© 202 4 Cengage , ISBN: 9780357714485 . All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 Solution Manual for Corporate Finance A Focused Approach, 8th Edition Michael C. Ehrhardt and Eugene F. Brigham Chapter 1 -17 Chapter 1 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. Invest ment 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 e ntity 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 activit ies 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 partne rship. 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 timin g associated with expected earnings per share and cash flows are considered in order to maximize the price of the firm’s common stock. Maximiz ing shareholder’s wealth is a duty that needs to be fulfill by corporations. d. A money market is a financial mar ket 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 © 202 4 Cengage , ISBN: 9780357714485 . All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 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 mark et. 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 publi c 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 standar dization. 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 i s obtain ed 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 l ocation 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 sel l 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 mat ching 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 for eign 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 de bt. Foreign trade surplus occurs when exports are more than imports. A s 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 attemp ts 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 par ticular 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 © 202 4 Cengage , ISBN: 9780357714485 . All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 thousands of times a day. Most HFT is done by firms that are created for this pur pose 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 corporatio n 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 tra nsfer, 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) un limited 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 rep orts 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. Intrinsi c 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 redu ce 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 curr ent year will dec line 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 whi ch 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 gi ve 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 t o 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 inter mediary obtains funds from savers in exchange for its own securities. The intermediary uses this money to buy and hold © 202 4 Cengage , ISBN: 9780357714485 . All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 businesses’ securities. Intermediaries literally create new forms of capital. The existence of intermediaries greatly increases the effic iency of money and capital markets. 1-6 What are financial intermediaries, and what economic functions do they perform? Answer : Financial intermediaries are business organizations that receive funds in one form and repackage them for the use of those who need funds. Through financial intermediation, resources are allocated more effectively, and the real output of the economy is thereby increased. 1-7 Is an initial public offering an example of a primary or a secondary market transaction? Answer : A primary market is the market in which corporations raise capital by issuing new securities. An initial public offering is a stock issue where privately held firms go to public. Therefore, an IPO would be an example of a primary market transaction. A secondary off ering of stock by a publicly traded company is also a primary market transaction. Other examples include bond issuances by companies or governments. A secondary market is for buying and selling securities that have already been issued. For example, a stock exchange is a secondary market. 1-8 Contrast and compare trading in face -to-face auctions, dealer markets, and automated trading platforms. Answer : Traders meet face to face in an open outcry auction at a particular location at an agreed rate . In a deale r market, there are ―market makers‖ who keep an inventory of the stock. These dealers list the prices at which they are willing to buy or sell. In a traditional dealer market, computerized quotation systems keep track of all bid and ask quotes, but they do n’t actually match buyers and sellers. Instead, traders must contact a specific dealer to complete the transaction. An automated trading platform is a computer system in which buyers and sellers post their orders and then let the computer automatically det ermine whether a match exists. If a match exists, the computer automatically executes and reports the trade. 1-9 Describe some similarities and differences among broker -dealer networks, alternative trading systems (ATSs), and registered stock exchanges. Answer : Broker -dealer networks are registered with the SEC but are much less regulated than alternative trading systems (ATS) and registered stock exchanges. In a typical broker -dealer network, the broker -dealer purchases the stock being offered for sale by a client and then immediately sells it to another client who wished to buy the stock. The broker -dealer is the counterparty to each of the clients. The broker -dealer must report the transactions, but not any information prior to the trade. An alternative trading system is a broker -dealer that registers with the SEC as an ATS. An ATS usually has an automated trading platform to match orders from clients, so the owner of the ATS is not always the counterparty, in contrast to a broker -dealer network. The ATS must report trades, but not any pre -trade information. Therefore, an ATS is often called a dark pool. Stocks can only be listed at a registered stock exchange, although they may be traded elsewhere. A stock exchange must comply with more regulations than a n ATS. In addition to reporting trades, a stock exchange must also report pre -trade information regarding bids and quotes. 1-10 What are some similarities and differences between the NYSE and the NASDAQ Stock Market? Answer : The NYSE and NASDAQ are the two largest registered stock exchange around the globe . These stock exchange provides trading platform for securities situated in New York . The NYSE is a market that uses designated markets makers. NASDAQ is a dealer market where every makers is in competitio n with each other. The NASDAQ Stock Market has the most listings because it is willing to list smaller corporations
