Fundamentals of Corporate Finance 9th Edition by Brealey Myers Marcus ISBN Solution Manual

Solution Manual for Fundamentals of Corporate Finance 9th Edition
by Brealey Myers Marcus ISBN 1259722619 9781259722615

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Solutions to Chapter 2
Financial Markets and Institutions
1. The story of Apple Computer provides three examples of financing sources: equity
investments by the founders of the company, trade credit from suppliers, and
investments by venture capitalists. Other sources include reinvested earnings of the
company and loans from banks and other financial institutions.
Est time: 01–05
Raising capital
2. Money markets: where short-term debt instruments are bought and sold.
Foreign-exchange markets: where currencies are traded; most trading takes place in
over-the-counter transactions between the major international banks.
Commodities markets: where agricultural commodities, fuels (including crude oil and
natural gas), and metals (such as gold, silver, and platinum) are traded.
Derivatives markets: where options and other derivative instruments are traded.
Est time: 01–05
Capital markets
3. a.False. Financing could flow through an intermediary, for example.
b. False. Investors can buy shares in a private corporation, for example.
c. False. There is no centralized FOREX exchange. Foreign exchange trading takes
place in the over-the-counter market.
d. False. Derivative markets are not sources of financing, but markets where the
financial manager can adjust the firm’s exposure to various business risks.
e. False. The opportunity cost of capital is the expected rate of return that
shareholders can earn 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 the financial markets. The opportunity cost of capital for risky
investments is normally higher than the firm’s borrowing rate.
Est time: 06–10
Raising capital
4. 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 New York, which lends money to
a regional department store chain.
2-1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
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.
Est time: 01–05
Types of financial institutions
5. Buy shares in a mutual fund. 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 mutual fund’s portfolio.
Est time: 01–05
Financial institution functions
6. Yes, an insurance company is a financial intermediary. 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.
Est time: 01–05
7.
a. Equities. As a percentage of all investors, households are the largest investor in equities.
b. Pension funds. Banks own almost no corporate equities, but instead rely on fixed-
income investments.
c. Commercial banks. In contrast, investment banks raise money for corporations.

Est time: 06–10
Financial institutions
8. NASDAQ and The Chicago Mercantile Exchange are financial markets.

Est time: 01–05
Financial institutions
9.
a. False. Exchange traded funds (ETFs) are portfolios of stocks that can be bought or sold
in a single trade.
b. False. Hedge funds may provide diversification, but usually have very high fees.
c. True. Insurance policy premiums are used to pay claims, create reserves and provide
financing for company operations.
d. True. The size of the pension investment is variable, depending on market conditions,
while the amount contributed is somewhat fixed.
Est time: 06-10
2-2
Education.
10. 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 that 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
securities.
Est time: 01–05
Liquidity
11. 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.
Est time: 01–05
12. Commercial banks accept deposits and provide financing primarily for businesses.
Investment banks do not accept deposits and do not loan money to businesses and
individuals. Investment banks may make bridge loans as temporary financing for a
takeover or acquisition. In addition, investment banks trade many different financial
contracts, such as bonds and options, while providing investment advice and portfolio
management for institutional and individual investors.
Est time: 01–05
13. Mutual funds collect money from small investors and invest the money in corporate
stocks or bonds, thus channeling savings from investors to corporations. For
individuals, the advantages of mutual funds are diversification, professional investment
management, and record keeping.
Est time: 01–05
Money and capital markets
14. Financial markets and financial intermediaries channel savings to real investments. They also
channel money from individuals who want to save for the future to those who need cash to
spend today. A third function of financial markets is to allow individuals and businesses to
adjust their risk. For example, mutual funds, such as the Vanguard Index fund, and ETFs, such
as the SPDR’s or “spiders,” allow individuals to spread their risk across a large number of
stocks. Financial markets provide other mechanisms for sharing risks. For example, a wheat
farmer and a baker may use the commodity markets to reduce their exposure to wheat prices.
Financial markets and intermediaries allow investors to turn an investment into cash when
needed. For example, the shares of public companies are
2-3
Education.
liquid because they are traded in huge volumes on the stock market. Banks are the main
providers of payment services by offering checking accounts and electronic transfers.
Finally, financial markets provide information. For example, the CFO of a company that is
contemplating an issue of debt can look at the yields on existing bonds to gauge how much
interest the company will need to pay.
Est time: 06-10
Capital markets
15. The major functions of financial markets and institutions in a modern

financial system are:
• Channeling savings to real investment: The savings of individual investors are
made available for real investments by corporations and other business entities
by way of financial markets and institutions.
• Transporting cash across time: Savers can save money now to be withdrawn
and spent at a later time, while borrowers can borrow cash today, in effect
spending today income to be earned in the future.
• Risk transfer and diversification: Insurance companies allow individuals and
business firms to transfer risk to the insurance company, for a price. Financial
institutions, such as mutual funds, allow an investor to reduce risk by
diversification of the investor’s holdings.
• Liquidity: Financial markets and institutions provide investors with the ability
to exchange an asset for cash on short notice, with minimal loss of value. A
deposit in a bank savings account earns interest but can be withdrawn at
almost any time. A share of stock in a publicly traded corporation can be sold
at virtually any time.
• Payment mechanism: Financial institutions provide alternatives to cash
payments, such as checks and credit cards.
• Information provided by financial markets: Financial markets reveal
information about important economic and financial variables such as
commodity prices, interest rates and company values (i.e., stock prices).
Est time: 06-10
16. 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.
Est time: 01–05
Primary and secondary markets
2-4
Education.
17. 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 U.S. 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, as
determined by trading on the New York Stock Exchange, NASDAQ, or stock
markets in London, Frankfurt, Tokyo, and so on.
Est time: 01–05
18.
a. 178.5 × $90 = $16.065 billion
b. 3.03 %
c. The farmer sells cattle since he raises them. The meat packer buys cattle because he
needs beef for processing.
Est time: 01–05
19.
a. False. The financial crisis had its roots in an easy monetary policy that provided
funds for banks to expand the supply of subprime mortgages to low-income
borrowers.
b. False. Subprime mortgages are for residential properties.
c. True. Most subprime mortgages were packaged together to be resold as
mortgage-backed securities (MBSs), though many banks retained exposure to
these securities.
d. False. The government arranged for Bank of America to take over Merrill but
did nothing to rescue Lehman Brothers, which filed for bankruptcy protection.
e. False. Though the massive bailout of Greece calmed the markets somewhat,
concerns over Greece and other weak eurozone countries, such as Portugal, Italy,
Spain, and even Ireland, remain today.
Est time: 01–05
Money and capital markets
2-5
Education.
Solution to Minicase for Chapter 4
Consult the accompanying Excel spreadsheet solution for this minicase.
Problems for HH are apparent in the areas of debt and assets. Leverage ratios improved
between 2011 and 2015, but debt (both long-term and short-term) has increased
significantly in 2016. Liquidity ratios began to deteriorate in 2015, at the same time that
the number of employees increased substantially. Further deterioration in liquidity ratios
occurred in 2016, when inventories more than doubled and current liabilities increased by
more than 85%. At the same time, sales remained virtually unchanged from 2015.
4-1
© 2018 by McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction
or further distribution permitted without the prior written consent of McGraw-Hill Education.
Chapter 2
Financial Markets and Institutions
The Instructor’s Manual is divided into two parts. The first is an overview of the chapter,
including a description of the material covered and a perspective on how the chapter
content relates to the balance of the textbook. The second part reviews the learning
objectives of the chapter and includes a list of challenges encountered by students when
learning the material. Where appropriate, pedagogical ideas and tips are provided to
improve student learning.
OVERVIEW
Chapter 2 covers the financial system, which is a significant part of the operating environment
of any business, especially a large, public corporation. The primary focus of this chapter is on
how financial markets and institutions supply financing for investments made by corporations.
Financial markets offer a constant "performance evaluation" of company performance in the form
of securities prices. The concept of opportunity cost of capital is expanded and presented as a
method by which financial markets establish expected returns.
The material in this chapter can be very exciting for some students as they come to this course
expecting to learn how to make money in the stock market. It is important to emphasize the
reason for studying this material is to understand how financial markets and institutions supply
financing for investment by corporations. Students can be enticed with this information to go on
and take an investment course, but the primary focus here is on the decisions of the corporate
financial manager.
REVIEW OF LEARNING OBJECTIVES (with teaching tips and notes)
The first learning objective of this chapter is an understanding of how financial markets and
institutions channel savings to corporate investment. Households and foreign investors provide
most of the savings for corporate financing; financial markets and institutions provide the
process and contracts to channel funds from savers to corporations for real investment. Figures
2.1 and 2.2 are an excellent graphics for facilitating this discussion.
Teaching Note: The Stock Market – The above warning notwithstanding, students
may benefit from creating a shadow investment portfolio and following it throughout the
course. This project can be run on paper or with one of the many stock simulation
software programs available to instructors. After discussion of the material in later
chapters, students can investigate the PE and Market-to-Book ratios of their portfolio
companies, calculate individual betas and a portfolio beta, and calculate a weighted
average cost of capital for each firm they are following. It may also be interesting, when
discussing the efficient market hypothesis, to compare student results to a randomly
selected portfolio.
The second learning objective of this chapter is an understanding of the basic structure of
banks, insurance companies, mutual funds, and pension funds. The financial intermediaries
described here include commercial banks, finance companies, life and casualty insurance
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
companies, credit unions, and savings and loan associations. Mutual funds and pension funds
are also explained.
Teaching Note: Capital Market Efficiency - Finance in Practice Box Micro Loans, Solid
Returns, offers insight into how interest rates are set. A beneficial exercise may
incorporate students offering explanations as to the differences between the
microfinance loan market and more traditional financial markets. Clearly, the size,
liquidity and risk associated with this market are good topics students may quickly
identify. It is interesting to see what other differences students see.
The third learning objective of this chapter is an explanation of the functions of financial
markets and institutions. The five functions covered are transporting cash across time, risk
transfer and diversification, liquidity, a payment mechanism, and information. The final function,
information, is important to discuss as the pricing of securities imparts required rate of return
information for new corporate investments (cost of capital) on a continuous basis.
Teaching Note: Capital Market Efficiency - Finance in Practice Box Prediction Markets,
provides an interesting example on how a market works. This example can prepare the
students for the later more in-depth discussion of the efficient market hypothesis. The
Iowa Electronic Markets is a good market to discuss if you are teaching during an
election year.
The fourth learning objective of this chapter is an understanding of the main events behind the
financial crisis of 2007–2009. The authors describe how a huge expansion in subprime
mortgage lending led to a collapse of the banking system which the government was forced to
bailout. The importance of the Federal Reserve to financial markets, the role of credit rating
agencies, and agency problems at banks are all discussed here.
Teaching Note: Ethical Issues – Section 2.4 includes a discussion of how banks expanded
the supply of sub-prime mortgages and tempted many would-be homeowners with teaser
introductory interest rates. The authors describe the agency problems surrounding bankers
that may been guilty of promoting these financial products.
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Chapter 2
Financial
Markets and
Institutions
Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered
2.1 The Importance of Financial Markets

and Institutions
2.2 The Flow of Savings to Corporations
2.3 Functions of Financial Markets and
Intermediaries
2.4 The Crisis of 2007-2009
2- 2
The Importance of Financial Markets (1 of 3)
 Businesses have to go to financial markets

and institutions for the financing they need
 to grow
  Financing Decision 
 – Source of Funds (Capital)
– Capital Structure
2- 3
Examples of financing decisions by Apple Computer
2- 4
Examples of financing decisions by Apple Computer (continued)
2- 5
The Flow of Savings to Corporations (1 of 15)
Cash raised from

share issues
Corporation Investors
Investment Cash
Shareholders in closely
in real assets reinvested held corporation
2- 6
Financial Markets
Stock markets Fixed-
income markets
Money markets
Corporation
Reinvestment Investors
Investment in
real assets
worldwide
Financial Institutions
Banks
Insurance Companies
Financial
Intermediaries
Mutual Funds
Pension Funds
2- 7
Money
Primary OTC
Markets Markets
Secondary
Markets
2- 8
  Financial Market
 – Market where securities are issued and traded
  Primary Market 
– Market for the sale of new securities by
 corporations
  Secondary Market
– Market in which previously issued securities
are traded among investors
2- 9
Fixed-income
• Market for debt securities
market
Capital • Market for long-

market term financing
Money • Market for short-term

market financing (less than 1 year)
2- 10
Foreign exchange markets

• Chapter 22
Commodities markets
• Chapter 24
Markets for options and other derivatives

• Chapters 23 and 24
2- 11
2016 U.S. Republican Convention Nomination Market
Source: Iowa Electronic Markets: Iowa Electronic Markets

2- 12
  Financial Intermediary
– An organization that raises money from
investors and provides financing for
individuals, companies, and other
 organizations
  Financial Institution
– A bank, insurance company, or similar financial
intermediary
2- 13
  Mutual Fund
– An investment company that pools the savings of
many investors and invests in a portfolio of
 securities
  Hedge Fund
– A private investment pool, open to wealthy or
institutional investors, that is only lightly regulated
and therefore can pursue more speculative
policies than mutual funds
  Pension Fund
– Fund set up by an employer to provide for
employees’ retirement
2- 14
$ $
Bank of Explorer
Investors
America Fund
Sells Issues
shares shares
2- 15
Company
Funds
Obligations
Intermediaries
Banks Insurance
Cos. Brokerage
Firms
2- 16
Intermediaries
Funds
Obligations
Investors
Depositors
Policy Holders
Investors
2- 17
Company
Obligations Funds
Banks Insurance
Intermediary/
Cos. Brokerage
Institutions
Firms
Obligations Funds
Depositors
Policyholders Investor
Investors
2- 18
Company
Loan $2.5 mil
Bank Institution
Deposits $2.5 mil
Depositors Investor
2- 19
Company
Issue Debt $2.5 mil

Insurance
Institution
Company
Sell Policies $2.5 mil
Policyholders Investor
2- 20
Total U.S. Financing (1 of 2)
Holdings of Corporate and Foreign Bonds (Qtr. 3, 2015)
Banks & savings Other Households Mutual funds, etc.
institutions 5.6% 4.3% 24.8%
6.0%
Rest of world
25.4%
Pension funds
10.7%
Insurance
companies
23.3%
2- 21
Total U.S. Financing (2 of 2)
Holdings of Corporate Equities (Qtr. 3, 2015)
Rest of world Other
16.0% 0.9%
Households
Insurance 37.2%
companies
5.8%
Pension funds
13.8%
Mutual funds, etc.

26.3%
2- 22
Function of Financial Markets (1 of 3)
  Transporting cash across time

  Risk transfer and diversification
  Liquidity
  Payment mechanism
 Provide information
2- 23
Information Provided by Financial Markets

  Commodity prices
  Interest rates
 Company values
Interest rates on long-term corporate bonds, March 2016
2- 24
Market Capitalization ($ millions)
Number of Market
x Stock Price =
Shares Capitalization
Callaway Golf
93.8 x $8.76 = $821.00
(ELY)
Alaska Air Group
124.7 x $80.77 = $10,074
(ALK)
Entergy (ETR) 178.5 x $75.92 = $13,551
Yum! Brands
408.7 x $77.77 = $31,875
(YUM)
General Electric
9,331.0 x $30.34 = $283,091
(GE)
2- 25
The Crisis of 2007-2009
  Easy money
  Subprime mortgages
  Mortgage backed securities
  Bear Sterns
  AIG
  IMF
 Greece
2- 26

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Solution Manual for Fundamentals of Corporate Finance 9th Edition

by Brealey Myers Marcus ISBN 1259722619 9781259722615

6. Yes, an insurance company is a financial intermediary. Insurance companies sell

c. Commercial banks. In contrast, investment banks raise money for corporations.

8. NASDAQ and The Chicago Mercantile Exchange are financial markets.

15. The major functions of financial markets and institutions in a modern

Consult the accompanying Excel spreadsheet solution for this minicase.

REVIEW OF LEARNING OBJECTIVES (with teaching tips and notes)

Copyright © 2018 by The McGraw-Hill Companies, Inc. All rights reserved

2.1 The Importance of Financial Markets

 Businesses have to go to financial markets

Examples of financing decisions by Apple Computer

Examples of financing decisions by Apple Computer (continued)

Cash raised from

Capital • Market for long-

Money • Market for short-term

Foreign exchange markets

Markets for options and other derivatives

2016 U.S. Republican Convention Nomination Market

Source: Iowa Electronic Markets: Iowa Electronic Markets

Loan $2.5 mil

Deposits $2.5 mil

Issue Debt $2.5 mil

Sell Policies $2.5 mil

Banks & savings Other Households Mutual funds, etc.

institutions 5.6% 4.3% 24.8%

Mutual funds, etc.

  Transporting cash across time

Information Provided by Financial Markets

Market Capitalization ($ millions)

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