TEST BANK FOR INTRODUCTION TO CORPORATE FINANCE, 5TH CANADIAN EDITION
,Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita
Answers to Concept Review Questions
2.1 Types of Business Organizations
Concept Review Questions
1. Describe the main advantages and disadvantages of sole proprietorships and partnerships.
The big advantage of a sole proprietorship is that setting one up is easy –- there is no paperwork
involved and all you really have to do is start the business. However, the critical thing is
unlimited liability, because you are liable not only to the extent of what you have invested in the
business, but also for any other assets you own.
N
The two main partnership forms are limited liability partnerships (LLPs), and limited and general
partnerships. LLPs are the new form of organizing professional firms, since each partner has
limited liability in terms of a possible suit against the firm. However, as a partnership, the
U
partner‘s income is still included as ordinary income and filed with individual tax returns.
Limited and general partnerships are generally used for tax reasons. In this case a general partner
operates the business and limited partners are passive investors. As long as the limited partners
R
are not active in the business, they have the advantage of limited liability in that all they can lose
is their initial investment. The general partner, on the other hand, has unlimited liability and is
the operator of the business.
2. How are trusts distinct from corporations?
SE
Trusts are used whenever you want to separate ownership from control. The use of trusts has
recently expanded out of their use in personal finance and mutual funds to income and royalty
trusts. The essence of income and royalty trusts is that the trust is set up to invest in the shares
and debt obligations of a company. Further, since the trust owns both the debt and equity of the
company, the use of debt can be maximized to reduce (or eliminate) any corporate income tax,
provided the trust pays out most (or all) of its income to unit-holders. In the jargon of finance
D
professionals, trusts are ―tax efficient.‖
3. What are the main advantages and disadvantages of the corporation structure?
O
Unlike a partnership or sole proprietorship, if you operate a business as a corporation, your
personal assets are separate from any malfeasance or failure at the corporate level. The most
difficult aspect of corporations is their control and taxation.
C
2.2 The Goals of the Corporation
Concept Review Questions
S
1. What is the primary goal of the corporation?
From an economics perspective, the goal of the firm is to maximize its profits. In finance we
extend the definition from that used in economics, since what the firm should really do is
enhance the owner‘s wealth.
2. What role does the board of directors serve?
The board of directors in directing the strategy of the firm should only be guided by what creates
shareholder value.
Solutions Manual 15 Chapter 1
Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
,Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita
3. Explain the costs imposed on society if firms become too big to fail, and discuss whether the
government should break up large firms when they pose such risks.
If firms become too big to fail, it will become the responsibility of the government to bail firms
out and protect the firms from failure and not let the firms fail. After all, firms hold privileged
status as corporations, because they act in the owners‘ interests, so the government has the right
to oversee their actions. Consequently, many argue that corporations should act in the ―social
interest,‖ rather than in the interests of their owners.
4. Should the government allow one of the Big Six Canadian banks to fail if it loses money on its
loan portfolio?
The creation of shareholder value has been widely accepted, not just by academic theorists but
N
also by regulators. In 1994, the TSX issued a report entitled Where Were the Directors,
commonly called the Dey Report, named after its chairman, Peter Dey. The report‘s mandate was
to look at the governance of Canadian companies after the serious recession of the early 1990s.
U
The Dey Report concluded in Section 1.11:
We recognize the principal objective of the direction and management of a
R
business is to enhance shareholder value, which includes balancing gain
with risk in order to enhance the financial viability of the business. (S1.11)
As you will see, this is exactly what finance takes as the objective of the firm. By not letting a
SE
firm fail, the government will have reduced the risks for the firm, and management could take on
more risk knowing the government will bail the company out.
2.3 The Role of Management and Agency Issues
Concept Review Questions
D
1. Describe the nature of the basic owner-manager agency relationship.
For smaller firms, managers and owners are often the same people, so there is no problem. Even
for some quite large Canadian companies, there is often a controlling shareholder to make sure
O
that managers act in the shareholder‘s best interests. However, for many companies, the
shareholders are widely dispersed and the firm‘s chief executive officer (CEO) is able to pack
the BOD with cronies that will not challenge his or her authority. In other words, the firm has
poor governance and few checks on management so it may be run in their interest rather than in
C
the interests of the shareholders.
2. Define agency costs and describe both types.
S
The costs associated with agency problems are referred to as agency costs. There are two major
types of agency costs: (1) direct costs, which arise due to suboptimal decisions that are made by
managers when they act in a manner that is not in the best interests of their company‘s
shareholders; and, (2) indirect costs, which are those that are incurred in attempting to avoid
direct agency costs.
2.4 Aligning Managers’ and Owners’ Interest
Solutions Manual 16 Chapter 1
Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
, Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita
1. How have management compensation schemes been designed to better align owner-manager
interests? How well have these schemes performed in this regard?
The idea behind share incentive plans is simply to have the best interests of CEOs and senior
managers coincide with those of shareholders. Often, shares are granted based on reaching
certain objectives, such as revenue targets or investment returns. Whether or not share
compensation schemes have successfully met their objectives, however, is doubtful.
2. What is moral hazard and why did it become the buzz word of the 2008 financial crisis?
In 1998, the U.S. government bailed out a hedge fund called Long-Term Capital Management
(LTCM), because it was deemed to pose a systemic risk to the U.S. financial system—that is, it
N
imposed an externality on others. This resulted in a common understanding that a financial
institution could take risks, because, in the event of failure, the U.S. government would bail out
the institution. This is the moral hazard problem: knowing that the U.S. government had bailed
U
out LTCM, the behaviour of other institutions changed.
2.5 Corporate Finance
R
Concept Review Questions
1. Describe the two key decision areas with respect to the financial management of assets?
The combination of the real asset decision and financial asset acquisition decisions represent
SE
acquisition or investment decisions. Generally, we talk about investment decisions in terms of
financial management.
2. What are some of the key corporate financing decisions made by firms?
How does a firm decide between raising money through debt or equity?
In terms of equity how does it raise the equity: through retaining earnings or through new
D
issues of equity?
In fact, how does a firm decide to go public and issue shares to the general public versus
remaining a non-traded private company?
O
If it decides to issue debt, what determine whether this is bank debt or bonds issued to the
public debt market?
What determines whether firms can access the short-term money market versus borrowing
C
from a bank?
3. What are the two key topics covered in the study of corporate finance?
The financial management of assets and corporate financing decisions represent the area of
S
corporate finance.
Solutions Manual 17 Chapter 1
Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
,Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita
Answers to Concept Review Questions
2.1 Types of Business Organizations
Concept Review Questions
1. Describe the main advantages and disadvantages of sole proprietorships and partnerships.
The big advantage of a sole proprietorship is that setting one up is easy –- there is no paperwork
involved and all you really have to do is start the business. However, the critical thing is
unlimited liability, because you are liable not only to the extent of what you have invested in the
business, but also for any other assets you own.
N
The two main partnership forms are limited liability partnerships (LLPs), and limited and general
partnerships. LLPs are the new form of organizing professional firms, since each partner has
limited liability in terms of a possible suit against the firm. However, as a partnership, the
U
partner‘s income is still included as ordinary income and filed with individual tax returns.
Limited and general partnerships are generally used for tax reasons. In this case a general partner
operates the business and limited partners are passive investors. As long as the limited partners
R
are not active in the business, they have the advantage of limited liability in that all they can lose
is their initial investment. The general partner, on the other hand, has unlimited liability and is
the operator of the business.
2. How are trusts distinct from corporations?
SE
Trusts are used whenever you want to separate ownership from control. The use of trusts has
recently expanded out of their use in personal finance and mutual funds to income and royalty
trusts. The essence of income and royalty trusts is that the trust is set up to invest in the shares
and debt obligations of a company. Further, since the trust owns both the debt and equity of the
company, the use of debt can be maximized to reduce (or eliminate) any corporate income tax,
provided the trust pays out most (or all) of its income to unit-holders. In the jargon of finance
D
professionals, trusts are ―tax efficient.‖
3. What are the main advantages and disadvantages of the corporation structure?
O
Unlike a partnership or sole proprietorship, if you operate a business as a corporation, your
personal assets are separate from any malfeasance or failure at the corporate level. The most
difficult aspect of corporations is their control and taxation.
C
2.2 The Goals of the Corporation
Concept Review Questions
S
1. What is the primary goal of the corporation?
From an economics perspective, the goal of the firm is to maximize its profits. In finance we
extend the definition from that used in economics, since what the firm should really do is
enhance the owner‘s wealth.
2. What role does the board of directors serve?
The board of directors in directing the strategy of the firm should only be guided by what creates
shareholder value.
Solutions Manual 15 Chapter 1
Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
,Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita
3. Explain the costs imposed on society if firms become too big to fail, and discuss whether the
government should break up large firms when they pose such risks.
If firms become too big to fail, it will become the responsibility of the government to bail firms
out and protect the firms from failure and not let the firms fail. After all, firms hold privileged
status as corporations, because they act in the owners‘ interests, so the government has the right
to oversee their actions. Consequently, many argue that corporations should act in the ―social
interest,‖ rather than in the interests of their owners.
4. Should the government allow one of the Big Six Canadian banks to fail if it loses money on its
loan portfolio?
The creation of shareholder value has been widely accepted, not just by academic theorists but
N
also by regulators. In 1994, the TSX issued a report entitled Where Were the Directors,
commonly called the Dey Report, named after its chairman, Peter Dey. The report‘s mandate was
to look at the governance of Canadian companies after the serious recession of the early 1990s.
U
The Dey Report concluded in Section 1.11:
We recognize the principal objective of the direction and management of a
R
business is to enhance shareholder value, which includes balancing gain
with risk in order to enhance the financial viability of the business. (S1.11)
As you will see, this is exactly what finance takes as the objective of the firm. By not letting a
SE
firm fail, the government will have reduced the risks for the firm, and management could take on
more risk knowing the government will bail the company out.
2.3 The Role of Management and Agency Issues
Concept Review Questions
D
1. Describe the nature of the basic owner-manager agency relationship.
For smaller firms, managers and owners are often the same people, so there is no problem. Even
for some quite large Canadian companies, there is often a controlling shareholder to make sure
O
that managers act in the shareholder‘s best interests. However, for many companies, the
shareholders are widely dispersed and the firm‘s chief executive officer (CEO) is able to pack
the BOD with cronies that will not challenge his or her authority. In other words, the firm has
poor governance and few checks on management so it may be run in their interest rather than in
C
the interests of the shareholders.
2. Define agency costs and describe both types.
S
The costs associated with agency problems are referred to as agency costs. There are two major
types of agency costs: (1) direct costs, which arise due to suboptimal decisions that are made by
managers when they act in a manner that is not in the best interests of their company‘s
shareholders; and, (2) indirect costs, which are those that are incurred in attempting to avoid
direct agency costs.
2.4 Aligning Managers’ and Owners’ Interest
Solutions Manual 16 Chapter 1
Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
, Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita
1. How have management compensation schemes been designed to better align owner-manager
interests? How well have these schemes performed in this regard?
The idea behind share incentive plans is simply to have the best interests of CEOs and senior
managers coincide with those of shareholders. Often, shares are granted based on reaching
certain objectives, such as revenue targets or investment returns. Whether or not share
compensation schemes have successfully met their objectives, however, is doubtful.
2. What is moral hazard and why did it become the buzz word of the 2008 financial crisis?
In 1998, the U.S. government bailed out a hedge fund called Long-Term Capital Management
(LTCM), because it was deemed to pose a systemic risk to the U.S. financial system—that is, it
N
imposed an externality on others. This resulted in a common understanding that a financial
institution could take risks, because, in the event of failure, the U.S. government would bail out
the institution. This is the moral hazard problem: knowing that the U.S. government had bailed
U
out LTCM, the behaviour of other institutions changed.
2.5 Corporate Finance
R
Concept Review Questions
1. Describe the two key decision areas with respect to the financial management of assets?
The combination of the real asset decision and financial asset acquisition decisions represent
SE
acquisition or investment decisions. Generally, we talk about investment decisions in terms of
financial management.
2. What are some of the key corporate financing decisions made by firms?
How does a firm decide between raising money through debt or equity?
In terms of equity how does it raise the equity: through retaining earnings or through new
D
issues of equity?
In fact, how does a firm decide to go public and issue shares to the general public versus
remaining a non-traded private company?
O
If it decides to issue debt, what determine whether this is bank debt or bonds issued to the
public debt market?
What determines whether firms can access the short-term money market versus borrowing
C
from a bank?
3. What are the two key topics covered in the study of corporate finance?
The financial management of assets and corporate financing decisions represent the area of
S
corporate finance.
Solutions Manual 17 Chapter 1
Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
