Fundamentals of corporate finance 8th edition pdf download

Capital structure - The mix of debt and equity used by a firm. What are the least expensive sources of funds? Is there a best mix? When and where to raise funds? Working capital management - Managing short-term assets and liabilities. How much cash and inventory to keep around? What is our credit policy? Where will we obtain shortterm loans?

Sole Proprietorship A. Sole Proprietorship Sole Proprietorship - A business owned by one person. Easy to start up, with low regulation, and profits are taxed as personal income. But involves unlimited liability, its life is limited to the owners, and the equity that can be raised is limited to the proprietors wealth. Limited partnership - One or more general partners will run the business and have unlimited liability. The limited partner's liability is limited to their contribution to the partnership.

Partnerships allow more equity capital than is available to a sole proprietorship, are relatively easy to start up, and are taxed at the personal rate. But there is unlimited liability, and the partnership dissolves upon death or sale. Corporation A corporation is a business created as a distinct legal entity composed of one or more individuals or entities. Corporations are the most important form of business organization in Canada. There are several advantages to the corporate form: 1.

Limited liability for stockholders. Unlimited life for the business. Ownership can be easily transferred. These characteristics make it easier for corporations to raise capital. The disadvantage to corporations is double taxation. Income Trust This non-corporate form of business grew dramatically in importance in Canada starting in The income generated by these entities is distributed to unitholders who are responsible for paying tax.

In late , the government changed the tax laws for income trusts to match that of other corporate forms and, after , the only income trusts that will be allowed to follow the old format will be real estate income trusts REITs. Possible Goals There are many possible goals - some involve profit, some not. The Goal of Financial Management Maximize the current value per share of existing stock.

A More General Goals To increase the market value of equity, even for private firms. The goal does not imply illegal or unethical practices. Agency Relationships The relationship between stockholders and management is called an agency relationship. This occurs when one party principal pays another agent to represent them. The possibility of conflict of interest between the parties is termed the agency problem.

Management Goals The goals of management may conflict with those of shareholders. Agency costs - Two types: direct and indirect. Direct costs come about in compensation and perquisites for management.

Indirect costs are the result of monitoring managers. Do Managers Act in the Stockholders Interests? The alignment between management and shareholders is influenced by compensation, possible change of control, and stakeholder claims. Control of the Firm - Management can be replaced by several methods which involve stockholders, such as proxy fights or takeovers. Stakeholders - Anyone who potentially has a claim on a firm, including creditors and employees. Corporate Social Responsibility and Ethical Investing Many large corporations maintain specific policies on important social issues and there is a growing trend among many investors to make an effort to invest in socially responsible firms while at the same time deemphasizing businesses engaged in various controversial business activities.

Issues include treatment of the community, customers, the environment, and human rights S1. Cash Flows to and from the Firm Financial markets: As is typical of other markets, financial markets are a mechanism that brings buyers and sellers together. Here debt and equity securities are bought and sold. Money versus Capital Markets Money market - The market in which short-term 1 year or less securities are bought and sold. Depreciation is a non-cash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting.

Market values can never be negative. 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. 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. 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 would have this effect. Negative net capital spending would mean more long-lived assets were liquidated than purchased.

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. 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 derivatives.

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. In general, it appears that investors prefer companies that have a steady earning 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.

However, given the questionable ethics of this practice, the company and shareholders will lose value if the practice is discovered. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred.

However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. To find the OCF, we first calculate net income. We already know OCF. The solution to this question works the income statement backwards. Accumulated ret. A negative market value in this case would imply that the company would pay you to own the stock. Net income was negative because of the tax deductibility of depreciation and interest expense.

However, the actual cash flow from operations was positive because depreciation is a non-cash expense and interest is a financing expense, not an operating expense. A firm can still pay out dividends if net income is negative; it just has to be sure there is sufficient cash flow to make the dividend payments.

The tax bubble causes average tax rates to catch up to marginal tax rates, thus eliminating the tax advantage of low marginal rates for high income corporations. Balance sheet as of Dec. 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. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1. Reducing short-term debt with cash increases the current ratio if it was initially greater than 1. 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.

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. Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged. Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases.

The firm has increased inventory relative to other current assets; therefore, assuming current liability levels remain unchanged, liquidity has potentially decreased. A current ratio of 0. 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. 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 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.

Cash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid asset cash. Total asset turnover measures how much in sales is generated by each dollar of firm assets. 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.

Long-term debt ratio measures the percentage of total firm capitalization funded by long-term debt. Profit margin is the accounting measure of bottom-line profit per dollar of sales.

Return on assets is a measure of bottom-line profit per dollar of total assets. Return on equity is a measure of bottom-line profit per dollar of equity. Price-earnings ratio reflects how much value per share the market places on a dollar of accounting earnings for a firm.

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. Common-base year financial statements express each account as a ratio between their current year nominal dollar value and some reference year nominal dollar value.

Using these ratios allows the total growth trend in the accounts to be measured. 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.

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.

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 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. 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. 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.

For a retailer such as Sears, expressing sales on a per square foot basis would be useful in comparing revenue production against other retailers. 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. For an on-line service provider such as AOL, using a per call basis for costs would allow for comparisons with smaller services.

A per subscriber basis would also make sense. For a hospital such as Holy Cross, revenues and costs expressed on a per bed basis would be useful. 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.

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. We need to find net income first. A large value for this ratio could imply that either 1 the company is having liquidity problems, making it difficult to pay off its short-term obligations, or 2 that the company has successfully negotiated lenient credit terms from its suppliers.

The common-size, common-base year answers for Question 15 are found by dividing the common- size percentage for by the common-size percentage for For example, the cash calculation is found by: 3.

In particular, the needed funds were raised by internal financing on a net basis , out of the additions to retained earnings and by an issue of long-term debt. This is a multi-step problem involving several ratios. The ratios given are all part of the DuPont Identity. The only DuPont Identity ratio not given is the profit margin. If we know the profit margin, we can find the net income since sales are given.

It is often easier to look backward to determine where to start. To calculate receivables turnover, we need credit sales, and to find credit sales, we need total sales. The solution to this problem requires a number of steps. The solution requires substituting two ratios into a third ratio.

This problem requires you to work backward through the income statement. The only ratio given which includes cost of goods sold is the inventory turnover ratio, so it is the last ratio used. This will be discussed in more detail in later chapters, but this assumption is generally true.

Using the book value of assets assumes that the assets can be replaced at the current value on the balance sheet. There are several reasons this assumption could be flawed. First, inflation during the life of the assets can cause the book value of the assets to understate the market value of the assets. Since assets are recorded at cost when purchased, inflation means that it is more expensive to replace the assets.

Second, improvements in technology could mean that the assets could be replaced with more productive, and possibly cheaper, assets. If this is true, the book value can overstate the market value of the assets. Finally, the book value of assets may not accurately represent the market value of the assets because of depreciation. Thus, the book value and market value can often diverge.

The reason is that, ultimately, sales are the driving force behind a business. Two assumptions of the sustainable growth formula are that the company does not want to sell new equity, and that financial policy is fixed. If the company raises outside equity, or increases its debt- equity ratio it can grow at a higher rate than the sustainable growth rate.

Of course the company could also grow faster than its profit margin increases, if it changes its dividend policy by increasing the retention ratio, or its total asset turnover increases. As the retention ratio is increased, the firm has more internal sources of funding, so the EFN will decline. Conversely, as the retention ratio is decreased, the EFN will rise. If the firm pays out all its earnings in the form of dividends, then the firm has no internal sources of funding ignoring the effects of accounts payable ; the internal growth rate is zero in this case and the EFN will rise to the change in total assets.

Conversely, if the retention ratio is decreased, the EFN will rise. If the retention rate is zero, both the internal and sustainable growth rates are zero, and the EFN will rise to the change in total assets.

Presumably not, but, of course, if the product had been much less popular, then a similar fate would have awaited due to lack of sales. Since customers did not pay until shipment, receivables rose. At the same time, costs were rising faster than cash revenues, so operating cash flow declined. Thus, all three components of cash flow from assets were negatively impacted.

Apparently not! In hindsight, the firm may have underestimated costs and also underestimated the extra demand from the lower price. Financing possibly could have been arranged if the company had taken quick enough action.

Sometimes it becomes apparent that help is needed only when it is too late, again emphasizing the need for planning. All three were important, but the lack of cash or, more generally, financial resources ultimately spelled doom. An inadequate cash resource is usually cited as the most common cause of small business failure. Demanding cash up front, increasing prices, subcontracting production, and improving financial resources via new owners or new sources of credit are some of the options.

When orders exceed capacity, price increases may be especially beneficial. It is important to remember that equity will not increase by the same percentage as the other assets. Dividends paid is the plug variable. Here we are given the dividend amount, so dividends paid is not a plug variable.

This is due to EFN. The maximum percentage sales increase is the sustainable growth rate. Below is the balance sheet with the percentage of sales for each account on the balance sheet. Notes payable, total current liabilities, long-term debt, and all equity accounts do not vary directly with sales.

We need to calculate the retention ratio to calculate the internal growth rate. We need to calculate the retention ratio to calculate the sustainable growth rate.

We first must calculate the ROE to calculate the sustainable growth rate. To do this we must realize two other relationships. To find the new level of fixed assets, we need to find the current percentage of fixed assets to full capacity sales.

We can calculate ROE from the sustainable growth rate equation. Remember that the equity multiplier is one plus the debt-equity ratio. We are given the profit margin. To calculate the sustainable growth rate, we first must calculate the retention ratio and ROE. The additional borrowing will be the new level of debt minus the current level of debt.

This will always occur whenever the equity increases. If equity increases, the ROE based on end of period equity is lower than the ROE based on the beginning of period equity. The ROE and sustainable growth rate in the abbreviated equation is based on equity that did not exist when the net income was earned.

The negative number in this case means the company has too much capital. There are two possible solutions. First, the company can put the excess funds in cash, which has the effect of changing the current asset growth rate. Second, the company can use the excess funds to repurchase debt and equity. To maintain the current capital structure, the repurchase must be in the same proportion as the current capital structure.

We must need the ROE to calculate the sustainable growth rate. The growth rate is not consistent with the other constraints. The lowest possible payout rate is 0, which corresponds to retention ratio of 1, or total earnings retention. TE is total equity and TA is total assets. The four parts are the present value PV , the future value FV , the discount rate r , and the life of the investment t. 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. Future values grow assuming a positive rate of return ; present values shrink. It would appear to be both deceptive and unethical to run such an ad without a disclaimer or explanation.

This will probably make the security less desirable. TMCC will only repurchase the security prior to maturity if it is to its advantage, i. Given the drop in interest rates needed to make this viable for TMCC, it is unlikely the company will repurchase the security. Such features are discussed at length in a later chapter. The key considerations would be: 1 Is the rate of return implicit in the offer attractive relative to other, similar risk investments?

Thus, our answer does depend on who is making the promise to repay. The Treasury security would have a somewhat higher price because the Treasury is the strongest of all borrowers. This rise is just a reflection of the time value of money. In , the price will probably be higher for the same reason. To answer this question, we can use either the FV or the PV formula. Both will give the same answer since they are the inverse of each other.

To find the length of time for money to double, triple, etc. This is an important concept of time value of money. This occurs when the FV is less than the PV. We need to find the FV of a lump sum.

However, the money will only be invested for six years, so the number of periods is six. However, you will not receive the money for another two years. Enter 6. Enter 20 8. Enter 4. Enter 67 Enter 6 7. The four pieces are the present value PV , the periodic cash flow C , the discount rate r , and the number of payments, or the life of the annuity, t.

Assuming positive cash flows, both the present and the future values will rise. Assuming positive cash flows, the present value will fall and the future value will rise. 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! If the total money is fixed, you want as much as possible as soon as possible.

The team or, more accurately, the team owner wants just the opposite. The better deal is the one with equal installments. Yes, they should. The only advantage is that they are easier to compute, but, with modern computing equipment, that advantage is not very important.

A freshman does. The reason is that the freshman gets to use the money for much longer before interest starts to accrue. 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. The problem is that the subsidy makes it easier to repay the loan, not obtain it. However, ability to repay the loan depends on future employment, not current need.

For example, consider a student who is currently needy, but is preparing for a career in a high-paying area such as corporate finance! Should this student receive the subsidy? How about a student who is currently not needy, but is preparing for a relatively low-paying job such as becoming a college professor? 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.

Ultimately, the decision rests on 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.

To solve this problem, we must find the PV of each cash flow and add them. The reason is that X has greater total cash flows. At a lower interest rate, the total cash flow is more important since the cost of waiting the interest rate is not as great. At a higher interest rate, Y is more valuable since it has larger cash flows. At the higher interest rate, these bigger cash flows early are more important since the cost of waiting the interest rate is so much greater.

To solve this problem, we must find the FV of each cash flow and add them. In other words, we do not need to compound this cash flow.

Here we have the PVA, the length of the annuity, and the interest rate. We want to calculate the annuity payment. Here we need to find the FVA. Here we have the FVA, the length of the annuity, and the interest rate. This cash flow is a perpetuity. Here we need to find the interest rate that equates the perpetuity cash flows with the PV of the cash flows. The number of compounding periods within a year will also affect the EAR. To account for this, we will divide the interest rate by two the number of compounding periods in a year , and multiply the number of periods by two.

To account for this, we will divide the interest rate by the number of days in a year, ignoring leap year , and multiply the number of periods by The APR is simply the interest rate per period times the number of periods in a year. We do this division to get the interest rate per period, but in this problem we are already given the interest rate per period. We first need to find the annuity payment. We have the PVA, the length of the annuity, and the interest rate.

Here we need to find the length of an annuity. We know the interest rate, the PV, and the payments. Here we are trying to find the interest rate when we know the PV and FV. This problem requires us to find the FVA. In the previous problem, the cash flows are monthly and the compounding period is monthly. This assumption still holds. Since the cash flows are annual, we need to use the EAR to calculate the future value of annual cash flows.

It is important to remember that you have to make sure the compounding periods of the interest rate times with the cash flows. In this case, we have annual cash flows, so we need the EAR since it is the true annual interest rate you will earn.

The cash flows are simply an annuity with four payments per year for four years, or 16 payments. The cash flows are annual and the compounding period is quarterly, so we need to calculate the EAR to make the interest rate comparable with the timing of the cash flows. Here the cash flows are annual and the given interest rate is annual, so we can use the interest rate given. We simply find the PV of each cash flow and add them together. The total interest paid by First Simple Bank is the interest rate per period times the number of periods.

In other words, the interest by First Simple Bank paid over 10 years will be:. Here we need to convert an EAR into interest rates for different compounding periods. Here we need to find the FV of a lump sum, with a changing interest rate. We must do this problem in two parts. We need to find the annuity payment in retirement. Our retirement savings ends and the retirement withdrawals begin, so the PV of the retirement withdrawals will be the FV of the retirement savings.

We need to find the FV of a lump sum in one year and two years. It is important that we use the number of months in compounding since interest is compounded monthly in this case. We could find the EAR, and use the number of years as our compounding periods.

We have simply made sure that the interest compounding period is the same as the number of periods we use to calculate the FV. Here we are finding the annuity payment necessary to achieve the same FV. The interest rate given is a 10 percent APR, with monthly deposits.

We must make sure to use the number of months in the equation. In this example, by reducing the savings period by one-half, the deposit necessary to achieve the same terminal value is about nine times as large. The number of periods is four, the number of quarters per year.

Since we have an APR compounded monthly and an annual payment, we must first convert the interest rate to an EAR so that the compounding period is the same as the cash flows. We can use the present value of a growing perpetuity equation to find the value of your deposits today. Here we are given the FVA, the interest rate, and the amount of the annuity. We need to solve for the number of payments. Here we are given the PVA, number of periods, and the amount of the annuity.

We need to solve for the interest rate. If you use trial and error, remember that increasing the interest rate lowers the PVA, and increasing the interest rate decreases the PVA. The amount of principal paid on the loan is the PV of the monthly payments you make. We are given the total PV of all four cash flows. If we find the PV of the three cash flows we know, and subtract them from the total PV, the amount left over must be the PV of the missing cash flow.

To solve this problem, we simply need to find the PV of each lump sum and add them together. Here we are finding interest rate for an annuity cash flow. We are given the PVA, number of periods, and the amount of the annuity.

We should also note that the PV of the annuity is not the amount borrowed since we are making a down payment on the warehouse. To find the interest rate, we need to solve this equation on a financial calculator, using a spreadsheet, or by trial and error. The profit the firm earns is just the PV of the sales price minus the cost to produce the asset.

We want to find the value of the cash flows today, so we will find the PV of the annuity, and then bring the lump sum PV back to today. To find the value today, we find the PV of this lump sum. This question is asking for the present value of an annuity, but the interest rate changes during the life of the annuity. We need to find the present value of the cash flows for the last eight years first. Now we can discount this lump sum to today. Here we are trying to find the dollar amount invested today that will equal the FVA with a known interest rate, and payments.

First we need to determine how much we would have in the annuity account. In other words, the interest rate quoted in the problem is only relevant to determine the total interest under the terms given. The cash flows in this problem are semiannual, so we need the effective semiannual rate.

So, the value at the various times the questions asked for uses this value 9 years from now. To do this, you need the EAR. To calculate the PVA due, we calculate the PV of an ordinary annuity for t — 1 payments, and add the payment that occurs today.

We then use this value as the PV of an ordinary annuity. The payment for a loan repaid with equal payments is the annuity payment with the loan value as the PV of the annuity. The ending balance is the beginning balance minus the principal payment. The ending balance for a period is the beginning balance for the next period. The interest payment is the beginning balance times the interest rate for the period, and the total payment is the principal payment plus the interest payment.

This is because more principal is repaid early in the loan, which reduces the total interest expense over the life of the loan. Challenge The cash flows for this problem occur monthly, and the interest rate given is the EAR.

Since the cash flows occur monthly, we must get the effective monthly rate. One way to do this is to find the APR based on monthly compounding, and then divide by The amount needed at retirement is the PV of the monthly spending plus the PV of the inheritance.

To answer this question, we should find the PV of both options, and compare them. Since we are purchasing the car, the lowest PV is the best option. The interest rate we would use for the leasing option is the same as the interest rate of the loan. To find the breakeven resale price, we need to find the resale price that makes the PV of the two options the same. To find the quarterly salary for the player, we first need to find the PV of the current contract. The cash flows for the contract are annual, and we are given a daily interest rate.

We need to find the EAR so the interest compounding is the same as the timing of the cash flows. We can simply subtract this amount from the PV of the new contract. The remaining amount will be the PV of the future quarterly paychecks. Using the daily interest rate, we can find the quarterly interest rate using the EAR equation, with the number of days being Here we have cash flows that would have occurred in the past and cash flows that would occur in the future.

We need to bring both cash flows to today. Before we calculate the value of the cash flows today, we must adjust the interest rate so we have the effective monthly interest rate. Finding the APR with monthly compounding and dividing by 12 will give us the effective monthly rate. Alternatively, we could have found the FV of the lump sum with the effective monthly rate as long as we used 12 periods. The answer would be the same either way. In this problem, we are calculating both the PV and FV of annuities.

So, by a lower interest rate, we are lowering the value of the back pay. But, we are also increasing the PV of the future salary. Since the future salary is larger and has a longer time, this is the more important cash flow to the plaintiff.

Again, to find the interest rate of a loan, we need to look at the cash flows of the loan. This is the same question as before, with different values.

Remember, we need to use the actual cash flows of the loan to find the interest rate. Be careful of interest rate quotations. The actual interest rate of a loan is determined by the cash flows.

Here we are solving a two-step time value of money problem. Each question asks for a different possible cash flow to fund the same retirement plan. Each savings possibility has the same FV, that is, the PV of the retirement spending when your friend is ready to retire. If your friend makes equal annual deposits into the account, this is an annuity with the FVA equal to the amount needed in retirement.

Here we need to find a lump sum savings amount. In this problem, we have a lump sum savings in addition to an annual deposit. Since we already know the value needed at retirement, we can subtract the value of the lump sum savings at retirement to find out how much your friend is short. Increased market share can be an inappropriate goal if it requires reducing prices to such an extent that the firm is harmed financially. Increasing market share can be part of a well-reasoned strategy, but one should always remember that market share is not a goal in itself.

The owners of the firm want managers to maximize the value of their investment in the firm. Minimizing costs can also conflict with the goal of value maximization. For example, suppose a firm receives a large order for a product.

The firm should be willing to pay overtime wages and to incur other costs in order to fulfill the order, as long as it can sell the additional product at a price greater than those costs. Even though costs per unit of output increase, the firm still comes out ahead if it agrees to fill the order. A policy of underpricing any competitor can lead the firm to sell goods at a price lower than the price that would maximize market value.

Again, in some situations, this strategy might make sense, but it should not be the ultimate goal of the firm. It should be evaluated with respect to its effect on firm value. Expanding profits is a poorly defined goal of the firm.

The text gives three reasons:. There may be a trade-off between accounting profits in one year and accounting profits in another year. Investing more in the firm can increase profits, even if the increase in profits is insufficient to justify the additional investment.

In this case the increased investment increases profits but can reduce shareholder wealth. Est time: 06—10 Goal of financial management. Make shareholders as wealthy as possible by investing in real assets.

The director is mistaken. The risk of the project is not determined by the borrowing rate from the bank. The opportunity cost of capital for this investment is the rate of return that investors can earn in the financial markets from safe investments, such as U. Treasury securities. The best estimate of the opportunity cost of capital would rely on interest rates on U.

Treasuries with the same maturity as that of the proposed investment, i. Since the government guarantees the payoff for the investment, the opportunity cost of capital is the rate of return on U. Treasuries with 1 year to maturity i. Est time: 01—05 Cost of capital — general There are not necessarily right or wrong answers to these issues. It is important, however, to keep in mind that short selling, acquisitions, and tax avoidance are all the by-product of an attempt to maximize shareholder value.

In the absence of laws banning companies from producing wealth for their owners, someone will use these techniques to create value for owners. Est time: 01—05 Ethics, governance, and regulation One of the mechanisms that stockholders rely on to mitigate agency problems is the threat that an underperforming company with an underperforming management will be taken over by another company.

If management is protected against takeovers by takeover defenses, it is more likely that managers will act in their own best interest, rather than in the interests of the firm and its stockholders. Est time: 01—05 Agency costs and problems The contingency arrangement aligns the interests of the lawyer with those of the client.

Neither makes any money unless the case is won. If a client is unsure about the skill or integrity of the lawyer, this arrangement can make sense. First, the lawyer has an incentive to work hard. Second, if the lawyer turns out to be incompetent and loses the case, the client will not have to pay a bill.

Third, the lawyer will not be tempted to accept a very weak case simply to generate bills. Fourth, there is no incentive for the lawyer to charge for hours not really worked. Once a client is more comfortable with the lawyer, and is less concerned with potential agency problems, a fee-for-service arrangement might make more sense. Est time: 06—10 Agency costs and problems This is an agency problem. In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a large stake in making sure that the loan can be repaid.

It is clearly worthwhile for the bank to spend considerable resources on monitoring the firm. Since managers are likely to seek to maximize their own income, linking their compensation to share price is likely to cause them to focus on increasing firm value. Long- term decisions may not produce short- term profits, thus managers may shy away from making good long- term decisions.

Salary compensation plans may induce better long- term decisions. Est time: 06—10 Agency costs and problems. Clear and comprehensive financial reports provide essential information to the numerous shareholders of large corporations, allowing the shareholders to monitor the performance of the corporation and its board of directors and management.

The debacles at WorldCom and Enron were directly related to a lack of clear and comprehensive financial reports. The mechanisms discussed in the text such as takeovers, compensation plans, and legal and regulatory requirements for ameliorating agency problems generally contribute to effective corporate governance.