Chapter 1
Corporate Finance and the
Financial Manager
,Note: All problems in this chapter are available in MyFinanceLab. An asterisk (* ) indicates
problems with a higher level of difficulty.
1. A corporation is a legal entity separate from its owners. This means ownership shares
in the corporation can be freely traded. None of the other organizational forms share
this characteristic.
2. Owners’ liability is limited to the amount they invested in the firm. Stockholders are not
responsible for any encumbrances of the firm; in particular, they cannot be required to
pay back any debts incurred by the firm.
3. Corporations and limited liability companies. Limited partnerships provide limited
liability for the limited partners, but not for the general partners.
4. Advantages: Limited liability, liquidity, infinite life
Disadvantages: Double taxation, separation of ownership and control
5. C corporations must pay corporate income taxes; S corporations do not pay corporate
taxes but must pass on the income to shareholders to whom it is taxable. S corporations
are also limited to 75 shareholders and cannot have corporate or foreign stockholders.
6. First, the corporation pays the taxes. After taxes, $2 (1 − 0.4) = $1.20 is left to pay
dividends. Once the dividend is paid, personal tax on this must be paid leaving $1.20
(1 − 0.3) = $0.84.
So after all the taxes are paid, you are left with 84¢.
7. An S corporation does not pay corporate income tax. So it distributes $2 to its
stockholders.
These stockholders must then pay personal income tax on the distribution. So they are
left with
$2 (1 − 0.3) = $1.40.
8. The investment decision is the most important decision that a financial manager makes,
as the manager must decide how to put the owners’ money to its best use.
9. The goal of maximizing shareholder wealth is agreed upon by all shareholders because
all shareholders are better off when this goal is achieved.
10. Shareholders can
a. Ensure that employees are paid with company stock and/or stock options.
b. Ensure that underperforming managers are fired.
c. Write contracts that ensure that the interests of the managers and shareholders are
closely aligned.
d. Mount hostile takeovers.
11. When your parents pay for the meal, you benefit from the food but do not take on the
cost of the food. This is similar to the agency problem in corporations, when managers
, can benefit from taking actions in their own personal interests using money that
belongs to shareholders.
12. The agent (renter) will not take the same care of the apartment as the principal (owner)
because the renter does not share in the costs of fixing damage to the apartment. To
mitigate this problem, having the renter pay a deposit would motivate the renter to keep
damages to a minimum. The deposit forces the renter to share in the costs of fixing any
problems that are caused by the renter.
13. There is an ethical dilemma when the CEO of a firm has opposite incentives to those of
the shareholders. In this case, you (as the CEO) have an incentive to potentially
overpay for another company (which would be damaging to your shareholders) because
your pay and prestige will improve.
14. The shares of a public corporation are traded on an exchange (or “over the counter” in
an electronic trading system), while the shares of a private corporation are not traded
on a public exchange.
15. A primary market is where the company sells shares of itself to investors. The
secondary market is where investors can buy and/or sell the company’s shares with
other investors (but not the company itself).
16. There are many differences to which one might point:
a. NYSE has a physical location, while NASDAQ is an OTC-computer-network.
b. NYSE is an auction market, whereas NASDAQ is a dealer market.
c. NYSE has a single market maker (the specialist) per stock, while NASDAQ has
multiple competing market makers.
d. NYSE has more stringent listing standards than those of NASDAQ.
17. Investors always buy at the ask and sell at the bid. Because ask prices always exceed
bid prices, investors “lose” this difference. It is one of the costs of transacting. Because
the market makers take the other side of the trade, they make up this difference.
18. You would need to pay the ask price to buy Yahoo! That price is $26.88 per share. If
you sold, you would receive the bid price: $26.85 per share.
19. The financial cycle describes how money flows from savers to companies and back. In the
financial cycle, (1) people invest and save their money; (2) that money, through loans
and stock, flows to companies who use it to fund growth through new products,
generating profits and wages; and (3) the money then flows back to the savers and
investors.
20. Insurance companies essentially pool premiums together from policyholders and pay
the claims of those who have an accident, fire, medical need, or die. This process
spreads the financial risk of these events out across a large pool of policyholders and the
investors in the insurance company. Similarly, mutual funds and pension funds take your
, savings and spread them out among the stocks and bonds of many different companies,
limiting your risk exposure to any one company.
21. Investment banking refers to the business of advising companies in major financial
transactions. Examples include buying and selling companies or divisions, and raising
new capital by issuing stock or bonds.
22. Mutual, pension, and hedge funds all pool together money and invest it on behalf of the
investors in the fund. They differ in terms of who the investors in the fund are and what
the primary objective is. Mutual and pension funds are most similar except that pension
funds are investing retirement savings invested through the workplace with the
objective of providing retirement income for those employees. Hedge funds are only
open to investments by wealthy individuals and endowments. They invest across all
asset categories, usually seeking low-risk investment strategies that will generate high
returns.
Corporate Finance and the
Financial Manager
,Note: All problems in this chapter are available in MyFinanceLab. An asterisk (* ) indicates
problems with a higher level of difficulty.
1. A corporation is a legal entity separate from its owners. This means ownership shares
in the corporation can be freely traded. None of the other organizational forms share
this characteristic.
2. Owners’ liability is limited to the amount they invested in the firm. Stockholders are not
responsible for any encumbrances of the firm; in particular, they cannot be required to
pay back any debts incurred by the firm.
3. Corporations and limited liability companies. Limited partnerships provide limited
liability for the limited partners, but not for the general partners.
4. Advantages: Limited liability, liquidity, infinite life
Disadvantages: Double taxation, separation of ownership and control
5. C corporations must pay corporate income taxes; S corporations do not pay corporate
taxes but must pass on the income to shareholders to whom it is taxable. S corporations
are also limited to 75 shareholders and cannot have corporate or foreign stockholders.
6. First, the corporation pays the taxes. After taxes, $2 (1 − 0.4) = $1.20 is left to pay
dividends. Once the dividend is paid, personal tax on this must be paid leaving $1.20
(1 − 0.3) = $0.84.
So after all the taxes are paid, you are left with 84¢.
7. An S corporation does not pay corporate income tax. So it distributes $2 to its
stockholders.
These stockholders must then pay personal income tax on the distribution. So they are
left with
$2 (1 − 0.3) = $1.40.
8. The investment decision is the most important decision that a financial manager makes,
as the manager must decide how to put the owners’ money to its best use.
9. The goal of maximizing shareholder wealth is agreed upon by all shareholders because
all shareholders are better off when this goal is achieved.
10. Shareholders can
a. Ensure that employees are paid with company stock and/or stock options.
b. Ensure that underperforming managers are fired.
c. Write contracts that ensure that the interests of the managers and shareholders are
closely aligned.
d. Mount hostile takeovers.
11. When your parents pay for the meal, you benefit from the food but do not take on the
cost of the food. This is similar to the agency problem in corporations, when managers
, can benefit from taking actions in their own personal interests using money that
belongs to shareholders.
12. The agent (renter) will not take the same care of the apartment as the principal (owner)
because the renter does not share in the costs of fixing damage to the apartment. To
mitigate this problem, having the renter pay a deposit would motivate the renter to keep
damages to a minimum. The deposit forces the renter to share in the costs of fixing any
problems that are caused by the renter.
13. There is an ethical dilemma when the CEO of a firm has opposite incentives to those of
the shareholders. In this case, you (as the CEO) have an incentive to potentially
overpay for another company (which would be damaging to your shareholders) because
your pay and prestige will improve.
14. The shares of a public corporation are traded on an exchange (or “over the counter” in
an electronic trading system), while the shares of a private corporation are not traded
on a public exchange.
15. A primary market is where the company sells shares of itself to investors. The
secondary market is where investors can buy and/or sell the company’s shares with
other investors (but not the company itself).
16. There are many differences to which one might point:
a. NYSE has a physical location, while NASDAQ is an OTC-computer-network.
b. NYSE is an auction market, whereas NASDAQ is a dealer market.
c. NYSE has a single market maker (the specialist) per stock, while NASDAQ has
multiple competing market makers.
d. NYSE has more stringent listing standards than those of NASDAQ.
17. Investors always buy at the ask and sell at the bid. Because ask prices always exceed
bid prices, investors “lose” this difference. It is one of the costs of transacting. Because
the market makers take the other side of the trade, they make up this difference.
18. You would need to pay the ask price to buy Yahoo! That price is $26.88 per share. If
you sold, you would receive the bid price: $26.85 per share.
19. The financial cycle describes how money flows from savers to companies and back. In the
financial cycle, (1) people invest and save their money; (2) that money, through loans
and stock, flows to companies who use it to fund growth through new products,
generating profits and wages; and (3) the money then flows back to the savers and
investors.
20. Insurance companies essentially pool premiums together from policyholders and pay
the claims of those who have an accident, fire, medical need, or die. This process
spreads the financial risk of these events out across a large pool of policyholders and the
investors in the insurance company. Similarly, mutual funds and pension funds take your
, savings and spread them out among the stocks and bonds of many different companies,
limiting your risk exposure to any one company.
21. Investment banking refers to the business of advising companies in major financial
transactions. Examples include buying and selling companies or divisions, and raising
new capital by issuing stock or bonds.
22. Mutual, pension, and hedge funds all pool together money and invest it on behalf of the
investors in the fund. They differ in terms of who the investors in the fund are and what
the primary objective is. Mutual and pension funds are most similar except that pension
funds are investing retirement savings invested through the workplace with the
objective of providing retirement income for those employees. Hedge funds are only
open to investments by wealthy individuals and endowments. They invest across all
asset categories, usually seeking low-risk investment strategies that will generate high
returns.
