Solution and Answer Guide: Brigham and Daves, Intermediate Financial Management, 15e, 2027, 9798214056814; Chapter 1: An Overview of Financial Management
and the Financial Environment
Solution and Answer Guide
BRIGHAM AND DAVES, INTERMEDIATE FINANCIAL MANAGEMENT, 15E, 2027, 9798214056814;
CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT
TABLE OF CONTENTS
Answers to Beginning-of-Chapter Questions...............................................................1
Answers to End-of-Chapter Questions.........................................................................4
Mini Case.......................................................................................................................9
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 What is presumed to be the primary objective of financial management? How is this goal related to other
societal goals and considerations? Is this goal consistent with the basic assumptions of microeconomics?
Are managers’ actions always consistent with this goal?
Answer:
The primary goal is assumed to be shareholder wealth maximization, which translates to stock price
maximization. That, in turn, means maximizing the present value (PV) of future free cash flows.
Maximizing shareholder wealth requires that the firm produce things that customers want and at the
lowest cost consistent with high quality. It also means holding risk down, which will result in a relatively
low cost of capital, which is necessary to maximize the PV of a given cash flow stream.
This also gets into the issue of capital structure—how much debt should we use? The more debt the firm
uses, the lower its taxes, and the fewer shares outstanding, hence less dilution of earnings. However,
more debt means more risk. So, it’s necessary to consider capital structure when attempting to maximize
share prices.
Dividend policy is also an issue—how much of its earnings should the firm pay out as dividends? The
answer to that question depends on a number of factors, including the firm’s investment opportunities, its
access to capital markets, its stockholders’ desires (and their tax rates), and the kind of signals stockholders get
from dividend actions.
Shareholder wealth maximization is partially consistent and partially inconsistent with generally accepted
societal goals. It is consistent because well-run firms produce good products at low costs, sell them at
competitive prices, employ people, pay taxes, and generally improve society. However, without constraints,
firms would tend to form monopolies and end up charging prices that are too high and not producing enough
output. They might also pollute the air and water, engage in unfair labor practices, and so on. So, constraints
(antitrust, labor, environmental, etc. laws) should be and are imposed on businesses. That said, stock
price maximization is consistent with a strong economy, economic progress, and “the
good life” for most citizens.
In standard introductory microeconomics courses, we assume that firms attempt to maximize
profits. In more advanced econ courses, the goal is broadened to value maximizing, so finance and
economics are indeed consistent.
© 2027 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 1
accessible website, in whole or in part.
,Solution and Answer Guide: Brigham and Daves, Intermediate Financial Management, 15e, 2027, 9798214056814; Chapter 1: An Overview of Financial Management
and the Financial Environment
As WorldCom, Enron, and other corporate scandals demonstrated very clearly, managers do not
always have stockholders’ interests as a primary goal—some managers have their own interests. This
point is further discussed below.
1-2 Finance is all about valuation—how to estimate asset values and what to do to increase them. We
develop and use Excel models throughout the book. We start that process in this chapter with simple
models used to value bonds, stocks, and capital budgeting projects. Working through the model will give
you a refresher in valuation plus a refresher on (or preview of) Excel.
a. Explain how to find the value of a bond given the rate of interest it pays
(its coupon rate), its par value (assume $1,000), and the going rate of interest
on bonds with the same risk and maturity.
b. Explain how to find the value of a stock given its last dividend, its expected growth rate, and its
required rate of return.
c. Explain how to find the value of a capital budgeting project given its cost, its expected annual net
cash flows, its life, and its cost of capital.
d. In each of these cases, discuss how changes in the inputs would affect the output. Would it matter if
the outputs were highly sensitive to changes in the inputs?
Answer for a. – d.
Refer to the model for quantitative answers to this question. All of these valuations involve applications
of the basic valuation model:
Values for CFt, r, and N are specified. For bonds, the CFs are interest payments and the maturity value, and
N is the bond’s life. Other things held constant, the higher the going interest rate, r, the lower the value of
the bond. Also, if the coupon rate is high, then CFs are also high, and that increases the value of the bond.
For a stock, the CFs are dividends, and for a capital budgeting project, they are operating cash flows.
The main point to get across with this question is that all assets are valued in essentially the same
way. The Excel model goes into a little more detail on sensitivity analysis. Much more comes later in the
book.
1-3 What are the advantages of the corporate form over a sole proprietorship or a partnership? What are the
disadvantages of this form?
Answer:
The advantages of a corporate form of ownership are that investor liability is limited to the amount
invested, corporations can raise capital through public offerings of stock, and ownership can be easily
transferred from person to person by simply selling shares of stock. In a sole proprietorship or
partnership, on the other hand, the owner or owners are exposed to potentially unlimited liability, it is
difficult to raise equity capital since either new partners must be found or the existing partners must put
up additional capital, and it is difficult to transfer ownership between partners or from a sole proprietor
to someone else.
The disadvantages of the corporate form are that there are numerous forms that must be filled out and
regulations that must be followed that are not required of a sole proprietorship or a partnership,
corporations are subject to double taxation of distributed earnings in that the corporation first pays taxes
on the pre-tax income, and then the owners must pay tax on the dividend or capital gains income, and the
separation of ownership (by the shareholders) and control (by management) can result in management
taking actions that are not in the owners’ best interests.
© 2027 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 2
accessible website, in whole or in part.
,Solution and Answer Guide: Brigham and Daves, Intermediate Financial Management, 15e, 2027, 9798214056814; Chapter 1: An Overview of Financial Management
and the Financial Environment
1-4 What are the various factors that affect the cost of money and hence interest rates? How will changes in
these components affect asset prices?
Answer:
The cost of money is affected by (1) production opportunities, (2) the time preference for consumption, (3)
risk, and (4) inflation. When production opportunities are good, and assets are earning high rates of return,
then interest rates tend to be higher because there is a larger demand for borrowing to finance these projects.
Also, investors who
are considering lending money recognize that their alternative investments have a high return and so demand a
high return on their investments. When investors have a
strong preference for current consumption, then they demand a higher return on their investments to
compensate them for having to defer current purchases, and so the
cost of money is higher. Investors demand a higher rate of return on riskier investments in order to
compensate them for having to be exposed to more risk. When investors expect future inflation, then the cost
of money increases so that investment returns better cover this future price increase.
If any of these factors change, then the cost of money will change, and hence the
yield and the price of a security will change as well. For example, if overall the time preference for
consumption increases, then overall interest rates will tend to increase and the yield on debt instruments will
tend to increase, and their prices will fall. If the underlying level of inflation declines, as it did through the
1990s, then interest rates on debt instruments will decline, driving up their prices. On the other hand, if a
company experiences financial problems, increasing the likelihood of default and bankruptcy and becoming
more risky, then the yield on its bonds will increase and their prices will fall.
1-5 Are most stocks traded on face-to-face exchanges or electronically? What impact has this had on retail
stock transactions? On portfolio management?
Answer:
Most stocks are now traded on electronic exchanges. Rather than only two or three face-to-face
exchanges, there are now dozens of electronic exchanges on which stocks trade. In electronic markets, a
computer program matches buy and sell orders quickly and automatically. The costs of electronic
exchanges are much lower than for a face-to-face exchange and transactions costs are much lower than
they were decades ago as a result. Retail trades occur fast and at a low cost and so retail customers have
benefited from the automation of markets. Portfolio managers have benefited similarly, although they
can be preyed upon by high-frequency traders.
1-6 What is securitization? How is securitization supposed to help banks and savings and loans (S&Ls)
manage risks and increase homeowners’ access to capital?
Answer:
Securitization is the process by which assets, such as mortgages held by banks, accounts receivables held
by companies, or credit card obligations held by banks and finance companies, are packaged together
and sold to investors. In the case of mortgages, a bank or savings and loan (S&L) may have a portfolio
of mortgages that it has originated (or issued). Typically, a bank will have financed these mortgages with
savings and checking account deposits and certificate of deposits (CDs), and once it has used up its
loanable funds, it must either stop making new loans or raise more funds if it wants to make more loans.
If the bank packages these mortgages and sells them to investors, then it can make more loans with the
funds it receives. The idea is that the bank acts as an intermediary in this case, analyzing credit and
making loans and then selling them off so it can make more loans; consumers get more loans, and banks
get to do what they (supposedly) do best, which is to analyze risk and originate loans.
If a bank doesn’t securitize its loans and, instead, holds them on its books, then it can be exposed to a lot
of interest rate risk. Back in the 1980s, S&Ls were raising money with short-term CDs and lending it out
© 2027 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 3
accessible website, in whole or in part.
,Solution and Answer Guide: Brigham and Daves, Intermediate Financial Management, 15e, 2027, 9798214056814; Chapter 1: An Overview of Financial Management
and the Financial Environment
long-term as 30-year fixed-rate mortgages. When interest rates skyrocketed, the interest they had to pay
on the CDs increased dramatically, but since the mortgages were fixed-rate, the interest income the
S&Ls received didn’t increase. This caused hundreds of S&Ls to go bankrupt and cost the federal
government and, ultimately, the U.S. taxpayers hundreds of billions of dollars. If, instead, S&Ls
securitized the loans, they would no longer be exposed to the interest rate risk since they would have
sold off the loans shortly after originating them. Of course, the interest rate risk doesn’t go away!
Instead, the investors in the securitized mortgages now receive the fixed interest payments. If these
investors have themselves financed the investment with short-term borrowing, then they will be exposed
to interest rate risk!
ANSWERS TO END-OF-CHAPTER QUESTIONS
1-1 Define each of the following terms:
a. Proprietorship; partnership; corporation; charter; bylaws
b. Limited partnership; limited liability partnership; professional corporation
c. Stockholder wealth maximization
d. Money market; capital market; primary market; secondary market
e. Private markets; public markets; derivatives
f. Investment bank; financial services corporation; financial intermediary
g. Mutual fund; money market fund
h. Open outcry auction; dealer market; automated trading platform
i. Production opportunities; time preferences for consumption
j. Foreign trade deficit
k. Algorithmic trading; high-frequency trading
© 2027 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 4
accessible website, in whole or in part.
and the Financial Environment
Solution and Answer Guide
BRIGHAM AND DAVES, INTERMEDIATE FINANCIAL MANAGEMENT, 15E, 2027, 9798214056814;
CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT
TABLE OF CONTENTS
Answers to Beginning-of-Chapter Questions...............................................................1
Answers to End-of-Chapter Questions.........................................................................4
Mini Case.......................................................................................................................9
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 What is presumed to be the primary objective of financial management? How is this goal related to other
societal goals and considerations? Is this goal consistent with the basic assumptions of microeconomics?
Are managers’ actions always consistent with this goal?
Answer:
The primary goal is assumed to be shareholder wealth maximization, which translates to stock price
maximization. That, in turn, means maximizing the present value (PV) of future free cash flows.
Maximizing shareholder wealth requires that the firm produce things that customers want and at the
lowest cost consistent with high quality. It also means holding risk down, which will result in a relatively
low cost of capital, which is necessary to maximize the PV of a given cash flow stream.
This also gets into the issue of capital structure—how much debt should we use? The more debt the firm
uses, the lower its taxes, and the fewer shares outstanding, hence less dilution of earnings. However,
more debt means more risk. So, it’s necessary to consider capital structure when attempting to maximize
share prices.
Dividend policy is also an issue—how much of its earnings should the firm pay out as dividends? The
answer to that question depends on a number of factors, including the firm’s investment opportunities, its
access to capital markets, its stockholders’ desires (and their tax rates), and the kind of signals stockholders get
from dividend actions.
Shareholder wealth maximization is partially consistent and partially inconsistent with generally accepted
societal goals. It is consistent because well-run firms produce good products at low costs, sell them at
competitive prices, employ people, pay taxes, and generally improve society. However, without constraints,
firms would tend to form monopolies and end up charging prices that are too high and not producing enough
output. They might also pollute the air and water, engage in unfair labor practices, and so on. So, constraints
(antitrust, labor, environmental, etc. laws) should be and are imposed on businesses. That said, stock
price maximization is consistent with a strong economy, economic progress, and “the
good life” for most citizens.
In standard introductory microeconomics courses, we assume that firms attempt to maximize
profits. In more advanced econ courses, the goal is broadened to value maximizing, so finance and
economics are indeed consistent.
© 2027 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 1
accessible website, in whole or in part.
,Solution and Answer Guide: Brigham and Daves, Intermediate Financial Management, 15e, 2027, 9798214056814; Chapter 1: An Overview of Financial Management
and the Financial Environment
As WorldCom, Enron, and other corporate scandals demonstrated very clearly, managers do not
always have stockholders’ interests as a primary goal—some managers have their own interests. This
point is further discussed below.
1-2 Finance is all about valuation—how to estimate asset values and what to do to increase them. We
develop and use Excel models throughout the book. We start that process in this chapter with simple
models used to value bonds, stocks, and capital budgeting projects. Working through the model will give
you a refresher in valuation plus a refresher on (or preview of) Excel.
a. Explain how to find the value of a bond given the rate of interest it pays
(its coupon rate), its par value (assume $1,000), and the going rate of interest
on bonds with the same risk and maturity.
b. Explain how to find the value of a stock given its last dividend, its expected growth rate, and its
required rate of return.
c. Explain how to find the value of a capital budgeting project given its cost, its expected annual net
cash flows, its life, and its cost of capital.
d. In each of these cases, discuss how changes in the inputs would affect the output. Would it matter if
the outputs were highly sensitive to changes in the inputs?
Answer for a. – d.
Refer to the model for quantitative answers to this question. All of these valuations involve applications
of the basic valuation model:
Values for CFt, r, and N are specified. For bonds, the CFs are interest payments and the maturity value, and
N is the bond’s life. Other things held constant, the higher the going interest rate, r, the lower the value of
the bond. Also, if the coupon rate is high, then CFs are also high, and that increases the value of the bond.
For a stock, the CFs are dividends, and for a capital budgeting project, they are operating cash flows.
The main point to get across with this question is that all assets are valued in essentially the same
way. The Excel model goes into a little more detail on sensitivity analysis. Much more comes later in the
book.
1-3 What are the advantages of the corporate form over a sole proprietorship or a partnership? What are the
disadvantages of this form?
Answer:
The advantages of a corporate form of ownership are that investor liability is limited to the amount
invested, corporations can raise capital through public offerings of stock, and ownership can be easily
transferred from person to person by simply selling shares of stock. In a sole proprietorship or
partnership, on the other hand, the owner or owners are exposed to potentially unlimited liability, it is
difficult to raise equity capital since either new partners must be found or the existing partners must put
up additional capital, and it is difficult to transfer ownership between partners or from a sole proprietor
to someone else.
The disadvantages of the corporate form are that there are numerous forms that must be filled out and
regulations that must be followed that are not required of a sole proprietorship or a partnership,
corporations are subject to double taxation of distributed earnings in that the corporation first pays taxes
on the pre-tax income, and then the owners must pay tax on the dividend or capital gains income, and the
separation of ownership (by the shareholders) and control (by management) can result in management
taking actions that are not in the owners’ best interests.
© 2027 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 2
accessible website, in whole or in part.
,Solution and Answer Guide: Brigham and Daves, Intermediate Financial Management, 15e, 2027, 9798214056814; Chapter 1: An Overview of Financial Management
and the Financial Environment
1-4 What are the various factors that affect the cost of money and hence interest rates? How will changes in
these components affect asset prices?
Answer:
The cost of money is affected by (1) production opportunities, (2) the time preference for consumption, (3)
risk, and (4) inflation. When production opportunities are good, and assets are earning high rates of return,
then interest rates tend to be higher because there is a larger demand for borrowing to finance these projects.
Also, investors who
are considering lending money recognize that their alternative investments have a high return and so demand a
high return on their investments. When investors have a
strong preference for current consumption, then they demand a higher return on their investments to
compensate them for having to defer current purchases, and so the
cost of money is higher. Investors demand a higher rate of return on riskier investments in order to
compensate them for having to be exposed to more risk. When investors expect future inflation, then the cost
of money increases so that investment returns better cover this future price increase.
If any of these factors change, then the cost of money will change, and hence the
yield and the price of a security will change as well. For example, if overall the time preference for
consumption increases, then overall interest rates will tend to increase and the yield on debt instruments will
tend to increase, and their prices will fall. If the underlying level of inflation declines, as it did through the
1990s, then interest rates on debt instruments will decline, driving up their prices. On the other hand, if a
company experiences financial problems, increasing the likelihood of default and bankruptcy and becoming
more risky, then the yield on its bonds will increase and their prices will fall.
1-5 Are most stocks traded on face-to-face exchanges or electronically? What impact has this had on retail
stock transactions? On portfolio management?
Answer:
Most stocks are now traded on electronic exchanges. Rather than only two or three face-to-face
exchanges, there are now dozens of electronic exchanges on which stocks trade. In electronic markets, a
computer program matches buy and sell orders quickly and automatically. The costs of electronic
exchanges are much lower than for a face-to-face exchange and transactions costs are much lower than
they were decades ago as a result. Retail trades occur fast and at a low cost and so retail customers have
benefited from the automation of markets. Portfolio managers have benefited similarly, although they
can be preyed upon by high-frequency traders.
1-6 What is securitization? How is securitization supposed to help banks and savings and loans (S&Ls)
manage risks and increase homeowners’ access to capital?
Answer:
Securitization is the process by which assets, such as mortgages held by banks, accounts receivables held
by companies, or credit card obligations held by banks and finance companies, are packaged together
and sold to investors. In the case of mortgages, a bank or savings and loan (S&L) may have a portfolio
of mortgages that it has originated (or issued). Typically, a bank will have financed these mortgages with
savings and checking account deposits and certificate of deposits (CDs), and once it has used up its
loanable funds, it must either stop making new loans or raise more funds if it wants to make more loans.
If the bank packages these mortgages and sells them to investors, then it can make more loans with the
funds it receives. The idea is that the bank acts as an intermediary in this case, analyzing credit and
making loans and then selling them off so it can make more loans; consumers get more loans, and banks
get to do what they (supposedly) do best, which is to analyze risk and originate loans.
If a bank doesn’t securitize its loans and, instead, holds them on its books, then it can be exposed to a lot
of interest rate risk. Back in the 1980s, S&Ls were raising money with short-term CDs and lending it out
© 2027 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 3
accessible website, in whole or in part.
,Solution and Answer Guide: Brigham and Daves, Intermediate Financial Management, 15e, 2027, 9798214056814; Chapter 1: An Overview of Financial Management
and the Financial Environment
long-term as 30-year fixed-rate mortgages. When interest rates skyrocketed, the interest they had to pay
on the CDs increased dramatically, but since the mortgages were fixed-rate, the interest income the
S&Ls received didn’t increase. This caused hundreds of S&Ls to go bankrupt and cost the federal
government and, ultimately, the U.S. taxpayers hundreds of billions of dollars. If, instead, S&Ls
securitized the loans, they would no longer be exposed to the interest rate risk since they would have
sold off the loans shortly after originating them. Of course, the interest rate risk doesn’t go away!
Instead, the investors in the securitized mortgages now receive the fixed interest payments. If these
investors have themselves financed the investment with short-term borrowing, then they will be exposed
to interest rate risk!
ANSWERS TO END-OF-CHAPTER QUESTIONS
1-1 Define each of the following terms:
a. Proprietorship; partnership; corporation; charter; bylaws
b. Limited partnership; limited liability partnership; professional corporation
c. Stockholder wealth maximization
d. Money market; capital market; primary market; secondary market
e. Private markets; public markets; derivatives
f. Investment bank; financial services corporation; financial intermediary
g. Mutual fund; money market fund
h. Open outcry auction; dealer market; automated trading platform
i. Production opportunities; time preferences for consumption
j. Foreign trade deficit
k. Algorithmic trading; high-frequency trading
© 2027 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 4
accessible website, in whole or in part.
