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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. 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
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.
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
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
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,
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
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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,
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
company’s stock price should increase due to the significant cost savings expected in the
future.
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
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
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
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always the counterparty, in contrast to a broker-dealer network. The ATS must report
trades, but not any pre-trade information. Therefore, an ATS is often called a dark pool.
Stocks can only be listed at a registered stock exchange, although they may be traded
elsewhere. A stock exchange must comply with more regulations than an ATS. In
addition to reporting trades, a stock exchange must also report pre-trade information
regarding bids and quotes.
1-10 The NYSE is the oldest U.S. registered stock exchange. The NASDAQ Stock Market has
the most listings because it is willing to list smaller corporations than the NYSE.
However, the NYSE’s listings have a much bigger market value than NASDAQ’s listed
stocks.
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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
partnership, the professional corporation, and the s corporation.
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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
managers of the firm act in their own self-interests and not in the interests of the
d. What should be the primary objective of managers?
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 significant
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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
development of products and services that consumers want and need, so the profit
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
business dealings. Furthermore, most executives believe that there is a positive
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
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g. What is the weighted average cost of capital?
Answer: The weighted average cost of capital (WACC) is the average rate of return required
by all of the company’s investors (stockholders and creditors). It is affected by the
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 cost that a borrower must pay to use debt capital? What two
components make up the cost of using 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 cost paid to use 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
consumption, (3) risk, and (4) inflation.
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k. What are some economic conditions that affect the cost of money?
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
Eurodollar deposits. Commercial loans (which have maturities up to seven years)
m. List some financial institutions.
Answer: Commercial banks, savings & loans, mutual savings banks, and credit unions, life
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n. What are some different types of markets?
Answer: A market is a method of exchanging one asset (usually cash) for another asset. Some
o. Along what two dimensions can we classify trading procedures??
Answer: They are categorized by “location” (physical location exchanges or
computer/telephone networks) and by the way that orders from buyers and sellers are
matched (open outcry auctions, dealers (i.e., market makers), and automated trading
platforms.
execute trades automatically
p. What are the differences between market orders and limit orders?
Answer: Market orders are to transact as quickly as possible at the current price. Limit orders
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q. Explain the differences among dealer-broker networks, alternative trading systems,
and registered stock exchanges.
Answer: 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-
r. Briefly explain mortgage securitization and how it contributed to the global
economic crisis.
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
the deal. Appraisers thought the real estate boom would continue and over-appraised
house values, getting paid at the time of the appraisal. Originating institutions (like
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