l
End of Chapter Solutions
Corporate Finance: Principles and Applications
6th edition
Ross, Westerfield, Jaffe, and Jordan
Prepared by
Brad Jordan
, CHAPTER 2 B - 2
University of Kentucky
Joe Smolira
Belmont University
, lOMoAR cPSD| 32793396
CHAPTER 1
INTRODUCTION TO CORPORATE FINANCE
Answers to Concept Questions
1. The three basic forms are sole proprietorships, partnerships, and corporations. Some disadvantages of sole proprietorships
partnerships are: unlimited liability, limited life, difficulty in transferring ownership, and hard to raise capital funds. So
advantages are: simplicity, less regulation, the owners are also the managers, and sometimes personal tax rates are better t
corporate tax rates. The primary disadvantage of the corporate form is the double taxation to shareholders on distributed earni
and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life. Whe
business is started, most take the form of a sole proprietorship or partnership because of the relative simplicity of starting th
forms of businesses.
2. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly traded or not).
3. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of
corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form
organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather t
those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the fir
4. Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is of
cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society. A be
approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is
maximize the value of the equity.
5. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-te
If this is correct, then the statement is false.
6. An argument can be made either way. At the one extreme, we could argue that in a market economy, all these things are pric
Thus, there is an optimal level of, for example, unethical and/or illegal behavior, and the framework of stock valuation explic
includes these. At the other extreme, we could argue that these are non-economic phenomena and are best handled through
political process. A classic (and highly relevant) thought question that illustrates this debate goes something like this: “A firm
estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving
safety of the product will only save $20 million in product liability claims. What should the firm do?”
7. The goal will be the same, but the best course of action toward that goal may be different because of differing social, political,
economic institutions.
, lOMoAR cPSD| 32793396
8. The goal of management should be to maximize the share price for the current shareholders. If management believes that it
improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outs
company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acqu
the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm bey
the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting
offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incen
to fight corporate takeovers in situations such as this.
9. We would expect agency problems to be less severe in other countries, primarily due to the relatively small percentage of individ
ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percent
of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning ri
projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individ
owners, based on the institutions’ deeper resources and experiences with their own management. The increase in institutio
ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction
agency problems for U.S. corporations and a more efficient market for corporate control.
10. How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest answer is that there is a market
executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true
athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason that execu
compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movem
is obviously consistent with the attempt to better align stockholder and management interests. When stock prices soar, managem
cleans up. It is sometimes argued that much of this reward is due to rising stock prices in general, not managerial performan
Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increase
excess of general market increases.
End of Chapter Solutions
Corporate Finance: Principles and Applications
6th edition
Ross, Westerfield, Jaffe, and Jordan
Prepared by
Brad Jordan
, CHAPTER 2 B - 2
University of Kentucky
Joe Smolira
Belmont University
, lOMoAR cPSD| 32793396
CHAPTER 1
INTRODUCTION TO CORPORATE FINANCE
Answers to Concept Questions
1. The three basic forms are sole proprietorships, partnerships, and corporations. Some disadvantages of sole proprietorships
partnerships are: unlimited liability, limited life, difficulty in transferring ownership, and hard to raise capital funds. So
advantages are: simplicity, less regulation, the owners are also the managers, and sometimes personal tax rates are better t
corporate tax rates. The primary disadvantage of the corporate form is the double taxation to shareholders on distributed earni
and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life. Whe
business is started, most take the form of a sole proprietorship or partnership because of the relative simplicity of starting th
forms of businesses.
2. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly traded or not).
3. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of
corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form
organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather t
those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the fir
4. Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is of
cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society. A be
approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is
maximize the value of the equity.
5. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-te
If this is correct, then the statement is false.
6. An argument can be made either way. At the one extreme, we could argue that in a market economy, all these things are pric
Thus, there is an optimal level of, for example, unethical and/or illegal behavior, and the framework of stock valuation explic
includes these. At the other extreme, we could argue that these are non-economic phenomena and are best handled through
political process. A classic (and highly relevant) thought question that illustrates this debate goes something like this: “A firm
estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving
safety of the product will only save $20 million in product liability claims. What should the firm do?”
7. The goal will be the same, but the best course of action toward that goal may be different because of differing social, political,
economic institutions.
, lOMoAR cPSD| 32793396
8. The goal of management should be to maximize the share price for the current shareholders. If management believes that it
improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outs
company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acqu
the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm bey
the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting
offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incen
to fight corporate takeovers in situations such as this.
9. We would expect agency problems to be less severe in other countries, primarily due to the relatively small percentage of individ
ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percent
of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning ri
projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individ
owners, based on the institutions’ deeper resources and experiences with their own management. The increase in institutio
ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction
agency problems for U.S. corporations and a more efficient market for corporate control.
10. How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest answer is that there is a market
executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true
athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason that execu
compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movem
is obviously consistent with the attempt to better align stockholder and management interests. When stock prices soar, managem
cleans up. It is sometimes argued that much of this reward is due to rising stock prices in general, not managerial performan
Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increase
excess of general market increases.
