Chapter 1
An Overview of Financial Management and
The Financial Environment
ANSWERS TO END-OF-CHAPTER QUESTIONS
1-1 a. A proprietorship, or sole proprietorship, is a business owned by one individual. A
partnership exists when two or more persons associate to conduct a business. In
contrast, a corporation is a legal entity created by a state. The corporation is separate
and distinct from its owners and managers.
b. In a limited partnership, limited partners’ liabilities, investment returns and control are
limited, while general partners have unlimited liability and control. A limited liability
partnership (LLP), sometimes called a limited liability company (LLC), combines the limited
liability advantage of a corporation with the tax advantages of a partnership. A professional
corporation (PC), known in some states as a professional association (PA), has most of the
benefits of incorporation but the participants are not relieved of professional (malpractice)
liability.
c. Stockholder wealth maximization is the appropriate goal for management decisions. The risk
and timing associated with expected earnings per share and cash flows are considered in
order to maximize the price of the firm’s common stock.
d. A money market is a financial market for debt securities with maturities of less than one year
(short-term). The New York money market is the world’s largest. Capital markets are the
financial markets for long-term debt and corporate stocks. The New York Stock Exchange is
an example of a capital market. Primary markets are the markets in which newly issued
securities are sold for the first time. Secondary markets are where securities are resold after
initial issue in the primary market. The New York Stock Exchange is a secondary market.
,e. In private markets, transactions are worked out directly between two parties and structured in
any manner that appeals to them. Bank loans and private placements of debt with insurance
companies are examples of private market transactions. In public markets, standardized
contracts are traded on organized exchanges. Securities that are issued in public markets,
such as common stock and corporate bonds, are ultimately held by a large number of
individuals. Private market securities are more tailor-made but less liquid, whereas public
market securities are more liquid but subject to greater standardization. Derivatives are
claims whose value depends on what happens to the value of some other asset. Futures and
options are two important types of derivatives, and their values depend on what happens to
the prices of other assets, say IBM stock, Japanese yen, or pork bellies. Therefore, the value
of a derivative security is derived from the value of an underlying real asset.
f. An investment banker is a middleman between businesses and savers. Investment
banking houses assist in the design of corporate securities and then sell them to savers
(investors) in the primary markets. Financial service corporations offer a wide range
of financial services such as brokerage operations, insurance, and commercial
banking. A financial intermediary buys securities with funds that it obtains by issuing
its own securities. An example is a common stock mutual fund that buys common
stocks with funds obtained by issuing shares in the mutual fund.
g. A mutual fund is a corporation that sells shares in the fund and uses the proceeds to
buy stocks, long-term bonds, or short-term debt instruments. The resulting dividends,
interest, and capital gains are distributed to the fund’s shareholders after the
deduction of operating expenses. Different funds are designed to meet different
objectives. Money market funds are mutual funds which invest in short-term debt
instruments and offer their shareholders check writing privileges; thus, they are
essentially interest-bearing checking accounts.
a. Physical location exchanges, such as the New York Stock Exchange, facilitate
communication between buyers and sellers of securities. Each physical location exchange is
a physical entity at a particular location and is governed by an elected board of governors. A
computer/telephone network, such as Nasdaq, consists of all the facilities that provide for
security transactions not conducted at a physical location exchange. These facilities are,
basically, the communications network that links the buyers and sellers.
b. An open outcry auction is a method of matching buyers and sellers. In an auction, the buyers
and sellers are face-to-face, with each stating the prices and which they will buy or sell. In a
dealer market, a dealer holds an inventory of the security and makes a market by offering to
buy or sell. Others who wish to buy or sell can see the offers made by the dealers, and can
, contact the dealer of their choice to arrange a transaction. In an ECN, orders from potential
buyers and sellers are automatically matched, and the transaction is automatically completed.
j. Production opportunities are the returns available within an economy from investment in
productive assets. The higher the production opportunities, the more producers would be
willing to pay for required capital. Consumption time preferences refer to the preferred
pattern of consumption. Consumer’s time preferences for consumption establish how much
consumption they are willing to defer, and hence save, at different levels of interest.
q. A foreign trade deficit occurs when businesses and individuals in the U. S. import more
goods from foreign countries than are exported. Trade deficits must be financed, and the
main source of financing is debt. Therefore, as the trade deficit increases, the debt financing
increases, driving up interest rates. U. S. interest rates must be competitive with foreign
interest rates; if the Federal Reserve attempts to set interest rates lower than foreign rates,
foreigners will sell U.S. bonds, decreasing bond prices, resulting in higher U. S. rates. Thus,
if the trade deficit is large relative to the size of the overall economy, it may hinder the Fed’s
ability to combat a recession by lowering interest rates.
1-2 Sole proprietorship, partnership, and corporation are the three principal forms of business
organization. The advantages of the first two include the ease and low cost of formation. The
advantages of the corporation include limited liability, indefinite life, ease of ownership transfer,
and access to capital markets.
The disadvantages of a sole 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) requirements to file state and federal reports for registration,
which are expensive, complex and time-consuming.
1-3 A firm’s fundamental, or intrinsic, value is the present value of its free cash flows when
discounted at the weighted average cost of capital. If the market price reflects all relevant
information, then the observed price is also the intrinsic price.
1-4 a. Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to
create a more attractive community that will make it easier to hire a productive work force.
This corporate philanthropy could be received by stockholders negatively, especially those
stockholders not living in its headquarters city. Stockholders are interested in actions that
, maximize share price, and if competing firms are not making similar contributions, the “cost”
of this philanthropy has to be borne by someone--the stockholders. Thus, stock price could
decrease.
b. Companies must make investments in the current period in order to generate future cash
flows. Stockholders should be aware of this, and assuming a correct analysis has been
performed, they should react positively to the decision. The Chinese plant is in this category.
Assuming that the correct capital budgeting analysis has been made, the stock price should
increase in the future.
1-5 Earnings per share in the current year will decline due to the cost of the investment made in the
current year and no significant performance impact in the short run. However, the company’s
stock price should increase due to the significant cost savings expected in the future.
1-6 In a well-functioning economy, capital will flow efficiently from those who supply capital to
those who demand it. This transfer of capital can take place in three different ways:
1. Direct transfers of money and securities occur when a business sells its stocks or bonds
directly to savers, without going through any type of financial institution. The business
delivers its securities to savers, who in turn give the firm the money it needs.
2. Transfers may also go through an investment banking house which underwrites the issue. An
underwriter serves as a middleman and facilitates the issuance of securities. The company
sells its stocks or bonds to the investment bank, which in turn sells these same securities to
savers. The businesses’ securities and the savers’ money merely “pass through” the
investment banking house.
3. Transfers can also be made through a financial intermediary. Here the intermediary obtains
funds from savers in exchange for its own securities. The intermediary uses this money to
buy and hold businesses’ securities. Intermediaries literally create new forms of capital. The
existence of intermediaries greatly increases the efficiency of money and capital markets.
1-7 Financial intermediaries are business organizations that receive funds in one form and repackage
them for the use of those who need funds. Through financial intermediation, resources are
allocated more effectively, and the real output of the economy is thereby increased.
1-8 a. If transfers between the two markets were costly, interest rates would be different in
the two areas. Area Y, with the relatively young population, would have less in
An Overview of Financial Management and
The Financial Environment
ANSWERS TO END-OF-CHAPTER QUESTIONS
1-1 a. A proprietorship, or sole proprietorship, is a business owned by one individual. A
partnership exists when two or more persons associate to conduct a business. In
contrast, a corporation is a legal entity created by a state. The corporation is separate
and distinct from its owners and managers.
b. In a limited partnership, limited partners’ liabilities, investment returns and control are
limited, while general partners have unlimited liability and control. A limited liability
partnership (LLP), sometimes called a limited liability company (LLC), combines the limited
liability advantage of a corporation with the tax advantages of a partnership. A professional
corporation (PC), known in some states as a professional association (PA), has most of the
benefits of incorporation but the participants are not relieved of professional (malpractice)
liability.
c. Stockholder wealth maximization is the appropriate goal for management decisions. The risk
and timing associated with expected earnings per share and cash flows are considered in
order to maximize the price of the firm’s common stock.
d. A money market is a financial market for debt securities with maturities of less than one year
(short-term). The New York money market is the world’s largest. Capital markets are the
financial markets for long-term debt and corporate stocks. The New York Stock Exchange is
an example of a capital market. Primary markets are the markets in which newly issued
securities are sold for the first time. Secondary markets are where securities are resold after
initial issue in the primary market. The New York Stock Exchange is a secondary market.
,e. In private markets, transactions are worked out directly between two parties and structured in
any manner that appeals to them. Bank loans and private placements of debt with insurance
companies are examples of private market transactions. In public markets, standardized
contracts are traded on organized exchanges. Securities that are issued in public markets,
such as common stock and corporate bonds, are ultimately held by a large number of
individuals. Private market securities are more tailor-made but less liquid, whereas public
market securities are more liquid but subject to greater standardization. Derivatives are
claims whose value depends on what happens to the value of some other asset. Futures and
options are two important types of derivatives, and their values depend on what happens to
the prices of other assets, say IBM stock, Japanese yen, or pork bellies. Therefore, the value
of a derivative security is derived from the value of an underlying real asset.
f. An investment banker is a middleman between businesses and savers. Investment
banking houses assist in the design of corporate securities and then sell them to savers
(investors) in the primary markets. Financial service corporations offer a wide range
of financial services such as brokerage operations, insurance, and commercial
banking. A financial intermediary buys securities with funds that it obtains by issuing
its own securities. An example is a common stock mutual fund that buys common
stocks with funds obtained by issuing shares in the mutual fund.
g. A mutual fund is a corporation that sells shares in the fund and uses the proceeds to
buy stocks, long-term bonds, or short-term debt instruments. The resulting dividends,
interest, and capital gains are distributed to the fund’s shareholders after the
deduction of operating expenses. Different funds are designed to meet different
objectives. Money market funds are mutual funds which invest in short-term debt
instruments and offer their shareholders check writing privileges; thus, they are
essentially interest-bearing checking accounts.
a. Physical location exchanges, such as the New York Stock Exchange, facilitate
communication between buyers and sellers of securities. Each physical location exchange is
a physical entity at a particular location and is governed by an elected board of governors. A
computer/telephone network, such as Nasdaq, consists of all the facilities that provide for
security transactions not conducted at a physical location exchange. These facilities are,
basically, the communications network that links the buyers and sellers.
b. An open outcry auction is a method of matching buyers and sellers. In an auction, the buyers
and sellers are face-to-face, with each stating the prices and which they will buy or sell. In a
dealer market, a dealer holds an inventory of the security and makes a market by offering to
buy or sell. Others who wish to buy or sell can see the offers made by the dealers, and can
, contact the dealer of their choice to arrange a transaction. In an ECN, orders from potential
buyers and sellers are automatically matched, and the transaction is automatically completed.
j. Production opportunities are the returns available within an economy from investment in
productive assets. The higher the production opportunities, the more producers would be
willing to pay for required capital. Consumption time preferences refer to the preferred
pattern of consumption. Consumer’s time preferences for consumption establish how much
consumption they are willing to defer, and hence save, at different levels of interest.
q. A foreign trade deficit occurs when businesses and individuals in the U. S. import more
goods from foreign countries than are exported. Trade deficits must be financed, and the
main source of financing is debt. Therefore, as the trade deficit increases, the debt financing
increases, driving up interest rates. U. S. interest rates must be competitive with foreign
interest rates; if the Federal Reserve attempts to set interest rates lower than foreign rates,
foreigners will sell U.S. bonds, decreasing bond prices, resulting in higher U. S. rates. Thus,
if the trade deficit is large relative to the size of the overall economy, it may hinder the Fed’s
ability to combat a recession by lowering interest rates.
1-2 Sole proprietorship, partnership, and corporation are the three principal forms of business
organization. The advantages of the first two include the ease and low cost of formation. The
advantages of the corporation include limited liability, indefinite life, ease of ownership transfer,
and access to capital markets.
The disadvantages of a sole 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) requirements to file state and federal reports for registration,
which are expensive, complex and time-consuming.
1-3 A firm’s fundamental, or intrinsic, value is the present value of its free cash flows when
discounted at the weighted average cost of capital. If the market price reflects all relevant
information, then the observed price is also the intrinsic price.
1-4 a. Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to
create a more attractive community that will make it easier to hire a productive work force.
This corporate philanthropy could be received by stockholders negatively, especially those
stockholders not living in its headquarters city. Stockholders are interested in actions that
, maximize share price, and if competing firms are not making similar contributions, the “cost”
of this philanthropy has to be borne by someone--the stockholders. Thus, stock price could
decrease.
b. Companies must make investments in the current period in order to generate future cash
flows. Stockholders should be aware of this, and assuming a correct analysis has been
performed, they should react positively to the decision. The Chinese plant is in this category.
Assuming that the correct capital budgeting analysis has been made, the stock price should
increase in the future.
1-5 Earnings per share in the current year will decline due to the cost of the investment made in the
current year and no significant performance impact in the short run. However, the company’s
stock price should increase due to the significant cost savings expected in the future.
1-6 In a well-functioning economy, capital will flow efficiently from those who supply capital to
those who demand it. This transfer of capital can take place in three different ways:
1. Direct transfers of money and securities occur when a business sells its stocks or bonds
directly to savers, without going through any type of financial institution. The business
delivers its securities to savers, who in turn give the firm the money it needs.
2. Transfers may also go through an investment banking house which underwrites the issue. An
underwriter serves as a middleman and facilitates the issuance of securities. The company
sells its stocks or bonds to the investment bank, which in turn sells these same securities to
savers. The businesses’ securities and the savers’ money merely “pass through” the
investment banking house.
3. Transfers can also be made through a financial intermediary. Here the intermediary obtains
funds from savers in exchange for its own securities. The intermediary uses this money to
buy and hold businesses’ securities. Intermediaries literally create new forms of capital. The
existence of intermediaries greatly increases the efficiency of money and capital markets.
1-7 Financial intermediaries are business organizations that receive funds in one form and repackage
them for the use of those who need funds. Through financial intermediation, resources are
allocated more effectively, and the real output of the economy is thereby increased.
1-8 a. If transfers between the two markets were costly, interest rates would be different in
the two areas. Area Y, with the relatively young population, would have less in
