Managerial Finance

b. Financial asset

c. Public corporation

d. Corporation

e. Treasurer

f. The cost resulting from conflicts of interest between managers and shareholders

2. Financing decisions involve sources of capital used in the running of a firm. Investment decisions, typically called capital budgeting, involve the uses of capital raised in the financing process.

c. Investment decision

d. Investment decision

e. Investment decision

f. Financing decision: On the surface, this may appear similar to a dividend decision, but in reality retiring debt is a change in capital structure and more closely aligned with a financing decision.

3. Both capital budgeting decisions and capital structure decisions are long-term financial decisions. However, capital budgeting decisions are long-term investment decisions, while capital structure decisions are long-term financing decisions. Capital structure decisions essentially involve selecting between equity financing and long-term debt financing.

4.

a. A share of stock financial

b. A personal IOU financial

c. A trademark real

d. A truck real

e. Undeveloped land real

f. The balance in the firm’s checking account financial

g. An experienced and hardworking sales force real

h. A bank loan agreement financial

5. “Companies usually buy real assets. These include both tangible assets such as executive airplanes and intangible assets such as brand names. To pay for these assets, they sell financial assets such as bonds. The decision about which assets to buy is usually termed the capital budgeting or investment decision. The decision about how to raise the money is usually termed the financing decision.”

6.

a. Private corporation

b. Partnership

c. Public corporation

d. Public corporation

7. Double taxation means that a corporation’s income is taxed first at the corporate tax rate, and then, when the income is distributed to shareholders as dividends, the income is taxed again at each shareholder’s personal tax rate.

8. C. Ownership can be transferred without affecting operations and D. Managers can be fired with no effect on ownership.

9. The individual stockholders of a corporation (i.e., the owners) are legally distinct from the corporation itself, which is a separate legal entity. Consequently, the stockholders are not personally liable for the debts of the corporation; the stockholders’ liability for the debts of the corporation is limited to the investment each stockholder has made in the shares of the corporation.

10. B. The corporation survives even if managers are dismissed and C. Shareholders can sell their holdings without disrupting the business.

Solutions to Chapter 2

Financial Markets and Institutions

1. The story of Apple Computer provides three examples of financing sources: equity investments by the founders of the company, trade credit from suppliers, and investments by venture capitalists. Other sources include reinvested earnings of the company and loans from banks and other financial institutions.

2. Money markets: where short-term debt instruments are bought and sold.

Foreign-exchange markets: where currencies are traded; most trading takes place in over-the-counter transactions between the major international banks.

Commodities markets: where agricultural commodities, fuels (including crude oil and natural gas), and metals (such as gold, silver, and platinum) are traded.

Derivatives markets: where options and other derivative instruments are traded.

3. a. False. Financing could flow through an intermediary, for example.

b. False. Investors can buy shares in a private corporation, for example.

c. False. There is no centralized FOREX exchange. Foreign exchange trading takes place in the over-the-counter market.

d. False. Derivative markets are not sources of financing, but markets where the financial manager can adjust the firm’s exposure to various business risks.

e. False. The opportunity cost of capital is the expected rate of return that shareholders can earn in the financial markets on investments with the same risk as the firm’s capital investments.

f. False. The cost of capital is an opportunity cost determined by expected rates of return in the financial markets. The opportunity cost of capital for risky investments is normally higher than the firm’s borrowing rate.

4. a. Investor A buys shares in a mutual fund, which buys part of a new stock issue by a rapidly growing software company.

b. Investor B buys shares issued by the Bank of New York, which lends money to a regional department store chain.

c. Investor C buys part of a new stock issue by the Regional Life Insurance Company, which invests in corporate bonds issued by Neighborhood Refineries, Inc.

5. Buy shares in a mutual fund. Mutual funds pool savings from many individual investors and then invest in a diversified portfolio of securities. Each individual investor then owns a proportionate share of the mutual fund’s portfolio.

6. Yes, an insurance company is a financial intermediary. Insurance companies sell policies and then invest part of the proceeds in corporate bonds and stocks and in direct loans to corporations. The returns from these investments help pay for losses incurred by policyholders.

7.

a. Equities. As a percentage of all investors, households are the largest investor in equities.

b. Pension funds. Banks own almost no corporate equities, but instead rely on fixed- income investments.

c. Commercial banks. In contrast, investment banks raise money for corporations.

8. NASDAQ and The Chicago Mercantile Exchange are financial markets.

9.

a. False. Exchange traded funds (ETFs) are portfolios of stocks that can be bought or sold in a single trade.

b. False. Hedge funds may provide diversification, but usually have very high fees.

c. True. Insurance policy premiums are used to pay claims, create reserves and provide financing for company operations.

d. True. The size of the pension investment is variable, depending on market conditions, while the amount contributed is somewhat fixed.

10. Liquidity is important because investors want to be able to convert their investments into cash quickly and easily when it becomes necessary or desirable to do so. Should personal circumstances or investment considerations lead an investor to conclude that it is desirable to sell a particular investment, the investor prefers to be able to sell the investment quickly and at a price that does not require a significant discount from market value.

Liquidity is also important to mutual funds. When the mutual fund’s shareholders want to redeem their shares, the mutual fund is often forced to sell its securities. In order to maintain liquidity for its shareholders, the mutual fund requires liquid securities.