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Chapter 1

FIN300 Ross Westerfield Corporate Finance Solutions Chapter 1 (8th Edition).pdf

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FIN 300
John Currie

CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE Learning Objectives LO1 The basic types of financial management decisions and the role of the financial manager. LO2 The financial implications of the different forms of business organization. LO3 The goal of financial management. LO4 The conflicts of interests that can arise between managers and owners. LO5 The roles of financial institutions and markets. Answers to Concepts Review and Critical Thinking Questions 1. (LO1) 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). (LO1) 2. (LO2) Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to raise capital funds. Some advantages: simpler, less regulation, the owners are also the managers. 3. (LO2) 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, unlimited life, and so forth. 4. (LO4) 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, while 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. 5. (LO3) To maximize the current market value (share price) of the equity of the firm (whether it’s publicly-traded or not). 6. (LO4) 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. 7. (LO5) A primary market transaction. 8. (LO5) In auction markets like the Toronto Stock Exchange (TSX), brokers and agents meet at a central location (the exchange) to match buyers and sellers of assets. Physical locations for stock markets are disappearing as trading becomes more electronic. Dealer markets like Nasdaq consist of dealers operating at dispersed locales who buy and sell assets themselves, communicating with other dealers either electronically or literally over-the-counter. Dealer markets are less transparent than auction markets where trades are reported publicly almost immediately. The auction market run by the TSX is where the stocks of larger Canadian companies are traded; the TSX also operates a dealer market called the Venture Exchange for companies too small to qualify for the TSX auction exchange. S1- 1 9. (LO3) 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. 10. (LO3) Presumably, the current stock 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. 11. (LO3) 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 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. 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?” 12. (LO3) 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. (LO4) The
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