SOLUTIONS MANUAL
CORPORATE FINANCE, A FOCUSED APPROACH
8TH EDITION
CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE
FINANCIAL ENVIRONMENT
ANSWERS TO END-OF-CHAPTER QUESTIONS
1-1 Define each of the following terms:
a. Proprietorship; partnership; corporation; charter; bylaws
b. Limited partnership; limited liability partnership; professional corporation
c. Stockholder wealth maximization
d. Money market; capital market; primary market; secondary market
e. Private markets; public markets; derivatives
f. Investment bank; financial services corporation; financial intermediary
g. Mutual fund; money market fund
h. Open outcry auction; dealer market; automated trading platform
i. Production opportunities; time preferences for consumption
j. Foreign trade deficit
k. Algorithmic trading; high-frequency trading
Answer:
a. A proprietorship, or sole proprietorship, is a business owned by one individual. A partnership exists when
two or more persons associate to conduct a business. In contrast, a corporation is a legal entity created by a
state. The corporation is separate and distinct from its owners and managers. A company must file a charter
to become a corporation. A charter includes the following information: (1) name of the proposed
corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and
(5) names and addresses of directors. The bylaws are a set of rules drawn up by the founders of the
corporation. Included are such points as: (1) how directors are to be elected (all elected each year or perhaps
one-third each year for 3-year terms), (2) whether the existing stockholders will have the first right to buy
any new shares the firm issues, and (3) procedures for changing the bylaws themselves, should conditions
require it.
b. In a limited partnership, limited partners’ liabilities, investment returns and control are limited, while
general partners have unlimited liability and control. In limited partnership, at least one partner is liable for
all the debts in the partnership. A limited liability partnership (LLP), sometimes called a limited liability
company (LLC), combines the limited liability advantage of a corporation with the tax advantages of a
, partnership. A professional corporation (PC), known in some states as a professional association (PA), has
most of the benefits of incorporation but the participants are not relieved of professional (malpractice)
liability.
c. Stockholder wealth maximization is the appropriate goal for management decisions. The risk and timing
associated with expected earnings per share and cash flows are considered in order to maximize the price
of the firm’s common stock. Maximizing shareholder’s wealth is a duty that needs to be fulfill by
corporations.
d. A money market is a financial market for debt securities with maturities of less than 1 year (short-
term). The New York money market is the example of money market. Capital markets are the financial
markets for long-term debt and corporate stocks. The New York Stock Exchange is an example of a
capital market. Primary markets are the markets in which newly issued securities are sold for the first
time. Secondary markets are where securities are resold after initial issue in the primary market. The
New York Stock Exchange is a secondary market.
e. In private markets, transactions are worked out directly between two parties and structured in any manners
that appeal to them. Bank loans and private placements of debt with insurance companies are examples of
private market transactions. In public markets, standardized contracts are traded on organized exchanges.
Securities that are issued in public markets, such as common stock and corporate bonds, are ultimately held
by a large number of individuals. Private market securities are more tailor-made but less liquid, whereas
public market securities are more liquid but subject to greater standardization. Derivatives are those
underlying asset that derives their value from other traded assets. Futures, options, forwards are the
examples of derivative market. Therefore, the value of a derivative security is derived from the value of an
underlying real asset.
f. An investment banker is a facilitator between businesses and savers. Investment banking houses assist in
the design of corporate securities and then sell them to savers (investors) in the primary markets. Financial
service corporations offer a wide range of financial services such as brokerage operations, insurance, and
commercial banking. A financial intermediary buys security with funds that is obtained by issuing its own
securities. An example is a common stock mutual fund that buys common stocks with funds obtained by
issuing shares in the mutual fund.
g. A mutual fund is an organization that pools the money deposited by savers to buy financial
instruments. These instruments receive dividends and interest on it. The resulting dividends, interest,
and capital gains are distributed to the fund’s shareholders after the deduction of operating expenses.
Different funds are designed to meet different objectives. Money market funds are mutual funds which
invest in short-term securities carry low-risk and also offer their shareholders interest-bearing
checking accounts.
, h. An open outcry auction is a method where traders meet face to face at particular location at an agreed
price and quantity. These traders communicate with each other through hand signals and shouts. In a
dealer market, a dealer holds an inventory of the security and makes a market by offering to buy or
sell. Others who wish to buy or sell can see the offers made by the dealers, and can contact the dealer
of their choice to arrange a transaction. An automated trading platform is a computer system in which
buyers and sellers post orders and in which trades are automatically executed for matching orders.
i. Production opportunities are the cash generating activity that require cash in the present but have the
ability to generate more cash in future. The higher the production opportunities, the more cash will be
demanded now. Consumption time preferences refer to the preferred pattern of consumption.
Consumers’ time preferences for consumption establish how much consumption they are willing to
save or consume at different levels of interest. It majorly impacts required rate of return.
j. A foreign trade deficit occurs when businesses and individuals in the United States import more goods
from foreign countries compared to exports. This cause an increase in an interest rate. Trade deficits
must be financed, and the main source of financing is debt. Foreign trade surplus occurs when exports
are more than imports. As the trade deficit increases, the debt financing increases, driving up interest
rates. U.S. interest rates must be competitive with foreign interest rates; if the Federal Reserve attempts
to set interest rates lower than foreign rates, foreigners will sell U.S. bonds, decreasing bond prices,
resulting in higher U.S. rates.
k. Algorithmic trading occurs when computers are programed to buy or sell stocks on behalf of
stockholders if a particular event or sequence of events happens. High frequency trading (HFT) is a
type of algorithmic trading in which HFT traders, which are computers, buy and sell hundreds or
thousands of times a day. Most HFT is done by firms that are created for this purpose because HFT
requires expensive computer systems and highly paid programmers.
1-2 What are the three principal forms of business organization? What are the advantages and disadvantages
of each?
Answer:
Sole proprietorship, partnership, and corporation are the three principal forms of business organization.
The advantages of the Sole proprietorship and partnership includes ease and low cost of formation. The
advantages of the corporation include limited liability, indefinite life, ease of ownership transfer, and access
to capital markets.
The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums of capital, (2)
unlimited personal liability for business debts, and (3) limited life. The disadvantages of a partnership are
(1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising
large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2)
, requirements to file state and federal reports for registration, which are expensive, complex, and time-
consuming.
1-3 What is a firm’s fundamental value (which is also called its intrinsic value)? What might cause a firm’s intrinsic
value to be different from its actual market value?
Answer:
A firm’s fundamental, or intrinsic, value is the present value of its free cash flows when discounted at the
weighted average cost of capital. If the market price reflects all relevant information, then the observed
price is also the intrinsic price. Intrinsic value depends on all of its expected future cash flows.
1-4 Edmund Corporation recently made a large investment to upgrade its technology. Although these improvements
won’t have much of an impact on performance in the short run, they are expected to reduce future costs
significantly. What impact will this investment have on Edmund’s earnings per share this year? What impact
might this investment have on the company’s intrinsic value and stock price?
Answer:
Earnings per share in the current year will decline due to cost of the investment made in the current year
and no significant performance impact in the short run. However, the company’s stock price should
increase due to the significant cost savings expected in the future.
1-5 Describe the ways in which capital can be transferred from suppliers of capital to those who are demanding
capital.
Answer:
In a well-functioning economy, capital will flow efficiently from those who supply capital to those who
demand it. This transfer of capital can take place in three different ways:
1. Direct transfers of money and securities occur when a business sells its stocks or bonds directly to
savers, without going through any type of financial institution. The business delivers its securities to
savers, who in turn give the money to the firm it needs.
2. Capital can also be transferred indirectly through an investment bank that underwrites the issue. An
underwriter serves as a middleman and facilitates the issuance of securities. The company sells its
stocks or bonds to the investment bank, which in turn sells these same securities to savers. The
businesses’ securities and the savers’ money merely “pass through” the investment banking house.
3. Transfers can also be made through a financial intermediary. Here, the intermediary obtains funds
from savers in exchange for its own securities. The intermediary uses this money to buy and hold
businesses’ securities. Intermediaries literally create new forms of capital. The existence of
intermediaries greatly increases the efficiency of money and capital markets.
