CHAPTER 1 t
Introduction to Corporate Finance t t t
The values shown in the solutions may be rounded for display purposes. However, the answers
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werederived using a spreadsheet without any intermediate rounding.
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Answers to Problem Sets t t t
1. a. real
b. executive airplanes t
c. brand names t
d. financial
e. bonds
*f. investment or capital expenditure t t t
*g. capital budgeting or investment t t t
h. financing
*Note that f and g are interchangeable in the question.
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2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are
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all real assets. Real assets are identifiable as items with intrinsic value. The others in
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the list are financial assets,that is, these assets derive value because of a contractu
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al claim. t
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3. a.
Financial assets, such as stocks or bank loans, are claims held by inves
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tors. Corporations sell financial assets to raise the cash to invest in real ass
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, ets such as plantand equipment. Some real assets are intangible.
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b. Capital expenditure means investment in real assets. Financing means rais
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ing the cashfor this investment.
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c. The shares of public corporations are traded on stock exchanges and can
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be purchasedby a wide range of investors. The shares of closely held corp
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orations are not publicly traded and are held by a small group of private i
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nvestors.
d. Unlimited liability: Investors are responsible for all the firm‘s debts. A sole
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proprietor hasunlimited liability. Investors in corporations have limited lia
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bility. 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, ow
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nership can betransferred without affecting operations, and managers can be fir
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ed with no effect on ownership. Other forms of business may have unlimited liabilit
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y and limited life.
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5. Separation of ownership facilitates the key attributes of a corporation, including l
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imited liability forinvestors, transferability of ownership, a separate legal person
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ality of the corporation, and delegated centralized management. These four attri
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butes provide substantial benefit for investors, including the ability to diversify th
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eir investment among many uncorrelated returns—
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a very valuable tool explored in later chapters. Also, these attributes allow invest
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ors to quickly exit,enter, or short sell an investment, thereby generating an active li
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quid market for corporations.
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However, these positive aspects also introduce substantial negative externalities
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as well. The separation of ownership from management typically leads to agency
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problems, where managersprefer to consume private perks or make other decisio
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ns for their private benefit—
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rather than maximize shareholder wealth. Shareholders tend to exercise less over
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sight of each individual investment as their diversification increases. Finally, the cor
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poration‘s separate legal personalitymakes it difficult to enforce accountability if
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they externalize costs onto society.
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6. Shareholders will only vote to maximize shareholder wealth. Shareholders ca t t t t t t t t t
n modify their pattern of consumption through borrowing and lending, match ri
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sk preferences, and hopefullybalance their own checkbooks (or hire a qualifie
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d 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. M
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s. Espinozacould then sell some or all these more valuable shares to provide for h
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er retirement income.
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8. a.
Assuming that the encabulator market is risky, an 8% ex t t t t t t t t t
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, pected return onthe F&H encabulator investments may be inf
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erior to a 4% return on U.S.
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government securities, depending on the relative risk between the two assets.
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b.
Unless the financial assets are as safe as U.S. government securities, the
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ir cost of capitalwould be higher. The CFO could consider expected returns
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on assets with similar risk. t t t t
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9. Managers would act in shareholders‘ interests because they have a legal duty to a
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ct in their interests. Managers may also receive compensation—
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bonuses, stock, and option payouts with value tied (roughly) to firm performance.
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Managers may fear personal reputational damage from not acting in shareholde
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rs‘ interests. And managers can be fired by the board of directors (electedby share
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holders). If managers still fail to act in shareholders‘ interests, shareholders may se
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ll their shares, lowering the stock price and potentially creating the possibility of a t
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akeover, which can again lead to changes in the board of directors and senior man
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agement.
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