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Fundamentals of Corporate Finance

Second European Edition

Solutions Manual
Chapter 2
Basic
8. Partnerships [LO1] Why are professional firms, such as
accountants and lawyers, more likely to have a partnership form
rather than a sole ownership or limited company structure?
Answer: Professional firms are more likely to choose a partnership
corporate form because it allows partners to maintain their sole
proprietorship business model but draw from the economies of scale
that come from combining business operations. That is, partners can
keep and grow their own clients and have the benefit of paying for a
share of admin resources, overheads and assets.
9. Macro Governance [LO3] Why do you think corporate behaviour
in bank-based financial systems would be different from that in
market-based financial systems? How do you think other differences
in the macro environment can affect corporate objectives?
Answer: Corporate behaviour in bank-based financial systems
would be different from market-based financial systems because of
the nature of financing between the two financial systems. In a bank
based financial system, companies will strive to meet the
requirements set out by their chief financiers, which are banks.
Banks, as a major source of funding, will influence corporate risk
taking behaviour and encourage longer investment horizons. On the
other hand, corporations in market based environment must satisfy
the needs of the investing public, who naturally focus on share price
performance.
10.
Corporate Governance Principles [LO3] In your opinion
what is the most important issue in corporate governance? Explain
your answer.
Answer: Many issues are important in running a firm and your
answer depends on the type of firm you are discussing. Moreover,
your role in a company would make you feel one issue is more
important than any other. For example, if you are a minority
shareholder, you would be concerned with how the majority or
controlling shareholders engage with management and whether
they are able to abuse their power. If you are an international
investor, then country-level corporate governance would be more
important.
11.
Corporate Governance [LO1] Explain why the corporate
governance of a sole proprietorship should be different from that of
a partnership, which in turn should be different from that of a limited
corporation.

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Second European Edition

Answer: In a sole proprietorship there is no real need for formal


governance structures since all business activities are concentrated
on one individual. That is, the stakeholders, the shareholders, and
the managers are all one individual. In a partnership, semi-formal
corporate governance structures are present, such as a Partnership
Agreement or Partnership Deed. These are designed to ensure that
each partner carries out his or her duties as expected. A limited
corporation is a separate legal entity that is different from a sole
proprietorship and partnership.
12.
Corporate Governance across the World [LO3] Why is
there no single code of corporate governance applied to all the
countries of the world? Would emerging-market firms have different
issues to consider?
Answer: While a corporations goal remains the same (maximization of share value),
different institutional, economic, legal, financial, and cultural characteristics means that the
corporate governance environment will vary across countries. Similarly, corporate governance
codes for emerging market firms should consider the real issues in each country such as poor
quality of law enforcement and limited ability to obtain independent directors. Thus,
corporate governance structures that are borrowed from developed markets such as the US,
UK, Japan, Germany and others must be adjusted in a manner that suits the environment in
emerging markets..

13.
Sole Proprietorship [LO1] Sole proprietorship is the most
common type of business throughout the world. Why do you think
this is the case? What are the benefits of sole proprietorships over
other forms of business?
Answer: Sole proprietorships are the most common types of
business throughout the world because they are the simplest to set
up. In many countries, you do not need to complete any forms or
registration to begin running a sole proprietorship.
14.
Stakeholders [LO2] Discuss what is meant by a stakeholder.
In what ways are stakeholders represented in two-tier board
structures? How does this differ from companies with a unitary
board structure? Use real examples to illustrate your answer.
Answer: A stakeholder is any party which has an interest in the
operations of the company, either directly or indirectly. Examples
include shareholders, employees, creditors, customers, suppliers,
normal citizens, etc. In a two tier board system, the board structure
is divided into two parts consisting of the supervisory and executive
board. The supervisory board is composed of outside shareholders
and other stakeholders, such as employee groups (trade unions) and
banks (capital providers). A good example of a supervisory board is
DaimlerChrysler AG, which was comprised of 20 members - half of
which were elected by shareholders at the Annual Meeting. The
other half comprises members elected by the companys employees
who work in Germany (Annual report, 2008). The supervisory board
can hire or fire any member of the executive board. The latter is
composed of executive directors who direct the day-to-day
McGraw-Hill Education 2014

Fundamentals of Corporate Finance


Second European Edition

operations of the firm. In a unitary board, the executive and nonexecutive directors sit on the same board and it is very rare for
stakeholders such as employees to be represented.

Intermediate
15.
Agency Problems [LO2] Who owns a corporation? Describe
the process whereby the owners control the firms management.
What is the main reason why an agency relationship exists in the
corporate form of organization? In this context, what kinds of
problem can arise?
Answer: In the corporate form of ownership, the shareholders are
the owners of the firm. The shareholders elect the directors of the
corporation, who in turn appoint the firms management. This
separation of ownership from control in the corporate form of
organization is what causes agency problems to exist. Management
may act in its own or someone elses best interests, rather than
those of the shareholders. If such events occur, they may contradict
the goal of maximizing the share price of the equity of the firm.
16.
Board Committees [LO2] Explain why you think public listed
companies have board subcommittees like the remuneration
committee, audit committee and risk management committee?
Why could this responsibility not simply be left to the board of
directors? Explain.
Answer: In large complex corporations, the sheer range of tasks
and responsibilities can be exceptionally large. The board of
directors or executive board should be seen as the apex of a
corporations management structure. If other tasks are required by
the board that draw on specialized skills or experiences, or if an
activity (such as audit or remuneration) must be handled
independently to ensure accountability, then sub-committees will be
formed.
17.
Corporate Governance [LO3] Is it possible to improve one
aspect of corporate governance in a firm but weaken another at the
same time? Use an illustration to explain your answer.
Answer: Yes, it is possible to improve one aspect of a corporate
governance principle and weaken another. For example, if you
improve the rights of shareholders, it may weaken the rights of
other stakeholders such as employees and communities. Many
examples can be given here and lecturers should encourage
students to come up with their own solutions.
18.
Government
Ownership
[LO3]
In
recent
years,
governments have taken control of banks through buying their
shares. What impact does this have on the lending culture of these
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banks? Is this consistent with shareholder maximization? Use an


example to illustrate your answer.
Answer: Governments have different objectives to shareholders.
Whereas shareholders wish to maximize the value of their own
investment, governments are more concerned with maximizing
social welfare. This can sometimes contradict that of shareholders.
For example, several governments purchased the shares of
financially stricken banks in 2008. Shortly afterwards, they put
pressure on the banks to lend to smaller companies and give
mortgages, even though the banks themselves felt that the lending
decisions were not value maximizing.
Challenge
19.
Agency Problems [LO2] Suppose you own equity in a
company. The current share price is 25. Another company has just
announced that it wants to buy your company, and will pay 35 per
share to acquire all the outstanding shares. Your companys
management immediately begins fighting off this hostile bid. Is
management acting in the shareholders best interests? Why or why
not?
Answer: Clearly the bidder thinks that the 35 is money well spent
and that your firm has untapped value that the market does not
appreciate. Managers have many agendas, including job safety.
However, it is also possible that they do not believe that the bidding
company will be good for the company over the longer term.
Chapter 22 on Mergers and Acquisitions covers a very similar
situation when Ryanair submitted a higher bid for Aer Lingus. In the
end, the bid was unsuccessful because the major shareholders did
not believe that the takeover was good for the company.
20.
Agency Problems and Corporate Ownership [LO3]
Corporate ownership varies around the world. Historically,
individuals have owned the majority of shares in public corporations
in the United States. In Germany and Japan, however, banks and
other large financial institutions own most of the equity in public
corporations. Do you think agency problems are likely to be more or
less severe in Germany and Japan than in the United States? Why?
In recent years, large financial institutions such as mutual funds and
pension funds have been becoming the dominant owners of shares
in the United Kingdom, and these institutions are becoming more
active in corporate affairs. What are the implications of this trend for
agency problems and corporate control?
Answer: We would expect agency problems to be less severe in
countries with a relatively small percentage of individual ownership.
Fewer individual owners should reduce the number of diverse
opinions concerning corporate goals. The high percentage of
institutional ownership might lead to a higher degree of agreement
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Fundamentals of Corporate Finance


Second European Edition

between owners and managers on decisions concerning risky


projects. In addition, institutions may be better able to implement
effective monitoring mechanisms on managers than can individual
owners, based on the institutions deeper resources and experiences
with their own management. The increase in institutional ownership
of equity in the United Kingdom and the growing activism of these
large shareholder groups may lead to a reduction in agency
problems for U.K. corporations and a more efficient market for
corporate control.
21.
Executive Compensation [LO2] Critics have charged that
compensation to top managers in the banking sector is simply too
high and should be cut back. Look at the financial accounts of some
banks in your region and determine the total pay of their chief
executive officers. Are such amounts excessive? In answering, it
might be helpful to recognize that superstar athletes such as
Cristiano Ronaldo and Lionel Messi, top entertainers such as Tom
Cruise and Kate Winslet, as well as many others at the top of their
respective fields earn at least as much, if not a great deal more.
Answer: How much is too much? Who is worth more, Cristiano
Ronaldo or Lionel Messi? The simplest answer is that there is a
market for executives just as there is for all types of labour.
Executive compensation is the price that clears the market. The
same is true for athletes and performers.
22.
Corporate Governance around the World [LO3] In the
Middle East, many companies have a Sharia Supervisory Board to
which the board of directors report. Evaluate the merits of such a
governance structure and argue whether this approach to
governance could be extended to other areas where the supervisory
board guides on ethical, social or environmental matters.
Answer: Supervisory boards, like the Sharia board, can be of use
when the objectives of a firm are tied to social, environmental or
ethical issues. The purpose of such a board is to guide executives in
making the correct decisions with respect to the companys remit.
An example of a supervisory board that may work in a separate area
is that of football teams. In this situation, the supervisory board
would consist of fan representatives and they would guide the
executive board on football decisions. Other areas include firms
with where public oversight is required, such as the banking sector.
23.
Institutional
Shareholders
[LO2]
Regulators
have
developed a number of new policies with respect to institutional
shareholder involvement in the running of firms. Review the reasons
why regulators would prefer more or less involvement of institutions
in the running of corporations. In addition, discuss the proposals
that have been put forward by regulators in your own country, and
whether these are likely to be effective.

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Fundamentals of Corporate Finance


Second European Edition

Answer: Institutional shareholders are increasingly becoming


instrumental in demanding good corporate governance in
companies in which they invest, (e.g. NAPF in UK and CalPERS in
US). The main reason why institutions are important in corporate
governance is because they are normally the largest shareholders in
the firm. As representatives of their investee base, they should take
the role of owners in monitoring firms. With respect to country
specific regulations, the student should review their own countrys
corporate governance code and take a view on the effectiveness of
the code.
24.
Codes of Corporate Governance [LO3] Download a set of
country codes from the European Corporate Governance Institute
website (www.ecgi.org) and identify any differences and similarities
between your chosen country and the US codes. What are the main
differences between your chosen country and the USs governance
codes?
Answer: The student would be expected to carry out this research
themselves.

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