(Solution Manual) Corporate Finance

Berk, DeMarzo, 5

Business

Solution Manual

5th Edition

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Solution Manual for Corporate Finance, The downloadable file consists of 381 pages, and the total size of the file is 4.66 MB. Purchase now only for highly discounted price.

Author(s): Berk, DeMarzo

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Study Note Preview

1 ©2020 Pearson Education, Inc. Chapter 1 The Corporation 1-1. What is the most important difference between a corporation and all other organizational 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 organizational 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 must 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 100 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 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   .(Corporate Finance 5e Jonathan Berk, Peter DeMarzo) (Solution Manual all Chapters)2 Berk/DeMarzo, Corporate Finance, Fifth Edition ©2020 Pearson Education, Inc. 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 th ree 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 that your company, therefore, should develop. ii. You will make the decision o n 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 inte rest on loans, and pay your employees. 1-9. When a pharmaceutical company develops a new drug, it often receives patent protection for that medication, allowing it to charge a higher price. Explain how this public policy of providing patent protection might help align the corporation’s interests with society’s interests. Without patent protection, the developer of the drug would be forced to lower prices to compe te with generic manufacturers. Because this price competition would lower expected future p rofits, the developer would be willing to spend much less in R&D to develop the drug initially, and drug innovation would be curtailed. Alternatively, by allowing the drug’s developer to earn higher profits that are commensurate with the value of the d rug to society, drug developers will find it in their best interests to spend more on R&D, and drug innovation is enhanced. Thus, patent protection can align the corporation’s and society’s interests and provide for more efficient spending on drug R&D. 1-10. 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 motivate d 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 sh areholders are closely aligned. iv. Mount hostile takeovers. 1-11. 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 apa rtment as the principal (owner) because the renter does not share in the costs of repairing 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 depos it forces the renter to share in the costs of repairing any problems that they cause. 1-12. 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, b ut 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 the 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. 1-13. Are hostile takeovers necessarily bad for firms or their investors? Explain. No. They are a way to discipline manage rs who are not working in the interests of shareholders. Chapter 1/The Corporation 3 ©2020 Pearson Education, Inc. 1-14. What is the difference between a public and private corporation? The shares of a public corporation are traded on a public exchange (or “over the counter” in an electronic trading system) , while the shares of a private corporation are not traded on a public exchange. 1-15. Describe the important changes that have occurred in stock markets over the last decade. Markets have become more fragmented, stocks no longer predominantly trade on the markets on which they are listed, off -exchange transactions in dark pools are now much more common, and off icial market makers have largely disappeared, replaced now by the limit order book. 1-16. Explain why the bid -ask spread is a transaction cost. Investors always buy at the ask and sell at the bid. Because ask prices always exceed bid prices, investors “lose” this difference. It is one of the costs of transacting. Because the market makers take the other side of the trade, they make this difference. 1-17. Explain how the bid -ask spread is determined in mos t markets today. The bid -ask spread of a stock is determined by the outstanding limit orders. The limit sell order with the lowest price is the ask price. The limit buy order with the highest price is the bid price. The bid - ask spread is determined by t he best bid and offer prices in the limit order book 1-18. The following quote on Altaba (formerly Yahoo!) stock appeared on June 13, 2018, on Yahoo! Finance: If you wanted to buy Altaba, what price would you pay? How much would you receive if you wanted to sell Altaba? You would buy at $81.99 and sell for $81.85. 1-19. Suppose the following orders are received by an exchange for Cisco stock: • Limit Order: Buy 200 shares at $25 • Limit Order: Sell 200 shares at $26 • Limit Order: Sell 100 shares at $25.50 • Limit Order: Buy 100 shares at $25.25 a) What are the best bid and ask prices for Cisco stock? Best bid = $25.25, Best ask = $25.50 4 Berk/DeMarzo, Corporate Finance, Fifth Edition ©2020 Pearson Education, Inc. b) What is t he current bid -ask spread for Cisco stock? Bid-Ask spread = $25.50 – 25.25 = $0.25 c) Suppose a market order arrives to buy 200 shares of Cisco. What average price will the buyer pay? Buy 100 shares at $25.50 and 100 shares at $26, for an average pri ce of $25.75 d) After the market order in (c) clears, what are the new best bid and ask prices, and what is the new bid -ask spread for Cisco? Best bid = $25.75, Best ask = $26, Bid -Ask spread = $0.25 1-20. Why has finance historically been an early ado pter of new technology? The financial industry has very large profits and is very competitive. Adopting the latest technology can lead to a competitive advantage. Given the large profits that a competitive advantage provides, the incentives to use the technology are high. 1-21. How are the following companies utilizing new technology in the provision of financial services? a) Wealthfront Wealthfront is a financial planning and robo-advisor. It used the advances in artificial intelligence to provide computer based investment advice. b) LendingTree Lending Tree is an alternative loan platform that links consumers to individual lenders using their online platform. c) Metromile Metromile is a car insurer that allows consumers to pay by the number of miles they dr ive. The data on how much its customers are driving is collected automatically through a small wireless device located in each insured car . d) Acorns Acorns is a robo -advisor with a twist. They link to customer purchases and automatically invest their money based on a rule such as “taking the change”. 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Chapter 3 Financial Decision Making and the Law of One Price 3-1. Honda Motor Company is considering offering a $2000 rebate on its minivan, lowering the vehicle’s price from $30,000 to $28,000. The marketing group estimates that this rebate will increase sales over the next year from 40,000 to 55,000 vehicles. Suppose Honda’s profit margin with the rebate is $6000 per vehicle. If the change in sales is the only consequence of this decis ion, what are its costs and benefits? Is it a good idea? The benefit of the rebate is that Honda will sell more vehicles and earn a profit on each additional vehicle sold: Benefit = Profit of $6,000 per vehicle × 15,000 additional vehicles sold = $90 milli on. The cost of the rebate is that Honda will make less on the vehicles it would have sold: Cost = Loss of $2,000 per vehicle × 40,000 vehicles that would have sold without rebate = $80 million. Thus, Benefit – Cost = $90 million – $80 million = $10 millio n, and offering the rebate looks attractive. (Alternatively, we could view it in terms of total, rather than incremental, profits. The benefit as $6000/vehicle × 55,000 sold = $ 330 million, and the cost is $8 000/vehicle × 40,000 sold = $320 million.) 3-2. You are an international shrimp trader. A food producer in the Czech Republic offers to pay you 2 million Czech koruna today in exchange for a year’s supply of frozen shrimp. Your Thai supplier will provide you with the same supply for 3 million Thai baht today. If the current competitive market exchange rates are 25.50 koruna per dollar and 41.25 baht per dollar, what is the value of this deal? Czech buyer’s offer = 2,000,000 CZK / (25.50 CZK/USD) = 78,431.37 USD. Thai supplier’s offer = 3,000,000 THB / (4 1.25 THB/USD) = 72,727.27 USD. The value of the deal is $78,431 – $72,727 = $5 ,704 today. 3-3. Suppose the current market price of corn is $3.75 per bushel. Your firm has a technology that can convert 1 bushel of corn to 3 gallons of ethanol. If the cost o f conversion is $1.60 per bushel, at what market price of ethanol does conversion become attractive? The price in which ethanol becomes attractive is ($3.75 + $1.60 / bushel of corn) / (3 gallons of ethanol / bushel of corn) = $1.78 per gallon of ethanol. 22 Berk/DeMarzo, Corporate Finance, Fifth Edition ©2020 Pearson Education, Inc. 3-4. Suppose your employer offers you a choice between a $5000 bonus and 100 shares of the company stock. Whichever one you choose will be awarded today. The stock is currently trading for $63 per share. a. Suppose that if you receive the stock bonus, you are free to trade it. Which form of the bonus should you choose? What is its value? b. Suppose that if you receive the stock bonus, you are required to hold it for at least one year. What can you say about the value of the stock bonus now? What will your decision depend on? a. Stock bonus = 100 × $63 = $6 300 Cash bonus = $5 000 Since you can sell (or buy) the stock for $6 300 in cash today, its value is $6 300 which is better than the cash bonus. b. Because you could buy the stock today for $6 300 if you wanted to, the value of the sto ck bonus cannot be more than $6 300. But if you are not allowed to sell the company’s stock for the next year, its val ue to you could be less than $6 300. Its value will depend on what you expect the s tock to be worth in one year as well as how you feel about the risk involved. You might decide t hat it is better to take the $5 000 in cash than wait for the uncertain value of the stock in one year. 3-5. You have decided to take your daughter skiing in Utah. The be st price you have been able to find for a roundtrip air ticket is $359. You notice that you have 20,000 frequent flier miles that are about to expire, but you need 25,000 miles to get her a free ticket. The airline offers to sell you 5000 additional miles for $0.03 per mile. a. Suppose that if you don’t use the miles for your daughter’s ticket they will become worthless. What should you do? b. What additional information would your decision depend on if the miles were not expiring? Why? a. The price of the ticket if you purchase it is $359. The price if you purchase the miles is $0.03 × 5,000. So you should purchase the miles. b. In part a, the existing miles are worthless if you don’t use them. They are not worthless now, so you must add in the cost of usin g them. Because there is no competitive market price for these miles (you can purchase at 3¢ but not sell for that price) the decision will depend on how much you value the existing miles (which will depend on your likelihood of using them in the future). 3-6. Suppose the risk -free interest rate is 4%. a. Having $200 today is equivalent to having what amount in one year? b. Having $200 in one year is equivalent to having what amount today? c. Which would you prefer, $200 today or $200 in one year? Does you r answer depend on when you need the money? Why or why not? a. Having $200 today is equivalent to having $200 × 1.04 = $208 in one year. b. Having $200 in one year is equivalent to having $200 / 1.04 = $192.31 today. c. Because money today is worth more th an money in the future, $200 today is preferred to $200 in one year. This answer is correct even if you don’t need the money today, because by investing the $200 you receive today at the current interest rate, you will have more than $200 in one year. Chapter 3/Financial Decision Making a nd the Law of One Price 23 ©2020 Pearson Education, Inc. 3-7. You have an investment opportunity in Japan. It requires an investment of $1 million today an d will produce a cash flow of ¥ 114 million in one year with no risk. Suppose the risk -free interest rate in the United States is 4%, the risk -free interest rate in Japan is 2%, and the current competitive exchange rate is ¥ 110 per $1. What is the NPV of this investment? Is it a good opportunity? Cost = $1 million today Benefit ¥114 million in one year ¥1.02 in one year¥114 million in one year ¥111.76 million today¥ today 110¥¥111.76 million today $1.016 million toda y$ today         NPV $1.016 million $1 million $16,000   The NPV is positive, so it is a good inves tment opportunity. 3-8. Your firm has a risk -free investment opportunity where it can invest $160,000 today and receive $170,000 in one year. For what level of interest rates is this project attractive? 160,000 × (1 + r) = 170,000 implies r = 170,000/160,0 00 – 1 = 6.25% 3-9. You run a construction firm. You have just won a contract to construct a government office building. It will take one year to construct it, requiring an investment of $10 million today and $5 million in one year. The government will pay you $20 million upon the building’s completion. Suppose the cash flows and their times of payment are certain, and the risk -free interest rate is 10%. a. What is the NPV of this opportunity? b. How can your firm turn this NPV into cash today? a. NPV PV PVBenefits Costs Benefits$1.10 in one yearPV = $20 million in one year ÷ $ today = $18.18 million  This year's costPV = $10 million today Next year's cost$1.10 in one yearPV = $5 million in one year ÷ $ today = $4.55 million today  NPV 18.18 10 4.55 $3.63 million today    b. The firm can borrow $18.18 million today, and pay it back with 10% interest using the $20 million it will receive from the government (18.18 × 1.10 = 20). The firm can use $10 million of the 18.18 million to cover its costs today and save $4.55 million in the bank to earn 10% interest to cover its cost of 4.55 × 1.10 = $5 million next year. This leaves 18.18 – 10 – 4.55 = $3.63 million in cash for the firm today. 3-10. Your firm has identified three potential investment projects. The projects and their cash flows are shown here: 24 Berk/DeMarzo, Corporate Finance, Fifth Edition ©2020 Pearson Education, Inc. Suppose all cash flows are certain and the risk -free interest rate is 10%. a. What is the NPV of each project? b. If the firm can choose only one of these projects, which should it choose? c. If the firm can choose any two of these projects, which should it choose? a. A20NPV 10 $8.181.1   B5NPV 5 $9.551.1   C10NPV 20 $10.911.1   b. If only one of the projects can be chosen, project C is the best choice because it has the highest NPV. c. If two of the projects can be chosen, projects B and C are the best choice because they offer a higher total NPV than any other combinations. 3-11. Your computer manufacturing firm must purchase 10,000 keyboards from a supplier. One supplier demands a payment of $100,000 today plus $10 per keyboard payable in one year. Another supplier will charge $21 per keyboard, also payable in one year. The risk -free interest rate is 6%. a. What is the difference in their offers in terms of dollars today? Which offer should your firm take? b. Suppose your firm does not want to spend cash today. How can it take the first offer and not spend $100, 000 of its own cash today? a. Costs10,000Supplier 1: PV = 100,000 + $10 × = $194 ,339.621.06 Costs10,000Supplier 2: PV = 21 × = $198,113.211.06 Costs are lower under the first supplier’s offer, so it is better choice. b. The firm can borrow $100,000 at 6% from a bank for one year to make the initial payment to th e first supplier. One year later, the firm will pay back the bank $106,000 ( $100,000 × 1.06) and the first supplier $100,000 ( $10 × 10,000), for a total of $206,000. This amount is less than the $210,000 ( $21 × 10,000) the second supplier asked for. 3-12. Suppose Bank One offers a risk -free interest rate of 5.5% on both savings and loans, and Bank Enn offers a risk -free interest rate of 6% on both savings and loans. a. What arbitrage opportunity is available? b. Which bank would experience a surge in the de mand for loans? Which bank would receive a surge in deposits? c. What would you expect to happen to the interest rates the two banks are offering? Chapter 3/Financial Decision Making a nd the Law of One Price 25 ©2020 Pearson Education, Inc. a. Take a loan from Bank One at 5.5% and save the money in Bank Enn at 6%. b. Bank One would experience a surge in the demand for loans, while Bank Enn would receive a surge in deposits. c. Bank One would increase the interest rate, and/or Bank Enn would decrease its rate. 3-13. Throughout the 1990s, interest rates in Japan were lower than interest rates in th e United States. As a result, many Japanese investors were tempted to borrow in Japan and invest the proceeds in the United States. Explain why this strategy does not represent an arbitrage opportunity. There is exchange rate risk. Engaging in such transac tions may incur a loss if the value of the dollar falls relative to the yen. Because a profit is not guaranteed, this strategy is not an arbitrage opportunity. 3-14. An American Depositary Receipt (ADR) is security issued by a U.S. bank and traded on a U.S . stock exchange that represents a specific number of shares of a foreign stock. For example, Nokia Corporation trades as an ADR with symbol NOK on the NYSE. Each ADR represents one share of Nokia Corporation stock, which trades with symbol NOK1V on the He lsinki stock exchange. If the U.S. ADR for Nokia is trading for $6.74 per share, and Nokia stock is trading on the Helsinki exchange for 6.20 € per share, use the Law of One Price to determine the current $/€ exchange rate. We can trade one share of Nokia stock for $6.74 per share in the U.S. and €6.20 per share in Helsinki. By the Law of One Price, these two competitive prices must be the same at the current exchange rate. Therefore, the exchange rate must be: $6.74/share of Nokia €6.20/share of Nokia=$1.087/€ today. 3-15. The promised cash flows of th ree securities are listed here. If the cash flows are risk -free, and the risk-free interest rate is 5%, determine the no -arbitrage price of each security before the first cash flow is paid. Cash Flows of A500PV = 500 + = $976.191.05 Cash Flows of B1000PV = = $952.381.05 Cash Flows of CPV = $1,000 While the total cash flows paid by each security are the same ($1000), securities A and B are worth less than $1000 because some or all of the money is received in the future. 3-16. An Exchange -Traded Fund (ETF) is a security that represents a portfolio of individual stocks. Consider an ETF for which each share represents a portfolio of two shares of Hewlett -Packard (HPQ), one share of Sears (SHLD), and three shares of General Electric (GE). Suppose the current stock prices of each individual stock are as shown here: