Fundamentals of Corporate Finance, 6th edition
Complete Chapters Solutions are included
Chapter 1- 26
Chapter 1
Corporate Finance and the
Financial Manager
Note: All problems in this chapter are available MyLab Finance
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 give their owners limited liability. 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 - 0.25) = $1.50 is left to pay
dividends. Once the dividend is paid, personal tax on this must be paid, leaving $1.50 ´ (1 -
0.2) = $1.20. So after all the taxes are paid, you are left with $1.20.
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. Thus, they are left
with $2 ´ (1 - 0.2) = $1.60.
8. The investment decision is the most important decision that a financial manager makes because
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.
, 2 Berk/DeMarzo/Harford • Fundamentals of Corporate Finance, Sixth Edition
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; and/or
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; 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) potentially have an incentive to overpay for
another company (which would be damaging to your shareholders) because your pay and
prestige will improve.
14. No—it will not necessarily make the shareholders better off. Even though you are reducing
costs, which could increase cash flows in the short-term, you will deal with more costly
warranty issues and with lost reputation with your customers, potentially leading them to buy
from your competitors, which would reduce cash flows in the long-run. Making a less
expensive, but lower quality product is NOT the same as maximizing the value of the shares
(making your shareholders better off).
15. No—it will not necessarily make the shareholders better off. Even though you are reducing
costs, which could increase cash flows in the short term, you will deal with more costly
warranty issues and with lost reputation with your customers, potentially leading them to buy
from your competitors, which would reduce cash flows in the long run. Making a less
expensive, but lower quality product is NOT the same as maximizing the value of the shares
(making your shareholders better off).
16. 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.
17. 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).
18. A limit order specifies a price at which you are willing to buy or sell. It will be executed when
there is demand or supply at that price. A market order is executed immediately at the best
outstanding limit order. For example, a market buy order will be immediately executed against
the best limit ask price.
Complete Chapters Solutions are included
Chapter 1- 26
Chapter 1
Corporate Finance and the
Financial Manager
Note: All problems in this chapter are available MyLab Finance
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 give their owners limited liability. 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 - 0.25) = $1.50 is left to pay
dividends. Once the dividend is paid, personal tax on this must be paid, leaving $1.50 ´ (1 -
0.2) = $1.20. So after all the taxes are paid, you are left with $1.20.
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. Thus, they are left
with $2 ´ (1 - 0.2) = $1.60.
8. The investment decision is the most important decision that a financial manager makes because
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.
, 2 Berk/DeMarzo/Harford • Fundamentals of Corporate Finance, Sixth Edition
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; and/or
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; 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) potentially have an incentive to overpay for
another company (which would be damaging to your shareholders) because your pay and
prestige will improve.
14. No—it will not necessarily make the shareholders better off. Even though you are reducing
costs, which could increase cash flows in the short-term, you will deal with more costly
warranty issues and with lost reputation with your customers, potentially leading them to buy
from your competitors, which would reduce cash flows in the long-run. Making a less
expensive, but lower quality product is NOT the same as maximizing the value of the shares
(making your shareholders better off).
15. No—it will not necessarily make the shareholders better off. Even though you are reducing
costs, which could increase cash flows in the short term, you will deal with more costly
warranty issues and with lost reputation with your customers, potentially leading them to buy
from your competitors, which would reduce cash flows in the long run. Making a less
expensive, but lower quality product is NOT the same as maximizing the value of the shares
(making your shareholders better off).
16. 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.
17. 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).
18. A limit order specifies a price at which you are willing to buy or sell. It will be executed when
there is demand or supply at that price. A market order is executed immediately at the best
outstanding limit order. For example, a market buy order will be immediately executed against
the best limit ask price.
