Chapter 01 - R. 1. R. 2. R. 3. R. 4. R. 5. R. 6. R. 7....

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Unformatted text preview: R. 1. R. 2. R. 3. R. 4. R. 5. R. 6. R. 7. CHAPTER 1 REVIEW QUESTIONS Economics is the study of the allocation of scarce resources, including how scarce resources are produced and consumed by the participants in the economy. Finance builds on economics and can be defined as applied economics, or more precisely, the economics of time and risk. Sole proprietorships, partnerships, and corporations differ by the contracts that are formed. Because sole proprietorships and partnerships are not formal organizations, the legal rights and responsibilities of the individuals or partners are equivalent to the rights and responsibilities of the person(s) who owns the business. In contrast, the corporation is a distinct legal entity defined by the contracts between individuals such as owners, creditors, workers, suppliers, customers, those in the surrounding communities, and between all forms of governments. The shareholders are the legal owners of the firm and have claim on the firm’s residual cash flow, that is, the cash flow that remains after all other claims have been satisfied. The stockholders supply capital and are the primary risk takers of the firm. The distinctive characteristics of corporations include (1) the ability of the shareholders to declare bankruptcy and therefore to enjoy a protective shield in the form of limited liability, (2) corporate earnings are taxed according to the corporate tax code, and (3) the fact that the corporation is often large enough that owners hire managers to run the firm day-to—day. As discussed in question 3 above, the shareholders are the legal owners of the firm. The argument set forth by the modern finance viewpoint is that corporations belong to the shareholders and to the shareholders belongs the right to determine its goals. Because shareholders are entitled to the wealth of the corporation once the contractual claims of others have been satisfied, corporate finance teaches that the goal of the firm is the maximization of shareholder wealth. In other words, shareholders want the market value of their shares to be as high as possible. An agency relationship is where one or more persons contract with one or more other persons to perform a decision making task for them. In corporate finance, the shareholders are the principals and the managers are the agents. Positive marginal utility is an economic principal stating that individuals derive more happiness (utility) with more of a certain item. Positive marginal utility of wealth means that people always prefer more wealth to less wealth. As long as shareholders are concerned about their level of wealth in the firm, and if positive marginal utility describes the firm’s shareholders, then financial managers should always choose the course of action that results in the highest level of shareholder wealth. R. 8. Diminishing marginal utility is an economic principal stating that the additional happiness (utility) that derives from consuming an item declines as consumption of the item increases. Diminishing marginal utility directs individuals making choices between items to seek lower levels of risk and to demand higher average returns for bearing risk. ' R. 9. Diminishing marginal return is an economic principal similar to diminishing marginal utility but measuring rates of return on investments not levels of happiness. The principal of diminishing marginal return instructs financial managers to rank order the firm’s investment opportunities from best to worst, and to stop investing when the rate of return from the next best investment is equal to the rate of return that can be earned in the financial marketplace. The shareholders do not wish the firm to invest in projects if the rate of return from investment is lower than what can be earned in the market. R. 10.The law of conservation of value says that identical cash flow streams must have identical values. Therefore, value cannot be created by adding things together or by breaking things apart. Conservation of value implies that financial managers should not focus on corporate activities that do not better the aggregate cashflows. R. 11.According to the economic principals given by positive marginal utility and diminishing marginal utility, the vegetarian would always prefer $100 of beef to $90 of vegetables. As long as beef and vegetables can be traded at market prices, the vegetarians could trade the $100 of beef for $90 of vegetables and have $10 left over. Accepting the $90 of vegetables would violate the principal of positive marginal utility. R. 12.The concept of separation refers to financial managers separating the consumption preferences of shareholders (consuming today or waiting until sometime in the future) with the shareholders desire to maximize the market value of wealth in the firm. With separation, the financial manager is instructed only to maximize the current share price of the firm. R. l3.A safe dollar is a dollar that will be realized in any future state of nature, while a risky dollar is a dollar that may or may not be realized depending on the specific state of nature that occurs. Even though they are both dollars, safe dollars are preferred because there is no uncertainty attached to receiving them. CHAPTER 1 PROBLEMS 1. Everyone should select d. since it can be returned to receive the most money ($19.99) and therefore the highest utility since the most desired CD can be purchased with money leftover. 2. Everyone should select a. since it produces the highest wealth and therefore the best opportunities (as above). For those students concerned with the ethical implications, it may be helpful to note that the $35 market price is a reliable signal that the firm’s assets will be put to better use as opposed to the CEO’s statement that the new owners will destroy the company. It may also be useful to note that this is a common reaction of management and,may only be an attempt to keep their jobs since they fear that the new owners will not view them as being worth their pay. 3. a. $1: 1 Ice Cream $2: 1 Ice Cream, 1 Cookie $3: 1 Ice Cream, 2 Cookies $5: 2 Ice Cream, 3 Cookies $7: 2 Ice Cream, 5 Cookies b. $2: 2 Cookies $5: 1 Ice Cream, 3 Cookies Maude eats less ice cream relative to cookies. . X. Otherwise, Maude is not maximizing her utility. . Generally, consume less of it. map 3 pounds. 4 pounds, 2 Pounds. X. . The price of milk will rise. More supplement will be produced and used. Therefore, more milk will be produced. Every cow should (at the margin) be able to produce 3.25 more pounds of milk from one more pound of grain supplement. g. Amazingly, we can conclude: 1. That every consumer is indifferent (receives identical marginal utility) from one pound of grain and 2.34 pounds of milk, and 2. That every farm generates the same increased product from using an extra pound of grain (2.34 pounds of milk). Otherwise, farmers and consumers would be acting irrationally. than?!» T": 5 a. 40% cattle, 60% hogs b. 85% cattle, 15% hogs 15% cattle, 85% hogs (problem should read "15% higher") produce all hogs, or all cattle, respectively c. That every rancher finds at current or "final" production levels that it is 50% harder or more costly to produce an extra pound of cattle than hogs. . In perfectly functioning markets, people seeking to maximize their utility and firms attempting to maximize their profits will reach optimal outcomes when they ensure that all decision are made using market values. Thus, consumers enjoy goods and services until the marginal utility that they enjoy for each item is directly proportional to its price. Similarly, producers generate output such that the cost or difficulty of making each product is directly proportional to its market price. Also, producers utilize inputs such that the marginal value of each item as a factor in the production process is directly proportional to its market price. Free markets and self—interest cause scarce resources to be produced, utilized as inputs and consumed using the same "priorities" (at the margin) — — even though the participants may not know about or care about each other. In finance, we are mainly concerned about the time value of money and the bearing of risk. In perfect markets, the ideal results of microeconomics with regard to commodities in the absence of risk and at a single point in time can be extended to the case of time and risk. CHAPTER 1 DISCUSSION QUESTIONS 1. The defense of the concept of shareholder wealth maximization rests in the concepts of private property rights and the idea that shareholders own the corporation. It is often useful to ask students their attitude towards their own property (books, cars, etc.). It is also useful to discuss the idea of a teenager who creates and operates a lawn mowing service. Who should set the goals and who should reap the benefits of the work? How would each student feel if the instuctor simply began confiscating books, calculators, purses, etc. and giving them to other people such as perhaps more needy students. 2. Since a corporation is simply a set of contracts, in a literal sense it is not possible for it to pollute. A more accurate view is that the shareholders of the corporation caused the pollution and perhaps they should be punished through fines, etc. according to due process. An interesting tangent is to discuss the true underlying creators of "normal pollution" (consumers) and therefore who ultimately must pay in the long run for cleaning up problems such as oil spills. 3. One would look for ice cubes in the freezer. a. Answers 1 & 2 can be rationally deduced. b. Answers 1 & 4 can be empirically confirmed. c. Only answer 1 is consistent with the theory and accurately predicts the real world 4. Is it possible that both Adam and Smithy will act similarly? The idea is that people will pay the most for the things that they most appreciate and will charge the least for providing those things that cause them the least burden. For example, there are two ways to pick grapes for juice: by hand and by machine. The machine method is quick and easy. Harvesting by hand is slow and hard. Smithy, driven by money, will tend to buy grape juice made from machine harvested grapes since it will be less expensive. However, Adam would also buy the machine harvested variety since his desire to help the farmer would lead him to select the product that was easiest for the farmer to harvest. In selecting a career, Smithy would prefer to harvest grapes by machine since he could make more money. But Adam would also harvest by machine since his desire to meet other people’s needs would lead him to select the more productive method of harvesting. In the mid—1700’s, the great economist and philospher Adam Smith set forth the idea that people acting in self—interest will be driven towards doing things that society wants and needs. It is possible that Adam, driven by his love for people, will donate money to the poor, refuse salary increases and pay people more than they ask. However, decisions regarding the production and consumption of scarce resources will be remarkably if not totally similar. 5. The law of conservation of value is derived in a perfect market. In an imperfect market the law does not necessarily hold. Thus, mergers can be explained using market imperfections such as imperfections in the markets for corporate assets, tax liabilities and managers. ...
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This note was uploaded on 11/30/2011 for the course FINOPMGT 301 taught by Professor Lacey during the Spring '10 term at UMass (Amherst).

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Chapter 01 - R. 1. R. 2. R. 3. R. 4. R. 5. R. 6. R. 7....

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