978-1259722615 Chapter 1 Solution Manual

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Solutions to Chapter 1

Goals and Governance of the Firm

a. Investment decision

2. Investment decisions, typically called capital budgeting, relate to investments in

tangible and intangible assets. Financing decisions relate to the raising of money

through debt and equity. Repayment of that money as well as interest and dividends

are also financing decisions.

a. Investment decision

b. Financing decision

c. Investment decision

3. Both capital budgeting decisions and capital structure decisions are long-term

financial decisions. However, capital budgeting decisions are long-term investment

a. A share of stock financial

b. A personal IOU financial

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5. “Companies usually buy real assets. These include both tangible assets such as

executive airplanes and intangible assets such as brand names. To pay for these

a. Private corporation

b. Partnership

7. Double taxation means that a corporation’s income is taxed first at the corporate tax

8. C. Ownership can be transferred without affecting operations and D. Managers can

9. The individual stockholders of a corporation (i.e., the owners) are legally distinct from

the corporation itself, which is a separate legal entity. Consequently, the stockholders

10. B. The corporation survives even if managers are dismissed and C. Shareholders

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11. Limited liability is generally advantageous to large corporations. Large corporations

would not be able to obtain financing from thousands or even millions of shareholders

12. B. Responsible for investing the firm’s spare cash and C. Responsible for arranging

13. The responsibilities of the treasurer include the following: supervising cash

management, raising capital, and banking relationships. The controller’s

14. A corporation might cut its labor force dramatically, which could reduce immediate

expenses and increase profits in the short term. Over the long term, however, the firm

Similarly, a corporation can boost profits over the short term by using less costly

materials even if this reduces the quality of the product. Once customers catch on,

The moral of these examples is that, because stock prices reflect present and future

15. Financial managers refer to the opportunity cost of capital because corporations

increase value for their shareholders only by accepting all investment projects that

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16. The stock price reflects the value of both current and future dividends that the

shareholders expect to receive. In contrast, profits reflect performance in the current

17. In this situation, a “superior” rate of return is a rate greater than the rate of return

investors could earn elsewhere in the financial markets from alternative investments

18.

a. This action might appear, superficially, to be a grant to former employees and thus

not consistent with value maximization. However, such “benevolent” actions

might enhance the firm’s reputation as a good place to work, might result in

b. The reduction in dividends, in order to allow increased reinvestment, can be

consistent with maximization of current market value. If the firm has attractive

c. The corporate jet would have to generate benefits in excess of its costs in order to

d. Although the drilling appears to be a bad bet, with a low probability of success,

the project may be value-maximizing if a successful outcome (although unlikely)

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19.

Shareholders want managers to maximize the market value of their investments. The firm

20.

a. Increased market share can be an inappropriate goal if it requires reducing prices to

such an extent that the firm is harmed financially. Increasing market share can be

b. Minimizing costs can also conflict with the goal of value maximization. For

example, suppose a firm receives a large order for a product. The firm should be

c. A policy of underpricing any competitor can lead the firm to sell goods at a price

d. Expanding profits is a poorly defined goal of the firm. The text gives three reasons:

(i) There may be a trade-off between accounting profits in one year and

accounting profits in another year. For example, writing off a bad

(ii) Investing more in the firm can increase profits, even if the increase in profits

(iii) Profits can be affected by accounting rules, so a decision that increases

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21. A. Make shareholders as wealthy as possible by investing in real assets.

22. The director is mistaken. The risk of the project is not determined by the borrowing

23. The opportunity cost of capital for this investment is the rate of return that investors

can earn in the financial markets from safe investments, such as U.S. Treasury

24.

a. Since the government guarantees the payoff for the investment, the opportunity

b. Since the average rate of return from an investment in carbon is expected to be

about 20%, this is the opportunity cost of capital for the investment under

25. Takeover defenses increase the target firm’s agency problems. One of the mechanisms

that stockholders rely on to mitigate agency problems is the threat that an

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26. The contingency arrangement aligns the interests of the lawyer with those of the client.

Neither makes any money unless the case is won. If a client is unsure about the skill or

integrity of the lawyer, this arrangement can make sense. First, the lawyer has an

27. Traders can earn huge bonuses when their trades are very profitable, but if the

trades lose large sums, as in the case of Barings Bank, the trader’s exposure is

28. Even if a shareholder could monitor and improve managers’ performance, and thereby

increase the value of the firm, the payoff would be small, since the ownership share in a

29.

a. Company B: Paying managers according to the performance of the firm’s

stock aligns their interest with those of the owners. Since managers are likely

to seek to maximize their own income, linking their compensation to share

30. Clear and comprehensive financial reports provide essential information to the

numerous shareholders of large corporations, allowing the shareholders to monitor

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31. While the answer to this question is largely a matter of opinion, and there are

significant numbers of “commentators” on each side of the issue, the perspective of the

authors is that failures of corporate governance are a matter of a few “bad apples”

32.

a. A fixed salary means that compensation is (at least in the short run) independent of

b. A salary linked to profits ties the employee’s compensation to this measure of the

c. A salary that is paid partly in the form of the company’s shares means that the

33. Agency costs are caused by conflicts of interest between managers and shareholders,

who are the owners of the firm. In most large corporations, the principals (i.e., the

stockholders) hire the agents (i.e., managers) to act on behalf of the principals in

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34. The national chain has a great incentive to impose quality control on all of its outlets.

If one store serves its customers poorly, that can result in lost future sales. The

The important distinction is not that Joe has one outlet while the national chain has

many. Instead, it is the likelihood of repeat relations with customers and the value of

35. Long-term relationships can encourage ethical behavior. If you know that you will

engage in business with another party on a repeated basis, you will be less likely to take

advantage of your business partner if an opportunity to do so arises. When people say

36. As the text notes, the first step in doing well is doing good by your customers.

Businesses cannot prosper for long if they do not provide to their customers the

products and services they desire. In addition, reputation effects often make it in the

In some circumstances, when firms have incentives to act in a manner inconsistent with

the public interest, taxes or fees can align private and public interests. For example,

taxes or fees charged on pollution make it more costly for firms to pollute, thereby

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37. There need not be a conflict between maximizing shareholder value and

maximizing the value of stakeholders. A good reputation with customers,

employees, and other stakeholders is important for the firm’s long-run profitability

38. There are not necessarily right or wrong answers to these issues. It is important,

however, to keep in mind that short selling, acquisitions, and tax avoidance are all

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