Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
Answers and Solutions: 1- 1
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.
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.
Answers and Solutions: 1- 2
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
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
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,
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
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.
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
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
Answers and Solutions: 1- 4
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.
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
1-8 The physical location exchanges are tangible physical entities. Each of the larger ones
occupies its own building, has a limited number of members, and has an elected
governing body. A dealer market is defined to include all facilities that are needed to
1-9 The two leading stock markets today are the New York Stock Exchange (NYSE) and the
Nasdaq stock market. The NYSE is a physical location exchange, while the Nasdaq is an
electronic dealer-based market.
Mini Case: 1- 5
MINI CASE
Assume that you recently graduated and have just reported to work as an investment
advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle
Dellatorre, a professional tennis player who has just come to the United States from Chile.
Dellatorre is a highly ranked tennis player who would like to start a company to produce
and market apparel that she designs. She also expects to invest substantial amounts of
money through Balik and Kiefer. Dellatorre is also very bright, and, therefore, she would
like to understand, in general terms, what will happen to her money. Your boss has
developed the following set of questions which you must ask and answer to explain the U.S.
financial system to Dellatorre.
a. Why is corporate finance important to all managers?
Answer: Corporate finance provides the skills managers need to: (1) identify and select the
b. Describe the organizational forms a company might have as it evolves from a start-up
to a major corporation. List the advantages and disadvantages of each form.
Answer: The three main forms of business organization are (1) sole proprietorships, (2)
partnerships, and (3) corporations. In addition, several hybrid forms are gaining
popularity. These hybrid forms are the limited partnership, the limited liability
Mini Case: 1- 6
c. How do corporations “go public” and continue to grow? What are agency
problems? What is corporate governance?
Answer: A company goes public when it sells stock to the public in an initial public as the firm
grows, it might issue additional stock or debt. An agency problem occurs when the
d. What should be the primary objective of managers?
Answer: The corporation’s primary goal is stockholder wealth maximization, which translates
d. 1. Do firms have any responsibilities to society at large?
Answer: Firms have an ethical responsibility to provide a safe working environment, to avoid
polluting the air or water, and to produce safe products. However, the most
Mini Case: 1- 7
d. 2. Is stock price maximization good or bad for society?
Answer: The same actions that maximize stock prices also benefit society. Stock price
maximization requires efficient, low-cost operations that produce high-quality goods
and services at the lowest possible cost. Stock price maximization requires the
d. 3. Should firms behave ethically?
Answer: Yes. Results of a recent study indicate that the executives of most major firms in the
United States believe that firms do try to maintain high ethical standards in all of their
e. What three aspects of cash flows affect the value of any investment?
Answer: (1) amount of expected cash flows; (2) timing of the cash flow stream; and (3)
f. What are free cash flows?
Answer: free cash flows are the cash flows available for distribution to all investors
(stockholders and creditors) after paying expenses (including taxes) and making the
g. What is the weighted average cost of capital?
Answer: The weighted average cost of capital (WACC) is the average rate of return required
Mini Case: 1- 8
h. How do free cash flows and the weighted average cost of capital interact to
determine a firm’s value?
Answer: A firm’s value is the sum of all future expected free cash flows, converted into
today’s dollars.
i. Who are the providers (savers) and users (borrowers) of capital? How is capital
transferred between savers and borrowers?
Answer: Households are net savers. Non-financial corporations are net borrowers.
Governments are net borrowers, although the U.S. government is a net saver when it
j. What do we call the price that a borrower must pay for debt capital? What is the
price of equity capital? What are the four most fundamental factors that affect
the cost of money, or the general level of interest rates, in the economy?
Answer: The interest rate is the price paid for borrowed capital, while the return on equity
capital comes in the form of dividends plus capital gains. The return that investors
require on capital depends on (1) production opportunities, (2) time preferences for
Mini Case: 1- 9
k. What are some economic conditions that affect the cost of money?
Answer: The cost of money will be influenced by such things as fed policy, fiscal deficits,
business activity, and foreign trade deficits.
The cost of money for an international investment is also affected by country risk,
which refers to the risk that arises from investing or doing business in a particular
currency to fall.
l. What are financial securities? Describe some financial instruments.
Answer: Financial assets are pieces of paper with contractual obligations. Some short-term
(i.e., they mature in less than a year) are instruments with low default risk are u.s.
treasury bills, banker’s acceptances, commercial paper, negotiable CDs, and
m. List some financial institutions.
Answer: Commercial banks, savings & loans, mutual savings banks, and credit unions, life
n. What are some different types of markets?
Mini Case: 1- 10
Answer: A market is a method of exchanging one asset (usually cash) for another asset. Some
o. How are secondary markets organized?
Answer: They are categorized by “location” (physical location exchanges or
o. 1. List some physical location markets and some computer/telephone networks.
Answer: Physical location exchanges include the NYSE, AMEX, CBOT, and Tokyo stock
o. 2. Explain the differences between open outcry auctions, dealer markets, and
electronic communications networks (ECNS).
Answer: The NYSE and AMEX are the two largest auction markets for stocks (NYSE is a
modified auction, with a “specialist”). Participants have a seat (or trading rights) on
the exchange, meet face-to-face, and place orders for themselves or for their clients;
p. Briefly explain mortgage securitization and how it contributed to the global
economic crisis.
Mini Case: 1- 11
Answer: Homeowners wanted better homes than they could afford. Mortgage brokers
encouraged homeowners to take mortgages that would reset to payments that the
borrowers might not be able to pay because the brokers got a commission for closing
