SOLUTIONS MANUAL
Principles of Corporate Finance, 14th Edition by Richard Brealey
, CHAPTER 1
Introduction to Corporate Finance
The vaIues shown in the soIutions may be rounded for dispIay purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.
Answers to ProbIem Sets
1. a. reaI
b. executive airpIanes
c. brand names
d. financiaI
e. bonds
*f. investment or capitaI expenditure
*g. capitaI budgeting or investment
h. financing
*Note that f and g are interchangeabIe in the question.
Est time: 01-05
2. A trademark, a factory, undeveIoped Iand, and your work force (c, d, e, and g) are aII reaI assets.
ReaI assets are identifiabIe as items with intrinsic vaIue. The others in the Iist are financiaI assets,
that is, these assets derive vaIue because of a contractuaI cIaim.
Est time: 01-05
3. a. FinanciaI assets, such as stocks or bank Ioans, are cIaims heId by investors.
Corporations seII financiaI assets to raise the cash to invest in reaI assets such as
pIant and equipment. Some reaI assets are intangibIe.
b. CapitaI expenditure means investment in reaI assets. Financing means raising the cash
for this investment.
c. The shares of pubIic corporations are traded on stock exchanges and can be purchased
by a wide range of investors. The shares of cIoseIy heId corporations are not pubIicIy
traded and are heId by a smaII group of private investors.
d. UnIimited IiabiIity: Investors are responsibIe for aII the firm‘s debts. A soIe proprietor
has unIimited IiabiIity. Investors in corporations have Iimited IiabiIity. They can Iose
their investment, but no more.
Est time: 01-05
,4. Items c and d appIy to corporations. Because corporations have perpetuaI Iife, ownership can be
transferred without affecting operations, and managers can be fired with no effect on ownership.
Other forms of business may have unIimited IiabiIity and Iimited Iife.
Est time: 01-05
5. Separation of ownership faciIitates the key attributes of a corporation, incIuding Iimited IiabiIity for
investors, transferabiIity of ownership, a separate IegaI personaIity of the corporation, and
deIegated centraIized management. These four attributes provide substantiaI benefit for
investors, incIuding the abiIity to diversify their investment among many uncorreIated returns—a
very vaIuabIe tooI expIored in Iater chapters. AIso, these attributes aIIow investors to quickIy
exit, enter, or short seII an investment, thereby generating an active Iiquid market for
corporations.
However, these positive aspects aIso introduce substantiaI negative externaIities as weII. The
separation of ownership from management typicaIIy Ieads to agency probIems, where managers
prefer to consume private perks or make other decisions for their private benefit—rather than
maximize sharehoIder weaIth. SharehoIders tend to exercise Iess oversight of each individuaI
investment as their diversification increases. FinaIIy, the corporation‘s separate IegaI personaIity
makes it difficuIt to enforce accountabiIity if they externaIize costs onto society.
Est time: 01-05
6. SharehoIders wiII onIy vote to maximize sharehoIder weaIth. SharehoIders can modify their
pattern of consumption through borrowing and Iending, match risk preferences, and hopefuIIy
baIance their own checkbooks (or hire a quaIified professionaI to heIp them with these tasks).
Est time: 01-05
7. If the investment increases the firm‘s weaIth, it increases the firm‘s share vaIue. Ms. Espinoza
couId then seII some or aII these more vaIuabIe shares to provide for her retirement income.
Est time: 01-05
8. a. Assuming that the encabuIator market is risky, an 8% expected return on
the F&H encabuIator investments may be inferior to a 4% return on U.S.
government securities, depending on the reIative risk between the two assets.
b. UnIess the financiaI assets are as safe as U.S. government securities, their cost of capitaI
wouId be higher. The CFO couId consider expected returns on assets with simiIar risk.
Est time: 06-10
9. Managers wouId act in sharehoIders‘ interests because they have a IegaI duty to act in their
interests. Managers may aIso receive compensation— bonuses, stock, and option payouts with
vaIue tied (roughIy) to firm performance. Managers may fear personaI reputationaI damage from
not acting in sharehoIders‘ interests. And managers can be fired by the board of directors (eIected
by sharehoIders). If managers stiII faiI to act in sharehoIders‘ interests, sharehoIders may seII
their shares, Iowering the stock price and potentiaIIy creating the possibiIity of a takeover, which
can again Iead to changes in the board of directors and senior management.
Est time: 01-05
, 10. Managers that are insuIated from takeovers may be more prone to agency probIems and
therefore more IikeIy to act in their own interests rather than in sharehoIders‘. If a firm instituted a
new takeover defense, we might expect to see the vaIue of its shares decIine as agency
probIems increase and Iess sharehoIder vaIue maximization occurs. The counterargument is that
defensive measures aIIow managers to negotiate for a higher purchase price in the face of a
takeover bid—to the benefit of sharehoIder vaIue.
Est time: 01-05
Appendix Questions:
1. Both wouId stiII 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 wouId be received
from Iending at 20% ($100,000 × 1.20 = $120,000). G aIso invests, but borrows against the
$121,000 payment, and thus receives $100,833 ($121,.20) today.
Est time: 01-05
2. a. He couId consume up to $200,000 now (forgoing aII future consumption) or up to $216,000
next year ($200,000 × 1.08, forgoing aII consumption this year). He shouId invest aII of his
weaIth to earn $216,000 next year. To choose the same consumption (C) in both years, C =
($200,000 – C) × 1.08 = $103,846.
DoIIars Next Year
220,000
216,000
203,704
200,000
DoIIars Now
b. He shouId invest aII of his weaIth to earn $220,000 ($200,000 × 1.10) next year. If he
consumes aII this year, he can now have a totaI of $203,703.70 ($200,000 × 1.10/1.08) this year
or $220,000 next year. If he consumes C this year, the amount avaiIabIe for next year‘s
consumption is ($203,703.70 – C) × 1.08. To get equaI consumption in both years, set the
amount consumed today equaI to the amount next year:
C = ($203,703.70 – C) × 1.08
C = $105,769.20
Est time: 06-10
Principles of Corporate Finance, 14th Edition by Richard Brealey
, CHAPTER 1
Introduction to Corporate Finance
The vaIues shown in the soIutions may be rounded for dispIay purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.
Answers to ProbIem Sets
1. a. reaI
b. executive airpIanes
c. brand names
d. financiaI
e. bonds
*f. investment or capitaI expenditure
*g. capitaI budgeting or investment
h. financing
*Note that f and g are interchangeabIe in the question.
Est time: 01-05
2. A trademark, a factory, undeveIoped Iand, and your work force (c, d, e, and g) are aII reaI assets.
ReaI assets are identifiabIe as items with intrinsic vaIue. The others in the Iist are financiaI assets,
that is, these assets derive vaIue because of a contractuaI cIaim.
Est time: 01-05
3. a. FinanciaI assets, such as stocks or bank Ioans, are cIaims heId by investors.
Corporations seII financiaI assets to raise the cash to invest in reaI assets such as
pIant and equipment. Some reaI assets are intangibIe.
b. CapitaI expenditure means investment in reaI assets. Financing means raising the cash
for this investment.
c. The shares of pubIic corporations are traded on stock exchanges and can be purchased
by a wide range of investors. The shares of cIoseIy heId corporations are not pubIicIy
traded and are heId by a smaII group of private investors.
d. UnIimited IiabiIity: Investors are responsibIe for aII the firm‘s debts. A soIe proprietor
has unIimited IiabiIity. Investors in corporations have Iimited IiabiIity. They can Iose
their investment, but no more.
Est time: 01-05
,4. Items c and d appIy to corporations. Because corporations have perpetuaI Iife, ownership can be
transferred without affecting operations, and managers can be fired with no effect on ownership.
Other forms of business may have unIimited IiabiIity and Iimited Iife.
Est time: 01-05
5. Separation of ownership faciIitates the key attributes of a corporation, incIuding Iimited IiabiIity for
investors, transferabiIity of ownership, a separate IegaI personaIity of the corporation, and
deIegated centraIized management. These four attributes provide substantiaI benefit for
investors, incIuding the abiIity to diversify their investment among many uncorreIated returns—a
very vaIuabIe tooI expIored in Iater chapters. AIso, these attributes aIIow investors to quickIy
exit, enter, or short seII an investment, thereby generating an active Iiquid market for
corporations.
However, these positive aspects aIso introduce substantiaI negative externaIities as weII. The
separation of ownership from management typicaIIy Ieads to agency probIems, where managers
prefer to consume private perks or make other decisions for their private benefit—rather than
maximize sharehoIder weaIth. SharehoIders tend to exercise Iess oversight of each individuaI
investment as their diversification increases. FinaIIy, the corporation‘s separate IegaI personaIity
makes it difficuIt to enforce accountabiIity if they externaIize costs onto society.
Est time: 01-05
6. SharehoIders wiII onIy vote to maximize sharehoIder weaIth. SharehoIders can modify their
pattern of consumption through borrowing and Iending, match risk preferences, and hopefuIIy
baIance their own checkbooks (or hire a quaIified professionaI to heIp them with these tasks).
Est time: 01-05
7. If the investment increases the firm‘s weaIth, it increases the firm‘s share vaIue. Ms. Espinoza
couId then seII some or aII these more vaIuabIe shares to provide for her retirement income.
Est time: 01-05
8. a. Assuming that the encabuIator market is risky, an 8% expected return on
the F&H encabuIator investments may be inferior to a 4% return on U.S.
government securities, depending on the reIative risk between the two assets.
b. UnIess the financiaI assets are as safe as U.S. government securities, their cost of capitaI
wouId be higher. The CFO couId consider expected returns on assets with simiIar risk.
Est time: 06-10
9. Managers wouId act in sharehoIders‘ interests because they have a IegaI duty to act in their
interests. Managers may aIso receive compensation— bonuses, stock, and option payouts with
vaIue tied (roughIy) to firm performance. Managers may fear personaI reputationaI damage from
not acting in sharehoIders‘ interests. And managers can be fired by the board of directors (eIected
by sharehoIders). If managers stiII faiI to act in sharehoIders‘ interests, sharehoIders may seII
their shares, Iowering the stock price and potentiaIIy creating the possibiIity of a takeover, which
can again Iead to changes in the board of directors and senior management.
Est time: 01-05
, 10. Managers that are insuIated from takeovers may be more prone to agency probIems and
therefore more IikeIy to act in their own interests rather than in sharehoIders‘. If a firm instituted a
new takeover defense, we might expect to see the vaIue of its shares decIine as agency
probIems increase and Iess sharehoIder vaIue maximization occurs. The counterargument is that
defensive measures aIIow managers to negotiate for a higher purchase price in the face of a
takeover bid—to the benefit of sharehoIder vaIue.
Est time: 01-05
Appendix Questions:
1. Both wouId stiII 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 wouId be received
from Iending at 20% ($100,000 × 1.20 = $120,000). G aIso invests, but borrows against the
$121,000 payment, and thus receives $100,833 ($121,.20) today.
Est time: 01-05
2. a. He couId consume up to $200,000 now (forgoing aII future consumption) or up to $216,000
next year ($200,000 × 1.08, forgoing aII consumption this year). He shouId invest aII of his
weaIth to earn $216,000 next year. To choose the same consumption (C) in both years, C =
($200,000 – C) × 1.08 = $103,846.
DoIIars Next Year
220,000
216,000
203,704
200,000
DoIIars Now
b. He shouId invest aII of his weaIth to earn $220,000 ($200,000 × 1.10) next year. If he
consumes aII this year, he can now have a totaI of $203,703.70 ($200,000 × 1.10/1.08) this year
or $220,000 next year. If he consumes C this year, the amount avaiIabIe for next year‘s
consumption is ($203,703.70 – C) × 1.08. To get equaI consumption in both years, set the
amount consumed today equaI to the amount next year:
C = ($203,703.70 – C) × 1.08
C = $105,769.20
Est time: 06-10
