Chapter 01 - Goals and Governance of the Firm
CHAPTER 1
Goals and Governance of the Firm
Answers to Problem Sets
1. a. real
b. executive airplanes
c. brand names
d. financial
e. bonds
f. investment
g. capital budgeting
h. financing
2. c, d, e, and g are real assets. Others are financial.
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 traded and are not generally available to investors.
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.
e. A corporation is a separate legal “person” with unlimited life. Its owners
hold shares in the business. A partnership is a limited-life agreement to
establish and run a business.
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,Chapter 01 - Goals and Governance of the Firm
4. c, d.
5. b, c.
6. 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.
7. 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.
8. 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).
9. 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.
10. As the Putnam 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.
11. 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
1-2
,Chapter 01 - Goals and Governance of the Firm
price, and potentially creating the possibility of a takeover, which can again lead to
changes in the board of directors and senior management.
12. 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.
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%). G also invests, but borrows against the
$121,000 payment, and thus receives $100,833 today.
2. a. He could consume up to $200,000 now (foregoing all future consumption) or
up to $216,000 next year (200,000*1.08, foregoing all consumption this 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 next year. If he consumes
all this year, he can now have a total of $203,703.7 (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 = (203,703.7 – C) x 1.08
C = $105,769.2
1-3
, Chapter 02 - How to Calculate Present Values
CHAPTER 2
How to Calculate Present Values
Answers to Problem Sets
1. If the discount factor is .507, then .507*1.126 = $1
2. 125/139 = .899
3. PV = 374/(1.09)9 = 172.20
4. PV = 432/1.15 + 137/(1.152) + 797/(1.153) = 376 + 104 + 524 = $1,003
5. FV = 100*1.158 = $305.90
6. NPV = -1,548 + 138/.09 = -14.67 (cost today plus the present value of the
perpetuity)
7. PV = 4/(.14-.04) = $40
8. a. PV = 1/.10 = $10
b. Since the perpetuity will be worth $10 in year 7, and since that is roughly
double the present value, the approximate PV equals $5.
PV = (1 / .10)/(1.10)7 = 10/2= $5 (approximately)
c. A perpetuity paying $1 starting now would be worth $10, whereas a
perpetuity starting in year 8 would be worth roughly $5. The difference
between these cash flows is therefore approximately $5. PV = 10 – 5= $5
(approximately)
d. PV = C/(r-g) = 10,000/(.10-.05) = $200,000.
9. a. PV = 10,000/(1.055) = $7,835.26 (assuming the cost of the car does not
appreciate over those five years).
b. You need to set aside (12,000 × 6-year annuity factor) = 12,000 × 4.623 =
2-1
CHAPTER 1
Goals and Governance of the Firm
Answers to Problem Sets
1. a. real
b. executive airplanes
c. brand names
d. financial
e. bonds
f. investment
g. capital budgeting
h. financing
2. c, d, e, and g are real assets. Others are financial.
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 traded and are not generally available to investors.
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.
e. A corporation is a separate legal “person” with unlimited life. Its owners
hold shares in the business. A partnership is a limited-life agreement to
establish and run a business.
1-1
,Chapter 01 - Goals and Governance of the Firm
4. c, d.
5. b, c.
6. 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.
7. 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.
8. 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).
9. 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.
10. As the Putnam 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.
11. 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
1-2
,Chapter 01 - Goals and Governance of the Firm
price, and potentially creating the possibility of a takeover, which can again lead to
changes in the board of directors and senior management.
12. 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.
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%). G also invests, but borrows against the
$121,000 payment, and thus receives $100,833 today.
2. a. He could consume up to $200,000 now (foregoing all future consumption) or
up to $216,000 next year (200,000*1.08, foregoing all consumption this 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 next year. If he consumes
all this year, he can now have a total of $203,703.7 (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 = (203,703.7 – C) x 1.08
C = $105,769.2
1-3
, Chapter 02 - How to Calculate Present Values
CHAPTER 2
How to Calculate Present Values
Answers to Problem Sets
1. If the discount factor is .507, then .507*1.126 = $1
2. 125/139 = .899
3. PV = 374/(1.09)9 = 172.20
4. PV = 432/1.15 + 137/(1.152) + 797/(1.153) = 376 + 104 + 524 = $1,003
5. FV = 100*1.158 = $305.90
6. NPV = -1,548 + 138/.09 = -14.67 (cost today plus the present value of the
perpetuity)
7. PV = 4/(.14-.04) = $40
8. a. PV = 1/.10 = $10
b. Since the perpetuity will be worth $10 in year 7, and since that is roughly
double the present value, the approximate PV equals $5.
PV = (1 / .10)/(1.10)7 = 10/2= $5 (approximately)
c. A perpetuity paying $1 starting now would be worth $10, whereas a
perpetuity starting in year 8 would be worth roughly $5. The difference
between these cash flows is therefore approximately $5. PV = 10 – 5= $5
(approximately)
d. PV = C/(r-g) = 10,000/(.10-.05) = $200,000.
9. a. PV = 10,000/(1.055) = $7,835.26 (assuming the cost of the car does not
appreciate over those five years).
b. You need to set aside (12,000 × 6-year annuity factor) = 12,000 × 4.623 =
2-1
