Ch01-Solutions-Manual

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 c ontrol

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.

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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 c apital 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. ? 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

In an ECN, orders from potential buyers and sellers are automatically matched, and

the transaction is automatically completed.

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. 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 ab ility 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 A firm’s fundamental, or intrinsic, value is the present value of its free cash flows whe n discounted at the weighted average cost of capital. If the market price reflects all relevant information, then the observed price is also the intrinsic price.

1-4 Earnings per share in the current year will decline due to the cost of the investment made in the current year and no significant performance impact in the short run. However, the company’s stock price should increase due to the significant cost savings expected in the future.

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1-5 In a well-functioning economy, capital will flow efficiently from those who supply capital to those who demand it. This transfer of capital can take place in three different ways:

1. Direct transfers of money and securities occur when a business sells its stocks or

bonds directly to savers, without going through any type of financial institution. The

business delivers its securities to savers, who in turn give the firm the money it needs.

2. Transfers may also go through an investment banking house which underwrites the

issue. An underwriter serves as a middleman and facilitates the issuance of securities.

The company sells its stocks or bonds to the investment bank, which in turn sells

these same securities to savers. The businesses’ securities and the savers’ money

merely “pass through” the invest ment banking house.

3. Transfers can also be made through a financial intermediary. Here the intermediary

obtains funds from savers in exchange for its own securities. The intermediary uses

this money to buy and hold businesses’ securities. Intermediar ies literally create new

forms of capital. The existence of intermediaries greatly increases the efficiency of

money and capital markets.

1-6 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.

1-7 A primary market is the market in which corporations raise capital by issuing new securities. An initial public offering is a stock issue in which privately held firms go

public. Therefore, an IPO would be an example of a primary market transaction.

1-8 The physical location exchanges are tangible physical entities. Each of the larger ones occupies its own building, has a limited number of members, and has an elected governing body. A dealer market is defined to include all facilities that are needed to conduct security transactions not made on the physical location exchanges. These facilities include (1) the relatively few dealers who hold inventories of these securities and who are said to “make a market” in these securities; (2) the thousands of brokers who act as agents in bringing the dealers together with investors; and (3) the computers, terminals, and electronic networks that provide a communication link between dealers and brokers.

1-9 The two leading stock markets today are the New York Stock Exchange (NYSE) and the Nasdaq stock market. The NYSE is a physical location exchange, while the Nasdaq is an electronic dealer-based market.

? 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.