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The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.
Answers to Problem Sets
1. a. real
b. executive airplanes
c. brand names
d. financial
e. bonds
*f. investment or capital budgeting
*g. capital budgeting or investment
h. financing
*Note that f and g are interchangeable in the question.
Est time: 01-05
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets.
Real assets are identifiable as items with intrinsic value. The others in the list are financial assets,
that is, these assets derive value because of a contractual claim.
Est time: 01-05
3. a. Financial assets, such as stocks or bank loans, are claims held by investors.
Corporations sell financial assets to raise the cash to invest in real assets such as plant
and equipment. Some real assets are intangible.
b. Capital budgeting means investment in real assets. Financing means raising the cash for
this investment.
b. The shares of public corporations are traded on stock exchanges and can be purchased
by a wide range of investors. The shares of closely held corporations are not publicly
traded and are held by a small group of private investors.
d. Unlimited liability: Investors are responsible for all the firm’s debts. A sole proprietor has
unlimited liability. Investors in corporations have limited liability. They can lose their
investment, but no more.
4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can be
transferred without affecting operations, and managers can be fired with no effect on ownership.
Other forms of business may have unlimited liability and limited life.
Est time: 01-05
5. Separation of ownership and management typically leads to agency problems,
where managers prefer to consume private perks or make other decisions for their private
benefit—rather than maximize shareholder wealth.
Est time: 01-05
6. a. Assuming that the encabulator market is risky, an 8% expected return on
the F&H encabulator investments may be inferior to a 4% return on U.S.
government securities.
b. Unless their financial assets are as safe as U.S. government securities, their cost of
capital would be higher. The CFO could consider what the expected return is on assets
with similar risk.
Est time: 01-05
7. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their
pattern of consumption through borrowing and lending, match risk preferences, and hopefully
balance their own checkbooks (or hire a qualified professional to help them with these tasks).
Est time: 01-05
8. If the investment increases the firm’s wealth, it will increase the value of the firm’s shares. Ms.
Espinoza could then sell some or all of these more valuable shares in order to provide for her
retirement income.
Est time: 06-10
9. As the Goldman Sachs example illustrates, the firm’s value typically falls by significantly more
than the amount of any fines and settlements. The firm’s reputation suffers in a financial scandal,
and this can have a much larger effect than the fines levied. Investors may also wonder whether
all of the misdeeds have been contained.
Est time: 01-05
10. Managers would act in shareholders’ interests because they have a legal duty to act in their
interests. Managers may also receive compensation, either bonuses or stock and option payouts
whose value is tied (roughly) to firm performance. Managers may fear personal reputational
damage that would result from not acting in shareholders’ interests. And managers can be fired
by the board of directors, which in turn is elected by shareholders. If managers still fail to act in
shareholders’ interests, shareholders may sell their shares, lowering the stock price and
potentially creating the possibility of a takeover, which can again lead to changes in the board of
directors and senior management.
Est time: 01-05
11. Managers that are insulated from takeovers may be more prone to agency problems and
therefore more likely to act in their own interests rather than in shareholders’. If a firm instituted a
new takeover defense, we might expect to see the value of its shares decline as agency
problems increase and less shareholder value maximization occurs. The counterargument is that
defensive measures allow managers to negotiate for a higher purchase price in the face of a
takeover bid—to the benefit of shareholder value.
12. Answers will vary. The principles of good corporate governance discussed in the chapter should
apply.
Est time: 06-10
Appendix Questions:
1. Both would still 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 would be received
from lending at 20% ($100,000 × 1.20 = $120,000). G also invests, but borrows against the
$121,000 payment, and thus receives $100,833 ($121,.20) today.
Est time: 01-05
2. a. He could consume up to $200,000 now (forgoing all future consumption) or up to $216,000
next year ($200,000 × 1.08, forgoing all consumption this year). He should invest all of his wealth
to earn $216,000 next year. To choose the same consumption (C) in both years, C = ($200,000
– C) × 1.08 = $103,846.
Dollars Next Year
22 0,000
21 6,000
203,704
200,000
Dollars Now
b. He should invest all of his wealth to earn $220,000 ($200,000 × 1.10) next year. If he
consumes all this year, he can now have a total 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 available for next year’s
consumption is ($203,703.70 – C) × 1.08. To get equal consumption in both years, set the
amount consumed today equal to the amount next year:
How to Calculate Present Values
The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.
5. a. False. The opportunity cost of capital varies with the risks associated with each individual
project or investment. The cost of borrowing is unrelated to these risks.
b. True. The opportunity cost of capital depends on the risks associated with each project and
its cash flows.
c. True. The opportunity cost of capital is dependent on the rates of returns shareholders can
earn on the own by investing in projects with similar risks
d. False. Bank accounts, within FDIC limits, are considered to be risk-free. Unless an investment
is also risk-free, its opportunity cost of capital must be adjusted upward to account for
the associated risks.
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