Chapter 1: The Scope of Corporate Finance

Answers to End of Chapter Questions

1-1. A financial manager needs to know all five basic finance areas because they all impact his or her job. While the managers primary responsibilities may be raising money or
choosing investment projects, the manager also needs to know about capital markets and debte!uity optimal levels, be able to manage risks of the business and governance
of the corporation. "orporate governance is a function because a manager wants to act in the best interest of its shareholders. #ew methods of managing risk have been
developed in recent years, and a manager must be aware of these in order to ma$imi%e shareholder value.
1-&. 'nternet e$ercise
1-(.
Advantages of )roprietorships and )artnerships *isadvantages
+asy to form ,imited life
-ew regulations .nlimited liability
#o corporate income ta$es /ard to raise capital
0eing ones own boss
Advantages of "orporations *isadvantages
.nlimited life *ouble ta$ation
+asy to transfer ownership "ostly set up
,imited liability "ostly periodic reports re!uired
+asier to raise capital
1-1. +ach country has somewhat different ta$ laws, although the basics are similar. 2ne difference is that most countries, unlike the ..3., do not ta$ dividend income at the
personal ta$ level4 in other words, there is no double ta$ation of dividends. 5he ..3., in spite of recent accounting scandals, is considered to have one of the most
transparent sets of accounting rules. -oreign companies wishing to be listed on ..3. e$changes must conform to 6AA) rule, though this may change in the future if the
..3. adopts international accounting and reporting standards. 5here are also differences in corporate governance, for e$ample, lenders and companies in 7apan have closer
relationships than among ..3. corporations. )rivati%ation is reducing these differences.
1-8. )rofit ma$imi%ation and ma$imi%ing shareholder wealth could conflict. -or e$ample, a company could accept very high return 9and also very high-risk projects: that do not
return enough to compensate for the high risk. )rofits, or net income, are accounting numbers and therefore subject to manipulation. 't would be possible to show positive
profits when shareholder wealth was actually being decreased.
1
& Chapter 1
1-;. 3takeholders include anyone with an interest in the company, including stockholders. 3takeholders are also management, employees, the government, the community,
suppliers, customers, and lenders. 3takeholder wealth preservation appears to favor socialism more than capitalism. 3takeholder wealth, for e$ample, keeping on too many
employees for the firm to be efficient, may be preserved at the e$pense of stockholder wealth.
1-<. Agency cost or agency conflict refers to any time a decision is made that does not ma$imi%e shareholder wealth. -or e$ample, managers may want e$cessive benefits, such
as a fleet of company planes that ma$imi%e their person satisfaction, but conflict with ma$imi%ing shareholder wealth. 5hese costs can be minimi%e by, for e$ample, tying
managements compensation to stock price so they have an incentive to work to ma$imi%e stock price. 3uch contracts can be effective if structured properly, although they
have been critici%ed as providing e$cessive gains to managers when the entire market was rising.
1-=. +thics are critical to stockholder wealth ma$imi%ation. .nethical behavior can have severe financial conse!uences to a company, for e$ample, Arthur Anderson went
bankrupt because of its role as a corporate accountant for +nron and its other clients because of the fallout from +nrons collapse. -or many businesses, reputation is critical
to conducting business. A firm with a reputation for shady dealing will lose value relative to its ethical competitors.
Solutions to End of Chapter Problems
1-1. 'f the firm is organi%ed as a partnership, operating income will be ta$ed only once, so investors will receive >8??,??? x 91-?.18: @ >&<8,???. 'f the firm is organi%ed as a
corporation, operating income will be ta$ed once at the corporate level and again at the personal level, so investors will receive only >8??,??? x 91-?.(;:91-?.18: @ >1<;,???.
5he Acorporate ta$ wedgeB is thus >CC,???, or 1C.= percentage points. .sing the pre-1C=1 ta$ rates, partnership investors would receive a net >18?,??? of operating income,
while corporate stockholders would be able to keep only ><8,??? of the >8??,??? in operating income.
1
1-&. )ayoffs to )roject D1
)robability
6ross
)rofit
Eanagers -lat )ay 3tockholders )ayoff
Eanagers 1?F
)ayoff
3tockholders )ayoff
1( > ? >(??,??? > -(??,??? > ? > ?
1( (,???,??? (??,??? &,<??,??? (??,??? &,<??,???
1( C,???,??? (??,??? =,<??,??? C??,??? =,1??,???
+$pected )ayoff >1,???,??? >(??,??? >(,<??,??? >1??,??? >(,;??,???
1
*
#ote that this solution assumes that the corporation is not re-investing any of its profits, but is distributing
all of its profits to shareholders as dividends.
The Scope of Corporate Finance (
)ayoff to )roject D&
)robability
6ross
)rofit
Eanagers -lat )ay 3tockholders )ayoff
Eanagers 1?F
)ayoff
3tockholders )ayoff
1& >;??,??? >(??,??? >(??,??? >;?,??? >81?,???
1& C??,??? (??,??? ;??,??? C?,??? =1?,???
+$pected )ayoff ><8?,??? >(??,??? >18?,??? ><8,??? >;<8,???
)roject D1 has the higher e$pected gross profit 9>1,???,??? vs. ><8?,??? for )roject D&: and stockholders payoff 9>(,;??,??? vs. >;<8,??? for )roject D&:. 'f )roject D1 is
chosen, the manager would prefer the 1?F payoff because it provides greater compensation 9>1??,??? vs. >(??,??? flat compensation:. 5echnically under a flat
compensation arrangement the manager would be indifferent because his or her compensation would be a flat >(??,??? in either case. .nder a profit-sharing arrangement,
the manager would prefer )roject D1 because it would provide him or her with greater compensation 9>1??,??? vs. ><8,??? for )roject D&:. 5he profit-sharing arrangement
better aligns the interests of the shareholders and manager and provides ma$imum benefit to both stockholders 9>(,;??,??? vs. >;<8,??? for )roject D&: and managers
9>1??,??? vs. ><8,??? for )roject D&:.