ANSWERS TO BEGINNING -OF-CHAPTER QUESTIONS

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© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.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.

(Intermediate Financial Management, 13e Eugene Brigham, Phillip Daves) (Solution Manual all Chapters) 1 / 4

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© 2019 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:

 =+ = N 0t t t r)(1 CF Value .

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. 2 / 4

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© 2019 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!

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© 2019 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.

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