Corporate Finance A Focused Approach,
8th Edition by
Michael C. Ehrhardt
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Complete Chapter Solutions Manual are
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included (Ch 1 to 17)
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Solution and Answer Guide
CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT
T ABLE OF C ONTENTS
ANSWERS TO END-OF-CHAPTER QUESTIONS ......................................................... 1
MINI CASE............................................................................................. 5
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ANSWERS TO END-OF-CHAPTER QUESTIONS
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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
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d. Money market; capital market; primary market; secondary market
e. Private markets; public markets; derivatives
f. Investment bank; financial services corporation; financial intermediary
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g. Mutual fund; money market fund
h. Open outcry auction; dealer market; automated trading platform
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i. Production opportunities; time preferences for consumption
j. Foreign trade deficit
k. Algorithmic trading; high-frequency trading
Answer:
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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
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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
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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-
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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.
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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
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market.
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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
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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
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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
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examples of derivative market. Therefore, the value of a derivative security is derived
from the value of an underlying real asset.
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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
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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.
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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
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shareholders after the deduction of operating expenses. Different funds are
designed to meet different objectives. Money market funds are mutual funds
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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
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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
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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
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higher U.S. rates.
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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
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requires expensive computer systems and highly paid programmers.
What are the three principal forms of business organization? What are the
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advantages and disadvantages of each?
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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
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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
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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,
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complex, and time-consuming.
1-3 What is a firm’s fundamental value (which is also called its intrinsic value)? What might
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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?
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