SOLUTION MANUAL FOR . .
Fundamentals.Of.Corporate.Finance.11ce.Stephen.A..Ross,.Randolph.W..Westerfield,.Bradfo
rd.D..Jordan,.J..Ari.Pandes,.Thomas.Holloway
Chapter1-26 .
CHAPTER 1 .
INTRODUCTIONTOCORPORATE FINANCE . . .
Learning.Objectives
LO1. The.basic.types.of.financial.management.decisions.and.the.role.of.the.financial.manager.
LO2. The.financial.implications.of.the.different.forms.of.business.organization.
LO3. The.goal.of.financial.management.
LO4. The.conflicts.of.interests.that.can.arise.between.managers.and.owners.
LO5. The.roles.of.financial.institutions.and.markets.
LO6. Types.of.financial.institutions.
LO7. Trends.in.financial.markets.
Answers.to.Concepts.Review.and.Critical.Thinking.Questions
1. (LO1).Capital.budgeting.(deciding.on.whether.to.expand.a.manufacturing.plant),.capital.structure.(decidi
ng.whether.to.issue.new.equity.and.use.the.proceeds.to.retire.outstanding.debt),.and.working.capital.manag
ement.(modifying.the.firm‘s.credit.collection.policy.with.its.customers)..(LO1)
2. (LO2).Disadvantages:.unlimited.liability,.limited.life,.difficulty.in.transferring.ownership,.hard.to.raise.ca
pital.funds..Some.advantages:.simpler,.less.regulation,.the.owners.are.also.the.managers.
3. (LO2).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,.unlimited.life,.and.so.forth.
4. (LO4).The.treasurer‘s.office.and.the.controller‘s.office.are.the.two.primary.organizational.groups.that.repo
rt.directly.to.the.chief.financial.officer..The.controller‘s.office.handles.cost.and.financial.accounting,.tax.m
anagement,.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.
5. (LO3).To.maximize.the.current.market.value.(share.price).of.the.equity.of.the.firm.(whether.it‘s.publicly-
traded.or.not).
6. (LO4).In.the.corporate.form.of.ownership,.the.shareholders.are.the.owners.of.the.firm..The.shareholders.el
ect.the.directors.of.the.corporation,.who.in.turn.appoint.the.firm‘s.management..This.separation.of.owners
hip.from.control.in.the.corporate.form.of.organization.is.what.causes.agency.problems.to.exist..Manageme
nt.may.act.in.its.own.or.someone.else‘s.best.interests,.rather.than.those.of.the.shareholders..If.such.events.o
ccur,.they.may.contradict.the.goal.of.maximizing.the.share.price.of.the.equity.of.the.firm.
7. (LO5).A.primary.market.transaction..A.secondary.market.transaction.would.entail.the.sale.between.two.3r
d.parties.(i.e..not.the.corporation).
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,8. (LO5).In.auction.markets.like.the.Toronto.Stock.Exchange.(TSX),.brokers.and.agents.meet.at.a.central.loc
ation.(the.exchange).to.match.buyers.and.sellers.of.assets..Physical.locations.for.stock.markets.are.disappe
aring.as.trading.becomes.more.electronic..Dealer.markets.like.Nasdaq.consist.of.dealers.operating.at.dispe
rsed.locales.who.buy.and.sell.assets.themselves,.communicating.with.other.dealers.either.electronically.or.
literally.over-the-
counter..Dealer.markets.are.less.transparent.than.auction.markets.where.trades.are.reported.publicly.almos
t.immediately.. The.auction.market.run.by.the.TSX.is.where.the.stocks.of.larger.Canadian.companies.are.tr
aded;.the.TSX.also.operates.a.dealer.market.called.the.Venture.Exchange.for.companies.too. small.to.qualif
y.for.the.TSX.auction. exchange.
9. (LO3).Such.organizations.frequently.pursue.social.or.political.missions,.so.many.different.goals.are.conce
ivable..One.goal.that.is.often.cited.is.revenue.minimization;.i.e.,.provide.whatever.goods.and.services.are.o
ffered.at.the.lowest.possible.cost.to.society..Another.would.be.to.best.serve.the.maximum.possible.number.
of.stakeholders.at.the.lowest.cost..A.better.approach.might.be.to.observe.that.even.a.not-for-
profit.business.has.equity..Thus,.one.answer.is.that.the.appropriate.goal.is.to.maximize.the.value.of.the.equi
ty.
10. (LO3).Presumably,.the.current.stock.value.reflects.the.risk,.timing,.and.magnitude.of.all.future.cash.flows,.
both.short-term.and.long-term..If.this.is.correct,.then.the.statement.is.false.
11. (LO3).An.argument.can.be.made.either.way..At.the.one.extreme,.we.could.argue.that.in.a.market.economy,.
all.of.these.things.are.priced..There.is.thus.an.optimal.level.of,.for.example,.ethical.and/or.illegal.behavior,.
and.the.framework.of.stock.valuation.explicitly.includes.these..At.the.other.extreme,.we.could.argue.that.th
ese.are.non-
economic.phenomena.and.are.best.handled.through.the.political.process..A.classic.(and.highly.relevant).th
ought.question.that.illustrates.this.debate.goes.something.like.this:.―A.firm.has.estimated.that.the.cost.of.i
mproving.the.safety.of.one.of.its.products.is.$30.million..However,.the.firm.believes.that.improving.the.saf
ety.of.the.product.will.only.save.$20. million.in.product.liability.claims.and.lost.customer.goodwill..What.s
hould.the.firm.do?‖
12. (LO3).The.goal.will.be.the.same,.but.the.best.course.of.action.toward.that.goal.may.be.different.because.of.
differing.social,.political,.and.economic.institutions.
13. (LO4).The.goal.of.management.should.be.to.maximize.the.share.price.for.the.current.shareholders..If.man
agement.believes.that.it.can.improve.the.profitability.of.the.firm.so.that.the.share.price.will.exceed.$35,.the
n.they.should.fight.the.offer.from.the.outside.company..If.management.believes.that.this.bidder.or.other.uni
dentified.bidders.will.actually.pay.more.than.$35.per.share.to.acquire.the.company,.then.they.should.still.fi
ght.the.offer..However,.if.the.current.management.cannot.increase.the.value.of.the.firm.beyond.the.bid.pric
e,.and.no.other.higher.bids.come.in,.then.management.is.not.acting.in.the.interests.of.the.shareholders.by.fig
hting.the.offer..Since.current.managers.often.lose.their.jobs.when.the.corporation.is.acquired,.poorly.monit
ored.managers.have.an.incentive.to.fight. corporate.takeovers.in.situations.such.as.this.
14. (LO4).We.would.expect.agency.problems.to.be.less.severe.in.other.countries,.primarily.due.to.the.relativel
y.small.percentage.of.individual.ownership..Fewer.individual.owners.means.that.each.individual.owner.ha
s.a.greater.incentive.to.monitor.and.control.the.firm—i.e..there.is.less.free-
riding..The.high.percentage.of.institutional.ownership.might.lead.to.a.higher.degree.of.agreement.between.
owners.and.managers.on.decisions.concerning.risky.projects..In.addition,.institutions.may.be.better.able.to.
implement.effective.monitoring.mechanisms.on.managers.than.can.individual.owners,.based.on.the.institu
tions‘.deeper.resources.and.experiences.with.their.own.management..The.increase.in.institutional.ownersh
ip.of.stock.in.Canada.and.in.the.United.States.and.the.growing.activism.of.these.large.shareholder.groups.m
ay.lead.to.a.reduction.in.agency.problems.for.Canadian.and.U.S..corporations.and.a.more.efficient.market.f
or.corporate.control.
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,15. (LO5).Major.institutions:
Chartered.banks.-
accept.deposits.and.issue.commercial.loans,.corporate.loans,.personal.loans.and.mortgages.
Trust.companies-
accept.deposits.and.make.loans,.but.also.engage.in.fiduciary.activities.such.as.managing.assets.for.estates,.
registered.retirement.savings.plans,.etc.
Investment.dealers.-non-depository.institutions.that.assist.firms.in.issuing.new.securities.
Insurance.companies.-
engage.in.indirect.financing.by.accepting.funds.in.a.form.similar.to.a.deposit.and.making.loans.
Pension.funds.-
invest.contributions.from.employers.and.employees.in.securities.offered.by.financial.markets.
Mutual.funds.-pool.individual.investments.to.purchase.a.diversified.portfolio.
Hedge.funds.-
cater.to.sophisticated.investors.and.seek.high.returns.by.using.aggressive.financial.strategies.prohibited.by.
mutual.funds.
Note.that.larger.financial.institutions.may.embody.many.of.these.different.institution..For.example,.CIBC.
is.a.chartered.bank.that.owns.an.investment.dealer.and.mutual.funds..Furthermore,.it.has.an.insurance.arm.
―CIBC.Insurance‖
Major.markets:
Money.market.-financial.markets.where.short-term.debt.instruments.are.bought.and.sold.
Capital.markets.-financial.markets.where.long-
term.debt.and.equity.securities.are.bought.and.sold..Derivatives.markets.–
.where.options.and.futures.are.traded.on.financial.instruments.and.commodities.Primary. markets. are. whe
re. securities. are. sold. for. the. first. time;. secondary. markets. are. where.outstanding.securities.trade.
16. (LO5).Spread.versus.Fee.Income:
Banks.earn.spread.or.interest.income.by.borrowing.from.depositors.and.lending.to.borrowers.(at.a.higher.yield)..
An.example.is.a.retail.deposit.and.a.mortgage..Banks.make.non-
interest.or.fee.income.when.they.charge.commissions.or.fees.for.services..An.example.is.an.overdraft.fee.or.AT
M.fee,.or.the.example.in.the.text,.the.stamping.fee.on.a.banker‘s.acceptance.(which.is.a.form.of.insurance.and.arra
nging.fee).
17. (LO5).Trends:
Financial.engineering.-
the.creation.of.new.securities.or.financial.processes..This.engineering.could.be.used.to.package.and.sell.ris
ky.assets.to.investors;.for.example,.banks.can.package.and.sell.mortgages.into.mortgage.backed.securities.
and.sell.these.on.to.other.investors.
Derivative.securities.-
options,.futures,.forwards,.and.other.securities.whose.value.is.derived.from.the.price.of.another,.underlyin
g.asset.. For.example,.a.futures.contract.to.purchase.oil.sets.a.fixed.purchase/selling.price.for.a.future.date,.
but.its.value.depends.on.the.price.of.oil..These.derivatives.can.help.businesses.divest.risks.that.are.not.core.t
o.their.business,.such.as.foreign.exchange.and.input.price.(like.oil).risk.
Regulatory.dialectic.-
the.pressures.that.financial.institutions.and.regulatory.bodies.exert.on.each. other.. For.example,.when.restr
ictions.are.removed,.growth.opportunities.may.increase.. However,.the.absence.of.regulatory.restrictions.
may.also.lead.to.problems.such.as.the.global.financial.crisis.starting.in.2007.caused.by.excessive.financial.l
everage,.so.it.is.important.that.there.be.an.appropriate.level.of.regulatory.oversight.
ESG.–
Investors.and.corporations.(and.their.many.stakeholders).are.increasingly.focused.on.Environmental,.Soci
etal,.and.Governance.issues..This.includes.employee.and.customer.welfare.as.well.as.climate.change.and.p
ollution.
Ross.et.al,.Fundamentals.of.Corporate.Finance.11th.Canadian.Edition.Solutions.Manual
©.2022.McGraw-Hill.Education.Ltd.
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, These.trends.have.made.financial.management.a.much.more.complex.and.technical.activity.
CHAPTER 2 .
FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
. . . . .
Learning.Objectives
LO1. The.difference.between.accounting.value.(or.―book‖.value).and.market.value.
LO2. The.difference.between.accounting.income.and.cash.flow.
LO3. How.to.determine.a.firm‘s.cash.flow.from.its.financial.statements.
LO4. The.difference.between.average.and.marginal.tax.rates.
LO5. The.basics.of.Capital.Cost.Allowance.(CCA).and.Undepreciated.Capital.Cost.(UCC).
Answers.to.Concepts.Review.and.Critical.Thinking.Questions
1. (LO1).Liquidity.measures.how.quickly.and.easily.an.asset.can.be.converted.to.cash.without.significant.los
s.in.value..It‘s.desirable.for.firms.to.have.high.liquidity.so.that.they.have.a.large.factor.of.safety.in.meeting.s
hort-term.creditor.demands..However,.since.liquidity.also.has.an.opportunity.cost.associated.with.it—
namely.that.higher.returns.can.generally.be.found.by.investing.the.cash.into.productive.assets—
low.liquidity.levels.are.also.desirable.to.the.firm..It‘s.up.to.the.firm‘s.financial.management.staff.to.find.a.re
asonable.compromise.between.these.opposing.needs.
2. (LO2).The.recognition.and.matching.principles.in.financial.accounting.call.for.revenues,.and.the. costs.ass
ociated.with.producing.those.revenues,.to.be.―booked‖.when.the.revenue.process.is.essentially.complete,.
not.necessarily.when.the.cash.is.collected.or.bills.are.paid..Note.that.this.way.is.not.necessarily.incorrect;.it‘
s.the.way.accountants.have.chosen.to.do.it.
3. (LO1).Historical.costs.can.be.objectively.and.precisely.measured.whereas.market.values.can.be.difficult.t
o.estimate,.and.different.analysts.would.come.up.with.different.numbers..Thus,.there.is.a.tradeoff.between.
relevance.(market.values).and.objectivity.(book.values).
4. (LO3).Depreciation.is.a.noncash.deduction.that.reflects.adjustments.made.in.asset.book.values.in.accorda
nce.with.the.matching.principle.in.financial.accounting..Interest.expense.is.a.cash.outlay,.but.it‘s.a.financin
g.cost,.not.an.operating.cost.
5. (LO1). Market. values. for. corporations. can. never. be. negative.. Imagine. a. share. of. stock. selling. for. –
$20..This.would.mean.that.if.you.placed.an.order.for.100.shares,.you.would.get.the.stock.along.with.a.check.
for.$2,000..How.many.shares.do.you.want.to.buy?.More.generally,.because.of.corporate.bankruptcy.laws,.
net.worth.for.a.corporation.cannot.be.negative,.implying.that.liabilities.cannot.exceed.assets.in.market.valu
e.
6. (LO3).For.a.successful.company.that.is.rapidly.expanding,.for.example,.capital.outlays.will.be.large,.possi
bly.leading.to.negative.cash.flow.from.assets..In.general,.what.matters.is.whether.the.money.is.spent.wisely
,.not.whether.cash.flow.from.assets.is.positive.or.negative.
7. (LO3).It‘s.probably.not.a.good.sign.for.an.established.company,.but.it.would.be.fairly.ordinary.for.a.start-
up,.so.it.depends.
8. (LO3).For.example,.if.a.company.were.to.become.more.efficient.in.inventory.management,.the.amount.of.
inventory.needed.would.decline..The.same.might.be.true.if.it.becomes.better.at.collecting.its.receivables..I
n.general,.anything.that.leads.to.a.decline.in.ending.NWC.relative.to.beginning. would.have.this.effect..Neg
ative.net.capital.spending.would.mean.more.long-lived.assets.were.liquidated.than.purchased.
Ross.et.al,.Fundamentals.of.Corporate.Finance.11th.Canadian.Edition.Solutions.Manual
©.2022.McGraw-Hill.Education.Ltd.
7-4
Fundamentals.Of.Corporate.Finance.11ce.Stephen.A..Ross,.Randolph.W..Westerfield,.Bradfo
rd.D..Jordan,.J..Ari.Pandes,.Thomas.Holloway
Chapter1-26 .
CHAPTER 1 .
INTRODUCTIONTOCORPORATE FINANCE . . .
Learning.Objectives
LO1. The.basic.types.of.financial.management.decisions.and.the.role.of.the.financial.manager.
LO2. The.financial.implications.of.the.different.forms.of.business.organization.
LO3. The.goal.of.financial.management.
LO4. The.conflicts.of.interests.that.can.arise.between.managers.and.owners.
LO5. The.roles.of.financial.institutions.and.markets.
LO6. Types.of.financial.institutions.
LO7. Trends.in.financial.markets.
Answers.to.Concepts.Review.and.Critical.Thinking.Questions
1. (LO1).Capital.budgeting.(deciding.on.whether.to.expand.a.manufacturing.plant),.capital.structure.(decidi
ng.whether.to.issue.new.equity.and.use.the.proceeds.to.retire.outstanding.debt),.and.working.capital.manag
ement.(modifying.the.firm‘s.credit.collection.policy.with.its.customers)..(LO1)
2. (LO2).Disadvantages:.unlimited.liability,.limited.life,.difficulty.in.transferring.ownership,.hard.to.raise.ca
pital.funds..Some.advantages:.simpler,.less.regulation,.the.owners.are.also.the.managers.
3. (LO2).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,.unlimited.life,.and.so.forth.
4. (LO4).The.treasurer‘s.office.and.the.controller‘s.office.are.the.two.primary.organizational.groups.that.repo
rt.directly.to.the.chief.financial.officer..The.controller‘s.office.handles.cost.and.financial.accounting,.tax.m
anagement,.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.
5. (LO3).To.maximize.the.current.market.value.(share.price).of.the.equity.of.the.firm.(whether.it‘s.publicly-
traded.or.not).
6. (LO4).In.the.corporate.form.of.ownership,.the.shareholders.are.the.owners.of.the.firm..The.shareholders.el
ect.the.directors.of.the.corporation,.who.in.turn.appoint.the.firm‘s.management..This.separation.of.owners
hip.from.control.in.the.corporate.form.of.organization.is.what.causes.agency.problems.to.exist..Manageme
nt.may.act.in.its.own.or.someone.else‘s.best.interests,.rather.than.those.of.the.shareholders..If.such.events.o
ccur,.they.may.contradict.the.goal.of.maximizing.the.share.price.of.the.equity.of.the.firm.
7. (LO5).A.primary.market.transaction..A.secondary.market.transaction.would.entail.the.sale.between.two.3r
d.parties.(i.e..not.the.corporation).
Ross.et.al,.Fundamentals.of.Corporate.Finance.11th.Canadian.Edition.Solutions.Manual
©.2022.McGraw-Hill.Education.Ltd.
7-1
,8. (LO5).In.auction.markets.like.the.Toronto.Stock.Exchange.(TSX),.brokers.and.agents.meet.at.a.central.loc
ation.(the.exchange).to.match.buyers.and.sellers.of.assets..Physical.locations.for.stock.markets.are.disappe
aring.as.trading.becomes.more.electronic..Dealer.markets.like.Nasdaq.consist.of.dealers.operating.at.dispe
rsed.locales.who.buy.and.sell.assets.themselves,.communicating.with.other.dealers.either.electronically.or.
literally.over-the-
counter..Dealer.markets.are.less.transparent.than.auction.markets.where.trades.are.reported.publicly.almos
t.immediately.. The.auction.market.run.by.the.TSX.is.where.the.stocks.of.larger.Canadian.companies.are.tr
aded;.the.TSX.also.operates.a.dealer.market.called.the.Venture.Exchange.for.companies.too. small.to.qualif
y.for.the.TSX.auction. exchange.
9. (LO3).Such.organizations.frequently.pursue.social.or.political.missions,.so.many.different.goals.are.conce
ivable..One.goal.that.is.often.cited.is.revenue.minimization;.i.e.,.provide.whatever.goods.and.services.are.o
ffered.at.the.lowest.possible.cost.to.society..Another.would.be.to.best.serve.the.maximum.possible.number.
of.stakeholders.at.the.lowest.cost..A.better.approach.might.be.to.observe.that.even.a.not-for-
profit.business.has.equity..Thus,.one.answer.is.that.the.appropriate.goal.is.to.maximize.the.value.of.the.equi
ty.
10. (LO3).Presumably,.the.current.stock.value.reflects.the.risk,.timing,.and.magnitude.of.all.future.cash.flows,.
both.short-term.and.long-term..If.this.is.correct,.then.the.statement.is.false.
11. (LO3).An.argument.can.be.made.either.way..At.the.one.extreme,.we.could.argue.that.in.a.market.economy,.
all.of.these.things.are.priced..There.is.thus.an.optimal.level.of,.for.example,.ethical.and/or.illegal.behavior,.
and.the.framework.of.stock.valuation.explicitly.includes.these..At.the.other.extreme,.we.could.argue.that.th
ese.are.non-
economic.phenomena.and.are.best.handled.through.the.political.process..A.classic.(and.highly.relevant).th
ought.question.that.illustrates.this.debate.goes.something.like.this:.―A.firm.has.estimated.that.the.cost.of.i
mproving.the.safety.of.one.of.its.products.is.$30.million..However,.the.firm.believes.that.improving.the.saf
ety.of.the.product.will.only.save.$20. million.in.product.liability.claims.and.lost.customer.goodwill..What.s
hould.the.firm.do?‖
12. (LO3).The.goal.will.be.the.same,.but.the.best.course.of.action.toward.that.goal.may.be.different.because.of.
differing.social,.political,.and.economic.institutions.
13. (LO4).The.goal.of.management.should.be.to.maximize.the.share.price.for.the.current.shareholders..If.man
agement.believes.that.it.can.improve.the.profitability.of.the.firm.so.that.the.share.price.will.exceed.$35,.the
n.they.should.fight.the.offer.from.the.outside.company..If.management.believes.that.this.bidder.or.other.uni
dentified.bidders.will.actually.pay.more.than.$35.per.share.to.acquire.the.company,.then.they.should.still.fi
ght.the.offer..However,.if.the.current.management.cannot.increase.the.value.of.the.firm.beyond.the.bid.pric
e,.and.no.other.higher.bids.come.in,.then.management.is.not.acting.in.the.interests.of.the.shareholders.by.fig
hting.the.offer..Since.current.managers.often.lose.their.jobs.when.the.corporation.is.acquired,.poorly.monit
ored.managers.have.an.incentive.to.fight. corporate.takeovers.in.situations.such.as.this.
14. (LO4).We.would.expect.agency.problems.to.be.less.severe.in.other.countries,.primarily.due.to.the.relativel
y.small.percentage.of.individual.ownership..Fewer.individual.owners.means.that.each.individual.owner.ha
s.a.greater.incentive.to.monitor.and.control.the.firm—i.e..there.is.less.free-
riding..The.high.percentage.of.institutional.ownership.might.lead.to.a.higher.degree.of.agreement.between.
owners.and.managers.on.decisions.concerning.risky.projects..In.addition,.institutions.may.be.better.able.to.
implement.effective.monitoring.mechanisms.on.managers.than.can.individual.owners,.based.on.the.institu
tions‘.deeper.resources.and.experiences.with.their.own.management..The.increase.in.institutional.ownersh
ip.of.stock.in.Canada.and.in.the.United.States.and.the.growing.activism.of.these.large.shareholder.groups.m
ay.lead.to.a.reduction.in.agency.problems.for.Canadian.and.U.S..corporations.and.a.more.efficient.market.f
or.corporate.control.
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,15. (LO5).Major.institutions:
Chartered.banks.-
accept.deposits.and.issue.commercial.loans,.corporate.loans,.personal.loans.and.mortgages.
Trust.companies-
accept.deposits.and.make.loans,.but.also.engage.in.fiduciary.activities.such.as.managing.assets.for.estates,.
registered.retirement.savings.plans,.etc.
Investment.dealers.-non-depository.institutions.that.assist.firms.in.issuing.new.securities.
Insurance.companies.-
engage.in.indirect.financing.by.accepting.funds.in.a.form.similar.to.a.deposit.and.making.loans.
Pension.funds.-
invest.contributions.from.employers.and.employees.in.securities.offered.by.financial.markets.
Mutual.funds.-pool.individual.investments.to.purchase.a.diversified.portfolio.
Hedge.funds.-
cater.to.sophisticated.investors.and.seek.high.returns.by.using.aggressive.financial.strategies.prohibited.by.
mutual.funds.
Note.that.larger.financial.institutions.may.embody.many.of.these.different.institution..For.example,.CIBC.
is.a.chartered.bank.that.owns.an.investment.dealer.and.mutual.funds..Furthermore,.it.has.an.insurance.arm.
―CIBC.Insurance‖
Major.markets:
Money.market.-financial.markets.where.short-term.debt.instruments.are.bought.and.sold.
Capital.markets.-financial.markets.where.long-
term.debt.and.equity.securities.are.bought.and.sold..Derivatives.markets.–
.where.options.and.futures.are.traded.on.financial.instruments.and.commodities.Primary. markets. are. whe
re. securities. are. sold. for. the. first. time;. secondary. markets. are. where.outstanding.securities.trade.
16. (LO5).Spread.versus.Fee.Income:
Banks.earn.spread.or.interest.income.by.borrowing.from.depositors.and.lending.to.borrowers.(at.a.higher.yield)..
An.example.is.a.retail.deposit.and.a.mortgage..Banks.make.non-
interest.or.fee.income.when.they.charge.commissions.or.fees.for.services..An.example.is.an.overdraft.fee.or.AT
M.fee,.or.the.example.in.the.text,.the.stamping.fee.on.a.banker‘s.acceptance.(which.is.a.form.of.insurance.and.arra
nging.fee).
17. (LO5).Trends:
Financial.engineering.-
the.creation.of.new.securities.or.financial.processes..This.engineering.could.be.used.to.package.and.sell.ris
ky.assets.to.investors;.for.example,.banks.can.package.and.sell.mortgages.into.mortgage.backed.securities.
and.sell.these.on.to.other.investors.
Derivative.securities.-
options,.futures,.forwards,.and.other.securities.whose.value.is.derived.from.the.price.of.another,.underlyin
g.asset.. For.example,.a.futures.contract.to.purchase.oil.sets.a.fixed.purchase/selling.price.for.a.future.date,.
but.its.value.depends.on.the.price.of.oil..These.derivatives.can.help.businesses.divest.risks.that.are.not.core.t
o.their.business,.such.as.foreign.exchange.and.input.price.(like.oil).risk.
Regulatory.dialectic.-
the.pressures.that.financial.institutions.and.regulatory.bodies.exert.on.each. other.. For.example,.when.restr
ictions.are.removed,.growth.opportunities.may.increase.. However,.the.absence.of.regulatory.restrictions.
may.also.lead.to.problems.such.as.the.global.financial.crisis.starting.in.2007.caused.by.excessive.financial.l
everage,.so.it.is.important.that.there.be.an.appropriate.level.of.regulatory.oversight.
ESG.–
Investors.and.corporations.(and.their.many.stakeholders).are.increasingly.focused.on.Environmental,.Soci
etal,.and.Governance.issues..This.includes.employee.and.customer.welfare.as.well.as.climate.change.and.p
ollution.
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, These.trends.have.made.financial.management.a.much.more.complex.and.technical.activity.
CHAPTER 2 .
FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
. . . . .
Learning.Objectives
LO1. The.difference.between.accounting.value.(or.―book‖.value).and.market.value.
LO2. The.difference.between.accounting.income.and.cash.flow.
LO3. How.to.determine.a.firm‘s.cash.flow.from.its.financial.statements.
LO4. The.difference.between.average.and.marginal.tax.rates.
LO5. The.basics.of.Capital.Cost.Allowance.(CCA).and.Undepreciated.Capital.Cost.(UCC).
Answers.to.Concepts.Review.and.Critical.Thinking.Questions
1. (LO1).Liquidity.measures.how.quickly.and.easily.an.asset.can.be.converted.to.cash.without.significant.los
s.in.value..It‘s.desirable.for.firms.to.have.high.liquidity.so.that.they.have.a.large.factor.of.safety.in.meeting.s
hort-term.creditor.demands..However,.since.liquidity.also.has.an.opportunity.cost.associated.with.it—
namely.that.higher.returns.can.generally.be.found.by.investing.the.cash.into.productive.assets—
low.liquidity.levels.are.also.desirable.to.the.firm..It‘s.up.to.the.firm‘s.financial.management.staff.to.find.a.re
asonable.compromise.between.these.opposing.needs.
2. (LO2).The.recognition.and.matching.principles.in.financial.accounting.call.for.revenues,.and.the. costs.ass
ociated.with.producing.those.revenues,.to.be.―booked‖.when.the.revenue.process.is.essentially.complete,.
not.necessarily.when.the.cash.is.collected.or.bills.are.paid..Note.that.this.way.is.not.necessarily.incorrect;.it‘
s.the.way.accountants.have.chosen.to.do.it.
3. (LO1).Historical.costs.can.be.objectively.and.precisely.measured.whereas.market.values.can.be.difficult.t
o.estimate,.and.different.analysts.would.come.up.with.different.numbers..Thus,.there.is.a.tradeoff.between.
relevance.(market.values).and.objectivity.(book.values).
4. (LO3).Depreciation.is.a.noncash.deduction.that.reflects.adjustments.made.in.asset.book.values.in.accorda
nce.with.the.matching.principle.in.financial.accounting..Interest.expense.is.a.cash.outlay,.but.it‘s.a.financin
g.cost,.not.an.operating.cost.
5. (LO1). Market. values. for. corporations. can. never. be. negative.. Imagine. a. share. of. stock. selling. for. –
$20..This.would.mean.that.if.you.placed.an.order.for.100.shares,.you.would.get.the.stock.along.with.a.check.
for.$2,000..How.many.shares.do.you.want.to.buy?.More.generally,.because.of.corporate.bankruptcy.laws,.
net.worth.for.a.corporation.cannot.be.negative,.implying.that.liabilities.cannot.exceed.assets.in.market.valu
e.
6. (LO3).For.a.successful.company.that.is.rapidly.expanding,.for.example,.capital.outlays.will.be.large,.possi
bly.leading.to.negative.cash.flow.from.assets..In.general,.what.matters.is.whether.the.money.is.spent.wisely
,.not.whether.cash.flow.from.assets.is.positive.or.negative.
7. (LO3).It‘s.probably.not.a.good.sign.for.an.established.company,.but.it.would.be.fairly.ordinary.for.a.start-
up,.so.it.depends.
8. (LO3).For.example,.if.a.company.were.to.become.more.efficient.in.inventory.management,.the.amount.of.
inventory.needed.would.decline..The.same.might.be.true.if.it.becomes.better.at.collecting.its.receivables..I
n.general,.anything.that.leads.to.a.decline.in.ending.NWC.relative.to.beginning. would.have.this.effect..Neg
ative.net.capital.spending.would.mean.more.long-lived.assets.were.liquidated.than.purchased.
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