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Answers to Review and Concept Check Questions Fundamentals of Corporate Finance, Canadian Edition, 4th edition Jonathan Berk, Peter DeMarzo, David A. Stangeland, Andras Marosi, Jarrad Harford Chapter 1-25

Chapter 1 Corporate Finance and the Financial Manager 

Answers to Chapter 1 Concept Check Questions

1. What are the advantages and disadvantages of organizing a business as a corporation? Advantages Disadvantages Corporation responsible for obligations More expensive to set up Not responsible for obligations of owners Double taxation More borrowing power/funding Articles of incorporation 2. What is a limited liability partnership (LLP)? How does it differ from a limited partnership? An LLP is similar to a general partnership in that the partners can be active in the management of the firm, and they do have a degree of unlimited liability. The limitation on a partner‘s liability is only in cases related to actions of negligence of other partners or those supervised by other partners. In all other respects, including a particular partner‘s own negligence or the negligence of those supervised by the particular partner, that partner has unlimited personal liability. Limited partners, however, have limited liability—that is, their liability is limited to their investment. Their private property cannot be seized to pay off the firm‘s outstanding debts. 3. What is an income trust? Which type of trust still gets preferential tax treatment after 2011? Canada Revenue Agency allows an exemption from double taxation for certain flow-through entities where all income produced by the business flows to the investors and virtually no earnings are retained within the business. This type of entities are called income trusts and they come in three forms, such as a business income trust, an energy trust, and a real estate investment trust (REIT). Income trusts formed before November 2006 are not taxed at the business level until 2011. REITs will continue to have no tax at the business level beyond 2011, but the other forms of income trusts are now taxed. 4. What are the main types of decisions that a financial manager makes? The financial manager has three main tasks which are described below: 1. Make investment decisions – capital budgeting investment opportunities 2. Make financial decisions – balance between debt and equity and the capital structure 3. Management of the short-term cash needs – cash planning for the firm.

5. What is the goal of the financial manager? Although there are many potential goals for the financial manager, the financial manager is the caretaker of the money (capital) the stockholders have invested in the company and the bottom line is the long-term maximization of the shareholders' wealth. 6. How do shareholders control a corporation? Shareholders control the corporation through their voting rights; however directors and executive are rarely replaced though a grassroots shareholder uprising. If shareholders are unhappy with a CEO‘s performance, they could, in principle, pressure the board to oust the CEO. Instead, dissatisfied investors often choose to sell their shares. Of course, somebody must be willing to buy the shares from the dissatisfied shareholders. If enough shareholders are dissatisfied, the only way to entice investors to buy (or hold) the shares is to offer them a low price. Similarly, investors who see a wellmanaged corporation will want to purchase shares, which drives the stock price up. Thus, the stock price of the corporation is a barometer for corporate leaders that continuously gives them feedback on the shareholders‘ opinion of their performance. 7. What types of jobs would a financial manager have in a corporation? There are various positions within a corporation that a financial manage may hold. The financial manager could hold the position of chief financial officer (CFO), controller, treasurer, budgeting, risk management or credit management. 8. What ethical issues could confront a financial manager? Managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of those shareholders (also called the principals). Managers face the ethical dilemma of whether to do what is in their own best interests or adhere to their responsibility to put the interests of shareholders first, For example, managers‘ compensation contracts are designed to ensure that most decisions in the shareholders‘ interests are also in the managers‘ interests; shareholders often tie the compensation of top managers to the corporation‘s profits or perhaps to its stock price. For example, biotech firms take big risks on drugs that fight cancer, AIDS, and other widespread diseases. The market for a successful drug is huge, but the risk of failure is high. Investors who put only some of their money in biotech may be comfortable with this risk, but a manager who has all of his or her compensation tied to the success of such a drug might opt to develop a less risky drug that has a smaller market. 9. What advantages does a stock market provide to corporate investors? Markets provide liquidity for a company‘s shares and determine the market price for those shares. An investor in a public company values the ability to turn his investment into cash easily and quickly by simply selling his shares on one of these markets. The analysis and trading by participants in these markets provide an evaluation of financial managers‘ decisions that not only determine the stock price, but also provide feedback to the managers on their decisions. 10. What is the importance of a stock market to a financial manager? The analysis and trading by participants in these markets provide an evaluation of financial managers‘ decisions that not only determine the stock price, but also provide feedback to the managers on their decisions.

11. What is the basic financial cycle? In the financial cycle, (1) people invest and save their money; (2) that money, through loans and stock, flows to companies that use it to fund growth through new products, generating profits and wages; and (3) the money then flows back to the savers and investors. All financial institutions play a role at some point in this cycle of connecting money with ideas and returning the profits back to the investors. 12. What are the three main roles financial institutions play? Financial institutions have a role beyond moving funds from those who have extra funds (savers) to those who need funds (borrowers and firms); they also move funds through time.

Chapter 2 Introduction to Financial Statement Analysis 

Answers to Chapter 2 Review Questions

1. Why do firms disclose financial information? Firms disclose financial statements to communicate financial information to the investment community. 2. Who reads financial statements? List at least three different categories of people. For each category, provide an example of the type of information they might be interested in and discuss why. Anyone interested in a firm can look to the financial statements for information. This includes:  Shareholders: Checking the profitability and performance of the firm.  Lenders: Looking for information about the credit-worthiness of the firm.

 Suppliers: Will this firm be a dependable customer?  Competitors: Seeking sales and profitability of the competition.  Management: How well are we running the firm? 3. 4. What is the purpose of the statement of financial position? The purpose of the statement of financial position is to show the financial position of the firm at a specific point in time. 5. How can you use the statement of financial position to assess the health of the firm? The statement of financial position can show how well the firm is managing the assets and financing the operations of the firm. 6. What is the purpose of the income statement? The purpose of the income statement is to report the firm‘s revenues, expenses, and earnings. It shows the profitability of the firm over a specific period of time. 7. How are the statement of financial position and the income statement related? The statement of financial position shows the financial situation of a firm at a given point in time, while the income statement shows the financial performance of the firm during the period leading up to the balance sheet date. The statements are linked through the retained earnings account on the balance sheet, which shows the cumulative profits of the firm during its existence. 8. What is the DuPont Identity and how can a financial manager use it? The DuPont Identity takes the return on equity (ROE) and breaks it into three components: net profit margin, asset turnover, and asset multiplier. The DuPont Identity equation is as shown below:

Return on Equity  Net Profit Margin  Asset Turnover  Equity Multiplier i.e., Net Income Net Income Sales Assets    Shareholder Equity Sales Assets Shareholder Equity The DuPont Identity is useful to managers, as it identifies three drivers that the manager can use to affect ROE. 9. How does the statement of cash flows differ from the income statement? The income statement measures the profits of the firm, while the statement of cash flows measures how cash moves in and out of the firm. These are not necessarily the same, as many non-cash flow transactions are included in the income statement (such as depreciation), while other cash flow transactions are not included in the income statement (such as investment in working capital and property, plant, and equipment). 10. Can a firm with positive net income run out of cash? Explain. Yes, a firm with positive net income can run out of cash. A rapidly growing firm, which is investing heavily in working capital and property, plant, and equipment, can have positive net income on the income statement but show negative cash flows from operating and investing activities. 11. What can you learn from management‘s discussion or notes to the financial statements? Management‘s discussion contains their analysis of the performance of the firm and identifies the risks that the business faces. The notes to the financial statements often clarify and augment the information used and reported in the financial statements.

12. How did accounting fraud contribute to the collapse of Enron? Enron utilized off-balance sheet transactions to inflate profits and hide liabilities.

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Answers to Chapter 2 Concept Check Questions

1. What is the role of an auditor? Investors also need some assurance that the financial statements are prepared accurately. Corporations are required to hire a neutral third party, known as an auditor, to check the annual financial statements, ensure they are prepared according to GAAP, and provide evidence to support the reliability of the information. 2. What are the four financial statements that all public companies must produce? Every public company is required to produce four financial statements: the statement of financial position or balance sheet, the statement of comprehensive income (which includes the income statement), the statement of cash flows, and the statement of changes in equity. 3. What is depreciation designed to capture? Because equipment tends to wear out or become obsolete over time, companies will reduce the value recorded for this equipment through a yearly deduction called depreciation according to a depreciation schedule that depends on an asset‘s life span. Depreciation is not an actual cash expense that the firm pays; it is a way of recognizing that buildings and equipment wear out and thus become less valuable the older they get. 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. An office building is listed on the balance sheet according to its historical cost less its accumulated depreciation. But the actual value of the office building today may be very different than this amount; in fact, it may be much more valuable. A second, and probably more important, problem is that many of the firm’s valuable assets are not captured on the balance sheet. Consider, for example, the expertise of the firm‘s employees, the firm‘s reputation in the marketplace, the relationships with customers and suppliers, and the quality of the management team. All these assets add to the value of the firm but do not appear on the balance sheet. For these reasons, the book value of equity is an inaccurate assessment of the actual value of the firm‘s equity. 5. What do a firm‘s earnings measure? The income statement shows the flow of revenues and expenses generated by those assets and liabilities between two dates. 6. What is meant by dilution? In the cases of stock options and convertible bonds, because there will be more total shares to divide the same earnings, this growth in the number of shares is referred to as dilution. Firms disclose the potential for dilution from options they have awarded by reporting diluted EPS, which shows the earnings per share the company would have if the stock options were exercised. 7. Why does a firm‘s net income not correspond to cash earned?

There are two reasons that net income does not correspond to cash earned. First, there are non-cash entries on the income statement, such as depreciation and amortization. Second, certain uses, such as the purchase of a building or expenditures on inventory, and sources of cash, such as the collection of accounts receivable, are not reported on the income statement. 8. What are the components of the statement of cash flows? The components roughly correspond to the three major jobs of the financial manager as given below: 1. Operating activity starts with net income from the income statement. It then adjusts this number by adding back all non-cash entries related to the firm‘s operating activities. 2. Investment activity lists the cash used for investment. 3. Financing activity shows the flow of cash between the firm and its investors. 9. Where do off-balance sheet transactions appear in a firm‘s financial statements? Management must also discuss any important risks that the firm faces or issues that may affect the firm‘s liquidity or resources. Management is also required to disclose any off-balance sheet transactions, which are transactions or arrangements that can have a material impact on the firm‘s future performance yet do not appear on the balance sheet. 10. What information do the notes to financial statements provide? In addition to the four financial statements, companies provide extensive notes with additional details on the information provided in the statements. For example, the notes document important accounting assumptions that were used in preparing the statements. They often provide information specific to a firm‘s subsidiaries or its separate product lines. They show the details of the firm‘s stock-based compensation plans for employees and the different types of debt the firm has outstanding. Details of acquisitions, spinoffs, leases, taxes, and risk management activities are also given. The information provided in the notes is often very important to a full interpretation of the firm‘s financial statements.

11. What does a high debt-equity ratio tell you? The debt-equity ratio is a common ratio used to assess a firm‘s leverage. Because of the difficulty of interpreting the book value of equity, the book debt-equity ratio is not especially useful. We will see later in the text, a firm‘s market debt-to-equity ratio has important consequences for the risk and return of its stock. 12. 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. We compute it as follows: Enterprise Value = Market Value of Equity + Debt – Cash. 13. How can a financial manager use the DuPont Identity to assess the firm‘s ROE? A financial manager looking for ways to increase ROE could turn to the DuPont Identity to assess the drivers behind its current ROE. 14. How do you use the price-earnings (P/E) ratio to gauge the market value of a firm? Analysts and investors use a number of ratios to gauge the market value of the firm The P/ E ratio is a simple measure that is used to assess whether a stock is over- or under-valued, based on the idea that the value of a stock should be proportional to the level of earnings it can generate for its shareholders. 15. Describe the transactions Enron used to increase its reported earnings. Enron sold assets at inflated prices to other firms (or, in many cases, business entities that Enron‘s CFO Andrew Fastow had created), together with a promise to buy back those assets at an even higher future price. Thus, Enron was effectively borrowing money, receiving cash today in exchange for a promise to pay more cash in the future. But Enron recorded the incoming cash as revenue and then, in a variety of ways, hid the promises to buy the assets back. In the end, much of Enron‘s revenue growth and profits in the late 1990s were the result of this type of manipulation. 16. What is the Sarbanes-Oxley Act? In 2002, the United States Congress passed the Sarbanes-Oxley Act (SOX) that 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 the financial statements later prove to be fraudulent. While SOX contains many provisions, the overall intent of the legislation was to improve the accuracy of information given to both boards and to shareholders. SOX attempted to achieve this goal in three ways: (1) by overhauling incentives and independence in the auditing process, (2) by stiffening penalties for providing false information, and (3) by forcing companies to validate their internal financial control processes.

Chapter 3 The Valuation Principle: The Foundation of Financial Decision Making

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Answers to Chapter 3 Critical Thinking Questions

1. What makes an investment decision a good one? A decision is a good one when the present value of the benefits is greater than the present value of the costs. 2. How important are our personal preferences in valuing an investment decision? When markets are competitive, personal preferences are irrelevant in determining the value of an investment. It is the market price that determines the cash value of a good. 3. Why are market prices useful to a financial manager? Market prices are useful to a manager because it is the market price that determines the value of a good. When market prices are not available, it becomes more difficult to value an investment. 4. What is the relation between the Law of One Price and the Principle of No Arbitrage? If the Law of One Price is violated that is the same goods are priced differently on different markets, then an arbitrage opportunity exists. The supply and demand forces will cause the price difference to disappear as astute investors try to take an advantage of the profitable opportunity. In a normal competitive market, arbitrage opportunities quickly disappear. Hence, in a normal competitive market, the supply and demand forces cause prices to equalize so that arbitrage opportunities are eliminated. This is the Principle of No Arbitrage. The actions that lead to the Principle of No Arbitrage are the same that resulted in the Law of One Price. 5. How does the Valuation Principle help a financial manager make decisions? The Valuation Principle helps a financial manager to evaluate the costs and benefits of a decision using market prices. It then guides the financial manager by showing him or her that only decisions where the value of the benefits outweighs the value of the costs will be good ones in the sense of increasing the value of the firm. 6. Can we directly compare dollar amounts received at different points in time? No, we cannot directly compare cash flows at different points in time. Doing so ignores the time value of money—that a dollar sooner is worth more than a dollar later.

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Answers to Chapter 3 Concept Check Questions

1. When costs and benefits are in different units or goods, how can we compare them? Determine a common denominator such as today‘s cash value or present value. 2. If canola trades in a competitive market, would a canola oil producer that has a use for the canola value it differently than another investor would? An individual may value it for more or less depending on his or her preferences for the good. 3. How do investors‘ profit motives keep competitive market prices correct? If arbitrage opportunities exist, investors will race to take advantage of it. Supply and demand forces, influenced by their trades, will cause prices to equalize across competitive markets and eliminate the arbitrage opportunity. 4. How do we determine whether a decision increases the value of the firm? Any decision in which the value of the benefits exceeds the costs will increase the value of the firm. 5. How is an interest rate like a price? Interest rate tells us the market price today of money in the future. It is the price for exchanging money today for money in a year. 6. Is the value today of money to be received in one year higher when interest rates are high or when interest rates are low? When interest rates are high, the value today is lower. You would need to invest a lower sum today to receive the same value in the future had the interest rates been lower. If the interest rates are lower, the value today is higher. An investor would need to invest more today to have the same value in the future and the interest had been higher. 7. How do you compare costs at different points in time? In general, a dollar today is worth more than a dollar in one year. To compare costs at different points in time, we either need to find the future value (compounding) of all the cash flows at the same point in time in the future or find the present value (discounting) of all the future cash flows today. 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 we must know the number of periods, the discounting rate for present value (PV), compounding rate for future value (FV) and cash flows.

Chapter 4 The Time Value of Money

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Answers to Chapter 4 Review Questions

1. What is the intuition behind the fact that the present value of a stream of cash flows is just the sum of the present values of each individual cash flow? Each cash flow in the future has a value today. The sum of value of the individual cash flows today represents the total value today of the investment for the investor. 2. What must be true about a cash flow stream in order for us to be able to use the shortcut formulas? In order to use the shortcut formulas, the cash flows have to be constant (or in the case of the growing perpetuities and growing annuities, growing at a constant rate), the cash flows must be paid every period, and the same discount rate must be used on each cash flow. 3. What is the difference between an annuity and a perpetuity? An annuity is a stream of constant cash flows paid in regular intervals for a finite period of time, while a perpetuity is a stream of constant cash flows paid every period, forever. 4. What are some examples of perpetuities? The perpetual bonds: The British government bond–the Consol, The Dutch water board bond– Hoogheemraadschap Lekdijk Bovendams. 5. How can a perpetuity have a finite value? The sum of an infinite number of positive terms could be finite. Cash flows in the future are discounted for an ever increasing number of periods, so their contribution to the sum eventually becomes negligible. 

C n n 1 (1  r )

PV  

6. What are some examples of annuities? Some examples of annuities are: car loans, mortgages, and bonds. 7. What must be true about the growth rate in order for a growing perpetuity to have a finite value? For a growing perpetuity to have a finite value, the growth rate must be less than the interest rate. So that each of the successive terms in the sum is less than the previous term and the overall sum is finite. C1 (1  g)n 1 (1  r )n n 1 

PV  