Essentials of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate) 9th Edition Solution Manual

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Solutions Manual
Essentials of Corporate Finance
Ross, Westerfield, and Jordan
9th edition
01/03/2016
Prepared by
Brad Jordan
University of Kentucky
Joe Smolira
Belmont University

CHAPTER 1
INTRODUCTION TO CORPORATE
FINANCE
Answers to Concepts Review and Critical Thinking Questions
1. 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).
2. 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, sometimes
personal tax rates are better than corporate tax rates.
3. 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.
4. 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.
5. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly
traded or not).
6. 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. A primary market transaction.
8. 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.
9. 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

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.
10. 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?”
11. 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.
12. 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.
13. 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.
14. How much is too much? Who is worth more, Michael Fries 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 simply 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.

3 – SOLUTIONS MANUAL
15. 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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