CHAPTER 1
Introduction to Corporate Finance
Answers to Problem Sets
1. a. real
b. executive airplanes
c. brand names
d. financial
e. bonds
*f. investment or capital budgeting
*g. capital budgeting or investment
h. financing
*Note that f and g are interchangeable in the question.
Est time: 01-05
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are
all real assets. Real assets are identifiable items with intrinsic value. The others in
the list are financial assets, that is, these assets derive value because of a
contractual claim.
Est time: 01-05
3. a. Financial assets, such as stocks or bank loans, are claims held by
investors. Corporations sell financial assets to raise the cash to invest in
real assets such as plant and equipment. Some real assets are intangible.
b. Capital budgeting means investment in real assets. Financing means
raising the cash for this investment.
c. The shares of public corporations are traded on stock exchanges and can
be purchased by a wide range of investors. The shares of closely held
corporations are 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 has unlimited liability. Investors in corporations have limited
liability. They can lose their investment, but no more.
Est time: 01-05
4. Items c and d apply to corporations. Because corporations have perpetual life,
ownership can be transferred without affecting operations, and managers can be
fired with no effect on ownership. Other forms of business may have unlimited
liability and limited life.
Est time: 01-05
5. Separation of ownership and management typically leads to agency problems,
where managers prefer to consume private perks or make other decisions for
their private benefit—rather than maximize shareholder wealth.
Est time: 01-05
6. a. Assuming that the encabulator market is risky, an 8% expected return on
the F&H encabulator investments may be inferior to a 4% return on U.S.
government securities.
b. Unless their financial assets are as safe as U.S. government securities,
their cost of capital would be higher. The CFO could consider what the
expected return is on assets with similar risk.
Est time: 01-05
7. Shareholders will only vote for: (a) maximize shareholder wealth. Shareholders
can modify their pattern of consumption through borrowing and lending, match
risk preferences, and hopefully balance their own checkbooks (or hire a qualified
professional to help them with these tasks).
Est time: 01-05
8. If the investment increases the firm’s wealth, it will increase the value of the firm’s
shares. Ms. Espinoza could then sell some or all of these more valuable shares
in order to provide for her retirement income.
Est time: 06-10
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,9. As the Goldman Sachs example illustrates, the firm’s value typically falls by
significantly more than the amount of any fines and settlements. The firm’s
reputation suffers in a financial scandal, and this can have a much larger effect
than the fines levied. Investors may also wonder whether all of the misdeeds
have been contained.
Est time: 01-05
10. Managers would act in shareholders’ interests because they have a legal duty to
act in their interests. Managers may also receive compensation, either bonuses
or stock and option payouts whose value is tied (roughly) to firm performance.
Managers may fear personal reputational damage that would result from not
acting in shareholders’ interests. And managers can be fired by the board of
directors, which in turn is elected by shareholders. If managers still fail to act in
shareholders’ interests, shareholders may sell their shares, lowering the stock
price and potentially creating the possibility of a takeover, which can again lead
to changes in the board of directors and senior management.
Est time: 01-05
11. Managers that are insulated from takeovers may be more prone to agency
problems and therefore more likely to act in their own interests rather than in
shareholders’. If a firm instituted a new takeover defense, we might expect to
see the value of its shares decline as agency problems increase and less
shareholder value maximization occurs. The counterargument is that defensive
measures allow managers to negotiate for a higher purchase price in the face of
a takeover bid—to the benefit of shareholder value.
12. Answers will vary. The principles of good corporate governance discussed in the
chapter should apply.
Est time: 06-10
Appendix Questions:
1. Both would still invest in their friend’s business. A invests and receives $121,000
for his investment at the end of the year—which is greater than the $120,000 it
would receive from lending at 20% ($100,000 x 1.20 = $120,000). G also
invests, but borrows against the $121,000 payment, and thus receives $100,833
($121,.20) today.
Est time: 01-05
2. a. He could consume up to $200,000 now (forgoing all future consumption) or up
to $216,000 next year (200,000 x 1.08, forgoing all consumption this year). He
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, should invest all of his wealth to earn $216,000 next year. To choose the same
consumption (C) in both years, C = (200,000 – C) x 1.08, or C = $103,846.
Dollars Next Year
220,000
216,000
203,704
200,000
Dollars Now
b. He should invest all of his wealth to earn $220,000 ($200,000 x 1.10) next
year. If he consumes all this year, he can now have a total of
$203,703.70(200,000 x 1.10/1.08) this year or $220,000 next year. If he
consumes C this year, the amount available for next year’s consumption is
(203,703.7 – C) x 1.08. To get equal consumption in both years, set the amount
consumed today equal to the amount next year:
C = (203,703.70 – C) x 1.08
C = $105,769.20
Est time: 06-10
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