ANSWERS TO END-OF-CHAPTER QUESTIONS

Brigham, Financial Management, 4Ce, Solutions © 2023 Cengage Learning Canada, Inc. 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 provincial or federal laws.The corporation is separate and distinct from its owners and managers.

• In a limited partnership, limited partners’ liabilities, investment returns, and control

are limited, while general partners have unlimited liability and control. The primary benefit of a limited liability partnership (LLP) is the protection it offers partners to liability exposure from their other partners’ professional negligence. Individual partners still maintain unlimited liability for their own negligence or negligence of those they directly supervise. A professional corporation (PC) has most of the benefits of incorporation but the participants are not relieved of professional (malpractice) liability.

• Shareholder 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.

• 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 stock. The New York Stock Exchange and Toronto Stock Exchange are examples of capital markets.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 and Toronto Stock Exchange are secondary markets.

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1-2 Brigham, Financial Management, 4Ce, Solutions © 2023 Cengage Learning Canada, Inc.

• 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 Tim Hortons shares, Japanese yen, or pork bellies. Therefore, the value of a derivative security is derived from the value of an underlying real asset.

• An investment banker is a middleman between businesses and savers. Investment

banks assist in the design of corporate securities and then sell them to savers (investors) in the primary markets. 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 shares with funds obtained by issuing shares in the mutual fund.

• A mutual fund is a corporation that sells shares in a 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 that invest in short-term debt instruments, typically with maturity dates of less than one year.

• 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. Consumers’ time preferences for consumption establish how much consumption they are willing to defer, and hence save, at different levels of interest.

• A foreign trade deficit occurs when businesses and individuals in a country 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. Interest rates, however, must be competitive with foreign interest rates; if the central bank attempts to set interest rates lower than foreign rates, foreigners will sell bonds, decreasing bond prices, resulting in higher rates. Thus, if the trade deficit is large relative to the size of the overall economy, it may hinder the central bank’s ability to combat a recession by lowering interest rates. 2 / 4

Brigham, Financial Management, 4Ce, Solutions © 2023 Cengage Learning Canada, Inc. 1-3 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 ownership transfer, and access to capital markets.The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums of capital, (2) unlimited personal liability for business debts, and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) requirements to file federal reports for registration, which are expensive, complex, and time consuming.

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. If material information is withheld from investors, the firm’s intrinsic value may differ from its actual market value.

1-4 a. Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to create a more attractive community that will make it easier to hire a productive workforce. This corporate philanthropy could be received by shareholders negatively, especially those shareholders not living in its headquarters’ city.Shareholders are interested in actions that maximize share price, and if competing firms are not making similar contributions, the “cost” of this philanthropy has to be borne by someone—the shareholders. Thus, the stock price could decrease.

• Companies must make investments in the current period in order to generate future

cash flows. Shareholders should be aware of this and, assuming a correct analysis has been performed, they should react positively to the decision. The Mexican plant is in this category. Assuming that the correct capital budgeting analysis has been made, the stock price should increase in the future.

1-5 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 intrinsic value and its share price should increase due to the significant cost savings expected in the future.

1-6 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:

• Direct transfers of money and securities occur when a business sells its shares 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.

• Transfers may also go through an investment banking house that underwrites the 3 / 4

1-4 Brigham, Financial Management, 4Ce, Solutions © 2023 Cengage Learning Canada, Inc.

issue. An underwriter serves as a middleman and facilitates the issuance of securities.The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. The businesses’ securities and the savers’ money merely “pass through” the investment banking house.

• Transfers can also be made through a financial intermediary. Here, the intermediary

obtains funds from savers in exchange for its own securities. The intermediary uses this money to buy and hold the businesses’ securities. Intermediaries literally create new forms of capital. The existence of intermediaries greatly increases the efficiency of money and capital markets.

1-7 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.

1-8 a. If transfers between the two markets were costly, interest rates would be different in the two areas. Area Y, with the relatively young population, would have less in savings accumulation and stronger loan demand. Area O, with the relatively old population, would have more savings accumulation and weaker loan demand as the members of the older population have already purchased their houses, and are less consumption oriented. Thus, supply/demand equilibrium would be at a higher rate of interest in Area Y.

• Yes. Nationwide branching would reduce the cost of financial transfers between the

areas. Thus, funds would flow from Area O with excess relative supply to Area Y with excess relative demand. This flow would increase the interest rate in Area O and decrease the interest rate in Y until the rates were roughly equal, the difference being the transfer cost.

1-9 The immediate effect would be to lower interest rates.

1-10 A primary market is the market in which corporations raise capital by issuing new securities. An initial public offering (IPO) is a share issue in which privately held firms go public. Therefore, an IPO would be an example of a primary market transaction.

1-11 The two stock markets today are the Toronto Stock Exchange (TSX) and the TSX Venture Exchange. The TSX trades shares of primarily senior Canadian issuers, while the TSX Venture Exchange trades shares of junior or speculative corporations.

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