TCDN

1. If the corporate form of business organization has so many advantages over the sole
proprietorship, why is it so common for small businesses to initially be formed as
sole proprietorships?
A significant advantage of the sole proprietorship is that it is cheap and easy to form. If the sole
proprietor has limited capital to start with, it may not be desirable to spend part of that capital
forming a corporation. Also, limited liability for business debts may not be a significant
advantage if the proprietor has limited capital, most of which is tied up in the business anyway.
Finally, for a typical small business, the heart and soul of the business is the person who founded
it, so the life of the business may effectively be limited to the life of the founder during its early
years.
2. What should be the goal of the financial manager of a corporation? Why?
The correct goal is to maximize the current value of the outstanding stock. This focuses correctly
on enhancing the returns to shareholders, the owners of the firm. Other goals, such as
maximizing earnings, focus too narrowly on accounting income and ignore the importance of
market values in managerial finance.
3. Do you think agency problems arise in sole proprietorships and/or partnerships?
Agency conflicts typically arise when there is a separation of ownership and management of a
business. In a sole proprietorship and a small partnership, such separation is not likely to exist to
the degree it does in a corporation. However, there is still potential for agency conflicts. For
example, as employees are hired to represent the firm, there is once again a separation of
ownership and management.
4. Assume for a moment that the stockholders in a corporation have unlimited liability
for corporate debts. If so, what impact would this have on the functioning of
primary and secondary markets for common stock?
With unlimited liability, you would be very careful which stocks you invest in. In particular, you
would not invest in companies you expected to be unable to satisfy their financial obligations.
Both the primary and secondary markets for common stock would be severely hampered if this
rule existed. It would be very difficult for a young, untested business to get enough capital to
grow.
5. What is a liquid asset and why is it necessary for a firm to maintain a reasonable
level of liquid assets?
A liquid asset is defined as a type of asset that can quickly and easily be converted into cash
while retaining its market value. Liquid assets are a particularly important safeguard to have if
you experience financial hardship and need cash fast. Your liquid assets also help contribute to
your overall net worth
6. Why is interest expense excluded from the operating cash flow calculation?
Operating cash flow is equal to revenues minus costs, excluding depreciation and interest.
Depreciation expense is excluded because it does not represent an actual cash flow; interest
expense is excluded because it represents a financing expense.
7. Explain why the income statement is not a good representation of cash flow.
Most income statements contain some noncash items, so these must be accounted for when
calculating cash flows. More importantly, however, since GAAP is used to create income
statements, revenues and expenses are booked when they accrue, not when their corresponding
cash flows occur.
8. Why is it important for managers to understand the importance of both the internal
and the sustainable rates of growth?
The internal growth rate and sustainable growth rate are both important concepts in financial
management. Both of these rates are important for companies to consider when planning for
future growth and managing their financial resources effectively
9. State the assumptions that underlie the sustainable growth rate and interpret what
the sustainable growth rate means.
The usual assumptions are: Costs, assets, and current accounts (excluding notes payable)
increase proportionately with sales, the dividend payout ratio is fixed (or is given), the current
debt-equity ratio is optimal and fixed, and no new equity sales will occur. The sustainable growth
rate is the maximum rate at which sales can increase given the stated assumptions while
maintaining the funding required by that growth.
10. Suppose a firm calculates its external funding needs and finds that it is negative.
What are the firm's options in this case?
With a negative external financing need, the firm can expect to have a surplus of funds given the
projected rate of growth. The firm can use those funds to reduce current liabilities, reduce long-
term debt, buy back common stock, increase dividends, or invest in assets and resources, as
needed, to increase its growth rate.