CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT

Financial Management Theory & Practice, 17e Eugene Brigham, Michael Ehrhardt

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Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

© 2024 Cengage, ISBN: 9780357714485. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.1 Solution and Answer Guide

CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT

TABLE OF CONTENTS

ANSWERS TO END -OF-CHAPTER QUESTIONS ................................................................... 1 MINI CASE ............................................................................................................................ 5

ANSWERS TO END-OF-CHAPTER QUESTIONS

1-1 Define each of the following terms:

• Proprietorship; partnership; corporation; charter; bylaws
• Limited partnership; limited liability partnership; professional corporation
• Stockholder wealth maximization
• Money market; capital market; primary market; secondary market
• Private markets; public markets; derivatives
• Investment bank; financial services corporation; financial intermediary
• Mutual fund; money market fund
• Open outcry auction; dealer market; automated trading platform
• Production opportunities; time preferences for consumption
• Foreign trade deficit
• Algorithmic trading; high-frequency trading

Answer:

• 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 company must file a charter to become a corporation. 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. In limited partnership, at least one partner is liable for all the debts in the partnership. 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. 2 / 4

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

© 2024 Cengage, ISBN: 9780357714485. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.2

• 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. Maximizing shareholder’s wealth is a duty that needs to be fulfill by corporations.

• A money market is a financial market for debt securities with maturities of less

than 1 year (short-term). The New York money market is the example of money market. 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.

• 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 those underlying asset that derives their value from other traded assets. Futures, options, forwards are the examples of derivative market. Therefore, the value of a derivative security is derived from the value of an underlying real asset.

• An investment banker is a facilitator 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 security with funds that is obtained 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 an organization that pools the money deposited by savers to

buy financial instruments. These instruments receive dividends and interest on it.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 securities carry low-risk and also offer their shareholders interest-bearing checking accounts.

• An open outcry auction is a method where traders meet face to face at particular

location at an agreed price and quantity. These traders communicate with each other through hand signals and shouts. 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.

• Production opportunities are the cash generating activity that require cash in the

present but have the ability to generate more cash in future. The higher the 3 / 4

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

© 2024 Cengage, ISBN: 9780357714485. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.3 production opportunities, the more cash will be demanded now. Consumption time preferences refer to the preferred pattern of consumption. Consumers’ time preferences for consumption establish how much consumption they are willing to save or consume at different levels of interest. It majorly impacts required rate of return.

• A foreign trade deficit occurs when businesses and individuals in the United

States import more goods from foreign countries compared to exports. This cause an increase in an interest rate. Trade deficits must be financed, and the main source of financing is debt. Foreign trade surplus occurs when exports are more than imports. 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.

• Algorithmic trading occurs when computers are programed to buy or sell stocks

on behalf of stockholders if a particular event or sequence of events happens.High frequency trading (HFT) is a type of algorithmic trading in which HFT traders, which are computers, buy and sell hundreds or thousands of times a day. Most HFT is done by firms that are created for this purpose because HFT requires expensive computer systems and highly paid programmers.

1-2 What are the three principal forms of business organization? What are the advantages and disadvantages of each?

Answer:

Sole proprietorship, partnership, and corporation are the three principal forms of business organization. The advantages of the Sole proprietorship and partnership includes 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 What is a firm’s fundamental value (which is also called its intrinsic value)? What might cause a firm’s intrinsic value to be different from its actual market value?

Answer:

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. Intrinsic value depends on all of its expected future cash flows.1-4 Edmund Corporation recently made a large investment to upgrade its technology.Although these improvements won’t have much of an impact on performance in the short run, they are expected to reduce future costs significantly. What impact will this investment have on Edmund’s earnings per share this year? What impact might this investment have on the company’s intrinsic value and stock price?

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