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Chapter1InvestmentEnvironment11

Part1
IntroductiontoManagerialFinance
ChaptersinthisPart
Chapter1

TheRoleandEnvironmentofManagerialFinance

Chapter2

FinancialStatementsandAnalysis

Chapter3

CashFlowandFinancialPlanning

Integrative Case 1: Track Software, Inc.

1Part1IntroductiontoManagerialFinance

Chapter1
TheRoleandEnvironmentofManagerialFinance

Instructors Resources
Overview
Thischapterintroducesthestudenttothefieldoffinanceandexplorescareeropportunitiesinboth
financialservicesandmanagerialfinance.Thethreebasiclegalformsofbusinessorganization(sole
proprietorship,partnership,andcorporation)andtheirstrengthsandweaknessesaredescribed,aswellas
therelationshipbetweenmajorpartiesinacorporation.Themanagerialfinancefunctionisdefinedand
differentiatedfromeconomicsandaccounting.Thechapterthensummarizesthethreekeyactivitiesofthe
financialmanager:financialanalysisandplanning,investmentdecisions,andfinancingdecisions.A
discussionofthefinancialmanagersgoalsmaximizingshareholderwealthandpreservingstakeholder
wealthandtheroleofethicsinmeetingthesegoalsispresented.Thechapterincludesdiscussionofthe
agencyproblemtheconflictthatexistsbetweenmanagersandownersinalargecorporation.Moneyand
capitalmarketsandtheirmajorcomponentsareintroducedinthischapter.Thefinalsectioncoversa
discussionoftheimpactoftaxationonthefirmsfinancialactivities.

Study Guide
ThefollowingStudyGuideexampleissuggestedforclassroompresentation:
Example
1
3

Topic
Earningspershare
Incometaxcalculation

Suggested Answer to Chapter Opening Critical


Thinking Question
WhatadditionalconcernsmightacorporateCFOfacewhenacompanyexpandsintointernational
markets?
Besidestheproblemofcurrencyrisk,therearetaxissues,personnelconsiderationsandlocal
bureaucraciesandregulations.Recently,ofcourse,securityconcernshavebecomeincreasingimportantin
someareasoftheworld.Theseissuescanvaryconsiderablyfromareaoftheglobetoanother.Notallof
theseconcernsfallsolelyupontheshouldersoftheCFO,buttheyallhavefinancialramificationstothe
companyandtheCFOmustbeabreastofwhatisgoingonineverypartofthecompany.Chapter18of
thistexthasmoretosayonthistopic.
Thismeansitismorallyrightformanagerstostrivetomaximizeshareholderwealth,orthestockprice,
andmorallywrongnottodoso.Whenmanagersshirktheirduties,orconsumeexcessiveperks,thisis
morallywrong.Maximizingshareholderwealthsubjecttoethicalconstraintsismorethanjustagoodidea
itistherightthingtodo.

Chapter1TheRoleandEnvironmentofManagerialFinance5

Answers to Review Questions


1.

Financeistheartandscienceofmanagingmoney.Financeaffectsallindividuals,businesses,and
governmentsintheprocessofthetransferofmoneythroughinstitutions,markets,andinstruments.

2.

Financialservicesistheareaoffinanceconcernedwiththedesignanddeliveryofadviceand
financialproductstoindividuals,businesses,andgovernment.
Managerialfinanceencompassesthefunctionsofbudgeting,financialforecasting,credit
administration,investmentanalysis,andfundsprocurementforthefirm.Managerialfinanceisthe
managementofthefirmsfundswithinthefirm.Thisfieldoffersmanycareeropportunities,
includingfinancialanalyst,capitalbudgetinganalyst,andcashmanager(Note:Otheranswers
possible).

3.

Soleproprietorshipsarethemostcommonformofbusinessorganization,whilecorporationsare
responsibleforthemajorityofbusinessreceiptsandprofits.Corporationsaccountforthemajorityof
businessreceiptsandprofitsbecausetheyreceivecertaintaxadvantagesandcanexpandmoreeasily
duetoaccesstocapitalmarkets.

4.

Stockholdersarethetrueowners,throughequityincommonandpreferredstock,ofacorporation.
Theyelecttheboardofdirectors,whichhastheultimateauthoritytoguidecorporateaffairsandset
generalpolicy.Theboardisusuallycomposedofkeycorporatepersonnelandoutsidedirectors.The
president(CEO)reportstotheboard.Heorsheisresponsiblefordaytodayoperationsandcarrying
outpoliciesestablishedbytheboard.Theownersofthecorporationdonothaveadirectrelationship
withmanagementbutgivetheirinputthroughtheelectionofboardmembersandvotingonmajor
charterissues.Theownersofthefirmarecompensatedthroughthereceiptofcashdividendspaidby
thefirmorbyrealizingcapitalgainsthroughincreasesinthepriceoftheircommonstockshares.

5.

Themostpopularformoflimitedliabilityorganizationsotherthancorporationsare:

LimitedpartnershipsApartnershipwithatleastonegeneralpartnerwithunlimitedliabilityand
oneormorelimitedpartnersthathavelimitedliability.Inreturnforthelimitedliability,the
limitedpartnersareprohibitedfromactivemanagementofthepartnership.
ScorporationIfcertainrequirementsaremet,theScorporationcanbetaxedasapartnership
butreceivemostofthebenefitsofthecorporateformoforganization.
Limitedliabilitycorporation(LLC)ThisformoforganizationislikeanScorporationinthatit
istaxedasapartnershipbutprimarilyfunctionslikeacorporation.TheLLCdiffersfromthe
Scorporationinthatitisallowedtoownothercorporationsandbeownedbyothercorporations,
partnerships,andnonU.S.residents.
Limitedliabilitypartnership(LLP)Apartnershipformauthorizedbymanystatesthatgivesthe
partnerslimitedliabilityfromtheactsofotherpartners,butnotfrompersonalindividualactsof
malpractice.TheLLPistaxedasapartnership.Thisformismostfrequentlyusedbylegaland
accountingprofessionals.

Thesefirmsgenerallydonothavelargenumbersofowners.Mosttypicallyhavefewerthan
100owners.

6Part1IntroductiontoManagerialFinance

6.

Virtuallyeveryfunctionwithinafirmisinsomewayconnectedwiththereceiptordisbursementof
cash.Thecashrelationshipmaybeassociatedwiththegenerationofsalesthroughthemarketing
department,theincurringofrawmaterialcoststhroughpurchasing,ortheearningsofproduction
workers.Sincefinancedealsprimarilywithmanagementofcashforoperationofthefirmevery
personwithinthefirmneedstobeknowledgeableoffinancetoeffectivelyworkwithemployeesof
thefinancialdepartments.

7.

Thetreasurerorfinancialmanagerwithinthematurefirmmustmakedecisionswithrespectto
handlingfinancialplanning,acquisitionoffixedassets,obtainingfundstofinancefixedassets,
managingworkingcapitalneeds,managingthepensionfund,managingforeignexchange,and
distributionofcorporateearningstoowners.

8.

Financeisoftenconsideredaformofappliedeconomics.Firmsoperatewithintheeconomyandmust
beawareofeconomicprinciples,changesineconomicactivity,andeconomicpolicy.Principles
developedineconomictheoryareappliedtospecificareasinfinance.Frommacroeconomicscomes
theinstitutionalstructureinwhichmoneyandcreditflowstakeplace.Frommicroeconomics,finance
drawstheprimaryprincipleusedinfinancialmanagement,marginalanalysis.Sincethisanalysisof
marginalbenefitsandcostsisacriticalcomponentofmostfinancialdecisions,thefinancialmanager
needsbasiceconomicknowledge.

9.

Accountantsoperateonanaccrualbasis,recognizingrevenuesatthepointofsaleandexpenseswhen
incurred.Thefinancialmanagerfocusesontheactualinflowsandoutflowsofcash,recognizing
revenueswhenactuallyreceivedandexpenseswhenactuallypaid.
Theaccountantprimarilygathersandpresentsfinancialdata;thefinancialmanagerdevotesattention
primarilytodecisionmakingthroughanalysisoffinancialdata.

10. Thetwokeyactivitiesofthefinancialmanagerasrelatedtothefirmsbalancesheetare:
(a) Makinginvestmentdecisions:Determiningboththemostefficientlevelandthebestmixof
assets;and
(b) Makingfinancingdecisions:Establishingandmaintainingthepropermixofshortandlongterm
financingandraisingneededfinancinginthemosteconomicalfashion.
Makinginvestmentdecisionsconcernsthelefthandsideofthebalancesheet(currentandfixed
assets).Makingfinancingdecisionsdealswiththerighthandsideofthebalancesheet(current
liabilities,longtermdebt,andstockholdersequity).
11. Profitmaximizationisnotconsistentwithwealthmaximizationdueto:(1)thetimingofearningsper
share,(2)earningswhichdonotrepresentcashflowsavailabletostockholders,and(3)afailureto
considerrisk.
12. Riskisthechancethatactualoutcomesmaydifferfromexpectedoutcomes.Financialmanagersmust
considerbothriskandreturnbecauseoftheirinverseeffectonthesharepriceofthefirm.Increased
riskmaydecreasetheshareprice,whileincreasedreturnmayincreasetheshareprice.
13. Thegoalofthefirm,andthereforeallmanagers,istomaximizeshareholderwealth.Thisgoalis
measuredbyshareprice;anincreasingpricepershareofcommonstockrelativetothestockmarket
asawholeindicatesachievementofthisgoal.

Chapter1TheRoleandEnvironmentofManagerialFinance7

14. Corporategovernancereferstoasystemoforganizationalcontrolthatisusedtodefineandestablish
linesofresponsibilityandaccountabilityamongmajorparticipantsinthecorporation.These
participantsincludetheshareholders,boardofdirectors,officersandmanagersofthecorporations
andotherstakeholders.Acompanysorganizationalchartisanexampleofabroadarrangementof
corporategovernance.Moredetailedresponsibilitieswouldbeestablishedwithineachbranchofthe
organizationalchart.
TheSarbanesOxleyActof2002isdirectedtowardreducingtheapparentconflictsofinterestthat
existinmanycorporatestructures.TheActhasmanyprovisions,butthemajorthrustoftheactisto
reducethenumberofsituationsinwhichaconflictofinterestcanariseandtoholdmanagementmore
accountableforthefinancialandoperatinginformationtheycommunicatedtothepublic.
15. Inrecentyearsthemagnitudeandseverityofwhitecollarcrimehasincreaseddramatically,witha
correspondingemphasisonprosecutionbygovernmentauthorities.Asaresult,theactionsofall
corporationsandtheirexecutiveshavebeensubjectedtocloserscrutiny.Thisincreasedscrutinyof
thistypeofcrimehasresultedinmanyfirmsestablishingcorporateethicsguidelinesandpoliciesto
coveremployeeactionsindealingwithallcorporateconstituents.Theadoptionofhighethical
standardsbyacorporationstrengthensitscompetitivepositionbyreducingthepotentialforlitigation,
maintainingapositiveimage,andbuildingshareholderconfidence.Theresultisenhancementof
longtermvalueandapositiveeffectonshareprice.
16. Marketforcesforexample,shareholderactivismfromlargeinstitutionalinvestorscanreduceor
avoidtheagencyproblembecausethesegroupscanusetheirvotingpowertoelectnewdirectorswho
supporttheirobjectivesandwillacttoreplacepoorlyperformingmanagers.Inthisway,thesegroups
placepressureonmanagementtotakeactionsthatmaximizeshareholderwealth.
Thethreatofhostiletakeoversalsoactsasadeterrenttotheagencyproblem.Hostiletakeoversoccur
whenacompanyorgroupnotsupportedbyexistingmanagementattemptstoacquirethefirm.
Becausetheacquirerlooksforcompaniesthatarepoorlymanagedandundervalued,thisthreat
motivatesmanagerstoactinthebestinterestsofthefirmsowners.
Institutionalinvestorsareapowerfulsourceofshareholderinvolvementinthemonitoringof
managerstoreducetheagencyproblem.Institutionsholdlargequantitiesofsharesinmanyofthe
corporationsintheirportfolio.Managersoftheseinstitutionsshouldbeactiveinthemonitoringof
managementandvotetheirsharesforthebenefitoftheshareholders.Thepowerofinstitutional
investorsfarexceedsthevotingpowerofindividualinvestors.
17. Firmsincuragencycoststopreventorminimizeagencyproblems.Itisunclearwhethertheyare
effectiveinpractice.Thefourcategoriesofagencycostaremonitoringexpendituresincurredbythe
ownersforauditandcontrolprocedures,bondingexpenditurestoprotectagainstthepotential
consequencesofdishonestactsbymanagers,structuringexpendituresthatusemanagerial
compensationplanstoprovidefinancialincentivesformanagerialactionsconsistentwithshareprice
maximization,andopportunitycostsresultingfromthedifficultiestypicallyencounteredbylarge
organizationsinrespondingtonewopportunities.
Theagencyproblemandtheassociatedagencycostscanbereducedbyaproperlyconstructedand
followedcorporategovernancestructure.Thestructureofthegovernancesystemshouldbedesigned
toinstituteasystemofchecksandbalancestoreducetheabilityandincentivesofmanagementto
deviatefromthegoalofshareholderwealthmaximization.

8Part1IntroductiontoManagerialFinance

Structuringexpendituresarecurrentlythemostpopularwaytodealwiththeagencyproblemand
alsothemostpowerfulandexpensive.Compensationplanscanbeeitherincentiveorperformance
plans.Incentiveplanstiemanagementperformancetoshareprice.Managersmayreceivestock
optionsgivingthemtherighttopurchasestockatasetprice.Thisprovidestheincentivetotake
actionsthatmaximizestockpricesothatthepricewillriseabovetheoptionspricelevel.Thisform
ofcompensationplanhasfallenfromfavorrecentlybecausemarketbehavior,whichhasasignificant
effectonshareprice,isnotundermanagementscontrol.Asaresult,performanceplansaremore
populartoday.Withthese,compensationisbasedonperformancemeasures,suchasearningsper
share(EPS),EPSgrowth,orotherreturnratios.Managersmayreceiveperformancesharesand/or
cashbonuseswhenstatedperformancegoalsarereached.
Inpractice,recentstudieshavebeenunabletodocumentanysignificantcorrelationbetweenCEO
compensationandshareprice.
18. Thekeyparticipantsinfinancialtransactionsareindividuals,businesses,andgovernments.These
partiesparticipatebothassuppliersanddemandersoffunds.Individualsarenetsuppliers,which
meansthattheysavemoredollarsthantheyborrow,whilebothbusinessesandgovernmentsarenet
demanderssincetheyborrowmorethantheysave.Onecouldsaythatindividualsprovidetheexcess
fundsrequiredbybusinessesandgovernments.
19. Financialmarketsprovideaforuminwhichsuppliersoffundsanddemandersofloansand
investmentscantransactbusinessdirectly.
Primarymarketisthenameusedtodenotethefactthatasecurityisbeingissuedbythedemanderof
fundstothesupplieroffunds.AnexamplewouldbeMicrosoftCorporationsellingnewsharesof
commonstocktothepublic.
Secondarymarketreferstothetradingofsecuritiesamonginvestorssubsequenttotheprimary
marketissuance.Insecondarymarkettrading,nonewfundsarebeingraisedbythedemanderof
funds.Thesecurityistradingownershipamonginvestors.AnexamplewouldbeindividualA
buyingcommonstockofMicrosoftthroughabroker.
Financialinstitutionsandfinancialmarketsarenotindependentofeachother.Itisquitecommonto
findfinancialinstitutionsactivelyparticipatinginboththemoneymarketandthecapitalmarketas
bothsuppliersanddemandersoffunds.Financialinstitutionsoftenchanneltheirinvestmentsand
obtainneededfinancingthroughthefinancialmarkets.Thisrelationshipexistssincetheseinstitutions
mustusethestructureofthefinancialmarketplacetofindasupplieroffunds.
20. Themoneymarketisafinancialrelationshipbetweenthesuppliersanddemandersofshorttermdebt
securitiesmaturinginoneyearorless,suchasU.S.Treasurybills,commercialpaper,andnegotiable
certificatesofdeposit.Themoneymarkethasnoonespecificphysicallocation.Typicallythe
suppliersanddemandersarematchedthroughthefacilitiesoflargebanksinNewYorkCityand
throughgovernmentsecuritiesdealers.
21. TheEurocurrencymarketistheinternationalequivalentoftheU.S.moneymarketandisusedfor
shorttermbanktimedepositsdenominatedindollarsorothermajorcurrencies.Thesedepositscan
belentbythebankstocreditworthycorporations,governments,orotherbanksattheLondon
InterbankOfferedRate(LIBOR)thebaserateusedforallEurocurrencyloans.

Chapter1TheRoleandEnvironmentofManagerialFinance9

22. Thecapitalmarketisafinancialrelationshipcreatedbyanumberofinstitutionsandarrangements
thatallowsthesuppliersanddemandersoflongtermfunds(withmaturitiesgreaterthanoneyear)to
maketransactions.Thekeysecuritiestradedinthecapitalmarketsarebondspluscommonand
preferredstock.
23. Securitiesexchangesprovideaforumfordebtandequitytransactions.Theybringtogether
demandersandsuppliersoffunds,createacontinuousmarketforsecurities,allocatescarcecapital,
determineandpublicizesecurityprices,andaidinnewfinancing.
Theoverthecountermarketisnotaspecificinstitution,butratheranintangiblemarketforthe
buyersandsellersofsecuritiesnotlistedonthemajorexchanges.Thedealersarelinkedwith
purchasersandsellersthroughtheNationalAssociationofSecuritiesDealersAutomatedQuotation
System(NASDAQ),acomplextelecommunicationsnetwork.Pricesoftradedsecuritiesare
determinedbybothcompetitivebidsandnegotiation.Theoverthecountermarketdiffersfrom
organizedsecurityexchangesinitslackofaphysicaltradinglocationandtheabsenceoflistingand
membershiprequirements.
24. InadditiontotheU.S.capitalmarkets,corporationscanraisedebtandequityfundsincapitalmarkets
locatedinothercountries.TheEurobondmarketistheoldestandlargestinternationaldebtmarket.
Corporateandgovernmentbondsissuedinthismarketaredenominatedindollarsorothermajor
currenciesandsoldtoinvestorsoutsidethecountryinwhosecurrencythebondsaredenominated.
Foreignbondmarketsalsoprovidecorporationswiththeopportunitytotapothercapitalsources.
Corporationsorgovernmentsissuebondsdenominatedinthelocalcurrencyandsoldonlyinthat
homemarket.Theinternationalequitymarketallowscorporationstosellblocksofstocktoinvestors
inseveralcountries,providingadiversifiedinvestorbaseandadditionalopportunitiestoraiselarger
amountsofcapital.
25. Anefficientmarketwillallocatefundstotheirmostproductiveusesduetocompetitionamong
wealthmaximizinginvestors.Investorsdeterminethepriceofassetsthroughtheirparticipationinthe
financialmarketsandpublicizethosepricesthatarebelievedtobeclosetotheirtruevalue.
26. Theordinaryincomeofacorporationisincomeearnedthroughthesaleofafirmsgoodsorservices.
Taxesoncorporateordinaryincomehavetwocomponents:afixedamountonthebasefigureforits
incomebracketlevel,plusaprogressivepercentage,rangingfrom15%to39%,appliedtotheexcess
overthebasebracketfigure.Acapitalgainoccurswhenacapitalassetissoldformorethanitsinitial
purchaseprice.Capitalgainsareaddedtoordinaryincomeandtaxedattheregularcorporaterates.
Theaveragetaxrateiscalculatedbydividingtaxespaidbytaxableincome.Forfirmswithtaxable
incomeof$10millionorless,itrangesfrom15to34percent.Forfirmswithtaxableincomein
excessof$10million,itrangesbetween34and35percent.Themarginaltaxrateistherateatwhich
additionalincomeistaxed.
27. Intercorporatedividendsarethosereceivedbyacorporationforstockheldinothercorporations.To
avoidtripletaxation,ifownershipislessthan20%,thesedividendsaresubjecttoa70%exclusion
fortaxpurposes.(Theexclusionpercentageishigherifownershipexceeds20%.)Sinceinterest
incomefromintercorporatebondinvestmentsistaxedinfull,thistaxexclusionincreasesthe
attractivenessofstockinvestmentsoverbondinvestmentsmadebyonecorporationinanother.
28. Thetaxdeductibilityofcorporateexpensesreducestheiractualaftertaxcost.Corporateinterestisa
taxdeductibleexpense,whiledividendsarenot.

10Part1IntroductiontoManagerialFinance

Suggested Answer to Critical Thinking Question


for in Practice and Global Focus Box
ThesharepriceofBRKAhasneverbeensplittomakethesharesmoreaffordabletoaverage
investors.Whymightthecompanyrefusetosplititssharestomakethemmoreaffordableto
averageinvestors?
TheprimaryreasonthatBerkshireHathawaydoesnotsplitthepriceofitscommonstockisbecause
WarrenBuffettsphilosophyisthatastocksplitismeaninglessfinanciallyandonlyservesasawayto
lowerthestockpricesothatmoreinvestorsareabletopurchasethestock.Mr.Buffetthasstatedhisbelief
thattrueinvestorsarelongterminvestorswhoholdastockthroughthickandthin.Withfewer
shareholders,therearelesspeoplethatthecompanymanagementhastoanswertoandinvestorswhocan
affordthesteeppriceoftheBerkshireHathawaystockarelikelytobeseriousindividualinvestorsor
institutionalinvestorssuchasmutualfunds.

Suggested Answer to Critical Thinking Question


for Focus on Ethics Box
Whatdoesitmeantosaythatmaximizingshareholderwealthisamoralimperativefor
managers?
Thismeansitismorallyrightformanagerstostrivetomaximizeshareholderwealth,orthestockprice,
andmorallywrongnottodoso.Whenmanagersshirktheirduties,orconsumeexcessiveperks,thisis
morallywrong.Maximizingshareholderwealthsubjecttoethicalconstraintsismorethanjustagoodidea
itistherightthingtodo.

Answers to Warm-Up Exercises


E11.

Comparisonofadvantagesanddisadvantagesofapartnershipvs.incorporation.

Answer: WhileJackandAnndisagreeoverwhetherornottheirfirmshouldincorporateorremainasa
partnership,eachformofbusinessorganizationhasitsadvantagesanddisadvantages.One
advantageofapartnershipisthatincomeistaxedateachpartnersindividualtaxratewhich
includes10%,15%,25%andhigherratesuptoatoprateof35%whilecorporateratesare
15%,25%,34%withatoprateof39%.Thecorporationisallowedtoretainaccumulated
taxableincome,butforapersonalservicecorporationsuchasJackandAnnstaxpreparation
service,thereisanadditionaltax,calledanaccumulatedearningstax,of15%foraccumulated
taxableincomeinexcessof$150,000.Ifcorporateearningsarepaidoutassalary,Jackand
Annwillpaytheirindividualratesastheydoontheirpartnershipearnings.Ifsomeofthe
incomeispaidoutintheformofdividendsitwillbetaxedtwice,firstascorporateincomeand
thenasdividendincome(generally5%or15%dependingupontheindividualstaxbracket).

Chapter1TheRoleandEnvironmentofManagerialFinance11

Whiletaxationofincomeisakeyfactorindecidingwhichformofbusinessorganizationto
select,twootherfactorsarealsoimportant.Inapartnership,eachpartnerhasunlimited
liabilityandmayhavetocoverdebtsofotherpartnerswhilecorporateownershavelimited
liabilitywhichguaranteesthattheycannotlosemorethantheyhaveinvestedinthe
corporation.Thethirdmajorconsiderationiseaseoftransferofthebusiness.Partnershipsare
hardertotransferandaretechnicallydissolvedwhenapartnerdieswhileacorporationcan
haveaverylonglifewithownershipreadilytransferredthroughthesaleofstock.
IfathirdpartywasaskedtodecidewhichlegalformofbusinessA&JTaxPreparationshould
take,itwouldbeusefultohavethefollowinginformation:

E12.

Maritalstatusandtaxsituationofeachpartner
Expectationofthelongevityofthefirm
Ageofthecurrentowners
Currentplanofsuccession
Risktoleranceoftheowners
Expectationoffuturetaxlawchanges
Capitalneedsofthefirm
Growthprospectsofthefirm
Reasonsforeachpartnersviewofthepreferredformofownership

SunkCosts

Answer: Marginalcostbenefitanalysisignoressunkcosts,sothe$2.5milliondollarsisirrelevanttothe
currentdecisionwhichmustbemade.Atthispointtherearetwoquestionsthatmustbe
answered.First,willthe$10,000additionalinvestmentgenerateapresentvalueofexpected
revenuewhichwillexceedthe$10,000investment?Inotherwords,willtheprojectgeneratea
positivenetpresentvalue?Ifitdoes,theprojectmustbeconsideredfurthertoseeifitisthe
bestuseofcapital.Ifthefirmhasaneedtorationcapital,theprojectmustthenbecomparedto
otherprojectscompetingforthelimitedcapitaltoseeifitisviable.Thefactthattheprojects
technologyhasbeensurpassedbynewtechnologydoesnotimmediatelydisqualifytheproject
sincenewtechnologydoesnotensureapositivecostbenefitresult.Inthiscase,asmall
$10,000investmentmightavoidaheavyexpenditureinnewtechnology.Dependinguponthe
industry,however,failuretokeepupwithcompetitorscanbedevastating.Thekeymaywell
lieinthedescriptiontheprojecthaslittlechancetobeviable,whichindicatesthatapproving
the$10,000islikelytobethrowinggoodmoneyafterbad.
E13.

Cashflowvs.AccruedProfits

Answer: Itisnotunusualforafirmtobeprofitableyetexperienceacashcrunch.Themostcommon
causeiswhenexpenseshaveashorterduedatethanexpectedrevenue.Insuchcasesthefirm
mustarrangeshorttermfinancingtomeetitsdebtobligationsbeforetherevenuearrives.Ifthe
forthcomingcashcrunchisnotanewsituationforthisfirm,managementshouldprobably
considergoingaheadwiththeyearendpartyifitisimportanttoemployeemoraleandthe
futuresuccessofthefirmaslongasadequateshorttermfundingcanbearranged.Ontheother
hand,ifthefirmhasnotexperiencedsuchacashcrunchbefore,theremaybelargerproblems
loomingaheadanditwouldbeunseemlytospendcashonapartywhenitwouldbebetter
spentmeetingthedebtobligationsofthefirm.

12Part1IntroductiontoManagerialFinance

E14.

AgencyCosts

Answer: Agencycostsarethecostsbornebystockholderstomaintainagovernancestructurethat
ensuresagainstdishonestactsofmanagement,andgivesmanagersthefinancialincentiveto
maximizeshareprice.Oneexampleofagencycostsisstockoptions,whichareusedtoprovide
anincentiveformanagerstoworkdiligentlyforthebenefitofthefirm.Tipsaresimilarto
stockoptionsinthattheyareofferedasrewardsforgoodservicemuchasstockoptionsare
usedtorewardmanagers,presumablybasedontheirgoodperformancewhichsubsequently
leadstoahigherstockprice.TheDonutShop,Inc.exampledoesnotrepresentaclearcaseof
agencycostsbecauseitisthemanagementitselfthathasinstitutedtheNotipspolicyandthe
employeeshaverespondedwithreducedperformance.Bybanningtips,themanagementhas
createdasituationwhereanagencycostmaybenecessarytoprovideanincentivefor
employeestoresumetheirformerlevelofperformance.
OnesolutionthatmayworkforDonutShop,Inc.istoinstituteaprofitsharingplanthat
reachesdowntotheemployeelevelwheretheslowdownandinefficiencyareoccurring.A
profitsharingplanisdesignedtomotivatetheemployeesandcouldalleviatetheaggravation
causedbythenotippolicy,butmustbeclearlyidentifiedasthereplacementtotippinginorder
tobeeffective.Aprofitsharingplanisusuallyviewedbytheemployeesasarewardforgood
performance,butdoesnothavetheimmediacyofthepositiveeffectthatanemployeegets
fromatip.
Itisunclearfromthecasewhetherthenewnotippolicyisacompanywidepolicyorsimply
theactionsofafewbranchmanagers.However,therealsolutionhereistorecognizethatthe
notippolicyhascreatedanunnecessarybacklashthatcanbealleviatedbyreversing
managementspositionwithoutincurringtheadditionalcostsofrevisingthecurrentemployee
benefitplanandpayingoutaportionofcorporateprofits.
E15.

StockDividendsvs.Interest

Answer: While100%ofcorporateinterestincomeistaxedatordinaryincometaxrates,only30%of
corporatedividendincomeistreatedastaxableincome.Basedsolelyonthetaxtreatmentof
corporatedividendincomeversusinterestincome,Pruro,Inc.wouldhavegreateraftertax
incomeifitchoosestheRestonstockpaying5%dividendsoverthepromissorynotepaying
5%interest.

Solution to Problems
P11.

LG1:LiabilityComparisons
Basic
(a) Ms.Harperhasunlimitedliability.
(b) Ms.Harperhasunlimitedliability.
(c) Ms.Harperhaslimitedliability,whichguaranteesthatshecannotlosemorethanshe
invested.

Chapter1TheRoleandEnvironmentofManagerialFinance13

P12.

LG2,4:Marginalcostbenefitanalysisandthegoalofthefirm
Intermediate
(a) Benefitsfromnewrobotics
Benefitsfromexistingrobotics
Marginalbenefits

$560,000
400,000
$160,000

(b) Initialcashinvestment
Receiptfromsaleofoldrobotics
Marginalcost

$220,000
70,000
$150,000

(c) Marginalbenefits
Marginalcost
Netbenefits

$160,000
150,000
$10,000

(d) Kenshouldrecommendthatthecompanyreplacetheoldroboticswiththenewrobotics.The
netbenefittoshareholdersispositivewhichshouldmaketheshareholdersbetteroff.
(e) Kenshouldconsidermorethanjustnetbenefits.Heshouldincorporatetheimportantpoints
oftiming,cashflow,andrisk,threeimportantfactorstodeterminingthetrueimpacton
shareholderswealth.
P13.

LG2:AnnualIncomeversusCashFlowforaPeriod
Basic
(a) Sales
Costofgoodsold
Netprofit

$760,000
300,000
$460,000

(b) CashReceipts
Costofgoodsold
Netcashflow

$690,000
300,000
$390,000

(c) Thecashflowstatementismoreusefultothefinancialmanager.Theaccountingnetincome
includesamountsthatwillnotbecollectedand,asaresult,donotcontributetothewealthof
theowners.
P14.

LG4:IdentifyingAgencyProblems,Costs,andResolutions
Intermediate
(a) Inthiscasetheemployeeisbeingcompensatedforunproductivetime.Thecompanyhasto
paysomeonetotakeherplaceduringherabsence.Installationofatimeclockthatmustbe
punchedbythereceptionisteverytimesheleavesworkandreturnswouldresultineither:
(1)herreturningontimeor(2)reducingthecosttothefirmbyreducingherpayforthelost
work.

14Part1IntroductiontoManagerialFinance

(b) Thecoststothefirmareintheformofopportunitycosts.Moneybudgetedtocoverthe
inflatedcostsofthisprojectproposalisnotavailabletofundotherprojectswhichmayhelpto
increaseshareholderwealth.Makethemanagementrewardsystembasedonhowclosethe
managersestimatescometotheactualcostratherthanhavingthemcomeinbelowcost.
(c) Themanagermaynegotiateadealwiththemergingcompetitorwhichisextremelybeneficial
totheexecutiveandthensellthefirmforlessthanitsfairmarketvalue.Agoodwayto
reducethelossofshareholderwealthwouldbetoopenthefirmupforpurchasebidsfrom
otherfirmsoncethemanagermakesitknownthatthefirmiswillingtomerge.Iftheprice
offeredbythecompetitoristoolow,otherfirmswillupthepriceclosertoitsfairmarket
value.
(d) Generallyparttimeortemporaryworkersarenotasproductiveasfulltimeemployees.These
workershavenotbeenonthejobaslongtoincreasetheirworkefficiency.Also,thebetter
employeesgenerallyneedtobehighlycompensatedfortheirskills.Thismanagerisgetting
ridofthehighestcostemployeestoincreaseprofits.Oneapproachtoreducingtheproblem
wouldbetogivethemanagerperformancesharesiftheymeetcertainstatedgoals.
Implementingastockincentiveplantyingmanagementcompensationtosharepricewould
alsoencouragethemanagertoretainqualityemployees.
P15.

LG6:CorporateTaxes
Basic
(a) Firmstaxliabilityon$92,500(fromTable1.4):
Totaltaxesdue$13,750[0.34($92,500$75,000)]
$13,750(0.34$17,500)
$13,750$5,950

$19,700
(b) Aftertaxearnings:$92,500$19,700$72,800
(c) Averagetaxrate:$19,700$92,50021.3%
(d) Marginaltaxrate:34%
P16.

LG6:AverageCorporateTaxRates
Basic
(a) TaxcalculationsusingTable1.4:
$10,000:

Taxliability:

$10,0000.15$1,500

Aftertaxearnings: $10,000$1,500$8,500
Averagetaxrate: $1,500$10,00015%
$80,000:

Taxliability:

$13,750[0.34(80,000$75,000)]
$13,750(0.34$5,000)
$13,750$1,700
$15,450Totaltax

Aftertaxearnings: $80,000$15,450$64,550
Averagetaxrate: $15,450$80,00019.3%

Chapter1TheRoleandEnvironmentofManagerialFinance15

$300,000:

Taxliability:

$22,250+[0.39($300,000$100,000)]
$22,250(0.39$200,000)
$22,250$78,000
$100,250Totaltax

Aftertaxearnings: $300,000$100,250$199,750
Averagetaxrate: $100,250$300,00033.4%
$500,000:

Taxliability:

$113,900[0.34($500,000$335,000)]
$113,900(0.34$165,000)
$113,900$56,100
$170,000Totaltax

Aftertaxearnings: $500,000$170,000$330,000
Averagetaxrate: $170,000$500,00034%
$1,500,000:

Taxliability:

$113,900[0.34($1,500,000$335,000)]
$113,900(0.34$1,165,000)
$113,900$396,100
$510,000Totaltax

Aftertaxearnings: $1,500,000$510,000$990,000
Averagetaxrate: $510,000$1,500,00034%
$10,000,000: Taxliability:

$113,900+[0.34($10,000,000$335,000)]
$113,900(0.34$9,665,000)
$113,900$3,286,100
$3,400,000Totaltax

Aftertaxearnings: $10,000,000$3,400,000$6,600,000
Averagetaxrate: $3,400,000$10,000,00034%
$15,000,000: Taxliability:

$3,400,000[0.34($15,000,000$10,000,000)]
$3,400,000(0.34$5,000,000)
$3,400,000$1,750,000
$5,150,000Totaltax

Aftertaxearnings: $15,000,000$5,150,000$9,850,000
Averagetaxrate: $5,150,000$15,000,00034.33%

16Part1IntroductiontoManagerialFinance

(b)

AverageTaxRateversusPretaxIncome
36
34
32
30
28
26
24
22
20
18
16
14
0

2000

4000 6000

8000 10000 12000 14000 16000

Average
TaxRate
%

PretaxIncomeLevel($000)

Asincomeincreases,therateapproachesbutdoesnotreach35%.
P17.

LG6:MarginalCorporateTaxRates
Basic
(a)

Chapter1TheRoleandEnvironmentofManagerialFinance17

Pretax
Income
$15,000
60,000
90,000
200,000
400,000
1,000,000
20,000,000

BaseTax
$0
7,500
13,750
22,250
113,900
113,900
3,400,000

TaxCalculation
Amount
%
overBase
(0.15
15,000)
(0.25
10,000)
(0.34
15,000)
(0.39
100,000)
(0.34
65,000)
(0.34
665,000)
(0.35 10,000,000)

Tax
$2,250
10,000
18,850
61,250
136,000
340,000
6,900,000

Marginal
Rate
15.0%
25.0%
34.0%
39.0%
34.0%
34.0%
35.0%

18Part1IntroductiontoManagerialFinance

(b)

MarginalTaxRateversusPretaxIncome

40
35
30
25
20
15
10
0

2000 4000 6000 8000 10000 12000 14000 16000 18000 20000

Marginal
TaxRate
%

PretaxIncomeLevel($000)

Asincomeincreasesto$335,000,themarginaltaxrateapproachesandpeaksat39%.For
incomeinexcessof$335,000,themarginaltaxratedeclinesto34%,andafter$10millionthe
marginalrateincreasesslightlyto35%.
P18.

LG6:InterestversusDividendIncome
Intermediate
(a) Taxonoperatingearnings:$490,0000.40taxrate$196,000

(b) and(c)

Chapter1TheRoleandEnvironmentofManagerialFinance19

Beforetaxamount
Less:Applicableexclusion
Taxableamount
Tax(40%)
Aftertaxamount

(b)
InterestIncome
$20,000
0
$20,000
8,000
$12,000

(c)
DividendIncome
$20,000
14,000
$6,000
2,400
$17,600

(0.70$20,000)

(d) Theaftertaxamountofdividendsreceived,$17,600,exceedstheaftertaxamountofinterest,
$12,000,duetothe70%corporatedividendexclusion.Thisincreasestheattractivenessof
stockinvestmentsbyonecorporationinanotherrelativetobondinvestments.
(e) Totaltaxliability:
Taxesonoperatingearnings(from(a))
Taxesoninterestincome(from(b))
Taxesondividendincome(from
(c))
Totaltaxliability

$196,000
8,000
2,400
$206,400

20Part1IntroductiontoManagerialFinance

P19.

LG6:InterestversusDividendExpense
Intermediate
(a) EBIT
Less:Interestexpense
Earningsbeforetaxes
Less:Taxes(40%)
Earningsaftertaxes*

$40,000
10,000
$30,000
12,000
$18,000

Thisisalsoearningsavailabletocommonstockholders.

(b) EBIT
Less:Taxes(40%)
Earningsaftertaxes
Less:Preferreddividends
Earningsavailablefor
commonstockholders

$40,000
16,000
$24,000
10,000
$14,000

P110. LG6:CapitalGainsTaxes
Basic
(a) Capitalgain:
AssetX$2,250$2,000$250
AssetY$35,000$30,000$5,000
(b) Taxonsaleofasset:
AssetX$2500.40$100
AssetY$5,0000.40$2,000
P111. LG6:CapitalGainsTaxes
Basic
(a) and(b)

Asset
A
B
C
D
E

SalePrice
(1)
$3,400
12,000
80,000
45,000
18,000

PurchasePrice
(2)
$3,000
12,000
62,000
41,000
16,500

CapitalGain
(1)(2)
(3)
$400
0
18,000
4,000
1,500

Tax
(3)0.40
(4)
$160
0
7,200
1,600
600

Chapter1TheRoleandEnvironmentofManagerialFinance21

P112. LG4:EthicsProblem
Intermediate
Maximizingshareholderwealth,orthestockprice,involvescarefullyevaluatingeachdecisions
impactoncashflowamount,timing,andrisk.However,thatstatementincludesnothingthat
directlyincorporatestheethicalaspectofdecisions.Thephrasesubjecttoethicalconstraints
impliesthatthereareethicalfacetsofbusinessdecisionsthatmayormaynotbeasignificantpart
ofadecisionscashflowprojections.Thinkofalldecisionsbeingsiftedthroughanethical
funnelsomedecisionsareunethicalanddonotmakeitthroughthefunnel,whileothersare
ethicalandpassthroughthefunnel.Examplesofethicalconsiderationsthatmightenterinto
decisionsincludenotexaggeratingproductqualityordurability,correctingenvironmental
problemseventhoughregulatorsorthegeneralpublicwouldneverknowaboutthem,andnot
exaggeratingfuturecashflowprojectionsinordertogetalowerinterestrateonabankloanor
bondissue.Eachoftheseexamplesmaydecreasethesizeordelaythetimingofcashinflows,or
increasetheriskinessoffuturecashflowstherebyreducingthestockpricerelativetowhatit
couldhavebeenhadoneactedunethically.Nodoubtyouhavethoughtofotherexamplesaswell.

Case
Assessing the Goal of Sports Products, Inc.
(a) Maximizationofshareholderwealth,whichmeansmaximizationofshareprice,shouldbethe
primarygoalofthefirm.Unlikeprofitmaximization,thisgoalconsiderstiming,cashflows,andrisk.
Italsoreflectstheworthoftheownersinvestmentinthefirmatanytime.Itisthevaluetheycan
realizeshouldtheydecidetoselltheirshares.
(b) Yes,thereappearstobeanagencyproblem.Althoughcompensationformanagementistiedto
profits,itisnotdirectlylinkedtoshareprice.Inaddition,managementsactionswithregardto
pollutioncontrolssuggestaprofitmaximizationfocus,whichwouldmaximizetheirearnings,rather
thananattempttomaximizeshareprice.
(c) Thefirmsapproachtopollutioncontrolseemstobequestionableethically.Whileitisunclear
whethertheiractswereintentionaloraccidental,itisclearthattheyareviolatingthelawanillegal
actpotentiallyleadingtolitigationcostsandasaresultaredamagingtheenvironment,animmoral
andunfairactthathaspotentialnegativeconsequencesforsocietyingeneral.Clearly,Sports
Productshasnotonlybrokenthelawbutalsoestablishedpoorstandardsofconductandmoral
judgment.
(d) Fromtheinformationgiventhereappearstobeaweakcorporategovernancesystem.Thefactthat
managementisabletomeasureandrewardtheirperformanceonprofitsindicatesthatnooneis
watchingoutfortheshareholders.LorenandDalesconcernsindicatethatemployeesapparently
haveaninterestinthelongrunsuccessofthefirm.Allowingthecontinuationofpollutionviolations
isalsoapparentlyescapingtheinterestandcontrolabilityofotherswhoshouldbemonitoringthe
firm.

22Part1IntroductiontoManagerialFinance

(e) Somespecificrecommendationsforthefirminclude:

Tiemanagement,andpossiblyemployee,compensationtosharepriceoraperformancebased
measureandmakesurethatallinvolvedownstockandhaveastakeinthefirm.Being
compensatedpartiallyonthebasisofsharepriceoranotherperformancemeasure,andowning
stockinthefirmwillmorecloselylinkthewealthofmanagersandemployeestothefirms
performance.
Complywithallfederalandstatelawsaswellasacceptedstandardsofconductormoral
judgment.
Establishacorporateethicspolicy,tobereadandsignedbyallemployees.
Setupacorporategovernancesystemthathasasitsbasistheoversightandwelfareofallthe
stakeholdersinthefirm.

(Otheranswersare,ofcourse,possible.)

Group Exercises
Notes for Adopters
Themotivationforthesegroupexercisesistoplacethelearninggoalsofeachchapterwithinthecontext
ofafictitiousfirmwhilegivingstudentsavaluablesetofteamworkskills.Creativityisencouraged,while
thestronglinksofeachassignmenttoarealworld,shadowfirmshouldgroundeachgroupsworkin
reality.Anyoftheseassignmentsandtheirdeliverablescanbemodifiedtobetterfitwithinanadopters
coursegoalsastheyweredesignedwithaneyetowardsflexibilityofuse.Thelearningthroughthese
exercisesshouldbesomethingstudentsenjoy,beingbothapplicabletotherealworldandlessconfining
thantraditionalhomework.
Thefirstissueforadopterstoaddressisgroupcompositionandsize.Shouldstudentsselfseparateorbe
dividedbytheirinstructor?Howbigshouldthegroupsbe?Thisisasemesterlongassignmentand
studentswillneedtogetalongwiththeirfellowgroupmembers.Ifstudentschoosetheirowngroupsit
may,thoughnotalways,reducetheincidenceofintragroupsquabbles.Diversitywithinthegroupsmight
thenbesacrificed,however.Onestrategyistoaskstudentstofirstpairoff.Theinstructorcanthenjointhe
pairsintogroupsof4.Thispairingofthepairscouldbedonerandomlythroughanumberinthehat
selectionprocess,ascouldtheentiregroupsetup.
Groupsizedoesmatterandtheseexercisesweredesignedforaworkloadspreadacrossaminimumof
3students.Largergroupswouldlessenthehomeworkload,however,theissueoffreeridingisoftenmore
prevalentinlargergroupswhereslackerscanhide.Managementoflargergroupsisalsomorechallenging
fortheparticipants.Thesuggestedgroupsizeisbetween35students.Groupleadershipisanotherissue.
ThebestsituationmightberotatingCEO/leaderwhereeachgroupmemberhasseveralopportunitiestobe
incharge.Lastly,theseexercisesweredesignedtoallowstudentsfreedombutwiththeresponsibilityof
workingsomewhatindependentoftheirinstructor.Inthisveintheinstructionsforeachassignmenthave
beenwrittentoberelativelyselfexplanatory.

Chapter1TheRoleandEnvironmentofManagerialFinance23

Chapter 1
Thisfirstchapterasksstudentstonametheirfictitiousfirmanddescribeitsbusiness.Asthisfirmisgoing
publicstudentsareaskedtoexplainwhyitisappropriateforthemtogopublic,andalsodiscussdifferent
managerialroleswithinthecorporation.Thegroupmustchooseashadowfirmtofollow.Thispublicly
tradedfirmshouldbeinanindustryrelatedtotheirfictitiousfirms.
Themostimportantcouncelstudentscouldgetattheoutsetistospendtimemakingtheseinitialdecisions.
Laterworkisgoingtobuildonthesechoicesandcarefulchoosingisparamount.Forexample,inchoosing
theshadowfirm,studentsshouldpickawellestablishedfirmwhoseinformation,includingfinancials,will
beeasilyfound.Thisalsoimpactstheirdecisionsregardingtheirownfictitiousfirm.Throughoutmanyof
thesubsequentchaptersstudentswillbetakingrealworldinformationfromtheirshadowfirmand
applyingittotheirfictitiousfirm;dressingtheirownfirmwiththeclothesoftheshadowfirm.Students
shouldfeelcomfortableintheseclothes,soencouragingthemtochooseindustriestheyrefamiliarwith,or
interestedin,ishelpful.

Answers to Web Exercises


Thisassignmentisasstraightforwardasthestudentsshouldexpect.TheyareaskedtogototheSECs
WebsiteandsummarizevariousreportsrelatedtotheSecuritiesandExchangeAct,withintheFilingsand
FormssectionunderDescriptionsofSECForms.Thesecondpartoftheirassignmentistochooseafirm,
lookuptheirreports,andcatalogueanyrelevantobservations.Thisassignmentisquitesimpleforthe
instructor,givenhis/herfamiliaritywiththeSECanditsfilings.Onesuggestionwouldbetousetheir
findingsasmotivationforinclassdiscussion.Youcoulddirectthestudentswhenassigningthis
homeworktoaparticularfiling(s)andaskthemtogathersimilarinformationfromeachoftheirfirms.
Lastly,adiscussionofthehistoryoffinancialmarketsregulationisusefulatanytimeduringthecourse.