Solution Manual -
Corporate finance
John Berk 6th Edition
,Contents
Part I: Introduction
Chapter 1 The Corporation and Financial Markets 1
Chapter 2 Introduction to Financial Statement Analysis 5
Part II: Tools
Chapter 3 Arbitrage and Financial Decision Making 15
Chapter 4 The Time Value of Money 26
Chapter 5 Interest Rates 49
Part III: Basic Valuation
Chapter 6 Valuing Bonds 65
Chapter 7 Valuing Stocks 77
Chapter 8 Investment Decision Rules 85
Chapter 9 Fundamentals of Capital Budgeting 100
Part IV: Risk and Return
Chapter 10 Capital Markets and the Pricing of Risk 108
Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 117
Chapter 12 Estimating the Cost of Capital 131
Chapter 13 Investor Behaviour and Capital Market Efficiency 137
Part V: Options
Chapter 14 Financial Options 143
Chapter 15 Option Valuation 152
Chapter 16 Real Options 162
Part VI: Capital Structure and Dividend Policy
Chapter 17 Capital Structure in a Perfect Market 185
Chapter 18 Debt and Taxes 192
Chapter 19 Financial Distress, Managerial Incentives, and Information 199
Chapter 20 Payout Policy 207
Part VII: Valuation
Chapter 21 Capital Budgeting and Valuation with Leverage 213
Chapter 22 Valuation and Financial Modelling: A Case Study 227
Part VIII: Long-Term Financing
Chapter 23 Raising Equity Capital 235
Chapter 24 Debt Financing 239
Chapter 25 Leasing 242
Part IX: Short-Term Financing
Chapter 26 Working Capital Management 248
Chapter 27 Short-Term Financial Planning 253
Part X: Special Topics
Chapter 28 Mergers and Acquisitions 257
Chapter 29 Corporate Governance 260
Chapter 30 Risk Management 263
Chapter 31 International Corporate Finance 272
,Chapter 1
The Corporation and Financial Markets
1-1. A corporation is a legal entity separate from its owners. This means ownership shares in the corporation can
be freely traded. None of the other organizational forms share this characteristic.
1-2. Owners’ liability is limited to the amount they invested in the firm. Shareholders are not responsible for any
encumbrances of the firm; in particular, they cannot be required to pay back any debts incurred by the firm.
1-3. Corporations (all shareholders have limited liability). Limited partnerships provide limited liability for the
limited partners, but not for the general partners.
1-4. Advantages: Limited liability, liquidity, infinite life. Disadvantages: Double taxation, separation of
ownership and control.
1-5. The corporation that only holds real estate must pay corporate income taxes. The real estate investment trust
(REIT) does not pay corporate taxes but must pass through substantially all of the income to the trust unit
holders to whom it is taxable.
1-6. First, the corporation pays the taxes. After taxes, $2 × (1 – 0.34) = $1.32 per share is left to pay dividends.
Once the dividend is paid, personal tax on this must be paid, leaving $1.32 × (1 – 0.18) = $1.0824 per share.
So after all the taxes are paid, you are left with $1.0824 per share.
1-7. As a real estate investment trust (REIT) pays no corporate tax, the full amount of $2 per unit can be paid out
to you as a trust unit holder. You must then pay personal income tax on the distribution. So you are left with
$2 × (1 – 0.4) = $1.20 per unit.
1-8. As the manager of an iPhone applications developer, you will make three types of financial decisions.
i. You will make investment decisions such as determining which type of iPhone application projects will
offer your company a positive NPV and should, therefore, be developed by your company.
ii. You will make the decision on how to fund your iPhone application investments and what mix of debt
and equity your company will have.
iii. You will be responsible for the cash management of your company, ensuring that your company has the
necessary funds to make investments, pay interest on loans, and pay your employees.
1-9. Shareholders can
i. ensure that employees are paid with company stock and/or stock options.
ii. ensure that underperforming managers are fired.
iii. write contracts that ensure that the interests of the managers and shareholders are closely aligned.
iv. mount hostile takeovers.
1-10. This will affect and hurt the customers. It will have a negative impact on the customers, for they will likely
get sour milk. It will also have a negative impact on shareholders because, in the long run, customers will
realize that the supermarket sells sour milk and will switch to other supermarkets. Thus, the value today of
the future income and cash flow streams generated by the supermarket will drop because of the long-term
loss of customers caused by this strategy. This will negatively affect the current stock price as shareholders
anticipate these long-term drawbacks.
, 1-11. The agent (renter) will not take the same care of the apartment as the principal (owner), because the renter
does not share in the costs of fixing damage to the apartment. This problem can be mitigated by having the
renter pay a deposit and agree to share in the costs of fixing any problems that are caused by the renter. Such
an arrangement should motivate the renter to keep damages to a minimum.
1-12. An ethical dilemma arises when the CEO of a firm has opposite incentives to those of the shareholders. In
this case, you (as the CEO) have an incentive to improve your pay and prestige by buying another company,
but the potential overpayment involved in the deal would be damaging to your shareholders.
1-13. No. They are a way to discipline managers who are not working in the interests of shareholders.
1-14. For each of (a) to (d), you must determine if your personal change in monetary wealth more than offsets the
value of the leisure time you would lose (valued at $51,000). If it does, then you would decide to proceed
with the new project.
a. If you owned 100% of the company and the project were accepted, your personal shares of stock would
increase in value by 100% of $1 million = $1 million. This would more than offset your personal cost of
lost leisure; therefore, your decision would be to proceed with the project.
b. If you owned 1% of the company and the project were accepted, your personal shares of stock would
increase in value by 1% of $1 million = $10,000. This would not be enough to offset your personal cost
of lost leisure; therefore, your decision would be to reject the project.
c. If you owned 3% of the company and the project were accepted, your personal shares of stock would
increase in value by 3% of $1 million = $30,000. In addition, you would receive a bonus of $25,000, so
in total your monetary wealth would increase by $55,000. This more than offsets your personal cost of
lost leisure; therefore, your decision would be to proceed with the project.
d. If you accept the project, your monetary wealth would increase by $25,000 + 3% of $X. For you to
decide to accept the project, this must be greater than $51,000 (the value of your lost leisure). Solving
for X, we get:
e. In part (a), you (as the CEO) are perfectly aligned with the owners of the company as you actually own
the whole company. Thus, you receive the full benefit of the $1 million increase in equity value and this
offsets the value of your lost leisure. There is no principal-agent problem in this case as you own the
entire company. In part (b), your incentives are not aligned with those of the shareholders because the
project should be accepted to maximize shareholder wealth, but you reject it because the increase in your
monetary wealth does not offset the cost of your extra effort and lost leisure time. Here the principal-
agent problem results in a decision that is costly to shareholders as a whole. In part (c), your incentives
are aligned with those of the shareholders as you receive enough of a monetary benefit to offset your
cost of lost leisure. In part (d), though, we can see that the bonus scheme does not always solve the
principal-agent problem. Your incentives are aligned with those of all shareholders when the project
increases the equity value by an amount greater than $866,666.67. However, if the increase in equity
value is lower, you would decide to reject the project even though accepting it would maximize
shareholder wealth. So, bonuses do not always solve principal-agent problems and, in some cases,
bonuses can encourage suboptimal behaviour.
1-15. There are many considerations for you as CEO. One is the cost-benefit analysis of constructing the SD project
and reaping the savings in disposal costs—that should show whether the SD project increases shareholder
value. In addition, if your bonus is tied to earnings, you may be tempted to accept the project because of
higher bonuses for each of the next 10 years. There are other considerations, though. For example, is the SD
Corporate finance
John Berk 6th Edition
,Contents
Part I: Introduction
Chapter 1 The Corporation and Financial Markets 1
Chapter 2 Introduction to Financial Statement Analysis 5
Part II: Tools
Chapter 3 Arbitrage and Financial Decision Making 15
Chapter 4 The Time Value of Money 26
Chapter 5 Interest Rates 49
Part III: Basic Valuation
Chapter 6 Valuing Bonds 65
Chapter 7 Valuing Stocks 77
Chapter 8 Investment Decision Rules 85
Chapter 9 Fundamentals of Capital Budgeting 100
Part IV: Risk and Return
Chapter 10 Capital Markets and the Pricing of Risk 108
Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 117
Chapter 12 Estimating the Cost of Capital 131
Chapter 13 Investor Behaviour and Capital Market Efficiency 137
Part V: Options
Chapter 14 Financial Options 143
Chapter 15 Option Valuation 152
Chapter 16 Real Options 162
Part VI: Capital Structure and Dividend Policy
Chapter 17 Capital Structure in a Perfect Market 185
Chapter 18 Debt and Taxes 192
Chapter 19 Financial Distress, Managerial Incentives, and Information 199
Chapter 20 Payout Policy 207
Part VII: Valuation
Chapter 21 Capital Budgeting and Valuation with Leverage 213
Chapter 22 Valuation and Financial Modelling: A Case Study 227
Part VIII: Long-Term Financing
Chapter 23 Raising Equity Capital 235
Chapter 24 Debt Financing 239
Chapter 25 Leasing 242
Part IX: Short-Term Financing
Chapter 26 Working Capital Management 248
Chapter 27 Short-Term Financial Planning 253
Part X: Special Topics
Chapter 28 Mergers and Acquisitions 257
Chapter 29 Corporate Governance 260
Chapter 30 Risk Management 263
Chapter 31 International Corporate Finance 272
,Chapter 1
The Corporation and Financial Markets
1-1. A corporation is a legal entity separate from its owners. This means ownership shares in the corporation can
be freely traded. None of the other organizational forms share this characteristic.
1-2. Owners’ liability is limited to the amount they invested in the firm. Shareholders are not responsible for any
encumbrances of the firm; in particular, they cannot be required to pay back any debts incurred by the firm.
1-3. Corporations (all shareholders have limited liability). Limited partnerships provide limited liability for the
limited partners, but not for the general partners.
1-4. Advantages: Limited liability, liquidity, infinite life. Disadvantages: Double taxation, separation of
ownership and control.
1-5. The corporation that only holds real estate must pay corporate income taxes. The real estate investment trust
(REIT) does not pay corporate taxes but must pass through substantially all of the income to the trust unit
holders to whom it is taxable.
1-6. First, the corporation pays the taxes. After taxes, $2 × (1 – 0.34) = $1.32 per share is left to pay dividends.
Once the dividend is paid, personal tax on this must be paid, leaving $1.32 × (1 – 0.18) = $1.0824 per share.
So after all the taxes are paid, you are left with $1.0824 per share.
1-7. As a real estate investment trust (REIT) pays no corporate tax, the full amount of $2 per unit can be paid out
to you as a trust unit holder. You must then pay personal income tax on the distribution. So you are left with
$2 × (1 – 0.4) = $1.20 per unit.
1-8. As the manager of an iPhone applications developer, you will make three types of financial decisions.
i. You will make investment decisions such as determining which type of iPhone application projects will
offer your company a positive NPV and should, therefore, be developed by your company.
ii. You will make the decision on how to fund your iPhone application investments and what mix of debt
and equity your company will have.
iii. You will be responsible for the cash management of your company, ensuring that your company has the
necessary funds to make investments, pay interest on loans, and pay your employees.
1-9. Shareholders can
i. ensure that employees are paid with company stock and/or stock options.
ii. ensure that underperforming managers are fired.
iii. write contracts that ensure that the interests of the managers and shareholders are closely aligned.
iv. mount hostile takeovers.
1-10. This will affect and hurt the customers. It will have a negative impact on the customers, for they will likely
get sour milk. It will also have a negative impact on shareholders because, in the long run, customers will
realize that the supermarket sells sour milk and will switch to other supermarkets. Thus, the value today of
the future income and cash flow streams generated by the supermarket will drop because of the long-term
loss of customers caused by this strategy. This will negatively affect the current stock price as shareholders
anticipate these long-term drawbacks.
, 1-11. The agent (renter) will not take the same care of the apartment as the principal (owner), because the renter
does not share in the costs of fixing damage to the apartment. This problem can be mitigated by having the
renter pay a deposit and agree to share in the costs of fixing any problems that are caused by the renter. Such
an arrangement should motivate the renter to keep damages to a minimum.
1-12. An ethical dilemma arises when the CEO of a firm has opposite incentives to those of the shareholders. In
this case, you (as the CEO) have an incentive to improve your pay and prestige by buying another company,
but the potential overpayment involved in the deal would be damaging to your shareholders.
1-13. No. They are a way to discipline managers who are not working in the interests of shareholders.
1-14. For each of (a) to (d), you must determine if your personal change in monetary wealth more than offsets the
value of the leisure time you would lose (valued at $51,000). If it does, then you would decide to proceed
with the new project.
a. If you owned 100% of the company and the project were accepted, your personal shares of stock would
increase in value by 100% of $1 million = $1 million. This would more than offset your personal cost of
lost leisure; therefore, your decision would be to proceed with the project.
b. If you owned 1% of the company and the project were accepted, your personal shares of stock would
increase in value by 1% of $1 million = $10,000. This would not be enough to offset your personal cost
of lost leisure; therefore, your decision would be to reject the project.
c. If you owned 3% of the company and the project were accepted, your personal shares of stock would
increase in value by 3% of $1 million = $30,000. In addition, you would receive a bonus of $25,000, so
in total your monetary wealth would increase by $55,000. This more than offsets your personal cost of
lost leisure; therefore, your decision would be to proceed with the project.
d. If you accept the project, your monetary wealth would increase by $25,000 + 3% of $X. For you to
decide to accept the project, this must be greater than $51,000 (the value of your lost leisure). Solving
for X, we get:
e. In part (a), you (as the CEO) are perfectly aligned with the owners of the company as you actually own
the whole company. Thus, you receive the full benefit of the $1 million increase in equity value and this
offsets the value of your lost leisure. There is no principal-agent problem in this case as you own the
entire company. In part (b), your incentives are not aligned with those of the shareholders because the
project should be accepted to maximize shareholder wealth, but you reject it because the increase in your
monetary wealth does not offset the cost of your extra effort and lost leisure time. Here the principal-
agent problem results in a decision that is costly to shareholders as a whole. In part (c), your incentives
are aligned with those of the shareholders as you receive enough of a monetary benefit to offset your
cost of lost leisure. In part (d), though, we can see that the bonus scheme does not always solve the
principal-agent problem. Your incentives are aligned with those of all shareholders when the project
increases the equity value by an amount greater than $866,666.67. However, if the increase in equity
value is lower, you would decide to reject the project even though accepting it would maximize
shareholder wealth. So, bonuses do not always solve principal-agent problems and, in some cases,
bonuses can encourage suboptimal behaviour.
1-15. There are many considerations for you as CEO. One is the cost-benefit analysis of constructing the SD project
and reaping the savings in disposal costs—that should show whether the SD project increases shareholder
value. In addition, if your bonus is tied to earnings, you may be tempted to accept the project because of
higher bonuses for each of the next 10 years. There are other considerations, though. For example, is the SD
