Solution manual for foundations of finance 7th edition by keown

First, it focuses on the goal of the firm, followed by a review of the legal forms of business organization, and a discussion of the tax implications relating to financial decisions.. In

CHAPTER 1

An Introduction to the Foundations

of Financial Management

CHAPTER ORIENTATION

This chapter lays a foundation for what will follow First, it focuses on the goal of the firm, followed by a review of the legal forms of business organization, and a discussion of the tax implications relating to financial decisions Ten Principles that form the foundations of financial management then follow

CHAPTER OUTLINE

I Goal of the firm

A In this book, we will designate maximization of shareholder wealth, by which

we mean maximization of the total market value of the firm’s common stock,

to be the goal of the firm To understand this goal and its inclusive nature, it is first necessary to understand the difficulties involved with the frequently suggested goal of profit maximization

B We have chosen the goal of shareholder wealth maximization because the

effects of all financial decisions are included in this goal

C In order to employ this goal, we need not consider every price change to be a

market interpretation of the worth of our decisions What we do focus on is

the effect that our decision should have on the stock price if everything were

held constant

II Five Principles that Form the Foundations of Finance

A Principle 1: Cash Flow Is What Matters In measuring value we will use

cash flows rather than accounting profits because it is only cash flows that the firm receives and is able to reinvest In addition, in making business decisions,

we will concern ourselves with only what happens as a result of that decision

B Principle 2: Money Has a Time Value Almost all financial decisions involve

comparing money in different time periods, perhaps investing today and receiving returns later, or borrowing money today and paying it off later A dollar received today is worth more than a dollar received in the future because of the time value of money

C Principle 3: Risk Requires a Reward There is a risk-return tradeoff in

finance—we won’t take additional risk unless we expect to be compensated with additional return Almost all financial decisions involve some sort of risk-return tradeoff

D Principle 4: Market Prices Are Generally Right In general, the markets are

quick to impound new information into stock prices, and the prices tend to be correct

E Principle 5: Conflicts of Interest Cause Agency Problems As a result of the

agency problem, managers will not work for the owners’ best interest unless it

is in the managers’ best interest as well The agency problem is a result of the separation of the decision makers and the owners of the firm As a result, managers may make decisions that are not in line with the goal of maximization of shareholder wealth

F Avoiding Financial Crisis—Back to the Principles Many of the financial

problems of the past can be traced back to ignoring the basic principles of finance

G The Essential Elements of Ethics and Trust Ethical behavior is doing the

right thing, and ethical dilemmas are everywhere in finance Ethical behavior

is important in financial management, just as it is important in everything we

do Unfortunately, precisely how we define what is and is not ethical behavior

is sometimes difficult Nevertheless, we should not give up the quest In addition, businesses cannot interact unless they trust each other

III The Role of Finance in Business

A There are three basic types of issues that are addressed by the study of finance

1 What long-term investments should the firm undertake? This area of

finance is generally referred to as capital budgeting

2 How should the firm raise money to fund these investments? The firm’s

funding choices are generally referred to as capital structure decisions

3 How can the firm best manage its cash flows as they arise in its

day-to-day operations? This area of finance is generally referred to as working capital management

IV The Legal Forms of Business Organization

A The significance of different legal forms

1 The predominant form of business organization in the United States in

pure numbers is the sole proprietorship

B Sole proprietorship: A business owned by a single person and which has a

minimum amount of legal structure

1 Advantages

a Easily established with few complications

b Minimal organizational costs

c Does not have to share profits or control with others

2 Disadvantages

a Unlimited liability for the owner

b Owner must absorb all losses

c Equity capital limited to the owner’s personal investment

d Business terminates immediately upon owner’s death

C Partnership: An association of two or more individuals coming together as

co-owners to operate a business for profit

1 Two types of partnerships

a General partnership: Relationship between partners is dictated

by the partnership agreement

(l) Advantages

(a) Minimal organizational requirements (b) Negligible government regulations (2) Disadvantages

(a) All partners have unlimited liability (b) Difficult to raise large amounts of capital (c) Partnership dissolved by the death or withdrawal

of general partner

b Limited partnership

(l) Advantages

(a) For the limited partners, liability limited to the

amount of capital invested in the company (b) Withdrawal or death of a limited partner does not

affect continuity of the business (c) Stronger inducement in raising capital (2) Disadvantages

(a) There must be at least one general partner who

has unlimited liability in the partnership (b) Names of limited partners may not appear in the

name of the firm (c) Limited partners may not participate in the

management of the business (d) More expensive to organize than general

partnership, as a written agreement is mandatory

D The corporation: An “impersonal”legal entity having the power to purchase,

sell, and own assets and to incur liabilities while existing separately and apart from its owners

1 Ownership is evidenced by shares of stock

2 Advantages

a Limited liability of owners

b Ease of transferability of ownership (i.e., by the sale of one’s

shares of stock)

c The death of an owner does not result in the discontinuance of

the firm’s life

d Ability to raise large amounts of capital is increased

3 Disadvantages

a Most difficult and expensive form of business to establish

b Control of corporation not guaranteed by partial ownership of

stock

c Corporations also suffer from a double taxation on dividends

The firm first pays taxes on the income it earns; after taxes have been paid on this income, it is paid to investors in the form

of dividends The investor then pays personal taxes on that dividend income

4 S-Type Corporations and Limited Liability Companies (LLC)

a The S-type corporation provides limited liability while allowing

the business owners to be taxed as if they were a partnership— that is, distributions back to the owners are not taxed twice as

is the case with dividends in the corporate form

b The limited liability company (LLC) is a cross between a

partnership and a corporation The LLC retains limited liability for its owners, but is run and taxed like a partnership

ANSWERS TO END-OF-CHAPTER QUESTIONS

1-1 The goal of profit maximization is too simplistic in that it assumes away the problems

of uncertainty of returns and the timing of returns Rather than use this goal, we have chosen maximization of shareholders’ wealth—that is, maximization of the market value of the firm’s common stock—because the effects of all financial decisions are included The shareholders react to poor investment or dividend decisions by causing the total value of the firm’s stock to fall and react to good decisions by pushing the

price of the stock upward In this way, all financial decisions are evaluated, and all financial decisions affect shareholder wealth

1-2 The goal of shareholder wealth maximization must be looked at as a long-run goal As

such, the public image of the firm may be of concern inasmuch as it may affect sales and legislation Thus, while these actions may not directly result in increased profits, they may affect consumers’ and legislators’ attitudes

1-3 Almost all financial decisions involve some sort of risk-return tradeoff The more risk

the firm is willing to accept, the higher the expected return for the given course of action For example, in the area of working capital management, the less inventory held, the higher the expected return, but also the greater the risk of running out of inventory While one manager might accept a given level of risk, another more risk-averse manager may not accept that level of risk This does not mean that one manager is correct and one is not; rather, it only means that not all managers will view the risk-return tradeoff in the same manner

1-4 The agency problem is a result of the separation of owners and managers, where

managers do what’s in their own best interests rather than what is in the best interest

of the shareholders Large firms are typically run by professional managers who own

a small fraction of the firms’ equity The individual actions of these managers are often motivated by self-interest, which may result in managers not acting in the best interests of the firm’s owners When this happens the firm’s owners will lose value 1-5 a A sole proprietorship is a business owned by a single individual who maintains

complete title to the assets, and is also personally liable for all indebtedness incurred

b A partnership is an association of two or more individuals coming together as

co-owners for the purpose of operating a business for profits The partnership

is equivalent to the sole proprietorship, except that the partnership has multiple owners

c A corporation is a legal entity functioning separate and apart from its owners

It can individually sue and be sued, purchase, sell, or own property, and be subject to criminal punishment for crimes

1-6 a The sole proprietor maintains title to the firm’s assets, has unlimited liability,

is entitled to the profits from the business, but must also absorb any losses realized This form of business is easily initiated Termination of the business comes by the owner discontinuing the business or upon his death

b In a partnership, all general partners have unlimited liability Each partner is

liable for the actions of the other partners The partnership agreement dictates the basic relationships among the partners within the firm As with the sole proprietorship, the partnership is terminated upon the desires of any partner within the organization, or upon a partner’s death Under certain conditions a partner’s liability may be restricted to the amount of capital invested in the partnership However, at least one general partner must remain in the association for whom the privilege of limited liability does not apply

c The corporation is legally separate from its owners Ownership of the

corporation is determined by the number of shares of common stock owned by

an individual Since the shares are transferable, the ownership in a corporation may be easily transferred Investors’ liability is limited to the amount of their

investment The life of the corporation is not dependent upon the status of the investors The death or withdrawal of an investor does not disrupt the corporate life However, the cost of forming a corporation is more expensive than a proprietorship or partnership

1-7 a Organizational requirements and costs favor the sole proprietorship or possibly

the general partnership depending upon the approach taken in forming the partnership

b Under corporation, owners have minimum liabilities

c The corporation is definitely the most favorable form of business because it

provides the continuity of the business regardless of an owner’s withdrawal or death

d If ease of ownership transferability is desired, the corporation is best

However, because of certain circumstances, the owners may prefer that ownership not be easily transferred, in which case the partnership would be the most desirable

e The sole proprietor is able to maintain complete and ultimate control and

minimize regulations

f The corporation is the strongest form of legal entity in terms of the ease of

raising capital from external investors

g In regard to income taxes, it is difficult to determine which form of business is

the most advantageous Such a selection is dependent upon individual circumstances

1-8 This is an internet question

1-9 This is an internet question

1-10 This is an internet question

SOLUTION TO MINI CASE

a The goal of profit maximization is too simplistic in that it assumes away the problems

of uncertainty of returns and the timing of returns Rather than use this goal, we have chosen maximization of shareholders’ wealth—that is, maximization of the market value of the firm’s common stock—because the effects of all financial decisions are included The shareholders react to poor investment or dividend decisions by causing the total value of the firm’s stock to fall and react to good decisions by pushing the price of the stock upward In this way, all financial decisions are evaluated, and all financial decisions affect shareholder wealth

b Simply put, investors will not put their money in risky investments unless they are

compensated for taking on that additional risk In effect, the return investors expect is composed of two parts First, they receive a return for delaying consumption, which must be greater than the anticipated rate of inflation Second, they receive a return for taking on added risk Otherwise, both risky and safe investments would have the same expected return associated with them, and no one would take on the risky investments

c The firm receives cash flows and is able to reinvest them, which cannot be done with

accounting profits In effect, accounting profits are shown when they are earned rather than when the money is actually in hand Unfortunately, a firm’s accounting profits and cash flows may not be timed to occur together For example, capital expenses, such as the purchase of a new plant or piece of equipment, are depreciated over several years, with the annual depreciation subtracted from profits However, the cash flow associated with these expenses generally occurs immediately It is the cash inflows that can be reinvested and cash outflows that involve paying out money Therefore, cash flows correctly reflect the true timing of the benefits and costs

d In an efficient market, information is impounded into security prices with such speed

that there are no opportunities for investors to profit from publicly available information Actually, what types of information are immediately reflected in security prices and how quickly that information is reflected determine how efficient the market actually is The implications for us are that stock prices reflect all publicly available information regarding the value of the company This means we can implement our goal of maximization of shareholder wealth by focusing on the effect each decision should have on the stock price, all else held constant It also means that earnings manipulations through accounting changes should not result in price changes In effect, our preoccupation with cash flows is validated

e The agency problem is the result of the separation of management and the ownership

of the firm As a result, managers may make decisions that are not in line with the goal of maximization of shareholder wealth To control this problem, we monitor managers and try to align the interests of shareholders and managers The interests of shareholders and managers can be aligned by setting up stock options, bonuses, and perquisites that are tied directly to how closely management decisions coincide with the interest of shareholders

f Ethical errors are not forgiven in the business world Business interaction is based

upon trust, and there is no way that trust can be eliminated quicker than through an ethical violation The fall of Ivan Boesky and Drexel, Burnham, Lanbert and the near collapse of Salomon Brothers illustrates this fact As a result, acting in an ethical manner is not only morally correct, but it is congruent with our goal of maximization

of shareholder wealth

g (1) A sole proprietorship is a business owned by a single individual who maintains

complete title to the assets, but who is also personally liable for all indebtedness incurred

(2) A partnership is an association of two or more individuals coming together as

co-owners for the purpose of operating a business for profit The partnership is equivalent to the sole proprietorship, except that the partnership has multiple owners

(3) A corporation is a legal entity functioning separate and apart from its owners

It can individually sue and be sued, purchase, sell, or own property, and be subject to criminal punishment for crimes

CASE PROBLEM

LIVING AND DYING WITH ASBESTOS:

WHAT HAPPENS WHEN YOU FIND YOUR MOST PROFITABLE PRODUCT IS DANGEROUS—AN ETHICAL DILEMMA FOR THE FINANCIAL MANAGER

Much of what we deal with in financial management centers around the evaluation of projects—when they should be accepted and when they should be terminated As new information surfaces regarding the future profitability of a project, the firm always has the choice of terminating that project When this new information raises the question of whether

or not it is ethical to produce a profitable project, the decision becomes more difficult Many times ethical dilemmas pit profits versus ethics These decisions become even more difficult when continuing to produce the product is within the law

Asbestos is a fibrous mineral used for fireproofing, electrical insulation, building materials, brake linings, and chemical filters If one is exposed long enough to asbestos particles— usually ten or more years—one can develop a chronic lung inflammation called asbestosis, which makes breathing difficult and infection easy Also linked to asbestos exposure is mesethelioma, a cancer of the chest lining This disease sometimes does not develop until 40 years after the first exposure Although the first major scientific conference on the dangers of asbestos was not held until 1964, the asbestos industry knew of the dangers of asbestos 60 years ago

As early as 1932, the British documented the occupational hazards of asbestos dust inhalation.1 Indeed, on September 25, 1935, the editors of the trade journal Asbestos wrote to

Sumner Simpson, president of Raybestos-Manhattan, a leading asbestos company, asking permission to publish an article on the dangers of asbestos Simpson refused and later praised the magazine for not printing the article In a letter to Vandivar Brown, secretary of Johns-Manville, another asbestos manufacturer, Simpson observed: “The less said about asbestos the better off we are.” Brown agreed, adding that any article on asbestosis should reflect American, not English, data

In fact, American data were available, and Brown, as one of the editors of the journal, knew

it Working on behalf of Raybestos-Manhattan and Johns-Manville and their insurance carrier, Metropolitan Life Insurance Company, Anthony Lanza had conducted research between 1929 and 1931 on 126 workers with three or more years of asbestos exposure But Brown and others were not pleased with the paper Lanza submitted to them for editorial review Lanza, said Brown, had failed to portray asbestosis as milder than silicosis, a lung disease caused by long-term inhalation of silica dust that results in chronic shortness of breath Under the then-pending Workmen’s Compensation law, silicosis was categorized as a compensable disease If asbestosis was worse than silicosis or indistinguishable from it, then

it too would have to be covered Apparently Brown did not want this and thus requested that Lanza depict asbestosis as less serious than silicosis Lanza complied and also omitted from his published report the fact that more than half the workers examined—67 of 126—were suffering from asbestosis

1 See Samuel S Epstein, “The Asbestos Pentagon Papers,” in Mark Green and Robert Massie, Jr., eds.,

The Big Business Reader: Essays on Corporate America (New York: Pilgrim Press, 1980), pp 154–65.

This article is the primary source of the facts and quotations reported here.

Meanwhile, Sumner Simpson was writing F H Schulter, president of Thermoid Rubber Company, to suggest that several manufacturers sponsor further asbestos experiments The sponsors, said Simpson, could exercise oversight prerogatives; they “could determine from time to time after the findings are made whether they wish any publication or not.” Added Simpson: “It would be a good idea to distribute the information to the medical fraternity, providing it is of the right type and would not injure our companies.” Lest there should be any question about the arbiter of publication, Brown wrote to officials at the laboratory conducting the tests:

It is our further understanding that the results obtained will be considered the property of those who are advancing the required funds, who will determine whether, to what extent, and in what manner they shall be made public In the event it is deemed desirable that the results be made public, the manuscript of your study will be submitted to us for approval prior to publication

Industry officials were concerned with more than controlling information flow They also sought to deny workers early evidence of their asbestosis Dr Kenneth Smith, medical director of a Johns-Manville plant in Canada, explained why seven workers he found to have asbestosis should not be informed of their disease:

It must be remembered that although these men have the X-ray evidence of asbestosis, they are working today and definitely are not disabled from asbestosis They have not been told of this diagnosis, for it is felt that as long as the man feels well, is happy at home and at work, and his physical condition remains good, nothing should be said When he becomes disabled and sick, then the diagnosis should be made and the claim submitted by the company The fibrosis of this disease is irreversible and permanent so that eventually compensation will be paid to each of these men But as long as the man is not disabled, it is felt that he should not be told of his condition so that he can live and work in peace and the company can benefit by his many years of experience Should the man be told of his condition today, there is a very definite possibility that he would become mentally and physically ill, simply through the knowledge that he has asbestosis

When lawsuits filed by asbestos workers who had developed cancer reached the industry in the 1950s, Dr Smith suggested that the industry retain the Industrial Health Foundation to conduct a cancer study that would, in effect, squelch the asbestos-cancer connection The asbestos companies refused, claiming that such a study would only bring further unfavorable publicity to the industry and that there was not enough evidence linking asbestos and cancer industry-wide to warrant it

Shortly before his death in 1977, Dr Smith was asked whether he had ever recommended to Johns-Manville officials that warning labels be placed on insulation products containing asbestos He provided the following testimony:

The reasons why the caution labels were not implemented immediately, it was a business decision as far as I could understand Here was a recommendation, the corporation is in business to make, to provide jobs for people and make money for stockholders and they had to take into consideration the effects of everything they did, and if the application of a caution label identifying a product as hazardous would cut out sales, there would be serious financial implications

And the powers that be had to make some effort to judge the necessity of the label vs the consequences of placing the label on the product

Dr Smith’s testimony and related documents have figured prominently in hundreds of asbestos-related lawsuits, totaling more than $1 billion In March 1981, a settlement was reached in nine separate lawsuits brought by 680 New Jersey asbestos workers at a Raybestos-Manhattan plant Several asbestos manufacturers, as well as Metropolitan Life Insurance, were named as defendants Under the terms of the settlement, the workers affected will share in a $9.4 million court-administered compensation fund Each worker will be paid compensation according to the length of exposure to asbestos and the severity of the disease contracted

By 1982, an average of 500 new asbestos cases were being filed each month against Manville (as Johns-Manville was now called), and the company was losing more than half the cases that went to trial In ten separate cases, juries had also awarded punitive damages, averaging

$616,000 a case By August, 20,000 claims had been filed against the company, and Manville filed for bankruptcy in federal court This action froze the lawsuits in their place and forced asbestos victims to stand in line with other Manville creditors After more than three years of legal haggling, Manville’s reorganization plan was finally approved by the bankruptcy court The agreement set up a trust fund valued at approximately $2.5 billion to pay Manville’s asbestos claimants To fund the trust, shareholders were required to surrender half the value

of their stock, and the company had to give up much of its projected earnings over the next

25 years.2

Claims, however, soon overwhelmed the trust, which ran out of money in 1990 With many victims still waiting for payment, Federal Judge Jack B Weinstein ordered the trust to restructure its payments and renegotiate Manville’s contributions to the fund As a result, the most seriously ill victims will now be paid first, but average payments to victims have been lowered significantly—from $145,000 to $43,000 Meanwhile, the trust’s stake in Manville has been increased to 80%, and Manville has been required to pay $300 million to it in additional dividends.3

Adapted by permission: William Shaw and Vincent Barry, Moral Issues in Business, 7th

ed., pp 224-227 Copyright 1995 by Wadsworth, Inc.

QUESTIONS

1 Should the asbestos companies be held morally responsible in the sense of being

capable of making a moral decision about the ill effects of asbestos exposure? Or does

it make sense to consider only the principal people involved as morally responsible, for example, Simpson and Brown?

2 Simpson and Brown presumably acted in what they thought were the best profit

interests of their companies Nothing they did was illegal On what grounds, if any, are their actions open to criticism?

2See Robert Mokhiber, Corporate Crime and Violence (San Francisco: Sierra Club Books, 1988), pp 285–86; and Arthur Sharplin, "Manville Lives On as Victims Continue to Die," Business and Society Review 65 (Spring

1988), 27–8.

3“Asbestos Claims to Be Reduced Under New Plan,” Wall Street Journal, November 20, 1990, p A4; and

“MacNeil-Lehrer Newshour.” December 18, 1990.