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SOLUTION MANUAL
FOR FUNDAMENTALS OF CORPORATE FINANCE
11CE STEPHEN A. ROSS RANDOLPH W.
WESTERFIELD, BRADFORD D. JORDAN, J. ARI
PANDES, THOMAS HOLLOWAY LATEST
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solution manual for
Fundamentals of corporatefinance11cestephen a. Ross, randolph w.
Westerfield, bradford d. Jordan, j. Ari pandes, thomas holloway
Chapter 1-26
1
Chapter
Introduction to corporate finance
Learning objectives
Lo1 the bas i c typesof financial managementdecisions and the role of the financial manager.
Lo2 the financial implications of the different forms of business organization.
Lo3 the goal of financial management.
Lo4 the conflicts of intereststhat can arise between managers and owners.
Lo5 the roles of financial institutionsand markets.
Lo6 types of financialinstitutions.
Lo7 trends in financial markets.
Answers to concepts review and critical thinking questions
1. (lo1) capital budgeting (deciding on 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). (lo1)
2. (lo2) 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.
3. (lo2) 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. (lo4) 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 offi ce 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. (lo3) to maximize the current market value (share price) of the equity of the firm (whether
it‘s publicly-traded or not).
6. (lo4) 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
2
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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. (lo5) a primary market transaction. A secondary market transaction would entail the
sale between two 3rd parties (i.e. Not the corporation).
8. (lo5) in auction markets like the toronto stock exchange (tsx), brokers and agents meet at a
central location (the exchange) to match buyers and sellers of assets. Physical locations for
stock markets are disappearing as trading becomes more electronic. 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. Dealer
markets are less transparent than auction markets where trades are reported publicly almost
immediately. The auction market run by the tsx is where the stocks of larger canadian
companies are traded; the tsx also operates a dealer market called the venture exchange for
companies too small to qualify for the tsx auction exchange.
9. (lo3) 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. Another would
be to best serve the maximum possible number of stakeholders at the lowest cost. A better
approach might be to observe that 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. (lo3) 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. (lo3) 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
and lost customer goodwill. What should the firm do?‖
12. (lo3) 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. (lo4) 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
4
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Often lose their jobs when the corporation is acquired, poorly monitoredmanagers have an
incentive to fight corporate takeovers in situations such as this.
14. (lo4) 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 means that
each individual owner has a greater incentive to monitor and control the firm—i.e. There is
less free-riding. 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
canada and in the united states and the growing activism of these large shareholder groups
may lead to a reduction in agency problems for canadian and u.s. Corporations and a more
efficient market for corporate control.
15. (lo5) major institutions:
Chartered banks -accept deposits and issue commercial loans, corporate loans, personal loans
and mortgages.
Trust companies-accept deposits and make loans, but also engage in fiduciary activities such
as managing assets for estates, registered retirement savings plans, etc.
Investment dealers -non-depository institutions that assist firms in issuing new securities.
Insurance companies -engage in indirect financing by accepting funds in a form similar to a
deposit and making loans.
Pension funds -invest contributions from employers and employees in securities offered by
financial markets.
Mutual funds -pool individual investments to purchase adiversified portfolio.
Hedge funds -cater to sophisticated investors and seek high returns by using aggressive
financial strategies prohibited by mutual funds.
Note that larger financial institutions may embody many of these different institution. For
example, cibc is a chartered bank that owns an investment dealer and mutual funds.
Furthermore, it has an insurance arm —cibc insurance‖
Major markets:
Money market -financial markets where short-term debt instruments are bought andsold.
Capital markets -financial markets where long-term debt and equity securities are bought
and sold. Derivatives markets – where options and futures are traded on
Financial instruments and commodities primary markets are where securities are sold for
the first time; secondary markets are where outstandingsecurities trade.
16. (lo5) spread versus fee income:
Banks earn spread or interest income by borrowing from depositors and lending to borrowers (at a
higher yield). An example is a retail deposit and a mortgage. Banks make non -interest or fee
income when they charge commissions or fees for services. An example is an overdraft fee or
atm fee, or the example in the text, the stamping fee on a banker‘s acceptance (which is a form of
insurance and arranging fee).
17. (lo5) trends:
Financial engineering -the creation of new securities or financial processes. This
engineering could be used to package and sell risky assets to investors; for example, banks
can package and sell mortgages into mortgage backed securities and sell these on to other
5i n v esto rs.
derivative securities -options, futures, forwards, and other securities whose value is derived
from the price of another, underlying asset. For example, a futures contract to purchase oil
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Stuvia.com - Th e M ark etp l ace to Buy an d S ell y o u r S tu d y M a t e ri a l
SOLUTION MANUAL
FOR FUNDAMENTALS OF CORPORATE FINANCE
11CE STEPHEN A. ROSS RANDOLPH W.
WESTERFIELD, BRADFORD D. JORDAN, J. ARI
PANDES, THOMAS HOLLOWAY LATEST
UPDATE100%A+
, [Type the docume n t t i t le ]
Stuvia.com - Th e M ark etp l ace to Buy an d S ell y o u r S tu d y M a t e ri a l
solution manual for
Fundamentals of corporatefinance11cestephen a. Ross, randolph w.
Westerfield, bradford d. Jordan, j. Ari pandes, thomas holloway
Chapter 1-26
1
Chapter
Introduction to corporate finance
Learning objectives
Lo1 the bas i c typesof financial managementdecisions and the role of the financial manager.
Lo2 the financial implications of the different forms of business organization.
Lo3 the goal of financial management.
Lo4 the conflicts of intereststhat can arise between managers and owners.
Lo5 the roles of financial institutionsand markets.
Lo6 types of financialinstitutions.
Lo7 trends in financial markets.
Answers to concepts review and critical thinking questions
1. (lo1) capital budgeting (deciding on 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). (lo1)
2. (lo2) 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.
3. (lo2) 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. (lo4) 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 offi ce 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. (lo3) to maximize the current market value (share price) of the equity of the firm (whether
it‘s publicly-traded or not).
6. (lo4) 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
2
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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. (lo5) a primary market transaction. A secondary market transaction would entail the
sale between two 3rd parties (i.e. Not the corporation).
8. (lo5) in auction markets like the toronto stock exchange (tsx), brokers and agents meet at a
central location (the exchange) to match buyers and sellers of assets. Physical locations for
stock markets are disappearing as trading becomes more electronic. 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. Dealer
markets are less transparent than auction markets where trades are reported publicly almost
immediately. The auction market run by the tsx is where the stocks of larger canadian
companies are traded; the tsx also operates a dealer market called the venture exchange for
companies too small to qualify for the tsx auction exchange.
9. (lo3) 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. Another would
be to best serve the maximum possible number of stakeholders at the lowest cost. A better
approach might be to observe that 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. (lo3) 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. (lo3) 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
and lost customer goodwill. What should the firm do?‖
12. (lo3) 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. (lo4) 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
4
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Often lose their jobs when the corporation is acquired, poorly monitoredmanagers have an
incentive to fight corporate takeovers in situations such as this.
14. (lo4) 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 means that
each individual owner has a greater incentive to monitor and control the firm—i.e. There is
less free-riding. 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
canada and in the united states and the growing activism of these large shareholder groups
may lead to a reduction in agency problems for canadian and u.s. Corporations and a more
efficient market for corporate control.
15. (lo5) major institutions:
Chartered banks -accept deposits and issue commercial loans, corporate loans, personal loans
and mortgages.
Trust companies-accept deposits and make loans, but also engage in fiduciary activities such
as managing assets for estates, registered retirement savings plans, etc.
Investment dealers -non-depository institutions that assist firms in issuing new securities.
Insurance companies -engage in indirect financing by accepting funds in a form similar to a
deposit and making loans.
Pension funds -invest contributions from employers and employees in securities offered by
financial markets.
Mutual funds -pool individual investments to purchase adiversified portfolio.
Hedge funds -cater to sophisticated investors and seek high returns by using aggressive
financial strategies prohibited by mutual funds.
Note that larger financial institutions may embody many of these different institution. For
example, cibc is a chartered bank that owns an investment dealer and mutual funds.
Furthermore, it has an insurance arm —cibc insurance‖
Major markets:
Money market -financial markets where short-term debt instruments are bought andsold.
Capital markets -financial markets where long-term debt and equity securities are bought
and sold. Derivatives markets – where options and futures are traded on
Financial instruments and commodities primary markets are where securities are sold for
the first time; secondary markets are where outstandingsecurities trade.
16. (lo5) spread versus fee income:
Banks earn spread or interest income by borrowing from depositors and lending to borrowers (at a
higher yield). An example is a retail deposit and a mortgage. Banks make non -interest or fee
income when they charge commissions or fees for services. An example is an overdraft fee or
atm fee, or the example in the text, the stamping fee on a banker‘s acceptance (which is a form of
insurance and arranging fee).
17. (lo5) trends:
Financial engineering -the creation of new securities or financial processes. This
engineering could be used to package and sell risky assets to investors; for example, banks
can package and sell mortgages into mortgage backed securities and sell these on to other
5i n v esto rs.
derivative securities -options, futures, forwards, and other securities whose value is derived
from the price of another, underlying asset. For example, a futures contract to purchase oil
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