INTRODUCTION TO CORPORATE

Solutions Manual Essentials of Corporate Finance Ross, Westerfield, and Jordan 10 th edition by Brad Jordan

Joe Smolira NOTE: For Complete File, Download link at the end of this File) 1 / 4

CHAPTER 1

INTRODUCTION TO CORPORATE

FINANCE

Answers to Concepts Review and Critical Thinking Questions

• Capital budgeting (deciding on whether to expand a manufacturing plant), capital structure (deciding

whether to issue new equity and use the proceeds to retire outstanding debt), and working capital management (modifying the firm’s credit collection policy with its customers).

• Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, difficulty in

raising capital funds. Some advantages: simpler, less regulation, the owners are also the managers, sometimes personal tax rates are better than corporate tax rates.

• The primary disadvantage of the corporate form is the double taxation to shareholders of distributed

earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life.

• The treasurer’s office and the controller’s office are the two primary organizational groups that report

directly to the chief financial officer. The controller’s office handles cost and financial accounting, tax management, and management information systems. The treasurer’s office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is concentrated within the functions of the treasurer’s office.

• To maximize the current market value (share price) of the equity of the firm (whether it’s publicly

traded or not).

• In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect

the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist.Management may act in its own or someone else’s best interests, rather than those of the shareholders.If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.

• A primary market transaction.

• In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to

buy and sell their assets. Dealer markets like NASDAQ represent dealers operating in dispersed locales who buy and sell assets themselves, usually communicating with other dealers electronically or literally over the counter.

• Since such organizations frequently pursue social or political missions, many different goals are

conceivable. One goal that is often cited is revenue minimization; i.e., providing their goods and NOTE: (For the Complete File, Download link at the end of this File) 2 / 4

CHAPTER 1 – 2

services to society at the lowest possible cost. Another approach might be to observe that even a not- for-profit business has equity. Thus, an appropriate goal would be to maximize the value of the equity.

• An argument can be made either way. At one extreme, we could argue that in a market economy, all

of these things are priced. This implies an optimal level of ethical and/or illegal behavior and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are non-economic phenomena and are best handled through the political process. The following is a classic (and highly relevant) thought question that illustrates this debate: “A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should the firm do?”

• The goal will be the same, but the best course of action toward that goal may require adjustments due

to different social, political, and economic climates.

• The goal of management should be to maximize the share price for the current shareholders. If

management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this.

• We would expect agency problems to be less severe in other countries, primarily due to the relatively

small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be able to implement more effective monitoring mechanisms than can individual owners, given institutions’ deeper resources and experiences with their own management. The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.S.corporations and a more efficient market for corporate control.

• How much is too much? Who is worth more, Michael Rapino or LeBron James? The simplest answer

is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is due to rising stock prices in general, not managerial performance.Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increases in excess of general market increases.

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3 – SOLUTIONS MANUAL

• The biggest reason that a company would “go dark” is because of the increased audit costs associated

with Sarbanes-Oxley compliance. A company should always do a cost-benefit analysis, and it may be the case that the costs of complying with Sarbox outweigh the benefits. Of course, the company could always be trying to hide financial issues of the company! This is also one of the costs of going dark: Investors surely believe that some companies are going dark to avoid the increased scrutiny from Sarbox. This taints other companies that go dark just to avoid compliance costs. This is similar to the lemon problem with used automobiles: Buyers tend to underpay because they know a certain percentage of used cars are lemons. So, investors will tend to pay less for the company stock than they otherwise would. It is important to note that even if the company delists, its stock is still likely traded, but on the over-the-counter market pink sheets rather than on an organized exchange. This adds another cost since the stock is likely to be less liquid now. All else the same, investors pay less for an asset with less liquidity. Overall, the cost to the company is likely a reduced market value. Whether delisting is good or bad for investors depends on the individual circumstances of the company. It is also important to remember that there are already many small companies that file only limited financial information.

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