Solution Manual For Fundamentals Of Corporate Finance, Seventh Canadian Edition

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1-1Brealey7CESolutions to Chapter 11.realexecutive airplanesbrand namesfinancialstocksinvestmentcapital budgetingfinancing2.A firm might cut its labour force dramatically which could reduce immediate expensesand increase profits in the short term. Over the long term, however, the firm might notbe able to serve its customers properly or it might alienate its remaining workers; if so,future profits will decrease, and the stock price will decrease in anticipation of theseproblems.The moral of thisexamples is that, because stock prices reflect presentand futureprofitability, the firm should not necessarily sacrifice future prospects for short-termgains.3.The key advantage of separating ownership and management in a large corporationis that it gives the corporation permanence. The corporation continues to exist ifmanagers are replacedor if stockholders sell their ownership interests to otherinvestors. The corporation’s permanence is an essential characteristic in allowingcorporations to obtain the large amounts of financing required by many businessentities.Both public and private corporations are distinct legal entities, separate from itsowners (ie., its shareholders). The key difference between public and privatecorporationsisthe rules governing the sale of their common shares. The commonshares of a public corporation are listed for trading on a stock exchange andinvestors can freely buy and sell the corporation’s shares at the current stock price.The common shares of a private corporation are not listed for trading on a stockexchange. Shareholders of private corporations must negotiate directly withpotential buyers and are subject to resale restrictions.

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1-2You can learn to identify the risks associated with investing in private companiesby going to Ontario Securities Commission's website at:http://www.osc.gov.on.ca/en/Investors_cbyi_index.htm4.A sole proprietorship is easy to set up with a minimum of legal work. The businessitself is not taxed. For tax purposes, the income of the proprietorship is treated as theincome of the proprietor. The main disadvantages of a proprietorship are theproprietor’s unlimited liability for the debts of the firm, and difficulty in raising largeamounts of financing as the business grows.A partnership has the same tax advantage as the proprietorship. The partnership per sedoes not pay taxes. The partnership files a tax return, but all of the partnership incomeis allocated to the partners and treated as personal income. Also, it is fairly easy to setup a partnership. Because there can be many partners, a partnership can raise capitalmore easily than a proprietorship. However, like sole proprietors,generalpartners haveunlimited liability for the debts of the firm. In fact, each partner has unlimited liabilityfor all the business’ debts, not just his or her share.Corporate organization has the advantage of limited liability. Its owners, theshareholders, are not personally responsible for the debts of the corporation. It alsoallows for separation of ownership and management, since shares in the firm can betraded without changing management.A public corporation has the added advantageof easier access to equity financing because its shares are traded in public stockmarkets. The major disadvantage of corporate organization is the double taxation ofincome. Corporations pay taxes on their income, and that income is taxed again whenit is passed through to shareholders in the form of dividends. Another disadvantage ofcorporate organization is the extra time and cost required in order to manage acorporation’s legal affairs. These costs arise because the corporation must be charteredand is considered a distinct legal entity. Such administrative costs are significant onlyfor small corporations, however. Furthermore, public corporations must provideinvestors with detailed financial information in their annual reports and informinvestors about significant events. Disclosure takes time and resources and may also becostly in the sense that competitor firmsbecome aware of inside information that thecorporation may not necessarily want competitors to be aware of.LLP’s may be considered to be hybrid organizations to the extent that while individualpartners have unlimited liability, they are not liable for the actions of their partners.5.Double taxationmeans that a corporation’s income is taxed first at thehands of thecorporation at thecorporate tax rate, and then, when the income is distributed toshareholders as dividends, the income is taxed again atthe hands of shareholders atthe shareholder’s personal tax rate.6.a, c, d.7.If you go tothe website,www.td.com,you will seea list of TD’s business andtheirfinancial products and services.To work as an investment banker, you would workfor TD Securities, Clicking on “TD Securities” and then on “About us ”takes you to a

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1-3webpage,www.tdsecurities.com/tds/content/AU_AboutUs1?language=en_CAthat says:With more than 4,000 people in 15 offices around the world, TD Securities provides awide range of capital market products and services to corporate, government andinstitutional clients who choose us for our knowledge, innovation and experience in thefollowing key areas of finance:Investment and Corporate BankingCapital MarketsInterest Rate, Currency and Derivative ProductsCommoditiesOur services include the underwriting and distribution of new debt and equity issues,providing advice on strategic acquisitions and divestitures, and executing daily tradingand investment needs.With our history of delivering results, we’ve developed considerable strengths, includingrecognized trading expertise and street-level market intelligence that we use toconsistently create value for our clients.To trade securities, join TD Asset Management,athttp://www.tdassetmanagement.com/Content/Homepage/p_Homepage.asp,“TD AssetManagement is committed to applying the new thinking necessary to address your mostimportant challenges. We take a collaborative team-based approach, focus on quality andemploy a comprehensive risk management discipline.”8.a. Investment decisionb. Financial assetc. Public corporationd. Corporatione. Treasurerf. The cost resulting from conflicts of interest between managers and shareholders9.Financing decisions involve sources of capital used in the running of a firm.Investment decisions, typically called capital budgeting, involve the uses ofcapital raised in the financing process.a. Investment decision

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1-4b. Financing decisionc. Investment decisiond. Investment decisione. Investment decisionf. Financing decision: On the surface, this may appear similar to a dividenddecision, but in reality retiring debt is a change in capital structure and moreclosely aligned with a financing decision.10.a.Private corporationb.Partnershipc.Public corporationd. Public corporation11.C. Ownership can be transferred without affecting operations and D. Managerscan be fired with no effect on ownership.12.The individual stockholders of a corporation (i.e., the owners) are legally distinctfrom the corporation itself, which is a separate legal entity. Consequently, thestockholders are not personally liable for the debts of the corporation; thestockholders’ liability for the debts of the corporation is limited to the investmenteach stockholder has made in the shares of the corporation.13.As discussed in Question 2which is similar,, acorporation might cut its laborforce dramatically, which could reduce immediate expenses and increase profitsin the short term. Over the long term, however, the firm might not be able toserve its customers properly, or it might alienate its remaining workers; if so,future profits will decrease, and the stock price, and the market value of the firm,will decrease in anticipation of these problems. Similarly,as another example,acorporation can boost profits over the short term by using less costly materialseven if this reduces the quality of the product. Once customers catch on, saleswill decrease and profits will fall in the future. The stock price will fall. Themoral of these examples is that, because stock prices reflect present and futureprofitability, the corporation should not necessarily sacrifice future prospects forshort-term gains14.Financial managers refer to the opportunity cost of capital because corporationsincrease value for their shareholders only by accepting all investment projects that

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1-5earn more than this rate. If the company earns below this rate, the market value ofthe company’s stock falls and stockholders look for other places to invest.Tofind the opportunity cost of capital for a safe investment, managers and investorslook at current interest rates on safe debt securities, such asCanadianTreasurydebt.15.There are not necessarily right or wrong answers to these issues. It is important,however, to keep in mind that short selling, acquisitions, and tax avoidance are allthe by-product of an attempt to maximize shareholder value. In the absence oflaws banning companies from producing wealth for their owners, someone willuse these techniques to create value for owners.16.a. A fixed salary means that compensation is (at least in the short run)independent of the firm’s success.b. A salary linked to profits ties the employee’s compensation to this measure ofthe success of the firm. However, profits are not a wholly reliable way tomeasure the success of the firm. The text points out that profits are subject todiffering accounting rules and reflect only the current year’s situation rather thanthe long-run prospects of the firm.c. A salary that is paid partly in the form of the company’s shares means that themanager earns the most when the shareholders’ wealth is maximized. This is,therefore,most likely to align the interests of managers and shareholders.17.a.A share of stockfinancialb.A personal IOUfinancialc.A trademarkreald.A truckreale.Undeveloped landrealf.The balance in the firm’s chequing accountfinancialg.An experienced and hardworking sales forcerealh.A bank loan agreementfinancial18.a.Real assets are items that are used to produce goods and services. Real assetsinclude both tangible and intangible items. Tangible (physical) real assetsinclude such items as machinery, building, and inventories. Intangible realassets include items such as research ideas, brand names and skilled workforce. In contrast, financial assets are items that have value only because oftheir claim to cash flows generated by real assets. Many different types offinancial assets exist, including bank loans, bonds, stocks, and options.b.Investment or capital budgeting decisions involve deciding which real assetsto acquire. Financing decisionsinvolve arranging the money needed to payfor investments in the real assets. So, when making investment decisions youdecide what to spend money on and when making financing decisions, youdecide how to get the money to spend.

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1-6c.Both capital budgeting and capital structure are long-term decisions. Capitalbudgeting decision is the process of deciding the real asset investment plans.Capital structure decision is the process of deciding the mix of the long-termfinancing to use to fund the firm’s assets. Essentially, capital structuredecision involvesselecting between equity financing and long-term debtfinancing.19.Capital budgeting decisionsShould a new computer be purchased?Should the firm develop a new drug?Should the firm shut down an unprofitable factory?Financing decisionsShould the firm borrow money from a bank or sell bonds?Should the firm issue preferred stock or common stock?Should the firm buy or lease a new machine that it is committed to acquiring?20.The stock price reflects the value of both current and future dividends the shareholderswill receive. In contrast, profits reflect performance in the current year only. Profitmaximizers may try to improve this year’s profits at the expense of future profits. Butstock price maximizers will take account of the entire stream of cash flows that the firmcan generate. They are more apt to be forward looking.21.a.This action might appear, superficially, to be a grant toformeremployees andthus not consistent with value maximization. However, such ‘benevolent’actions might enhance the firm’s reputation as a good place to work, mightresult in greater loyalty on the part of current employees, and might contributeto the firm’s recruiting efforts. Therefore, from a broader perspective, theaction may be value maximizing.b.The reduction in dividends to allow increased reinvestment can be consistentwith maximization of current market value. If the firm has attractiveinvestment opportunities, and wants to save the expenses associated withissuing new shares to the public, then it could make sense to reduce thedividend in order to free up capital for the additional investments.c.The corporate jet would have to generate benefits in excess of its costs inorder to be considered stock-price enhancing. Such benefits might includetime savings for executives, and greater convenience and flexibility in travel.22.a.Increased market share can be an inappropriate goal if it requires reducing pricesto such an extent that the firm is harmed financially. Increasing market sharecanbe part of a well-reasoned strategy, but one should always remember that marketshare is not a goal in itself. The owners of the firm want managers to maximizethe value of their investment in the firm.

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1-7b.Minimizing costs can also conflict with the goal of value maximization. Forexample, suppose a firm receives a large order for a product. The firm should bewilling to pay overtime wages and to incur other costs in order to fulfill the order,as long as it can sell the additional product at a price greater than those costs.Even though costs per unit of output increase, the firm still comes out ahead if itagrees to fill the order.c.A policy of underpricing any competitor can lead the firm to sell goods at a pricelower than the price that would maximize market value. Again, in somesituations, this strategy might make sense, but it should not be the ultimate goal ofthe firm. It should be evaluated with respect to its effect on firm value.d.Expanding profits is a poorly defined goal of the firm. The text gives threereasons:(i)There may be a trade-off between accounting profits in one year versusaccounting profits in another year. For example, writing off a badinvestment may reduce this year’s profits but increase profits in future years.Which year’s profits should be maximized?(ii)Investing more in the firm can increase profits, even if the increase in profitsis insufficient to justify the additional investment. In this case the increasedinvestment increases profits, but can reduce shareholder wealth.(iii)Profits can be affected by accounting rules, so a decision that increasesprofits using one set of rules may reduce profits using another.23.The contingency arrangement aligns the interests of the lawyer with those of the client.Neither makes any money unless the case is won. If a client is unsure about the skill orintegrity of the lawyer, this arrangement can make sense. First, the lawyer has anincentive to work hard. Second, if the lawyer turns out to be incompetent and loses thecase, the client will not have to pay a bill. Third, the lawyer will not be tempted toaccept a very weak case simply to generate bills. Fourth, there is no incentive for thelawyer to charge for hours not really worked. Once a client is more comfortable withthe lawyer, and is less concerned with potential agency problems, a fee-for-servicearrangement might make more sense.24.The national chain has a great incentive to impose quality control on all of its outlets.If one store serves its customers poorly, that can result in lost future salesin all itslocations. The reputation of each restaurant in the chain depends on the quality in allthe other stores. In contrast, if Joe’s serves mostly passing travelers who are unlikely toshow up again, unsatisfied customers pose a far lower cost. They are unlikely to beseen again anyway, so reputation is not a valuable asset.The important distinction isnotthat Joe has one outlet while the national chain hasmany. Instead, it is the likelihood of repeat relations with customers and the value ofreputation. If Joe’sstore waslocated in the center of town instead of on the highway,

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1-8one would expect his clientele to be repeat customers from town. He would then havethe same incentive to establish a good reputation as the chain.25.While a compensation plan that depends solely on the firm’s performance would serveto motivate managers to work hard, it would also burden them with considerablepersonal risk tied to the fortunes of the firm. This would be unattractive to managersand might cause them to value their compensation packages less highly; it might alsoelicit excessive caution when evaluating business opportunities.26.Takeover defenses make it harder for underperforming managers to be removed bydissatisfied shareholders, or by firms that might attempt to acquire the firm. Byprotecting such managers, these provisions exacerbate agency problemsas they aremore likely to act in their own interestrather than the firm’s.27.Traders can earn huge bonuses when their trades are very profitable, but if thetrades lose large sums, as in the case of Barings Bank, the trader’s exposure islimited. This asymmetry can create an incentive to take big risks with the firm’s(i.e., the shareholders’) money. This is an agency problem.28.a.A fixed salary means that compensation is (at least in the short run) independentof the firm’s success.b.A salary linked to profits ties the employee’s compensation tohe success of thefirm as measured by profits.However, profits are not a wholly reliable way tomeasure the success of the firm. The text points out that profits are subject todiffering accounting rules, and reflect only the current year’s situation rather thanthe long-run prospects of the firm.c.A salary that is paid partly in the form of the company’s shares means that themanager earns the most when the shareholders’ wealth is maximized. This is,therefore,most likely to align the interests of managers and shareholders.d.Stock options create great incentives for managers to contribute to the firm’ssuccess. In some cases, however, stock options can lead to agency problems. Forexample, a manager with many options might be tempted to take on a very riskyproject, reasoning that if the project succeeds the payoff will be huge, while if itfails, the losses are limited to the lost value of the options. Shareholders, incontrast, bear the losses as well as the gains on the project, and might be lesswilling to assume the risk.29.Even if a shareholder could monitor and improve managers’ performance, and therebyincrease the value of the firm, the payoff would be small, since the ownership share in alarge corporation is very small. For example, if you own $10,000 of GM stock and canincrease the value of the firm by 5 percent, a very ambitious goal, you benefit by only:(0.05$10,000) = $500.

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1-9In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a largestake in making sure that the loan can be repaid. It is clearly worthwhile for the bank tospend considerable resources on monitoring the firm.30.Long-term relationships can encourage ethical behavior. If you know that you willengage in business with another party on a repeated basis, you will be less likely to takeadvantage of your business partner if an opportunity to do so arises. When people say"what goes around comes around," they recognize that the way they deal with theirassociates will influence the way their associates treat them. When relationships areshort-lived, however, the temptation to be unfair is greater since there is less reason tofear reprisal, and less opportunity for fair dealing to be reciprocated.31.As the text notes, the first step in doing well is doing good by your customers.Businesses cannot prosper for long if they do not provide to their customers theproducts and services they desire. In addition, reputation effects often make it in thefirm’s own interest to act ethically toward its business partners and employees since thefirm’s ability to make deals and to hire skilled labour depends on its reputation fordealing fairly.In some circumstances, when firms have incentives to act in a manner inconsistent withthe public interest, taxes or fees can align private and public interests. For example,taxes or fees charged on pollution make it more costly for firms to pollute, therebyaffecting the firm’s decisions regarding activities that cause pollution. Other“incentives” used by governments to align private interests with public interestsinclude: legislation to provide for worker safety and product, or consumer, safety,building code requirements enforced by local governments, and pollution and gasolinemileage requirements imposed on automobile manufacturers.32.Some customers might consider this practice unethical. They might view the firm asgouging its customers during heat waves. On the other hand, the firm might try toconvince customers that this practice allows it to chargelowerprices in cooler periods,and that over long periods of time, prices even out. Whether customers and firms havean “implicit contract” to charge and pay stable prices is something of a cultural issue.33.Thiswebsite provides information on the various types of business structures.However, to find out some details on rules and regulationsask your students to gotohttp://www.canadabusiness.ca/eng/page/2853/For province-specific rules regardingregistration of sole proprietorships or partnerships you can go tohttps://www.canada.ca/en/services/business/start/register-with-gov/register-sole-prop-partner.htmlRules and regulations governing different forms of business share similaritiesand differences across provinces.In general, while provinces enjoy the authority to regulate businesses within theirjurisdictions and may have differing statutes on occasion, closer examinationindicates that the rules and regulation are actually quite similar.Turning to the question of how not-for-profit organizations differ from the for-

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1-10profit structures, the same basic information on not-for-profit organizations isprovided on each province’s website, under the heading “Not-for-ProfitOrganization vs. Other Business Structures”. The most basic information is foundat “).https://www.canada.ca/en/revenue-agency/services/tax/non-profit-organizations.html.The key point: a not-for-profit organization cannot be organizedfor commercial purposes and members, the not-for-profit equivalent ofshareholders, must not benefit personally as investors. Unlike shareholders who areentitled to receive dividends from the profits generated in the pursuit of business,the members of a not-for-profit cannot receive any financial gain from theorganization.Not-for-profits can be set up as not-for-profit corporations, providing separationbetween management and members and limited liability for its members. Thesebenefits are similar to those for shareholder of for-profit corporations. Moreinformation on not-for-profit corporations is provided by Industry Canada, found athttp://www.ic.gc.ca/eic/site/ic1.nsf/eng/h_00076.html34.Careers in Finance. Here are examples of two areas of employment in finance:Corporate Finance-A career in corporate finance means you would work for a companyto help it find money to run the business, grow the business, makeacquisitions, plan forits financial future and manage any cash on hand. You might work for a largemultinational company or a smaller player with high growth prospects. Responsibilitycan come fast and your problem-solving skills will get put to work quickly in corporatefinance jobs.The job of the financial officer is to create value for a company. For example, the financegroup atAmerican Electric Powerof Columbus, Ohio has four main areas ofconcentration: liquidity, flexibility, compliance with laws and regulatory support. AEP'sFinance Department carries out four main activities to meet its objectives: 1) designing,implementing and monitoring financial policies, 2) planning and executing the financingprogram, 3) managing cash resources, and 4) interfacing with the financial communityand investors.Jobs in corporate finance are also relatively stable. Performance in these jobs counts, butyour job is not going to depend on whether you're selling enough this week or gettinggood deals finished this quarter. Rather the key to performing well in corporate finance isto work with a long view of whatisgoing to make your company successful.Many would argue that corporate finance jobs are the most desirable in the entirefield of finance.Some of the benefits of working in corporate finance are:1.You generally work in teams which help you work with people2.It'sa lotof fun to tackle business problems that really matter3.You'll have many opportunities to travel and meet people and

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1-114.The pay in corporate finance is generally quite good.Commercial Banking-Commercial banks are in the business of providing bankingservices to individuals, small businesses and large organizations. While the bankingsector has been consolidating, it is worth noting that far more people have jobs in thecommercial banking sector than any other part of the financial services industry. Jobs inbanking can be exciting and offer excellent opportunities to learn about business, interactwith people and build up a clientele.Today's commercial banks are more diverse than ever. You'll find a tremendous range ofopportunities in commercial banking, starting at the branch level where you might startout as a teller to a wide variety of other services such as leasing, credit card banking,international finance and trade credit.If you are well-prepared and enthusiastic about entering the field, you are likely to find awide variety of commercial banking jobs open to you.35.This question provides students with a website for exploring career informationprovided by the Government of Canada. The answer to the first part of the questionis whatever the students learn about their interests and careers that are associatedwith these interests.From the homepage ofjobbank.gc.ca, for instance type “Financial Managers” andclick on the Financial Managers search result. You will find the description of theoccupation with its NOC code and also some relevant job titles. From here, you canclick on “Choose this occupation” and then choose your province or territory to getthe detailed information about your selected occupation, such as job postings,average wage, outlook and prospects, licence and certification, main duties, job andskill requirements, and education and training.

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2-1Brealey7CESolutions to Chapter 21.One example is Blackberry (formerly Research In Motion or RIM).Theearlystoryof RIM provides three examples of financing sources: equity investments by thefounders of the company, loans from friends andfamily, and loans by governments.Other sources include reinvested earnings of the company and loans from banks andother financial institutions.2.Yes. When the corporation retains cash and reinvests in the firm’s operations, thatcash is saved and invested on behalf of the firm’s shareholders. The reinvested cashcould have been paid out to the shareholders. By not taking the cash, these investorshave reinvested their savings in the corporation. Individuals can also save andinvest in a corporation by lending to, or buying shares in, a financial intermediarysuch as a bank or mutual fund that subsequently invests in the corporation.3.Money markets, where short-term debt instruments are bought and sold.Foreign-exchange markets. Most trading takes place in over-the-countertransactions between the major international banks.Commodities marketsfor agricultural commodities, fuels (including crude oil andnatural gas) and metals (such as gold, silver and platinum).Derivatives markets, where options and other derivative instruments are traded.4.Buy shares in an exchange-traded fund (ETF) or a mutual fund. Both ETFs and mutualfunds pool savings from many individual investors and then invest in a diversifiedportfolio ofsecurities. Each individual investor then owns a proportionate share of theETF or mutual fund’s portfolio.5.Defined contribution pension plans provide three key advantages as vehicles forretirement savings:Professional management.Diversification at low cost.Pension plan contributions are tax-deductible, and taxes on the earnings in thefund are deferred until the fund’s assets are distributed to retired employees.6.Yes. Insurance companies sell policies and then invest part of the proceeds incorporate bonds and stocks and in direct loans to corporations. The returns fromthese investments help pay for losses incurred by policyholders.

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2-27.The largest institutional investors in bonds are insurance companies. Other majorinstitutional investors in bonds are pension funds, mutual funds, banks and othersavings institutions. The largest institutional investors in shares are pension funds,mutual funds, and insurance companies.8.The market price of gold can be observed from transactions in commodity markets.For example, gold is traded on the Comex division of the New York MercantileExchange. Look up the price of gold and compare it to $2,500/6 = $416.67 perounce.9.Financial markets provide extensive data that can be useful to financial managers.Examples include:Prices for agricultural commodities, metals and fuels.Interest rates for a wide array of loans and securities, including money marketinstruments, corporate and Canadian government bonds, and interest rates forloans and investments in foreign countries.Foreign exchange rates.Stock prices and overall market values for publicly listed corporations aredetermined by trading on the TSX, New York Stock Exchange, NASDAQ orstock markets in London, Frankfurt, Tokyo, etc.10.We also discussed this in Chapter 1, Question 14.The opportunity cost of capital isthe expected rate of return offered by the best alternative investment opportunity.When the firm makes capital investments on behalf of the owners of the firm (i.e.,the shareholders), it must consider the shareholders’other investment opportunities.The firm should not invest unless the expected return on investment at least equalsthe expected return the shareholders could obtain on their own by investing in thefinancial markets.The opportunity cost of capital for a safe investment is the rate of return thatshareholders could earn if they invested in risk-free securities, for example inGovernment of Canada Treasury Bills.11.When stockholders have access to modern financial markets and institutions,stockholders can readily avail themselves of the functions served by these markets andinstitutions: for example, transporting cash across time, risk transfer and diversification,liquidity, and access to payment mechanisms. Therefore, the objective of valuemaximization makes sense for stockholders because this is the only task stockholdersrequire of corporate management. In addition, the financial markets provide the pricingmechanism and the information stockholders require in order to assess the performanceof the firm’s management in achieving this objective.

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2-312.a.False. Financing could flow through an intermediary, for example.b.False. Investors can buy shares in a private corporation, for example.c.True. Sale of insurance policies are the largest source of financing forinsurance companies, which then invest a significant portion of the proceedsin corporate debt and equities.d.False. There is no centralized FOREX exchange. Foreign exchange is tradedover-the-counter.e.False. The opportunity cost of capital is the expected rate of return thatshareholders can obtain in the financial markets on investments with the samerisk as the firm’s capital investments.f.False. The cost of capital is anopportunitycost determined by expected ratesof return in financial markets. The opportunity cost of capital for riskyinvestments is normally higher than the firm’s borrowing rate.13.Liquidity is important because investors want to be able to convert theirinvestments into cash quickly and easily when it becomes necessary ordesirable to do so. Should personal circumstances or investmentconsiderations lead an investor to conclude that it is desirable to sell aparticular investment, the investor prefers to be able to sell the investmentquickly and at a price that does not require a significant discount from marketvalue.Liquidity is also important to mutual funds. When the mutual fund’sshareholders want to redeem their shares, the mutual fund is often forced tosell its securities. In order to maintain liquidity for its shareholders, themutual fund requires liquid securities.14.The key to the bank’s ability to provide liquidity to depositors is the bank’s abilityto pool relatively small deposits from many investors into large, illiquid loans tocorporate borrowers. A withdrawal by any one depositor can be satisfied from anyof a number of sources, including new deposits, repayments of other loans made bythe bank, bank reserves and the bank’s debt and equity financing.15.a.Investor A buys shares in a mutual fund, which buys part of a new stock issueby a rapidly growing software company.b.Investor B buys shares issued by the Bank of Saskatchewan, which lendsmoney to a regional department store chain.c.Investor C buys part of a new stock issue by the Regional Life InsuranceCompany, which invests in corporate bonds issued by NeighborhoodRefineries, Inc.

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2-416.Mutual funds and ETFs collectmoney from small investors and invest the money incorporate stocks or bonds, thus channeling savings from investors to corporations. Theadvantages of mutual funds and ETFs for individuals are diversification, professionalinvestment management and recordkeeping.17.In this situation, a “superior” rate of return is a rate of return that is greater than the rateof return investors could earn elsewhere in the financial markets from alternativeinvestments with risk level equal to that of the “low-risk capital investment” describedin the problem. Fritz (who is risk-averse) will applaud the investment because he canmaintain the risk level he prefers while earning ahigherreturn. Frieda (who is risk-tolerant) will applaud the investment because investors will be willing to pay more forthe shares Frieda owns than they would have paid if the firm had not made this “low-risk capital investment.” Frieda would be likely to sell her shares to a more risk-averseinvestor, and use the proceeds of her sale to invest in shares of a company with a veryhigh rate of return, and commensurate high level of risk.18.If you believe that the rate of return is truly guaranteed to be 8 percent, then theinvestment is very low risk.The relevant opportunity cost of capital for thisinvestment is the rate of return that investors can earn in the financial markets fromthe safest investments, such as Canadian government securities and top-quality(AAA) corporate debt issues of equivalent term to maturity, ie.30years. Thehighest quality investments inTable 2.2areAAA and paid 3.35% per year.AA-rated corporate debt isriskier than AAA-rated.19.a.Since the government guarantees the payoff for the investment, theopportunity cost of capital is the rate of return on Canadian GovernmentTreasury bills with one year to maturity (i.e., one-year Treasury bills).b.The opportunity cost for the investment under consideration by PollutionBusters, Inc. is 20%, the expected rate of return available on an investment incarbon.The sequester is expected to pay $115,000 on a $100,000investment, a gain of $15,000. Ifthe $100,000 was invested in the LondonCarbon Exchange, the expected payback is0.2×$100,000, or $20,000. Thepurchase of additional sequesters is not a worthwhile capital expenditure. Thesame risk investment in the London Carbon Exchange produces an additional$5,000 ($20,000-$15,000). This can also be expressed in terms of rates ofreturn. Purchase of the additional sequesters is not aworthwhilecapitalinvestment because the expected rate of return is only 15 percent (i.e., a$15,000 gain on a $100,000 investment, $15,000/$100,000 =0.15 or 15%),less than the 20% opportunity cost of capital.20.Mutual funds; pension funds; venture capital firms; credit unions and caissespopulaires.

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