ANSWERS TO END-OF-CHAPTER QUESTIONS

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© 2020 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 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 addresses of directors. The bylaws are a set of rules drawn up by the founders of the corporation. Included are such points as: (1) how directors are to be elected (all elected each year or perhaps one-third each year for 3-year terms), (2) whether the existing stockholders will have the first right to buy any new shares the firm issues, and (3) procedures for changing the bylaws themselves, should conditions require it.

• 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.

• Stockholder 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 stocks. The New York Stock Exchange is an example of a capital market. 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 is a secondary market.

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• 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 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 IBM stock, 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

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.

• 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, 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 which invest in short-term debt instruments and offer their shareholders check writing privileges; thus, they are essentially interest-bearing checking accounts.

• 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.

• 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 buy or sell. In a dealer market, a dealer holds an inventory of the security and makes a market by offering to buy or sell. Others who wish to buy or sell can see the offers made by the dealers, and can contact the dealer of their choice to arrange a transaction. An automated trading platform is a computer system in which buyers and sellers post orders and in which trades are automatically executed for matching orders.

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• 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.

• 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, and the main source of financing is debt. Therefore, as the trade deficit increases, the debt financing increases, driving up interest rates. U. S. interest rates must be competitive with foreign interest rates; if the Federal Reserve attempts to set interest rates lower than foreign rates, foreigners will sell U.S. bonds, decreasing bond prices, resulting in higher U. S. rates. Thus, if the trade deficit is large relative to the size of the overall economy, it may hinder the Fed’s ability to combat a recession by lowering interest rates.

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 state and 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.

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.

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© 2020 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.1-5 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:

• 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.

• Transfers may also go through an investment banking house which underwrites the

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 businesses’ securities. Intermediaries literally create new forms of capital. The existence of intermediaries greatly increases the efficiency of money and capital markets.

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 are willing to buy or sell. In a traditional dealer market, computerized quotation systems keep track of all bid and ask quotes, but they don’t actually match buyers and sellers.Instead, traders must contact a specific dealer to complete the transaction. An automated trading platform is a computer system in which buyers and sellers post their orders and then let the computer automatically determine whether a match exists. If a match exists, the computer automatically executes and reports the trade.

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 the broker-dealer is the counterparty to each of the clients. The broker-dealer must report the transactions, but not any information prior to the trade. An alternative trading system is a broker-dealer than registers with the SEC as an ATS. An ATS usually has an automated trading platform to match orders from clients, so the owner of the ATS is not

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