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Fundamental of Corporate Finance (Solution Manual)

Fundamental of Corporate Finance (Solution Manual)

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Published by Waqar Shaikh

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Published by: Waqar Shaikh on Nov 03, 2010
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03/07/2013

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Solutions to Chapter 1The Firm and the Financial Manager
1. realexecutive airplanesbrand namesfinancialstock investmentcapital budgetingfinancing2. A firm might cut its labor force dramatically which could reduce immediate expensesand increase profits in the short term. Over the long term, however, the firm might notbe able to serve its customers properly or it might alienate its remaining workers; if so,future profits will decrease, and the stock price will decrease in anticipation of theseproblems.Similarly, a firm can boost profits over the short term by using less costly materialseven if this reduces the quality of the product. Once customers catch on, sales willdecrease 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 firm should not necessarily sacrifice future prospects for short-termgains.3. The key advantage of separating ownership and management in a large corporationis that it gives the corporation permanence. The corporation continues to exist if managers are replaced or if stockholders sell their ownership interests to otherinvestors. The corporation’s permanence is an essential characteristic in allowingcorporations to obtain the large amounts of financing required by many businessentities.4. A sole proprietorship is easy to set up with a minimum of legal work. The businessitself is not taxed. For tax purposes, the income of the proprietorship is treated as theincome of the proprietor. The disadvantages of a proprietorship are unlimited liabilityfor the debts of the firm, and difficulty in raising large amounts of capital as thebusiness grows.http://shaikhwaqar.blogspot.com1-1
 
A partnership has the same tax advantage as the proprietorship. The partnership per sedoes not pay taxes. The partnership files a tax return, but all of the partnership incomeis allocated to the partners and treated as personal income. Also, it is fairly easy to setup a partnership. Because there can be many partners, a partnership can raise capitalmore easily than a proprietorship. However, like sole proprietors, partners haveunlimited liability for the debts of the firm. In fact, each partner has unlimited liabilityfor all the business’s debts, not just his or her share.Corporate organization has the advantage of limited liability. It also allows forseparation of ownership and management, since shares in the firm can be tradedwithout changing management. The corporation also has easier access to capitalmarkets. The major disadvantage of corporate organization is the double taxation of income. Corporations pay taxes on their income, and that income is taxed again whenit is passed through to shareholders in the form of dividends. Another disadvantage of corporate organization is the extra time and cost required in order to manage acorporation’s legal affairs. These costs arise because the corporation must be charteredand is considered a distinct legal entity. Such administrative costs are significant onlyfor small corporations, however.5.
 Double taxation
means that a corporation’s income is taxed first at the corporate taxrate, and then, when the income is distributed to shareholders as dividends, theincome is taxed again at the shareholder’s personal tax rate.6. a, c, d.7. a. A share of stock financialb. A personal IOU financialc. A trademark reald. A truck reale. Undeveloped land realf. The balance in the firm’s checking account financialg. An experienced and hardworking sales force realh. A bank loan agreement financial8.
 
Agency costs are caused by conflicts of interest between managers andshareholders, the owners of the firm. In most large corporations, the principals (i.e.,the stockholders) hire the agents (i.e., managers) to act on behalf of the principals inmaking many of the major decisions affecting the corporation and its owners.However, it is unrealistic to believe that the agents’ actions will always beconsistent with the objectives that the stockholders would like to achieve.Managers may choose not to work hard enough, to over-compensate themselves, toengage in empire building, to over-consume perquisites, and so on.Corporations use numerous arrangements in an attempt to ensure that managers’actions are consistent with stockholders’ objectives. Agency costs can be mitigatedby ‘carrots,’ linking the manager’s compensation to the success of the firm, or byhttp://shaikhwaqar.blogspot.com1-2
 
‘sticks,’ creating an environment in which poorly performing managers can beremoved.9. Capital budgeting decisionsShould a new computer be purchased?Should the firm develop a new drug?Should the firm shut down an unprofitable factory?Financing decisionsShould the firm borrow money from a bank or sell bonds?Should the firm issue preferred stock or common stock?Should the firm buy or lease a new machine that it is committed to acquiring?10. A bank loan is not a ‘real’ asset that can be used to produce goods or services. Rather,a bank loan is a claim on cash flows generated by other activities, which makes it afinancial asset.11. Investment in research and development creates ‘know-how.’ This knowledge isthen used to produce goods and services, which makes it a real asset.12. The responsibilities of the treasurer include the following: supervises cashmanagement, raising capital, and banking relationships.The controller’s responsibilities include: supervises accounting, preparation of financial statements, and tax matters.The CFO of a large corporation supervises both the treasurer and the controller.The CFO is responsible for large-scale corporate planning and financial policy.13. The stock price reflects the value of both current and future dividends theshareholders will receive. In contrast, profits reflect performance in the currentyear only. Profit maximizers may try to improve this year’s profits at the expenseof future profits. But stock price maximizers will take account of the entire streamof cash flows that the firm can generate. They are more apt to be forward looking.14. a. This action might appear, superficially, to be a grant to
 former 
employees andthus not consistent with value maximization. However, such ‘benevolent’actions might enhance the firm’s reputation as a good place to work, mightresult in greater loyalty on the part of current employees, and might contributeto the firm’s recruiting efforts. Therefore, from a broader perspective, theaction may be value maximizing.b. The reduction in dividends to allow increased reinvestment can be consistentwith maximization of current market value. If the firm has attractiveinvestment opportunities, and wants to save the expenses associated withhttp://shaikhwaqar.blogspot.com1-3

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