CHAPTER 1
INTRODUCTION TO CORPORATE
FINANCE
Answers to Concepts Review and Critical Thinking Questions
1. Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding
whether to issue new equity and use the proceeds to retire outstanding debt), and working capital
management (modifying the firm’s credit collection policy with its customers).
2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to raise
capital funds. Some advantages: simpler, less regulation, the owners are also the managers,
sometimes personal tax rates are better than corporate tax rates.
3. The primary disadvantage of the corporate form is the double taxation to shareholders of distributed
earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to
raise capital, unlimited life, and so forth.
4. The treasurer’s office and the controller’s office are the two primary organizational groups that
report directly to the chief financial officer. The controller’s office handles cost and financial
accounting, tax management, and management information systems, while the treasurer’s office is
responsible for cash and credit management, capital budgeting, and financial planning. Therefore,
the study of corporate finance is concentrated within the treasury group’s functions.
5. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly-
traded or not).
6. 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 own 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.
7. A primary market transaction.
8. In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to
match buyers and sellers of assets. Dealer markets like NASDAQ consist of dealers operating at
dispersed locales who buy and sell assets themselves, communicating with other dealers either
electronically or literally over-the-counter.
9. 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
, CHAPTER 1 B2
even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to
maximize the value of the equity.
10. 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.
11. 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?”
12. 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.
13. 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 lose
their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight
corporate takeovers in situations such as this.
14. 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. 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.
15. How much is too much? Who is worth more, Jack Welch 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 simply 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.
, CHAPTER 2
FINANCIAL STATEMENTS, TAXES AND
CASH FLOW
Answers to Concepts Review and Critical Thinking Questions
1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss
in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in
meeting short-term creditor demands. However, since liquidity also has an opportunity cost
associated with it—namely that higher returns can generally be found by investing the cash into
productive assets—low liquidity levels are also desirable to the firm. It’s up to the firm’s financial
management staff to find a reasonable compromise between these opposing needs.
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. Historical costs can be objectively and precisely measured whereas market values can be difficult to
estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff
between relevance (market values) and objectivity (book values).
4. Depreciation is a non-cash deduction that reflects adjustments made in asset book values in
accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but
it’s a financing cost, not an operating cost.
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 along 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 positive or negative.
7. It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-
up, so it depends.
8. For example, if a company were to become more efficient in inventory management, the amount of
inventory needed would decline. The same might be true if it becomes better at collecting its
receivables. In general, anything that leads to a decline in ending NWC relative to beginning would
INTRODUCTION TO CORPORATE
FINANCE
Answers to Concepts Review and Critical Thinking Questions
1. Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding
whether to issue new equity and use the proceeds to retire outstanding debt), and working capital
management (modifying the firm’s credit collection policy with its customers).
2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to raise
capital funds. Some advantages: simpler, less regulation, the owners are also the managers,
sometimes personal tax rates are better than corporate tax rates.
3. The primary disadvantage of the corporate form is the double taxation to shareholders of distributed
earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to
raise capital, unlimited life, and so forth.
4. The treasurer’s office and the controller’s office are the two primary organizational groups that
report directly to the chief financial officer. The controller’s office handles cost and financial
accounting, tax management, and management information systems, while the treasurer’s office is
responsible for cash and credit management, capital budgeting, and financial planning. Therefore,
the study of corporate finance is concentrated within the treasury group’s functions.
5. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly-
traded or not).
6. 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 own 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.
7. A primary market transaction.
8. In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to
match buyers and sellers of assets. Dealer markets like NASDAQ consist of dealers operating at
dispersed locales who buy and sell assets themselves, communicating with other dealers either
electronically or literally over-the-counter.
9. 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
, CHAPTER 1 B2
even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to
maximize the value of the equity.
10. 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.
11. 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?”
12. 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.
13. 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 lose
their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight
corporate takeovers in situations such as this.
14. 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. 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.
15. How much is too much? Who is worth more, Jack Welch 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 simply 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.
, CHAPTER 2
FINANCIAL STATEMENTS, TAXES AND
CASH FLOW
Answers to Concepts Review and Critical Thinking Questions
1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss
in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in
meeting short-term creditor demands. However, since liquidity also has an opportunity cost
associated with it—namely that higher returns can generally be found by investing the cash into
productive assets—low liquidity levels are also desirable to the firm. It’s up to the firm’s financial
management staff to find a reasonable compromise between these opposing needs.
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. Historical costs can be objectively and precisely measured whereas market values can be difficult to
estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff
between relevance (market values) and objectivity (book values).
4. Depreciation is a non-cash deduction that reflects adjustments made in asset book values in
accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but
it’s a financing cost, not an operating cost.
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 along 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 positive or negative.
7. It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-
up, so it depends.
8. For example, if a company were to become more efficient in inventory management, the amount of
inventory needed would decline. The same might be true if it becomes better at collecting its
receivables. In general, anything that leads to a decline in ending NWC relative to beginning would
