Solutions Manual All

Solutions Manual (All Chapters) Fundamentals of Corporate Finance (Australia) 8 th

edition Ross, Westerfield and Jordan

Brad Jordan Joe Smolira © McGraw-Hill Australia Ross, Fundamentals of Corporate Finance, 8e 1 / 4

© McGraw-Hill Australia Ross, Fundamentals of Corporate Finance, 8e

CHAPTER 1

INTRODUCTION TO CORPORATE

FINANCE

Answers to Concepts review and critical thinking questions

• Capital budgeting (deciding 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 for some shareholders. Some advantages include: limited liability, ease of transferability, ability to raise capital and unlimited life.

• In response to stricter corporate governance legislations, some small firms have elected to go

dark because of the costs of compliance. The costs to comply with some of the corporate governance legislations can be up to several million dollars, which can be a large percentage of a small firm’s profits. A major cost of going dark is less access to capital. Since the firm is no longer publicly traded, it can no longer raise money in the public market. Although the company will still have access to bank loans and the private equity market, the costs associated with raising funds in these markets are usually higher than the costs of raising funds in the public market.

• The treasurer’s office and the chief accountant’s office are the two primary organisational

groups that report directly to the chief financial officer. The chief accountant’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 treasury group’s functions.

• The financial manager is the person responsible for making decisions in the interest of

shareholders of a firm. The financial manager of a firm should be motivated to make good financial management decisions. The goal to maximise the current market value (share price) of the equity of the firm (whether it is publicly traded or not) always motivates the actions of the firm’s financial manager.

• 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. 2 / 4

2 SOLUTIONS MANUAL

This separation of ownership from control in the corporate form of organisation 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 maximising the share price of the equity of the firm.

• The Initial Public Offering (IPO) is a primary market transaction. The IPO is made to raise

capital by the issue of new securities and the primary market is the place where the new securities are traded to raise capital. Hence, IPO is a primary market transaction.

• In auction markets like the ASX, brokers buy and sell shares on the instructions of their clients,

placing orders on the ASX’s automated trading system. Dealer markets such as NASDAQ in the US represent dealers operating in dispersed locales that buy and sell assets themselves.They usually communicate with other dealers electronically or literally over the counter.

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

are conceivable. One goal that is often cited is revenue minimisation; that is, 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 maximise the value of the equity.

• Presumably, the current shares’ 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.

• 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 implies an optimal level of, for example, ethical and/or illegal behaviour, and the framework of share valuation explicitly includes these. At the other extreme, we could argue that these are noneconomic phenomena and are best handled through the political process. 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 of financial management is always to maximise the wealth of the shareholders. If

the financial management is assumed in a foreign country, the goal remains the same.However, the best course of action towards that goal may require adjustments. This is due to different social, political and economic climates, which differ country to country.

• The goal of management should be to maximise 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 3 / 4

CHAPTER 1 - 3

monitored managers have an incentive to fight corporate takeovers in situations such as this one.

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

the relatively small percentage of individual shareholders. Fewer individual shareholders should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional shareholding might lead to a higher degree of agreement between shareholders and management on decisions concerning risky projects. In addition, institutional shareholders may be better able to implement effective monitoring mechanisms on management than can individual shareholders, based on the institutional shareholders’ deeper resources and experiences with their own management. The increase in institutional shareholdings of companies in Australia and the growing activism of these large shareholder groups may lead to a reduction in agency problems for Australian companies and a more efficient market for corporate control.

• How much is too much? Who is worth more, Andrew Barkla or Chris Hemsworth? The

simplest answer is that there is a market for executives just as there is for all types of labour.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 remuneration has grown so dramatically is that companies have increasingly moved to share-based remuneration. Such movement is obviously consistent with the attempt to better align shareholder and management interests. In recent years, share prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is due to rising share prices in general, not managerial performance. Perhaps in the future, executive remuneration will be designed to reward only differential performance, that is, share price increases in excess of general market increases.

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