Solutions to questions and problems

Foundations of Finance

  1. List the advantages and disadvantages of the following forms of business:
    1. Sole proprietorship

      1. Easy to form.
      2. Low cost to form.
      3. Owner is typically the manager of the business.
      4. Income is taxed only once (at proprietor level).
      1. Unlimited liability for the owner.
      2. Limited access to additional capital.
      3. Life of proprietorship ends with proprietor.

    2. Partnership

      1. Easier to form than a corporation.
      2. Low cost to form.
      3. Income and assets are shared according to the partnership agreement.
      4. Income is taxed only once (at partner level).
      1. Unlimited liability for the owners.
      2. Limited acces to additonal capital.
      3. Life of partnership ends with partners.

    3. Corporation

      1. Limited liability for the owners.
      2. Ready access to capital.
      1. Double taxation.
      2. Must be granted corporate charter by a state.
      3. Agency problems arise as owners become separated from management.

  2. List and briefly describe the advantages of a limited liability company form of business relative to the corporate form of business.

    1. Easier to form.
    2. If designed to satify tax laws, not subject to double taxation.

  3. Explain the difference, if any, between accounting profit and economic profit.

    1. Accounting profit is based on accounting principles that use, in part, historical values.
    2. Economic profit considers the opportunity cost of capital, whereas accounting profit does not.
    3. Accounting profit can be manipulated by the judicious choice of accounting methods; economic profit, theoretically, can only be determined using one method.
    4. Maximizing economic profit is consistent with maximizing the value of the firm; maximizing accoutnig profit may not be.

  4. What is the goal of the firm and how does it relate to a company's profit?

    1. The goal of the firm is to maximize value,
    2. Maximizing a firm's economic profit is consistent with maximizing the firm's value.
    3. The maximization of accounting profit is not necessarily consistent with the goal of maximizing a firm's value.

  5. List and briefly describe three compensation devices that may be used to provide incentives for managers to maximize owners' wealth.

    1. Bonus: a cash amount that is rewarded based on meeting specified performance targets.
    2. Options: options that give the employeed the right to buy stock at a specified price within a specified period of time.
    3. Stock appreciation rights: compensation corresponding to changes in the firm's share price.
    4. Performance shares: shares of stock given as rewards based on operating performance.
    5. Restricted stock grant: options to buy stock, where the stock must be owned for a period of time.

  6. What is the role of Sarbanes-Oxley in corporate governance?

    Sarbanes-Oxley affects corporate governance with the several provisions that affect corporate governance, including:
    1. Creates the Public Company Accounting Oversight Board, which monitors the accounting profession and auditing of public companies.
    2. Requires the Board's Audit Committee members to be independent and increases the responsibilities of the members of the committee.
    3. Requires disclosure regarding whether the company's Audit Committee has a financial expert as one of its members.
    4. Addresses potential conflicts of interest with regard to the auditing accounting firm.