Solutions Manual for Fundamentals of Corporate Finance 6th
Edition by Jonathan Berk, Peter DeMarzo
,Contents
Chapter 1 The Corporation 1
Chapter 2 Introduction to Financial Statement Analysis 4
Chapter 3 Arbitrage and Financial Decision Making 16
Chapter 4 The Time Value of Money 26
Chapter 5 Interest Rates 50
Chapter 6 Investment Decision Rules 69
Chapter 7 Fundamentals of Capital Budgeting 89
Chapter 8 Valuing Bonds 106
Chapter 9 Valuing Stocks 123
Chapter 10 Capital Markets and the Pricing of Risk 134
Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 148
Chapter 12 Estimating the Cost of Capital 166
Chapter 13 Investor Behavior and Capital Market Efficiency 175
Chapter 14 Capital Structure in a Perfect Market 184
Chapter 15 Debt and Taxes 193
Chapter 16 Financial Distress, Managerial Incentives, and Information 202
Chapter 17 Payout Policy 216
Chapter 18 Capital Budgeting and Valuation with Leverage 225
Chapter 19 Valuation and Financial Modeling: A Case Study 244
Chapter 20 Financial Options 253
Chapter 21 Option Valuation 263
Chapter 22 Real Options 274
Chapter 23 Raising Equity Capital 300
Chapter 24 Debt Financing 306
Chapter 25 Leasing 310
Chapter 26 Working Capital Management 317
Chapter 27 Short-Term Financial Planning 324
Chapter 28 Mergers and Acquisitions 331
Chapter 29 Corporate Governance 337
Chapter 30 Risk Management 340
Chapter 31 International Corporate Finance 352
,Chapter 1
The Corporation
1-1. What is the most important difference between a corporation and all other organization forms?
A corporation is a legal entity separate from its owners.
1-2. What does the phrase limited liability mean in a corporate context?
Owners’ liability is limited to the amount they invested in the firm. Stockholders are not responsible
for any encumbrances of the firm; in particular, they cannot be required to pay back any debts incurred
by the firm.
1-3. Which organization forms give their owners limited liability?
Corporations and limited liability companies give owners limited liability. Limited partnerships
provide limited liability for the limited partners, but not for the general partners.
1-4. What are the main advantages and disadvantages of organizing a firm as a corporation?
Advantages: Limited liability, liquidity, infinite life
Disadvantages: Double taxation, separation of ownership and control
1-5. Explain the difference between an S corporation and a C corporation.
C corporations much pay corporate income taxes; S corporations do not pay corporate taxes but must
pass through the income to shareholders to whom it is taxable. S corporations are also limited to 75
shareholders and cannot have corporate or foreign stockholders.
1-6. You are a shareholder in a C corporation. The corporation earns $2 per share before taxes. Once
it has paid taxes it will distribute the rest of its earnings to you as a dividend. The corporate tax
rate is 40% and the personal tax rate on (both dividend and non-dividend) income is 30%. How
much is left for you after all taxes are paid?
First the corporation pays the taxes. After taxes, $2 (1− 0.4) = $1.20 is left to pay dividends. Once the
dividend is paid, personal tax on this must be paid, which leaves $1.20 (1 − 0.3) = $0.84 . So after all
the taxes are paid, you are left with 84¢.
1-7. Repeat Problem 6 assuming the corporation is an S corporation.
An S corporation does not pay corporate income tax. So it distributes $2 to its stockholders. These
stockholders must then pay personal income tax on the distribution. So they are left with
$2 (1 − 0.3) = $1.40 .
, 2
1-8. You have decided to form a new start-up company developing applications for the iPhone. Give
examples of the three distinct types of financial decisions you will need to make.
As the manager of an iPhone applications developer, you will make three types of financial decisions.
i. You will make investment decisions such as determining which type of iPhone application
projects will offer your company a positive NPV and therefore your company should develop.
ii. You will make the decision on how to fund your iPhone application investments and what mix of
debt and equity your company will have.
iii. You will be responsible for the cash management of your company, ensuring that your company
has the necessary funds to make investments, pay interest on loans, and pay your employees.
1-9. Corporate managers work for the owners of the corporation. Consequently, they should make
decisions that are in the interests of the owners, rather than their own. What strategies are
available to shareholders to help ensure that managers are motivated to act this way?
Shareholders can do the following.
i. Ensure that employees are paid with company stock and/or stock options.
ii. Ensure that underperforming managers are fired.
iii. Write contracts that ensure that the interests of the managers and shareholders are closely aligned.
iv. Mount hostile takeovers.
1-10. Suppose you are considering renting an apartment. You, the renter, can be viewed as an agent
while the company that owns the apartment can be viewed as the principal. What principal-
agent conflicts do you anticipate? Suppose, instead, that you work for the apartment company.
What features would you put into the lease agreement that would give the renter incentives to
take good care of the apartment?
The agent (renter) will not take the same care of the apartment as the principal (owner), because the
renter does not share in the costs of fixing damage to the apartment. To mitigate this problem, having
the renter pay a deposit should motivate the renter to keep damages to a minimum. The deposit forces
the renter to share in the costs of fixing any problems that are caused by the renter.
1-11. You are the CEO of a company and you are considering entering into an agreement to have your
company buy another company. You think the price might be too high, but you will be the CEO
of the combined, much larger company. You know that when the company gets bigger, your pay
and prestige will increase. What is the nature of the agency conflict here and how is it related to
ethical considerations?
There is an ethical dilemma when the CEO of a firm has opposite incentives to those of the
shareholders. In this case, you (as the CEO) have an incentive to potentially overpay for another
company (which would be damaging to your shareholders) because your pay and prestige will
improve.
1-12. Are hostile takeovers necessarily bad for firms or their investors? Explain.
No. They are a way to discipline managers who are not working in the interests of shareholders.
1-13. What is the difference between a public and private corporation?
The shares of a public corporation are traded on an exchange (or "over the counter" in an electronic
trading system) while the shares of a private corporation are not traded on a public exchange.
1-14. Explain why the bid-ask spread is a transaction cost.
Investors always buy at the ask and sell at the bid. Since ask prices always exceed bid prices, investors
“lose” this difference. It is one of the costs of transacting. Since the market makers take the other side
of the trade, they make this difference.
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