SOLUTIONS MANUAL
FUNDAMENTALS OF CORPORATE FINANCE
5TH CANADIAN EDITION
CHAPTER NO. 01: CORPORATE FINANCE AND THE FINANCIAL
MANAGER
Note: All problems in this chapter are available in MyLabFinance. 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. Real estate corporations must pay corporate income taxes but REITs do not pay
corporate tax; instead, they must pass through substantially all of the income to the
trust unit holders to whom the income is taxable.
6. Excel Solution
Plan: First find the value remaining after corporate taxes. Then determine the
remainder after personal taxes.
Execute: First the corporation pays the taxes. After taxes, $2 × (1 – 0.34) = $1.32
per share is left to pay dividends. Once the dividend is paid, personal tax on this
must be paid leaving $1.32 × (1 – 0.18) = $1.0824 per share.
Evaluate: After all the taxes are paid, you are left with $1.0824 per share.
,7. Excel Solution
Plan: First find the value remaining after corporate taxes. Then determine the
remainder after personal taxes.
Execute: As a REIT, there is no corporate tax so the full $2 per share can be paid
out to you as a unit holder. You must then pay personal income tax on the
distribution. So you are left with $2 × (1 – 0.4) = $1.20 per share.
Evaluate: After all the taxes are paid, you are left with $1.20 per share.
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 do the following:
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. Plan: For each of parts (a) to (d) you must determine if your personal change in
monetary wealth more than offsets the value to you of losing your leisure time
(valued at $51,000). If it does, then you would decide to proceed with the new
project.
Execute:
a. If you owned 100% of the company and the project were accepted, your
personal shares of stock would increase in value by 100% of $1 million =
$1 million. This would more than offset your personal cost of lost leisure;
therefore, your decision would be to proceed with the project.
b. If you owned 1% of the company and the project were accepted, your personal
shares of stock would increase in value by 1% of $1 million = $10,000. This
would not be enough to offset your personal cost of lost leisure; therefore your
decision would be to reject the project.
c. If you owned 3% of the company and the project were accepted, your personal
shares of stock would increase in value by 3% of $1 million = $30,000. In
addition, you would receive a bonus of $25,000, so in total your monetary
wealth would increase by $55,000. This more than offsets your personal cost of
lost leisure; therefore, your decision would be to proceed with the project.
d. If you accept the project your monetary wealth would increase by $25,000 +
3% of $X. For you to decide to accept the project, this must be greater than
$51,000 (the value of your lost leisure). Solving for X we get the following:
$25,000 + 0.03X > $51,000
0.03X > $26,000
X > $866,666.67
Evaluate:
e. In part (a), you (as the CEO) are perfectly aligned with the owners of the
company as you actually own the whole company. Thus, you receive the full
benefit of the $1 million increase in equity value and this offsets the value to
you of the lost leisure. In part (b), your incentives are not aligned with
shareholders because the project should be accepted to maximize shareholder
wealth, but you reject it because the increase in your monetary wealth does not
offset the cost of your extra effort and lost leisure time. Here, the principal–
agent problem results in a decision that is costly to shareholders as a whole. In
part (c), your incentives are aligned with shareholders as you receive enough of
a monetary benefit to offset your cost of lost leisure. In part (d), though, we can
, see that the bonus scheme does not always solve the principal-agent problem.
Your incentives are aligned with all shareholders when the project increases the
equity value by an amount greater than $866,666.67. However, if the increase
in equity value is lower, you would decide to reject the project even though
accepting it would maximize shareholder wealth.
15. This will impact and hurt the customers. It will be a negative impact for the
customers as they will likely get sour milk. It will also be a negative impact for
shareholders because, in the long run, customers will realize that the supermarket
sells sour milk and they will switch supermarkets. Thus, the value today of the
future income and cash flow streams generated by the supermarket will drop
because of the long-term loss of customers caused by this strategy. This will
negatively impact the current stock price as stockholders anticipate these long-term
negative effects.
*16. There are many considerations for you as CEO. One is the cost–benefit analysis of
constructing the SD project and reaping the savings in disposal costs—that should
show whether the SD project increases shareholder value. In addition, if your bonus
is tied to earnings, you may be tempted to accept the project because of your higher
bonuses for each of the next 10 years. There are other considerations, though. For
example, is the SD method legal? If not, then the company could face substantial
fines and reputational damage by using SD. Also, SD may leak into the ground
water—that could further damage SPB’s reputation, cause major lawsuits, and
necessitate environmental clean-up charges. These costs would affect the cost-
benefit analysis for sure. For your personal situation, will you be retiring soon and
just care about the next bonus or do you plan on working for this company over the
long term? Will you hold this company’s stock for the long term or do you plan to
sell it quickly before a catastrophe from the project might occur? This situation ties
into the principal-agent problem in that as CEO you may accept SD due to your
higher bonus and potentially even a higher short-term stock price, but the ultimate
effect on SPB’s true shareholder value may drop if the project is made public, a
catastrophe happens, or other negative factors outlined above are factored in.
17. 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.
18. 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).
FUNDAMENTALS OF CORPORATE FINANCE
5TH CANADIAN EDITION
CHAPTER NO. 01: CORPORATE FINANCE AND THE FINANCIAL
MANAGER
Note: All problems in this chapter are available in MyLabFinance. 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. Real estate corporations must pay corporate income taxes but REITs do not pay
corporate tax; instead, they must pass through substantially all of the income to the
trust unit holders to whom the income is taxable.
6. Excel Solution
Plan: First find the value remaining after corporate taxes. Then determine the
remainder after personal taxes.
Execute: First the corporation pays the taxes. After taxes, $2 × (1 – 0.34) = $1.32
per share is left to pay dividends. Once the dividend is paid, personal tax on this
must be paid leaving $1.32 × (1 – 0.18) = $1.0824 per share.
Evaluate: After all the taxes are paid, you are left with $1.0824 per share.
,7. Excel Solution
Plan: First find the value remaining after corporate taxes. Then determine the
remainder after personal taxes.
Execute: As a REIT, there is no corporate tax so the full $2 per share can be paid
out to you as a unit holder. You must then pay personal income tax on the
distribution. So you are left with $2 × (1 – 0.4) = $1.20 per share.
Evaluate: After all the taxes are paid, you are left with $1.20 per share.
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 do the following:
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. Plan: For each of parts (a) to (d) you must determine if your personal change in
monetary wealth more than offsets the value to you of losing your leisure time
(valued at $51,000). If it does, then you would decide to proceed with the new
project.
Execute:
a. If you owned 100% of the company and the project were accepted, your
personal shares of stock would increase in value by 100% of $1 million =
$1 million. This would more than offset your personal cost of lost leisure;
therefore, your decision would be to proceed with the project.
b. If you owned 1% of the company and the project were accepted, your personal
shares of stock would increase in value by 1% of $1 million = $10,000. This
would not be enough to offset your personal cost of lost leisure; therefore your
decision would be to reject the project.
c. If you owned 3% of the company and the project were accepted, your personal
shares of stock would increase in value by 3% of $1 million = $30,000. In
addition, you would receive a bonus of $25,000, so in total your monetary
wealth would increase by $55,000. This more than offsets your personal cost of
lost leisure; therefore, your decision would be to proceed with the project.
d. If you accept the project your monetary wealth would increase by $25,000 +
3% of $X. For you to decide to accept the project, this must be greater than
$51,000 (the value of your lost leisure). Solving for X we get the following:
$25,000 + 0.03X > $51,000
0.03X > $26,000
X > $866,666.67
Evaluate:
e. In part (a), you (as the CEO) are perfectly aligned with the owners of the
company as you actually own the whole company. Thus, you receive the full
benefit of the $1 million increase in equity value and this offsets the value to
you of the lost leisure. In part (b), your incentives are not aligned with
shareholders because the project should be accepted to maximize shareholder
wealth, but you reject it because the increase in your monetary wealth does not
offset the cost of your extra effort and lost leisure time. Here, the principal–
agent problem results in a decision that is costly to shareholders as a whole. In
part (c), your incentives are aligned with shareholders as you receive enough of
a monetary benefit to offset your cost of lost leisure. In part (d), though, we can
, see that the bonus scheme does not always solve the principal-agent problem.
Your incentives are aligned with all shareholders when the project increases the
equity value by an amount greater than $866,666.67. However, if the increase
in equity value is lower, you would decide to reject the project even though
accepting it would maximize shareholder wealth.
15. This will impact and hurt the customers. It will be a negative impact for the
customers as they will likely get sour milk. It will also be a negative impact for
shareholders because, in the long run, customers will realize that the supermarket
sells sour milk and they will switch supermarkets. Thus, the value today of the
future income and cash flow streams generated by the supermarket will drop
because of the long-term loss of customers caused by this strategy. This will
negatively impact the current stock price as stockholders anticipate these long-term
negative effects.
*16. There are many considerations for you as CEO. One is the cost–benefit analysis of
constructing the SD project and reaping the savings in disposal costs—that should
show whether the SD project increases shareholder value. In addition, if your bonus
is tied to earnings, you may be tempted to accept the project because of your higher
bonuses for each of the next 10 years. There are other considerations, though. For
example, is the SD method legal? If not, then the company could face substantial
fines and reputational damage by using SD. Also, SD may leak into the ground
water—that could further damage SPB’s reputation, cause major lawsuits, and
necessitate environmental clean-up charges. These costs would affect the cost-
benefit analysis for sure. For your personal situation, will you be retiring soon and
just care about the next bonus or do you plan on working for this company over the
long term? Will you hold this company’s stock for the long term or do you plan to
sell it quickly before a catastrophe from the project might occur? This situation ties
into the principal-agent problem in that as CEO you may accept SD due to your
higher bonus and potentially even a higher short-term stock price, but the ultimate
effect on SPB’s true shareholder value may drop if the project is made public, a
catastrophe happens, or other negative factors outlined above are factored in.
17. 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.
18. 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).
