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 expenditure
*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
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
,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 expenditure means investment in real assets. Financing means raising the cash
for this investment.
c. 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
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
,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 facilitates the key attributes of a corporation, including limited liability for
investors, transferability of ownership, a separate legal personality of the corporation, and
delegated centralized management. These four attributes provide substantial benefit for
investors, including the ability to diversify their investment among many uncorrelated returns—a
very valuable tool explored in later chapters. Also, these attributes allow investors to quickly exit,
enter, or short sell an investment, thereby generating an active liquid market for corporations.
However, these positive aspects also introduce substantial negative externalities as well. The
separation of ownership from 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. Shareholders tend to exercise less oversight of each individual
investment as their diversification increases. Finally, the corporation‘s separate legal personality
makes it difficult to enforce accountability if they externalize costs onto society.
Est time: 01-05
6. 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
7. If the investment increases the firm‘s wealth, it increases the firm‘s share value. Ms. Espinoza
could then sell some or all these more valuable shares to provide for her retirement income.
Est time: 01-05
8. 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, depending on the relative risk between the two assets.
b. Unless the financial assets are as safe as U.S. government securities, their cost of capital
would be higher. The CFO could consider expected returns on assets with similar risk.
Est time: 06-10
9. Managers would act in shareholders‘ interests because they have a legal duty to act in their
interests. Managers may also receive compensation— bonuses, stock, and option payouts with
value tied (roughly) to firm performance. Managers may fear personal reputational damage from
not acting in shareholders‘ interests. And managers can be fired by the board of directors (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
© nMcGraw nHill nLLC. nAll nrights nreserved. nNo nreproduction nor ndistribution nwithout nthe nprior nwritten nconsent nof nMcGraw
Hill LLC.
, 10. Managers nthat nare ninsulated nfrom ntakeovers nmay nbe nmore nprone nto nagency nproblems nand
ntherefore nmore nlikely nto nact nin ntheir nown ninterests nrather nthan nin nshareholders‘. n If na nfirm
ninstituted na nnew ntakeover ndefense, nwe nmight nexpect nto nsee nthe nvalue nof nits nshares ndecline nas
nagency n problems nincrease nand nless nshareholder nvalue nmaximization noccurs. nThe
ncounterargument nis nthat ndefensive nmeasures nallow nmanagers nto nnegotiate nfor na nhigher
npurchase nprice nin nthe nface nof na ntakeover nbid—to nthe nbenefit nof nshareholder nvalue.
Est ntime: n01-05
Appendix nQuestions:
1. Both nwould nstill ninvest nin ntheir nfriend‘s nbusiness. n A ninvests nand nreceives n$121,000 nfor nhis
ninvestment nat nthe nend nof nthe nyear—which nis ngreater nthan nthe n$120,000 nthat nwould nbe
nreceived nfrom nlending nat n20% n($100,000 n× n1.20 n= n$120,000). n G nalso ninvests, nbut
nborrows nagainst nthe
$121,000 npayment, nand nthus nreceives n$100,833 n($121,000 n/ n1.20) ntoday.
Est ntime: n01-05
2. a. nHe ncould nconsume nup nto n$200,000 nnow n(forgoing nall nfuture nconsumption) nor nup nto
n$216,000 nnext nyear n($200,000 n× n1.08, nforgoing nall nconsumption nthis nyear). nHe nshould ninvest
nall nof nhis nwealth nto nearn n$216,000 nnext nyear. n To nchoose nthe nsame nconsumption n(C) nin nboth
nyears, nC n= n($200,000 n– nC) n× n1.08 n= n$103,846.
Dollars n Next n Year
220,000
216,000
203,704
200,000
Dollars n Now
b. He nshould ninvest nall nof nhis nwealth nto nearn n$220,000 n($200,000 n× n1.10) nnext nyear. n If nhe
nconsumes nall nthis nyear, nhe ncan nnow nhave na ntotal nof n$203,703.70 n($200,000 n× n1.10/1.08) nthis
nyear nor n$220,000 nnext nyear. n If nhe nconsumes nC nthis nyear, nthe namount navailable nfor nnext
nyear‘s nconsumption nis n($203,703.70 n– nC) n× n1.08. n To nget nequal nconsumption nin nboth nyears,
nset nthe namount nconsumed ntoday nequal nto nthe namount nnext nyear:
C n= n ($203,703.70 n – n C) n × n 1.08
C n= n$105,769.20
Est ntime: n06-10
© nMcGraw nHill nLLC. nAll nrights nreserved. nNo nreproduction nor ndistribution nwithout nthe nprior nwritten nconsent nof nMcGraw
Hill LLC.
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 expenditure
*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
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
,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 expenditure means investment in real assets. Financing means raising the cash
for this investment.
c. 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
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
,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 facilitates the key attributes of a corporation, including limited liability for
investors, transferability of ownership, a separate legal personality of the corporation, and
delegated centralized management. These four attributes provide substantial benefit for
investors, including the ability to diversify their investment among many uncorrelated returns—a
very valuable tool explored in later chapters. Also, these attributes allow investors to quickly exit,
enter, or short sell an investment, thereby generating an active liquid market for corporations.
However, these positive aspects also introduce substantial negative externalities as well. The
separation of ownership from 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. Shareholders tend to exercise less oversight of each individual
investment as their diversification increases. Finally, the corporation‘s separate legal personality
makes it difficult to enforce accountability if they externalize costs onto society.
Est time: 01-05
6. 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
7. If the investment increases the firm‘s wealth, it increases the firm‘s share value. Ms. Espinoza
could then sell some or all these more valuable shares to provide for her retirement income.
Est time: 01-05
8. 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, depending on the relative risk between the two assets.
b. Unless the financial assets are as safe as U.S. government securities, their cost of capital
would be higher. The CFO could consider expected returns on assets with similar risk.
Est time: 06-10
9. Managers would act in shareholders‘ interests because they have a legal duty to act in their
interests. Managers may also receive compensation— bonuses, stock, and option payouts with
value tied (roughly) to firm performance. Managers may fear personal reputational damage from
not acting in shareholders‘ interests. And managers can be fired by the board of directors (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
© nMcGraw nHill nLLC. nAll nrights nreserved. nNo nreproduction nor ndistribution nwithout nthe nprior nwritten nconsent nof nMcGraw
Hill LLC.
, 10. Managers nthat nare ninsulated nfrom ntakeovers nmay nbe nmore nprone nto nagency nproblems nand
ntherefore nmore nlikely nto nact nin ntheir nown ninterests nrather nthan nin nshareholders‘. n If na nfirm
ninstituted na nnew ntakeover ndefense, nwe nmight nexpect nto nsee nthe nvalue nof nits nshares ndecline nas
nagency n problems nincrease nand nless nshareholder nvalue nmaximization noccurs. nThe
ncounterargument nis nthat ndefensive nmeasures nallow nmanagers nto nnegotiate nfor na nhigher
npurchase nprice nin nthe nface nof na ntakeover nbid—to nthe nbenefit nof nshareholder nvalue.
Est ntime: n01-05
Appendix nQuestions:
1. Both nwould nstill ninvest nin ntheir nfriend‘s nbusiness. n A ninvests nand nreceives n$121,000 nfor nhis
ninvestment nat nthe nend nof nthe nyear—which nis ngreater nthan nthe n$120,000 nthat nwould nbe
nreceived nfrom nlending nat n20% n($100,000 n× n1.20 n= n$120,000). n G nalso ninvests, nbut
nborrows nagainst nthe
$121,000 npayment, nand nthus nreceives n$100,833 n($121,000 n/ n1.20) ntoday.
Est ntime: n01-05
2. a. nHe ncould nconsume nup nto n$200,000 nnow n(forgoing nall nfuture nconsumption) nor nup nto
n$216,000 nnext nyear n($200,000 n× n1.08, nforgoing nall nconsumption nthis nyear). nHe nshould ninvest
nall nof nhis nwealth nto nearn n$216,000 nnext nyear. n To nchoose nthe nsame nconsumption n(C) nin nboth
nyears, nC n= n($200,000 n– nC) n× n1.08 n= n$103,846.
Dollars n Next n Year
220,000
216,000
203,704
200,000
Dollars n Now
b. He nshould ninvest nall nof nhis nwealth nto nearn n$220,000 n($200,000 n× n1.10) nnext nyear. n If nhe
nconsumes nall nthis nyear, nhe ncan nnow nhave na ntotal nof n$203,703.70 n($200,000 n× n1.10/1.08) nthis
nyear nor n$220,000 nnext nyear. n If nhe nconsumes nC nthis nyear, nthe namount navailable nfor nnext
nyear‘s nconsumption nis n($203,703.70 n– nC) n× n1.08. n To nget nequal nconsumption nin nboth nyears,
nset nthe namount nconsumed ntoday nequal nto nthe namount nnext nyear:
C n= n ($203,703.70 n – n C) n × n 1.08
C n= n$105,769.20
Est ntime: n06-10
© nMcGraw nHill nLLC. nAll nrights nreserved. nNo nreproduction nor ndistribution nwithout nthe nprior nwritten nconsent nof nMcGraw
Hill LLC.
