Solutions Manual for Corporate
b b b
,Finance by Ross, Westerfield,
b b b b b
th
and Jaffe 13 Edition
b b b b
Solutions Manual b
Corporate Finance b
Ross, Westerfield, and Jaffe
b b b
13th edition
b b
,Solutions b Manual
CHAPTER 1 b
INTRODUCTION TO CORPORATE b b
FINANCE
b
Answers to Concept Questions
b b b
1. In the corporate form of ownership, the shareholders are the owners of the firm. The
b b b b b b b b b b b b b b
bshareholders elect the directors of the corporation, who in turn appoint the firm‘s management. This
b b b b b b b b b b b b b b
bseparation of ownership from control in the corporate form of organization is what causes
b b b b b b b b b b b b b
b agency problems to exist. Management may act in its own or someone else‘s best interests, rather
b b b b b b b b b b b b b b b
bthan those of the shareholders. If such events occur, they may contradict the goal of maximizing the
b b b b b b b b b b b b b b b b
bshare price of the equity of the firm.
b b b b b b b
2. Such organizations frequently pursue social or political missions, so many different goals are
b b b b b b b b b b b b
conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and
b b b b b b b b b b b b b b b
services are offered at the lowest possible cost to society. A better approach might be to observe that
b b b b b b b b b b b b b b b b b b
even a not-for-profit business has equity. Thus, one answer is that the appropriate goal
b b b b b b b b b b b b b b
bis to maximize the value of the equity.
b b b b b b b
3. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows,
b b b b b b b b b b b b b b b
both short-term and long-term. If this is correct, then the statement is false.
b b b b b b b b b b b b b
4. An argument can be made either way. At the one extreme, we could argue that in a market economy,
b b b b b b b b b b b b b b b b b b
ball of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal
b b b b b b b b b b b b b b b b b
behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we
b b b b b b b b b b b b b b b
could argue that these are non-economic phenomena and are best handled through the political
b b b b b b b b b b b b b b
process. A classic (and highly relevant) thought question that illustrates this debate goes something
b b b b b b b b b b b b b b
blike this: ―A firm has estimated that the cost of improving the safety of one of its products is $30
b b b b b b b b b b b b b b b b b b b
million. However, the firm believes that improving the safety of the product will only save $20
b b b b b b b b b b b b b b b b
bmillion in product liability claims. What should the firm do?‖
b b b b b b b b b
5. The goal will be the same, but the best course of action toward that goal may be different because of
b b b b b b b b b b b b b b b b b b b
differing social, political, and economic institutions.
b b b b b b
6. The goal of management should be to maximize the share price for the current shareholders. If
b b b b b b b b b b b b b b b
management believes that it can improve the profitability of the firm so that the share price will
b b b b b b b b b b b b b b b b b
bexceed $35, then they should fight the offer from the outside company. If management believes that
b b b b b b b b b b b b b b b
this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the
b b b b b b b b b b b b b b b b b
company, then they should still fight the offer. However, if the current management cannot increase
b b b b b b b b b b b b b b b
bthe value of the firm beyond the bid price, and no other higher bids come in, then management is not
b b b b b b b b b b b b b b b b b b b
acting in the interests of the shareholders by fighting the offer. Since current managers
b b b b b b b b b b b b b b
boften lose b
, their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight
b b b b b b b b b b b b b b
bcorporate takeovers in situations such as this.
b b b b b b
7. We would expect agency problems to be less severe in other countries, primarily due to the relatively
b b b b b b b b b b b b b b b b
small percentage of individual ownership. Fewer individual owners should reduce the number of
b b b b b b b b b b b b b
diverse opinions concerning corporate goals. The high percentage of institutional ownership might
b b b b b b b b b b b b
blead to a higher degree of agreement between owners and managers on decisions concerning risky
b b b b b b b b b b b b b b
projects. In addition, institutions may be better able to implement effective monitoring
b b b b b b b b b b b b
mechanisms on managers than can individual owners, based on the institutions‘ deeper resources and
b b b b b b b b b b b b b b
experiences with their own management.
b b b b b
8. The increase in institutional ownership of stock in the United States and the growing
b b b b b b b b b b b b b
bactivism of these large shareholder groups may lead to a reduction in agency problems for U.S.
b b b b b b b b b b b b b b b
corporations and a more efficient market for corporate control. However, this may not always be the
b b b b b b b b b b b b b b b b
case. If the managers of the mutual fund or pension plan are not concerned with the interests of the
b b b b b b b b b b b b b b b b b b b
investors, the agency problem could potentially remain the same, or even increase since there is the
b b b b b b b b b b b b b b b b
possibility of agency problems between the fund and its investors.
b b b b b b b b b b
9. How much is too much? Who is worth more, Larry Ellsion or Tiger Woods? The simplest answer is
b b b b b b b b b b b b b b b b b
that there is a market for executives just as there is for all types of labor. Executive compensation
b b b b b b b b b b b b b b b b b b
is the price that clears the market. The same is true for athletes and performers. Having said that, one
b b b b b b b b b b b b b b b b b b b
aspect of executive compensation deserves comment. A primary reason executive compensation has
b b b b b b b b b b b b
grown so dramatically is that companies have increasingly moved to stock-based
b b b b b b b b b b b
bcompensation. Such movement is obviously consistent with the attempt to better align stockholder
b b b b b b b b b b b b
and management interests. In recent years, stock prices have soared, so management has cleaned up.
b b b b b b b b b b b b b b b
It is sometimes argued that much of this reward is simply due to rising stock prices in general, not
b b b b b b b b b b b b b b b b b b b
managerial performance. Perhaps in the future, executive compensation will be designed to reward
b b b b b b b b b b b b b
bonly differential performance, i.e., stock price increases in excess of general market increases.
b b b b b b b b b b b b
10. Maximizing the current share price is the same as maximizing the future share price at any future
b b b b b b b b b b b b b b b b
period. The value of a share of stock depends on all of the future cash flows of company.
b b b b b b b b b b b b b b b b b b
Another way to look at this is that, barring large cash payments to shareholders, the
b b b b b b b b b b b b b b b
expected price of the stock must be higher in the future than it is today. Who would buy a stock
b b b b b b b b b b b b b b b b b b b b
for $100 today when the share price in one year is expected to be $80?
b b b b b b b b b b b b b b b
b b b
,Finance by Ross, Westerfield,
b b b b b
th
and Jaffe 13 Edition
b b b b
Solutions Manual b
Corporate Finance b
Ross, Westerfield, and Jaffe
b b b
13th edition
b b
,Solutions b Manual
CHAPTER 1 b
INTRODUCTION TO CORPORATE b b
FINANCE
b
Answers to Concept Questions
b b b
1. In the corporate form of ownership, the shareholders are the owners of the firm. The
b b b b b b b b b b b b b b
bshareholders elect the directors of the corporation, who in turn appoint the firm‘s management. This
b b b b b b b b b b b b b b
bseparation of ownership from control in the corporate form of organization is what causes
b b b b b b b b b b b b b
b agency problems to exist. Management may act in its own or someone else‘s best interests, rather
b b b b b b b b b b b b b b b
bthan those of the shareholders. If such events occur, they may contradict the goal of maximizing the
b b b b b b b b b b b b b b b b
bshare price of the equity of the firm.
b b b b b b b
2. Such organizations frequently pursue social or political missions, so many different goals are
b b b b b b b b b b b b
conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and
b b b b b b b b b b b b b b b
services are offered at the lowest possible cost to society. A better approach might be to observe that
b b b b b b b b b b b b b b b b b b
even a not-for-profit business has equity. Thus, one answer is that the appropriate goal
b b b b b b b b b b b b b b
bis to maximize the value of the equity.
b b b b b b b
3. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows,
b b b b b b b b b b b b b b b
both short-term and long-term. If this is correct, then the statement is false.
b b b b b b b b b b b b b
4. An argument can be made either way. At the one extreme, we could argue that in a market economy,
b b b b b b b b b b b b b b b b b b
ball of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal
b b b b b b b b b b b b b b b b b
behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we
b b b b b b b b b b b b b b b
could argue that these are non-economic phenomena and are best handled through the political
b b b b b b b b b b b b b b
process. A classic (and highly relevant) thought question that illustrates this debate goes something
b b b b b b b b b b b b b b
blike this: ―A firm has estimated that the cost of improving the safety of one of its products is $30
b b b b b b b b b b b b b b b b b b b
million. However, the firm believes that improving the safety of the product will only save $20
b b b b b b b b b b b b b b b b
bmillion in product liability claims. What should the firm do?‖
b b b b b b b b b
5. The goal will be the same, but the best course of action toward that goal may be different because of
b b b b b b b b b b b b b b b b b b b
differing social, political, and economic institutions.
b b b b b b
6. The goal of management should be to maximize the share price for the current shareholders. If
b b b b b b b b b b b b b b b
management believes that it can improve the profitability of the firm so that the share price will
b b b b b b b b b b b b b b b b b
bexceed $35, then they should fight the offer from the outside company. If management believes that
b b b b b b b b b b b b b b b
this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the
b b b b b b b b b b b b b b b b b
company, then they should still fight the offer. However, if the current management cannot increase
b b b b b b b b b b b b b b b
bthe value of the firm beyond the bid price, and no other higher bids come in, then management is not
b b b b b b b b b b b b b b b b b b b
acting in the interests of the shareholders by fighting the offer. Since current managers
b b b b b b b b b b b b b b
boften lose b
, their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight
b b b b b b b b b b b b b b
bcorporate takeovers in situations such as this.
b b b b b b
7. We would expect agency problems to be less severe in other countries, primarily due to the relatively
b b b b b b b b b b b b b b b b
small percentage of individual ownership. Fewer individual owners should reduce the number of
b b b b b b b b b b b b b
diverse opinions concerning corporate goals. The high percentage of institutional ownership might
b b b b b b b b b b b b
blead to a higher degree of agreement between owners and managers on decisions concerning risky
b b b b b b b b b b b b b b
projects. In addition, institutions may be better able to implement effective monitoring
b b b b b b b b b b b b
mechanisms on managers than can individual owners, based on the institutions‘ deeper resources and
b b b b b b b b b b b b b b
experiences with their own management.
b b b b b
8. The increase in institutional ownership of stock in the United States and the growing
b b b b b b b b b b b b b
bactivism of these large shareholder groups may lead to a reduction in agency problems for U.S.
b b b b b b b b b b b b b b b
corporations and a more efficient market for corporate control. However, this may not always be the
b b b b b b b b b b b b b b b b
case. If the managers of the mutual fund or pension plan are not concerned with the interests of the
b b b b b b b b b b b b b b b b b b b
investors, the agency problem could potentially remain the same, or even increase since there is the
b b b b b b b b b b b b b b b b
possibility of agency problems between the fund and its investors.
b b b b b b b b b b
9. How much is too much? Who is worth more, Larry Ellsion or Tiger Woods? The simplest answer is
b b b b b b b b b b b b b b b b b
that there is a market for executives just as there is for all types of labor. Executive compensation
b b b b b b b b b b b b b b b b b b
is the price that clears the market. The same is true for athletes and performers. Having said that, one
b b b b b b b b b b b b b b b b b b b
aspect of executive compensation deserves comment. A primary reason executive compensation has
b b b b b b b b b b b b
grown so dramatically is that companies have increasingly moved to stock-based
b b b b b b b b b b b
bcompensation. Such movement is obviously consistent with the attempt to better align stockholder
b b b b b b b b b b b b
and management interests. In recent years, stock prices have soared, so management has cleaned up.
b b b b b b b b b b b b b b b
It is sometimes argued that much of this reward is simply due to rising stock prices in general, not
b b b b b b b b b b b b b b b b b b b
managerial performance. Perhaps in the future, executive compensation will be designed to reward
b b b b b b b b b b b b b
bonly differential performance, i.e., stock price increases in excess of general market increases.
b b b b b b b b b b b b
10. Maximizing the current share price is the same as maximizing the future share price at any future
b b b b b b b b b b b b b b b b
period. The value of a share of stock depends on all of the future cash flows of company.
b b b b b b b b b b b b b b b b b b
Another way to look at this is that, barring large cash payments to shareholders, the
b b b b b b b b b b b b b b b
expected price of the stock must be higher in the future than it is today. Who would buy a stock
b b b b b b b b b b b b b b b b b b b b
for $100 today when the share price in one year is expected to be $80?
b b b b b b b b b b b b b b b
