Chapter 1
An Overview of Corporate Finance and
The Financial Environment
ANSWERS TO END-OF-CHAPTER QUESTIONS
1-1 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.
b. In a limited partnership, limited partners’ liabilities, investment returns and control
are limited, while general partners have unlimited liability and control. 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.
d. A money market is a financial market for debt securities with maturities of less than
one year (short-term). The New York money market is the world’s largest. 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.
Answers and Solutions: 1- 1
,e. In private markets, transactions are worked out directly between two parties and
structured in any manner that appeals 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 claims whose
value depends on what happens to the value of some other asset. Futures and
options are two important types of derivatives, and their values depend on what
happens to the prices of other assets, say IBM stock, Japanese yen, or pork bellies.
Therefore, the value of a derivative security is derived from the value of an
underlying real asset.
f. An investment banker is a middleman 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 securities with funds that it obtains 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 a corporation that sells shares in the fund and uses the
proceeds to buy stocks, long-term bonds, or short-term debt instruments.
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 debt instruments and offer their
shareholders check writing privileges; thus, they are essentially
interest-bearing checking accounts.
h. Physical location exchanges, such as the New York Stock Exchange, facilitate
communication between buyers and sellers of securities. Each physical location
exchange is a physical entity at a particular location and is governed by an elected
board of governors. A computer/telephone network, such as Nasdaq, consists of all
the facilities that provide for security transactions not conducted at a physical
location exchange. These facilities are, basically, the communications network that
links the buyers and sellers.
i. An open outcry auction is a method of matching buyers and sellers. In an auction,
the buyers and sellers are face-to-face, with each stating the prices and which they
will buy or sell. 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
Answers and Solutions: 1- 2
, the offers made by the dealers, and can contact the dealer of their choice to arrange a
transaction. In an ECN, orders from potential buyers and sellers are automatically
matched, and the transaction is automatically completed.
j. Production opportunities are the returns available within an economy from
investment in productive assets. The higher the production opportunities, the more
producers would be willing to pay for required capital. Consumption time
preferences refer to the preferred pattern of consumption. Consumer’s time
preferences for consumption establish how much consumption they are willing to
defer, and hence save, at different levels of interest.
k. The real risk-free rate is that interest rate which equalizes the aggregate supply of,
and demand for, riskless securities in an economy with zero inflation. The real
risk-free rate could also be called the pure rate of interest since it is the rate of interest
that would exist on very short-term, default-free U.S. Treasury securities if the
expected rate of inflation were zero. It has been estimated that this rate of interest,
denoted by r*, has fluctuated in recent years in the United States in the range of 2 to 4
percent. The nominal risk-free rate of interest, denoted by rRF, is the real risk-free
rate plus a premium for expected inflation. The short-term nominal risk-free rate is
usually approximated by the U.S. Treasury bill rate, while the long-term nominal
risk-free rate is approximated by the rate on U.S. Treasury bonds. Note that while
T-bonds are free of default and liquidity risks, they are subject to risks due to changes
in the general level of interest rates.
l. The inflation premium is the premium added to the real risk-free rate of interest to
compensate for the expected loss of purchasing power. The inflation premium is the
average rate of inflation expected over the life of the security. Default risk is the
risk that a borrower will not pay the interest and/or principal on a loan as they
become due. Thus, a default risk premium (DRP) is added to the real risk-free rate
to compensate investors for bearing default risk. Liquidity refers to a firm’s cash
and marketable securities position, and to its ability to meet maturing obligations. A
liquid asset is any asset that can be quickly sold and converted to cash at its “fair”
value. Active markets provide liquidity. A liquidity premium is added to the real
risk-free rate of interest, in addition to other premiums, if a security is not liquid.
m. Interest rate risk arises from the fact that bond prices decline when interest rates rise.
Under these circumstances, selling a bond prior to maturity will result in a capital loss,
and the longer the term to maturity, the larger the loss. Thus, a maturity risk
premium must be added to the real risk-free rate of interest to compensate for interest
rate risk. Reinvestment rate risk occurs when a short-term debt security must be
“rolled over.” If interest rates have fallen, the reinvestment of principal will be at a
lower rate, with correspondingly lower interest payments and ending value. Note
that long-term debt securities also have some reinvestment rate risk because their
interest payments have to be reinvested at prevailing rates.
Answers and Solutions: 1- 3
, n. The term structure of interest rates is the relationship between yield to maturity and
term to maturity for bonds of a single risk class. The yield curve is the curve that
results when yield to maturity is plotted on the Y-axis with term to maturity on the
X-axis.
o. When the yield curve slopes upward, it is said to be “normal,” because it is like this
most of the time. Conversely, a downward-sloping yield curve is termed
“abnormal” or “inverted.”
p. The expectations theory states that the slope of the yield curve depends on
expectations about future inflation rates and interest rates. Thus, if the annual rate
of inflation and future interest rates are expected to increase, the yield curve will be
upward sloping, whereas the curve will be downward sloping if the annual rates are
expected to decrease.
r. A foreign trade deficit occurs when businesses and individuals in the U. S. import
more goods from foreign countries than are exported. Trade deficits must be
financed, and the main source of financing is debt. Therefore, 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. Thus, if the trade deficit is large relative
to the size of the overall economy, it may hinder the Fed’s ability to combat a
recession by lowering interest rates.
1-2 Sole proprietorship, partnership, and corporation are the three principal forms of business
organization. The advantages of the first two include the 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 The three primary determinants of a firm’s cash flows are: (1) sales revenues; (2)
operating expenses, such as raw materials costs and labor costs; and (3) the necessary
investments in operating capital, such as buildings, equipment, and inventory.
1-4 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,
Answers and Solutions: 1- 4
An Overview of Corporate Finance and
The Financial Environment
ANSWERS TO END-OF-CHAPTER QUESTIONS
1-1 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.
b. In a limited partnership, limited partners’ liabilities, investment returns and control
are limited, while general partners have unlimited liability and control. 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.
d. A money market is a financial market for debt securities with maturities of less than
one year (short-term). The New York money market is the world’s largest. 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.
Answers and Solutions: 1- 1
,e. In private markets, transactions are worked out directly between two parties and
structured in any manner that appeals 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 claims whose
value depends on what happens to the value of some other asset. Futures and
options are two important types of derivatives, and their values depend on what
happens to the prices of other assets, say IBM stock, Japanese yen, or pork bellies.
Therefore, the value of a derivative security is derived from the value of an
underlying real asset.
f. An investment banker is a middleman 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 securities with funds that it obtains 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 a corporation that sells shares in the fund and uses the
proceeds to buy stocks, long-term bonds, or short-term debt instruments.
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 debt instruments and offer their
shareholders check writing privileges; thus, they are essentially
interest-bearing checking accounts.
h. Physical location exchanges, such as the New York Stock Exchange, facilitate
communication between buyers and sellers of securities. Each physical location
exchange is a physical entity at a particular location and is governed by an elected
board of governors. A computer/telephone network, such as Nasdaq, consists of all
the facilities that provide for security transactions not conducted at a physical
location exchange. These facilities are, basically, the communications network that
links the buyers and sellers.
i. An open outcry auction is a method of matching buyers and sellers. In an auction,
the buyers and sellers are face-to-face, with each stating the prices and which they
will buy or sell. 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
Answers and Solutions: 1- 2
, the offers made by the dealers, and can contact the dealer of their choice to arrange a
transaction. In an ECN, orders from potential buyers and sellers are automatically
matched, and the transaction is automatically completed.
j. Production opportunities are the returns available within an economy from
investment in productive assets. The higher the production opportunities, the more
producers would be willing to pay for required capital. Consumption time
preferences refer to the preferred pattern of consumption. Consumer’s time
preferences for consumption establish how much consumption they are willing to
defer, and hence save, at different levels of interest.
k. The real risk-free rate is that interest rate which equalizes the aggregate supply of,
and demand for, riskless securities in an economy with zero inflation. The real
risk-free rate could also be called the pure rate of interest since it is the rate of interest
that would exist on very short-term, default-free U.S. Treasury securities if the
expected rate of inflation were zero. It has been estimated that this rate of interest,
denoted by r*, has fluctuated in recent years in the United States in the range of 2 to 4
percent. The nominal risk-free rate of interest, denoted by rRF, is the real risk-free
rate plus a premium for expected inflation. The short-term nominal risk-free rate is
usually approximated by the U.S. Treasury bill rate, while the long-term nominal
risk-free rate is approximated by the rate on U.S. Treasury bonds. Note that while
T-bonds are free of default and liquidity risks, they are subject to risks due to changes
in the general level of interest rates.
l. The inflation premium is the premium added to the real risk-free rate of interest to
compensate for the expected loss of purchasing power. The inflation premium is the
average rate of inflation expected over the life of the security. Default risk is the
risk that a borrower will not pay the interest and/or principal on a loan as they
become due. Thus, a default risk premium (DRP) is added to the real risk-free rate
to compensate investors for bearing default risk. Liquidity refers to a firm’s cash
and marketable securities position, and to its ability to meet maturing obligations. A
liquid asset is any asset that can be quickly sold and converted to cash at its “fair”
value. Active markets provide liquidity. A liquidity premium is added to the real
risk-free rate of interest, in addition to other premiums, if a security is not liquid.
m. Interest rate risk arises from the fact that bond prices decline when interest rates rise.
Under these circumstances, selling a bond prior to maturity will result in a capital loss,
and the longer the term to maturity, the larger the loss. Thus, a maturity risk
premium must be added to the real risk-free rate of interest to compensate for interest
rate risk. Reinvestment rate risk occurs when a short-term debt security must be
“rolled over.” If interest rates have fallen, the reinvestment of principal will be at a
lower rate, with correspondingly lower interest payments and ending value. Note
that long-term debt securities also have some reinvestment rate risk because their
interest payments have to be reinvested at prevailing rates.
Answers and Solutions: 1- 3
, n. The term structure of interest rates is the relationship between yield to maturity and
term to maturity for bonds of a single risk class. The yield curve is the curve that
results when yield to maturity is plotted on the Y-axis with term to maturity on the
X-axis.
o. When the yield curve slopes upward, it is said to be “normal,” because it is like this
most of the time. Conversely, a downward-sloping yield curve is termed
“abnormal” or “inverted.”
p. The expectations theory states that the slope of the yield curve depends on
expectations about future inflation rates and interest rates. Thus, if the annual rate
of inflation and future interest rates are expected to increase, the yield curve will be
upward sloping, whereas the curve will be downward sloping if the annual rates are
expected to decrease.
r. A foreign trade deficit occurs when businesses and individuals in the U. S. import
more goods from foreign countries than are exported. Trade deficits must be
financed, and the main source of financing is debt. Therefore, 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. Thus, if the trade deficit is large relative
to the size of the overall economy, it may hinder the Fed’s ability to combat a
recession by lowering interest rates.
1-2 Sole proprietorship, partnership, and corporation are the three principal forms of business
organization. The advantages of the first two include the 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 The three primary determinants of a firm’s cash flows are: (1) sales revenues; (2)
operating expenses, such as raw materials costs and labor costs; and (3) the necessary
investments in operating capital, such as buildings, equipment, and inventory.
1-4 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,
Answers and Solutions: 1- 4
