Chapter 1

Question 1

Proprietorships and Partnerships (Advantages)

Answer 1

• Ease of formation
• Subject to few regulations
• No corporate income taxes

Question 2

Proprietorships and Partnerships (Disadvantages)

Answer 2

• Difficult to raise capital
• Unlimited liability
• Limited life
• Often set up through LLCs/LLPs

Question 3

Corporations (Advantages)

Answer 3

• Unlimited life
• Easy transfer of ownership
• Limited liability
• Ease of raising capital

Question 4

Corporations (Disadvantages)

Answer 4

• Double taxation

- Cost of setup and report filing

Question 5

Stock Prices and its determinants

Answer 5

Determinants:
Managerial Actions, the Economic Environment, Taxes, and the Political Climate:
-“Perceived” Investor Cash Flows
-“Perceived” Risk

***Market Equilibrium: Intrinsic Value = Stock Price

Question 6

Intrinsic Value and its determinants

Answer 6

Determinants:
Managerial Actions, the Economic Environment, Taxes, and the Political Climate:
-“True” Investor Cash Flows
-“True” Risk

A long-run concept.

To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value.

Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run.

Question 7

Stockholder-Manager Conflicts

Answer 7

Managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders).

But the following factors affect managerial behavior:

• Managerial compensation packages
• Direct intervention by shareholders
• The threat of firing
• The threat of takeover

Question 8

Stockholder-Debtholder Conflicts

Answer 8

Stockholders are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds. By contrast, bondholders receive fixed payments and are more interested in limiting risk.

Bondholders are particularly concerned about the use of additional debt.

Bondholders attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers’ actions.