Chapter 1
An Overview of Financial Management and
The Financial Environment
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.
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.
e. In private markets, transactions are worked out directly between two parties and
structured in any manner that appeals 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, such as the New York Stock Exchange, facilitate
communication between buyers and sellers of securities. Each physical location exchange
is a physical entity at a particular location and is governed by an elected board of
governors. A computer/telephone network, such as Nasdaq, consists of all the facilities that
provide for security transactions not conducted at a physical location exchange. These
facilities are, basically, the communications network that links the buyers and sellers.
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. In an ECN,
orders from potential buyers and sellers are automatically matched, and the transaction is
automatically completed.
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.
q. 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.
