CHAPTER 1
Introduction to Corporate Finance
The values shown in the solutions may be rounded for display purposes. However, the answers were derived
using a spreadsheet without any intermediate rounding.
Answers to Problem Sets
1. a. real
b. executive airplanes
c. brand names
d. financial
e. bonds
*f. investment or capital budgeting
*g. capital budgeting or investment
h. financing
*Note that f and g are interchangeable in the question.
,Est time: 01-05
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets. Real
assets are identifiable as items with intrinsic value. The others in the list are financial assets, that is,
these assets derive value because of a contractual claim.
Est time: 01-05
3. a. Financial assets, such as stocks or bank loans, are claims held by investors.
Corporations sell financial assets to raise the cash to invest in real assets such as plant and
equipment. Some real assets are intangible.
b. Capital budgeting means investment in real assets. Financing means raising the cash for
this investment.
b. The shares of public corporations are traded on stock exchanges and can be purchased by a
wide range of investors. The shares of closely held corporations are not publicly traded and
are held by a small group of private investors.
d. Unlimited liability: Investors are responsible for all the firm’s debts. A sole proprietor has
unlimited liability. Investors in corporations have limited liability. They can lose their
investment, but no more.
Est time: 01-05
4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can be
transferred without affecting operations, and managers can be fired with no effect on ownership.
Other forms of business may have unlimited liability and limited life.
,Est time: 01-05
5. Separation of ownership and management typically leads to agency problems,
where managers prefer to consume private perks or make other decisions for their private benefit—
rather than maximize shareholder wealth.
Est time: 01-05
6. a. Assuming that the encabulator market is risky, an 8% expected return on
the F&H encabulator investments may be inferior to a 4% return on U.S.
government securities.
b. Unless their financial assets are as safe as U.S. government securities, their cost of capital
would be higher. The CFO could consider what the expected return is on assets with similar
risk.
Est time: 01-05
7. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their pattern
of consumption through borrowing and lending, match risk preferences, and hopefully balance their
own checkbooks (or hire a qualified professional to help them with these tasks).
Est time: 01-05
8. If the investment increases the firm’s wealth, it will increase the value of the firm’s shares. Ms.
Espinoza could then sell some or all of these more valuable shares in order to provide for her
retirement income.
Est time: 06-10
, 9. As the Goldman Sachs example illustrates, the firm’s value typically falls by significantly more than
the amount of any fines and settlements. The firm’s reputation suffers in a financial scandal, and this
can have a much larger effect than the fines levied. Investors may also wonder whether all of the
misdeeds have been contained.
Est time: 01-05
10. Managers would act in shareholders’ interests because they have a legal duty to act in their interests.
Managers may also receive compensation, either bonuses or stock and option payouts whose value is
tied (roughly) to firm performance. Managers may fear personal reputational damage that would
result from not acting in shareholders’ interests. And managers can be fired by the board of directors,
which in turn is elected by shareholders. If managers still fail to act in shareholders’ interests,
shareholders may sell their shares, lowering the stock price and potentially creating the possibility of
a takeover, which can again lead to changes in the board of directors and senior management.
Est time: 01-05
11. Managers that are insulated from takeovers may be more prone to agency problems and therefore
more likely to act in their own interests rather than in shareholders’. If a firm instituted a new
takeover defense, we might expect to see the value of its shares decline as agency problems increase
and less shareholder value maximization occurs. The counterargument is that defensive measures
allow managers to negotiate for a higher purchase price in the face of a takeover bid—to the benefit
of shareholder value.
12. Answers will vary. The principles of good corporate governance discussed in the chapter should
apply.
Est time: 06-10
Appendix Questions:
1. Both would still invest in their friend’s business. A invests and receives $121,000 for his investment
at the end of the year—which is greater than the $120,000 that would be received from lending at
Introduction to Corporate Finance
The values shown in the solutions may be rounded for display purposes. However, the answers were derived
using a spreadsheet without any intermediate rounding.
Answers to Problem Sets
1. a. real
b. executive airplanes
c. brand names
d. financial
e. bonds
*f. investment or capital budgeting
*g. capital budgeting or investment
h. financing
*Note that f and g are interchangeable in the question.
,Est time: 01-05
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets. Real
assets are identifiable as items with intrinsic value. The others in the list are financial assets, that is,
these assets derive value because of a contractual claim.
Est time: 01-05
3. a. Financial assets, such as stocks or bank loans, are claims held by investors.
Corporations sell financial assets to raise the cash to invest in real assets such as plant and
equipment. Some real assets are intangible.
b. Capital budgeting means investment in real assets. Financing means raising the cash for
this investment.
b. The shares of public corporations are traded on stock exchanges and can be purchased by a
wide range of investors. The shares of closely held corporations are not publicly traded and
are held by a small group of private investors.
d. Unlimited liability: Investors are responsible for all the firm’s debts. A sole proprietor has
unlimited liability. Investors in corporations have limited liability. They can lose their
investment, but no more.
Est time: 01-05
4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can be
transferred without affecting operations, and managers can be fired with no effect on ownership.
Other forms of business may have unlimited liability and limited life.
,Est time: 01-05
5. Separation of ownership and management typically leads to agency problems,
where managers prefer to consume private perks or make other decisions for their private benefit—
rather than maximize shareholder wealth.
Est time: 01-05
6. a. Assuming that the encabulator market is risky, an 8% expected return on
the F&H encabulator investments may be inferior to a 4% return on U.S.
government securities.
b. Unless their financial assets are as safe as U.S. government securities, their cost of capital
would be higher. The CFO could consider what the expected return is on assets with similar
risk.
Est time: 01-05
7. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their pattern
of consumption through borrowing and lending, match risk preferences, and hopefully balance their
own checkbooks (or hire a qualified professional to help them with these tasks).
Est time: 01-05
8. If the investment increases the firm’s wealth, it will increase the value of the firm’s shares. Ms.
Espinoza could then sell some or all of these more valuable shares in order to provide for her
retirement income.
Est time: 06-10
, 9. As the Goldman Sachs example illustrates, the firm’s value typically falls by significantly more than
the amount of any fines and settlements. The firm’s reputation suffers in a financial scandal, and this
can have a much larger effect than the fines levied. Investors may also wonder whether all of the
misdeeds have been contained.
Est time: 01-05
10. Managers would act in shareholders’ interests because they have a legal duty to act in their interests.
Managers may also receive compensation, either bonuses or stock and option payouts whose value is
tied (roughly) to firm performance. Managers may fear personal reputational damage that would
result from not acting in shareholders’ interests. And managers can be fired by the board of directors,
which in turn is elected by shareholders. If managers still fail to act in shareholders’ interests,
shareholders may sell their shares, lowering the stock price and potentially creating the possibility of
a takeover, which can again lead to changes in the board of directors and senior management.
Est time: 01-05
11. Managers that are insulated from takeovers may be more prone to agency problems and therefore
more likely to act in their own interests rather than in shareholders’. If a firm instituted a new
takeover defense, we might expect to see the value of its shares decline as agency problems increase
and less shareholder value maximization occurs. The counterargument is that defensive measures
allow managers to negotiate for a higher purchase price in the face of a takeover bid—to the benefit
of shareholder value.
12. Answers will vary. The principles of good corporate governance discussed in the chapter should
apply.
Est time: 06-10
Appendix Questions:
1. Both would still invest in their friend’s business. A invests and receives $121,000 for his investment
at the end of the year—which is greater than the $120,000 that would be received from lending at
