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Solution Manual For Fundamentals Of Corporate Finance, Seventh Canadian Edition

Solution Manual For Fundamentals Of Corporate Finance, Seventh Canadian Edition simplifies even the toughest textbook questions with step-by-step solutions and easy explanations.

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    1 - 1 Brealey 7 CE Solutions to Chapter 1 1. real executive airplanes brand names financial stock s investment capital budgeting financing 2. A firm might cut its labour force dramatically which could reduce immediate expenses and increase profits in the short term. Over the long term, however, the firm might not be 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 these problems. The moral of th is examples is that, because stock prices reflect present and future profitability, the firm should not necessarily sacrifice future prospects for short - term gains. 3. The key advantage of separating ownership and management in a large corporation is that it gives the corporation permanence. The corporation continues to exist if managers are replaced or if stockholders sell their ownership interests to other investors. The corporation’s permanence is an essential characteristic in allowing corporations to obtain the large amounts of financing required by many business entities. Both public and private corporations are distinct legal entit ies , separate from its owners (ie., its shareholders). The key difference between public and private corporations is the rules governing the sale of their common shares. The common shares of a public corporation are listed for trading on a stock exchange and investors 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 stock exchange. Shareholders of private corporations must negotiate directly with potential buyers and are subject to resale restrictions.

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    1 - 2 You can learn to identify the risks associated with investing in private companies by going to Ontario Securities Commission's website at: http://www.osc.gov.on.ca/en/Investors_cbyi_index.htm 4. A sole proprietorship is easy to set up with a minimum of legal work. The business itself is not taxed. For tax purposes, the income of the proprietorship is treated as the income of the proprietor. The main disadvantages of a proprietorship are the proprietor’s unlimited liability for the debts of the firm, and difficulty in raising large amounts of financing as the business grows. A partnership has the same tax advantage as the proprietorship. The partnership per se does not pay taxes. The partnership files a tax return, but all of the partnership income is allocated to the partners and treated as personal income. Also, it is fairly easy to set up a partnership. Because there can be many partners, a partnership can raise capital more easily than a proprietorship. However, like sole proprietors, general partners have unlimited liability for the debts of the firm. In fact, each partner has unlimited liability for all the business’ debts, not just his or her share. Corporate organization has the advantage of limited liability. Its owners, the shareholders, are not personally responsible for the debts of the corporation. It also allows for separation of ownership and management, since shares in the firm can be traded without changing management. A public corporation has the added advantage of easier access to equity financing because its shares are traded in public stock markets. The major disadvantage of corporate organization is the double taxation of income. Corporations pay taxes on their income, and that income is taxed again when it is passed through to shareholders in the form of dividends. Another disadvantage of corporate organization is the extra time and cost required in order to manage a corporation’s legal affairs. These costs arise because the corporation must be chartered and is considered a distinct legal entity. Such administrative costs are significant only for small corporations, however. Furthermore, public corporations must provide investors with detailed financial information in their annual reports and inform investors about significant events. Disclosure takes time and resources and may also be costly in the sense that co mpetitor firms become aware of inside information that the corporation may not necessarily want competitors to be aware of. LLP’s may be considered to be hybrid organizations to the extent that while individual partners have unlimited liability, they are not liable for the actions of their partners. 5. Double taxation means that a corporation’s income is taxed first at the hands of the corporation at the corporate tax rate, and then, when the income is distributed to shareholders as dividends, the income is taxed again at the hands of shareholders at the shareholder’s personal tax rate. 6. a, c, d. 7. If you go to the website, www.td.com , you will see a list of TD’s business and their financial products and services . To work as an investment banker, you would work for TD Securities, Clicking on “TD Securities” and then on “ About us ” takes you to a

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    1 - 3 webpage, www.tdsecurities.com/tds/content/AU_AboutUs1?language=en_CA that says: With more than 4,000 people in 15 offices around the world, TD Securities provides a wide range of capital market products and services to corporate, government and institutional clients who choose us for our knowledge, innovation and experience in the following key areas of finance:  Investment and Corporate Banking  Capital Markets  Interest Rate, Currency and Derivative Products  Commodities Our services include the underwriting and distribution of new debt and equity issues, providing advice on strategic acquisitions and divestitures, and executing daily trading and investment needs. With our history of delivering results, we’ve developed considerable strengths, including recognized trading expertise and street - level market intelligence that we use to consistently create value for our clients. To trade securities, join TD Asset Management, at http://www.tdassetmanagement.com/Content/Homepage/p_Homepage.asp , “ TD Asset Management is committed to applying the new thinking necessary to address your most important challenges. We take a collaborative team - based approach, focus on quality and employ a comprehensive risk management discipline. ” 8. a. Investment decision b. Financial asset c. Public corporation d. Corporation e. Treasurer f. The cost resulting from conflicts of interest between managers and shareholders 9. Financing decisions involve sources of capital used in the running of a firm. Investment decisions, typically called capital budgeting, involve the uses of capital raised in the financing process. a. Investment decision

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    1 - 4 b. Financing decision c. Investment decision d. Investment decision e. Investment decision f. Financing decision: On the surface, this may appear similar to a dividend decision, but in reality retiring debt is a change in capital structure and more closely aligned with a financing decision. 10. a. Private corporation b. Partnership c. Public corporation d. Public corporation 11. C. Ownership can be transferred without affecting operations and D. Managers can be fired with no effect on ownership. 12. The individual stockholders of a corporation (i.e., the owners) are legally distinct from the corporation itself, which is a separate legal entity. Consequently, the stockholders are not personally liable for the debts of the corporation; the stockholders’ liability for the debts of the corporation is limited to the investment each stockholder has made in the shares of the corporation. 13. As discussed in Question 2 which is similar, , a corporation might cut its labor force dramatically, which could reduce immediate expenses and increase profits in the short term. Over the long term, however, the firm might not be able to serve 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, a corporation can boost profits over the short term by using less costly materials even if this reduces the quality of the product. Once customers catch on, sales will decrease and profits will fall in the future. The stock price will fall. The moral of these examples is that, because stock prices reflect present and future profitability, the corporation should not necessarily sacrifice future prospects for short - term gains 14. Financial managers refer to the opportunity cost of capital because corporations increase value for their shareholders only by accepting all investment projects that

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    1 - 5 earn more than this rate. If the company earns below this rate, the market value of the company’s stock falls and stockholders look for other places to invest. To find the opportunity cost of capital for a safe investment, managers and investors look at current interest rates on safe debt securities, such as Canadian Treasury debt . 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 all the by - product of an attempt to maximize shareholder value. In the absence of laws banning companies from producing wealth for their owners, someone will use 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 of the success of the firm. However, profits are not a wholly reliable way to measure the success of the firm. The text points out that profits are subject to differing accounting rules and reflect only the current year’s situation rather than the long - run prospects of the firm. c. A salary that is paid partly in the form of the company’s shares means that the manager 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 stock financial b. A personal IOU financial c. A trademark real d. A truck real e. Undeveloped land real f. The balance in the firm’s chequing account financial g. An experienced and hardworking sales force real h. A bank loan agreement financial 18 . a. Real assets are items that are used to produce goods and services. Real assets include both tangible and intangible items. Tangible (physical) real assets include such items as machinery, building, and inventories. Intangible real assets include items such as research ideas, brand names and skilled work force. In contrast, financial assets are items that have value only because of their claim to cash flows generated by real assets. Many different types of financial assets exist, including bank loans, bonds, stocks, and options. b. Investment or capital budgeting decisions involve deciding which real assets to acquire. Financing decision s involve arranging the money needed to pay for investments in the real assets. So, when making investment decisions you decide what to spend money on and when making financing decisions, you decide how to get the money to spend.

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    1 - 6 c. Both capital budgeting and capital structure are long - term decisions. Capital budgeting decision is the process of deciding the real asset investment plans. Capital structure decision is the process of deciding the mix of the long - term financing to use to fund the firm’s assets. Essentially, capital structure decision involve s selecting between equity financing and long - term debt financing. 1 9 . Capital budgeting decisions Should a new computer be purchased? Should the firm develop a new drug? Should the firm shut down an unprofitable factory? Financing decisions Should 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 shareholders will receive. In contrast, profits reflect performance in the current year only. Profit maximizers may try to improve this year’s profits at the expense of future profits. But stock price maximizers will take account of the entire stream of cash flows that the firm can generate. They are more apt to be forward looking. 21 . a. This action might appear, superficially, to be a grant to former employees and thus not consistent with value maximization. However, such ‘benevolent’ actions might enhance the firm’s reputation as a good place to work, might result in greater loyalty on the part of current employees, and might contribute to the firm’s recruiting efforts. Therefore, from a broader perspective, the action may be value maximizing. b. The reduction in dividends to allow increased reinvestment can be consistent with maximization of current market value. If the firm has attractive investment opportunities, and wants to save the expenses associated with issuing new shares to the public, then it could make sense to reduce the dividend in order to free up capital for the additional investments. c. The corporate jet would have to generate benefits in excess of its costs in order to be considered stock - price enhancing. Such benefits might include time savings for executives, and greater convenience and flexibility in travel. 22 . a. Increased market share can be an inappropriate goal if it requires reducing prices to such an extent that the firm is harmed financially. Increasing market share can be part of a well - reasoned strategy, but one should always remember that market share is not a goal in itself. The owners of the firm want managers to maximize the value of their investment in the firm.

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    1 - 7 b. Minimizing costs can also conflict with the goal of value maximization. For example, suppose a firm receives a large order for a product. The firm should be willing 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 it agrees to fill the order. c. A policy of underpricing any competitor can lead the firm to sell goods at a price lower than the price that would maximize market value. Again, in some situations, this strategy might make sense, but it should not be the ultimate goal of the 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 three reasons: (i) There may be a trade - off between accounting profits in one year versus accounting profits in another year. For example, writing off a bad investment 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 profits is insufficient to justify the additional investment. In this case the increased investment increases profits, but can reduce shareholder wealth. (iii) Profits can be affected by accounting rules, so a decision that increases profits 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 or integrity of the lawyer, this arrangement can make sense. First, the lawyer has an incentive to work hard. Second, if the lawyer turns out to be incompetent and loses the case, the client will not have to pay a bill. Third, the lawyer will not be tempted to accept a very weak case simply to generate bills. Fourth, there is no incentive for the lawyer to charge for hours not really worked. Once a client is more comfortable with the lawyer, and is less concerned with potential agency problems, a fee - for - service arrangement 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 sales in all its locations . The reputation of each restaurant in the chain depends on the quality in all the other stores. In contrast, if Joe’s serves mostly passing travelers who are unlikely to show up again, unsatisfied customers pose a far lower cost. They are unlikely to be seen again anyway, so reputation is not a valuable asset. The important distinction is not that Joe has one outlet while the national chain has many. Instead, it is the likelihood of repeat relations with customers and the value of reputation. If Joe’s store was located in the center of town instead of on the highway,

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    1 - 8 one would expect his clientele to be repeat customers from town. He would then have the same incentive to establish a good reputation as the chain. 25 . While a compensation plan that depends solely on the firm’s performance would serve to motivate managers to work hard, it would also burden them with considerable personal risk tied to the fortunes of the firm. This would be unattractive to managers and might cause them to value their compensation packages less highly; it might also elicit excessive caution when evaluating business opportunities. 26 . Takeover defenses make it harder for underperforming managers to be removed by dissatisfied shareholders, or by firms that might attempt to acquire the firm. By protecting such managers, these provisions exacerbate agency problems as they are more likely to act in their own interest rather than the firm’s . 27 . Traders can earn huge bonuses when their trades are very profitable, but if the trades lose large sums, as in the case of Barings Bank, the trader’s exposure is limited. 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) independent of the firm’s success. b. A salary linked to profits ties the employee’s compensation to he success of the firm as measured by profits. However, profits are not a wholly reliable way to measure the success of the firm. The text points out that profits are subject to differing accounting rules, and reflect only the current year’s situation rather than the long - run prospects of the firm. c. A salary that is paid partly in the form of the company’s shares means that the manager 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’s success. In some cases, however, stock options can lead to agency problems. For example, a manager with many options might be tempted to take on a very risky project, reasoning that if the project succeeds the payoff will be huge, while if it fails, the losses are limited to the lost value of the options. Shareholders, in contrast, bear the losses as well as the gains on the project, and might be less willing to assume the risk. 2 9 . Even if a shareholder could monitor and improve managers’ performance, and thereby increase the value of the firm, the payoff would be small, since the ownership share in a large corporation is very small. For example, if you own $10,000 of GM stock and can increase 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 - 9 In contrast, a bank that has a multimillion - dollar loan outstanding to the firm has a large stake in making sure that the loan can be repaid. It is clearly worthwhile for the bank to spend considerable resources on monitoring the firm. 30 . Long - term relationships can encourage ethical behavior. If you know that you will engage in business with another party on a repeated basis, you will be less likely to take advantage 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 their associates will influence the way their associates treat them. When relationships are short - lived, however, the temptation to be unfair is greater since there is less reason to fear 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 the products and services they desire. In addition, reputation effects often make it in the firm’s own interest to act ethically toward its business partners and employees since the firm’s ability to make deals and to hire skilled labour depends on its reputation for dealing fairly. In some circumstances, when firms have incentives to act in a manner inconsistent with the 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, thereby affecting the firm’s decisions regarding activities that cause pollution. Other “incentives” used by governments to align private interests with public interests include: legislation to provide for worker safety and product, or consumer, safety, building code requirements enforced by local governments, and pollution and gasoline mileage requirements imposed on automobile manufacturers. 32 . Some customers might consider this practice unethical. They might view the firm as gouging its customers during heat waves. On the other hand, the firm might try to convince customers that this practice allows it to charge lower prices in cooler periods, and that over long periods of time, prices even out. Whether customers and firms have an “implicit contract” to charge and pay stable prices is something of a cultural issue. 33 . This website provides information on the various types of business structures. However, to find out some details on ru les and regulations ask your students to go to http://www.canadabusiness.ca/eng/page/2853/ For province - specific rules regarding registration of sole proprietorships or partnerships you can go to https://www.canada.ca/en/services/business/start/register - with - gov/register - sole - prop - partner.html Rules and regulations governing different forms of business share similarities and differences across provinces. In general, while provinces enjoy the authority to regulate businesses within their jurisdictions and may have differing statutes on occasion, closer examination indicates 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 - 10 profit structures, the same basic information on not - for - profit organizations is provided on each province’s website, under the heading “ Not - for - Profit Organization vs. Other Business Structures ”. The most basic information is found at “ ). https://www.canada.ca/en/revenue - agency/services/tax/non - profit - organizations.html . The key point: a not - for - profit organization c annot be organized for commercial purposes and members, the not - for - profit equivalent of shareholders, must not benefit personally as investors. Unlike shareholders who are entitled to receive dividends from the profits generated i n the pursuit of business, the members of a not - for - profit cannot receive any financial gain from the organization. Not - for - profits can be set up as not - for - profit corporations, providing separation between management and members and limited liability for its members. These benefits are similar to those for shareholder of for - profit corporations. More information on not - for - profit corporations is provided by Industry Canada, found at http://www.ic.gc.ca/eic/site/ic1.nsf/eng/h_00076.html 34 . 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 company to help it find money to run the business, grow the business, make acquisitions , plan for its financial future and manage any cash on hand. You might work for a large multinational company or a smaller player with high growth prospects. Responsibility can come fast and your problem - solving skills will get put to work quickly in corporate finance jobs. The job of the financial officer is to create value for a company. For example, the finance group at American Electric Power of Columbus, Ohio has four main areas of concentration: liquidity, flexibility, compliance with laws and regulatory support. AEP's Finance Department carries out four main activities to meet its objectives: 1) designing, implementing and monitoring financial policies, 2) planning and executing the financing program, 3) managing cash resources, and 4) interfacing with the financial community and investors. Jobs in corporate finance are also relatively stable. Performance in these jobs counts, but your job is not going to depend on whether you're selling enough this week or getting good deals finished this quarter. Rather the key to performing well in corporate finance is to work with a long view of what is going to make your company successful. Many would argue that corporate finance jobs are the most desirable in the entire field of finance. Some of the benefits of working in corporate finance are: 1. You generally work in teams which help you work with people 2. It's a lot of fun to tackle business problems that really matter 3. You'll have many opportunities to travel and meet people and

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    1 - 11 4. The pay in corporate finance is generally quite good. Commercial Banking - Commercial banks are in the business of providing banking services to individuals, small businesses and large organizations. While the banking sector has been consolidating, it is worth noting that far more people have jobs in the commercial banking sector than any other part of the financial services industry. Jobs in banking can be exciting and offer excellent opportunities to learn about business, interact with people and build up a clientele. Today's commercial banks are more diverse than ever. You'll find a tremendous range of opportunities in commercial banking, starting at the branch level where you might start out 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 a wide variety of commercial banking jobs open to you. 35 . This question provides students with a website for exploring career information provided by the Government of Canada. The answer to the first part of the question is whatever the students learn about their interests and careers that are associated with these interests. From the homepage of jobbank .gc.ca, for instance type “Financial Managers” and click on the Financial Managers search result. You will find the description of the occupation with its NOC code and also some relevant job titles. From here, you can click on “Choose this occupation” and then choose your province or territory to get the detailed information about your selected occupation, such as job postings, average wage, outlook and prospects, licence and certification, main duties, job and skill requirements, and education and training.

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    2 - 1 Brealey 7 CE Solutions to Chapter 2 1. One example is Blackberry (formerly Research In Motion or RIM). The early story of RIM provides three examples of financing sources: equity investments by the founders of the company, loans from friends and family, and loans by governments. Other sources include reinvested earnings of the company and loans from banks and other financial institutions. 2. Yes. When the corporation retains cash and reinvests in the firm’s operations, that cash is saved and invested on behalf of the firm’s shareholders. The reinvested cash could have been paid out to the shareholders. By not taking the cash, these invest ors have reinvested their savings in the corporation. Individuals can also save and invest in a corporation by lending to, or buying shares in, a financial intermediary such 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 - counter transactions between the major international banks. Commodities markets for agricultural commodities, fuels (including crude oil and natural 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 mutual funds pool savings from many individual investors and then invest in a diversified portfolio of securities. Each individual investor then owns a proportionate share of the ETF or mutual fund’s portfolio. 5. Defined contribution pension plans provide three key advantages as vehicles for retirement savings:  Professional management.  Diversification at low cost.  Pension plan contributions are tax - deductible, and taxes on the earnings in the fund 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 in corporate bonds and stocks and in direct loans to corporations. The returns from these investments help pay for losses incurred by policyholders.

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    2 - 2 7. The largest institutional investors in bonds are insurance companies. Other major institutional investors in bonds are pension funds, mutual funds, banks and other savings 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 Mercantile Exchange. Look up the price of gold and compare it to $2,500/6 = $416.67 per ounce. 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 market instruments, corporate and Canadian government bonds, and interest rates for loans and investments in foreign countries.  Foreign exchange rates.  Stock prices and overall market values for publicly listed corporations are determined by trading on the TSX, New York Stock Exchange, NASDAQ or stock markets in London, Frankfurt, Tokyo, etc. 10. We also discussed this in Chapter 1, Question 14. The opportunity cost of capital is the 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 equals the expected return the shareholders could obtain on their own by investing in the fi nancial markets. The opportunity cost of capital for a safe investment is the rate of return that shareholders could earn if they invested in risk - free securities, for example in Government 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 and institutions: for example, transporting cash across time, risk transfer and diversification, liquidity, and access to payment mechanisms. Therefore, the objective of value maximization makes sense for stockholders because this is the only task stockholders require of corporate management. In addition, the financial markets provide the pricing me chanism and the information stockholders require in order to assess the performance of the firm’s management in achieving this objective.

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    2 - 3 12. 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 for insurance companies, which then invest a significant portion of the proceeds in corporate debt and equities. d. False. There is no centralized FOREX exchange. Foreign exchange is traded over - the - counter. e. False. The opportunity cost of capital is the expected rate of return that shareholders can obtain in the financial markets on investments with the same risk as the firm’s capital investments. f. False. The cost of capital is an opportunity cost determined by expected rates of return in financial markets. The opportunity cost of capital for risky investments is normally higher than the firm’s borrowing rate. 13. Liquidity is important because investors want to be able to convert their investments into cash quickly and easily when it becomes necessary or desirable to do so. Should personal circumstances or investment considerations lead an investor to conclude tha t it is desirable to sell a particular investment, the investor prefers to be able to sell the investment quickly and at a price that does not require a significant discount from market value. Liquidity is also important to mutual funds. When the mutual fund’s shareholders want to redeem their shares, the mutual fund is often forced to sell its securities. In order to maintain liquidity for its shareholders, the mutual fund requires liquid sec urities. 14. The key to the bank’s ability to provide liquidity to depositors is the bank’s ability to pool relatively small deposits from many investors into large, illiquid loans to corporate borrowers. A withdrawal by any one depositor can be satisfied from any of a number of sources, including new deposits, repayments of other loans made by the 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 issue by a rapidly growing software company. b. Investor B buys shares issued by the Bank of Saskatchewan, which lends money to a regional department store chain. c. Investor C buys part of a new stock issue by the Regional Life Insurance Company, which invests in corporate bonds issued by Neighborhood Refineries, Inc.

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    2 - 4 16. Mutual funds and ETFs collect money from small investors and invest the money in corporate stocks or bonds, thus channeling savings from investors to corporations. The advantages of mutual funds and ETFs for individuals are diversification, professional investment management and record keeping. 17. In this situation, a “superior” rate of return is a rate of return that is greater than the rate of return investors could earn elsewhere in the financial markets from alternative investments with risk level equal to that of the “low - risk capital inves tment” described in the problem. Fritz (who is risk - averse) will applaud the investment because he can maintain the risk level he prefers while earning a higher return. Frieda (who is risk - tolerant) will applaud the investment because investors will be w illing to pay more for the 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 - averse investor, and use the proceeds of her sale to invest in sh ares of a company with a very high 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 the investment is very low risk. The relevant opportunity cost of capital for this investment is the rate of return that investors can earn in the financial markets from the safest investments, such as Canadian government securities and top - quality (AAA) corporate debt issues of equivalen t term to maturity, ie. 30 years. The highest quality investments in Table 2 . 2 are AAA and paid 3.35% per year. AA - rated corporate debt is riskier than AAA - rate d . 19. a. Since the government guarantees the payoff for the investment, the opportunity cost of capital is the rate of return on Canadian Government Treasury bills with one year to maturity (i.e., one - year Treasury bills). b. The opportunity cost for the investment under consideration by Pollution Busters, Inc. is 20%, the expected rate of return available on an investment in carbon. The sequester is expected to pay $115,000 on a $100,000 investment, a gain of $15,000. If the $100,000 was invested in the London Carbon Exchange, the expected payback is 0 .2×$100,000, or $20,000. The purchase of additional sequesters is not a worthwhile capital expenditure. The same risk investment in the London Carbon Exchange produces an a dditional $5,000 ($20,000 - $15,000). This can also be expressed in terms of rates of return. Purchase of the additional sequesters is not a worthwhile capital investment 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 caisses populaires.

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