CH 2 - Corporate Finance

Question 1

What is a limited liability?

Answer 1

The owner is not responsible for the debts of the company, the most that can be lost is the amount invested in the business.

Question 2

What is an unlimited liability?

Answer 2

The owner is personally responsible for all of the company’s debts.

Question 3

What is the agency problem?

Answer 3

Arises when the interests of the principal and agent are not aligned.

Depends on the interests of the managers and how they are compensated.

Question 4

What are the costs associated with the agency problem?

Answer 4

(1) Direct agency cost

(2) Indirect agency cost

Question 5

Define direct agency cost

Answer 5

Costs that are incurred when agent makes a decision that does not benefit the company.

 A company investing the firm’s money into a bad project

 The CEO using the corporate jet to take his friends to Cancun.

Question 6

Define indirect agency cost

Answer 6

Costs incurred in order to prevent direct agency costs.

 Costs of monitoring employees
 Extra compensation to incentivize management to work well.

Question 7

How does one align managers and owners interests?

Answer 7

Use stock based compensation

The managers become shareholders and will have same interests as the owners.

Stock-based compensation is better than profit-based compensation because managers can play with the numbers to make
profits look higher.