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