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© Pearson Education Limited 2008
The Business, Tax, and Financial Environments
Corporation, n. An ingenious device for obtaining
individual profit without individual responsibility.
AMBROSE BIERCE
The Devil’s Dictionary
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
ANSWERS TO QUESTIONS
1. The principal advantage of the corporate form of business organization is that the
corporation has limited liability. The owner of a small family restaurant might be required
2. The liability is limited to the amount of the investment in both the limited partnership and in
the corporation. However, the limited partner generally does not have a role in selecting the
3. With both a sole proprietorship and partnership, a major drawback is the legal liability of
the owners. It extends beyond the financial resources of the business to the owners
personally. Fringe benefits are not deductible as an expense. Also, both forms of
5. Accelerated depreciation is used up to the point it is advantageous to switch to straight line
depreciation. A one-half year convention is followed in the first year, which reduces the
6. The immunity from each other’s taxing power dates back to the early part of the 19th
8. With the differential taxation of ordinary income and capital gains, securities with a higher
10. One advantage to S becoming a corporation occurs when investors have outside income
Chapter 2: The Business, Tax, and Financial Environments
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© Pearson Education Limited 2008
11. Tax incentives are the result of special interest groups influencing legislators. For example,
exporters influenced the passage of DISCs. Doctors and attorneys influenced the passage of
12. The purpose of the carryback and carryforward provisions is to allow the cyclical company
with large profit swings to obtain most of the tax benefits available to a company with more
13. Financial markets allow for efficient allocation in the flow of savings in an economy to
ultimate users. In a macro sense, savings originate from savings-surplus economic units
whose savings exceed their investment in real assets. The ultimate users of these savings are
14. Financial intermediaries provide an indirect channel for the flow of funds from savers to
ultimate users. These institutions include commercial banks, savings and loan associations,
15. Differences in maturity, default risk, marketability, taxability, and option features affect
yields on financial instruments. In general, the longer the maturity, the greater the default
risk, the lower the marketability and the more the return is subject to ordinary income
16. The market becomes more efficient when the cost of financial intermediation is reduced.
This cost is represented by the difference in interest rate between what the ultimate saver
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
17. These exchanges serve as secondary markets wherein the buyer and seller meet to exchange
18. a. All other things being the same, the cost of funds (interest rates) would rise. If there are
b. Given a somewhat segmented market for mortgages, it would result in mortgage rates
c. It would lower the demand for common stock, bonds selling at a discount, real estate,
d. Great uncertainty would develop in the money and capital markets and the effect would
e. Financial markets would be less efficient in channeling funds from savers to investors
19. Answers to this question will differ depending on the financial intermediary that is chosen.
The economic role of all is to channel savings to investments at a lower cost and/or with
20. Money markets serve the short-term liquidity needs of investors. The usual line of
However, both markets are financial markets with the same economic purpose so the
21. Transaction costs impede the efficiency of financial markets. The larger they are, the less
efficient are financial markets. Financial institutions and brokers perform an economic
23. Financial brokers, such as investment bankers in particular as well as mortgage bankers,
Chapter 2: The Business, Tax, and Financial Environments
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© Pearson Education Limited 2008
SOLUTIONS TO PROBLEMS
1. a. Under the partnership, $418,000 in actual liabilities. If sued, they could lose up to their
b. Creditors should be less willing to extend credit, because the personal net worths of the
2.
Equipment Machine
Cost $28,000.00 $53,000.00
Depreciation in year:
1 9,332.40 10,600.00
3. Tripex rates
Payment
Percent Subject
to Taxes
Amount Subject
to Taxes
Taxes
4. Corporate income tax
Year Profit Taxes
20X1 $ 0 $ 0
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
5. a. The expected real rate of return is 5 percent, and the inflation premium is 4 percent.
b. The lender gains in that his real return is 7 percent instead of the 5 percent that was
c. With 6 percent inflation, the real return of the lender is only 3 percent, so he suffers
whereas the borrower gains.
SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. a. Henry is responsible for all liabilities, book as well as contingent. If the lawsuit were
b. He still could lose all his net assets because Kobayashi’s net worth is insufficient to
c. Under the corporate form, he could lose the business, but that is all. The net worth of
2. Depreciation charges for the equipment:
Year Percent Amount
1 20.00% $ 3,200.00
3. a. At $2 million in expenses per $100 million in loans, administrative costs come to 2
percent. Therefore, to just break even, the firm must set rates so that (at least) a 2
b. Before-tax profit of 1 percent on $100 million in loans equals $1 million.
Chapter 2: The Business, Tax, and Financial Environments
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© Pearson Education Limited 2008
