McGraw-Hill Education 2014

© McGraw-Hill Education 2014

Solutions Manual Chapter 1

Basic

• Auction versus Dealer Markets [LO3] What does it mean when we say that

Euronext is an auction market? How are auction markets different from dealer markets? What kind of market is the London Stock Exchange?

Answer: In auction markets like Euronext, brokers and agents meet at a physical

location (the exchange) to match buyers and sellers of assets. Dealer markets like the foreign exchange market consist of dealers operating at dispersed locales who buy and sell assets themselves, communicating with other dealers either electronically or literally over-the-counter. The London Stock Exchange is a hybrid market where the largest securities are traded in an auction market and the other securities are traded in a dealer market.

5. Goal of the Firm [LO2] Evaluate the following statement: Managers should not

focus on the current equity value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

Answer: Presumably, the current equity value reflects the risk, timing, and

magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.

• Corporate Finance [LO1] Your grandmother sees you reading a fantastic book

called Fundamentals of Corporate Finance. She asks you, ‘What does corporate finance mean?’ Explain to her in a way that doesn’t put her to sleep.Answer: Finance relates to the decision-making and strategies of corporations. It is composed of three main elements.

• The investment decision.
• The financing decision.
• Short-term capital management.

Each decision is framed within the general objective of maximizing firm value while ensuring that risk is appropriately managed.

Think of a family, with one parent earning the monthly salary and the other looking after the children. Every month, money comes into the house and there will be times when the family needs to spend money on items like furniture. This will usually come from savings. However, sometimes, the family will want to buy a car or a house and will need to take out a loan for the investment. At all times, the family must have enough cash and this applies every single day. This example concerns a family, but if you change the object to a corporation, the same decisions need to be made. When we talk about financial decisions relating to families, this is known as personal finance, whereas when we talk about corporations, we call this corporate finance.

(Fundamentals of Corporate Finance 2e (European Edition) by David Hillier, Iain Clacher, Stephen Ross) (Solution Manual, For Complete File, Download link at the end of this File) 1 / 4

Fundamentals of Corporate Finance Second European Edition © McGraw-Hill Education 2014

• Financing Goals [LO2] Small firms tend to raise funds from private investors and

venture capitalists. As these firms grow larger, they focus more on raising capital from the organized capital markets. Explain why this occurs.Answer: The main reason firms choose different forms of financing relates to their cost. The financial manager should choose the funding flow that is cheapest and less risky. When firms are small, they are not able to list on stock exchanges and therefore they will only have access to private investment, be it a bank or a private investor. As they get bigger, stock exchanges become a viable option for funding and hence it can also be used.

• Financial Management Goals [LO2] You have read the first chapter of this textbook

and have taken over a company that you now discover is losing £100,000 a week. At the rate things are going, the company won’t have any cash left in 6 months to pay its creditors. What are your goals as a financial manager? Is this consistent with what you have read in this chapter? Explain.

Answer: As a financial manager, the need to balance between the short and long

term objectives of the firm is important. When the company is in trouble, the financial manager should manage financial planning to enhance short term liquidity to meet the firm’s obligations. Therefore, in this case the objective of the firm will change from maximizing shareholders’ wealth to firm survival and bankruptcy avoidance. However, other options such as asset sell-off can also be undertaken in order to pay creditors. This is consistent with maximizing firm value over the longer term if the manager can ensure that the firm survives.

• Dealer versus Auction Markets [LO3] Explain the difference between dealer and

auction markets. Why do you think both types of market exist? Is there one type of market that is the best? Explain.

Answer: Dealer markets are those markets where firms make continuous quotations

of prices for which they stand ready to buy and sell money market instruments on their own inventory and at their own risk. Agency markets are those in which stockbrokers act as agents for customers in buying or selling shares on most stock exchanges; an agent does not actually acquire the securities. A well-functioning financial system will utilize both systems.

Intermediate

• Corporate Cash Flows [LO3] Strang plc raised £2 million in equity financing last year.

This year, they were able to earn a net 10 per cent on these funds. The company pays a 23 per cent tax on earnings and has a 75 per cent pay-out ratio. How much money did it pay in taxes and dividends? How much did it retain for future

operations? Note: taxes are always paid before dividends.

Answer: We create a summary Income Statement for Strang plc.

Earnings Before Taxes (£2,000,000 x 10%) £200,000 Tax (23% x £200,000) £46,000 Net Income £154,000 Dividends (75% x £154,000) £115,500 2 / 4

Fundamentals of Corporate Finance Second European Edition © McGraw-Hill Education 2014

Retained Earnings £38,500

• Not-for-Profit Firm Goals [LO2] Suppose you were the financial manager of a not-

for-profit business (a not-for-profit hospital, perhaps). What kinds of goals do you think would be appropriate?Answer: Such organizations frequently pursue social or political missions; so many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society. A better approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximize the value of the equity.

• International Firm Goal [LO2] Would our goal of maximizing equity value be

different if we were thinking about financial management in a foreign country? Why or why not?Answer: The goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions.

• Financial Management Goals [LO2] If you are in charge of a private firm and it

doesn’t have a share price, what should be your goal as a financial manager? Explain.Answer: The objective of the firm will remain the same, which is to maximize the market value of existing owners’ equity. Principally, the goal does not change whether the company is private or public since good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it.

Challenge

• Corporate Case Study [LO1, LO2, LO3] Google is special in many ways because of the

firm’s meteoric success and now dominant position in the world. Extend the case study on Google by looking at the title of each chapter and then identifying a similar event or news story about the firm that captures the material covered by the chapter.Answer: This is quite a difficult task for students but it is useful in getting them to read through news stories and to familiarize them with financial websites. The expectations of the instructor should not be too great and the question is very useful for a first lecture in a Corporate Finance class. This answer to this question is very much up to the student. Give them websites that they can visit to collect data including Google, Yahoo! Finance, Reuters, and FT.Com. As an introductory question, it is an excellent way to get students to practically engage with the material and do their own research. You can even get them to prepare a presentation or do the question in groups.

• Ethics and Firm Goals [LO2] Can our goal of maximizing equity value conflict with

other goals, such as avoiding unethical or illegal behaviour? In particular, do you think issues such as customer and employee safety, the environment, and the 3 / 4

Fundamentals of Corporate Finance Second European Edition © McGraw-Hill Education 2014

general good of society fit in this framework, or are they essentially ignored? Think of some specific examples to illustrate your answer.

Answer: An argument can be made either way. At the one extreme, we could argue

that in a market economy, all of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal behavior, and the framework of equity 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. A classic (and highly relevant) thought question that illustrates this debate goes something like this: “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?”

• Financial Management Goals [LO2] You have been the manager of a small

company for 20 years and have become great friends with your employees. In the last month new Norwegian owners have bought out the company’s founding owner and have told you that they need to cut costs in order to maximize the value of the company. One of the things they suggest is to lay off 40 per cent of the workforce.However, you believe that the workforce is the company’s greatest asset. On what basis do you argue against the new owners’ opinions?Answer: The manager can argue on the basis of cost implications, since redundancy packages may be expensive. In addition, there could also be lawsuits and union activity all having a negative effect on firm image. Furthermore, redundancies may adversely affect the production process which will not only affect the firm’s sales but also its loyal customers. Instead the new owners can identify other cost centres where cost savings can be made.

• Financial Market Regulators [LO3] The UK’s Financial Services Authority states that

its objectives are to promote efficient, orderly and fair markets, help retail consumers achieve a fair deal, and improve the country’s business capacity and effectiveness. The German financial markets regulator, BaFin, states that ‘The objective of securities supervision is to ensure the transparency and integrity of the financial market and the protection of investors.’ Are the British and German objectives consistent with each other? Explain.

Answer: Yes. The main theme of UK and Germany regulation is similar which is on

addressing investor protection and protection of quality of the information that market participants receive. The latter will ensure that investors are informed before making decisions and enhance confidence which is crucial element for any well- functioning financial market.

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