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