SOLUTION MANUAL *IMMMM *I*I*I
CHAPTER 1 *I
Introduction to Corporate Finance *I *I *I
The values shown in the solutions may be rounded for display purposes. However, the answers were deri
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
ved using a spreadsheet without any intermediate rounding.
*I *I *I *I *I *I *I
Answers to Problem Sets
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1. a. real
b. executive airplanes *I
c. brand names *I
d. financial
e. bonds
*f. investment or capital expenditure *I *I *I
*g. capital budgeting or investment *I *I *I
h. financing
*Note that f and g are interchangeable in the question.
*I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets. R
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
eal assets are identifiable as items with intrinsic value. The others in the list are financial assets, that
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
is, these assets derive value because of a contractual claim.
*I *I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
3. a.
Financial assets, such as stocks or bank loans, are claims held by investors. Corporat
*I *I *I *I *I *I *I *I *I *I *I *I *I
ions sell financial assets to raise the cash to invest in real assets such as plant and equipm
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
ent. Some real assets are intangible.
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b. Capital expenditure means investment in real assets. Financing means raising the cash fo
*I *I *I *I *I *I *I *I *I *I *I *I
r this investment.
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c. The shares of public corporations are traded on stock exchanges and can be purchased by
*I *I *I *I *I *I *I *I *I *I *I *I *I *I
, a wide range of investors. The shares of closely held corporations are not publicly trade
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
d and are held by a small group of private investors.
*I *I *I *I *I *I *I *I *I *I
d. Unlimited liability: Investors are responsible for all the firm‘s debts. A sole proprietor ha
*I *I *I *I *I *I *I *I *I *I *I *I *I
s unlimited liability. Investors in corporations have limited liability. They can lose their
*I *I *I *I *I *I *I *I * I *I *I *I *I
investment, but no more. *I *I *I
Est time: 01-05
*I *I
,4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can be t
*I *I *I *I *I *I * I *I *I *I *I *I *I *I *I
ransferred without affecting operations, and managers can be fired with no effect on ownership.
*I *I *I *I *I *I *I *I *I *I *I *I *I *I
Other forms of business may have unlimited liability and limited life.
*I *I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
5. Separation of ownership facilitates the key attributes of a corporation, including limited liability fo
*I *I *I *I *I *I *I *I *I *I *I *I *I
r investors, transferability of ownership, a separate legal personality of the corporation, and deleg
*I *I *I *I *I *I *I *I *I *I *I *I *I
ated centralized management. These four attributes provide substantial benefit for investors, incl
*I *I * I *I *I *I *I *I *I *I *I
uding the ability to diversify their investment among many uncorrelated returns—
*I *I *I *I *I *I *I *I *I *I
a very valuable tool explored in later chapters. Also, these attributes allow investors to quickly ex
*I *I *I *I *I *I *I * I *I *I *I *I *I *I *I
it, enter, or short sell an investment, thereby generating an active liquid market for corporations.
*I *I *I *I *I *I *I *I *I *I *I *I *I *I
However, these positive aspects also introduce substantial negative externalities as well. The sep
*I *I *I *I *I *I *I *I *I *I * I *I
aration of ownership from management typically leads to agency problems, where managers pref
*I *I *I *I *I *I *I *I *I *I *I *I
er to consume private perks or make other decisions for their private benefit—
*I *I *I *I *I *I *I *I *I *I *I *I
rather than maximize shareholder wealth. Shareholders tend to exercise less oversight of each in
*I *I *I *I * I *I *I *I *I *I *I *I *I
dividual investment as their diversification increases. Finally, the corporation‘s separate legal per
*I *I *I *I *I * I *I *I *I *I *I
sonality makes it difficult to enforce accountability if they externalize costs onto society.
*I *I *I *I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
6. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their
*I *I *I *I *I *I *I * I *I *I *I *I
pattern of consumption through borrowing and lending, match risk preferences, and hopefull
*I *I *I *I *I *I *I *I *I *I *I
y balance their own checkbooks (or hire a qualified professional to help them with these tasks)
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
.
Est time: 01-05
*I *I
7. If the investment increases the firm‘s wealth, it increases the firm‘s share value. Ms. Espinoza c
*I *I *I *I *I *I *I *I *I *I *I *I * I *I *I
ould then sell some or all these more valuable shares to provide for her retirement income.
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
8. a.
Assuming that the encabulator market is risky, an 8% expected return *I *I *I *I *I *I *I *I *I *I *
on the F&H encabulator investments may be inferior to a 4% return on U.
I *I *I *I *I *I *I *I *I *I *I *I *I *I
S.
government securities, depending on the relative risk between the two assets. *I *I *I *I *I *I *I *I *I *I
b. Unless the financial assets are as safe as U.S. government securities, their cost of capital wo
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
uld be higher. The CFO could consider expected returns on assets with similar risk.
*I *I *I *I *I *I *I *I *I *I *I *I *I
Est time: 06-10
*I *I
, 9. Managers would act in shareholders‘ interests because they have a legal duty to act in their interes
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
ts. Managers may also receive compensation—
* I *I *I *I *I
bonuses, stock, and option payouts with value tied (roughly) to firm performance. Managers ma
*I *I *I *I *I *I *I *I *I *I *I *I * I *I
y fear personal reputational damage from not acting in shareholders‘ interests. And managers can
*I *I *I *I *I *I *I *I *I *I *I *I *I *I
be fired by the board of directors (elected by shareholders). If managers still fail to act in sharehol
*I *I *I *I *I *I *I *I *I * I *I *I *I *I *I *I *I
ders‘ interests, shareholders may sell their shares, lowering the stock price and potentially creating
*I *I *I *I *I *I *I *I *I *I *I *I *I
the possibility of a takeover, which can again lead to changes in the board of directors and senior
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
management.
Est time: 01-05
*I *I
CHAPTER 1 *I
Introduction to Corporate Finance *I *I *I
The values shown in the solutions may be rounded for display purposes. However, the answers were deri
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
ved using a spreadsheet without any intermediate rounding.
*I *I *I *I *I *I *I
Answers to Problem Sets
*I *I *I
1. a. real
b. executive airplanes *I
c. brand names *I
d. financial
e. bonds
*f. investment or capital expenditure *I *I *I
*g. capital budgeting or investment *I *I *I
h. financing
*Note that f and g are interchangeable in the question.
*I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets. R
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
eal assets are identifiable as items with intrinsic value. The others in the list are financial assets, that
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
is, these assets derive value because of a contractual claim.
*I *I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
3. a.
Financial assets, such as stocks or bank loans, are claims held by investors. Corporat
*I *I *I *I *I *I *I *I *I *I *I *I *I
ions sell financial assets to raise the cash to invest in real assets such as plant and equipm
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
ent. Some real assets are intangible.
*I *I *I *I *I
b. Capital expenditure means investment in real assets. Financing means raising the cash fo
*I *I *I *I *I *I *I *I *I *I *I *I
r this investment.
*I *I
c. The shares of public corporations are traded on stock exchanges and can be purchased by
*I *I *I *I *I *I *I *I *I *I *I *I *I *I
, a wide range of investors. The shares of closely held corporations are not publicly trade
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
d and are held by a small group of private investors.
*I *I *I *I *I *I *I *I *I *I
d. Unlimited liability: Investors are responsible for all the firm‘s debts. A sole proprietor ha
*I *I *I *I *I *I *I *I *I *I *I *I *I
s unlimited liability. Investors in corporations have limited liability. They can lose their
*I *I *I *I *I *I *I *I * I *I *I *I *I
investment, but no more. *I *I *I
Est time: 01-05
*I *I
,4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can be t
*I *I *I *I *I *I * I *I *I *I *I *I *I *I *I
ransferred without affecting operations, and managers can be fired with no effect on ownership.
*I *I *I *I *I *I *I *I *I *I *I *I *I *I
Other forms of business may have unlimited liability and limited life.
*I *I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
5. Separation of ownership facilitates the key attributes of a corporation, including limited liability fo
*I *I *I *I *I *I *I *I *I *I *I *I *I
r investors, transferability of ownership, a separate legal personality of the corporation, and deleg
*I *I *I *I *I *I *I *I *I *I *I *I *I
ated centralized management. These four attributes provide substantial benefit for investors, incl
*I *I * I *I *I *I *I *I *I *I *I
uding the ability to diversify their investment among many uncorrelated returns—
*I *I *I *I *I *I *I *I *I *I
a very valuable tool explored in later chapters. Also, these attributes allow investors to quickly ex
*I *I *I *I *I *I *I * I *I *I *I *I *I *I *I
it, enter, or short sell an investment, thereby generating an active liquid market for corporations.
*I *I *I *I *I *I *I *I *I *I *I *I *I *I
However, these positive aspects also introduce substantial negative externalities as well. The sep
*I *I *I *I *I *I *I *I *I *I * I *I
aration of ownership from management typically leads to agency problems, where managers pref
*I *I *I *I *I *I *I *I *I *I *I *I
er to consume private perks or make other decisions for their private benefit—
*I *I *I *I *I *I *I *I *I *I *I *I
rather than maximize shareholder wealth. Shareholders tend to exercise less oversight of each in
*I *I *I *I * I *I *I *I *I *I *I *I *I
dividual investment as their diversification increases. Finally, the corporation‘s separate legal per
*I *I *I *I *I * I *I *I *I *I *I
sonality makes it difficult to enforce accountability if they externalize costs onto society.
*I *I *I *I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
6. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their
*I *I *I *I *I *I *I * I *I *I *I *I
pattern of consumption through borrowing and lending, match risk preferences, and hopefull
*I *I *I *I *I *I *I *I *I *I *I
y balance their own checkbooks (or hire a qualified professional to help them with these tasks)
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
.
Est time: 01-05
*I *I
7. If the investment increases the firm‘s wealth, it increases the firm‘s share value. Ms. Espinoza c
*I *I *I *I *I *I *I *I *I *I *I *I * I *I *I
ould then sell some or all these more valuable shares to provide for her retirement income.
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
Est time: 01-05
*I *I
8. a.
Assuming that the encabulator market is risky, an 8% expected return *I *I *I *I *I *I *I *I *I *I *
on the F&H encabulator investments may be inferior to a 4% return on U.
I *I *I *I *I *I *I *I *I *I *I *I *I *I
S.
government securities, depending on the relative risk between the two assets. *I *I *I *I *I *I *I *I *I *I
b. Unless the financial assets are as safe as U.S. government securities, their cost of capital wo
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
uld be higher. The CFO could consider expected returns on assets with similar risk.
*I *I *I *I *I *I *I *I *I *I *I *I *I
Est time: 06-10
*I *I
, 9. Managers would act in shareholders‘ interests because they have a legal duty to act in their interes
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
ts. Managers may also receive compensation—
* I *I *I *I *I
bonuses, stock, and option payouts with value tied (roughly) to firm performance. Managers ma
*I *I *I *I *I *I *I *I *I *I *I *I * I *I
y fear personal reputational damage from not acting in shareholders‘ interests. And managers can
*I *I *I *I *I *I *I *I *I *I *I *I *I *I
be fired by the board of directors (elected by shareholders). If managers still fail to act in sharehol
*I *I *I *I *I *I *I *I *I * I *I *I *I *I *I *I *I
ders‘ interests, shareholders may sell their shares, lowering the stock price and potentially creating
*I *I *I *I *I *I *I *I *I *I *I *I *I
the possibility of a takeover, which can again lead to changes in the board of directors and senior
*I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I *I
management.
Est time: 01-05
*I *I
