Fundamentals of Corporate Finance

Second European Edition

Solutions Manual
Chapter 1
Basic
4. 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.
6. 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 doesnt put her to sleep.
Answer: Finance relates to the decision-making and strategies of
corporations. It is composed of three main elements.
a. The investment decision.
b. The financing decision.
c. 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
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Fundamentals of Corporate Finance

Second European Edition

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.
7. 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.
8. 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 wont 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 firms
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.
9. 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
10.
Corporate Cash Flows [LO3] Strang plc raised 2 million in
equity financing last year. This year, they were able to earn a net
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Fundamentals of Corporate Finance

Second European Edition

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
Retained Earnings
38,500
11.
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.
12.
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.
13.
Financial Management Goals [LO2]If you are in charge
of a private firm and it doesnt 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
14.
Corporate Case Study [LO1, LO2, LO3] Google is special in
many ways because of the firms 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
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Fundamentals of Corporate Finance

Second European Edition

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.
15.
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 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?
16.
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 companys 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 companys 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 firms sales but also
its loyal customers. Instead the new owners can identify other cost
centres where cost savings can be made.

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Fundamentals of Corporate Finance

Second European Edition

17.
Financial Market Regulators [LO3]The UKs 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 countrys 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.

McGraw-Hill Education 2014