,Chapter 1
Introduction To Corporate Finance
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 Expenditure
*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.
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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 Expenditure Means Investment In Real Assets. Financing Means Raising The
Cash For This Investment.
c. 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.
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,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.
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5. Separation Of Ownership Facilitates The Key Attributes Of A Corporation, Including Limited
Liability For Investors, Transferability Of Ownership, A Separate Legal Personality Of The
Corporation, And Delegated Centralized Management. These Four Attributes Provide
Substantial Benefit For Investors, Including The Ability To Diversify Their Investment Among
Many Uncorrelated Returns—A Very Valuable Tool Explored In Later Chapters. Also, These
Attributes Allow Investors To Quickly Exit, Enter, Or Short Sell An Investment, Thereby
Generating An Active Liquid Market For Corporations.
However, These Positive Aspects Also Introduce Substantial Negative Externalities As Well. The
Separation Of Ownership From 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. Shareholders Tend To Exercise Less Oversight Of
Each Individual Investment As Their Diversification Increases. Finally, The Corporation‘S
Separate Legal Personality Makes It Difficult To Enforce Accountability If They Externalize Costs
Onto Society.
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6. 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).
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7. If The Investment Increases The Firm‘S Wealth, It Increases The Firm‘S Share Value. Ms.
Espinoza Could Then Sell Some Or All These More Valuable Shares To Provide For Her
Retirement Income.
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8. 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, Depending On The Relative Risk Between The Two Assets.
b. Unless The Financial Assets Are As Safe As U.S. Government Securities, Their Cost Of
Capital Would Be Higher. The Cfo Could Consider Expected Returns On Assets With
Similar Risk.
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9. Managers Would Act In Shareholders‘ Interests Because They Have A Legal Duty To Act In Their
Interests. Managers May Also Receive Compensation— Bonuses, Stock, And Option Payouts
With Value Tied (Roughly) To Firm Performance. Managers May Fear Personal Reputational
Damage From Not Acting In Shareholders‘ Interests. And Managers Can Be Fired By The Board
Of Directors (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.
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