Solutions to Chapter 1

Goals and Governance of the Corporation

1. What are the differences between a corporation and a sole proprietorship?

A corporation is a distinct legal entity, separate from its owners (i.e., stockholders). The stockholders have limited liability for the debts and other obligations of the corporation. The liability of the individual stockholder is generally limited to the amount of the stockholder’s investment in the shares of the corporation. Creation of a corporation is a legal process that requires the preparation of articles of incorporation.

On the other hand, a sole proprietorship is not distinct from the individual who operates the business. Therefore, the sole proprietor (i.e., the individual) directly owns the business assets, manages the business, and is personally responsible for the debts of the sole proprietorship.

2. What do we mean when we say that corporate income is subject o double taxation?

Double taxation means that a corporation’s income is taxed first at the corporate tax rate, and then, when the income is distributed to shareholders as dividends, the income is taxed again at each shareholder’s personal tax rate.

3. Explain why each of the following may not be appropriate corporate goals. a. Increase market share b. Minimize costs c. Underprice any competitors d. Expand profits

Increased market share can be an inappropriate goal if it requires reducing prices to such an extent that the firm is harmed financially. Increasing market share can be part of a well-reasoned strategy, but one should always remember that market share is not a goal in itself. The owners of the firm want managers to maximize the value of their investment in the firm.

Minimizing costs can also conflict with the goal of value maximization. For example, suppose a firm receives a large order for a product. The firm should be willing to pay overtime wages and to incur other costs in order to fulfill the order, as long as it can sell the additional product at a price greater than those costs. Even though costs per unit of output increase, the firm still comes out ahead if it agrees to fill the order.

A policy of underpricing any competitor can lead the firm to sell goods at a price lower than the price that would maximize market value. Again, in some situations, this strategy might make sense, but it should not be the ultimate goal of the firm. It should be evaluated with respect to its effect on firm value.

Expanding profits is a poorly defined goal of the firm. The text gives three reasons:

(i) There may be a trade-off between accounting profits in one year and accounting profits in another year. For example, writing off a bad investment may reduce this year’s profits but increase profits in future years. Which year’s profits should be maximized?

(ii) Investing more in the firm can increase profits, even if the increase in profits is insufficient to justify the additional investment. In this case the increased investment increases profits but can reduce shareholder wealth.

(iii) Profits can be affected by accounting rules, so a decision that increases profits using one set of rules may reduce profits using another.

4. Discuss which of the following forms of compensation is most likely to align the interests of managers and shareholders. a. a fixed salary b. A salary linked to company profits. c A salary that is paid partly in the form of the company’s share

a. A fixed salary means that compensation is (at least in the short run) independent of the firm’s success.

b. A salary linked to profits ties the employee’s compensation to this measure of the success of the firm. However, profits are not a wholly reliable way to measure the success of the firm. The text points out that profits are subject to differing accounting rules and reflect only the current year’s situation rather than the long-run prospects of the firm.

c. A salary that is paid partly in the form of the company’s shares means that the manager earns the most when the shareholders’ wealth is maximized. This is therefore most likely to align the interests of managers and shareholders.

5. Explain the differences between the CFO’s responsibilities and the treasurer’s and controllers’ responsibilities

The responsibilities of the treasurer include the following: supervising cash management, raising capital, and banking relationships. The controller’s responsibilities include supervision of accounting, preparation of financial statements, and tax matters. The CFO of a large corporation supervises both the treasurer and the controller. The CFO is responsible for large-scale corporate planning and financial policy.