Fundamentals of Corporate Finance 2nd Edition Solutions Berk PDF

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Concept Check Questions and Answers for Berk/DeMarzo/Harford Fundamentals of Corporate Finance, 2e

Chapter 1: Corporate Finance and the Financial Manager 1. What is a limited liability company (LLC)? How does it differ from a limited partnership? All of the owners of a limited liability company have limited liability and can actively run the business. A limited partnership has two types of owners: general partners and limited partners. The general partners run the business and are personally liable for the firm’s debt obligations. The limited partners cannot run the business and their liability is limited to their investment in the company. 2. What are the advantages and disadvantages of organizing a business as a corporation? The advantages of organizing as a corporation are: (1) limited stockholder liability, (2) easy transfer of ownership, (3) unlimited life of the corporation, and (4) future business prospects are the only limitation for outside funding. The disadvantage of a corporation is double taxation; the corporation pays taxes on its profits and then shareholders pay taxes on the profits that are distributed to them. 3.

What are the main types of decisions that a financial manager makes

The financial manager makes the financial decisions of the business for the stockholders. The financial manager makes investment decisions, makes financing decisions, and manages cash flow from operating activities. 4.

What is the goal of the financial manager?

A financial manager is a caretaker of the stockholders’ money. The financial manager’s job is to make decisions that are in the best interests of the shareholders. The financial manager compares the costs and benefits of a decision to determine which will maximize the wealth of the stockholders. 5.

How do shareholders control a corporation?

The shareholders of a corporation elect the board of directors. This board of directors has the ultimate decision-making authority in the corporation. If the board of directors is not making decisions that are in the best interests of the shareholders, the shareholders will vote to replace the board. 6.

What types of jobs would a financial manager have in a corporation?

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Financial managers can be found working in the treasury department of firms, in capital budgeting, risk management and credit management, or for the controller in the accounting or tax divisions. 7.

What ethical issues could confront a financial manager?

Managers are hired to be caretakers of the shareholders’ money. Their job is to make decisions that add wealth for the owners. Managers face the ethical dilemma of whether to adhere to their responsibility to put the interests of the shareholders first when it conflicts with their own self-interests. 8. What advantage does a stock market provide to corporate investors? To financial managers? A stock market allows investors to easily sell their shares in the corporation when they want to turn their investment into cash. The stock market provides liquidity and determines the market price for the shares. 9.

What are the main differences between the NYSE and NASDAQ?

The NYSE is an auction market; prices are set through direct interaction between buyers and sellers. NASDAQ is an over-the-counter, or dealer, market. On the NYSE, each stock has only one market maker, but a stock can have multiple market makers competing against each other in a dealer market such as NASDAQ. 10.

What is the basic financial cycle?

The financial cycle consists of (1) people saving and investing their money; (2) that money flowing to companies who use it to fund growth, generating profits and wages; and (3) the money flowing back to savers and investors. 11.Wh a ta r et hr e ema i nr ol e sfina nc i a li ns t i t ut i onspl a y ?

Financial institutions help move money through the financial system and help move money through time. They also help in spreading out risk in the financial markets.

Chapter 2: Introduction to Financial Statement Analysis 1.

What is the role of an auditor?

An auditor is a neutral third party hired by the corporation to check the annual financial statements, ensure they are prepared according to the generally accepted accounting principles (GAAP), and verify that the information is reliable. 2.

What are the four financial statements that all public companies must produce?

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All public companies must produce the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders’ equity. 3.

What is depreciation designed to capture?

Depreciation measures the decline in an asset’s value because of its increasing age and usage. 4. The book value of a company’s assets usually does not equal the market value of those assets. What are some reasons for this difference? Many of the assets listed on the balance sheet are valued based on their historical cost rather than their true value today. Also, many of the firm’s valuable assets, such as the firm’s reputation in the marketplace, are not captured on the balance sheet. 5.

What does a high debt-to-equity ratio tell you?

A high debt-to-equity ratio means that a company is using a lot of debt to finance its assets. In other words, the company is using a lot of financial leverage. 6.

What is a firm’s enterprise value?

The enterprise value of a firm assesses the value of the underlying business assets, unencumbered by debt and separate from any cash and marketable securities. 7.

What do a firm’s earnings measure?

Earnings measure how much is left over for the shareholders after all expenses have been paid. 8.

What is dilution?

A growth in the number of shares in a corporation is referred to as dilution because there will be more total shares to divide the same earnings. 9.

How can a financial manager use the DuPont identity to assess the firm’s ROE?

The DuPont Identity allows a manager to look at the drivers of net income: profit margin, asset turnover, and equity multiplier. 10. How do you use the price-earnings (P/E) ratio to gauge the market value of a firm? The P/E ratio is the ratio of the stock price to the firm’s earnings per share. It is a measure that is used to assess whether a stock is over, under, or fairly valued based on the idea that

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the value of a stock should be proportional to the level of earnings it can generate for its shareholders. P/E ratios tend to be higher for firms with high growth rates. 11.

Why does a firm’s net income not correspond to cash earned?

Net income does not correspond to cash earned for two reasons. First, there are non cash expenses on the income statement, such as depreciation and amortization. Second, certain uses of cash, such as the purchase of a building, are not reported on the income statement. 12.

What are the components of the statement of cash flows?

The statement of cash flows is divided into three sections: operating activities, investment activities, and financing activities. 13.

Where do off-balance sheet transactions appear in a firm’s financial statements?

Off-balance sheet transactions are disclosed on the management discussion and analysis (MD&A). Even though off-balance sheet transactions do not appear on the balance sheet, they can have a material impact on the firm’s future performance. 14.

What information do the notes to the financial statements provide?

The notes to the financial statements provide information such as the accounting assumptions that were used in preparing the statements. Also, details of acquisitions, spin-offs, leases, taxes, and risk management activities are shown in these notes. 15.

Describe the transactions Enron used to increase its reported earnings.

Enron sold assets at inflated prices to other firms and promised to buy back those assets at even higher prices in the future. Thus, Enron received cash today in exchange for a promise to pay more cash in the future. Enron recorded the incoming cash as revenue and hid the obligation to buy the assets back in a variety of ways. 16.

What is the Sarbanes-Oxley Act?

In 2002, Congress passed the Sarbanes-Oxley Act. This act requires, among other things, that CEOs and CFOs certify the accuracy and appropriateness of their firm’s financial statements and increases the penalties against them if their financial statements later prove to be fraudulent.

Chapter 3: Time Value of Money: An Introduction 1. When costs and benefits are in different units or goods, how can we compare them? When costs and benefits are in different units or goods, we must quantify their values in equivalent terms—cash today.

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2. If crude oil trades in a competitive market, would an oil refiner that has a use for the oil value it differently than another investor would? No, the oil refiner would not value the crude oil differently than any other investor would. The oil refiner would value the crude oil based upon the market price of the crude oil. 3.

How does investors’ profit motive keep competitive market prices correct?

If an item, such as gold, were trading in one market for a price that was lower than in another market, investors would have the incentive to make a profit by purchasing the item in the low price market and selling it in the high price market. This action would drive the price up in the low price market and the price down in the high price market until the price was identical in the two markets. 4.

How do we determine whether a decision increases the value of the firm?

First, we must identify the costs and benefits of a decision. Second, we must quantify the costs and benefits. If the benefits exceed the costs, then the decision adds value. 5.

How is an interest rate like a price?

The interest rate is like a price because it is the cost of borrowing money or the amount that we will be paid when we lend money. 6. Is the value today of money to be received in one year higher when interest rates are high or when interest rates or low? The value of money to be received in one year is higher when interest rates are lower because it is not being discounted at as high of a rate.

7.

Can you compare or combine cash flows at different times?

No, you cannot compare or combine cash flows that occur at different times because a dollar today and a dollar at another point in time are not equivalent. 8.

What do you need to know to compute a cash flow’s present or future value?

To compute a cash flow’s present or future value you need to know the interest rate and the number of time periods for discounting or compounding.

Chapter 4: Time Value of Money: Valuing Cash Flow Streams 1.

How do you calculate the present value of a cash flow stream?

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To calculate the present value of a cash flow stream, you must calculate the present value of each cash flow and then add these values together. 2.

How do you calculate the future value of a cash flow stream?

To calculate the future value of a cash flow stream, you must calculate the future value of each cash flow and then add these values together. 3.

What are some examples of perpetuities?

The perpetual bonds issued in the seventeenth century by the Hoogheemraadschap Lekdijk Bovendams are perpetuities that are still paying interest today. A common example of a perpetuity would be providing the money for an endowment that would allow an institution to spend money on a particular event every year forever. 4. What is the intuition behind the fact that an infinite stream of cash flows has a finite present value? While an infinite stream of cash flows pays a cash flow forever, the very distant cash flows have very little value today (due to the time value of money). Thus, the stream of payments of a perpetuity can be replicated using a finite amount of money. 5.

What are some examples of annuities?

A lottery that pays $20,000 a year for ten years to the winner would be an example of an annuity. Another example of an annuity would be saving $200 a month for 30 years in a retirement savings account. 6.

What is the difference between an annuity and a perpetuity?

An annuity ends at some point in time while a perpetuity continues into infinity. 7.

How can an infinitely growing stream of cash flows have a finite value?

While an infinitely growing stream of cash flows pays a cash flow forever, the very distant cash flows have very little value today (due to the time value of money). Thus, the stream of payments of a growing perpetuity can be replicated using a finite amount of money. 8.

What is an example of a growing perpetuity?

An example of a growing perpetuity would be donating an amount of money that would fund a $10,000 scholarship next year and then a scholarship that increases at a rate of 4% each year to keep up with inflation forever. 9.

How do you calculate the cash flow of an annuity?

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The present value of an annuity of C for n periods with interest rate r is: 1 1  PV( a n n u i t yo ffC o rN p e r i o d s ) C 1    N r ( 1 r ) 

10.

How do you calculate the rate of return on an investment?

The rate of return on an investment is the interest rate that sets the net present value of the cash flows equal to zero. You can guess the rate of return and manually calculate its value. An easier solution is to use a spreadsheet or calculator to automate the guessing process.

Chapter 5: Interest Rates 1.

What is the difference between an EAR and an APR quote?

An annual percentage rate (APR) is the rate that interest earns in one year before the effect of compounding. An effective annual rate (EAR) is the rate that the amount of interest actually earns at the end of one year. Because the APR does not include the effect of compounding, it is typically less than the EAR. 2.

Why can’t the APR be used as a discount rate?

Because the APR does not reflect the true amount you will earn in one year, the APR itself cannot be used as a discount rate. 3.

How is the principal repaid in an amortizing loan?

The principal is repaid over the life of the loan in an amortizing loan. When each payment is made, some of the payment goes toward principal and some toward interest. 4.

Why does the part of your loan payment covering interest change over time?

Each time a payment is made, the outstanding balance on the loan is reduced. Since the interest is calculated on the outstanding balance, the amount of interest owed decreases over time. 5.

What is the difference between a nominal and real interest rate?

The nominal interest rate is the rate quoted by banks and other financial institutions, whereas the real interest rate is the rate of growth of purchasing power, after adjusting for inflation. The real interest rate is approximately equal to the nominal rate less the rate of inflation.

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6.

How are interest rates and the level of investment made by businesses related?

When the costs of an investment precede the benefits, an increase in the interest rate will decrease the investment’s PV. All else being equal, higher interest rates will therefore tend to shrink the set of positive-PV investments available to firms. 7.

What is the opportunity cost of capital?

The opportunity cost of capital is the best available return offered in the market on an investment of comparable risk and term to the cash flow being discounted. 8.

Can you ignore the cost of capital if you already have the funds inside the firm?

No, you cannot ignore the cost of capital if you already have funds inside the firm. These funds still have an opportunity cost and investors expect a return on these funds.

Chapter 6: Bonds 1.

What types of cash flows does a bond buyer receive?

The cash flows that a bond buyer receives are the coupon payments and the par value at maturity. 2.

How are the periodic interest payments on a bond determined?

The periodic interest payments on a bond are determined by multiplying the coupon rate by the bond’s par value, and dividing by the number of coupon payments per year. 3. Why would you want to know the yield to maturity of a bond? The yield to maturity of a bond is the internal rate of return that an investor earns on the bond by holding the bond to maturity. 4.

What is the relationship between a bond’s price and its yield to maturity?

The bond’s price and yield to maturity are inversely related. 5.

What cash flows does a company pay to investors holding its coupon bonds?

Companies pay bond investors regular coupon payments and the par value at maturity. 6.

What do we need in order to value a coupon bond?

In order to value a bond, we need to know the cash flows that will occur and the interest rate to use to discount those cash flows. For a coupon bond, the coupon rate multiplied by the face value of the bond gives us the periodic cash flows and the face value of the bond will occur at the bond’s maturity.

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7.

Why do interest rates and bond prices move in opposite directions?

Bond prices and interest rates move in opposite directions because the interest rates are used to discount the future cash flows of the bond. Thus, when interest rates increase, the present value of the cash flows decreases. 8. If a bond’s yield to maturity does not change, how does its cash price change between coupon payments? The accrued interest changes as a bond moves from one coupon payment to the next. It is this accrued interest that causes a bond’s price to increase between coupon payments, even if the yield to maturity stays constant. 9.

What is a junk bond?

A junk bond, also known as a speculative bond, is a bond rated BB or lower by Standard and Poor’s or Ba or lower by Moody’s. 10.

How will the yield to maturity of a bond vary with the bond’s risk of default?

The yield to maturity will increase as a bond’s risk of default increases, as investors want to be compensated for taking additional risk with their investment.

Chapter 7: Stock Valuation 1.

What is a share of stock and what are dividends?

Common stock is a share of ownership in a corporation. Dividends are periodic payments, usually in the form of cash, ...