SOLUTION MANUAL
Fundamentals of Corporate Finance, 5th Edition
by Robert Parrino, David Kidwell, All Chapters 1 – 21
,TABLE OF CONTENTS
CHAPTER 1: The Financial Manager and the Firm
CHAPTER 2: The Financial System and the Level of Interest Rates
CHAPTER 3: Financial Statements, Cash Flows, and Taxes
CHAPTER 4: Analyzing Financial Statements
CHAPTER 5: The Time Value of Money
CHAPTER 6: Discounted Cash Flows and Valuation
CHAPTER 7: Risk and Return
CHAPTER 8: Bond Valuation and the Structure of Interest Rates
CHAPTER 9: Stock Valuation
CHAPTER 10: The Fundamentals of Capital Budgeting
CHAPTER 11: Cash Flows and Capital Budgeting
CHAPTER 12: Evaluating Project Economics
CHAPTER 13: The Cost of Capital
CHAPTER 14: Working Capital Management
CHAPTER 15: How Firms Raise Capital
CHAPTER 16: Capital Structure Policy
CHAPTER 17: Dividends, Stock Repurchases, and Payout Policy
CHAPTER 18: Business Formation, Growth, and Valuation
CHAPTER 19: Financial Planning and Managing Growth
CHAPTER 20: Options and Corporate Finance
CHAPTER 21: International Financial Management
, Chapter 1
The Financial Manager and the Firm
Before You Go On Questions and Answers
Section 1.1
1. What are the three basic types of financial decisions managers must make?
The three basic decisions each business must make are the capital budgeting decision, the
financing decision, and the working capital management decision. These decisions determine
which productive assets to buy, how to pay for or finance these purchases, and how to manage
the day-to-day financial matters so the company can pay its bills.
2. Explain why you would make an investment if the value of the expected cash flows
exceeds the cost of the project.
You would accept an investment project whose cash flows exceed the cost of the project
because such projects will increase the value of the firm, making the owners wealthier. Most
people start a business to increase their wealth. Remember that the cost of capital (time value of
money) will affect the decision about whether to invest.
3. Why are capital budgeting decisions among the most important decisions in the life of a
firm?
The capital budgeting decisions are considered the most important in the life of the firm
because these decisions determine which productive assets the firm purchases, and which assets
generate most of the firm’s cash flows. Furthermore, capital budgeting decisions are
, long-term decisions and if you make a mistake in selecting a productive asset, you are stuck with
the decision for a long time.
Section 1.2
1. Why are many businesses operated as sole proprietorships or partnerships?
Many businesses elect to operate as sole proprietorships or partnerships because of the small
operating scale and capital base of their firms. Both of these forms of business organization are
fairly easy to start and impose few regulations on the owners.
2. What are some advantages and disadvantages of operating as a public corporation? The
main advantages of operating as a public corporation are the access to the public securities
markets, which makes it easier to raise large amounts of capital, and the ease of ownership
transfer. All the shareholders have to do is to call their broker to buy or sell shares of stock.
Since a public corporation usually has many shares outstanding, large blocks of securities can be
purchased or sold without an appreciable impact on the price of the stock. The major
disadvantage of corporations is the tax situation. Not only must the corporation pay taxes on its
income, but the owners of the corporation get taxed again when dividends are paid to them.
This is referred to as double taxation. In addition to taxes, public corporations are subject to
stringent reporting requirements, and the incentives may convince managers to focus on
shorter-term profitability than longer-term wealth creation.
3. Explain why professional partnerships such as physicians’ groups organize as limited liability partnerships.
Professional partnerships such as physicians’ groups desire to organize as limited liability partnerships
(LLPs) to take advantage of the tax arrangements of partnerships combined with the advantages of the
limited liability of a corporation. By operating as an LLP, the partnership is able to avoid a potential
financial disaster resulting from the misconduct of one partner.
Section 1.3
1. What are the major responsibilities of the CFO?
, The major responsibilities of a CFO include analysis and recommendations for financial
decisions. The CFO, who reports directly to the CEO, focuses on managing all aspects of the
firm’s finances and works with the CEO on strategic issues. The CFO also interacts with staff
in other functional areas on a regular basis related to financial issues that affect the business.
2. Identify the financial officers who typically report to the CFO and describe their duties.
The financial officers discussed in the chapter who report to the CFO are the controller, the
treasurer, the risk manager, and the internal auditor.
The controller is the firm’s chief accounting officer, and thus prepares the financial statements
and taxes. This position also requires close cooperation with the external auditors. The
treasurer’s responsibility is the collection and disbursement of cash, investing excess cash,
raising new capital, handling foreign exchange, and overseeing the company’s pension fund
management. This individual also assists the CFO in handling important Wall Street
relationships. The risk manager monitors and manages the firm’s risk exposure in financial and
commodity markets and the firm’s relationships with insurance providers. Finally, the internal
auditor is responsible for conducting risk assessment and performing audits of high- risk areas.
3. Why does the internal auditor report to both the CFO and the audit committee of the
board of directors?
The internal auditor reports to the CFO on a day-to-day basis but is ultimately accountable for
reporting any accounting irregularities to the board of directors. The dual reporting system
serves as a check to ensure that there are no discrepancies in the company’s financial
statements.
Section 1.4
1. Why is profit maximization an unsatisfactory goal for managing a firm?
Profit maximization is not a satisfactory goal when managing a firm because it is rather difficult
to define profits since accountants can apply and interpret the same accounting
, principles differently. Also, profit maximization does not define the size, the uncertainty, and
the timing of cash flows; it ignores the time value of money concept.
2. Explain why maximizing the market price of a firm’s stock is an appropriate goal for
the firm’s management.
Maximizing the current market price of a firm’s stock is an appropriate goal for the firm’s
management because it is an unambiguous objective and is easy to measure for a firm whose
stock is publicly traded. One can simply look at the value of the company’s stock on any given
day to determine whether the market price went up or down. Maximizing the market value of
the stock is not inconsistent with maximizing the value of claims to the firm’s other
stakeholders. In maximizing the value of the stock, managers must make decisions that
account for the interests of all stakeholders. This is also true for firms without publicly traded
stocks. In these cases, the statement can be interpreted as maximizing the current value of
owner’s equity.
3. What is the fundamental determinant of an asset’s value?
The fundamental determinant of an asset’s value is the future cash flows the asset is expected to
generate including the size, timing, and riskiness of these cash flows. Other factors that may
help determine the price of an asset are internal decisions, such as the company’s expansion
strategy, as well as external stimulants, such as the state of the economy.
Section 1.5
1. What are agency conflicts?
An agency conflict occurs when the goals of the principals or the stockholders are not aligned
with the goals of the agents or the company management. Management is often more
concerned with pursuing its own self-interest, and so the maximization of shareholder value is
pushed to the side.
2. What are corporate raiders?
Corporate raiders can make the company more efficient by keeping top managers on their
toes. Top managers know that if the company’s performance declines and its stock slips, it
, makes itself vulnerable to takeovers by corporate raiders who are just waiting to temporarily
acquire a company, turn it around, and sell it for profit. Therefore, the role of the corporate
raiders is twofold: first, the fear of takeovers pushes managers to do a better job, and second, if
managers are not performing up to expectations, the company can be rescued and restructured
into becoming a strong performer. However, the threat of a corporate raider could result in an
incentive conflict for managers, inducing them to focus on short-term profitability over long-
term value creation.
3. List the three main objectives of the Sarbanes-Oxley Act.
The three main goals of the Sarbanes-Oxley Act are to reduce agency costs in corporations, to
restore ethical conduct within the business sector, and to improve the integrity of accounting
reporting systems within firms.
Section 1.6
1. What is a conflict of interest in a business setting?
Conflict of interest in the business setting refers to a conflict between an individual’s personal
or institutional gain and the obligation to serve the interest of another party. For example, the
chapter discussed the problem that arises when the real estate agent helping you buy a house is
also the listing agent.
2. How would you define an ethical business culture?
An ethical business culture means that people have a set of principles, or a moral compass, that
helps them identify moral issues and then make ethical judgments without being told what to
do.
Self-Study Problems and Solutions
1.1 Give an example of a capital budgeting decision and a financing decision.
Solution:
, Capital budgeting involves deciding in which productive assets the firm invests, such as
buying a new plant or investing in the renovation of an existing facility. Financing decisions
determine how a firm will raise capital. Examples of financing decisions include the
decision to borrow from a bank or issue debt in the public capital markets.
LO: 1
Level: Basic
1.2 What is the appropriate decision criterion for financial managers to use when
selecting a capital project?
Solution:
Financial managers should select a capital project only if the value of the project’s expected
future cash flows exceeds the cost of the project. In other words, managers should only
make investments that will increase firm value, and thus increase the stockholders’ wealth.
LO: 1
Level: Basic
1.3 What are some of the things that managers do to manage a firm’s working capital?
Solution:
Working capital management is the day-to-day management of a firm’s short-term assets
and liabilities. Working capital can be managed by maintaining the optimal level of
inventory, managing receivables and payables, deciding to whom the firm should extend
credit, and making appropriate investments with excess cash.
LO: 1
Level: Basic
1.4 Which one of the following characteristics does not pertain to corporations?
a. Can enter into contracts
b. Can borrow money
c. Are the easiest type of business to form
d. Can be sued
, e. Can own stock in other companies
Solution:
The answer that does not pertain to corporations is: c. Are the easiest type of business to
form.
LO: 2
Level: Basic
1.5 What are typically the main components of an executive compensation package?
Solution:
The three main components of a typical executive compensation package are: base salary,
bonus based on accounting performance, and compensation tied to the firm’s stock price.
LO: 5
Level: Basic
Discussion Questions and Answers
1.1 Describe the cash flows between a firm and its stakeholders.
Cash flows are generated by a firm’s productive assets that were purchased through either
issuing debt or raising equity. These assets generate revenues through the sale of goods and
services. A portion of this revenue is then used to pay wages and salaries to employees, pay
suppliers, pay taxes, and pay interest on the borrowed money. The leftover money, residual
cash, is then either reinvested back in the business or is paid out to stockholders in the form
of dividends.
LO: 1
Level: Basic
Bloomcode: Comprehension
AACSB: Analytic
IMA: Corporate Finance
AICPA: Industry/Sector Perspective
, 1.2 What are the three fundamental decisions the financial manager is concerned with,
and how do they affect the firm’s balance sheet?
The primary financial management decisions every company faces are capital budgeting
decisions, financing decisions, and working capital management decisions. Capital
budgeting addresses the question of which productive assets to buy; thus, it affects the asset
side of the balance sheet. Financing decisions focus on raising the money the firm needs to
buy productive assets. These decisions are typically accomplished by issuing long-term debt
and equity, which affect both the long-term debt and stockholders’ equity components of
the balance sheet. Finally, working capital decisions involve how firms manage their current
assets and liabilities. The focus here is ensuring that a firm has enough money to pay its
bills, and that any excess money is invested to earn a return.
These decisions affect current assets and current liabilities on the balance sheet.
LO: 1
Level: Basic
Bloomcode: Comprehension
AACSB: Analytic
IMA: Decision Analysis AICPA:
Decision Modeling
1.3 What is the difference between stockholders and stakeholders?
Stockholders, also referred to as shareholders, are the owners of the company. A
stakeholder, on the other hand, is anyone with a claim on the assets of the firm, including,
but not limited to, shareholders. Stakeholders include the firm’s employees, suppliers,
creditors, and the government.
LO: 1
Level: Basic
Bloomcode: Analysis
AACSB: Analytic
IMA: Corporate Finance
AICPA: Industry/Sector Perspective
