CHAPTER 1

1. What are the three types of financial management decisions? Give examples
+ 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.
+ Working Capital Management : Modifying the firm's credit collection policy with
its customers.
2. What are the four primary disadvantages to the sole proprietorship and partnership
forms of business organization?
Unlimited liability
Limited life
Difficulty in transferring ownership
Hard to raise capital funds
3. What benefits are there to these types of business organization as opposed to the
corporate form?
Simpler
Less regulation
The owners are also the managers
Sometimes personal tax rates are better than corporate tax rates
4. What is the primary disadvantage of the corporate form of organization?
The primary disadvantage of the corporate form is the double taxation to shareholders of
distributed earning and dividends.
5. Name at least 2 advantages of corporate organization
Limited liability
Ease of transferability
Ability to raise capital
Unlimited life
6. In response to the Sarbanes-Oxley Act, many small firms in the US have opted to
"go dark" and delist their stock. Why might a company choose this route? What are
the costs of "going dark"?
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 then 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 coast 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.

7. In a large corporation, what are the two distinct groups that report to the chief
financial officer? Which group is the focus of corporate finance?
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 treasure's office.
8. What goal should always motivate the actions of the firm's financial manager?
To maximize the current market value (share price) of the equity of the firm (whether its
publicly traded or not)
9. Who owns a corporation?
In the corporate form of ownership, the shareholders are the owners of the firm.
10. Describe the process whereby the owners control the firm's management.
The shareholders elect the directors of the corporation, who in turn appoint the firm's
management.
11. What is the main reason that an agency relationship exists in the corporate form of
organization?
This separation of ownership from control in the corporate form of organization is what
causes agency problems to exist.
12. In this context, what kinds of problems can arise?
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.
13. You've probably noticed coverage in the financial press of an initial public offering
(IPO) of a company's securities. Social networking company Facebook is a relatively
recent example. Is an IPO a primary-market transaction or a secondary-market
transaction?
A primary market transaction.
14. What does it mean when we say the New York Stock Exchange is an auction
market?
In auction markets like the NYSE, brokers and agents meet at a physical location (the
exchange) to buy and sell their assets.
15. How are auction markets different from dealer markets?
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.
16. What kind of market is NASDAQ?
 A dealer market
17. Suppose you were the financial manager of a not-for-profit business (a not for
profit hospital, perhaps). What kinds of goals do you think would be appropriate?
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 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.
18. Can our goal of maximizing he call of the stock conflict with other goals, such as
avoiding unethical or illegal behavior? In particular, do you think subjects such as
customer and employee safety, the environment, and the general good of society fit
in this framework, or are they essentially ignored? Try to think of some specific
scenarios to illustrate your answer.
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 planes.
What should the firm do?"
19. Would our goal of maximizing the value of the stock be different if we were
thinking about financial management in a foreign country? Why or why not?
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.
20. Suppose you own stock in a company. The current price per share is $25. Another
company has just announced that it wants to buy your company and will pay $35
per share to acquire all the outstanding stock. Your company's management
immediately begins fighting off this hostile bid. Is management acting in the
shareholders' best interests? Why or why not?
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.
21. Corporate ownership varies around the world. Historically, individuals have owned
the majority of shares in public corporations in the US. In Germany and Japan,
 however, banks, other large financial institutions, and other companies own most of
the stock in public corporations. Do you think agency problems are likely to be
more or less severe in Germany and Japan than in the US? Why? In recent years,
large financial institutions such as mutual funds and pension funds have been
becoming the dominant owners of stock in the US, and these institutions are
becoming more active in corporate affairs. What are the implications of this trend
for agency problems and corporate control?
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 that can individual owners, given an
institutions' deeper resources and experiences with their own management. The increase
in institutional ownership of stock in the US and the growing activism of these large
shareholder groups may lead to a reduction in agency problems for US corporations and a
more efficient market for corporate control.
22. Critics have charged that compensation to top management in the US is simply too
high and should be cut back. For example, focusing on large corporations, John
Hammergren, CEO of McKesson, earned about $131 million in 2011 and about
$285 million over the 2007-2011 period. Are such amounts excessive? In answering,
it might be helpful to recognize that superstar athletes such as LeBron James, top
entertainers such as Oprah Winfrey, and many others at the top of their respective
fields earn at least as much, if not more.
How much is too much? Who is worth more, John Hammergren or Tiger Woods? 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 argues 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.

CHAPTER 2
1. What does liquidity measure? Explain the trade-off a firm faces between high-
liquidity and low-liquidity levels
Liquidity measures how quickly and easily an asset can be
converted to cash without significant loss in value. It's desirable for firms
 to have high liquidity so that they can more safely meet short-term creditor
demands. However, liquidity also has an opportunity cost. Firms generally reap
higher returns by investing in illiquid, productive assets. It's up to the
firm's financial management staff to find a reasonable compromise between these
opposing needs.
2. Why is it that the revenue and cost figures shown on a standard income statement
may not be representative of the actual cash inflows and outflows that occurred
during a period?
The recognition and matching principles in financial accounting call for revenues,
and the costs associated with producing those revenues, to be "booked" when the
revenue process is essentially complete, not necessarily when the cash is
collected or bills are paid. Note that this way is not necessarily correct;
it's the way accountants have chosen to do it.
3. In preparing a balance sheet, why do you think standard accounting practice
focuses on historical cost rather than market value?
Historical costs can be objectively and precisely measured, whereas market values can be
difficult to estimate, and different analysts would come up with different
numbers. Thus, there is a tradeoff between relevance (market values) and
objectivity (book values).
4. In comparing accounting net income and operating cash flow, what two items do
you find in net income that are not in operating cash flow? Explain what each is and
why it is excluded in operating cash flow.
Depreciation is a non-cash deduction that reflects adjustments made in asset book values
in accordance with the matching principle in financial accounting. Interest
expense is a cash outlay, but it's a financing cost, not an operating cost.
5. Under standard accounting rules, it is possible for a company's liabilities to exceed
its assets. When this occurs, the owners' equity is negative. Can this happen with
market values? Why or why not?
Market values can never be negative. Imagine a share of stock selling for -$20. This
would mean that if you placed an order for 100 shares, you would get the stock
along with a check for $2,000. How many shares do you want to buy? More
generally, because of corporate and individual bankruptcy laws, net worth for a
person or a corporation cannot be negative, implying that liabilities cannot
exceed assets in market value.
6. Suppose a company's cash flow from assets was negative for a particular period. Is
this necessarily a good sign or a bad sign?
For a successful company that is rapidly expanding, for example, capital outlays will
be large, possibly leading to negative cash flow from assets. In general, what matters
is whether the money is spent wisely, not whether cash flow from assets is positive or
negative
7. Suppose a company's operating cash flow was negative for several years running. Is
this necessarily a good sign or a bad sign?
 It's probably not a good sign for an established company, but it would be fairly
ordinary for a start-up, so it depends
8. Could a company's change in NWC be negative in a given year? (Hint: Yes.)
Explain how this might come about. What about net capital spending?
For example, if a company were to
become more efficient in inventory management, the amount of inventory needed
would decline. The same might be true if it becomes better at collecting its
receivables. In general, anything that leads to a decline in ending NWC
relative to beginning NWC would have this effect. Negative net capital spending
would mean more long-lived assets were liquidated than purchased.
9. Could a company's cash flow to stockholders be negative in a given year? (Hint:
Yes.) Explain how this might come about. What about cash flow to creditors?
If a company raises more money from selling stock than it pays in dividends in a
particular period, its cash flow to stockholders will be negative. If a company
borrows more than it pays in interest, its cash flow to creditors will be
negative.
10. Referring back to the homebuilder examples used at the beginning of the chapter,
note that we suggested that stockholders probably didn't suffer as a result of the
reported loss. What do you think was the basis for our conclusion?
The adjustments discussed
were purely accounting changes; they had no cash flow or market value
consequences unless the new accounting information caused stockholders to
revalue the company.
11. A firm's enterprise value is equal to the market value of its debt and equity, less the
firm's holdings of cash and cash equivalents. This figure is particularly relevant to
potential purchasers of the firm. Why?
Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer
would have to take on the company's debt but would pocket its cash. Enterprise value
differs significantly from simple market capitalization in several ways, and it may be a
more accurate representation of a firm's value. In a takeover, the value of a firm's debt
would need to be paid by the buyer when taking over a company. This enterprise value
provides a much more accurate takeover valuation because it includes debt in its value
calculation.
12. Companies often try to keep accounting earnings growing at a relatively steady
pace, thereby avoiding large swings in earnings from period to period. They also try
to meet earnings targets. To do so, they use a variety of tactics. The simplest way is
to control the timing of accounting revenues and costs, which all firms can do at
least some extent. For example, if earnings are looking too low this quarter, then
some accounting costs can be deferred until next quarter. This practice is called
earnings management. It is common, and it raises a lot of questions. Why do firms
do it? Why are firms even allowed to do it under GAAP? Is it ethical? What are the
implications for cash flow and shareholder wealth?
In general, it appears that investors prefer companies that have a steady earnings stream.
If true, this encourages companies to manage earnings. Under GAAP, there are numerous
choices for the way a company reports its financial statements. Although not the reason
for the choices under GAAP, one outcome is the ability of a company to manage
earnings, which is not an ethical decision. Even though earnings and cash flow are often
related, earnings management should have little effect on cash flow (except for tax
implications). If the market is "fooled" and prefers steady earnings, shareholder wealth
can be increased, at least temporarily. However, given the questionable ethics of this
practice, the company (and shareholders) will lose value if the practice is discovered.

CHAPTER 3
1. What effect would the following actions have on a firm's current ratio? Assume
that net working capital is positive.

Inventory is purchased.
A supplier is paid.
A short-term bank loan is repaid.
A long-term debt is paid off early.
A customer pays off a credit account.
Inventory is sold at cost.
Inventory is sold for a profit.
a. If inventory is purchased with cash, then
there is no change in the current ratio. If inventory is purchased on credit,
then there is a decrease in the current ratio if it was initially greater than
1.0.
b. Reducing accounts payable
with cash increases the current ratio if it was initially greater than 1.0.
c. Reducing short-term debt
with cash increases the current ratio if it was initially greater than 1.0.
d. As long-term debt
approaches maturity, the principal repayment and the remaining interest expense
become current liabilities. Thus, if debt is paid off with cash, the current
ratio increases if it was initially greater than 1.0. If the debt has not yet
become a current liability, then paying it off will reduce the current ratio
since current liabilities are not affected.
e. Reduction of accounts
receivables and an increase in cash leaves the current ratio unchanged.
f. Inventory sold at cost
reduces inventory and raises cash, so the current ratio is unchanged.
g. Inventory sold for a profit raises cash in
excess of the inventory recorded at cost, so the current ratio increases.
 2. In recent years, Dixie Co. has greatly increased its current ratio. At the same
time, the quick ratio has fallen. What has happened? Has the liquidity of the
company improved?
The firm has increased inventory relative to other
current assets; therefore, assuming current liability levels remain mostly
unchanged, liquidity has potentially decreased.
3. Explain what it means for a firm to have a current ratio equal to .50. Would the
firm be better off if the current ratio were 1.50? What if it were 15.0? Explain
your answers.
A current ratio of 0.50 means that the firm has twice as much in
current liabilities as it does in current assets; the firm potentially has poor
liquidity. If pressed by its short-term creditors and suppliers for immediate
payment, the firm might have a difficult time meeting its obligations. A
current ratio of 1.50 means the firm has 50% more current assets than it does
current liabilities. This probably represents an improvement in liquidity;
short-term obligations can generally be met com-pletely with a safety factor
built in. A current ratio of 15.0, however, might be excessive. Any excess
funds sitting in current assets generally earn little or no return. These
excess funds might be put to better use by investing in productive long-term
assets or distributing the funds to shareholders.
4. Fully explain the kind of information the following financial ratios provide about
a firm:

Quick ratio
Cash ratio
Capital intensity ratio
Total asset turnover
Equity multiplier p. 84
Times interest earned ratio
Profit margin
Return on assets
Return on equity
Price-earnings ratio
a. Quick
ratio provides a measure of the short-term liquidity of the firm, after
removing the effects of inventory, generally the least liquid of the firm's
current assets. b. Cash ratio represents the
ability of the firm to completely pay off its current liabilities balance with
its most liquid asset (cash).

c. The capital intensity

ratio tells us the dollar amount investment in assets needed to generate one
dollar in sales. d. Total asset turnover
measures how much in sales is generated by each dollar of firm assets. e. Equity
multiplier
represents the degree of leverage for an equity investor of the firm; it
measures the dollar worth of firm assets each equity dollar has a claim to. f. Times
interest earned
ratio provides a relative measure of how well the firm's operating earnings can
cover current interest obligations. g. Profit margin is the
accounting measure of bottom-line profit per dollar of sales. h. Return on assets is a
measure of bottom-line profit per dollar of total assets. i. Return
on equity is a measure of bottom-line profit per dollar of equity. j. Price-earnings ratio
reflects how much value per share the market places on a dollar of accounting
earnings for a firm
5. What types of information do common-size financial statements reveal about the
firm? What is the best use for these common-size statements?
Common size financial statements express all balance sheet
accounts as a percentage of total assets and all income statement accounts as a
percentage of total sales. Using these percentage values rather than nominal
dollar values facilitates comparisons between firms of different size or
business type.
6. Explain what peer group analysis means. As a financial manager, how could you
use the results of peer group analysis to evaluate the performance of your firm?
How is a peer group different from an aspirant group?
Peer group analysis involves comparing the financial ratios and
operating performance of a particular firm to a set of peer group firms in the
same industry or line of business. Comparing a firm to its peers allows the
financial manager to evaluate whether some aspects of the firm's operations,
finances, or investment activities are out of line with the norm, thereby
providing some guidance on appropriate actions to take to adjust these ratios,
if appropriate. An aspirant group would be a set of firms whose performance the
company in question would like to emulate. The financial manager often uses the
financial ratios of aspirant groups as the target ratios for his or her firm;
some managers are evaluated by how well they match the performance of an
identified aspirant group.
7. Why is the Du Pont identity a valuable tool for analyzing the performance of a
firm? Discuss the types of information it reveals as compared to ROE considered
by itself.
Return on equity is probably the most important accounting ratio
that measures the bottom-line performance of the firm with respect to the
equity shareholders. The Du Pont identity emphasizes the role of a firm's
profitability, asset utilization efficiency, and financial leverage in
achieving a ROE figure. For example, a firm with ROE of 20% would seem to be
doing well, but this figure may be misleading if it were a marginally
 profitable (low profit margin) and highly levered (high equity multiplier). If
the firm's margins were to erode slightly, the ROE would be heavily impacted
8. Specialized ratios are sometimes used in specific industries. For example, the so-
called book-to-bill ratio is closely watched for semiconductor manufacturers. A
ratio of .93 indicates that for every $100 worth of chips shipped over some
period, only $93 worth of new orders were received. In January 2009, the North
American semiconductor equipment industry's book-to-bill ratio was 0.48, with
orders of $285.6 million and billings of $579.1 million. The most recent peak in
the book-to-bill ratio was in December 2003 when it reached 1.23. Orders for
January 2009 declined 54 percent from the January 2008 level of $1.28 billion.
What is this ratio intended to measure? Why do you think it is so closely
followed?
The book-to-bill ratio is intended to measure whether demand is growing or falling.
It is closely followed because it is a barometer for the entire high-tech
industry where levels of revenues and earnings have been relatively volatile
9. So-called same-store sales are a very important measure for companies as
diverse as McDonald's and Sears. As the name suggests, examining same-store
sales means comparing revenues from the same stores or restaurants at two
different points in time. Why might companies focus on same-store sales rather
than total sales?
If a company is growing by opening new stores, then presumably total revenues
would be rising. Comparing total sales at two different points in time might be
misleading. Same-store sales control for this by only looking at revenues of
stores open within a specific period
10. There are many ways of using standardized financial information beyond those
discussed in this chapter. The usual goal is to put firms Page 85on an equal
footing for comparison purposes. For example, for auto manufacturers, it is
common to express sales, costs, and profits on a per-car basis. For each of the
following industries, give an example of an actual company and discuss one or
more potentially useful means of standardizing financial information:
a. Public utilities.
b. Large retailers.
c. Airlines.
d. Online services.
e. Hospitals.
f. College textbook publishers.

a. For an electric utility such as Con Ed, expressing costs on a per-kilowatt-hour

basis would be a way to compare costs with other utilities of different sizes.
b. For a retailer such as Sears, expressing sales on a per-square-foot basis would
be useful in comparing revenue production against other retailers.
c. For an airline such as Southwest, expressing costs on a per-passenger-mile
basis allows for comparisons with other airlines by examining how much it costs
 to fly one passenger one mile.
d. For an online service provider such as Comcast, using a cost per internet
session would allow for comparisons with smaller services. A per subscriber basis
would also make sense.
e. For a hospital such as Holy Cross, revenues and costs expressed on a per-bed
basis would be useful.
f.For a college textbook publisher such as McGraw-Hill Education, the leading
publisher of finance textbooks for the college market, the obvious standardization
would be per book sold.
11. In recent years, several manufacturing companies have reported the cash flow
from the sale of Treasury securities in the cash from operations section of the
statement of cash flows. What is the problem with this practice? Is there any
situation in which this practice would be acceptable?
Reporting the sale of Treasury securities as cash flow from operations is an
accounting "trick," and as such, should constitute a possible red flag about the
companies accounting practices. For most companies, the gain from a sale of
securities should be placed in the financing section. Including the sale of securities in
the cash flow from operations would be acceptable for a financial company, such as
an investment or commercial bank.
12. Suppose a company lengthens the time it takes to pay suppliers. How would this
affect the statement of cash flows? How sustainable is the change in cash flows
from this practice?
Increasing the payables period increases the cash flow from operations. This could be
beneficial for the company as it may be a cheap form of financing, but it is basically a
one-time change. The payables period cannot be increased indefinitely as it will
negatively affect the company's credit rating if the payables period becomes too long.

CHAPTER 5
1. [Present Value] The basic present value equation had four parts. What are
they?
The four parts are:
- the present value (PV)
-the future value (FV)
-the discount rate (r)
-the life of the investment (t)
2. [Compounding] What is compounding? What is discounting?
Compounding refers to the growth of a dollar amount through time via
reinvestment of interest earned. It is also the process of determining the future
value of an investment. Discounting is the process of determining the value today
of an amount to be received in the future.
3. [Compounding and Period] As you increase the length of time involved, what
happens to future values? What happens to present values?
Future values grow (assuming a positive rate of return); present values shrink.
4. What happens to future value if you increase the rate r?
The future value rises (assuming it's positive)
5. What happens to the present value if you increase the rate r?
present value falls
6. Take a look back at example 5.7. Is it deceptive advertising? Is it unethical to
advertise a future value like this without a disclaimer?
It would appear to be both deceptive and unethical to run such an ad without a
disclaimer or explanation.
7. Why would TMCC be willing to accept such a small amount todayin
exchange for a promise to repay about 4 times that amount in the future?
It's a reflection of the time value of money. TMCC gets to use the $24,099. If
TMCC uses it wisely, it will be worth more than $100,000 in thirty years.
8. TMCC has the right to buy back the securities on the anniversary date at a
price established when the securities were issued (this feature is a term of this
particulardeal). What impact does this feature have on the desirability of this
security as an investment?
The provision will reduce the desirability security. The provision will reduce the
market value of the security and will be traded at the established price as a reduce by
the required by the market yield for the duration of time to maturity
9. Would you be willing to pay $24,099 today in exchange for $100,000 in 30
years? What would be the key considerations in answering yes or no? Would
your answer depend on who is making the promises to repay?
There are two factors to answer this question. Is the rate of return implicit in the
offer attractive relative too other, and they similar risk with investments? And
how risky is the investment, and how certain are we that we will actually get the
$100,000 in 30 years. The answer does depend on who is going to make the
promise to repay.
10. Supposed that when TMCC offered security for $24,099 the U.S. Treasury
had offered an essentially identical security. Do you think it would have been
higher or lower? Why ?
The Treasury security would have a somewhat higher price because the Treasury
is the strongest of all borrowers.
11. The tmcc security is bought and sold in the ny stock exchange do you think
the price today would exceed the original price? why? if you looked in 10
more years do u think the price would be higher or lower than today's price?
Why ?
yes it would because as time passes the security will tend to moves toward
100,000. As time passes the time until the receipt of 100000 grows shorter and the
present value rises. We could not be sure however because interest rates could be
much higher.

CHAPTER 6
1. There are four pieces to an annuity present value. what are they?
 present value(PV), periodic cash flow (C), discount rate (r), number of
payments or life of the annuity (t)
2. As you increase the length of time involved, what happens to the present
value of an annuity?
assuming positive cash flows, both the present and the future values will rise
3. What happens to the future value of an annuity if you increase the rate r?
what happens to the present value?
assuming positive cash flows, the present value will fall and the future value
will rise.
4. What do you think about the tri-state megabucks lottery discussed in the
chapter advertising a 50,000 prize when the lump sum option is 250,000?
is it deceptive advertising?
It's deceptive, but very common. The basic concept of time value of money is
that a dollar today is not worth the same as a dollar tomorrow. the deception is
particularly irritating given that such lotteries are usually government
sponsored.
5. If you were an athlete negotiating a contract, would you want a big
signing bonus payable immediately and smaller payments in the future,
or vice versa?
If the total money is fixed, you want as much as possible as soon as possible. The
team wants the opposite.
6. Suppose two athletes sign 10-year contracts for $80 million. In one case,
we're told that the $80 million will be paid in 10 equal installments. In the
other case, we're told that the $80 million will be paid in 10 installments,
but the installments will increase by 5 percent per year. Who got the
better deal?
The better deal is the one with equal installments. Given that the total value of
both annuities must be the same, $80 million, the second annuity's first
payment would have to be rather small to have the payments on the second
annuity grow at 5% per year.
7. Should lending laws be changed to require lenders to report EARs
instead of APRs? Why or why not?
Yes, they should. APRs generally don't provide the relevant rate. The only
advantage is that they are easier to compute, but, with modern computing
equipment, that advantage is not very important. Also, the APR's on debt
generally look more attractive that the true rate charged.
8. On subsidized Stafford loans, a common source of financial aid for
college students, interest does not begin to accrue until repayment begins.
Who receives a bigger subsidy a freshman or a senior? Explain.
A freshman does. The reason is that the freshman gets to use the money for
much longer before
interest starts to accrue
9. Eligibility for a subsidized Stafford loan is based on current financial
need. However, both subsidized and unsubsidized Stafford loans are
repaid out of future income. Given this, do you see a possible objection to
having two types?
The subsidy is the present value (on the day the loan is made) of the interest
that would have accrued
up until the time it actually begins to accrue
10. A vatical settlement is a lump sum of money given to a terminally ill
inidivual in exchange for his life insurance policy. When the insured
person dies, the purchaser receives the payout from the life insurance
policy. what factors determine the value of ht viatical settlement?
In general, viatical settlements are ethical. In the case of a viatical settlement,
it is simply an exchange of cash today for payment in the future, although the
payment depends on the death of the seller. The purchaser of the life insurance
policy is bearing the risk that the insured individual will live longer than
expected. Although viatical settlements are ethical, they may not be the best
choice for an individual. In a Businessweek article (October 31, 2005),
options were examined for a 72-year-old male with a life expectancy of eight
years and a $1 million dollar life insurance policy with an annual premium of
$37,000. The four options were: (1) Cash the policy today for $100,000. (2)
Sell the policy in a viatical settlement for $275,000. (3) Reduce the death
benefit to $375,000, which would keep the policy in force for 12 years
without premium payments. (4) Stop paying premiums and don't reduce the
death benefit. This will run the cash value of the policy to zero in five years,
but the viatical settlement would be worth $475,000 at that time. If he died
within five years, the beneficiaries would receive $1 million. Ultimately, the
decision rests with the individual on what they perceive as best for
themselves. The values that will affect the value of the viatical settlement are
the discount rate, the face value of the policy, and the health of the individual
selling the policy.
11. What happens to the future value of a perpetuity if interest rates
increase? What if interest rates decrease?
This is a trick question. The future value of a perpetuity is undefined since the
payments are perpetual. Finding the future value at any particular point
automatically ignores all cash flows beyond that point.
12. In the chapter, we gave several examples of so called pay day loans. As
you saw, the interest rates on these loans can be extremely high and are
even called predatory by some. Do you think such high interest loans are
ethical? Why or why not?
The ethical issues surrounding payday loans are more complex than they might
first appear. On the one hand, the interest rates are astronomical, and the people
paying those rates are typically among the worst off financially to begin with. On
the other hand, and unfortunately, payday lenders are essentially the lenders of
last resort for some. And the fact is that paying $15 for a two-week loan of $100
might be a bargain compared to the alternatives such as having utilities
disconnected or paying bank overdraft fees. Restricting or banning payday
lending also has the effect of encouraging loan sharking, where rates are even
higher and collection practices much less consumer friendly (no payday loan
company has ever demanded a pound of flesh nearest the heart as did Shylock in
The Merchant of Venice). As a final note, such loans are by definition extremely
risky, with a higher likelihood of default. As we will discuss later, higher-risk
investments necessarily demand a higher return.

CHAPTER 9
1. If a project with conventional cash flows has a payback period less than
the project's life can you definitively state the algebraic sign of the NPV?
If you know the discounted payback period is less than the project's life,
what can you say about the NPV?
If a payback period is less than the project's life, that means NPV is positive
for a zero discount rate. If we are using discounted payback, then NPV must
be positive.
2. Suppose a project has conventional cashflows (only one sign change) and
a positive NPV. What do you know about the payback? Discounted
payback? Profitability index? IRR?
If a project has a positive NPV then the discounted payback period must be
less than the project's life, the PI must be greater than 1, and the IRR is bigger
than the rate of return.
3. Describe how the payback period is calculated and describe the
information this measure provides about a sequence of cash flows. What's
the payback criterion rule?
Payback period is the accounting break even point of a series of cash flows.
Point in time where initial cash outflows are fully recovered. Accept project if
payback period is less than your project's life.
4. What are the problems associated with using payback period to evaluate
cash flows?
It does not take into account the TVM and is biased toward short term projects
and ignores cash flows after cutoff period.
5. What are the advantages of using payback period?
It is useful for simplicity and for projects that are biased toward liquidity.
6. Describe how the discounted payback period is calculated, and describe
the information this measure provides about a sequence of cash flows.
What is the decision rule?
 Calculated the same way as payback but each cash flow has to be set to
present value. Accept projects whose discounted cash flows payback before
cutoff period.
7. What are the problems associated with discounted payback?
It ignores all cashflows after the cutoff date.
8. What conceptual advantage does discounted payback method have over
the regular payback method?
It takes into account the time value of money and is usually smaller than
payback.
9. Describe how the NPV is calculated and describe the information this
measure provides about a sequence of cash flows. What is the decision
rule?
NPV is the present value of a project's cash flows. It measures the net increase
or decrease in firm wealth due to a project. Accept project if NPV is positive.

10. Why is NPV considered to be a superior method of evaluating the cash

flows from a project? Suppose the NPV for a project's cash flows is
computed to be $2,500. What does this number represent with respect to
the firm's shareholders?
it has no serious flaws. NPV unambiguously ranks mutually exclusive
projects, and can differentiate between projects of different scale and time
horizon. only drawback is that it relies on cash flow and discount rate values
that are often estimates and not certain.
NPV=2,500 implies that the total shareholder wealth of the firm will increase
by 2,500 if the project is accepted
11. Describe how the IRR is calculated and describe the information this
measure provides about a sequence of cash flows. What is the decision
rule?
IRR is the discount rate where NPV=0. So it is a financial break even rate of
return. Accept project if IRR is greater than discount rate.
12. What is the relationship between IRR and NPV? Where would you prefer
one over the other?
IRR makes NPV=0. NPV is considered ideal compared to IRR and IRR
shouldn't be used for nonconventional (more than one sign change) projects.
13. [IRR] despite its shortcomings in some situations, why do most financial
managers use IRR along with NPV when evaluating projects? can you
think of a situation in which IRR might be more appropriate measure to
use than NPV? Explain ?
It is easier for financial managers to rate performance in relative terms, 12%
(IRR), than in absolute terms, $46,000 (NPV),
IRR would be preferred in a situation where the discount rate was unknown,
IRR would provide more information about the project than would NPV
 14. Describe how the profitability index is calculated, and describe the
information this measure provides about a sequence of cash flows. What
is the decision rule?
The PI is the present value of inflows over outflows. It is a benefit/cost ratio
providing a measure of the relative profitability of a project. Accept projects
with a PI > 1
15. What is the relationship between profitability index and NPV? Are there
situations you would prefer one over the other?
PI = (NPV + cost)/cost =1 + (NPV/cost).
if a firm has a lot of projects with positive NPV and is subject to
capital rationing, PI may provide a good ranking of the projects
16. A project has perpetual cash flows of C per period, a cost of I, and a
required rate of R. what is the relationship between the project's payback
and its IRR? what implications does your answer have for long-lived
projects with relatively constant cash flows?
payback ratio= I/C
IRR=C/1
IRR is the reciprocal of the payback ratio
long lived projects: the sooner the project pays back, the greater is the IRR
17. In oct 2010, automobile manufacturer BMW announced plans to invest
$750 million to increase production at its SC plant by 50%. BMW
apparently felt that it would be better able to compete and create value
with US based facilities. other companies such as Fuji Film and Swiss
chemical company Lonza have reached similar conclusions and taken
similar actions. What are some of the reasons that foreign manufacturers
of products as diverse as automobiles, film, and chemicals might arrive at
this same conclusion?

Manufacturing in the US places the finished product much closer to the point
of sale (savings in transportation costs)
goods spend less time in transit (reduces inventories)
higher portion of costs are paid in dollars. since sales are in dollars, the net
effect is to immunize profits to a large extent against fluctuations in exchange
rates
18. One of the less flattering interpretations of the acronym MIRR is
"meaningless internal rate of return". why do you think this term is
applied to MIRR?
calculated: finding the present value of all cash outflows, the future value of
all cash inflows to the end of the project, ad then calculating the IRR of the
two cash flows
19. What are some of the difficulties that might come up in actual
applications of the various criteria we discussed in this chapter? Which
 one would be the easiest to implement in actual applications? The most
difficult?
The single biggest difficulty, by far, is coming up with reliable cash flow
estimates. Determining an appropriate discount rate is also not a simple task.
These issues are discussed in greater depth in the next several chapters. The
payback approach is probably the simplest, followed by the AAR, but even
these require revenue and cost projections. The discounted cash flow
measures (NPV, IRR, and profitability index) are really only slightly more
difficult in practice.
20. Are the capital budgeting criteria we discussed applicable to not-for-
profit corporations? How should such entities make capital budgeting
decisions? What about the U.S. government? Should it evaluate spending
proposals using these techniques?

Yes, they are. Such entities generally need to allocate available capital
efficiently, just as for-profits do. However, it is frequently the case that the
"revenues" from not-for-profit ventures are not tangible. For example,
charitable giving has real opportunity costs, but the benefits are generally hard
to measure. To the extent that benefits are measurable, the question of an
appropriate required return remains. Payback rules are commonly used in such
cases. Finally, realistic cost/benefit analysis along the lines indicated should
definitely be used by the U.S. government and would go a long way toward
balancing the budget!
21. It is sometimes stated that "the net present value approach assumes
reinvestment of the intermediate cash flows at the required return." Is
this claim correct? To answer, suppose you calculate the NPV of a project
in the usual way. Next, suppose you do the following:

a. Calculate the future value (as of the end of the project) of all the cash
flows other than the initial outlay assuming they are reinvested at the
required return, producing a single future value figure for the project.

b. Calculate the NPV of the project using the single future value
calculated in the previous step and the initial outlay. It is easy to verify
that you will get the same NPV as in your original calculation only if you
use the required return as the reinvestment rate in the previous step.

 Answer :
The statement is incorrect. It is true that if you calculate the future value of
all intermediate cash flows to the end of the project at the required return,
then calculate the NPV of this future value and the initial investment, you
will get the same NPV. However, NPV says nothing about reinvestment of
intermediate cash flows. The NPV is the present value of the project cash
 flows. What is actually done with those cash flows once they are
generated is not relevant. Put differently, the value of a project depends on
the cash flows generated by the project, not on the future value of those
cash flows. The fact that the reinvestment "works" only if you use the
required return as the reinvestment rate is also irrelevant simply because
reinvestment is not relevant in the first place to the value of the project.
One caveat: Our discussion here assumes that the cash flows are truly
available once they are generated, meaning that it is up to firm
management to decide what to do with the cash flows. In certain cases,
there may be a requirement that the cash flows be reinvested. For example,
in international investing, a company may be required to reinvest the cash
flows in the country in which they are generated and not "repatriate" the
money. Such funds are said to be "blocked" and reinvestment becomes
relevant because the cash flows are not truly available.

22. It is sometimes stated that "the internal rate of return approach assumes
reinvestment of the intermediate cash flows at the internal rate of
return." Is this claim correct? To answer, suppose you calculate the IRR
of a project in the usual way. Next, suppose you do the following:

a. Calculate the future value (as of the end of the project) of all the cash
flows other than the initial outlay assuming they are reinvested at the
IRR, producing a single future value figure for the project.

b. Calculate the IRR of the project using the single future value
calculated in the previous step and the initial outlay. It is easy to verify
that you will get the same IRR as in your original calculation only if you
use the IRR as the reinvestment rate in the previous step.

 Answer :
The statement is incorrect. It is true that if you calculate the future value of
all intermediate cash flows to the end of the project at the IRR, then
calculate the IRR of this future value and the initial investment, you will
get the same IRR. However, as in the previous question, what is done with
the cash flows once they are generated does not affect the IRR. Consider
the following example:

C0 C1 C2 IRR
Project A -$100 $10 $110 10%

Suppose this $100 is a deposit into a bank account. The IRR of the cash
flows is 10 percent. Does the IRR change if the Year 1 cash flow is
reinvested in the account, or if it is withdrawn and spent on pizza? No.
Finally, consider the yield to maturity calculation on a bond. If you think
about it, the YTM is the IRR on the bond, but no mention of a
reinvestment assumption for the bond coupons is suggested. The reason is
that reinvestment is irrelevant to the YTM calculation; in the same way,
reinvestment is irrelevant in the IRR calculation. Our caveat about blocked
funds applies here as well.

CHAPTER 10

1. In the context of capital budgeting, what is an opportunity cost?

In this context, an opportunity cost refers to the value of an asset or
other input that will be used in a project. The relevant cost is what the
asset or input is actually worth today, not, for example, what it cost to
acquire
2. Given the choice, would a firm prefer to use MACRS depreciation
or straight-line
depreciation? Why?
For tax purposes, a firm would choose MACRS because it provides for
larger depreciation deductions earlier. These larger deductions reduce
taxes, but have no other cash consequences. Notice that the choice
between MACRS and straight-line is purely a time value issue; the
total depreciation is the
same, only the timing differs.
3. In our capital budgeting examples, we assumed that a firm would
recover all of the working capital it invested in a project. Is this a
reasonable assumption? When might it not be valid?
It's probably only a mild over-simplification. Current liabilities will all
be paid presumably. The cash portion of current assets will be
retrieved. Some receivables won't be collected, and some inventory
will not be sold, of course. Counterbalancing these losses is the fact
that inventory sold above cost (and not replaced at the end of the
project's life) acts to increase working capital. These effects tend to
offset.
4. Suppose a financial manager is quoted as saying, "Our firm uses
the standalone principle. Because we treat projects like minifirms
in our evaluation process, we include financing costs because they
are relevant at the firm level." Critically evaluate this statement.
Management's discretion to set the firm's capital structure is
applicable at the firm level. Since any one particular project could
be financed entirely with equity, another project could be financed
with debt, and the firm's overall capital structure remain
unchanged, financing costs are not relevant in the analysis of a
project's incremental cash flows according to the stand-alone
principle.
5. "When evaluating projects, we're only concerned with the
relevant incremental aftertax cash flows. Therefore, because
depreciation is a noncash expense, we should ignore its effects
when evaluating projects." Critically evaluate this statement.
Depreciation is a non-cash expense, but it is tax-deductible on the
income statement. Thus depreciation causes taxes paid, an actual cash
outflow, to be reduced by an amount equal to the depreciation tax
shield TCD. A reduction in taxes that would otherwise be paid is the
same thing as a cash inflow, so
the effects of the depreciation tax shield must be added in to get the
total incremental after-tax cash flows
6. When is EAC analysis appropriate for comparing two or more
projects? Why is this method used? Are there any implicit
assumptions required by this method that you find troubling?
The EAC approach is appropriate when comparing mutually exclusive
projects with different lives that will be replaced when they wear out.
This type of analysis is necessary so that the projects have a common
life span over which they can be compared. For example, if one project
has a three-year life and the other has a five-year life, then a 15-year
horizon is the minimum necessary to place the two projects on an
equal footing, implying that one project will be repeated five times and
the other will be repeated three times. Note the shortest common life
may be quite long when there are more than two alternatives and/or the
individual project lives are relatively long. Assuming this type of
analysis is valid implies that the project cash flows remain the same
over the common life, thus ignoring the possible effects of, among
other things: (1) inflation, (2) changing economic conditions, (3) the
increasing unreliability of cash flow estimates that occur far into the
future, and (4) the possible effects of future technology improvement
that could alter the project cash flows.
7. A major college textbook publisher as an exisiting fin text book.
the publisher is debating whether to produce an essentialized
version, meaning shorter and lower priced. what are some of the
considerations that should come into play?
- one would consider both positive and negative side effects such as
the McDonald's example I used in class. 1) There are two particularly
important considerations. The first is erosion. Will the essentialized
book simply displace copies of the existing book that would have
otherwise been sold? This is of special concern given the lower price.
The second consideration is competition. Will other publishers step
inand produce such a product? If so, then any erosion is much less
relevant. A particular concern to book publishers (and producers of a
variety of other product types) is that the publisher only makes money
from the sale of new books. Thus, it is important to examine whether
the new book would displace sales of used books (good from the
 publisher's perspective) or new books (not The concern arises any time
there is an active market for used product
8. In evaluating the Cayenne, would you consider the possible
damage to porsche's reputation erosion?
--> Yes, the damage to Porsche's reputation is a factor the company
needed to consider. If the reputation was damaged, the company would
have lost sales of its existing car lines.
9. Porsche was one of the last manufacturers to enter the sports
utility vehicle market. Why would one company decide to proceed
with a product when other companies, at least initially, decide not
to enter the market?
One company may be able to produce at lower incremental cost or
market better. Also, of course, one of the two may have made a
mistake!
10. In evaluating the Cayenne, what do you think Porsche needs to
assume regarding the substantial profit margins that exist in this
market? Is it likely they will be maintained as the market becomes
more competitive, or will Porsche be able to maintain the profit
margin because of its image and the performance of the Cayenne?

Porsche would recognize that the outsized profits would dwindle as more product
comes to market and competition becomes more intense.

CHAPTER 14

1. On the most basic level, if a firm's WACC is 12 percent, what does this mean?
It is the minimum rate of return the firm must earn overall on its existing assets. If it
earns more than this, value is created
2. In calculating the WACC, if you had to use book values for either debt or equity,
which would you choose? Why?
Book values for debt are likely to be much closer to market values than are equity book
values.
3. If you can borrow all the money you need for a project at 6 percent, doesn't it
follow that 6 percent is your cost of capital for the project?
No. The cost of capital depends on the risk of the project, not the source of the money.
4. Why do we use an aftertax figure for cost of debt but not for cost of equity?
Interest expense is tax-deductible. There is no difference between pretax and aftertax
equity costs.
5. What are the advantages of using the DCF model for determining the cost of equity
capital?
The primary advantage of the DCF model is its simplicity.
6. What are the disadvantages?
The method is disadvantaged in that (a) the model is applicable only to firms that actually
pay dividends; many do not; (b) even if a firm does pay dividends, the DCF model
requires a constant dividend growth rate forever; (c) the estimated cost of equity from this
 method is very sensitive to changes in g, which is a very uncertain parameter; and (d) the
model does not explicitly consider risk, although risk is implicitly considered to the
extent that the market has impounded the relevant risk of the stock into its market price.
7. What specific piece of information do you need to find the cost of equity using this
model?
While the share price and most recent dividend can be observed in the market, the
dividend growth rate must be estimated.
8. What are some of the ways in which you could get this estimate?
Two common methods of estimating g are to use analysts' earnings and payout forecasts
or to determine some appropriate average historical g from the firm's available data.
9.  What are the advantages of using the SML approach to finding the cost of equity
capital?
Two primary advantages of the SML approach are that the model explicitly incorporates
the relevant risk of the stock and the method is more widely applicable than is the
dividend discount model, since the SML doesn't make any assumptions about the firm's
dividends.
10. What are the disadvantages?
The primary disadvantages of the SML method are (a) three parameters (the risk-free
rate, the expected return on the market, and beta) must be estimated, and (b) the method
essentially uses historical information to estimate these parameters.
11. What specific pieces of information are needed to use this method? Are all of these
variables observable, or do they need to be estimated?

The risk-free rate is usually estimated to be the yield on very short maturity T-bills and is,
hence, observable; the market risk premium is usually estimated from historical risk
premiums and, hence, is not observable. The stock beta, which is unobservable,
12. What are some of the ways in which you could get these estimates?
Is usually estimated either by determining some average historical beta from the firm and
the market's return data, or by using beta estimates provided by analysts and investment
firms. is usually estimated either by determining some average historical beta from the
firm and the market's return data, or by using beta estimates provided by analysts and
investment firms.
13. How do you determine the appropriate cost of debt for a company?
The appropriate aftertax cost of debt to the company is the interest rate it would have to
pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the
company is observed, the company has an accurate estimate of its cost of debt.
14. Does it make a difference if the company's debt is privately placed as opposed to
being publicly traded? How would you estimate the cost of debt for a firm whose
only debt issues are privately held by institutional investors?
If the debt is privately placed, the firm could still estimate its cost of debt by (a) looking
at the cost of debt for similar firms in similar risk classes, (b) looking at the average debt
cost for firms with the same credit rating (assuming the firm's private debt is rated), or (c)
consulting analysts and investment bankers. Even if the debt is publicly traded, an
additional complication occurs when the firm has more than one issue outstanding; these
issues rarely have the same yield because no two issues are ever completely
homogeneous.
 15. Suppose Tom O'Bedlam, president of Bedlam Products, Inc., has hired you to
determine the firm's cost of debt and cost of equity capital.
The stock currently sells for $50 per share, and the dividend per share will
probably be about $5. Tom argues, "It will cost us $5 per share to use the
stockholders' money this year, so the cost of equity is equal to 10 percent (= $5/50)."
What's wrong with this conclusion?

a.This only considers the dividend yield component of the required return on equity.
16. Based on the most recent financial statements, Bedlam Products' total liabilities
are $8 million. Total interest expense for the coming year will be about $1 million.
Tom therefore reasons, "We owe $8 million, and we will pay $1 million interest.
Therefore, our cost of debt is obviously $1 milliony8 million = 12.5%." What's
wrong with this conclusion?
b. This is the current yield only, not the promised yield to maturity. In addition, it is
based on the book value of the liability, and it ignores taxes.
17. Based on his own analysis, Tom is recommending that the company increase its use
of equity financing because "debt costs 12.5 percent, but equity costs only 10
percent; thus equity is cheaper." Ignoring all the other issues, what do you think
about the conclusion that the cost of equity is less than the cost of debt?

c. Equity is inherently more risky than debt (except, perhaps, in the unusual case
where a firm's assets have a negative beta). For this reason, the cost of equity
exceeds the cost of debt. If taxes are considered in this case, it can be seen that at
reasonable tax rates, the cost of equity does exceed the cost of debt.
18. Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major
natural gas producer, are thinking of investing in natural gas wells near Houston.
Both companies are all equity financed. Dow and Superior are looking at identical
projects. They've analyzed their respective investments, which would involve a
negative cash flow now and positive expected cash flows in the future. These cash
flows would be the same for both firms. No debt would be used to finance the
projects. Both companies estimate that their projects would have a net present
value of $1 million at an 18 percent discount rate and a −$1.1 million NPV at a 22
percent discount rate. Dow has a beta of 1.25, whereas Superior has a beta of .75.
The expected risk premium on the market is 8 percent, and risk-free bonds are
yielding 12 percent. Should either company proceed? Should both? Explain.

RSup = .12 + .75(.08) = .1800, or 18.00%

Both should proceed. The appropriate discount rate does not depend on which company
is investing; it depends on the risk of the project. Since Superior is in the business, it is
closer to a pure play. Therefore, its cost of capital should be used. With an 18 percent
cost of capital, the project has an NPV of $1 million regardless of who takes it.
19. Under what circumstances would it be appropriate for a firm to use different costs
of capital for its different operating divisions? If the overall firm WACC were used
as the hurdle rate for all divisions, would the riskier divisions or the more
conservative divisions tend to get most of the investment projects? Why? If you
were to try to estimate the appropriate cost of capital for different divisions, what
 problems might you encounter? What are two techniques you could use to develop
a rough estimate for each division's cost of capital?

If the different operating divisions were in much different risk classes, then separate cost of
capital figures should be used for the different divisions; the use of a single, overall cost of
capital would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to
receive more funds for investment projects, since their return would exceed the hurdle rate
despite the fact that they may actually plot below the SML and, hence, be unprofitable projects
on a risk-adjusted basis. The typical problem encountered in estimating the cost of capital for a
division is that it rarely has its own securities traded on the market, so it is difficult to observe the
market's valuation of the risk of the division. Two typical ways around this are to use a pure play
proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on
the perceived risk of the division.

CHAPTER 15

1. In the aggregate, debt offerings are much more common than equity offerings and
typically much larger as well. Why?
A company's internally generated cash flow provides a source of equity financing. For a
profitable company, outside equity may never be needed. Debt issues are larger because
large companies have the greatest access to public debt markets. Equity Issuers are
frequently small companies going public; such issues are often quite small.
2. Why are the costs of selling equity so much larger than the costs of selling debt?
Economies of scale are part of the answer. Debt issues are also simply easier and less
risky to sell from an investment bank's perspective. Very large amounts of debt securities
can be sold to a relatively small number of buyers (pension funds & insurance
companies), and debt securities are much easier to price.
3. Why do noninvestment-grade bonds have much higher direct costs that investment-
grade issues?
They are riskier and harder to market from an investment bank's perspective.
4. Why is underpricing not a great concern with bond offerings?
Yields on comparable bonds can usually be readily observed, so pricing a bond issue
accurately is much less difficult.
5. The Zipcar IPO was underpriced by about 56 percent. Should Zipcar be upset at
Goldman over the underpricing?
When underpricing occurs, a company loses out on the difference between the market
value of the new offering and the offered IPO share price. This money is considered "left
on the table," and is an indirect cost of issuing new securities. Assuch, a 56%
underpricing in Zipcar's IPO is a significant amount of money that has been lost by the
company due to the underwriter's inability to accurately estimate the appropriate IPO
offering price. This is well above the norm for underpricing an IPO, and Zipcar should be
upset.
6. In the previous question, how would it affect your thinking to know that the
company was incorporated about 10 years earlier, had only $186 million in revenues
in 2010, and had never earned a profit? Additionally, the viability of the company's
business model was still unproven.
 It would not affect my thinking due to the fact that the underwriters should have
considered all this information in determining the appropriate IPO per share price.
7. In the previous two questions, how would it affect your thinking to know that in
addition to the 9.68 million shares offered in the IPO, Zipcar had an additional 30
million shares outstanding? Of those 30 million shares, 14.1 million shares were
owned by four venture capital firms and 15.5 million shares were owned by the 12
directors and executive officers.

Of almost 40 million shares, approximately only 1/4thof them were underpriced. The
remaining 30 million outstanding shares are priced appropriately, so that may be taken
into consideration.
8. Ren-Stimpy International is planning to raise fresh equity capital by selling a large
new issue of common stock. Ren-Stimpy is currently a publicly traded corporation
and is trying to choose between an underwritten cash offer and a rights offering (not
underwritten) to current shareholders. Ren-Stimpy management is interested in
minimizing the selling costs and has asked you for advice on the choice of issue
methods. What is your recommendation and why?

We recommend that RS management in minimizing the selling share holders that are not
underwritten right offers are rare and also involves hidden cost.

9. In 1980, a certain assistant professor of finance bought 12 initial public offerings of

common stock…… Did he have bad luck or should he have expected to do worse
than the average initial public offering investor? Explain.
Bought a total opf 12 ipo when the company has issued shares, in 1980 oil and gas
companies had a very good year and a total 22 comapnies issued ipos in the year 1980.
used to purchase shares through the IPO and after a month he used to sell the shares. total
he has invested 8,400 and gets only 10,000 that is only 20% return on the purchase price
of IPO

CHAPTER 16

1. Business Risk versus Financial Risk [LO1] Explain what is meant by business risk
and financial risk . Suppose Firm A has greater business risk than Firm B. Is it true
that Firm A also has a higher cost of equity capital? Explain.
→ Business risk is the equity risk arising from the nature of the firm's operating
activity, and is directly related to the systematic risk of the firm's assets. Financial
risk is the equity risk that is due entirely to the firm's chosen capital structure. As
financial leverage, or the use of debt financing, increases, so does financial risk and,
hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity
if it uses greater leverage
2. M&M Propositions [LO1] How would you answer in the following debate?
 Q: Isn’t it true that the riskiness of a firm's equity will rise if the firm increases its
use of debt financing?
A: Yes, that’s the essence of M&M Proposition II.
Q: And isn’t it true that, as a firm increases its use of borrowing, the likelihood of
default increases, thereby increasing the risk of the firm's debt?
A: Yes.
Q: In other words, increased borrowing increases the risk of the equity and the
debt?
A: That’s right.
Q: Well, given that the firm uses only debt and equity financing, and given that the
risks of both are increased by increased borrowing, does it not follow that increasing
debt increases the overall risk of the firm and therefore decreases the value of the
firm?
A: ??
→ No, it doesn't follow. While it is true that the equity and debt costs are rising, the
key thing to remember is that the cost of debt is still less than the cost of equity.
Since we are using more and more debt, the WACC does not necessarily rise, so the
value of the firm does not necessarily fall.
3. Optimal Capital Structure [LO1] Is there an easily identifiable debt–equity ratio
that will maximize the value of a firm? Why or why not?
→ Because many relevant factors such as bankruptcy costs, tax asymmetries, and
agency costs cannot easily be identified or quantified, it's practically impossible to
determine the precise debt-equity ratio that maximizes the value of the firm.
However, if the firm's cost of new debt suddenly becomes much more expensive, it's
probably true that the firm is too highly leveraged.
4. Observed Capital Structures [LO1] Refer to the observed capital structures given in
Table 16.7 of the text. What do you notice about the types of industries with respect
to their average debt–equity ratios? Are certain types of industries more likely to be
highly leveraged than others? What are some possible reasons for this observed
segmentation? Do the operating results and tax history of the firms play a role?
How about their future earnings prospects? Explain.
→ The more capital intensive industries, such as airlines, cable television, and
electric utilities, tend to use greater financial leverage. Also, industries with less
predictable future earnings, such as computers or drugs, tend to use less financial
leverage. Such industries also have a higher concentration of growth and startup
firms. Overall, the general tendency is for firms with identifiable, tangible assets
and relatively more predictable future earnings to use more debt financing. These
 are typically the firms with the greatest need for external financing and the greatest
likelihood of benefiting from the interest tax shelter.
5. Financial Leverage [LO1] Why is the use of debt financing referred to as financial
“leverage”?
→ It's called leverage (or "gearing" in the UK) because it magnifies gains or losses.
6. Homemade Leverage [LO1] What is homemade leverage?
→ Homemade leverage refers to the use of borrowing on the personal level as
opposed to the corporate level.
7. Bankruptcy and Corporate Ethics [LO3] As mentioned in the text, some firms have
filed for bankruptcy because of actual or likely litigation-related losses. Is this a
proper use of the bankruptcy process?
→ One answer is that the right to file for bankruptcy is a valuable asset, and the
financial manager acts in shareholders' best interest by managing this asset in ways
that maximize its value. To the extent that a bankruptcy filing prevents "a race to
the courthouse steps," it would seem to be a reasonable use of the process.
8. Bankruptcy and Corporate Ethics [LO3] Firms sometimes use the threat of a
bankruptcy filing to force creditors to renegotiate terms. Critics argue that in such
cases, the firm is using bankruptcy laws “as a sword rather than a shield.” Is this an
ethical tactic?
→ As in the previous question, it could be argued that using bankruptcy laws as a
sword may simply be the best use of the asset. Creditors are aware at the time a loan
is made of the possibility of bankruptcy, and the interest charged incorporates it.
9. Bankruptcy and Corporate Ethics [LO3] As mentioned in the text, Continental
Airlines filed for bankruptcy, at least in part, as a means of reducing labor costs.
Whether this move was ethical, or proper, was hotly debated. Give both sides of the
argument.
→ One side is that Continental was going to go bankrupt because its costs made it
uncompetitive. The bankruptcy filing enabled Continental to restructure and keep
flying. The other side is that Continental abused the bankruptcy code. Rather than
renegotiate labor agreements, Continental simply abrogated them to the detriment
of its employees. In this question, as well as the last several, an important thing to
keep in mind is that the bankruptcy code is a creation of law, not economics. A
strong argument can always be made that making the best use of the bankruptcy
code is no different from, for example,
minimizing taxes by making the best use of the tax code. Indeed, a strong case can
be made that it is the financial manager's duty to do so. As the case of Continental
illustrates, the code can be changed if socially undesirable outcomes are a problem.
 10. Capital Structure Goal [LO1] What is the basic goal of financial management with
regard to capital structure?
→ The basic goal is to minimize the value of non marketed claims.
CHAPTER 18
1. Operating Cycle [LO1] What are some of the characteristics of a firm with a long
operating cycle?
→ These are firms with relatively long inventory periods and/or relatively long
receivables periods. Thus, such firms tend to keep inventory on hand, and they
allow customers to purchase on credit and take a relatively long time to pay.
2. Cash Cycle [LO1] What are some of the characteristics of a firm with a long cash
cycle?
→ These are firms that have a relatively long time between the time purchased
inventory is paid for and the time that inventory is sold and payment received.
Thus, these are firms that have relatively short payables periods and/or relatively
long receivable cycles.
3. Sources and Uses [LO4] For the year just ended, you have gathered the following
information about the Holly Corporation:
a. A $200 dividend was paid.
→ Use: The cash balance declined by $200 to pay the dividend.
b. Accounts payable increased by $500.
→ Source:The cash balance increased by $500, assuming the goods bought on
payable credit were sold for cash.
c. Fixed asset purchases were $900.
→ Use: The cash balance declined by $900 to pay for the fixed assets
d. Inventories increased by $625.
→ Use: The cash balance declined by $625 to pay for the higher level of inventory.
e. Long-term debt decreased by $1,200. Label each as a source or use of cash and
describe its effect on the firm's cash balance.
→ Use: The cash balance declined by $1,200 to pay for the redemption of debt.
4. Cost of Current Assets [LO2] Loftis Manufacturing, Inc., has recently installed a
just-in-time (JIT) inventory system. Describe the effect this is likely to have on the
company’s carrying costs, shortage costs, and operating cycle.
→ Carrying costs will decrease because they are not holding goods in inventory.
Shortage costs will probably increase depending on how close the suppliers are and
 how well they can estimate need. The operating cycle will decrease because the
inventory period is decreased.
5. Operating and Cash Cycles [LO1] Is it possible for a firm's cash cycle to be longer
than its operating cycle? Explain why or why not.
→ Since the cash cycle equals the operating cycle minus the accounts payable
period, it is not possible for the cash cycle to be longer than the operating cycle if the
accounts payable period is positive. Moreover, it is unlikely that the accounts
payable period would ever be negative since that implies the firm pays its bills
before they are incurred.
Use the following information to answer Questions 6–10: Last month, BlueSky
Airline announced that it would stretch out its bill payments to 45 days from 30
days. The reason given was that the company wanted to “control costs and optimize
cash flow.” The increased payables period will be in effect for all of the company’s
4,000 suppliers.
6. Operating and Cash Cycles [LO1] What impact did this change in payables policy
have on BlueSky’s operating cycle? Its cash cycle?
→ 6.It lengthened its payables period, thereby shortening its cash cycle. It will have
no effect on the operating cycle
7. Operating and Cash Cycles [LO1] What impact did the announcement have on
BlueSky’s suppliers?
→ The supplier's receivables period will increase, thereby increasing their operating
and cash cycles.
8. Corporate Ethics [LO1] Is it ethical for large firms to unilaterally lengthen their
payables periods, particularly when dealing with smaller suppliers?
→ It is sometimes argued that large firms take advantage of smaller firms by
threatening to take their business elsewhere. However, considering a move to
another supplier to get better terms is the nature of competitive free enterprise.
9. Payables Period [LO1] Why don’t all firms simply increase their payables periods to
shorten their cash cycles?
→ They would like to! The payables period is a subject of much negotiation, and it
is one aspect of the price a firm pays its suppliers. A firm will generally negotiate the
best possible combination of payables period and price. Typically, suppliers provide
strong financial incentives for rapid payment. This issue is discussed in detail in a
later chapter on credit policy.
10. Payables Period [LO1] BlueSky lengthened its payables period to “control costs and
optimize cash flow.” Exactly what is the cash benefit to BlueSky from this change?
→ BlueSky will need less financing because it is essentially borrowing more from its
suppliers. Among other things, BlueSky will likely need less short-term borrowing
from other sources, so it will save on interest expense.
CHAPTER 19
1. Cash Management [LO3] Is it possible for a firm to have too much cash? Why
would shareholders care if a firm accumulates large amounts of cash?
→ Shareholders should care if a firm accumulates large amounts of cash because
high levels of cash on the balance sheet can frequently signal danger ahead. If cash
is more or less a permanent feature of the company's balance sheet, investors need
to ask why the money is not being put to use. Cash could be there because
management has run out of investment opportunities or is too short sighted and
doesn't know what to do with the cash.
If a firm believes it has too much cash then it should be redistributed to
shareholders either through dividends or share buybacks. If the company then
discovers a new investment opportunity, managers should turn to the capital
markets to raise the needed funds.
However , on the other hand if the firm holds some amount of reserves after meeting
all its expenditures then it could mean the firm is performing well and it can also
mean it has distributed excess earnings as dividends to shareholders.
2. Cash Management [LO3] What options are available to a firm if it believes it has
too much cash? How about too little?
→
3. Agency Issues [LO3] Are stockholders and creditors likely to agree on how much
cash a firm should keep on hand?
→

4. Motivations for Holding Cash [LO3] In the chapter opening, we discussed the
enormous cash positions of several companies. Why would firms such as these hold
such large quantities of cash?
→
5. Cash Management versus Liquidity Management [LO3] What is the difference
between cash management and liquidity management?
→
6. Short-Term Investments [LO3] Why is a preferred stock with a dividend tied to
short-term interest rates an attractive short-term investment for corporations with
excess cash?
→ Dividend tied to short-term interest rates offers a lucrative return because the
dividend is adjusted according to the market interest rate. This also helps to
stabilize the preferred stock price. So, the stable price along with market adjusted
dividend makes it an attractive option for a corporation to utilize its excess cash.
7. Collection and Disbursement Floats [LO1] Which would a firm prefer: a net
collection float or a net disbursement float? Why?
→ Net Disbursement Float because this float is money spent, but not yet taken out
of the account. Collection float is money deposited, but not yet cleared. They want
their deposits to clear before their checks written are cashed.
8. Float [LO1] Suppose a firm has a book balance of $2 million. At the automatic teller
machine (ATM), the cash manager finds out that the bank balance is $2.5 million.
What is the situation here? If this is an ongoing situation, what ethical dilemma
arises?
→
9. Short-Term Investments [LO3] For each of the short-term marketable securities
given here, provide an example of the potential disadvantages the investment has for
meeting a corporation’s cash management goals:
a. U.S. Treasury bills.
→
b. Ordinary preferred stock.
→
c. Negotiable certificates of deposit (NCDs).
→
d. Commercial paper.
→
e. Revenue anticipation notes.
→
f. Repurchase agreements.
 →
10. Agency Issues [LO3] It is sometimes argued that excess cash held by a firm can
aggravate agency problems (discussed in Chapter 1 ) and, more generally, reduce
incentives for shareholder wealth maximization. How would you frame the issue
here?
→ As per a feature of corporate enterprise there is separation of ownership and
management as a corollary of which the management enjoys substantial autonomy
in regards to affairs of the firm. With widely diffused ownership, scattered and ill
organized shareholders hardly exercise any influence on management which may be
inclined to act in its own interest rather than those of the owner. Sometimes it is
argued that excess cash held by the firm can aggravate agency problems and, more
generally, reduce incentives for shareholder wealth maximization. It is likely that
managers may start placing their personal goals ahead of corporate goals by
retaining excess cash. .However ,due to the threat of being dismissed of poor
performance management would have an inclination to achieve a minimum
acceptable level of performance to satisfy the shareholders’ requirement while
focusing primarily on their individual...
11. Use of Excess Cash [LO3] One option a firm usually has with any excess cash is to
pay its suppliers more quickly. What are the advantages and disadvantages of this
use of excess cash?
→
12. Use of Excess Cash [LO3] Another option usually available is to reduce the firm's
outstanding debt. What are the advantages and disadvantages of this use of excess
cash?
→
13. Float [LO1] An unfortunately common practice goes like this (warning: don’t try
this at home): Suppose you are out of money in your checking account; however,
your local grocery store will, as a convenience to you as a customer, cash a check for
you. So, you cash a check for $200. Of course, this check will bounce unless you do
something. To prevent this, you go to the grocery the next day and cash another
check for $200. You take this $200 and deposit it. You repeat this process every day,
and, in doing so, you make sure that no checks bounce. Eventually, manna from
heaven arrives (perhaps in the form of money from home), and you are able to cover
your outstanding checks. To make it interesting, suppose you are absolutely certain
that no checks will bounce along the way. Assuming this is true, and ignoring any
question of legality (what we have described is probably illegal check kiting), is
there anything unethical about this? If you say yes, then why? In particular, who is
harmed?
→
CHAPTER 20
1. Credit Instruments [LO1] Describe each of the following:
a. Sight draft.
→ commercial draft that is payable immediately
b. Time draft.
→ commercial draft that does not require immediate payment
c. Banker’s acceptance.
→ banks guarantee of the future payment of a commercial draft
d. Promissory note.
→ an IOW that the customer signs
e. Trade acceptance.
→ buyers acceptance of the commercial draft and promise to pay it in the future
2. Trade Credit Forms [LO1] In what form is trade credit most commonly offered?
What is the credit instrument in this case?
→ Trade credit is usually granted on an open account. The invoice is the credit
instrument
3. Receivables Costs [LO1] What costs are associated with carrying receivables? What
costs are associated with not granting credit? What do we call the sum of the costs
for different levels of receivables?
→ Credit costs: costs of debt, probability of default, and the cash discount
No-credit costs: lost sales
The sum of these are carrying costs
4. Five C's of Credit [LO1] What are the five C's of credit? Explain why each is
important.
→ the five Cs of credit, they include capacity, capital, conditions, character, and
collateral. There is no regulatory standard that requires the use of the five Cs of
credit, but the majority of lenders review most of this information prior to allowing
a borrower to take on debt.
Although each financial institution employs its own variation of the process to
determine creditworthiness, most lenders place the greatest amount of weight on a
borrower's capacity.
 Character: To find out how trustworthy and reliable the borrower is; generally,
lenders will evaluate the borrower's credit score, credit history ― bankruptcies,
foreclosures, and judgments ― and how he has handled your debt obligations.

Capacity: This considers the borrower's cash flows and measures his ability to
repay the debt obligations. Lenders try to establish whether potential borrowers
have enough cash to pay back what they borrow.

Capital: Lenders look at the debt level of the borrower to find out the
leverage.Higher the equity, the lower the leverage, which is a positive thing

Conditions: Lenders want to understand the current market conditions would

impact the borrower, and his business, and the impact of such conditions on the size
of the loan, the interest rate, given the industry that the borrower operates in.

Collateral: The business and personal assets that the borrower can pledge to back
the loan.

5. Credit Period Length [LO1] What are some of the factors that determine the length
of the credit period? Why is the length of the buyer’s operating cycle often
considered an upper bound on the length of the credit period?
→ 1-perishability and collateral value
2-Consumer demand
3-Cost, Profitability, and standardization
4-Credit Risk
5-The size of the account
6-Competition
7-Customer type
If the credit period exceeds the customers operating cycle, then the selling firm is
financing the receivables, and other aspects of the customers business that go
beyond the purchase of the selling firm's merchandise
6. Credit Period Length [LO1] In each of the following pairings, indicate which firm
would probably have a longer credit period and explain your reasoning.
a. Firm A sells a miracle cure for baldness; Firm B sells toupees.
b. Firm A specializes in products for landlords; Firm B specializes in products for
renters.
c. Firm A sells to customers with an inventory turnover of 10 times; Firm B sells to
customers with an inventory turnover of 20 times.
 d. Firm A sells fresh fruit; Firm B sells canned fruit.
e. Firm A sells and installs carpeting; Firm B sells rugs.
→
7. Inventory Types [LO3] What are the different inventory types? How do the types
differ? Why are some types said to have dependent demand whereas other types are
said to have independent demand?
→ a) Raw Material: Starting pint in the production process. Eg: Iron ore, disk
drives and so on.

b) Work - in - progress: Unfinished product.

c) Finished goods: Products ready to ship or sell off.

8. Just-in-Time Inventory [LO3] If a company moves to a JIT inventory management

system, what will happen to inventory turnover? What will happen to total asset
turnover? What will happen to return on equity (ROE)? ( Hint: Remember the
DuPont equation from Chapter 3 .)
→ Inventory turnover = Cost of Goods Sold / Average Inventory
Implementation of JIT decreases average inventory held by the business. In fact,
companies with JIT hold very little inventories. As the denominator decreases, the
numerator remaining unchanged, inventory turnover would increase.

Total Asset Turnover = Sales / Average Total Assets

As inventories decrease, total assets would also decrease, and total asset turnover
would increase.

ROE = Profit Margin x Asset Turnover x Equity Multiplier = Net Income / Sales *
Sales / Total Assets * Total Assets / Equity.

As investment in inventory decreases, net income would increase, leading to a higher

profit margin. As already stated, asset turnover also increases. There would be a
slight dip in the equity multiplier as the numerator decreases. But overall, ROE is
expected to increase.

9. Inventory Costs [LO3] If a company’s inventory carrying costs are $5 million per
year and its fixed order costs are $8 million per year, do you think the firm keeps
too much inventory on hand or too little? Why?
 →
10. Inventory Period [LO3] At least part of Dell’s corporate profits can be traced to its
inventory management. Using just-in-time inventory, Dell typically maintains an
inventory of three to four days’ sales. Competitors such as Hewlett-Packard and
IBM have attempted to match Dell’s inventory policies, but lag far behind. In an
industry where the price of PC components continues to decline, Dell clearly has a
competitive advantage. Why would you say that it is to Dell’s advantage to have
such a short inventory period? If doing this is valuable, why don’t all other PC
manufacturers switch to Dell’s approach?
→