Frino 4e SM Ch01

Chapter 1
Preliminary concepts
Concepts Overview
The important concepts discussed in Chapter 1 were:

1.1
 The main objective underlying corporate financial decisions is to maximise the
value of the company, which in turn maximises shareholder wealth. This involves
the optimal use of scarce resources. Fisher’s Separation theorem formally links the
concepts covered in the chapter to provide a single decision rule for a firm’s
investment decisions. This decision rule is that management’s role is to maximise
the present value of the firm’s investments in productive assets. Corporate
managers face three important decisions in their attempt to maximise shareholder
wealth. These decisions are: investment decisions, financing decisions and
dividend decisions.
 The investment decision relates to the manner in which funds raised in capital
markets are employed in productive activities. The objective of such investments is
to generate future cash flows, thus providing a ‘return’ to investors. The capital
budgeting or project evaluation function is the process by which the investment
decision is undertaken.
 The financing decision relates to the mix of funding obtained from capital markets;
that is, the mix of debt and equity issued by the firm to fund its operations.
 The dividend decision relates to the form in which the returns generated by the
firm are passed on to equity holders.
1.2
 The nature of financial assets is simply a claim to a series of cash flows against
some economic unit. Only something that produces cash flows, or that you can sell
to produce a cash flow in the future, is a financial asset. This is opposed to real
assets which are those that can be put to productive use to generate returns; for
example, machinery and equipment.
1.3
 The flow of funds through the capital market and its relationship to corporate
finance begins with investors. Investors make consumption and investment
decisions. They decide whether, and to what extent, they are willing to trade their
present consumption for future consumption. If they decide to forgo present
consumption, they may put their money in the bank or buy shares, thereby placing
their cash into the capital market
 The financing, or capital structure, decision is associated with this flow of funds
from the capital market to the company. Individual companies will normally
acquire funding through the sale of financial assets; either equity (shares) or debt
Instructor’s Manual: Frino, Hill, Chen Introduction to Corporate Finance 4e © 2009 Pearson Australia 1-1
(bonds). Once a company acquires funds, it will generally purchase real
(productive) assets – the investment decision.
 The key corporate objective is to maximise the wealth of the owners of a company.
This is measured by market capitalisation, which is found by multiplying the
current market price of each share by the number of shares on issue.
 There are a number of incentives and mechanisms in place that encourage the
directors of a company to make decisions that maximise the wealth of owners:
regulation by the Australian Securities and Investments Commission (ASIC),
remuneration packages that tie the remuneration of management to company value,
and the market for corporate control (i.e. the takeover market).
1.4
 One of the most important concepts in corporate finance is value – in particular,
the value of assets. This chapter describes how to value an asset paying a single
cash flow. Valuations of assets that generate cash flows over time involve
consideration of the time value of money. For example, consider a simple asset
that guarantees the holder a cash flow of $105 in one year’s time, while at the same
time a bank is offering a 5% p.a. rate or return. To value the asset offering a cash
flow of $105 in one year’s time the 5% p.a. offered by the bank can be used as the
opportunity cost or discount rate for the asset to determine its value in today’s
dollars. We can discount the $105 to be received in one year’s time to re-express it
in today’s equivalent purchasing power.
PV = 105/1 + .05 = $100
Hence $105 to be received in one year’s time is equivalent to having $100 today if
the opportunity cost or prevailing interest rate that could be earned on the $100
invested for one year is 5%.
 The Fisher Separation Theorem develops a single rule for a firm’s investment
decision – a firm should invest in projects that have a return equal to or greater
than the market rate of interest. Managers of a firm need not concern themselves
with shareholder consumption preferences, because they can borrow or invest in
the capital market to satisfy their consumption preferences and maximise utility.
 The rates of return on an asset can be defined as the gain from an asset (economic
profit) divided by the cost of acquiring the asset (the cost of the investment). A
generic formula for calculating the rate of return from holding assets is as follows:
1.5
1.6
 This formula can be adapted to cater for different types of assets, such as shares,
debt securities, and property. For example the formula would be changed for
shares in the following way:
1.7 and 1.8
 This chapter also provides information on how to read some of the information
contained in financial journals such as the Australian Financial Review. The
markets section lists all stocks that are traded on the ASX, together with a host of
market and other information. The most important information is the closing stock
price for company. Other important information includes the opening price of the
share and buy & sell quotes, as well as the volume of shares traded.
Suggested Answers to Concept Questions
(p.2)
1. What is the objective of the firm from a financial management perspective?
ANSWER
The corporate objective of the firm is to ‘maximise the value of the company’. It can
be demonstrated that this is the same as: ‘maximise shareholder wealth’. It is a simple
application of one of the basic principles of economics – make optimal use of scarce
resources. The optimal use of resources ensures that the value of the company, and
the wealth of shareholders, is maximised.
2. What are the three key decisions facing corporate financial managers? Are these
decisions interrelated or independent?
ANSWER
Major financial decisions confronting management:
1. Investment:
• Evaluation of investment projects
• Amount and type of assets held (current/fixed)
• Review past investments
2. Financing:
• Where to obtain funds (public v private)
• Type of funds (i.e. debt v equity)
• Cost of funds (interest rates, cost of issue, etc)
• When to raise funds and for how long
3. Dividend:
• Increase/decrease/maintain
• Availability of cash to pay dividends
• Imputation credits (the need to pass tax credits to shareholders)
These decisions are interrelated because a company’s cash inflows equal its cash
outflows. Hence new external financing plus cash profits (cash inflows) =
Investments plus dividends (cash outflows). This can be represented using the
following equation:
Therefore we cannot change one without affecting at least one other.
(p.4)
3. What distinguishes ‘financial’ assets from other types of assets?
ANSWER
A financial asset is a claim to a series of cash flows against some economic unit.
Only something that produces cash flows, or that you can sell to produce a cash flow
in the future, is a financial asset. For example, a bank account is a financial asset
because it entitles the holder to cash flows – some interest in the future, plus the
amount initially deposited into the account. Other types of assets are referred to as
‘real assets’, which are those that can be put to productive use to generate returns; for
example, machinery and equipment.
4. Is a bond a real asset or a financial asset?
ANSWER
A bond is a financial asset that provides a claim against an economic entity. The cash
flows that stem from bonds are interest payments and the repayment of the principal
on maturity.
(p.7)
5. How does market capitalisation relate to owners’ wealth?
ANSWER
Owner wealth is measured by the ‘market capitalisation’ of securities. For shares,

market capitalisation is simply the total market value of all the shares of a company
on issue. This is a direct measure of the total wealth of shareholders that is invested
in the company. It is measured as the number of shares on issue multiplied by the
current trading price of each share.
6. Are the interests of the managers of a company necessarily aligned with increasing
share-holders’ wealth?
ANSWER
Not necessarily. It may be that the managers are tempted to maximise their own
benefits and wealth to the detriment of the shareholders, but there are mechanisms
that act to minimise this.
7. What mechanisms are used to align the interests of managers with the interests of
shareholders?
ANSWER
(a) The Australian Securities and Investments Commission (ASIC)

 The company regulator is charged with preventing corporate crime and
protecting shareholders.
(b) Management remuneration packages

 Compensation based on performance / profits.
 Stock options whose value increases with the value of the firm.
(c) The market for corporate control

 Directors can be ousted by shareholder revolt (e.g. at the AGM).
 They can be removed by a takeover (poor management creates takeover
targets).
 They are not likely to be promoted to larger companies.
 They may find difficult to get another job (reputation effects).
(p.10)
8. Can an individual be indifferent to receiving a dollar now or a dollar one year from
now? Explain.
ANSWER
No. A dollar in one year’s time is not equal to a dollar today. This concept is related
to the ‘time value of money’, which is derived from the fact that interest can be
earned on an alternative investment opportunity (for example, a bank account). The
only way in which an individual might be indifferent is if there is zero interest, which
is unlikely. Even then, having the dollar now gives the individual more choice as to
when to consume.
9. If the best interest rate I could receive in the market was 10%, would I prefer $100
now or a guaranteed $110 in one year’s time?
ANSWER
Given an interest rate of 10% p.a. $100 today is equivalent to $110 in one year’s time.
You would indifferent between these two cash flows.
The present value of $100 can be expressed in future value terms:
Conversely the future value of $110 can be expressed in present value terms:
(p.12)
10. How can managers make investment decisions without considering the consumption
needs of their shareholders?
ANSWER
The key feature of Fisher’s separation theorem is that it shows that the investment
choice of investors is independent of their consumption preferences. Investors can
lend or borrow in the capital market to satisfy current consumption preferences. For
firm managers, the theorem means that their decisions are separate from their
shareholders’ (owners’) individual consumption/investment preferences.
Modern finance theory is built on the behaviour of individual shareholders, firms and
the capital market. Since Fisher’s separation theorem combines these three elements,
it is not surprising that many basic notions of modern finance theory can be found in
the theorem. Rational individuals are interested in maximising their utility, and since
an investor’s utility is directly related to his wealth level, firms can maximise
investors’ wealth by investing in all projects with a net present value greater than
zero.
The implications of Fisher’s Separation Theorem are that all investors will agree on
the firm’s policy to maximise net present value, as it will allow them, as individuals,
to achieve their highest level of consumption.
11. How does the existence of a capital market allow individuals to trade off between
present and future consumption?
ANSWER
The existence of capital markets enables individuals to adjust their income and
consumption patterns to suit their needs. Those who need to spend more now and less
later can borrow the money they need (for example, through a housing loan for their
house) and use future income to repay the loan. Those with high future consumption
needs can invest their excess current income at the market rate of interest and have
more consumption later. However, while capital markets enable individuals to trade
off between consumption now and consumption later, the amount one can consume is
limited by income. The level of consumption in all periods can be increased if we can
earn more.
(p.13)
12. What are the two types of gain one can get from holding a share?
ANSWER
One part of the gain is in the form of a capital gain from holding the share for a period
of time. The second type of gain from a holding a share is a dividend if you are
fortunate enough to be holding the share on the day it pays a dividend.
13. How do you calculate the rate of return on a share?
ANSWER
The rate of return on an asset can be defined as the gain from an asset (economic
profit), divided by the cost of acquiring the asset (the cost of the investment, or
invested capital).
The opening price of the share is the amount that it was purchased for, or the invested
capital.
(p.17)
14. Financial information sources contain various measures of the activities in the
market, market highs and lows, daily closing price, and buy and sell quotes. Which
measure is the best indicator of the market value of a firm’s shares?
ANSWER
Daily closing price found in the ‘last sale’ column is the best indicator of a firm’s
market value.
15. If you wished to compare the performance of a share with some general measure of
performance, which index would you use?
ANSWER
Broad based market indices such as the All Ordinaries Accumulation index or the
S&P/ASX 200 are good measures to compare the performance of a share with some
general measure of performance.
Discussion questions
1. The text refers to three types of financial decision – the investment decision, the
financing decision and the dividend decision. Describe each in detail, and explain
how these decisions relate to the corporate objective. Categorise each of the
following decisions in terms of whether it is an investment, financing or dividend
decision and explain why it is in that category.
(a) Javelin Pharmaceutical Ltd purchases all of the shares in O’Hara Ltd.
(b) Tabcorp Holdings Ltd buys new poker machines for its business.
(c) Brushwood Ltd hopes to raise $53 million in an equity issue of ordinary
shares and will use the funds to repay its long-term debt.
(d) Devastation Games Ltd purchases the copyright for a new video game.
(e) News Corporation declares a dividend of 20c per share.
(f) Brushwood Ltd pays $5 million to repurchase 1% of the shares held by its
current shareholders.
(g) Creek Ltd announces the raising of $50 million in bonds in the United States.
(h) Charles Grogin sells shares to finance his new online wine cellar.
ANSWER
The investment decision relates to the manner in which funds raised in capital markets
are employed in productive activities. The objective of such investments is to generate
future cash flows, thus providing a ‘return’ to investors. The capital budgeting or
project evaluation function is the process by which the investment decision is
undertaken. Maximising the future cash flows generated will maximise the value of
the firm and the wealth of owners.
The financing decision relates to the mix of funding obtained from capital markets;
that is, the mix of debt and equity issued by the firm to fund its operations. Obtaining
the most appropriate sources of finance, taking into account the cost of finance and
the risk, will maximise the value of the firm and therefore the wealth of owners.
The dividend decision relates to the form in which the returns generated by the firm
are passed on to equity holders. There is a substantial body of theory that indicates
that an appropriate dividend policy can also maximise firm value and owner wealth.
(a) Investment decision – the firm has invested in shares with the intention of
using them to generate return for their own shareholders.
(b) Investment decision – this is a project that will generate cash flows.
(c) Financing decision – the decision to issue shares as a source of finance.
(d) Investment decision – a project designed to generate cash flows.
(e) Dividend decision – deciding how to distribute returns to shareholders.
(f) Financing decision – just as issuing shares to raise finance is a financing

decision, buying back shares to reduce the amount of equity finance is also
part of the financing decision.
(g) Financing decision – the decision to use debt as a source of finance.
(h) Financing decision – the decision to issue shares as a source of finance.
2. On what basis is the corporate objective of ‘maximising shareholder wealth’

justified? How does this corporate objective affect corporate financial decision-
making?
ANSWER
This is the simple application of one of the basic principles of economics – make
optimal use of scarce resources. The scarce resources that are used by the company
are, primarily, capital and labour. To ensure optimal benefits to an economy, it is
imperative that companies apply these resources in the most efficient manner
possible. When this is done, the corporate objective is met – optimal use of resources
ensures that the value of the company, and the wealth of shareholders, is maximised.
Corporate financial decision should be made with this objective in mind – investment
decisions that maximise return to shareholders, and financing and dividend decisions
that are appropriate and therefore maximise the value of the firm and the wealth of
owners.
3. ‘Maximising the value of the firm to its shareholders is consistent with the firm
exercising considerable social responsibility.’ Discuss.
ANSWER
As explained above, maximising the value of the firm means using scarce resources as
efficiently as possible, which is in the interests of the economy as a whole. If all
companies operate in this way, the wealth created within the economy will be
maximised. In addition, socially responsible companies are likely to benefit from
considerable goodwill and custom, which in turn translates into the maximisation of
firm value and owner wealth in the long run.
4. What is the difference between a real asset and a financial asset? Give an example of
each.
ANSWER
A financial asset is a claim to a series of future cash flows. Examples are bonds and
shares. Financial assets are issued by companies to raise the finance needed to
purchase real assets.
Real assets are assets that can be put to productive use to generate income. Examples
are computers, vehicles, property and equipment. The income generated by the real
assets of a company belong to the providers of capital – the owners of the financial
assets issued by the company.
5. What is a capital market? Give examples of Australian capital markets, and state the
main participants in these markets.
ANSWER
A capital market is the medium for issue and exchange of financial assets. The ‘big
four’ banks are probably the best known elements of the Australian capital market.
They are the ANZ Bank, Commonwealth Bank of Australia, National Australia Bank
and Westpac. The traditional role of these banks has been to hold deposits on behalf
of customers, and to lend funds for purposes such as purchasing property, expanding a
business, buying a car, and so on. These days, however, banks are involved in a lot
more than just the borrowing and lending of money. For example, some of them
operate share-broking businesses. That is, they trade shares in Australian (and
sometimes overseas) companies. Others are also money-market dealers, involved in
trading bonds. These activities also form part of the capital market.
Another well-known element of the Australian capital market is the Australian Stock
Exchange (ASX). The ASX essentially constitutes the ‘meeting place’ for buyers and
sellers of shares. Until October 1990, one of the meeting places was a trading floor
located at 20 Bond Street, Sydney. However, buyers and sellers of shares no longer
physically meet on trading floors. The market is now electronic, and transactions in
shares are executed using a network of computer terminals.
The Australian government bond market is another important element of the

Australian capital market. Again, there is no physical trading floor where traders
meet to buy and sell bonds. The bond market is an ‘over-the-counter’ market. For
practical purposes, this means that transactions are typically arranged by telephone.
The bond market is also known as a ‘dealer’ market. Dealers are traders who are in
the business of buying and selling bonds on their own account. An investor who
wants to buy a bond would normally phone a bond broker, who in turn will usually
phone a dealer to organise the transaction. Dealers typically post their quotes on
electronic bulletin boards, operated by information vendors such as Reuters and
Bloomberg.
6. How do capital markets allow consumers to meet their present and future
consumption needs?
ANSWER
The capital market is a place where individuals exchange current consumption for
future consumption. For example, when you buy shares, you are forgoing current
consumption and supplying the capital market with cash in the hope that in the future
you will get your cash back plus a bit more (a return). It is likely that when you
liquidate your shareholding in the future, you will be doing it to generate cash for
consumption.
7. How does maximising the price of a firm’s share equate to maximising shareholder
wealth?
ANSWER
The key corporate objective requires that a company should make decisions that
increase the wealth of its owners. That is, the company makes decisions that increase
the value of the firm. The two are synonymous, because the owners hold the value of
a firm and every time the directors of a company make a good decision, whereby its
securities increase in value, the owners of these securities become wealthier.
8. What is a bond? What are the cash flows that are received by bondholders?
ANSWER
A bond is a claim against an economic entity. It is a security issued by companies and

governments that raise funds for the issuer in the form of debt. The bonds can either
pay regular periodic interest payments and the face value on maturity or pay zero
interest and are therefore sold at a discount to face value. Government bonds are
widely used and in Australia the Government is the major issuer of bonds. Cash
flows stemming from bonds are the interest payments and principal.
9. Discuss some of the institutional mechanisms that exist in Australia for ensuring that
financial managers act in the best interests of the company owners.
ANSWER
Regulators such as the Australian Securities and Investments Commission (ASIC) are
among these mechanisms. Two important roles of ASIC are to prevent corporate
crime and to protect investors. Both of these roles are consistent with the
maximisation of owners’ wealth. It is unlikely, however, that the existence of ASIC
will provide an airtight guarantee that directors of a company will pursue the interests
of shareholders.
Remuneration packages are another way in which the owners of a company can
promote decision-making by a company that maximises owner wealth. Directors’
salaries can be packaged such that the wealth of directors is linked to the value of a
company; e.g. tying directors’ and managers’ remuneration to the market
capitalisation of a company. Directors often hold shares in the companies that they
run. This practice increases the likelihood that a director will attempt to maximise the
wealth of shareholders, because the director’s wealth will increase simultaneously.
The market for corporate control (i.e. the takeover market) may also promote the
maximisation of shareholder wealth. The idea is that if management is running a
company inefficiently, the company’s share price will be depressed. Corporate
raiders aim to take over such companies by purchasing a majority shareholding, then
using their acquired voting power to partly or completely replace the existing
management team. In theory, the new (or upgraded) management team operates the
business more efficiently (and therefore profitably), thereby resulting in gains. The
threat of job loss associated with corporate raids therefore provides an incentive to
management to pursue the objective of maximisation of share value; that is,
shareholder wealth. This mechanism is sometimes referred to as the ‘discipline of the
capital market’.
Another mechanism that encourages management of a company to increase owner

wealth is owner voting power. For example, a group of shareholders who are
dissatisfied with the manner in which a company is run may decide to sack the
management.
10. It has been said that the objective of a firm is to look after the interest of the owners of
the firm – the ordinary shareholders. However, firms are run by managers (directors)
who are often not owners (shareholders). Surely then managers would be more
interested in looking after their own interests rather than those of some face-less crowd.
True or false? Explain. Are the interests of the two groups necessarily incompatible?
ANSWER
Despite the fact that the mechanisms referred to earlier are in place, there is always
the presence of an ‘agency’ problem. Since the managers of a company (the agents)
have control over the funds of shareholders (the principals), there is always a danger
that they may not act in the best interests of shareholders. This is because they might
prefer to take actions that enhance their own personal position, even if such actions
are against shareholders’ best interests. Accordingly, the mechanisms that we have
discussed here may not always be adequate to guarantee that the interests of owners of
the firm will be pursued.
11. Managers of companies face an impossible task because they cannot really increase
the wealth of each and every shareholder. Because there are thousands of
shareholders, it is impossible to find projects that allow the manager to meet the
investment and consumption needs of every shareholder. As a consequence,
managers should follow the rule that they should invest in projects that provide them
with the best satisfaction and not consider the needs of investors. Do you agree?
What investment rules should managers follow and why?
ANSWER
All investors will agree on the firm’s policy to maximise net present value, as it will
allow them, as individuals, to achieve their highest level of consumption. Firms
should follow the rule that says they should invest in projects that have a return equal
to or higher than the market rate of interest. That is, investment in projects that
achieve a positive net present value. Regardless of whether the investors want
consumption now or later, they will benefit if the firm follows this decision rule. This
frees the managers of the firm from having to consider the consumption preferences
of its owners. They will behave in the best interest of their investors if they invest in
projects with a return higher than the market rate of interest.
Investors can then lend or borrow in the capital market to satisfy their consumption
preferences and maximise their utility. Those who find that returns available as a
result of the company’s investment decisions given them insufficient funds to finance
their current consumption preferences can borrow, sacrificing future consumption for
current consumption. Those who find they have more than need to finance current
consumption can invest in the capital market, sacrificing current consumption in order
to increase future consumption.
12. What is meant by ‘the market for corporate control’? How does this market
contribute to the efficiency of capital markets overall?
ANSWER
The market for corporate control is also known as “the takeover market”. The threat
of losing control of a company to a better management team motivates management
to maximise firm value. Poorly managed assets will be acquired and inefficient
management will be replaced. This process enhances the efficiency of capital
markets.
13. A security exists that exists that promises to pay $300 in one year’s time. If the
market rate of interest is 20% p.a. and the security is for sale for $200, what would
you do and why? Ultimately, what would you expect to happen?
ANSWER
Since the true value is $250 and it is for sale at $200, I would buy the security because
it is underpriced.
There will be a large number of investors who would want to buy the asset. Current
owners of the asset would be irrational to sell at less than $250, and potential buyers
will pay up to $250 for it; e.g. if a potential buyer was to bid $210, then another buyer
would overbid with $220 and still make a $30 profit. Another potential buyer would
be prepared to pay, say, $225 since there is still, at $225, a $25 profit to be made.
Prices will be bid up until equilibrium is reached with the market price at $250. Note
it is unlikely that any assets would have been sold at the undervalued price since at
any price less than $250 there will always have been a bidder prepared to offer more.
14. How does investing in projects that have a rate of return equal to or greater than the
market rate of interest maximise shareholders’ wealth?
ANSWER
The investment rule is to invest until the return on the marginal dollar invested equals
the cost of funds; that is, maximise net present value. What is evident is that if
investors place their money with a firm that is earning superior returns compared with
investing at the market rate of interest, they will earn much higher income later. The
present value of this income, less the investment, measures the increase in wealth
achieved by investing in firms that offer a return that is higher than the rate of interest
prevailing in the capital markets. That is, as long as the firm can earn a rate of return
that is higher than the market rate, the investors will be better off allowing the firm to
invest in projects that increase their wealth – those that have a higher present value
than the amount invested. This will be the case with all investment opportunities that
earn more than the market rate of interest. Because they have more future income
through future payouts from the firm, the investors have higher wealth now.
Practical questions
1. Refer to Table 1.1 in the chapter. Assume that one week earlier (i.e. 31 December
2008) prices on Newscorp’s major securities were:
ASX Stock No. issued Last sale

Security Code (m) price ($)
Class B common stock NWS 1045 22.66
Class A common stock NWSLV 1893 18.99
What is Newscorp’s market capitalisation as at 31 December 2008?
ANSWER
No. issued Last sale Market

Security (m) price ($) cap. ($b)
Class B common stock 1045 22.66 23.7
Class A common stock 1893 18.99 35.9
TOTAL 59.6
2. If you placed $5000 in a bank for one year, how much would you have accumulated in
one year if the rate of return was 6.75%?
ANSWER
3. What is the rate of return on an asset that will pay $104,000 in one year, if it is priced
at $97,000 today?
ANSWER
4. What is the rate of return on an asset priced at $4,695 today that will pay $5,000 in
one year?
ANSWER
5. How much would you receive in one year, if you invest in an asset priced at $8,000
today, with a rate of return of 5.25%?
ANSWER
6. How much would you have to invest today to accumulate $20,000 in one year, if the
current rate of return is 9.8%?
ANSWER
7. If you were able to obtain a rate of return of 6.5% by placing funds in a bank for one
year, how much would you be willing to pay for an alternative asset that promises to
return $18,000 in one year?
ANSWER
8. (a) Would you pay $100,000 today for an asset that will pay $105,000 in one year
if the rate of return is currently 6% p.a.? Explain your answer.
(b) Would you pay $98,000 today for an asset that will pay $105,000 in one year if
the rate of return is currently 6% p.a.? Explain your answer.
ANSWER
(a)
No, I wouldn’t pay $100,000, as this asset is only worth $99,056.60.
(b) Yes, I would pay $98,000 for an asset worth $99,056.60.
9. (a) What is the rate of return on the All Ordinaries Index if its opening value is
4,030.3 points and its closing value is 4,096.6 points?
(b) What is the rate of return on the All Ordinaries Index if its opening value is
4,041.5 points and its closing value is 4,033.3 points?
ANSWER
(a)
(b)
10. If you purchased National Australia Bank shares in the morning at $28.78 and sold
them at the end of the day at $28.93, what rate of return have you realised?
ANSWER
11. A firm has identified the following six potential projects. Each project requires an
investment of $100 and will return (without risk) the following amounts.
Project A $124
Project B $106
Project C $112
Project D $118
Project E $108
Project F $110
(a) If the firm has $500 to invest, which projects (if any) should it select?
(b) If the firm has $500 to invest and the opportunity to lend to or borrow from the
capital market at 10% p.a., what investments should it make?
(c) If the firm has $500 to invest and the opportunity to lend to or borrow from the
capital market at 5% p.a., what investments should it make?
ANSWER
(a) In the absence of alternative investments, the firm should invest in Projects A,
C, D, E and F, as these are the 5 projects that provide the greatest return.
(b) The return from each project can be calculated using the following formula:
Dollar Return Percentage Return
Project A $124 24%
Project B $106 6%
Project C $112 12%
Project D $118 18%
Project E $108 8%
Project F $110 10%
The firm should invest in Projects A, C and D, as their return is greater than the
return available from investing in the capital market. They would be indifferent
as to whether or not to invest in Project F. Surplus funds could be invested in
the capital market or returned to shareholders (on the assumption that they can
also invest in the capital market for a return of 10%.
The firm would be indifferent between investing in Project F or retaining the

funds for investment in the capital or returning them to shareholders.
(c) The firm should invest in all six projects, as they all generate a return greater
than that available in the capital market. They should do this by borrowing
$100 in the capital market at an interest rate of 5% in order to invest in all six
projects.
12. Refer back to Figure 1.3. Using the information provided for Lion Nathan Ltd and
National Australia Bank, work out:
(a) Which stock is more liquid.

(b) Which stock is more volatile.
(c) Which stock is more expensive to trade (in terms of the bid ask spread).
ANSWER
(a) National Australia Bank was more liquid, because about six billion
shares were traded compared to just over one billion for Lion Nathan.
(b) Lion Nathan had been more volatile over the previous year. The
difference between its lowest and highest price over the previous 12 months
was $2.84, or just under 50%. In the case of NAB, the difference between its
lowest and highest price over the previous 12 months was $6.08, or about 23%.
(c) NAB was more expensive to trade, because its bid-ask spread was 24
cents, or 48 cents for a ‘round-trip’ transaction. The bid-ask spread for Lion
Nathan was 2 cents, or 4 cents for a ‘round-trip’ transaction. Even expressed in
percentage terms, NAB’s bid-ask spread was about 4 times more costly than
Lion Nathan’s.
13. Refer back to Figure 1.3 and 1.4.
(a) What is the rate of return on Lion Nathan and National Australia Bank, and
what is the price volatility of the shares over the year?
(b) What is the return on the All Ordinaries Index?
(c) Have the shares outperformed or underperformed the index? Do you think you
can provide an explanation for this?
ANSWER
(a) Rate of return on Lion Nathan
Price volatility of Lion Nathan over 12 months = $5.86 – $8.70.
Rate of return on NAB
Price volatility of NAB over 12 months = $26.04 – $32.12.
(b) Rate of return on All Ordinaries
(c) Both shares have underperformed the index – Lion Nathan more so than NAB.
This is most likely to have been caused by other information, unique to Lion
Nathan and NAB, or perhaps the industries in which they operate, that has
caused investors to reevaluate these companies and caused prices to adjust
through buying and selling pressures.
14. (a) Write an equation which enables you to calculate the price (Pt) of a cash flow
to be received in one years time (Ft) when the interest rate is r.
(b) Rearrange the equation to make r the subject of the formula
(c) Explain what happens to returns as the future cash flow increases.
(d) Explain what happens to returns as the price you pay for the asset increases.
ANSWER
(a) P(t) = F(t)

------
1+r
(b) r = F(t)
-----
P(t) – 1/ n
(c) When the future cash flow increases and all other variables remain constant,
then the returns will also increase as future cash flow increases.
(d) When the price you pay for the asset increases and all other variables remain
constant then the returns will reduce.
15. A financial asset is expected to return $400,000 exactly one year from today. It is
expected to return $400,000 exactly two years from today. If the opportunity cost of
capital for one year is 10%.
ANSWER
(a) Calculate the value of cash flow to be received in Year 1 today

FV = PV (1+r)
$400,000 = $363,636.36*1.10
(b) Calculate the value of cash flow to be received in Year 2 today

FV = PV (1+r)
$400,000 = $330,578.51*1.21
(c) What is the (total) value of the asset today?

FV = PV (1+r)
$400,000 = $400,000*1.00
16. Refer to the table below.
Company JB Hi Fi Limited (JBH) Rio Tinto Limited (RIO)

Chief Executive Officer Richard Uechtritz Tom Albanese
Cash Remuneration 2006 $1,217,631 $1,741,000
Cash Remuneration 2007 $1,631,757 $2,771,000
Share Price 31 Dec 2006 $6.55 $74.79
Share Price 31 Dec 2007 $15.60 $133.95
(a) Calculate the return on JB Hi-Fi and Rio Tinto Shares.
ANSWER
Rate of return on share = (closing price – opening price) + dividend

opening price
JBH = ($15.60 - $6.55) = 138.17%

$6.55
RIO = ($133.95 - $74.79) = 79.10%

$74.79
(b) Calculate the percentage change in the cash remuneration of Richard Uechtritz
and Tom Albanese.
ANSWER
Cash Remuneration 2007 – Cash Remuneration 2006

-----------------------------------------------------------------
Cash Remuneration 2006
% Change in Remuneration – Richard Uechtritz = $1,631,757 - $1,217,631

----------------------------- = 34.01%
$1,217,631
% Change in Remuneration – Tom Albanese = $2,771,000 - $1,741,000

----------------------------- = 59.16%
$1,741,000
(c) Which company has a cash remuneration policy which is more likely to align the
interests of the CEO with that of the companies’ shareholders?
ANSWER
JBH has a cash remuneration policy that aligns the interests of the CEO with that of
the company shareholders as the return on JBH shares is 138.17% for an increase in
CEO remuneration of 34.01% as opposed to RIO shareholders return on shares of
79.10% for an increase in CEO remuneration of 59.16%
(d) What other types of remuneration may the CEO’s of JB Hi-Fi and Rio Tinto
receive that would align their interests with those of shareholders?
ANSWER
Other types of remuneration that CEO’s of JBH and RIO may receive to align their
interests with those of shareholders are performance related cash bonuses and share
options which are the most common form of performance based remuneration over
and above salaries.

Frino 4e SM Ch01

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Frino 4e SM Ch01

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Chapter 1

The important concepts discussed in Chapter 1 were:

PV = 105/1 + .05 = $100

Suggested Answers to Concept Questions

1. What is the objective of the firm from a financial management perspective?

Major financial decisions confronting management:

Therefore we cannot change one without affecting at least one other.

3. What distinguishes ‘financial’ assets from other types of assets?

4. Is a bond a real asset or a financial asset?

5. How does market capitalisation relate to owners’ wealth?

Owner wealth is measured by the ‘market capitalisation’ of securities. For shares,

(a) The Australian Securities and Investments Commission (ASIC)

(b) Management remuneration packages

(c) The market for corporate control

The present value of $100 can be expressed in future value terms:

(e) News Corporation declares a dividend of 20c per share.

(c) Financing decision – the decision to issue shares as a source of finance.

(d) Investment decision – a project designed to generate cash flows.

(e) Dividend decision – deciding how to distribute returns to shareholders.

(f) Financing decision – just as issuing shares to raise finance is a financing

(g) Financing decision – the decision to use debt as a source of finance.

(h) Financing decision – the decision to issue shares as a source of finance.

2. On what basis is the corporate objective of ‘maximising shareholder wealth’

The Australian government bond market is another important element of the

A bond is a claim against an economic entity. It is a security issued by companies and

Another mechanism that encourages management of a company to increase owner

ASX Stock No. issued Last sale

What is Newscorp’s market capitalisation as at 31 December 2008?

No. issued Last sale Market

No, I wouldn’t pay $100,000, as this asset is only worth $99,056.60.

(b) Yes, I would pay $98,000 for an asset worth $99,056.60.

Dollar Return Percentage Return

The firm would be indifferent between investing in Project F or retaining the

(a) Which stock is more liquid.

(a) Rate of return on Lion Nathan

Price volatility of Lion Nathan over 12 months = $5.86 – $8.70.

Rate of return on NAB

Price volatility of NAB over 12 months = $26.04 – $32.12.

(b) Rate of return on All Ordinaries

(a) P(t) = F(t)

(a) Calculate the value of cash flow to be received in Year 1 today

(b) Calculate the value of cash flow to be received in Year 2 today

(c) What is the (total) value of the asset today?

16. Refer to the table below.

Company JB Hi Fi Limited (JBH) Rio Tinto Limited (RIO)

(a) Calculate the return on JB Hi-Fi and Rio Tinto Shares.

Rate of return on share = (closing price – opening price) + dividend

JBH = ($15.60 - $6.55) = 138.17%

RIO = ($133.95 - $74.79) = 79.10%

Cash Remuneration 2007 – Cash Remuneration 2006

% Change in Remuneration – Richard Uechtritz = $1,631,757 - $1,217,631

% Change in Remuneration – Tom Albanese = $2,771,000 - $1,741,000

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