with the decision for a long time.
Section 1.2
1. Why are many businesses operated as sole proprietorships or partnerships?
Many businesses elect to operate as sole proprietorships or partnerships because of the small
operating scale and capital base of their firms. Both of these forms of business organization
are fairly easy to start and impose few regulations on the owners.
2. What are some advantages and disadvantages of operating as a public corporation?
The main advantages of operating as a public corporation are the access to the public
securities markets, which makes it easier to raise large amounts of capital, and the ease of
ownership transfer. All the shareholders have to do is to call their broker to buy or sell shares
of stock. Since a public corporation usually has many shares outstanding, large blocks of
securities can be purchased or sold without an appreciable impact on the price of the stock.
The major disadvantage of corporations is the tax situation. Not only must the corporation
pay taxes on its income, but the owners of the corporation get taxed again when dividends
are paid to them. This is referred to as double taxation. In addition to taxes, public
corporations are subject to stringent reporting requirements, and the incentives may convince
managers to focus on shorter-term profitability than longer-term wealth creation.
3. Explain why professional partnerships such as physicians’ groups organize as limited
liability partnerships.
Professional partnerships such as physicians’ groups desire to organize as limited liability
partnerships (LLPs) to take advantage of the tax arrangements of partnerships combined with
the advantages of the limited liability of a corporation. By operating as an LLP, the
partnership is able to avoid a potential financial disaster resulting from the misconduct of one
partner.
Section 1.3
1. What are the major responsibilities of the CFO?
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The major responsibilities of a CFO include analysis and recommendations for financial
decisions. The CFO, who reports directly to the CEO, focuses on managing all aspects of the
firm’s finances and works with the CEO on strategic issues. The CFO also interacts with
staff in other functional areas on a regular basis related to financial issues that affect the
business.
2. Identify the financial officers who typically report to the CFO and describe their duties.
The financial officers discussed in the chapter who report to the CFO are the controller, the
treasurer, the risk manager, and the internal auditor.
The controller is the firm’s chief accounting officer, and thus prepares the financial
statements and taxes. This position also requires close cooperation with the external auditors.
The treasurer’s responsibility is the collection and disbursement of cash, investing excess
cash, raising new capital, handling foreign exchange, and overseeing the company’s pension
fund management. This individual also assists the CFO in handling important Wall Street
relationships. The risk manager monitors and manages the firm’s risk exposure in financial
and commodity markets and the firm’s relationships with insurance providers. Finally, the
internal auditor is responsible for conducting risk assessment and performing audits of high-
risk areas.
3. Why does the internal auditor report to both the CFO and the audit committee of the
board of directors?
The internal auditor reports to the CFO on a day-to-day basis but is ultimately accountable
for reporting any accounting irregularities to the board of directors. The dual reporting
system serves as a check to ensure that there are no discrepancies in the company’s financial
statements.
Section 1.4
1. Why is profit maximization an unsatisfactory goal for managing a firm?
Profit maximization is not a satisfactory goal when managing a firm because it is rather
difficult to define profits since accountants can apply and interpret the same accounting
, @PROFDOCDIGITALLIBRARIES
principles differently. Also, profit maximization does not define the size, the uncertainty, and
the timing of cash flows; it ignores the time value of money concept.
2. Explain why maximizing the market price of a firm’s stock is an appropriate goal for
the firm’s management.
Maximizing the current market price of a firm’s stock is an appropriate goal for the firm’s
management because it is an unambiguous objective and is easy to measure for a firm whose
stock is publicly traded. One can simply look at the value of the company’s stock on any
given day to determine whether the market price went up or down. Maximizing the market
value of the stock is not inconsistent with maximizing the value of claims to the firm’s other
stakeholders. In maximizing the value of the stock, managers must make decisions that
account for the interests of all stakeholders. This is also true for firms without publicly
traded stocks. In these cases, the statement can be interpreted as maximizing the current
value of owner’s equity.
3. What is the fundamental determinant of an asset’s value?
The fundamental determinant of an asset’s value is the future cash flows the asset is expected
to generate including the size, timing, and riskiness of these cash flows. Other factors that
may help determine the price of an asset are internal decisions, such as the company’s
expansion strategy, as well as external stimulants, such as the state of the economy.
Section 1.5
1. What are agency conflicts?
An agency conflict occurs when the goals of the principals or the stockholders are not
aligned with the goals of the agents or the company management. Management is often more
concerned with pursuing its own self-interest, and so the maximization of shareholder value
is pushed to the side.
2. What are corporate raiders?
Corporate raiders can make the company more efficient by keeping top managers on their
toes. Top managers know that if the company’s performance declines and its stock slips, it
Solution Manual for
Fundamentals of Corporate Finance, 5th Edition by Robert Parrino, David
Kidwell, Bates & Gillan
Chapter 1-21
Chapter 1
The Financial Manager and the Firm
Before You Go on Questions and Answers
Section 1.1
1. What are the three basic types of financial decisions managers must make?
The three basic decisions each business must make are the capital budgeting decision, the
financing decision, and the working capital management decision. These decisions determine
which productive assets to buy, how to pay for or finance these purchases, and how to
manage the day-to-day financial matters so the company can pay its bills.
2. Explain why you would make an investment if the value of the expected cash flows
exceeds the cost of the project.
You would accept an investment project whose cash flows exceed the cost of the project
because such projects will increase the value of the firm, making the owners wealthier. Most
people start a business to increase their wealth. Remember that the cost of capital (time value
of money) will affect the decision about whether to invest.
3. Why are capital budgeting decisions among the most important decisions in the life of a
firm?
The capital budgeting decisions are considered the most important in the life of the firm
because these decisions determine which productive assets the firm purchases, and which
assets generate most of the firm’s cash flows. Furthermore, capital budgeting decisions are
,@PROFDOCDIGITALLIBRARIES
long-term decisions and if you make a mistake in selecting a productive asset, you are stuck
with the decision for a long time.
Section 1.2
1. Why are many businesses operated as sole proprietorships or partnerships?
Many businesses elect to operate as sole proprietorships or partnerships because of the small
operating scale and capital base of their firms. Both of these forms of business organization
are fairly easy to start and impose few regulations on the owners.
2. What are some advantages and disadvantages of operating as a public corporation?
The main advantages of operating as a public corporation are the access to the public
securities markets, which makes it easier to raise large amounts of capital, and the ease of
ownership transfer. All the shareholders have to do is to call their broker to buy or sell shares
of stock. Since a public corporation usually has many shares outstanding, large blocks of
securities can be purchased or sold without an appreciable impact on the price of the stock.
The major disadvantage of corporations is the tax situation. Not only must the corporation
pay taxes on its income, but the owners of the corporation get taxed again when dividends
are paid to them. This is referred to as double taxation. In addition to taxes, public
corporations are subject to stringent reporting requirements, and the incentives may convince
managers to focus on shorter-term profitability than longer-term wealth creation.
3. Explain why professional partnerships such as physicians’ groups organize as limited
liability partnerships.
Professional partnerships such as physicians’ groups desire to organize as limited liability
partnerships (LLPs) to take advantage of the tax arrangements of partnerships combined with
the advantages of the limited liability of a corporation. By operating as an LLP, the
partnership is able to avoid a potential financial disaster resulting from the misconduct of one
partner.
Section 1.3
1. What are the major responsibilities of the CFO?
,@PROFDOCDIGITALLIBRARIES
The major responsibilities of a CFO include analysis and recommendations for financial
decisions. The CFO, who reports directly to the CEO, focuses on managing all aspects of the
firm’s finances and works with the CEO on strategic issues. The CFO also interacts with
staff in other functional areas on a regular basis related to financial issues that affect the
business.
2. Identify the financial officers who typically report to the CFO and describe their duties.
The financial officers discussed in the chapter who report to the CFO are the controller, the
treasurer, the risk manager, and the internal auditor.
The controller is the firm’s chief accounting officer, and thus prepares the financial
statements and taxes. This position also requires close cooperation with the external auditors.
The treasurer’s responsibility is the collection and disbursement of cash, investing excess
cash, raising new capital, handling foreign exchange, and overseeing the company’s pension
fund management. This individual also assists the CFO in handling important Wall Street
relationships. The risk manager monitors and manages the firm’s risk exposure in financial
and commodity markets and the firm’s relationships with insurance providers. Finally, the
internal auditor is responsible for conducting risk assessment and performing audits of high-
risk areas.
3. Why does the internal auditor report to both the CFO and the audit committee of the
board of directors?
The internal auditor reports to the CFO on a day-to-day basis but is ultimately accountable
for reporting any accounting irregularities to the board of directors. The dual reporting
system serves as a check to ensure that there are no discrepancies in the company’s financial
statements.
Section 1.4
1. Why is profit maximization an unsatisfactory goal for managing a firm?
Profit maximization is not a satisfactory goal when managing a firm because it is rather
difficult to define profits since accountants can apply and interpret the same accounting
, @PROFDOCDIGITALLIBRARIES
principles differently. Also, profit maximization does not define the size, the uncertainty, and
the timing of cash flows; it ignores the time value of money concept.
2. Explain why maximizing the market price of a firm’s stock is an appropriate goal for
the firm’s management.
Maximizing the current market price of a firm’s stock is an appropriate goal for the firm’s
management because it is an unambiguous objective and is easy to measure for a firm whose
stock is publicly traded. One can simply look at the value of the company’s stock on any
given day to determine whether the market price went up or down. Maximizing the market
value of the stock is not inconsistent with maximizing the value of claims to the firm’s other
stakeholders. In maximizing the value of the stock, managers must make decisions that
account for the interests of all stakeholders. This is also true for firms without publicly
traded stocks. In these cases, the statement can be interpreted as maximizing the current
value of owner’s equity.
3. What is the fundamental determinant of an asset’s value?
The fundamental determinant of an asset’s value is the future cash flows the asset is expected
to generate including the size, timing, and riskiness of these cash flows. Other factors that
may help determine the price of an asset are internal decisions, such as the company’s
expansion strategy, as well as external stimulants, such as the state of the economy.
Section 1.5
1. What are agency conflicts?
An agency conflict occurs when the goals of the principals or the stockholders are not
aligned with the goals of the agents or the company management. Management is often more
concerned with pursuing its own self-interest, and so the maximization of shareholder value
is pushed to the side.
2. What are corporate raiders?
Corporate raiders can make the company more efficient by keeping top managers on their
toes. Top managers know that if the company’s performance declines and its stock slips, it
