INSTRUCTOR'S SOLUTIONS MANUAL
FUNDAMENTALS OF FINANCIAL MANAGEMENT
CONCISE 12TH EDITION
CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT
TABLE OF CONTENTS
• Learning Objectives
• Lecture Suggestions
• Answer to Self-Test Question
• Answers to Questions
• Answer to Financial Analytics Case
• 1-15 Pulling SEC Filings in Edgar
• Case Solution.
ANSWER TO SELF-TEST QUESTION
ST-1 Key Terms Define each of the following terms:
a. Sarbanes-Oxley Act
b. Proprietorship; partnership; corporation
c. S corporations; limited liability company (LLC); limited liability partnership (LLP)
d. Intrinsic value; market price
e. Marginal investor; equilibrium
f. Corporate governance
g. Corporate raiders; hostile takeover
h. Shareholder wealth maximization
i. Business ethics
j. Environmental, social, and governance (ESG) measures
Solutions:
a. Sarbanes-Oxley Act: A law passed by Congress that requires the CEO and CFO to certify that
their firms’ financial statements are accurate.
b. Proprietorship: An unincorporated business owned by one individual.
Partnership: An unincorporated business owned by two or more persons.
Corporation: A legal entity created by a state, separate and distinct from its owners and
managers, having unlimited life, easy transferability of ownership, and limited liability.
c. S corporations: A special designation that allows small businesses that meet qualifications to
be taxed as if they were a proprietorship or a partnership rather than a corporation.
Limited liability company (LLC): A popular type of organization that is a hybrid between a
partnership and a corporation.
Limited liability partnership (LLP): Similar to an LLC but used for professional firms in the
fields of accounting, law, and architecture. It provides personal asset protection from business
debts and liabilities but is taxed as a partnership.
, d. Intrinsic value: An estimate of a stock’s “true” value based on accurate risk and return data.
The intrinsic value can be estimated, but not measured precisely.
Market price: The stock value based on perceived but possibly incorrect information as seen
by the marginal investor.
e. Marginal investor: An investor whose views determine the actual stock price.
Equilibrium: The situation in which the actual market price equals the intrinsic value, so investors
are indifferent between buying and selling a stock.
f. Corporate governance: Establishment of rules and practices by Board of Directors to ensure
that managers act in shareholders’ interests while balancing the needs of other key
constituencies.
g. Corporate raiders: Individuals who target corporations for takeovers because they are
undervalued.
Hostile takeover: The acquisition of a company over the opposition of its management.
h. Shareholder wealth maximization: The primary financial goal for managers of publicly
owned companies implies that decisions should be made to maximize the long-run value of
the firm’s common stock.
i. Business ethics: A company’s attitude and conduct toward its employees, customers,
community, and stockholders.
j. Environmental, social, and governance (ESG) measures: Three main factors for measuring
social responsibility in a firm.
ANSWERS TO QUESTIONS
1-1 What is a firm’s intrinsic value? Its current stock price? Is the stock’s “true” long-run value more
closely related to its intrinsic value or to its current price?
Solution:
A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data.
It can be estimated but not measured precisely. A stock’s current price is its market price—the value
based on perceived but possibly incorrect information as seen by the marginal investor. From these
definitions, you can see that a stock’s “true” long-run value is more closely related to its intrinsic value
rather than its current price.
1-2 When is a stock said to be in equilibrium? Why might a stock at any point in time not be in
equilibrium?
Solution:
Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are
indifferent between buying and selling a stock. If a stock is in equilibrium, then there is no
fundamental imbalance, hence no pressure for a change in the stock’s price. At any given time, most
stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium. However, at
times stock prices and equilibrium values are different, so stocks can be temporarily undervalued or
overvalued. Investor optimism and pessimism, along with imperfect knowledge about the true
intrinsic value, lead to deviations between the actual prices and intrinsic values.
1-3 Suppose three honest individuals gave you their estimates of Stock X’s intrinsic value. One
person is your current roommate, the second person is a professional security analyst with an
, excellent reputation on Wall Street, and the third person is Company X’s CFO. If the three
estimates differed, in which one would you have the most confidence? Why?
Solution:
If the three intrinsic value estimates for Stock X were different, you would have the most
confidence in Company X’s CFO’s estimate. Intrinsic values are strictly estimates, and different
analysts with different data and different views of the future will form different estimates of the
intrinsic value for any given stock. However, a firm’s managers have the best information about
the company’s future prospects, so managers’ estimates of intrinsic value are generally better than
the estimates of outside investors.
1-4 Is it better for a firm’s actual stock price in the market to be under, over, or equal to its intrinsic
value? Would your answer be the same from the standpoints of stockholders in general and a
CEO who is about to exercise a million dollars in options and then retire? Explain.
Solution:
If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium and there is
no pressure (buying/selling) to change the stock’s price. So, theoretically, it is better that the two
be equal; however, intrinsic value is a long-run concept. Management’s goal should be to
maximize the firm’s intrinsic value, not its current price. So, maximizing the intrinsic value will
maximize the average price over the long run but not necessarily the current price at each point in
time. So, stockholders in general would probably expect the firm’s market price to be under the
intrinsic value—realizing that if management is doing its job the current price at any point in time
would not necessarily be maximized. However, the CEO would prefer that the market price be
high—since it is the current price that he will receive when exercising his stock options. In
addition, he will be retiring after exercising those options, so there will be no repercussions to
him (with respect to his job) if the market price drops—unless he did something illegal during his
tenure as CEO.
1-5 If a company’s board of directors wants management to maximize shareholder wealth, should the
CEO’s compensation be set as a fixed dollar amount, or should the compensation depend on how
well the firm performs? If it is to be based on performance, how should performance be
measured? Would it be easier to measure performance by the growth rate in reported profits or
the growth rate in the stock’s intrinsic value? Which would be the better performance measure?
Why?
Solution:
The board of directors should set CEO compensation dependent on how well the firm performs.
The compensation package should be sufficient to attract and retain the CEO but not go beyond
what is needed. Compensation should be structured so that the CEO is rewarded based on the
stock’s performance over the long run, not the stock’s price on an option exercise date. This
means that options (or direct stock awards) should be phased in over several years so the CEO
will have an incentive to keep the stock price high over time. If the intrinsic value could be
measured in an objective and verifiable manner, then performance pay could be based on changes
in intrinsic value. However, it is easier to measure the growth rate in reported profits than the
intrinsic value, although reported profits can be manipulated through aggressive accounting
procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable,
compensation must be based on the stock’s market price—but the price used should be an
average over time rather than on a specific date.
, 1-6 What are the various forms of business organization? What are the advantages and disadvantages
of each?
Solution:
The different forms of business organization are proprietorships, partnerships, corporations, and
limited liability corporations and partnerships. The advantages of the first two include the ease
and low cost of formation. The advantages of corporations include limited liability, indefinite life,
ease of ownership transfer, and access to capital markets. Limited liability companies and
partnerships have limited liability like corporations.
The disadvantages of a proprietorship are (1) difficulty in obtaining large sums of capital, (2)
unlimited personal liability for business debts, and (3) limited life. The disadvantages of a
partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and
(4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1)
double taxation of earnings and (2) setting up a corporation and filing required state and federal
reports, which are complex and time-consuming. Among the disadvantages of limited liability
corporations and partnerships are the difficulty in raising capital and the complexity of setting
them up.
1-7 Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For
example, if one action increases a firm’s stock price from a current level of $20 to $25 in 6
months and then to $30 in 5 years, but another action keeps the stock at $20 for several years but
then increases it to $40 in 5 years, which action would be better? Think of some specific
corporate actions that have these general tendencies.
Solution:
Stockholder wealth maximization is a long-run goal. Companies, and consequently the
stockholders, prosper by management making decisions that will produce long-term earnings
increases. Actions that are continually shortsighted often “catch up” with a firm and, as a result, it
may find itself unable to compete effectively against its competitors. There has been much
criticism in recent years that U.S. firms are too short-run profit-oriented. A prime example is the
U.S. auto industry, which has been accused of continuing to build large “gas guzzler”
automobiles because they had higher profit margins rather than retooling for smaller, more fuel-
efficient models.
1-8 What are some actions that stockholders can take to ensure that management’s and stockholders’
interests are aligned?
Solution:
Useful motivational tools that will aid in aligning stockholders’ and management’s interests
include: (1) reasonable compensation packages, (2) direct intervention by shareholders, including
firing managers who don’t perform well, and (3) the threat of takeover.
The compensation package should be sufficient to attract and retain able managers but not go
beyond what is needed. Also, compensation packages should be structured so that managers are
rewarded based on the stock’s performance over the long run, not the stock’s price on an option
exercise date. This means that options (or direct stock awards) should be phased in over several
years so managers will have an incentive to keep the stock price high over time. Since intrinsic
value is not observable, compensation must be based on the stock’s market price—but the price
used should be an average over time rather than on a specific date.
FUNDAMENTALS OF FINANCIAL MANAGEMENT
CONCISE 12TH EDITION
CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT
TABLE OF CONTENTS
• Learning Objectives
• Lecture Suggestions
• Answer to Self-Test Question
• Answers to Questions
• Answer to Financial Analytics Case
• 1-15 Pulling SEC Filings in Edgar
• Case Solution.
ANSWER TO SELF-TEST QUESTION
ST-1 Key Terms Define each of the following terms:
a. Sarbanes-Oxley Act
b. Proprietorship; partnership; corporation
c. S corporations; limited liability company (LLC); limited liability partnership (LLP)
d. Intrinsic value; market price
e. Marginal investor; equilibrium
f. Corporate governance
g. Corporate raiders; hostile takeover
h. Shareholder wealth maximization
i. Business ethics
j. Environmental, social, and governance (ESG) measures
Solutions:
a. Sarbanes-Oxley Act: A law passed by Congress that requires the CEO and CFO to certify that
their firms’ financial statements are accurate.
b. Proprietorship: An unincorporated business owned by one individual.
Partnership: An unincorporated business owned by two or more persons.
Corporation: A legal entity created by a state, separate and distinct from its owners and
managers, having unlimited life, easy transferability of ownership, and limited liability.
c. S corporations: A special designation that allows small businesses that meet qualifications to
be taxed as if they were a proprietorship or a partnership rather than a corporation.
Limited liability company (LLC): A popular type of organization that is a hybrid between a
partnership and a corporation.
Limited liability partnership (LLP): Similar to an LLC but used for professional firms in the
fields of accounting, law, and architecture. It provides personal asset protection from business
debts and liabilities but is taxed as a partnership.
, d. Intrinsic value: An estimate of a stock’s “true” value based on accurate risk and return data.
The intrinsic value can be estimated, but not measured precisely.
Market price: The stock value based on perceived but possibly incorrect information as seen
by the marginal investor.
e. Marginal investor: An investor whose views determine the actual stock price.
Equilibrium: The situation in which the actual market price equals the intrinsic value, so investors
are indifferent between buying and selling a stock.
f. Corporate governance: Establishment of rules and practices by Board of Directors to ensure
that managers act in shareholders’ interests while balancing the needs of other key
constituencies.
g. Corporate raiders: Individuals who target corporations for takeovers because they are
undervalued.
Hostile takeover: The acquisition of a company over the opposition of its management.
h. Shareholder wealth maximization: The primary financial goal for managers of publicly
owned companies implies that decisions should be made to maximize the long-run value of
the firm’s common stock.
i. Business ethics: A company’s attitude and conduct toward its employees, customers,
community, and stockholders.
j. Environmental, social, and governance (ESG) measures: Three main factors for measuring
social responsibility in a firm.
ANSWERS TO QUESTIONS
1-1 What is a firm’s intrinsic value? Its current stock price? Is the stock’s “true” long-run value more
closely related to its intrinsic value or to its current price?
Solution:
A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data.
It can be estimated but not measured precisely. A stock’s current price is its market price—the value
based on perceived but possibly incorrect information as seen by the marginal investor. From these
definitions, you can see that a stock’s “true” long-run value is more closely related to its intrinsic value
rather than its current price.
1-2 When is a stock said to be in equilibrium? Why might a stock at any point in time not be in
equilibrium?
Solution:
Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are
indifferent between buying and selling a stock. If a stock is in equilibrium, then there is no
fundamental imbalance, hence no pressure for a change in the stock’s price. At any given time, most
stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium. However, at
times stock prices and equilibrium values are different, so stocks can be temporarily undervalued or
overvalued. Investor optimism and pessimism, along with imperfect knowledge about the true
intrinsic value, lead to deviations between the actual prices and intrinsic values.
1-3 Suppose three honest individuals gave you their estimates of Stock X’s intrinsic value. One
person is your current roommate, the second person is a professional security analyst with an
, excellent reputation on Wall Street, and the third person is Company X’s CFO. If the three
estimates differed, in which one would you have the most confidence? Why?
Solution:
If the three intrinsic value estimates for Stock X were different, you would have the most
confidence in Company X’s CFO’s estimate. Intrinsic values are strictly estimates, and different
analysts with different data and different views of the future will form different estimates of the
intrinsic value for any given stock. However, a firm’s managers have the best information about
the company’s future prospects, so managers’ estimates of intrinsic value are generally better than
the estimates of outside investors.
1-4 Is it better for a firm’s actual stock price in the market to be under, over, or equal to its intrinsic
value? Would your answer be the same from the standpoints of stockholders in general and a
CEO who is about to exercise a million dollars in options and then retire? Explain.
Solution:
If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium and there is
no pressure (buying/selling) to change the stock’s price. So, theoretically, it is better that the two
be equal; however, intrinsic value is a long-run concept. Management’s goal should be to
maximize the firm’s intrinsic value, not its current price. So, maximizing the intrinsic value will
maximize the average price over the long run but not necessarily the current price at each point in
time. So, stockholders in general would probably expect the firm’s market price to be under the
intrinsic value—realizing that if management is doing its job the current price at any point in time
would not necessarily be maximized. However, the CEO would prefer that the market price be
high—since it is the current price that he will receive when exercising his stock options. In
addition, he will be retiring after exercising those options, so there will be no repercussions to
him (with respect to his job) if the market price drops—unless he did something illegal during his
tenure as CEO.
1-5 If a company’s board of directors wants management to maximize shareholder wealth, should the
CEO’s compensation be set as a fixed dollar amount, or should the compensation depend on how
well the firm performs? If it is to be based on performance, how should performance be
measured? Would it be easier to measure performance by the growth rate in reported profits or
the growth rate in the stock’s intrinsic value? Which would be the better performance measure?
Why?
Solution:
The board of directors should set CEO compensation dependent on how well the firm performs.
The compensation package should be sufficient to attract and retain the CEO but not go beyond
what is needed. Compensation should be structured so that the CEO is rewarded based on the
stock’s performance over the long run, not the stock’s price on an option exercise date. This
means that options (or direct stock awards) should be phased in over several years so the CEO
will have an incentive to keep the stock price high over time. If the intrinsic value could be
measured in an objective and verifiable manner, then performance pay could be based on changes
in intrinsic value. However, it is easier to measure the growth rate in reported profits than the
intrinsic value, although reported profits can be manipulated through aggressive accounting
procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable,
compensation must be based on the stock’s market price—but the price used should be an
average over time rather than on a specific date.
, 1-6 What are the various forms of business organization? What are the advantages and disadvantages
of each?
Solution:
The different forms of business organization are proprietorships, partnerships, corporations, and
limited liability corporations and partnerships. The advantages of the first two include the ease
and low cost of formation. The advantages of corporations include limited liability, indefinite life,
ease of ownership transfer, and access to capital markets. Limited liability companies and
partnerships have limited liability like corporations.
The disadvantages of a proprietorship are (1) difficulty in obtaining large sums of capital, (2)
unlimited personal liability for business debts, and (3) limited life. The disadvantages of a
partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and
(4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1)
double taxation of earnings and (2) setting up a corporation and filing required state and federal
reports, which are complex and time-consuming. Among the disadvantages of limited liability
corporations and partnerships are the difficulty in raising capital and the complexity of setting
them up.
1-7 Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For
example, if one action increases a firm’s stock price from a current level of $20 to $25 in 6
months and then to $30 in 5 years, but another action keeps the stock at $20 for several years but
then increases it to $40 in 5 years, which action would be better? Think of some specific
corporate actions that have these general tendencies.
Solution:
Stockholder wealth maximization is a long-run goal. Companies, and consequently the
stockholders, prosper by management making decisions that will produce long-term earnings
increases. Actions that are continually shortsighted often “catch up” with a firm and, as a result, it
may find itself unable to compete effectively against its competitors. There has been much
criticism in recent years that U.S. firms are too short-run profit-oriented. A prime example is the
U.S. auto industry, which has been accused of continuing to build large “gas guzzler”
automobiles because they had higher profit margins rather than retooling for smaller, more fuel-
efficient models.
1-8 What are some actions that stockholders can take to ensure that management’s and stockholders’
interests are aligned?
Solution:
Useful motivational tools that will aid in aligning stockholders’ and management’s interests
include: (1) reasonable compensation packages, (2) direct intervention by shareholders, including
firing managers who don’t perform well, and (3) the threat of takeover.
The compensation package should be sufficient to attract and retain able managers but not go
beyond what is needed. Also, compensation packages should be structured so that managers are
rewarded based on the stock’s performance over the long run, not the stock’s price on an option
exercise date. This means that options (or direct stock awards) should be phased in over several
years so managers will have an incentive to keep the stock price high over time. Since intrinsic
value is not observable, compensation must be based on the stock’s market price—but the price
used should be an average over time rather than on a specific date.
