k
, CHAPTER 1 k
Introduction to Corporate Finance k k k
The values shown in the solutions may be rounded for display purposes. However, the answers were
k k k k k k k k k k k k k k k
derived using a spreadsheet without any intermediate rounding.
k k k k k k k k
Answers to Problem Sets k k k
1. a. real k
b. executive airplanes k k
c. brand names k k
d. financial k
e. bonds k
*f. investment or capital expenditure k k k k
*g. capital budgeting or investment
k k k
k h. financing k
*Note that f and g are interchangeable in the question.
k k k k k k k k k k
Est time: 01-05
k k
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets.
k k k k k k k k k k k k k k k k k k
Real assets are identifiable as items with intrinsic value. The others in the list are financial
k k k k k k k k k k k k k k k k
assets, that is, these assets derive value because of a contractual claim.
k k k k k k k k k k k k k
Est time: 01-05
k k
3. a. Financial assets, such as stocks or bank loans, are claims held by investors.
k k k k k k k k k k k k
Corporations sell financial assets to raise the cash to invest in real assets such as
k k k k k k k k k k k k k k k
plant and equipment. Some real assets are intangible.
k k k k k k k k k
b. Capital expenditure means investment in real assets. Financing means raising the
k k k k k k k k k k
cash for this investment.
k k k k k
c. The shares of public corporations are traded on stock exchanges and can be
k k k k k k k k k k k k
purchasedby a wide range of investors. The shares of closely held corporations are
k k k k k k k k k k k k k k
not publicly traded and are held by a small group of private investors.
k k k k k k k k k k k k k k
d. Unlimited liability: Investors are responsible for all the firm‘s debts. A sole proprietor
k k k k k k k k k k k k
has unlimited liability. Investors in corporations have limited liability. They can lose
k k k k k k k k k k k k
their investment, but no more.
k k k k k k
Est time: 01-05
k k
k
, 4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can
k k k k k k k k k k k k k
be transferred without affecting operations, and managers can be fired with no effect on
k k k k k k k k k k k k k k
ownership. Other forms of business may have unlimited liability and limited life.
k k k k k k k k k k k k k
Est time: 01-05
k k
5. Separation of ownership facilitates the key attributes of a corporation, including limited liability
k k k k k k k k k k k k
for investors, transferability of ownership, a separate legal personality of the corporation, and
k k k k k k k k k k k k k
delegated centralized management. These four attributes provide substantial benefit for
k k k k k k k k k k
investors, including the ability to diversify their investment among many uncorrelated returns—a
k k k k k k k k k k k k
very valuable tool explored in later chapters. Also, these attributes allow investors to quickly
k k k k k k k k k k k k k k
exit, enter, or short sell an investment, thereby generating an active liquid market for
k k k k k k k k k k k k k k
corporations.
k k
However, these positive aspects also introduce substantial negative externalities as well. The
k k k k k k k k k k k
separation of ownership from management typically leads to agency problems, where managers
k k k k k k k k k k k k
prefer to consume private perks or make other decisions for their private benefit—rather than
k k k k k k k k k k k k k k
maximize shareholder wealth. Shareholders tend to exercise less oversight of each individual
k k k k k k k k k k k k
investment as their diversification increases. Finally, the corporation‘s separate legal personality
k k k k k k k k k k k
makes it difficult to enforce accountability if they externalize costs onto society.
k k k k k k k k k k k k k
Est time: 01-05
k k
6. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their
k k k k k k k k k k k
pattern of consumption through borrowing and lending, match risk preferences, and
k k k k k k k k k k k
hopefully balance their own checkbooks (or hire a qualified professional to help them with
k k k k k k k k k k k k k k
these tasks).
k k k
Est time: 01-05
k k
7. If the investment increases the firm‘s wealth, it increases the firm‘s share value. Ms.
k k k k k k k k k k k k k
Espinoza could then sell some or all these more valuable shares to provide for her
k k k k k k k k k k k k k k k
retirement income.
k k k
Est time: 01-05
k k
8. a. Assuming that the encabulator market is risky, an 8% expected returnk k k k k k k k k k
on the F&H encabulator investments may be inferior to a 4% return on
k k k k k k k k k k k k k
U.S.
k k
government securities, depending on the relative risk between the two assets. k k k k k k k k k k k
b. Unless the financial assets are as safe as U.S. government securities, their cost of
k k k k k k k k k k k k k
capital would be higher. The CFO could consider expected returns on assets with
k k k k k k k k k k k k k
similar risk.
k k k
Est time: 06-10
k k
9. Managers would act in shareholders‘ interests because they have a legal duty to act in their
k k k k k k k k k k k k k k k
interests. Managers may also receive compensation— bonuses, stock, and option payouts with
k k k k k k k k k k k k
value tied (roughly) to firm performance. Managers may fear personal reputational damage from
k k k k k k k k k k k k k
not acting in shareholders‘ interests. And managers can be fired by the board of directors
k k k k k k k k k k k k k k k
(elected by shareholders). If managers still fail to act in shareholders‘ interests, shareholders
k k k k k k k k k k k k k
may sell their shares, lowering the stock price and potentially creating the possibility of a
k k k k k k k k k k k k k k k
k
, k takeover, which can again lead to changes in the board of directors and senior management.
k k k k k k k k k k k k k k k
Est time: 01-05
k k
k
, CHAPTER 1 k
Introduction to Corporate Finance k k k
The values shown in the solutions may be rounded for display purposes. However, the answers were
k k k k k k k k k k k k k k k
derived using a spreadsheet without any intermediate rounding.
k k k k k k k k
Answers to Problem Sets k k k
1. a. real k
b. executive airplanes k k
c. brand names k k
d. financial k
e. bonds k
*f. investment or capital expenditure k k k k
*g. capital budgeting or investment
k k k
k h. financing k
*Note that f and g are interchangeable in the question.
k k k k k k k k k k
Est time: 01-05
k k
2. A trademark, a factory, undeveloped land, and your work force (c, d, e, and g) are all real assets.
k k k k k k k k k k k k k k k k k k
Real assets are identifiable as items with intrinsic value. The others in the list are financial
k k k k k k k k k k k k k k k k
assets, that is, these assets derive value because of a contractual claim.
k k k k k k k k k k k k k
Est time: 01-05
k k
3. a. Financial assets, such as stocks or bank loans, are claims held by investors.
k k k k k k k k k k k k
Corporations sell financial assets to raise the cash to invest in real assets such as
k k k k k k k k k k k k k k k
plant and equipment. Some real assets are intangible.
k k k k k k k k k
b. Capital expenditure means investment in real assets. Financing means raising the
k k k k k k k k k k
cash for this investment.
k k k k k
c. The shares of public corporations are traded on stock exchanges and can be
k k k k k k k k k k k k
purchasedby a wide range of investors. The shares of closely held corporations are
k k k k k k k k k k k k k k
not publicly traded and are held by a small group of private investors.
k k k k k k k k k k k k k k
d. Unlimited liability: Investors are responsible for all the firm‘s debts. A sole proprietor
k k k k k k k k k k k k
has unlimited liability. Investors in corporations have limited liability. They can lose
k k k k k k k k k k k k
their investment, but no more.
k k k k k k
Est time: 01-05
k k
k
, 4. Items c and d apply to corporations. Because corporations have perpetual life, ownership can
k k k k k k k k k k k k k
be transferred without affecting operations, and managers can be fired with no effect on
k k k k k k k k k k k k k k
ownership. Other forms of business may have unlimited liability and limited life.
k k k k k k k k k k k k k
Est time: 01-05
k k
5. Separation of ownership facilitates the key attributes of a corporation, including limited liability
k k k k k k k k k k k k
for investors, transferability of ownership, a separate legal personality of the corporation, and
k k k k k k k k k k k k k
delegated centralized management. These four attributes provide substantial benefit for
k k k k k k k k k k
investors, including the ability to diversify their investment among many uncorrelated returns—a
k k k k k k k k k k k k
very valuable tool explored in later chapters. Also, these attributes allow investors to quickly
k k k k k k k k k k k k k k
exit, enter, or short sell an investment, thereby generating an active liquid market for
k k k k k k k k k k k k k k
corporations.
k k
However, these positive aspects also introduce substantial negative externalities as well. The
k k k k k k k k k k k
separation of ownership from management typically leads to agency problems, where managers
k k k k k k k k k k k k
prefer to consume private perks or make other decisions for their private benefit—rather than
k k k k k k k k k k k k k k
maximize shareholder wealth. Shareholders tend to exercise less oversight of each individual
k k k k k k k k k k k k
investment as their diversification increases. Finally, the corporation‘s separate legal personality
k k k k k k k k k k k
makes it difficult to enforce accountability if they externalize costs onto society.
k k k k k k k k k k k k k
Est time: 01-05
k k
6. Shareholders will only vote to maximize shareholder wealth. Shareholders can modify their
k k k k k k k k k k k
pattern of consumption through borrowing and lending, match risk preferences, and
k k k k k k k k k k k
hopefully balance their own checkbooks (or hire a qualified professional to help them with
k k k k k k k k k k k k k k
these tasks).
k k k
Est time: 01-05
k k
7. If the investment increases the firm‘s wealth, it increases the firm‘s share value. Ms.
k k k k k k k k k k k k k
Espinoza could then sell some or all these more valuable shares to provide for her
k k k k k k k k k k k k k k k
retirement income.
k k k
Est time: 01-05
k k
8. a. Assuming that the encabulator market is risky, an 8% expected returnk k k k k k k k k k
on the F&H encabulator investments may be inferior to a 4% return on
k k k k k k k k k k k k k
U.S.
k k
government securities, depending on the relative risk between the two assets. k k k k k k k k k k k
b. Unless the financial assets are as safe as U.S. government securities, their cost of
k k k k k k k k k k k k k
capital would be higher. The CFO could consider expected returns on assets with
k k k k k k k k k k k k k
similar risk.
k k k
Est time: 06-10
k k
9. Managers would act in shareholders‘ interests because they have a legal duty to act in their
k k k k k k k k k k k k k k k
interests. Managers may also receive compensation— bonuses, stock, and option payouts with
k k k k k k k k k k k k
value tied (roughly) to firm performance. Managers may fear personal reputational damage from
k k k k k k k k k k k k k
not acting in shareholders‘ interests. And managers can be fired by the board of directors
k k k k k k k k k k k k k k k
(elected by shareholders). If managers still fail to act in shareholders‘ interests, shareholders
k k k k k k k k k k k k k
may sell their shares, lowering the stock price and potentially creating the possibility of a
k k k k k k k k k k k k k k k
k
, k takeover, which can again lead to changes in the board of directors and senior management.
k k k k k k k k k k k k k k k
Est time: 01-05
k k
k
