Solutions Manualv
For
Corporate Finance
v
Ross, Westerfield, Jaffe and Jordan
v v v v v
13th edition
v v
, CHAPTER 2 - 2 v v v
CHAPTER 1 v
INTRODUCTIONTOCORPORATE v v
FINANCE
v
Answers to Concept Questions
v v v
1. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect
v v v v v v v v v v v v v v v v
vthe directors of the corporation, who in turn appoint the firm‟s management. This separation of
v v v v v v v v v v v v v v
vownership from control in the corporate form of organization is what causes agency problems to exist.
v v v v v v v v v v v v v v v
vManagement may act in its own or someone else‟s best interests, rather than those of the shareholders.
v v v v v v v v v v v v v v v v
vIf such events occur, they may contradict the goal of maximizing the share price of the equity of the
v v v v v v v v v v v v v v v v v v
vfirm.
2. Such organizations frequently pursue social or political missions, so many different goals are
v v v v v v v v v v v v
conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and
v v v v v v v v v v v v v v v
services are offered at the lowest possible cost to society. A better approach might be to observe
v v v v v v v v v v v v v v v v v
that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to
v v v v v v v v v v v v v v v v v
maximize the value of the equity.
v v v v v v
3. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows,
v v v v v v v v v v v v v v v
both short-term and long-term. If this is correct, then the statement is false.
v v v v v v v v v v v v v
4. An argument can be made either way. At the one extreme, we could argue that in a market
v v v v v v v v v v v v v v v v v
economy, all of these things are priced. There is thus an optimal level of, for example, ethical
v v v v v v v v v v v v v v v v v
and/or illegal behavior, and the framework of stock valuation explicitly includes these. At the other
v v v v v v v v v v v v v v v
extreme, we could argue that these are non-economic phenomena and are best handled through the
v v v v v v v v v v v v v v v
political process. A classic (and highly relevant) thought question that illustrates this debate goes
v v v v v v v v v v v v v v
something like this: “A firm has estimated that the cost of improving the safety of one of its
v v v v v v v v v v v v v v v v v v
products is $30 million. However, the firm believes that improving the safety of the product will
v v v v v v v v v v v v v v v v
only save $20 million in product liability claims. What should the firm do?”
v v v v v v v v v v v v v
5. The goal will be the same, but the best course of action toward that goal may be different because
v v v v v v v v v v v v v v v v v v
of differing social, political, and economic institutions.
v v v v v v v
6. The goal of management should be to maximize the share price for the current shareholders. If
v v v v v v v v v v v v v v v
management believes that it can improve the profitability of the firm so that the share price will exceed
v v v v v v v v v v v v v v v v v v
$35, then they should fight the offer from the outside company. If management believes that this
v v v v v v v v v v v v v v v
bidder, or other unidentified bidders, will actually pay more than $35 per share to acquire the company,
v v v v v v v v v v v v v v v v v
then they should still fight the offer. However, if the current management cannot increase the value of
v v v v v v v v v v v v v v v v v
the firm beyond the bid price, and no other higher bids come in, then management is not acting in
v v v v v v v v v v v v v v v v v v v
the interests of the shareholders by fighting the offer. Since current managers often lose their jobs
v v v v v v v v v v v v v v v v
when the corporation is acquired, poorly monitored managers have an incentive to fight corporate
v v v v v v v v v v v v v v
takeovers in situations such as this.
v v v v v v
, CHAPTER 2 - 3 v v v
7. We would expect agency problems to be less severe in other countries, primarily due to the
v v v v v v v v v v v v v v v
relatively small percentage of individual ownership. Fewer individual owners should reduce the
v v v v v v v v v v v v
number of diverse opinions concerning corporate goals. The high percentage of institutional
v v v v v v v v v v v v
ownership might lead to a higher degree of agreement between owners and managers on decisions
v v v v v v v v v v v v v v v
concerning risky projects. In addition, institutions may be better able to implement effective
v v v v v v v v v v v v v
monitoring mechanisms on managers than can individual owners, based on the institutions‟ deeper
v v v v v v v v v v v v v
resources and experiences with their own management.
v v v v v v v
8. The increase in institutional ownership of stock in the United States and the growing activism of these
v v v v v v v v v v v v v v v v
large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more
v v v v v v v v v v v v v v v v v
efficient market for corporate control. However, this may not always be the case. If the managers of
v v v v v v v v v v v v v v v v v
the mutual fund or pension plan are not concerned with the interests of the investors, the agency
v v v v v v v v v v v v v v v v v
problem could potentially remain the same, or even increase, since there is the possibility of agency
v v v v v v v v v v v v v v v v
problems between the fund and its investors.
v v v v v v v
9. How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest answer is
v v v v v v v v v v v v v v v v v
that there is a market for executives just as there is for all types of labor. Executive compensation is
v v v v v v v v v v v v v v v v v v v
the price that clears the market. The same is true for athletes and performers. Having said that, one
v v v v v v v v v v v v v v v v v v
aspect of executive compensation deserves comment. A primary reason executive compensation has
v v v v v v v v v v v v
grown so dramatically is that companies have increasingly moved to stock-based compensation. Such
v v v v v v v v v v v v v
movement is obviously consistent with the attempt to better align stockholder and management
v v v v v v v v v v v v v
interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes
v v v v v v v v v v v v v v v v
argued that much of this reward is due to rising stock prices in general, not managerial
v v v v v v v v v v v v v v v v
performance. Perhaps in the future, executive compensation will be designed to reward only
v v v v v v v v v v v v v
differential performance, i.e., stock price increases in excess of general market increases.
v v v v v v v v v v v v
10. Maximizing the current share price is the same as maximizing the future share price at any future
v v v v v v v v v v v v v v v v
period. The value of a share of stock depends on all of the future cash flows of company. Another way
v v v v v v v v v v v v v v v v v v v v
to look at this is that, barring large cash payments to shareholders, the expected price of the stock must
v v v v v v v v v v v v v v v v v v v
be higher in the future than it is today. Who would buy a stock for $100 today when the share price
v v v v v v v v v v v v v v v v v v v v v
in one year is expected to be $80?
v v v v v v v v
, CHAPTER 2 v
FINANCIAL STATEMENTS AND CASH v v v
FLOW
v
Answers to Concepts Review and Critical Thinking Questions
v v v v v v v
1. True. Every asset can be converted to cash at some price. However, when we are referring to a
v v v v v v v v v v v v v v v v v
liquid asset, the added assumption that the asset can be quickly converted to cash at or near market
v v v v v v v v v v v v v v v v v v
value is important.
v v v
2. The recognition and matching principles in financial accounting call for revenues, and the costs
v v v v v v v v v v v v v
associated with producing those revenues, to be “booked” when the revenue process is essentially
v v v v v v v v v v v v v v
complete, not necessarily when the cash is collected or bills are paid. Note that this way is not
v v v v v v v v v v v v v v v v v v
necessarily correct; it‟s the way accountants have chosen to do it.
v v v v v v v v v v v
3. The bottom line number shows the change in the cash balance on the balance sheet. As such, it is
v v v v v v v v v v v v v v v v v v
not a useful number for analyzing a company.
v v v v v v v v
4. The major difference is the treatment of interest expense. The accounting statement of cash flows
v v v v v v v v v v v v v v
treats interest as an operating cash flow, while the financial cash flows treat interest as a financing
v v v v v v v v v v v v v v v v v
cash flow. The logic of the accounting statement of cash flows is that since interest appears on the
v v v v v v v v v v v v v v v v v v
income statement, which shows the operations for the period, it is an operating cash flow. In reality,
v v v v v v v v v v v v v v v v v
interest is a financing expense, which results from the company‟s choice of debt and equity. We
v v v v v v v v v v v v v v v v
will have more to say about this in a later chapter. When comparing the two cash flow statements,
v v v v v v v v v v v v v v v v v v
the financial statement of cash flows is a more appropriate measure of the company‟s performance
v v v v v v v v v v v v v v v
because of its treatment of interest.
v v v v v v
5. Market values can never be negative. Imagine a share of stock selling for –$20. This would mean that
v v v v v v v v v v v v v v v v v
if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How
v v v v v v v v v v v v v v v v v v v v
many shares do you want to buy? More generally, because of corporate and individual bankruptcy
v v v v v v v v v v v v v v v
laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed
v v v v v v v v v v v v v v v v v
assets in market value.
v v v v
6. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly
v v v v v v v v v v v v v v v
leading to negative cash flow from assets. In general, what matters is whether the money is spent
v v v v v v v v v v v v v v v v v
wisely, not whether cash flow from assets is positive or negative.
v v v v v v v v v v v
7. It‟s probably not a good sign for an established company to have negative cash flow from
v v v v v v v v v v v v v v v
voperations, but it would be fairly ordinary for a start-up, so it depends.
v v v v v v v v v v v v
For
Corporate Finance
v
Ross, Westerfield, Jaffe and Jordan
v v v v v
13th edition
v v
, CHAPTER 2 - 2 v v v
CHAPTER 1 v
INTRODUCTIONTOCORPORATE v v
FINANCE
v
Answers to Concept Questions
v v v
1. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect
v v v v v v v v v v v v v v v v
vthe directors of the corporation, who in turn appoint the firm‟s management. This separation of
v v v v v v v v v v v v v v
vownership from control in the corporate form of organization is what causes agency problems to exist.
v v v v v v v v v v v v v v v
vManagement may act in its own or someone else‟s best interests, rather than those of the shareholders.
v v v v v v v v v v v v v v v v
vIf such events occur, they may contradict the goal of maximizing the share price of the equity of the
v v v v v v v v v v v v v v v v v v
vfirm.
2. Such organizations frequently pursue social or political missions, so many different goals are
v v v v v v v v v v v v
conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and
v v v v v v v v v v v v v v v
services are offered at the lowest possible cost to society. A better approach might be to observe
v v v v v v v v v v v v v v v v v
that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to
v v v v v v v v v v v v v v v v v
maximize the value of the equity.
v v v v v v
3. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows,
v v v v v v v v v v v v v v v
both short-term and long-term. If this is correct, then the statement is false.
v v v v v v v v v v v v v
4. An argument can be made either way. At the one extreme, we could argue that in a market
v v v v v v v v v v v v v v v v v
economy, all of these things are priced. There is thus an optimal level of, for example, ethical
v v v v v v v v v v v v v v v v v
and/or illegal behavior, and the framework of stock valuation explicitly includes these. At the other
v v v v v v v v v v v v v v v
extreme, we could argue that these are non-economic phenomena and are best handled through the
v v v v v v v v v v v v v v v
political process. A classic (and highly relevant) thought question that illustrates this debate goes
v v v v v v v v v v v v v v
something like this: “A firm has estimated that the cost of improving the safety of one of its
v v v v v v v v v v v v v v v v v v
products is $30 million. However, the firm believes that improving the safety of the product will
v v v v v v v v v v v v v v v v
only save $20 million in product liability claims. What should the firm do?”
v v v v v v v v v v v v v
5. The goal will be the same, but the best course of action toward that goal may be different because
v v v v v v v v v v v v v v v v v v
of differing social, political, and economic institutions.
v v v v v v v
6. The goal of management should be to maximize the share price for the current shareholders. If
v v v v v v v v v v v v v v v
management believes that it can improve the profitability of the firm so that the share price will exceed
v v v v v v v v v v v v v v v v v v
$35, then they should fight the offer from the outside company. If management believes that this
v v v v v v v v v v v v v v v
bidder, or other unidentified bidders, will actually pay more than $35 per share to acquire the company,
v v v v v v v v v v v v v v v v v
then they should still fight the offer. However, if the current management cannot increase the value of
v v v v v v v v v v v v v v v v v
the firm beyond the bid price, and no other higher bids come in, then management is not acting in
v v v v v v v v v v v v v v v v v v v
the interests of the shareholders by fighting the offer. Since current managers often lose their jobs
v v v v v v v v v v v v v v v v
when the corporation is acquired, poorly monitored managers have an incentive to fight corporate
v v v v v v v v v v v v v v
takeovers in situations such as this.
v v v v v v
, CHAPTER 2 - 3 v v v
7. We would expect agency problems to be less severe in other countries, primarily due to the
v v v v v v v v v v v v v v v
relatively small percentage of individual ownership. Fewer individual owners should reduce the
v v v v v v v v v v v v
number of diverse opinions concerning corporate goals. The high percentage of institutional
v v v v v v v v v v v v
ownership might lead to a higher degree of agreement between owners and managers on decisions
v v v v v v v v v v v v v v v
concerning risky projects. In addition, institutions may be better able to implement effective
v v v v v v v v v v v v v
monitoring mechanisms on managers than can individual owners, based on the institutions‟ deeper
v v v v v v v v v v v v v
resources and experiences with their own management.
v v v v v v v
8. The increase in institutional ownership of stock in the United States and the growing activism of these
v v v v v v v v v v v v v v v v
large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more
v v v v v v v v v v v v v v v v v
efficient market for corporate control. However, this may not always be the case. If the managers of
v v v v v v v v v v v v v v v v v
the mutual fund or pension plan are not concerned with the interests of the investors, the agency
v v v v v v v v v v v v v v v v v
problem could potentially remain the same, or even increase, since there is the possibility of agency
v v v v v v v v v v v v v v v v
problems between the fund and its investors.
v v v v v v v
9. How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest answer is
v v v v v v v v v v v v v v v v v
that there is a market for executives just as there is for all types of labor. Executive compensation is
v v v v v v v v v v v v v v v v v v v
the price that clears the market. The same is true for athletes and performers. Having said that, one
v v v v v v v v v v v v v v v v v v
aspect of executive compensation deserves comment. A primary reason executive compensation has
v v v v v v v v v v v v
grown so dramatically is that companies have increasingly moved to stock-based compensation. Such
v v v v v v v v v v v v v
movement is obviously consistent with the attempt to better align stockholder and management
v v v v v v v v v v v v v
interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes
v v v v v v v v v v v v v v v v
argued that much of this reward is due to rising stock prices in general, not managerial
v v v v v v v v v v v v v v v v
performance. Perhaps in the future, executive compensation will be designed to reward only
v v v v v v v v v v v v v
differential performance, i.e., stock price increases in excess of general market increases.
v v v v v v v v v v v v
10. Maximizing the current share price is the same as maximizing the future share price at any future
v v v v v v v v v v v v v v v v
period. The value of a share of stock depends on all of the future cash flows of company. Another way
v v v v v v v v v v v v v v v v v v v v
to look at this is that, barring large cash payments to shareholders, the expected price of the stock must
v v v v v v v v v v v v v v v v v v v
be higher in the future than it is today. Who would buy a stock for $100 today when the share price
v v v v v v v v v v v v v v v v v v v v v
in one year is expected to be $80?
v v v v v v v v
, CHAPTER 2 v
FINANCIAL STATEMENTS AND CASH v v v
FLOW
v
Answers to Concepts Review and Critical Thinking Questions
v v v v v v v
1. True. Every asset can be converted to cash at some price. However, when we are referring to a
v v v v v v v v v v v v v v v v v
liquid asset, the added assumption that the asset can be quickly converted to cash at or near market
v v v v v v v v v v v v v v v v v v
value is important.
v v v
2. The recognition and matching principles in financial accounting call for revenues, and the costs
v v v v v v v v v v v v v
associated with producing those revenues, to be “booked” when the revenue process is essentially
v v v v v v v v v v v v v v
complete, not necessarily when the cash is collected or bills are paid. Note that this way is not
v v v v v v v v v v v v v v v v v v
necessarily correct; it‟s the way accountants have chosen to do it.
v v v v v v v v v v v
3. The bottom line number shows the change in the cash balance on the balance sheet. As such, it is
v v v v v v v v v v v v v v v v v v
not a useful number for analyzing a company.
v v v v v v v v
4. The major difference is the treatment of interest expense. The accounting statement of cash flows
v v v v v v v v v v v v v v
treats interest as an operating cash flow, while the financial cash flows treat interest as a financing
v v v v v v v v v v v v v v v v v
cash flow. The logic of the accounting statement of cash flows is that since interest appears on the
v v v v v v v v v v v v v v v v v v
income statement, which shows the operations for the period, it is an operating cash flow. In reality,
v v v v v v v v v v v v v v v v v
interest is a financing expense, which results from the company‟s choice of debt and equity. We
v v v v v v v v v v v v v v v v
will have more to say about this in a later chapter. When comparing the two cash flow statements,
v v v v v v v v v v v v v v v v v v
the financial statement of cash flows is a more appropriate measure of the company‟s performance
v v v v v v v v v v v v v v v
because of its treatment of interest.
v v v v v v
5. Market values can never be negative. Imagine a share of stock selling for –$20. This would mean that
v v v v v v v v v v v v v v v v v
if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How
v v v v v v v v v v v v v v v v v v v v
many shares do you want to buy? More generally, because of corporate and individual bankruptcy
v v v v v v v v v v v v v v v
laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed
v v v v v v v v v v v v v v v v v
assets in market value.
v v v v
6. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly
v v v v v v v v v v v v v v v
leading to negative cash flow from assets. In general, what matters is whether the money is spent
v v v v v v v v v v v v v v v v v
wisely, not whether cash flow from assets is positive or negative.
v v v v v v v v v v v
7. It‟s probably not a good sign for an established company to have negative cash flow from
v v v v v v v v v v v v v v v
voperations, but it would be fairly ordinary for a start-up, so it depends.
v v v v v v v v v v v v
