3. Business Finance SM - Practice materials PDF

Preview

Summary

Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder 1 of 4IntroductionSolutions to questions In investment decisions , managers consider the amount invested in the assets of the business and the composition of that investment. Managers of the business are,...

Description

Chapter 1 Introduction Solutions to questions 1. In investment decisions, managers consider the amount invested in the assets of the business and the composition of that investment. Managers of the business are, therefore, involved in the task of choosing, usually from a long list of available projects, those that are to be undertaken. In addition to decisions about the amount and composition of investments, managers have to decide how to finance them. These are financing decisions. This will involve generating funds internally, or raising funds from sources external to the business. Financing decisions also involve dividend decisions, because payment of dividends reduces the internally-generated funds that are available. 2. (a) A sole proprietorship is a business owned by one person. Many small service businesses, retail stores and professional practices are operated as sole proprietorships. Although the owner of a sole proprietorship is legally liable for its debts, the business should be regarded by the proprietor as a separate entity. (b) A partnership is a business owned by two or more people acting as partners. Partnerships are not separate legal entities, and the partners are therefore personally liable for the debts of the partnership. From the viewpoint of managing the business, however, a partnership is treated as an entity separate from the partners. Many small service businesses, retail stores and professional practices are operated as partnerships. (c) A company is a separate legal entity formed under the Corporations Act 2001. The owners of a company are called shareholders, because their ownership interests are represented by shares in the company’s capital. Separate legal entity status enables a company to conduct its operations in its own name as a legal entity. Companies vary greatly in size and objectives—the Corporations Act distinguishes between public companies, which may invite members of the public to invest in them, and proprietary companies, which have no such intention.

Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder © McGraw-Hill Education (Australia) 2015

1 of 4

3. The advantages of a sole proprietorship structure include: (a) Control of the business rests with the owner, so it is relatively easy to make decisions, and there is no scope for disagreements between owners. (b) A sole proprietorship is easy and inexpensive to both form and dissolve. Initially, the owner makes an investment in the business, and may borrow money to supplement this investment. If it is decided to dissolve the business, the owner can simply cease operations, sell the assets, pay any amounts owing and keep any proceeds that remain. (c) A sole proprietorship is not treated as a separate entity for tax purposes. Any business profits belong to the owner, and therefore are taxed only once as part of the owner’s assessable income for the year. The disadvantages of a sole proprietorship include: (a) A sole proprietorship is not a separate legal entity, and therefore the owner has unlimited liability for debts incurred as a result of the business’s operations. In other words, all obligations of the business are personal obligations of the owner, so if the business fails and some of its debts are unpaid, then those to whom money is owed may be able to lay claim to the owner’s personal assets. (b) The size of the business is limited by the wealth of the owner and by the amount that can be borrowed. It can, therefore, be difficult to raise funds for a sole proprietorship, because lenders are usually reluctant to lend large amounts to an individual. (c) Ownership of a sole proprietorship can be transferred only by selling the business to a new owner. If a sole proprietorship is not sold, then it will cease to exist when the owner retires or dies. 4. The advantages of a partnership structure include: (a) A partnership is easy and inexpensive to form, because there are no legal requirements that need to be met. All that is necessary is an agreement, preferably in writing, to avoid future disagreements by those forming the partnership. (b) A partnership can combine the wealth and talents of several individuals, and employees can be offered the prospect of becoming owners in the future. There are also important disadvantages of a partnership structure, which include: (a) Partnerships are not separate legal entities, and the partners are therefore personally liable for the debts of the partnership. (b) It can be difficult for partners to withdraw their investment, because the partnership will terminate if a partner’s interest in the partnership is sold or a partner dies. In either case, a new partnership will have to be formed. (c) Disputes between partners or former partners can be very damaging. 5. Compared with sole proprietorships and partnerships, companies have the advantages of: (a) limited liability of shareholders for debts incurred by those companies. (b) relative ease of transferring shares from one owner to another. (c) unlimited life.

Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder © McGraw-Hill Education (Australia) 2015

2 of 4

6. Investors (shareholders) in companies have limited liability. Companies are separat legal entities. A company is, therefore, treated as a legal entity with all the rights, duties and responsibilities of a person. As a result, the shareholders of most companies have limited liability. This means that shareholders’ obligation to contribute to the assets of the company is limited to any amount unpaid on the shares held in it. If a company fails, and is unable to pay its debts, then the owners of fully-paid shares are not obliged to contribute further funds to meet the company’s obligations to creditors. However, if the shares are partly paid, then shareholders can be obliged to contribute the unpaid amount of the subscription price. 7. The value of an investment made by a company depends on the amount and timing of the cash flows generated by the investment. Similarly, the value of debt securities or shares depends on the amount and timing of the cash flows to debtholders or shareholders. This gives rise to a fundamental principle of finance —that individuals prefer to receive a dollar today rather than a dollar in the future. This is because the dollar received today can be invested to receive income. This concept is referred to as the time value of money. 8. This statement relates to the distinction between nominal and real amounts. During a period of inflation, there is an increase in the general level of prices, with a consequent decrease in the general purchasing power of money. It is necessary, therefore, to distinguish between the nominal, or face value, of money and the real or inflationadjusted value of money. For example, if the annual rate of inflation is 15 per cent, the real value of a dollar is decreasing annually by 15 per cent. Borrowing during times of high inflation means that a company will be repaying the loan in real dollars that have a much lower value than the nominal dollars borrowed. 9. A difficulty facing the financial manager is to measure the riskiness of an investment and to establish the trade-off between risk and expected return. A model that has been developed to assist managers in this task is the capital asset pricing model (CAPM). Risk can be attributed to two sources: (a) market-wide factors, such as interest rates and foreign exchange rates—this is referred to as non-diversifiable risk (also referred to as systematic, or market risk); (b) factors that are specific to a particular company—this is referred to as diversifiable risk (also referred to as unsystematic, or unique risk).

Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder © McGraw-Hill Education (Australia) 2015

3 of 4

While diversifiable risk can be largely eliminated for an investor who holds a well diversified portfolio, non-diversifiable risk cannot be eliminated. According to the CAPM, risk-averse investors would diversify their investments to eliminate diversifiable risk. Consequently, the market will only reward investors for bearing non-diversifiable risk. The financial manager should, therefore, focus on this type of risk when deciding on the required rate of return for a proposed investment. 10. In an efficient market, security prices adjust instantaneously and without bias in response to new information. The concept of an efficient market means that we should expect securities and other assets to be fairly priced, given their expected risks and returns. Successful security traders will be those who discover new information and are among the first to trade on that information, since by doing so they will be able to recognise which securities are wrongly priced. But, typically, there will be numerous wellinformed security traders competing intensively to discover new information and to be the first to trade on it. Therefore, few securities will be wrongly priced, and any that are will quickly be recognised and traded until their prices again reflect the information available. Thus, it is competition between profit-driven security traders which causes the security market to be efficient. 11. Arbitrage precludes perfect substitutes from selling at different prices in the same market. 12. In an agency relationship, one party, known as the principal, delegates decision-making authority to another party, the agent. The principal and the agent enter into a contract that defines the relationship. In negotiating such a contract, both the principal and the agent recognise that the other party is a self-interested individual. Examples of such relationships are those between a company’s shareholders and its managers, and between shareholders and debtholders. The principal–agent relationship gives rise to agency costs. One component of these costs is the reduction in the value of the company directly attributable to managers acting in their own interest. To modify this behaviour, shareholders attempt to monitor the behaviour of managers, and to institute contracts so as to bond (align) the interests of managers and shareholders.

Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder © McGraw-Hill Education (Australia) 2015

4 of 4

Chapter 2 Consumption, investment and the capital market Solutions to questions 1. The role of the company is to invest the funds supplied by its owners in activities that will increase the wealth of its owners. The role of shareholders is to supply capital to the company. Each shareholder can allocate his or her wealth between consumption and investment, and can also borrow or lend via the capital market. The role of the capital market is to facilitate borrowing or lending by individuals. By so doing, individuals can allocate their wealth between consumption and investment so as to achieve a pattern of consumption over time that maximises their utility. The role of the company then is reduced to that of maximising the wealth (present value) of the shareholders. 2. Modern finance theory is built on the behaviour of individual shareholders, companies and the capital market. Since Fisher’s Separation Theorem combines these three elements, it is not surprising that many basic notions of modern finance theory can be found in the theorem. Rational individuals are interested in maximising their utility and an investor’s utility is directly related to his wealth level. Companies can maximise investors’ wealth by investing in all projects with a net present value greater than zero. 3. It follows from Fisher’s Separation Theorem that a company’s investment decisions can be made independently of the consumption preferences of the company’s shareholders. As a result, there is a unique preferred level of investment that will make all the company’s shareholders better off. It also follows that the company’s financing and dividend decisions are irrelevant. 4. With certainty, and perfect and complete markets, Fisher ’s analysis shows that in order to maximise shareholders’ wealth, a company should accept all investments that have a positive net present value. The financing and dividend decisions are irrelevant. In this case, financial decision making is, indeed, trivial. 5. The most important implication of different borrowing and lending rates is that (except under fairly restrictive assumptions) Fisher ’s Separation Theorem breaks down—that is, there is no unique set of financial decisions which a company can make that will be favoured by all shareholders.

Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder ©McGraw-Hill Education (Australia) 2015

1 of 8

CHAPTER 2

Solutions to problems 1. (a) In the absence of a capital market, the person cannot easily engage in any borrowing or lending activities. At time zero, she will consume $400, which means she has $1600 available for her consumption in Year 1. Together with her endowment in Year 1, the person has a total of $2600 available for consumption. In Year 2, the person wants to consume $1200, which is $700 more than her endowment in that period ($500). This means that $700 has to be put aside in Year 1 for consumption in Year 2. Hence, the person’s consumption in Year 1 is $1900 ($2600 – $700). This is shown in the table below: Year 0

Year 1

Year 2

$400

?

$1200

$2000

$1000

$500

Distribution of Year 0 surplus

–$1600

+$1600

+$700

Distribution of Year 1 surplus

___

–$700

$1200

$400

$1900

Desired consumption Endowment

Actual consumption

(b) With a capital market, the person can lend $1600 now at i = 5 per cent. This would give her $1680 in Year 1 ($1600  1.05). Since she needs an extra $700 to achieve her consumption target in Year 2, the person could set aside $666.67 in Year 1 and lend this amount at i = 5 per cent, (i.e. $700 = $666.67  1.05). Therefore, her consumption in Year 1 is $1000 + $1680 – $666.67, which is equal to $2013.33. Compared with (a) above, the existence of a capital market has enabled the person to increase her consumption in Year 1 without causing any reduction in consumption in the other 2 years. This is shown in the table below.

Desired consumption Endowment Distribution of Year 0 surplus(a)

Year 0

Year 1

Year 2

$400

?

$1200

$2000

$1000.00

$500

–$1600

+$1680.00

+$700

–$666.67

$1200

Distribution of Year 1 surplus(a) Actual consumption (a)

$400

$2013.33

with interest

Note:

$1600  1.05 = $1680 $666.67  1.05 = $700

Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder ©McGraw-Hill Education (Australia) 2015

2 of 8

CHAPTER 2

2. (a) The net present values of the projects are:

$12 1000  $110 000 1.05  $5238.10

NPV (Small ) 

NPV (Upgrade ) 

$65000  $60000 1.05  $1904.76

Because both NPVs are positive, both projects are acceptable investments. (b) First calculate the total dividend payouts, and then the dividends per shareholder. Total dividend payouts are: Today:

$200 000 − $110 000 − $60 000 = $30 000

Later:

$121 000 + $65 000 = $186 000.

The shareholders hold equal numbers of shares so dividends per shareholder are: Today:

$30 000 / 2 = $15 000

Later:

$186 000 / 2 = $93 000.

(c) Shareholder A will need to borrow $40 000 − $15 000 = $25 000. The repayment required, with 5% interest, is $25 000 × 1.05 = $26 250. Her consumption per period is shown in the table below: Now

Later

Dividend

$15 000

$93 000

Borrow / Repay

$25 000

−$26 250

Consumption

$40 000

$66 750

If the company had instead undertaken only Project Small, then Shareholder A’s consumption outcomes would have been: Now

Later

$45 000(a)

$60 500(b)

Lend / Receive

–$5000

$5250(c)

Consumption

$40 000

$65750

Dividend

Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder ©McGraw-Hill Education (Australia) 2015

3 of 8

CHAPTER 2 (a )

($200 000 − $110 000) / 2 = $45 000

(b )

$121 000 / 2 = $60 500

(c)

$5000 × 1.05 = $5250

Under this alternative, Shareholder A has the same consumption now ($40 000), but lower consumption later ($65 750 < $66 750). (d) Let P be the amount that Shareholder A must borrow now, which, with interest added, will require a repayment of 1.05P later. The consumption outcomes are shown in the table below: Now

Later

$15 000

$93 000

Borrow/repay

P

−1.05P

Consumption

$15 000 + P

Dividend

$93 000 − 1.05P

Equate consumption now and consumption later and solve for P: $15000 P  $93000  1.05P 2.05P  $78000 P  $38048.78

Shareholder A should borrow $38048.78 today. The repayment required is, thus, $38048.78 × 1.05 = $39 951.22. The consumption outcomes are shown in the table below: Now

Later

Dividend

$15 000.00

$93 000.00

Borrow / Repay

$38 048.78

−$39 951.22

Consumption

$53 048.78

$53 048.78

As required, Shareholder A is able to consume the same amount in both periods. 3. (a) The net present values of the projects are:

$12 1000 $110 000 1.09  $1009.17

NPV (Small ) 

Solutions manual to accompany Business Finance 12e by Peirson, Brown, Easton, Howard and Pinder ©McGraw-Hill Education (Australia) 2015

4 of 8

CHAPTER 2

NPV (Upgrade ) 

$65000  $60000 1.09  $366.97

Project Small is accepted because it has a positive NPV. Project Upgrade is rejected because it has a negative NPV. (b) First calculate the total dividend payouts, and then the dividends per shareholder. Total dividend payouts are: Today:

$200 000 − $110 000 = $90 000

Later:

$121 000

The shareholders hold equal shares. Therefore, dividends per shareholder are: Today:

$90000 / 2 = $45 000

Later:

$121 000 / 2 = $60 500

(c) Shareholder A will lend $45 000 − $40 000 = $5000. The future repayment received, with 9% interest, is $5000 × 1.09 = $5450. Her consumption per period is shown in the table below: Now

Later

Dividend

$45 000

$60 500

Lend / Receive

–$5000

$5450

Consumption

$40 000

$65 950

(d) In Problem 2(c), consumption is $40 000 today and $66 750 later. In Problem 3(c), consumption is $40 000 today and $65 950 later. Therefore, Shareholder A has greater consumption, and hence greater utility, in Problem 2 than in Problem 3. Note that in Problem 2, Shareholder A borrows at the interest rate of 5%, while in Problem 3, Shareholder A lends at the interest rate of 9%. Thus, counter-intuitively, it is possible that a lender (like Shareholder A in Problem 3) can benefit ...