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Solutions to Chapter 1

The Firm and the Financial Manager

1. real
executive airplanes
brand names
financial
stock
investment
capital budgeting
financing

2. A firm might cut its labor force dramatically which could reduce immediate expenses and increase profits in the short term. Over the long term, however, the firm might not be able to serve its customers properly or itmight alienate its remaining workers; if so, future profits will decrease, and the stock price will decrease in anticipation of these problems.

Similarly, a firm can boost profits over the short term by using less costly materials even if this reduces the quality of the product. Once customers catch on, sales will decrease 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-term gains.

3. The key advantage of separating ownership and management in a large corporation is that it gives the corporation permanence. The corporation continues to exist if managers are replaced or if stockholderssell their ownership interests to other investors. The corporation’s permanence is an essential characteristic in allowing corporations to obtain the large amounts of financing required by many business entities.

4. A sole proprietorship is easy to set up with a minimum of legal work. The business itself is not taxed. For tax purposes, the income of the proprietorship is treated as the incomeof the proprietor. The disadvantages of a proprietorship are unlimited liability for the debts of the firm, and difficulty in raising large amounts of capital as the business grows.

A partnership has the same tax advantage as the proprietorship. The partnership per se does not pay taxes. The partnership files a tax return, but all of the partnership income is allocated to the partnersand treated as personal income. Also, it is fairly easy to set up a partnership. Because there can be many partners, a partnership can raise capital more easily than a proprietorship. However, like sole proprietors, partners have unlimited liability for the debts of the firm. In fact, each partner has unlimited liability for all the business’s debts, not just his or her share.
Corporateorganization has the advantage of limited liability. It also allows for separation of ownership and management, since shares in the firm can be traded without changing management. The corporation also has easier access to capital markets. 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 a corporation’s legal affairs. These costs arise because the corporation must be chartered and is considered a distinct legal entity. Such administrative costs are significant only for small corporations, however.

5. Doubletaxation means that a corporation’s income is taxed first at the corporate tax rate, and then, when the income is distributed to shareholders as dividends, the income is taxed again at the shareholder’s personal tax rate.

6. a, c, d.

7. a. A share of stock financial
b. A personal IOU financial
c. A trademark real
d. A truck real
e. Undeveloped land real
f. The balance in the firm’schecking account financial
g. An experienced and hardworking sales force real
h. A bank loan agreement financial

8. Agency costs are caused by conflicts of interest between managers and shareholders, 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 in making many of the major...