, Solution manual for Intermediate Financial
Management, 14th Edition Eugene F. Brigham
Notes
1- The file is chapter after chapter.
2- We have shown you 10 or five pages.
3- The file contains all Appendix and Excel
sheet if it exists.
4- We have all what you need, we make
update at every time. There are many
new editions waiting you.
5- If you think you purchased the wrong file
You can contact us at every time, we can
replace it with true one.
Our email:
,Chapter 1 An Overview of Financial Management and
The Financial Environment
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 The primary goal is assumed to be shareholder wealth maximization, which translates to
stock price maximization. That, in turn, means maximizing the PV of future free cash
flows.
Maximizing shareholder wealth requires that the firm produce things that customers
want, and at the lowest cost consistent with high quality. It also means holding risk
down, which will result in a relatively low cost of capital, which is necessary to
maximize the PV of a given cash flow stream.
This also gets into the issue of capital structure—how much debt should we use? The
more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less
dilution of earnings. However, more debt means more risk. So, it’s necessary to
consider capital structure when attempting to maximize share prices.
Dividend policy is also an issue—how much of its earnings should the firm pay out as
dividends? The answer to that question depends on a number of factors, including the
firm’s investment opportunities, its access to capital markets, its stockholders’ desires
(and their tax rates), and the kind of signals stockholders get from dividend actions.
Shareholder wealth maximization is partially consistent and partially inconsistent
with generally accepted societal goals. It is consistent because well-run firms produce
good products at low costs, sell them at competitive prices, employ people, pay taxes, and
generally improve society. However, without constraints, firms would tend to form
monopolies and end up charging prices that are too high and not producing enough
output. They might also pollute the air and water, engage in unfair labor practices, and so
on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed
on businesses. That said, stock price maximization is consistent with a strong
economy, economic progress, and “the good life” for most citizens.
In standard introductory microeconomics courses, we assume that firms attempt to
maximize profits. In more advanced econ courses, the goal is broadened to value
maximizing, so finance and economics are indeed consistent.
As WorldCom, Enron, and other corporate scandals demonstrated very clearly,
managers do not always have stockholders’ interests as a primary goal—some managers
have their own interests. This point is discussed further below.
1- 1
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
,1-2 See the model for quantitative answers to this question. All of these valuations involve
applications of the basic valuation model:
.
Values for CFt , r, and N are specified. For bonds, the CFs are interest payments and the
maturity value, and N is the bond’s life. Other things held constant, the higher the going
interest rate, r, the lower the value of the bond. Also, if the coupon rate is high, then CFs
are also high, and that increases the value of the bond. For a stock, the CFs are
dividends, and for a capital budgeting project, they are operating cash flows.
The main point to get across with this question is that all assets are valued in
essentially the same way. The Excel model goes into a little more detail on sensitivity
analysis. Much more comes later in the book.
1-3 The advantages of a corporate form of ownership are that investor liability is limited to
the amount invested, corporations can raise capital through public offerings of stock, and
ownership can be easily transferred from person to person by simply selling shares of
stock. In a sole proprietorship or partnership, on the other hand, the owner or owners are
exposed to potentially unlimited liability, it is difficult to raise equity capital since either
new partners must be found or the existing partners must put up additional capital, and it
is difficult to transfer ownership between partners or from a sole proprietor to someone
else.
The disadvantages of the corporate form are that there are numerous forms that must
be filled out and regulations that must be followed that are not required of a sole
proprietorship or a partnership, corporations are subject to double taxation of distributed
earnings in that the corporation first pays taxes on the pre-tax income, and then the
owners must pay tax on the dividend or capital gains income, and the separation of
ownership (by the shareholders) and control (by management) can result in management
taking actions that are not in the owners’ best interests.
1-4 The cost of money is affected by (1) production opportunities, (2) the time preference for
consumption, (3) risk, and (4) inflation. When production opportunities are good, and
assets are earning high rates of return, then interest rates tend to be higher because there
is a larger demand for borrowing to finance these projects. Also, investors who are
considering lending money recognize that their alternative investments have a high
return, and so demand a high return on their investments. When investors have a strong
preference for current consumption, then they demand a higher return on their
investments to compensate them for having to defer current purchases, and so the cost of
money is higher. Investors demand a higher rate of return on riskier investments in order
to compensate them for the having to be exposed to more risk, and when investors expect
future inflation, then the cost of money increases so that investment returns better cover
this future price increase.
1- 2
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, If any of these factors change, then the cost of money will change, and hence the
yield and the price of a security will change as well. For example, if overall the time
preference for consumption increases, then overall interest rates will tend to increase and
the yield on debt instruments will tend to increase, and their prices will fall. If the
underlying level of inflation declines, as it did through the 1990s, then interest rates on
debt instruments will decline, driving up their prices. On the other hand, if a company
experiences financial problems, increasing the likelihood of default and bankruptcy and
becoming more risky, then the yield on its bonds will increase and their prices will fall.
1-5 Most stocks are now traded on electronic exchanges. Rather than only 2 or 3 face-to-face
exchanges, there are now dozens of electronic exchanges on which stocks trade. In
electronic markets, a computer program matches buy and sell orders quickly and
automatically. The costs of electronic exchanges are much lower than for a face-to-face
exchange and transactions costs are much lower than they were decades ago as a result.
Retail trades occur fast and at a low cost and so retail customers have benefited from the
automation of markets. Portfolio managers have benefitted similarly, although they can
be preyed upon by high frequency traders.
1-6 Securitization is the process by which assets, such as mortgages held by banks, accounts
receivables held by companies, or credit card obligations held by banks and finance
companies, are packaged together and sold to investors. In the case of mortgages, a bank
or savings and loan (S&L) may have a portfolio of mortgages that it has originated (or
issued). Typically, a bank will have financed these mortgages with savings and checking
account deposits and CDs and once it has used up its loanable funds, it must either stop
making new loans, or raise more funds if it wants to make more loans. If the bank
packages these mortgages and sells them to investors, then it can make more loans with
the funds it receives. The idea is that bank acts as an intermediary in this case, analyzing
credit and making loans, and then selling them off so it can make more loans; consumers
get more loans, and banks get to do what they (supposedly) do best, which is to analyze
risk and originate loans.
If a bank doesn’t securitize its loans and, instead, holds them on its books, then it can
be exposed to a lot of interest rate risk. Back in the 1980s, S&Ls were raising money with
short-term CDs and lending it out long-term as 30-year fixed-rate mortgages. When
interest rates skyrocketed, the interest they had to pay on the CDs increased dramatically,
but since the mortgages were fixed-rate, the interest income the S&Ls received didn’t
increase. This caused hundreds of S&Ls to go bankrupt, and cost the federal government,
and ultimately, the U.S. taxpayers, hundreds of billions of dollars. If, instead, S&Ls
securitized the loans, they would no longer be exposed to the interest rate risk since they
would have sold off the loans shortly after originating them. Of course, the interest rate
risk doesn’t go away! Instead, the investors in the securitized mortgages now receive the
fixed interest payments. If these investors have themselves financed the investment with
short-term borrowing, then they will be exposed to interest rate risk!
1- 3
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
,1-7 Just like the Great Depression that preceded it 80 years earlier, the causes of the Great
Recession of 2007 and the financial crisis that followed will likely be the subject of
vigorous debate for years to come. As an example of one small aspect of the crisis,
consider how securitized mortgages end up in retirement portfolios, and how a decline in
housing prices in, say Florida, can bankrupt investors half a world away: A mortgage
company makes a bunch of loans to homeowners in Florida; a bank securitizes these
loans and creates tranches consisting interest payments, principal payments, other
combinations of payments, and the various tranches have different seniority levels—
some get paid first, others are residual claimants; a ratings agency rates some of these
pools as investment grade, so pension funds and even individual investors can purchase
them; and Norwegian investors purchase some of these to hold in their retirement
accounts because they offer good rates of return and were highly rated by the ratings
agency.
1- 4
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, 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. A charter includes the following
information: (1) name of the proposed corporation, (2) types of activities it will
pursue, (3) amount of capital stock, (4) number of directors, and (5) names and
addresses of directors. The bylaws are a set of rules drawn up by the founders of the
corporation. Included are such points as: (1) how directors are to be elected (all
elected each year or perhaps one-third each year for 3-year terms), (2) whether the
existing stockholders will have the first right to buy any new shares the firm issues,
and (3) procedures for changing the bylaws themselves, should conditions require it.
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.
1- 5
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, e. In private markets, transactions are worked out directly between two parties and
structured in any manners that appeal 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 have face-to-face communication between buyers and
sellers of securities. In contrast, a computer/telephone network links buyers and
sellers electronically, not face-to-face.
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 the offers
made by the dealers, and can contact the dealer of their choice to arrange a
transaction. An automated trading platform is a computer system in which buyers and
sellers post orders and in which trades are automatically executed for matching
orders.
1- 6
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, 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. 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 A firm’s fundamental, or intrinsic, value is the present value of its free cash flows when
discounted at the weighted average cost of capital. If the market price reflects all relevant
information, then the observed price is also the intrinsic price.
1-4 Earnings per share in the current year will decline due to the cost of the investment made
in the current year and no significant performance impact in the short run. However, the
company’s stock price should increase due to the significant cost savings expected in the
future.
1- 7
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, 1-5 In a well-functioning economy, capital will flow efficiently from those who supply
capital to those who demand it. This transfer of capital can take place in three different
ways:
1. Direct transfers of money and securities occur when a business sells its stocks or
bonds directly to savers, without going through any type of financial institution. The
business delivers its securities to savers, who in turn give the firm the money it needs.
2. Transfers may also go through an investment banking house which underwrites the
issue. An underwriter serves as a middleman and facilitates the issuance of securities.
The company sells its stocks or bonds to the investment bank, which in turn sells
these same securities to savers. The businesses’ securities and the savers’ money
merely “pass through” the investment banking house.
3. Transfers can also be made through a financial intermediary. Here the intermediary
obtains funds from savers in exchange for its own securities. The intermediary uses
this money to buy and hold businesses’ securities. Intermediaries literally create new
forms of capital. The existence of intermediaries greatly increases the efficiency of
money and capital markets.
1-6 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,
resources are allocated more effectively, and the real output of the economy is thereby
increased.
1-7 A primary market is the market in which corporations raise capital by issuing new
securities. An initial public offering is a stock issue in which privately held firms go
public. Therefore, an IPO would be an example of a primary market transaction.
1-8 Traders meet face-to-face in an open outcry auction. In a dealer market, there are “market
makers” who keep an inventory of the stock. These dealers list the prices at which they
are willing to buy or sell. In a traditional dealer market, computerized quotation systems
keep track of all bid and ask quotes, but they don’t actually match buyers and sellers.
Instead, traders must contact a specific dealer to complete the transaction. An automated
trading platform is a computer system in which buyers and sellers post their orders and
then let the computer automatically determine whether a match exists. If a match exists,
the computer automatically executes and reports the trade.
1-9 Broker-dealer networks are registered with the SEC but are much less regulated than
alternative trading systems (ATS) and registered stock exchanges. In a typical broker-
dealer network, the broker-dealer purchases the stock being offered for sale by a client
and then immediately sells it to another client who wished to buy the stock. Notice that
the broker-dealer is the counterparty to each of the clients. The broker-dealer must report
the transactions, but not any information prior to the trade. An alternative trading system
is a broker-dealer than registers with the SEC as an ATS. An ATS usually has an
automated trading platform to match orders from clients, so the owner of the ATS is not
1- 8
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
Management, 14th Edition Eugene F. Brigham
Notes
1- The file is chapter after chapter.
2- We have shown you 10 or five pages.
3- The file contains all Appendix and Excel
sheet if it exists.
4- We have all what you need, we make
update at every time. There are many
new editions waiting you.
5- If you think you purchased the wrong file
You can contact us at every time, we can
replace it with true one.
Our email:
,Chapter 1 An Overview of Financial Management and
The Financial Environment
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 The primary goal is assumed to be shareholder wealth maximization, which translates to
stock price maximization. That, in turn, means maximizing the PV of future free cash
flows.
Maximizing shareholder wealth requires that the firm produce things that customers
want, and at the lowest cost consistent with high quality. It also means holding risk
down, which will result in a relatively low cost of capital, which is necessary to
maximize the PV of a given cash flow stream.
This also gets into the issue of capital structure—how much debt should we use? The
more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less
dilution of earnings. However, more debt means more risk. So, it’s necessary to
consider capital structure when attempting to maximize share prices.
Dividend policy is also an issue—how much of its earnings should the firm pay out as
dividends? The answer to that question depends on a number of factors, including the
firm’s investment opportunities, its access to capital markets, its stockholders’ desires
(and their tax rates), and the kind of signals stockholders get from dividend actions.
Shareholder wealth maximization is partially consistent and partially inconsistent
with generally accepted societal goals. It is consistent because well-run firms produce
good products at low costs, sell them at competitive prices, employ people, pay taxes, and
generally improve society. However, without constraints, firms would tend to form
monopolies and end up charging prices that are too high and not producing enough
output. They might also pollute the air and water, engage in unfair labor practices, and so
on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed
on businesses. That said, stock price maximization is consistent with a strong
economy, economic progress, and “the good life” for most citizens.
In standard introductory microeconomics courses, we assume that firms attempt to
maximize profits. In more advanced econ courses, the goal is broadened to value
maximizing, so finance and economics are indeed consistent.
As WorldCom, Enron, and other corporate scandals demonstrated very clearly,
managers do not always have stockholders’ interests as a primary goal—some managers
have their own interests. This point is discussed further below.
1- 1
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
,1-2 See the model for quantitative answers to this question. All of these valuations involve
applications of the basic valuation model:
.
Values for CFt , r, and N are specified. For bonds, the CFs are interest payments and the
maturity value, and N is the bond’s life. Other things held constant, the higher the going
interest rate, r, the lower the value of the bond. Also, if the coupon rate is high, then CFs
are also high, and that increases the value of the bond. For a stock, the CFs are
dividends, and for a capital budgeting project, they are operating cash flows.
The main point to get across with this question is that all assets are valued in
essentially the same way. The Excel model goes into a little more detail on sensitivity
analysis. Much more comes later in the book.
1-3 The advantages of a corporate form of ownership are that investor liability is limited to
the amount invested, corporations can raise capital through public offerings of stock, and
ownership can be easily transferred from person to person by simply selling shares of
stock. In a sole proprietorship or partnership, on the other hand, the owner or owners are
exposed to potentially unlimited liability, it is difficult to raise equity capital since either
new partners must be found or the existing partners must put up additional capital, and it
is difficult to transfer ownership between partners or from a sole proprietor to someone
else.
The disadvantages of the corporate form are that there are numerous forms that must
be filled out and regulations that must be followed that are not required of a sole
proprietorship or a partnership, corporations are subject to double taxation of distributed
earnings in that the corporation first pays taxes on the pre-tax income, and then the
owners must pay tax on the dividend or capital gains income, and the separation of
ownership (by the shareholders) and control (by management) can result in management
taking actions that are not in the owners’ best interests.
1-4 The cost of money is affected by (1) production opportunities, (2) the time preference for
consumption, (3) risk, and (4) inflation. When production opportunities are good, and
assets are earning high rates of return, then interest rates tend to be higher because there
is a larger demand for borrowing to finance these projects. Also, investors who are
considering lending money recognize that their alternative investments have a high
return, and so demand a high return on their investments. When investors have a strong
preference for current consumption, then they demand a higher return on their
investments to compensate them for having to defer current purchases, and so the cost of
money is higher. Investors demand a higher rate of return on riskier investments in order
to compensate them for the having to be exposed to more risk, and when investors expect
future inflation, then the cost of money increases so that investment returns better cover
this future price increase.
1- 2
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, If any of these factors change, then the cost of money will change, and hence the
yield and the price of a security will change as well. For example, if overall the time
preference for consumption increases, then overall interest rates will tend to increase and
the yield on debt instruments will tend to increase, and their prices will fall. If the
underlying level of inflation declines, as it did through the 1990s, then interest rates on
debt instruments will decline, driving up their prices. On the other hand, if a company
experiences financial problems, increasing the likelihood of default and bankruptcy and
becoming more risky, then the yield on its bonds will increase and their prices will fall.
1-5 Most stocks are now traded on electronic exchanges. Rather than only 2 or 3 face-to-face
exchanges, there are now dozens of electronic exchanges on which stocks trade. In
electronic markets, a computer program matches buy and sell orders quickly and
automatically. The costs of electronic exchanges are much lower than for a face-to-face
exchange and transactions costs are much lower than they were decades ago as a result.
Retail trades occur fast and at a low cost and so retail customers have benefited from the
automation of markets. Portfolio managers have benefitted similarly, although they can
be preyed upon by high frequency traders.
1-6 Securitization is the process by which assets, such as mortgages held by banks, accounts
receivables held by companies, or credit card obligations held by banks and finance
companies, are packaged together and sold to investors. In the case of mortgages, a bank
or savings and loan (S&L) may have a portfolio of mortgages that it has originated (or
issued). Typically, a bank will have financed these mortgages with savings and checking
account deposits and CDs and once it has used up its loanable funds, it must either stop
making new loans, or raise more funds if it wants to make more loans. If the bank
packages these mortgages and sells them to investors, then it can make more loans with
the funds it receives. The idea is that bank acts as an intermediary in this case, analyzing
credit and making loans, and then selling them off so it can make more loans; consumers
get more loans, and banks get to do what they (supposedly) do best, which is to analyze
risk and originate loans.
If a bank doesn’t securitize its loans and, instead, holds them on its books, then it can
be exposed to a lot of interest rate risk. Back in the 1980s, S&Ls were raising money with
short-term CDs and lending it out long-term as 30-year fixed-rate mortgages. When
interest rates skyrocketed, the interest they had to pay on the CDs increased dramatically,
but since the mortgages were fixed-rate, the interest income the S&Ls received didn’t
increase. This caused hundreds of S&Ls to go bankrupt, and cost the federal government,
and ultimately, the U.S. taxpayers, hundreds of billions of dollars. If, instead, S&Ls
securitized the loans, they would no longer be exposed to the interest rate risk since they
would have sold off the loans shortly after originating them. Of course, the interest rate
risk doesn’t go away! Instead, the investors in the securitized mortgages now receive the
fixed interest payments. If these investors have themselves financed the investment with
short-term borrowing, then they will be exposed to interest rate risk!
1- 3
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
,1-7 Just like the Great Depression that preceded it 80 years earlier, the causes of the Great
Recession of 2007 and the financial crisis that followed will likely be the subject of
vigorous debate for years to come. As an example of one small aspect of the crisis,
consider how securitized mortgages end up in retirement portfolios, and how a decline in
housing prices in, say Florida, can bankrupt investors half a world away: A mortgage
company makes a bunch of loans to homeowners in Florida; a bank securitizes these
loans and creates tranches consisting interest payments, principal payments, other
combinations of payments, and the various tranches have different seniority levels—
some get paid first, others are residual claimants; a ratings agency rates some of these
pools as investment grade, so pension funds and even individual investors can purchase
them; and Norwegian investors purchase some of these to hold in their retirement
accounts because they offer good rates of return and were highly rated by the ratings
agency.
1- 4
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, 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. A charter includes the following
information: (1) name of the proposed corporation, (2) types of activities it will
pursue, (3) amount of capital stock, (4) number of directors, and (5) names and
addresses of directors. The bylaws are a set of rules drawn up by the founders of the
corporation. Included are such points as: (1) how directors are to be elected (all
elected each year or perhaps one-third each year for 3-year terms), (2) whether the
existing stockholders will have the first right to buy any new shares the firm issues,
and (3) procedures for changing the bylaws themselves, should conditions require it.
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.
1- 5
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, e. In private markets, transactions are worked out directly between two parties and
structured in any manners that appeal 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 have face-to-face communication between buyers and
sellers of securities. In contrast, a computer/telephone network links buyers and
sellers electronically, not face-to-face.
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 the offers
made by the dealers, and can contact the dealer of their choice to arrange a
transaction. An automated trading platform is a computer system in which buyers and
sellers post orders and in which trades are automatically executed for matching
orders.
1- 6
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, 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. 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 A firm’s fundamental, or intrinsic, value is the present value of its free cash flows when
discounted at the weighted average cost of capital. If the market price reflects all relevant
information, then the observed price is also the intrinsic price.
1-4 Earnings per share in the current year will decline due to the cost of the investment made
in the current year and no significant performance impact in the short run. However, the
company’s stock price should increase due to the significant cost savings expected in the
future.
1- 7
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, 1-5 In a well-functioning economy, capital will flow efficiently from those who supply
capital to those who demand it. This transfer of capital can take place in three different
ways:
1. Direct transfers of money and securities occur when a business sells its stocks or
bonds directly to savers, without going through any type of financial institution. The
business delivers its securities to savers, who in turn give the firm the money it needs.
2. Transfers may also go through an investment banking house which underwrites the
issue. An underwriter serves as a middleman and facilitates the issuance of securities.
The company sells its stocks or bonds to the investment bank, which in turn sells
these same securities to savers. The businesses’ securities and the savers’ money
merely “pass through” the investment banking house.
3. Transfers can also be made through a financial intermediary. Here the intermediary
obtains funds from savers in exchange for its own securities. The intermediary uses
this money to buy and hold businesses’ securities. Intermediaries literally create new
forms of capital. The existence of intermediaries greatly increases the efficiency of
money and capital markets.
1-6 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,
resources are allocated more effectively, and the real output of the economy is thereby
increased.
1-7 A primary market is the market in which corporations raise capital by issuing new
securities. An initial public offering is a stock issue in which privately held firms go
public. Therefore, an IPO would be an example of a primary market transaction.
1-8 Traders meet face-to-face in an open outcry auction. In a dealer market, there are “market
makers” who keep an inventory of the stock. These dealers list the prices at which they
are willing to buy or sell. In a traditional dealer market, computerized quotation systems
keep track of all bid and ask quotes, but they don’t actually match buyers and sellers.
Instead, traders must contact a specific dealer to complete the transaction. An automated
trading platform is a computer system in which buyers and sellers post their orders and
then let the computer automatically determine whether a match exists. If a match exists,
the computer automatically executes and reports the trade.
1-9 Broker-dealer networks are registered with the SEC but are much less regulated than
alternative trading systems (ATS) and registered stock exchanges. In a typical broker-
dealer network, the broker-dealer purchases the stock being offered for sale by a client
and then immediately sells it to another client who wished to buy the stock. Notice that
the broker-dealer is the counterparty to each of the clients. The broker-dealer must report
the transactions, but not any information prior to the trade. An alternative trading system
is a broker-dealer than registers with the SEC as an ATS. An ATS usually has an
automated trading platform to match orders from clients, so the owner of the ATS is not
1- 8
© 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
