Table Of ContentChapter 1
An Overview of Corporate Finance and
The Financial Environment
ANSWERS TO END-OF-CHAPTER QUESTIONS
1-1 a. A proprietorship, or sole proprietorship, is a business owned by one individual. A
partnership exists when two or more persons associate to conduct a business. In
contrast, a corporation is a legal entity created by a state. The corporation is separate
and distinct from its owners and managers.
b. In a limited partnership, limited partners’ liabilities, investment returns and control
are limited, while general partners have unlimited liability and control. A limited
liability partnership (LLP), sometimes called a limited liability company (LLC),
combines the limited liability advantage of a corporation with the tax advantages of a
partnership. A professional corporation (PC), known in some states as a professional
association (PA), has most of the benefits of incorporation but the participants are not
relieved of professional (malpractice) liability.
c. Stockholder wealth maximization is the appropriate goal for management decisions.
The risk and timing associated with expected earnings per share and cash flows are
considered in order to maximize the price of the firm’s common stock.
d. A money market is a financial market for debt securities with maturities of less than
one year (short-term). The New York money market is the world’s largest. Capital
markets are the financial markets for long-term debt and corporate stocks. The New
York Stock Exchange is an example of a capital market. Primary markets are the
markets in which newly issued securities are sold for the first time. Secondary
markets are where securities are resold after initial issue in the primary market. The
New York Stock Exchange is a secondary market.
Answers and Solutions: 1- 1
e. In private markets, transactions are worked out directly between two parties and
structured in any manner that appeals to them. Bank loans and private placements of
debt with insurance companies are examples of private market transactions. In public
markets, standardized contracts are traded on organized exchanges. Securities that
are issued in public markets, such as common stock and corporate bonds, are
ultimately held by a large number of individuals. Private market securities are more
tailor-made but less liquid, whereas public market securities are more liquid but
subject to greater standardization. Derivatives are claims whose value depends on
what happens to the value of some other asset. Futures and options are two important
types of derivatives, and their values depend on what happens to the prices of other
assets, say IBM stock, Japanese yen, or pork bellies. Therefore, the value of a
derivative security is derived from the value of an underlying real asset.
f. An investment banker is a middleman between businesses and savers. Investment
banking houses assist in the design of corporate securities and then sell them to savers
(investors) in the primary markets. Financial service corporations offer a wide range
of financial services such as brokerage operations, insurance, and commercial
banking. A financial intermediary buys securities with funds that it obtains by issuing
its own securities. An example is a common stock mutual fund that buys common
stocks with funds obtained by issuing shares in the mutual fund.
g. A mutual fund is a corporation that sells shares in the fund and uses the proceeds to
buy stocks, long-term bonds, or short-term debt instruments. The resulting dividends,
interest, and capital gains are distributed to the fund’s shareholders after the
deduction of operating expenses. Different funds are designed to meet different
objectives. Money market funds are mutual funds which invest in short-term debt
instruments and offer their shareholders check writing privileges; thus, they are
essentially interest-bearing checking accounts.
h. Physical location exchanges, such as the New York Stock Exchange, facilitate
communication between buyers and sellers of securities. Each physical location
exchange is a physical entity at a particular location and is governed by an elected
board of governors. A computer/telephone network, such as Nasdaq, consists of all
the facilities that provide for security transactions not conducted at a physical location
exchange. These facilities are, basically, the communications network that links the
buyers and sellers.
i. An open outcry auction is a method of matching buyers and sellers. In an auction, the
buyers and sellers are face-to-face, with each stating the prices and which they will
buy or sell. In a dealer market, a dealer holds an inventory of the security and makes
a market by offering to buy or sell. Others who wish to buy or sell can see the offers
made by the dealers, and can contact the dealer of their choice to arrange a
transaction. In an ECN, orders from potential buyers and sellers are automatically
matched, and the transaction is automatically completed.
Answers and Solutions: 1- 2
j. Production opportunities are the returns available within an economy from investment
in productive assets. The higher the production opportunities, the more producers
would be willing to pay for required capital. Consumption time preferences refer to
the preferred pattern of consumption. Consumer’s time preferences for consumption
establish how much consumption they are willing to defer, and hence save, at
different levels of interest.
k. The real risk-free rate is that interest rate which equalizes the aggregate supply of,
and demand for, riskless securities in an economy with zero inflation. The real risk-
free rate could also be called the pure rate of interest since it is the rate of interest that
would exist on very short-term, default-free U.S. Treasury securities if the expected
rate of inflation were zero. It has been estimated that this rate of interest, denoted by
r*, has fluctuated in recent years in the United States in the range of 2 to 4 percent.
The nominal risk-free rate of interest, denoted by r , is the real risk-free rate plus a
RF
premium for expected inflation. The short-term nominal risk-free rate is usually
approximated by the U.S. Treasury bill rate, while the long-term nominal risk-free
rate is approximated by the rate on U.S. Treasury bonds. Note that while T-bonds are
free of default and liquidity risks, they are subject to risks due to changes in the
general level of interest rates.
l. The inflation premium is the premium added to the real risk-free rate of interest to
compensate for the expected loss of purchasing power. The inflation premium is the
average rate of inflation expected over the life of the security. Default risk is the risk
that a borrower will not pay the interest and/or principal on a loan as they become
due. Thus, a default risk premium (DRP) is added to the real risk-free rate to
compensate investors for bearing default risk. Liquidity refers to a firm’s cash and
marketable securities position, and to its ability to meet maturing obligations. A
liquid asset is any asset that can be quickly sold and converted to cash at its “fair”
value. Active markets provide liquidity. A liquidity premium is added to the real
risk-free rate of interest, in addition to other premiums, if a security is not liquid.
m. Interest rate risk arises from the fact that bond prices decline when interest rates rise.
Under these circumstances, selling a bond prior to maturity will result in a capital
loss, and the longer the term to maturity, the larger the loss. Thus, a maturity risk
premium must be added to the real risk-free rate of interest to compensate for interest
rate risk. Reinvestment rate risk occurs when a short-term debt security must be
“rolled over.” If interest rates have fallen, the reinvestment of principal will be at a
lower rate, with correspondingly lower interest payments and ending value. Note that
long-term debt securities also have some reinvestment rate risk because their interest
payments have to be reinvested at prevailing rates.
Answers and Solutions: 1- 3
n. The term structure of interest rates is the relationship between yield to maturity and
term to maturity for bonds of a single risk class. The yield curve is the curve that
results when yield to maturity is plotted on the Y-axis with term to maturity on the X-
axis.
o. When the yield curve slopes upward, it is said to be “normal,” because it is like this
most of the time. Conversely, a downward-sloping yield curve is termed “abnormal”
or “inverted.”
p. The expectations theory states that the slope of the yield curve depends on
expectations about future inflation rates and interest rates. Thus, if the annual rate of
inflation and future interest rates are expected to increase, the yield curve will be
upward sloping, whereas the curve will be downward sloping if the annual rates are
expected to decrease.
r. A foreign trade deficit occurs when businesses and individuals in the U. S. import
more goods from foreign countries than are exported. Trade deficits must be
financed, and the main source of financing is debt. Therefore, as the trade deficit
increases, the debt financing increases, driving up interest rates. U. S. interest rates
must be competitive with foreign interest rates; if the Federal Reserve attempts to set
interest rates lower than foreign rates, foreigners will sell U.S. bonds, decreasing
bond prices, resulting in higher U. S. rates. Thus, if the trade deficit is large relative
to the size of the overall economy, it may hinder the Fed’s ability to combat a
recession by lowering interest rates.
1-2 Sole proprietorship, partnership, and corporation are the three principal forms of business
organization. The advantages of the first two include the ease and low cost of formation.
The advantages of the corporation include limited liability, indefinite life, ease of
ownership transfer, and access to capital markets.
The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums
of capital; (2) unlimited personal liability for business debts; and (3) limited life. The
disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of
transferring ownership, and (4) difficulty of raising large amounts of capital. The
disadvantages of a corporation are (1) double taxation of earnings and (2) requirements to
file state and federal reports for registration, which are expensive, complex and time-
consuming.
1-3 The three primary determinants of a firm’s cash flows are: (1) sales revenues; (2)
operating expenses, such as raw materials costs and labor costs; and (3) the necessary
investments in operating capital, such as buildings, equipment, and inventory.
1-4 Financial intermediaries are business organizations that receive funds in one form and
repackage them for the use of those who need funds. Through financial intermediation,
resources are allocated more effectively, and the real output of the economy is thereby
increased.
Answers and Solutions: 1- 4
1-5 Short-term rates are more volatile because (1) the Fed operates mainly in the short-term
sector, hence Federal Reserve intervention has its major effect here, and (2) long-term
rates reflect the average expected inflation rate over the next 20 to 30 years, and this
average does not change as radically as year-to-year expectations.
1-6 a. If transfers between the two markets were costly, interest rates would be different in
the two areas. Area Y, with the relatively young population, would have less in
savings accumulation and stronger loan demand. Area O, with the relatively old
population, would have more savings accumulation and weaker loan demand as the
members of the older population have already purchased their houses, and are less
consumption oriented. Thus, supply/demand equilibrium would be at a higher rate of
interest in Area Y.
b. Yes. Nationwide branching, and so forth, would reduce the cost of financial transfers
between the areas. Thus, funds would flow from Area O with excess relative supply
to Area Y with excess relative demand. This flow would increase the interest rate in
Area O and decrease the interest rate in Y until the rates were roughly equal, the
difference being the transfer cost.
1-7 a. The immediate effect on the yield curve would be to lower interest rates in the short-
term end of the market, since the Fed deals primarily in that market segment.
However, people would expect higher future inflation, which would raise long-term
rates. The result would be a much steeper yield curve.
b. If the policy is maintained, the expanded money supply will result in increased rates
of inflation and increased inflationary expectations. This will cause investors to
increase the inflation premium on all debt securities, and the entire yield curve would
rise; that is, all rates would be higher.
Answers and Solutions: 1- 5
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
1-1 r* = 3%; I = 2%; I = 4%; I = 4%; MRP = 0; r = ?; r = ?
1 2 3 T-2 T-3
r = r* + IP + DRP + LP + MRP.
Since these are Treasury securities, DRP = LP = 0.
r = r* + IP
T-2 2
IP = (2% + 4%)/2 = 3%
2
r = 3% + 3% = 6%.
T-2
r = r* + IP
T-3 3
IP = (2% + 4% + 4%)/3 = 3.33%
3
r = 3% + 3.33% = 6.33%.
T-3
1-2 r = 6%; r = 8%; LP = 0.5%; DRP = ?
T-10 C-10
r = r* + IP + DRP + LP + MRP.
r = 6% = r* + IP + MRP; DRP = LP = 0.
T-10
r = 8% = r* + IP + DRP + 0.5% + MRP.
C-10
Because both bonds are 10-year bonds the inflation premium and maturity risk premium
on both bonds are equal. The only difference between them is the liquidity and default
risk premiums.
r = 8% = r* + IP + MRP + 0.5% + DRP. But we know from above that r* + IP +
C-10
MRP = 6%; therefore,
r = 8% = 6% + 0.5% + DRP
C-10
1.5% = DRP.
1-3 r* = 3%; IP = 3%; r = 6.2%; MRP = ?
T-2 2
r = k* + IP + MRP = 6.2%
T-2
r = 3% + 3% + MRP = 6.2%
T-2
MRP = 0.2%.
Answers and Solutions: 1- 6
1-4 r = r* + IP + MRP + DRP + LP.
r* = 0.03.
IP = [0.03 + 0.04 + (5)(0.035)]/7 = 0.035.
MRP = 0.0005(6) = 0.003.
DRP = 0.
LP = 0.
r = 0.03 + 0.035 + 0.003 = 0.068 = 6.8%.
1-5 First, note that we will use the equation r = 3% + IP + MRP. We have the data needed
t t t
to find the IPs:
8% + 5% + 4% + 4% + 4%
IP = = 25% = 5%.
5
5
5
IP = 8% + 5% = 6.5%.
2
2
Now we can substitute into the equation:
r = 3% + 6.5% + MRP = 10%. r = 3% + 5% + MRP = 10%.
2 2 5 5
Now we can solve for the MRPs, and find the difference:
MRP = 10% - 8% = 2%. MRP = 10% - 9.5% = 0.5%.
5 2
Difference = (2% - 0.5%) = 1.5%.
Answers and Solutions: 1- 7
1-6 Basic relevant equations:
r = r* + IP + DRP + MRP + LP.
t t t t t
But here IP is the only premium, so r = r* + IP.
t t
IP = Avg. inflation = (I + I + ...)/N.
t 1 2
We know that I = IP = 3% and r* = 2%. Therefore,
1 1
r = 2% + 3% = 5%. r = r + 2% = 5% + 2% = 7%. But,
1 3 1
r = r* + IP = 2% + IP = 7%, so
3 3 3
IP = 7% - 2% = 5%.
3
We also know that I = Constant after t = 1.
t
We can set up this table:
r* I Avg. I = IP r = r* + IP
t t
1 2 3 3%/1 = 3% 5%
2 2 I (3% + I)/2 = IP
2
3 2 I (3% + I + I)/3 = IP r = 7%, so IP = 7% - 2% = 5%.
3 3 3
Avg. I = IP = (3% + 2I)/3 = 5%
3
2I = 12%
I = 6%.
Answers and Solutions: 1- 8
1-7 a. Real
Years to Risk-Free
Maturity Rate (r*) IP** MRP r = r* + IP + MRP
T
1 2% 7.00% 0.2% 9.20%
2 2 6.00 0.4 8.40
3 2 5.00 0.6 7.60
4 2 4.50 0.8 7.30
5 2 4.20 1.0 7.20
10 2 3.60 1.0 6.60
20 2 3.30 1.0 6.30
**The computation of the inflation premium is as follows:
Expected Average
Year Inflation Expected Inflation
1 7% 7.00%
2 5 6.00
3 3 5.00
4 3 4.50
5 3 4.20
10 3 3.60
20 3 3.30
For example, the calculation for 3 years is as follows:
7% + 5% + 3%
= 5.00%.
3
Thus, the yield curve would be as follows:
Answers and Solutions: 1- 9
Interest Rate
(%)
11.0
10.5
10.0
9.5
9.0
8.5
LILCO
8.0
7.5
Exxon
7.0
6.5
T-bonds
0 2 4 6 8 10 12 14 16 18 20
Years to Maturity
b. The interest rate on the Exxon bonds has the same components as the Treasury
securities, except that the Exxon bonds have default risk, so a default risk premium
must be included. Therefore,
r = r* + IP + MRP + DRP.
Exxon
For a strong company such as Exxon, the default risk premium is virtually zero for
short-term bonds. However, as time to maturity increases, the probability of default,
although still small, is sufficient to warrant a default premium. Thus, the yield risk
curve for the Exxon bonds will rise above the yield curve for the Treasury securities.
In the graph, the default risk premium was assumed to be 1.0 percentage point on the
20-year Exxon bonds. The return should equal 6.3% + 1% = 7.3%.
c. LILCO bonds would have significantly more default risk than either Treasury
securities or Exxon bonds, and the risk of default would increase over time due to
possible financial deterioration. In this example, the default risk premium was
assumed to be 1.0 percentage point on the 1-year LILCO bonds and 2.0 percentage
points on the 20-year bonds. The 20-year return should equal 6.3% + 2% = 8.3%.
Answers and Solutions: 1- 10
