Titman/Keown/Martin
Financial Management, Fourteenth Global Edition
SOLUTION MANUAL FOR Financial Management Principles And Applications 14e Global Edition Sheridan Titman Part 1 Study Questions [Solutions to Study Questions] Part Two Study Problems [Solutions to End-of-Chapter Problems]
Part 1 Study Questions
Chapter 1 Solutions to Study Questions 1-1. The solution to this problem is dependent upon the student‘s experiences. 1-2. There are three basic types of issues that are addressed by the study of finance: a. What long-term investments should the firm undertake? This area of finance is generally referred to as capital budgeting. b. How should the firm raise money to fund these investments? The firm‘s funding choices are generally referred to as capital structure decisions. c. How can the firm best manage its cash flows as they arise in its day-to-day operations? This area of finance is generally referred to as working capital management. 1-3. First, investors demand a minimum return for delaying consumption that must be greater than the anticipated rate of inflation. If they didn‘t receive enough to compensate for anticipated inflation, investors would purchase whatever goods they desired ahead of time. There isn‘t much incentive to postpone consumption if your savings are going to decline in terms of purchasing power. Investment alternatives have different amounts of risk and expected returns. Investors sometimes choose to put their money in risky investments because these investments offer higher expected returns. The more risk an investment has, the higher will be its expected return – that‘s because risk investors don‘t like risk, in particular, they don‘t like the chance that they might lose their money. That makes risky investments less attractive, which means that to attract investors, riskier investments must be priced to offer investors a higher expected rate of return. This relationship between risk and expected return is shown in Figure 1.3. Notice that we keep referring to expected return rather than actual return. We may have expectations of what the returns for investing will be, but we can‘t peer into the future and see what those returns are actually going to be. Until after the fact, you are never sure what the return on an investment will be. That is why General Motors bonds pay more interest than U.S. Treasury bonds of the same maturity. The additional interest induces some investors to take on the added risk of purchasing a General Motors bond. Copyright © 2021 Pearson Education Ltd.
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Financial Management, Fourteenth Global Edition
1-4. Incremental cash flows describe the total cash effect on a company. This involves assessing the difference between total cash flow to the company with the cash flow, and without the cash flow. A company can then value these cash flows to see if it is worth more with the project or without it. 1-5. The three business forms are: 1. Sole Proprietorship. 2. Partnership. 3. Corporation.
1. Sole Proprietorship: Advantage: • Forming a sole proprietorship is very easy; there are no forms to file and no partners to consult since the founder of the business is the sole owner. Disadvantage : • These organizations typically have limited access to the alternative sources of financing. The owners of a sole proprietorship typically raise money by investing their own funds, and by borrowing from a bank. 2. Partnership Advantage : • An important advantage of the partnership is that it provides access to equity, or ownership, financing from multiple owners in return for partnership shares, or units of ownership. Disadvantage : • Conflict on division of profits between partners. 3. Corporation. Advantages : • The shareholders‘ liability is confined to the amount of their investment in the company. In other words, if the corporation goes under, the owners can only lose their investment. • The life of the business is not tied to the life of the founding owners. For example, the inventor Thomas Edison founded General Electric (GE) over a century ago. Edison died in 1931, but the corporation lives on. Disadvantage : • Though management is expected to make ethical decisions that reflect the best interests of the firm‘s owners, this is not always the case. Indeed, managers often face situations where their own personal interests differ from the interests of shareholders. If you were to start a lawn mowing business for the summer, you‘d probably form a sole proprietorship. That is the simplest one to form – you don‘t have to do anything. Moreover, Copyright © 2021 Pearson Education Ltd.
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Financial Management, Fourteenth Global Edition
with a lawn mowing business the probability of a law suit is quite low, so the advantage of limited liability is not particularly important. 1-6. The shareholders are the owners of the corporation. The management should run business so as to maximize the shareholder wealth without being greedy for quick money generation by unethical conducts and practices. 1-7. Shareholder wealth maximization isn‘t the goal of every firm. Privately owned Newman‘s Own, the makers of salad dressing, spaghetti sauces, and other food products, was established in 1982 with the goal of making money for educational and charitable purposes. Paul Newman‘s estate and the Newman‘s Own Foundation donate all profits and royalties after taxes for educational and charitable purposes. 1-8. Extreme ethical lapses such as those evident in the Madoff Ponzi scheme may also break laws and result in fines or imprisonment. In less extreme cases, deceptive accounting practices or sales techniques once exposed lead to a loss of trust. Because individuals and firms are reluctant to do business with those they mistrust, a reputation for unethical behavior over the long run leads to adversarial relations with business partners, a loss of customers, and destruction of the firm's value
Chapter 2 Solutions to Study Questions 2-1. The ―Regardless of Your Major‖ box describes two types of retirement plans: defined contribution and defined benefit. The ―defined‖ part of each name means that benefits are specified, or defined; the difference between the two plans is in when those benefits are defined. Defined benefit (DB) plans specify the amounts to be paid in retirement—that is, the benefits the retiree will receive are specified. Thus, the sponsor of the plan promises to make specific payments to the retiree, and then the sponsor accepts the responsibility for investing a pool of assets now (or at least, before the covered person retires) to ensure that those benefits in fact can be paid in the future. Managing pension assets to ensure future payments is complicated, and companies these days prefer to offer defined contribution plans, like 401(k) plans, instead of defined benefit plans. Defined contribution (DC) plans specify the contributions that will be made to the plan (now), not the benefits that will be paid at retirement. It‘s a lot easier to specify an amount to be paid today than it is to ensure that one will be made in the future. With defined contribution plans, employees accept the responsibility of investing their funds to ensure adequate resources in retirement, removing that burden from employers. It‘s therefore not surprising that employers prefer defined contribution plans, while employees who have defined benefit plans count themselves lucky.
2-2. The three players who interact in the financial markets are borrowers, savers, and financial intermediaries.
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Financial Management, Fourteenth Global Edition
Borrowers need money to help finance some specific purpose—a student loan to help pay for college, an auto loan for a car, or a mortgage for a house. Savers have money that they don‘t need for consumption today, so they set this money aside to use in the future. Financial intermediaries bring the two together, channeling the savers‘ ―extra‖ money to the borrowers for their immediate use. If the borrowers and savers could get together themselves somehow, they could ―cut out the middleman‖ and save the intermediation costs. This might sound good—but is it feasible? Financial intermediaries specialize in evaluating the creditworthiness of borrowers, so they help ensure that savers‘ money is channeled to borrowers who will repay. They also allow efficient aggregation of small amounts of individual savings into blocks of loanable funds large enough to be useful to borrowers.
lenders
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FINANCIAL INTERMEDIARIES
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borrowers
2-3. As outlined in section 2.2 of the text, a financial intermediary is a firm that collects money from savers, bundles it into attractive sizes with attractive terms, and lends it to borrowers. The principal types of financial intermediaries in the United States are: COMMERCIAL BANKS Commercial banks are depository institutions that take deposits (such as checking or savings deposits) and make loans (such as mortgage loans or auto loans). Commercial banks are also integral parts of our national payment system. Their importance to the functioning of our economy has led to their being heavily regulated and subject to extensive oversight (for example, by the FDIC, which insures their deposits, and by the Fed, which mandates their reserve requirements). NONBANK FINANCIAL INTERMEDIARIES While these businesses channel money from those who have it to those who need it,
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Titman/Keown/Martin
Financial Management, Fourteenth Global Edition
they do not both take deposits and make loans, as a depository institution does. financial services corporations: Financial services corporations, like GE Capital, provide loans and credit to businesses and individuals (including credit card services). Some of these companies are charged with ensuring financing for the expensive products of large manufacturing companies (for example, Ford Motor Credit). These institutions do not take deposits, so they are missing one of the two elements of a depository institution‘s job description. insurance companies: Insurance companies insure individuals and businesses against certain types of risks (for example, the risk that your automobile will be damaged in a collision, and/or cause damage or injury to someone else; the risk that your house will burn down; the risk that you will die unexpectedly, leaving your heirs without their major breadwinner). Insurance companies are major players in the financial markets, because they must invest the premiums they collect until the money is needed to pay claims. The type of insurance a firm provides tends to determine the type of market in which they invest most frequently. For example, life insurers often have decades between premium collection and claim payments, so they are large players in the capital markets. On the other hand, property and casualty companies (like auto and home insurers) must stay closer to their money, since their claims may come much sooner; they are larger players in the money markets. investment banks: Investment banks like Goldman Sachs and Morgan Stanley advise firms about their financing needs and act as intermediaries when the firms float new securities. For example, an investment banker may advise a client about the most favorable terms for a new bond issue (e.g., covenants, term, options, coupon), then underwrite the issuance of the bonds (buying the bonds from the issuer, then selling them to investors, taking inventory risk in return for a spread). INVESTMENT COMPANIES These companies take savings and invest them in other companies‘ securities. As the text puts it, they are ―financial institutions that pool the savings of individual savers and invest the money, purely for investment purposes, in the securities issued by other companies.‖ Perhaps the most familiar type of investment company is the mutual fund. mutual funds: Mutual funds collect money from investors, then invest that money into specific types of financial assets. Each mutual fund has a prospectus that describes the particular type of assets that the fund may buy: for example, the fund may buy bonds, or stocks, or money market assets, or some combination. Mutual fund investors own shares of the fund that entitle them to a proportional share of the assets held by the fund. Be careful to distinguish mutual fund shares from the shares of stock that a mutual fund may own. Say an equity mutual fund has 10 investors who each put $1,000 into the fund. The fund‘s size is therefore $10,000, and each investor owns 1/10th of the fund. Let‘s assume that the fund issues 1,000 mutual fund shares—100 to each investor. Now, say the fund takes its $10,000 and buys 1 share of stock (a very expensive, $10,000/share stock!). Each investor has 100 mutual fund shares, representing a 1/10th interest in a single share of the fund‘s chosen (very expensive) stock. exchange-traded funds (ETFs): ETFs are like mutual funds that trade on exchanges, as Copyright © 2021 Pearson Education Ltd.