© fMcGraw fHill fLLC. fAll frights freserved. fNo freproduction for fdistribution fwithout fthe fprior fwritten fconsent fof fMcGraw fHill fLLC.
, CHAPTER 1 f
Introduction to Corporate Finance f f f
The values shown in the solutions may be rounded for display purposes. However, the answers were
f f f f f f f f f f f f f f f
derived using a spreadsheet without any intermediate rounding.
f f f f f f f f
Answers to Problem Sets f f f
1. a. real
b. executive airplanes f
c. brand names f
d. financial
e. bonds
*f. investment or capital expenditure f f f
*g. capital budgeting or investment f f f
h. financing
*Note that f and g are interchangeable in the question.
f f f f f f f f f
Est time: 01-05
f f
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets.
f f f f f f f f f f f f f f f f f f
Real assets are identifiable as items with intrinsic value. The others in the list are financial assets,
f f f f f f f f f f f f f f f f f
that is, these assets derive value because of a contractual claim.
f f f f f f f f f f f
Est time: 01-05
f f
3. a. Financial assets, such as stocks or bank loans, are claims held by investors.
f f f f f f f f f f f f
Corporations sell financial assets to raise the cash to invest in real assets such as plant
f f f f f f f f f f f f f f f f
and equipment. Some real assets are intangible.
f f f f f f f
b. Capital expenditure means investment in real assets. Financing means raising the cash
f f f f f f f f f f f
for this investment.
f f f
c. The shares of public corporations are traded on stock exchanges and can be purchased
f f f f f f f f f f f f f
by a wide range of investors. The shares of closely held corporations are not publicly
f f f f f f f f f f f f f f f
traded and are held by a small group of private investors.
f f f f f f f f f f f
d. Unlimited liability: Investors are responsible for all the firm‘s debts. A sole proprietor has
f f f f f f f f f f f f f
unlimited liability. Investors in corporations have limited liability. They can lose their
f f f f f f f f f f f f
investment, but no more.
f f f f
Est time: 01-05
f f
© fMcGraw fHill fLLC. fAll frights freserved. fNo freproduction for fdistribution fwithout fthe fprior fwritten fconsent fof fMcGraw fHill fLLC.
,4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can be
f f f f f f f f f f f f f f
transferred without affecting operations, and managers can be fired with no effect on ownership.
f f f f f f f f f f f f f f
Other forms of business may have unlimited liability and limited life.
f f f f f f f f f f f
Est time: 01-05
f f
5. Separation of ownership facilitates the key attributes of a corporation, including limited liability for
f f f f f f f f f f f f f
investors, transferability of ownership, a separate legal personality of the corporation, and
f f f f f f f f f f f f
delegated centralized management. These four attributes provide substantial benefit for
f f f f f f f f f f
investors, including the ability to diversify their investment among many uncorrelated returns—a
f f f f f f f f f f f f
very valuable tool explored in later chapters. Also, these attributes allow investors to quickly exit,
f f f f f f f f f f f f f f f
enter, or short sell an investment, thereby generating an active liquid market for corporations.
f f f f f f f f f f f f f f
However, these positive aspects also introduce substantial negative externalities as well. The
f f f f f f f f f f f
separation of ownership from management typically leads to agency problems, where managers
f f f f f f f f f f f f
prefer to consume private perks or make other decisions for their private benefit—rather than
f f f f f f f f f f f f f f
maximize shareholder wealth. Shareholders tend to exercise less oversight of each individual
f f f f f f f f f f f f
investment as their diversification increases. Finally, the corporation‘s separate legal personality
f f f f f f f f f f f
makes it difficult to enforce accountability if they externalize costs onto society.
f f f f f f f f f f f f
Est time: 01-05
f f
6. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their f f f f f f f f f f f
pattern of consumption through borrowing and lending, match risk preferences, and hopefully
f f f f f f f f f f f f
balance their own checkbooks (or hire a qualified professional to help them with these tasks).
f f f f f f f f f f f f f f f
Est time: 01-05
f f
7. If the investment increases the firm‘s wealth, it increases the firm‘s share value. Ms. Espinoza
f f f f f f f f f f f f f f
could then sell some or all these more valuable shares to provide for her retirement income.
f f f f f f f f f f f f f f f f
Est time: 01-05
f f
8. a. Assuming that the encabulator market is risky, an 8% expected return on f f f f f f f f f f f
the F&H encabulator investments may be inferior to a 4% return on U.S.
f f f f f f f f f f f f f
government securities, depending on the relative risk between the two assets. f f f f f f f f f f
b. Unless the financial assets are as safe as U.S. government securities, their cost of capital
f f f f f f f f f f f f f f
would be higher. The CFO could consider expected returns on assets with similar risk.
f f f f f f f f f f f f f f
Est time: 06-10
f f
9. Managers would act in shareholders‘ interests because they have a legal duty to act in their
f f f f f f f f f f f f f f f
interests. Managers may also receive compensation— bonuses, stock, and option payouts with
f f f f f f f f f f f f
value tied (roughly) to firm performance. Managers may fear personal reputational damage from
f f f f f f f f f f f f f
not acting in shareholders‘ interests. And managers can be fired by the board of directors (elected
f f f f f f f f f f f f f f f f
by shareholders). If managers still fail to act in shareholders‘ interests, shareholders may sell
f f f f f f f f f f f f f f
their shares, lowering the stock price and potentially creating the possibility of a takeover, which
f f f f f f f f f f f f f f f
can again lead to changes in the board of directors and senior management.
f f f f f f f f f f f f f
Est time: 01-05
f f
© fMcGraw fHill fLLC. fAll frights freserved. fNo freproduction for fdistribution fwithout fthe fprior fwritten fconsent fof fMcGraw fHill fLLC.
, 10. Managers that are insulated from takeovers may be more prone to agency problems and therefore
f f f f f f f f f f f f f f
more likely to act in their own interests rather than in shareholders‘. If a firm instituted a new
f f f f f f f f f f f f f f f f f f
takeover defense, we might expect to see the value of its shares decline as agency problems
f f f f f f f f f f f f f f f f
increase and less shareholder value maximization occurs. The counterargument is that defensive
f f f f f f f f f f f f
measures allow managers to negotiate for a higher purchase price in the face of a takeover bid—to
f f f f f f f f f f f f f f f f f
the benefit of shareholder value.
f f f f f
Est time: 01-05
f f
Appendix Questions: f
1. Both would still invest in their friend‘s business. A invests and receives $121,000 for his
f f f f f f f f f f f f f f
investment at the end of the year—which is greater than the $120,000 that would be received
f f f f f f f f f f f f f f f f
from lending at 20% ($100,000 × 1.20 = $120,000). G also invests, but borrows against the
f f f f f f f f f f f f f f f f
$121,000 payment, and thus receives $100,833 ($121,.20) today.
f f f f f f f f f
Est time: 01-05
f f
2. a. He could consume up to $200,000 now (forgoing all future consumption) or up to $216,000 next
f f f f f f f f f f f f f f f f
year ($200,000 × 1.08, forgoing all consumption this year). He should invest all of his wealth to
f f f f f f f f f f f f f f f f f
earn $216,000 next year. To choose the same consumption (C) in both years, C = ($200,000 –
f f f f f f f f f f f f f f f f f
C) × 1.08 = $103,846.
f f f f f
Dollars f Next fYear
220,000
216,000
203,704
200,000
Dollars f Now
b. He should invest all of his wealth to earn $220,000 ($200,000 × 1.10) next year. If he
f f f f f f f f f f f f f f f f
consumes all this year, he can now have a total of $203,703.70 ($200,000 × 1.10/1.08) this year
f f f f f f f f f f f f f f f f f
or $220,000 next year. If he consumes C this year, the amount available for next year‘s
f f f f f f f f f f f f f f f f
consumption is ($203,703.70 – C) × 1.08. To get equal consumption in both years, set the
f f f f f f f f f f f f f f f f
amount consumed today equal to the amount next year:
f f f f f f f f f
C = ($203,703.70 – C) × 1.08
f f f f f f
C = $105,769.20 f f
Est time: 06-10
f f
© fMcGraw fHill fLLC. fAll frights freserved. fNo freproduction for fdistribution fwithout fthe fprior fwritten fconsent fof fMcGraw fHill fLLC.
, CHAPTER 1 f
Introduction to Corporate Finance f f f
The values shown in the solutions may be rounded for display purposes. However, the answers were
f f f f f f f f f f f f f f f
derived using a spreadsheet without any intermediate rounding.
f f f f f f f f
Answers to Problem Sets f f f
1. a. real
b. executive airplanes f
c. brand names f
d. financial
e. bonds
*f. investment or capital expenditure f f f
*g. capital budgeting or investment f f f
h. financing
*Note that f and g are interchangeable in the question.
f f f f f f f f f
Est time: 01-05
f f
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets.
f f f f f f f f f f f f f f f f f f
Real assets are identifiable as items with intrinsic value. The others in the list are financial assets,
f f f f f f f f f f f f f f f f f
that is, these assets derive value because of a contractual claim.
f f f f f f f f f f f
Est time: 01-05
f f
3. a. Financial assets, such as stocks or bank loans, are claims held by investors.
f f f f f f f f f f f f
Corporations sell financial assets to raise the cash to invest in real assets such as plant
f f f f f f f f f f f f f f f f
and equipment. Some real assets are intangible.
f f f f f f f
b. Capital expenditure means investment in real assets. Financing means raising the cash
f f f f f f f f f f f
for this investment.
f f f
c. The shares of public corporations are traded on stock exchanges and can be purchased
f f f f f f f f f f f f f
by a wide range of investors. The shares of closely held corporations are not publicly
f f f f f f f f f f f f f f f
traded and are held by a small group of private investors.
f f f f f f f f f f f
d. Unlimited liability: Investors are responsible for all the firm‘s debts. A sole proprietor has
f f f f f f f f f f f f f
unlimited liability. Investors in corporations have limited liability. They can lose their
f f f f f f f f f f f f
investment, but no more.
f f f f
Est time: 01-05
f f
© fMcGraw fHill fLLC. fAll frights freserved. fNo freproduction for fdistribution fwithout fthe fprior fwritten fconsent fof fMcGraw fHill fLLC.
,4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can be
f f f f f f f f f f f f f f
transferred without affecting operations, and managers can be fired with no effect on ownership.
f f f f f f f f f f f f f f
Other forms of business may have unlimited liability and limited life.
f f f f f f f f f f f
Est time: 01-05
f f
5. Separation of ownership facilitates the key attributes of a corporation, including limited liability for
f f f f f f f f f f f f f
investors, transferability of ownership, a separate legal personality of the corporation, and
f f f f f f f f f f f f
delegated centralized management. These four attributes provide substantial benefit for
f f f f f f f f f f
investors, including the ability to diversify their investment among many uncorrelated returns—a
f f f f f f f f f f f f
very valuable tool explored in later chapters. Also, these attributes allow investors to quickly exit,
f f f f f f f f f f f f f f f
enter, or short sell an investment, thereby generating an active liquid market for corporations.
f f f f f f f f f f f f f f
However, these positive aspects also introduce substantial negative externalities as well. The
f f f f f f f f f f f
separation of ownership from management typically leads to agency problems, where managers
f f f f f f f f f f f f
prefer to consume private perks or make other decisions for their private benefit—rather than
f f f f f f f f f f f f f f
maximize shareholder wealth. Shareholders tend to exercise less oversight of each individual
f f f f f f f f f f f f
investment as their diversification increases. Finally, the corporation‘s separate legal personality
f f f f f f f f f f f
makes it difficult to enforce accountability if they externalize costs onto society.
f f f f f f f f f f f f
Est time: 01-05
f f
6. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their f f f f f f f f f f f
pattern of consumption through borrowing and lending, match risk preferences, and hopefully
f f f f f f f f f f f f
balance their own checkbooks (or hire a qualified professional to help them with these tasks).
f f f f f f f f f f f f f f f
Est time: 01-05
f f
7. If the investment increases the firm‘s wealth, it increases the firm‘s share value. Ms. Espinoza
f f f f f f f f f f f f f f
could then sell some or all these more valuable shares to provide for her retirement income.
f f f f f f f f f f f f f f f f
Est time: 01-05
f f
8. a. Assuming that the encabulator market is risky, an 8% expected return on f f f f f f f f f f f
the F&H encabulator investments may be inferior to a 4% return on U.S.
f f f f f f f f f f f f f
government securities, depending on the relative risk between the two assets. f f f f f f f f f f
b. Unless the financial assets are as safe as U.S. government securities, their cost of capital
f f f f f f f f f f f f f f
would be higher. The CFO could consider expected returns on assets with similar risk.
f f f f f f f f f f f f f f
Est time: 06-10
f f
9. Managers would act in shareholders‘ interests because they have a legal duty to act in their
f f f f f f f f f f f f f f f
interests. Managers may also receive compensation— bonuses, stock, and option payouts with
f f f f f f f f f f f f
value tied (roughly) to firm performance. Managers may fear personal reputational damage from
f f f f f f f f f f f f f
not acting in shareholders‘ interests. And managers can be fired by the board of directors (elected
f f f f f f f f f f f f f f f f
by shareholders). If managers still fail to act in shareholders‘ interests, shareholders may sell
f f f f f f f f f f f f f f
their shares, lowering the stock price and potentially creating the possibility of a takeover, which
f f f f f f f f f f f f f f f
can again lead to changes in the board of directors and senior management.
f f f f f f f f f f f f f
Est time: 01-05
f f
© fMcGraw fHill fLLC. fAll frights freserved. fNo freproduction for fdistribution fwithout fthe fprior fwritten fconsent fof fMcGraw fHill fLLC.
, 10. Managers that are insulated from takeovers may be more prone to agency problems and therefore
f f f f f f f f f f f f f f
more likely to act in their own interests rather than in shareholders‘. If a firm instituted a new
f f f f f f f f f f f f f f f f f f
takeover defense, we might expect to see the value of its shares decline as agency problems
f f f f f f f f f f f f f f f f
increase and less shareholder value maximization occurs. The counterargument is that defensive
f f f f f f f f f f f f
measures allow managers to negotiate for a higher purchase price in the face of a takeover bid—to
f f f f f f f f f f f f f f f f f
the benefit of shareholder value.
f f f f f
Est time: 01-05
f f
Appendix Questions: f
1. Both would still invest in their friend‘s business. A invests and receives $121,000 for his
f f f f f f f f f f f f f f
investment at the end of the year—which is greater than the $120,000 that would be received
f f f f f f f f f f f f f f f f
from lending at 20% ($100,000 × 1.20 = $120,000). G also invests, but borrows against the
f f f f f f f f f f f f f f f f
$121,000 payment, and thus receives $100,833 ($121,.20) today.
f f f f f f f f f
Est time: 01-05
f f
2. a. He could consume up to $200,000 now (forgoing all future consumption) or up to $216,000 next
f f f f f f f f f f f f f f f f
year ($200,000 × 1.08, forgoing all consumption this year). He should invest all of his wealth to
f f f f f f f f f f f f f f f f f
earn $216,000 next year. To choose the same consumption (C) in both years, C = ($200,000 –
f f f f f f f f f f f f f f f f f
C) × 1.08 = $103,846.
f f f f f
Dollars f Next fYear
220,000
216,000
203,704
200,000
Dollars f Now
b. He should invest all of his wealth to earn $220,000 ($200,000 × 1.10) next year. If he
f f f f f f f f f f f f f f f f
consumes all this year, he can now have a total of $203,703.70 ($200,000 × 1.10/1.08) this year
f f f f f f f f f f f f f f f f f
or $220,000 next year. If he consumes C this year, the amount available for next year‘s
f f f f f f f f f f f f f f f f
consumption is ($203,703.70 – C) × 1.08. To get equal consumption in both years, set the
f f f f f f f f f f f f f f f f
amount consumed today equal to the amount next year:
f f f f f f f f f
C = ($203,703.70 – C) × 1.08
f f f f f f
C = $105,769.20 f f
Est time: 06-10
f f
© fMcGraw fHill fLLC. fAll frights freserved. fNo freproduction for fdistribution fwithout fthe fprior fwritten fconsent fof fMcGraw fHill fLLC.
