Solutions Manual
,
, CHAPTER 1
INTRODUCTION TO CORPORATE
FINANCE
Answers to Concepts Review and Critical Thinking Questions
1. Capital budgeting (deciding on whether to expand a manufacturing plant), capital
structure (deciding whether to issue new equity and use the proceeds to retire outstanding
debt), and working capital management (modifying the firm’s credit collection policy with
its customers).
2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership,
difficulty in raising capital funds. Some advantages: simpler, less regulation, the owners are
also the managers, sometimes personal tax rates are better than corporate tax rates.
3. The primary disadvantage of the corporate form is the double taxation to shareholders of
distributed earnings and dividends. Some advantages include: limited liability, ease of
transferability, ability to raise capital, and unlimited life.
4. The treasurer’s office and the controller’s office are the two primary organizational
groups that report directly to the chief financial officer. The controller’s office handles cost
and financial accounting, tax management, and management information systems. The
treasurer’s office is responsible for cash and credit management, capital budgeting, and
financial planning. Therefore, the study of corporate finance is concentrated within the
functions of the treasurer’s office.
5. To maximize the current market value (share price) of the equity of the firm (whether it’s
publicly traded or not).
6. In the corporate form of ownership, the shareholders are the owners of the firm. The
shareholders elect the directors of the corporation, who in turn appoint the firm’s
management. This separation of ownership from control in the corporate form of
organization is what causes agency problems to exist. Management may act in its own or
someone else’s best interests, rather than those of the shareholders. If such events occur,
they may contradict the goal of maximizing the share price of the equity of the firm.
7. A primary market transaction.
8. In auction markets like the NYSE, brokers and agents meet at a physical location (the
exchange) to buy and sell their assets. Dealer markets like NASDAQ represent dealers
, operating in dispersed locales who buy and sell assets themselves, usually communicating
with other dealers electronically or literally over the counter.
9. Since such organizations frequently pursue social or political missions, many different
goals are conceivable. One goal that is often cited is revenue minimization; i.e., providing
their goods and services to society at the lowest possible cost. Another approach might be to
observe that even a not-for-profit business has equity. Thus, an appropriate goal would be to
maximize the value of the equity.
10. An argument can be made either way. At one extreme, we could argue that in a
market economy, all of these things are priced. This implies an optimal level of ethical
and/or illegal behavior and the framework of stock valuation explicitly includes these. At the
other extreme, we could argue that these are non-economic phenomena and are best handled
through the political process. The following is a classic (and highly relevant) thought
question that illustrates this debate: “A firm has estimated that the cost of improving the
safety of one of its products is $30 million. However, the firm believes that improving the
safety of the product will only save $20 million in product liability claims. What should the
firm do?”
11. The goal will be the same, but the best course of action toward that goal may
require adjustments due to different social, political, and economic climates.
12. The goal of management should be to maximize the share price for the current
shareholders. If management believes that it can improve the profitability of the firm so that
the share price will exceed $35, then they should fight the offer from the outside company. If
management believes that this bidder or other unidentified bidders will actually pay more
than $35 per share to acquire the company, then they should still fight the offer. However, if
the current management cannot increase the value of the firm beyond the bid price, and no
other higher bids come in, then management is not acting in the interests of the shareholders
by fighting the offer. Since current managers often lose their jobs when the corporation is
acquired, poorly monitored managers have an incentive to fight corporate takeovers in
situations such as this.
13. We would expect agency problems to be less severe in other countries, primarily
due to the relatively small percentage of individual ownership. Fewer individual owners
should reduce the number of diverse opinions concerning corporate goals. The high
percentage of institutional ownership might lead to a higher degree of agreement between
owners and managers on decisions concerning risky projects. In addition, institutions may
be able to implement more effective monitoring mechanisms than can individual owners,
given institutions’ deeper resources and experiences with their own management. The
increase in institutional ownership of stock in the United States and the growing activism of
these large shareholder groups may lead to a reduction in agency problems for U.S.
corporations and a more efficient market for corporate control.
14. How much is too much? Who is worth more, Michael Rapino or LeBron James?
The simplest answer is that there is a market for executives just as there is for all types of
labor. Executive compensation is the price that clears the market. The same is true for
,
, CHAPTER 1
INTRODUCTION TO CORPORATE
FINANCE
Answers to Concepts Review and Critical Thinking Questions
1. Capital budgeting (deciding on whether to expand a manufacturing plant), capital
structure (deciding whether to issue new equity and use the proceeds to retire outstanding
debt), and working capital management (modifying the firm’s credit collection policy with
its customers).
2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership,
difficulty in raising capital funds. Some advantages: simpler, less regulation, the owners are
also the managers, sometimes personal tax rates are better than corporate tax rates.
3. The primary disadvantage of the corporate form is the double taxation to shareholders of
distributed earnings and dividends. Some advantages include: limited liability, ease of
transferability, ability to raise capital, and unlimited life.
4. The treasurer’s office and the controller’s office are the two primary organizational
groups that report directly to the chief financial officer. The controller’s office handles cost
and financial accounting, tax management, and management information systems. The
treasurer’s office is responsible for cash and credit management, capital budgeting, and
financial planning. Therefore, the study of corporate finance is concentrated within the
functions of the treasurer’s office.
5. To maximize the current market value (share price) of the equity of the firm (whether it’s
publicly traded or not).
6. In the corporate form of ownership, the shareholders are the owners of the firm. The
shareholders elect the directors of the corporation, who in turn appoint the firm’s
management. This separation of ownership from control in the corporate form of
organization is what causes agency problems to exist. Management may act in its own or
someone else’s best interests, rather than those of the shareholders. If such events occur,
they may contradict the goal of maximizing the share price of the equity of the firm.
7. A primary market transaction.
8. In auction markets like the NYSE, brokers and agents meet at a physical location (the
exchange) to buy and sell their assets. Dealer markets like NASDAQ represent dealers
, operating in dispersed locales who buy and sell assets themselves, usually communicating
with other dealers electronically or literally over the counter.
9. Since such organizations frequently pursue social or political missions, many different
goals are conceivable. One goal that is often cited is revenue minimization; i.e., providing
their goods and services to society at the lowest possible cost. Another approach might be to
observe that even a not-for-profit business has equity. Thus, an appropriate goal would be to
maximize the value of the equity.
10. An argument can be made either way. At one extreme, we could argue that in a
market economy, all of these things are priced. This implies an optimal level of ethical
and/or illegal behavior and the framework of stock valuation explicitly includes these. At the
other extreme, we could argue that these are non-economic phenomena and are best handled
through the political process. The following is a classic (and highly relevant) thought
question that illustrates this debate: “A firm has estimated that the cost of improving the
safety of one of its products is $30 million. However, the firm believes that improving the
safety of the product will only save $20 million in product liability claims. What should the
firm do?”
11. The goal will be the same, but the best course of action toward that goal may
require adjustments due to different social, political, and economic climates.
12. The goal of management should be to maximize the share price for the current
shareholders. If management believes that it can improve the profitability of the firm so that
the share price will exceed $35, then they should fight the offer from the outside company. If
management believes that this bidder or other unidentified bidders will actually pay more
than $35 per share to acquire the company, then they should still fight the offer. However, if
the current management cannot increase the value of the firm beyond the bid price, and no
other higher bids come in, then management is not acting in the interests of the shareholders
by fighting the offer. Since current managers often lose their jobs when the corporation is
acquired, poorly monitored managers have an incentive to fight corporate takeovers in
situations such as this.
13. We would expect agency problems to be less severe in other countries, primarily
due to the relatively small percentage of individual ownership. Fewer individual owners
should reduce the number of diverse opinions concerning corporate goals. The high
percentage of institutional ownership might lead to a higher degree of agreement between
owners and managers on decisions concerning risky projects. In addition, institutions may
be able to implement more effective monitoring mechanisms than can individual owners,
given institutions’ deeper resources and experiences with their own management. The
increase in institutional ownership of stock in the United States and the growing activism of
these large shareholder groups may lead to a reduction in agency problems for U.S.
corporations and a more efficient market for corporate control.
14. How much is too much? Who is worth more, Michael Rapino or LeBron James?
The simplest answer is that there is a market for executives just as there is for all types of
labor. Executive compensation is the price that clears the market. The same is true for
