,CHAPTER 1
INTRODUCTION TO CORPORATE
FINANCE
Answers to Concepts Review and Critical Thinking Questions
1. Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding
whether to issue new equity and use the proceeds to retire outstanding debt), and working capital
management (modifying the firm‗s credit collection policy with its customers).
2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, difficulty in
raising capital funds. Some advantages: simpler, less regulation, the owners are also the managers,
sometimes personal tax rates are better than corporate tax rates.
3. The primary disadvantage of the corporate form is the double taxation to shareholders of distributed
earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to
raise capital, and unlimited life.
4. In response to Sarbanes-Oxley, small firms have elected to go dark because of the costs of
compliance. The costs to comply with Sarbox can be several million dollars, which can be a large
percentage of a small firm‗s profits. A major cost of going dark is less access to capital. Since the
firm is no longer publicly traded, it can no longer raise money in the public market. Although the
company will still have access to bank loans and the private equity market, the costs associated with
raising funds in these markets are usually higher than the costs of raising funds in the public market.
5. The treasurer‗s office and the controller‗s office are the two primary organizational groups that
report directly to the chief financial officer. The controller‗s office handles cost and financial
accounting, tax management, and management information systems, while the treasurer‗s office is
responsible for cash and credit management, capital budgeting, and financial planning. Therefore,
the study of corporate finance is concentrated within the treasury group‗s functions.
6. To maximize the current market value (share price) of the equity of the firm (whether it‗s publicly
traded or not).
7. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders
elect the directors of the corporation, who in turn appoint the firm‗s management. This separation of
ownership from control in the corporate form of organization is what causes agency problems to
exist. Management may act in its own or someone else‗s best interests, rather than those of the
shareholders. If such events occur, they may contradict the goal of maximizing the share price of the
equity of the firm.
8. A primary market transaction.
,2 M SOLUTIONS MMANUAL
9. In Mauction Mmarkets Mlike Mthe MNYSE, Mbrokers Mand Magents Mmeet Mat Ma Mphysical Mlocation M(the
Mexchange) Mto Mmatch Mbuyers Mand Msellers Mof Massets. MDealer Mmarkets Mlike MNASDAQ Mconsist Mof
Mdealers Moperating Mat Mdispersed Mlocales Mwho Mbuy Mand Msell Massets Mthemselves, Mcommunicating
Mwith Mother Mdealers Meither Melectronically Mor Mliterally Mover-the-counter.
10. Such Morganizations Mfrequently Mpursue Msocial Mor Mpolitical Mmissions, Mso Mmany Mdifferent Mgoals Mare
Mconceivable. MOne Mgoal Mthat Mis Moften Mcited Mis Mrevenue Mminimization; Mthat Mis, Mprovide Mwhatever
Mgoods M and Mservices Mare Moffered Mat Mthe Mlowest Mpossible Mcost Mto Msociety. MA Mbetter Mapproach
Mmight Mbe Mto Mobserve Mthat Meven Ma Mnot-for-profit Mbusiness Mhas Mequity. MThus, Mone Manswer Mis
Mthat Mthe Mappropriate Mgoal Mis Mto Mmaximize Mthe Mvalue Mof Mthe Mequity.
11. Presumably, Mthe Mcurrent Mstock Mvalue Mreflects Mthe Mrisk, Mtiming, Mand Mmagnitude Mof Mall Mfuture
Mcash Mflows, Mboth Mshort-term Mand Mlong-term. MIf Mthis Mis Mcorrect, Mthen Mthe Mstatement Mis Mfalse.
12. An Margument Mcan Mbe Mmade Meither Mway. MAt Mthe Mone Mextreme, Mwe Mcould Margue Mthat Min Ma
Mmarket Meconomy, Mall Mof Mthese Mthings Mare Mpriced. MThere Mis Mthus Man Moptimal Mlevel Mof, Mfor
Mexample, Methical Mand/or Millegal Mbehavior, Mand Mthe Mframework Mof Mstock Mvaluation Mexplicitly
Mincludes Mthese. MAt Mthe Mother Mextreme, Mwe Mcould Margue Mthat Mthese Mare Mnoneconomic
Mphenomena Mand Mare Mbest Mhandled Mthrough Mthe Mpolitical Mprocess. MA Mclassic M(and Mhighly
Mrelevant) Mthought Mquestion Mthat Millustrates Mthis Mdebate Mgoes Msomething Mlike Mthis: M―A Mfirm
Mhas Mestimated Mthat Mthe Mcost Mof Mimproving Mthe Msafety Mof Mone Mof Mits Mproducts Mis M$30 Mmillion.
MHowever, Mthe Mfirm Mbelieves Mthat Mimproving Mthe Msafety Mof Mthe Mproduct Mwill Monly Msave M$20
Mmillion Min Mproduct Mliability Mclaims. MWhat Mshould Mthe Mfirm Mdo?‖
13. The Mgoal Mwill Mbe Mthe Msame, Mbut Mthe Mbest Mcourse Mof Maction Mtoward Mthat Mgoal Mmay Mbe Mdifferent
Mbecause Mof Mdiffering Msocial, Mpolitical, Mand Meconomic Minstitutions.
14. The Mgoal Mof Mmanagement Mshould Mbe Mto Mmaximize Mthe Mshare Mprice Mfor Mthe Mcurrent
Mshareholders. MIf Mmanagement Mbelieves Mthat Mit Mcan Mimprove Mthe Mprofitability Mof Mthe Mfirm Mso
Mthat Mthe Mshare Mprice Mwill Mexceed M$35, Mthen Mthey Mshould Mfight Mthe Moffer Mfrom Mthe Moutside
Mcompany. MIf Mmanagement Mbelieves Mthat Mthis Mbidder Mor Mother Munidentified Mbidders Mwill Mactually
Mpay Mmore Mthan M$35 Mper Mshare Mto Macquire Mthe Mcompany, Mthen Mthey Mshould Mstill Mfight Mthe
Moffer. MHowever, Mif Mthe Mcurrent Mmanagement Mcannot Mincrease Mthe Mvalue Mof Mthe Mfirm Mbeyond
Mthe Mbid Mprice, Mand Mno Mother Mhigher Mbids Mcome Min, Mthen Mmanagement Mis Mnot Macting Min Mthe
Minterests Mof Mthe Mshareholders Mby Mfighting Mthe Moffer. MSince Mcurrent Mmanagers Moften Mlose Mtheir
Mjobs Mwhen Mthe Mcorporation Mis Macquired, Mpoorly Mmonitored Mmanagers Mhave Man Mincentive Mto
Mfight Mcorporate Mtakeovers Min Msituations Msuch Mas Mthis.
15. We Mwould Mexpect Magency Mproblems Mto Mbe Mless Msevere Min Mcountries Mwith Ma Mrelatively Msmall
Mpercentage M of Mindividual Mownership. MFewer Mindividual Mowners Mshould Mreduce Mthe Mnumber Mof
Mdiverse Mopinions Mconcerning Mcorporate Mgoals. MThe Mhigh Mpercentage Mof Minstitutional Mownership
Mmight Mlead Mto Ma Mhigher Mdegree Mof Magreement Mbetween Mowners Mand Mmanagers Mon Mdecisions
Mconcerning Mrisky Mprojects. MIn Maddition, Minstitutions Mmay Mbe Mbetter Mable Mto Mimplement Meffective
Mmonitoring Mmechanisms Mon Mmanagers Mthan Mcan Mindividual Mowners, Mbased Mon Mthe Minstitutions‗
Mdeeper Mresources Mand Mexperiences Mwith Mtheir Mown Mmanagement. MThe Mincrease Min Minstitutional
Mownership Mof Mstock Min Mthe MUnited MStates Mand Mthe Mgrowing Mactivism Mof Mthese Mlarge
Mshareholder Mgroups Mmay Mlead Mto Ma Mreduction Min Magency Mproblems Mfor
U.S. Mcorporations Mand Ma Mmore Mefficient Mmarket Mfor Mcorporate Mcontrol.
, CHAPTER M2 M-
3
16. How Mmuch Mis Mtoo Mmuch? MWho Mis Mworth Mmore, MMark MParker Mor MLeBron MJames? MThe Msimplest
Manswer Mis Mthat Mthere Mis Ma Mmarket Mfor Mexecutives Mjust Mas Mthere Mis Mfor Mall Mtypes Mof Mlabor.
MExecutive Mcompensation Mis Mthe Mprice Mthat Mclears Mthe Mmarket. MThe Msame Mis Mtrue Mfor Mathletes
Mand Mperformers. MHaving Msaid Mthat, Mone Maspect Mof Mexecutive Mcompensation Mdeserves Mcomment.
MA Mprimary Mreason Mexecutive Mcompensation Mhas Mgrown Mso Mdramatically Mis Mthat Mcompanies
Mhave Mincreasingly Mmoved Mto Mstock-based Mcompensation. M Such Mmovement Mis Mobviously
Mconsistent Mwith Mthe Mattempt Mto Mbetter Malign Mstockholder Mand Mmanagement Minterests. MIn Mrecent
Myears, Mstock Mprices Mhave Msoared, Mso Mmanagement Mhas Mcleaned Mup. MIt Mis Msometimes Margued
Mthat Mmuch Mof Mthis Mreward Mis Mdue Mto Mrising Mstock Mprices Min Mgeneral, Mnot Mmanagerial
Mperformance. MPerhaps Min Mthe Mfuture, Mexecutive Mcompensation Mwill Mbe Mdesigned Mto Mreward Monly
Mdifferential Mperformance, Mthat Mis, Mstock Mprice Mincreases Min Mexcess Mof Mgeneral Mmarket Mincreases.
CHAPTER 2 M
FINANCIAL STATEMENTS, TAXES, AND M M M
CASH FLOW
M M
Answers Mto MConcepts MReview Mand MCritical MThinking MQuestions
1. Liquidity Mmeasures Mhow Mquickly Mand Measily Man Masset Mcan Mbe Mconverted Mto Mcash Mwithout
Msignificant Mloss Min Mvalue. MIt‗s Mdesirable Mfor Mfirms Mto Mhave Mhigh Mliquidity Mso Mthat Mthey Mhave Ma
Mlarge Mfactor Mof Msafety Min Mmeeting Mshort-term Mcreditor Mdemands. MHowever, Msince Mliquidity Malso
Mhas Man Mopportunity Mcost Massociated Mwith Mit—namely Mthat Mhigher Mreturns Mcan Mgenerally Mbe
Mfound Mby Minvesting Mthe Mcash Minto Mproductive Massets—low Mliquidity Mlevels Mare Malso Mdesirable
Mto Mthe Mfirm. MIt‗s Mup Mto Mthe Mfirm‗s Mfinancial Mmanagement Mstaff Mto Mfind Ma Mreasonable
Mcompromise Mbetween Mthese Mopposing Mneeds.
2. The Mrecognition Mand Mmatching Mprinciples Min Mfinancial Maccounting Mcall Mfor Mrevenues, Mand Mthe
Mcosts Massociated Mwith Mproducing Mthose Mrevenues, Mto Mbe M―booked‖ Mwhen Mthe Mrevenue Mprocess
Mis Messentially Mcomplete, Mnot Mnecessarily Mwhen Mthe Mcash Mis Mcollected Mor Mbills Mare Mpaid. MNote
Mthat Mthis Mway Mis Mnot Mnecessarily Mcorrect; Mit‗s Mthe Mway Maccountants Mhave Mchosen Mto Mdo Mit.
3. Historical Mcosts Mcan Mbe Mobjectively Mand Mprecisely Mmeasured Mwhereas Mmarket Mvalues Mcan Mbe
Mdifficult Mto Mestimate, Mand Mdifferent Manalysts Mwould Mcome Mup Mwith Mdifferent Mnumbers. MThus,
Mthere Mis Ma Mtrade-off Mbetween Mrelevance M(market Mvalues) Mand Mobjectivity M(book Mvalues).
4. Depreciation Mis Ma Mnoncash Mdeduction Mthat Mreflects Madjustments Mmade Min Masset Mbook Mvalues Min
Maccordance Mwith Mthe Mmatching Mprinciple Min Mfinancial Maccounting. MInterest Mexpense Mis Ma Mcash
Moutlay, Mbut Mit‗s Ma Mfinancing Mcost, Mnot Man Moperating Mcost.
5. Market Mvalues Mcan Mnever Mbe Mnegative. MImagine Ma Mshare Mof Mstock Mselling Mfor M–$20. MThis
Mwould Mmean M that Mif Myou Mplaced Man Morder Mfor M100 Mshares, Myou Mwould Mget Mthe Mstock Malong
Mwith Ma Mcheck Mfor M$2,000. MHow Mmany Mshares Mdo Myou Mwant Mto Mbuy? MMore Mgenerally, Mbecause
Mof Mcorporate Mand Mindividual Mbankruptcy Mlaws, Mnet Mworth Mfor Ma Mperson Mor Ma Mcorporation
Mcannot Mbe Mnegative, Mimplying Mthat Mliabilities Mcannot Mexceed Massets Min Mmarket Mvalue.
