, CHAPTER 1 il.
Introduction to Corporate Finance il. il. il.
The values shown in the solutions may be rounded for display purposes. However, the answers
il. il. il. il. il. il. il. il. il. il. il. il. il. il.
werederived using a spreadsheet without any intermediate rounding.
il. il. il. il. il. il. il. il. il.
Answers to Problem Sets il. il. il.
1. a. real
b. executive airplanes il.
c. brand names il.
d. financial
e. bonds
*f. investment or capital expenditure il. il. il.
*g. capital budgeting or investment il. il. il.
h. financing
*Note that f and g are interchangeable in the question.
il. il. il. il. il. il. il. il. il.
Est time: 01-05
il. il.
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real
il. il. il. il. il. il. il. il. il. il. il. il. il. il. il. il. il.
assets. Real assets are identifiable as items with intrinsic value. The others in the list are
il. il. il. il. il. il. il. il. il. il. il. il. il. il. il. il.
financial assets,that is, these assets derive value because of a contractual claim.
il. il. il. il. il. il. il. il. il. il. il. il. il.
Est time: 01-05
il. il.
3. a. Financial assets, such as stocks or bank loans, are claims held by investors. il. il. il. il. il. il. il. il. il. il. il. il .
Corporations sell financial assets to raise the cash to invest in real assets such as
il. il. il. il. il. il. il. il. il. il. il. il. il. il. il.
plantand equipment. Some real assets are intangible.
il. il. il. il. il. il. il. il.
b. Capital expenditure means investment in real assets. Financing means raising the
il. il. il. il. il. il. il. il. il. il.
cashfor this investment.
il. il. il. il.
c. The shares of public corporations are traded on stock exchanges and can be
il. il. il. il. il. il. il. il. il. il. il. il.
purchasedby a wide range of investors. The shares of closely held corporations are
il. il. il. il. il. il. il. il. il. il. il. il. il. il.
not publicly traded and are held by a small group of private investors.
il. il . il. il. il. il. il. il. il. il. il. il. il.
d. Unlimited liability: Investors are responsible for all the firm‘s debts. A sole proprietor
il. il. il. il. il. il. il. il. il. il. il. il.
hasunlimited liability. Investors in corporations have limited liability. They can lose
il. il. il. il. il. il. il. il. il. il. il. il.
their investment, but no more.
il. il. il. il. il.
Est time: 01-05
il. il.
,4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can
il. il. il. il. il. il. il. il. il. il. il. il. il.
betransferred without affecting operations, and managers can be fired with no effect on
il. il. il. il. il. il. il. il. il. il. il. il. il. il.
ownership. Other forms of business may have unlimited liability and limited life.
il. il. il. il. il. il. il. il. il. il. il. il.
Est time: 01-05
il. il.
5. Separation of ownership facilitates the key attributes of a corporation, including limited liability
il. il. il. il. il. il. il. il. il. il. il. il.
forinvestors, transferability of ownership, a separate legal personality of the corporation, and
il. il. il. il. il. il. il. il. il. il. il. il. il.
delegated centralized management. These four attributes provide substantial benefit for
il. il. il. il. il. il. il. il. il. il.
investors, including the ability to diversify their investment among many uncorrelated
il. il . il. il . il. il. il. il. i l. il. il.
returns—a very valuable tool explored in later chapters. Also, these attributes allow investors to
il. il. il. il. il. il. il. il. il. il. il. il. il. il.
quickly exit,enter, or short sell an investment, thereby generating an active liquid market for
il. il. il. il. il. il. il. il. il. il. il. il. il. il. il.
corporations.
il.
However, these positive aspects also introduce substantial negative externalities as well. The
il. il. il. il. il. il. il. il. il. il. i l .
separation of ownership from management typically leads to agency problems, where
il. il. il. il. il. il. il. il. il. il. il.
managersprefer to consume private perks or make other decisions for their private benefit—
il. il. il. il. il. il. il. il. il. il. il. il. il. il .
rather than maximize shareholder wealth. Shareholders tend to exercise less oversight of each
il. il. il. il. il. il. il. il. il. il. il. il.
individual investment as their diversification increases. Finally, the corporation‘s separate legal
il. il. il. il. il. il. il. il. il. il. il.
personalitymakes it difficult to enforce accountability if they externalize costs onto society.
il. il. il. il. il. il. il. il. il. il. il. il. il.
Est time: 01-05
il. il.
6. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their il. il. il. il. il. il. il. il. il. il. il.
pattern of consumption through borrowing and lending, match risk preferences, and
il. il. il. il. il. il. il. il. il. il. il.
hopefullybalance their own checkbooks (or hire a qualified professional to help them with
il. il. il. il. il. il. il. il. il. il. il. il. il. il.
these tasks).
il. il.
Est time: 01-05
il. il.
7. If the investment increases the firm‘s wealth, it increases the firm‘s share value. Ms.
il. il. il. il. il. il. il. il. il. il. il. il. il.
Espinozacould then sell some or all these more valuable shares to provide for her retirement
il. il. il. il. il. il. il. il. il. il. il. il. il. il. il. il.
income.
il.
Est time: 01-05
il. il.
8. a. Assuming that the encabulator market is risky, an 8% expected return il. il. il. il. il. il. il. il. il. il.
onthe F&H encabulator investments may be inferior to a 4% return on
il. il. il. il. il. il. il. il. il. il. il. il. il.
U.S.
il.
government securities, depending on the relative risk between the two assets. il. il. il. il. il. il. il. il. il. il.
b. Unless the financial assets are as safe as U.S. government securities, their cost of
il. il. il. il. il. il. il. il. il. il. il. il. il.
capitalwould be higher. The CFO could consider expected returns on assets with
il. il. il. il. il. il. il. il. il. il. il. il. il.
similar risk.
il. il.
Est time: 06-10
il. il.
9. Managers would act in shareholders‘ interests because they have a legal duty to act in their
il. il. il. il. il. il. il. il. il. il. il. il. il. il. il.
interests. Managers may also receive compensation— bonuses, stock, and option payouts
il. il. il . il. il. il. il . il. il. il . il.
with value tied (roughly) to firm performance. Managers may fear personal reputational damage
il. il. il. il. il. il. il. il. il. il. il. il. il.
from not acting in shareholders‘ interests. And managers can be fired by the board of directors
il. il. il. il. il. il. il. il. il. il. il. il. il. il. il. il.
(electedby shareholders). If managers still fail to act in shareholders‘ interests, shareholders
il. il. il. i l . il. il. il. il. il. il. il. il. il.
may sell their shares, lowering the stock price and potentially creating the possibility of a
il. il. il. il. il. il. il. il. il. il. il. il. il. il. il.
, takeover, which can again lead to changes in the board of directors and senior management.
il. il. il. il. il. il. il. il. il. il. il. il. il. il. il.
Est time: 01-05
il. il.
