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 it might 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 stockholders sell 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 income of 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