Principles of Finance 6e Chapter 6
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CHAPTER 6
ANSWERS
6-1 Proprietorship, partnership, and corporation are the three principal forms of business organization.
The advantages of the first two include the ease and low cost of formation. The advantages of the
6-3 Stockholder wealth maximization is a long-run goal. Companies, and consequently the
6-4 The management of an oligopolistic firm would be more likely to engage voluntarily in “socially
6-5 Profit maximization abstracts from (1) the timing of profits and (2) the riskiness of different operating
6-6 Such factors as a compensation system that is based on management performance (bonuses tied
6-7 a. Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to
create a more attractive community that will make it easier to hire a productive work force. This
corporate philanthropy could be received by stockholders negatively, especially those
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6-8 Taking into account differential labor costs overseas, transportation, tax advantages, and so forth,
6-9 The corporate structure of foreign firms generally is characterized by greater concentration in
ownership, which often means more involvement in ownership and operations by large lenders,
such as banks and other financial institutions, and by large groups or families. In many instances,
this means that banks, other financial institutions, and ownership groups can meet most or all of the
financing needs of a firm. In the United States, on the other hand, banks and financial institutions
6-10 The value of any asset is measured by translating the cash flows that the asset is expected to
generate in the future into current dollars—that is, by finding the present value of the expected
6-11 Corporate governance refers to the “set of rules” that a firm follows when conducting business. In
general, corporate governance relates to the manner in which a firm is operated. Corporate
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governance affects the manner in which a firm approaches its decision-making tasks, treats its
employees and customers, constructs its financial statements, and so forth. Because its
governance policy affects how a company does business, corporate governance is a major factor
that determines whether a firm “acts” ethically. If a firm does not have a good corporate governance
policy—that is, a good set of rules to follow—then there is a chance that management might behave
unethically—either intentionally or unintentionally—at some point. Firms that have good corporate
governance policies generally have higher values than firms that don’t.
6-12 A firm must consider all of its stakeholders—that is, investors, customers, employees, local
6-13 Factors that make financial decision making more complicated for firms that operate in foreign
6-14 a. Because capital gains are taxed only when they are received, the tax laws would favor
retention of earnings for an investor who does not need current income.
6-16 If the business were organized as a partnership or a proprietorship, its income could be taken out
by the owners without being subject to double taxation. Also, if you expected to have losses for a
6-17 Because interest paid by a corporation is deductible but dividend payments are not, all else equal,
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SOLUTIONS
6-1 a. Tax = $22,250 + ($200,000 – $100,000)(0.39) = $61,250.
6-2 a. Income $365,000
Less: Interest deduction ( 50,000)
b. The company’s marginal tax rate is 39 percent. The company’s average tax rate is
6-3 a. If Deanna holds the stock for only five months, the gain is a short-term capital gain that is taxed
at the marginal tax rate appropriate for Deanna’s income level, which is 25 percent. Thus, the
capital gains tax liability here is:
Capital gains tax liability = [($40 – $35) x 100 shares] x 0.25 = $500 x 0.25 = $125
6-4 a. The holding period is two years, so the 15 percent capital gains rate applies. There is no capital
gains tax exemption to holding municipal bonds; only the annual interest is tax exempt.
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c. The holding period is two years, so the long-term capital gains rate applies. The long-term capital
gains rate for corporations is the same as its ordinary income tax rate. The capital gains tax
liability would be:
Capital gains tax liability = [($57 – $55) x 100] x 0.35 = $70
6-5 The firm has to first amend its tax forms from the most recent two years.
Prior Two Years Last Year Two Years Ago
Profit earned $150,000 $150,000
Carryback credit (150,000) (150,000)
Adjusted taxable income $ 0 $ 0
6-6 2015 taxes = $0, because the firm had a loss. The $95,000 loss will be used to offset future
income.
2016 taxes = $0; $70,000 income offset by 2015 loss; $25,000 = $95,000 – $70,000 of the 2015
loss remains for carryover to subsequent years
6-7 a. 2016 2017 2018
Taxes as a corporation:
Income before salary & taxes $90,000.0 $120,000.0 $150,000.0
Less salary (60,000.0) ( 60,000.0) ( 60,000.0)
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Computations for proprietorship tax:
2016: $1,815.00 + ($54,700 – $18,151) x 0.15 = $7,297.5
b. On the basis of these figures, Brown has a decision to make, because her tax liability would be
6-8 a. Calculation of gross income:
2015
Salary $60,000
Interest Income (IBM bonds only) 5,000
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Calculation of taxable income:
Gross Income $66,000
b. Marginal tax rate = 25%.
c. The IBM bonds provide an after-tax yield equal to:
d. 9% = 11%(1 – T). Now solve for T:
9 = 11 – 11T
11T = 2
6-9 a. Salary $45,200.00
Exemptions = 2 x $3,950 ( 7,900.00)
6-10 a. Salary and income:a
Donald’s salary $50,000.0
Expenses, exemptions, and deductions:
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Exemptions = 2 x $3,950 $ 7,900.0
a We could have included Maryanne’s salary in this section, but then we would have had to
recognize the amount she earned as an expense associated with the rental property.
b. Salary and income:
Donald’s salary $50,000.0
Interest from bonds 2,500.0
Adjusted income $52,500.0
c. Expenses incurred to generate business income are tax deductible, but personal expenses are
6-11 Integrative Problem
a. The three main forms of business organization are the proprietorship, the partnership, and the
b. Mr. Kimble probably should organize as a proprietorship, because it is easy to start the
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c. If the company is so successful that it grows to be a large organization, then Mr. Kimble
d. Mr. Kimble should operate the business so that his best interests are met. Perhaps he would
e. After converting to a corporation and selling stock to outsiders, PAR will have multiple owners,
f. U.S. and foreign companies “go international” for the following major reasons:
1. To seek new markets. After a company has saturated its home market, growth
opportunities often are better in foreign markets.
g. 1. Different currency denominations. Cash flows in various parts of a multinational
corporate system often are denominated in different currencies. Hence, an analysis of
exchange rates and the effects of fluctuating currency values must be included in all
financial analyses.
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5. Role of governments. Most traditional models in finance assume the existence of a
competitive marketplace in which the terms of trade are determined by the participants.
6-12 Integrative Problem
a. (1) Calculation of taxable income:
Salary $50,000
Interest received 3,000
b. Taxes as a corporation:
Income $100,000
c. Your marginal tax rate is 25 percent.
After-tax return:
At what tax rate will the after-tax yields on the two investments be the same?
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Thus, wealthy investors in the top brackets (33% and 35%) are more likely to buy tax-exempt
bonds than people in lower tax brackets.
6-13 Computer-Related Problem
(1) Payout ratio = 50%
INPUT DATA: 2014 2015 2016
Business income $90,000 $120,000 $150,000
Itemized deductions $19,500 $19,500 $19,500
Number of exemptions 4 4 4
MODEL-GENERATED DATA:
Taxes as a corporation: 2014 2015 2016
Income before salary & taxes $90,000.0 $120,000.0 $150,000.0
Less salary -60,000.0 -60,000.0 -60,000.0
Taxable income, corporate 30,000.0 60,000.0 90,000.0
(2) Payout ratio = 100%
INPUT DATA: 2014 2015 2016
Business income $90,000 $120,000 $150,000
Itemized deductions $19,500 $19,500 $19,500
Number of exemptions 4 4 4
Chapter 6 Principles of Finance 6e
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MODEL-GENERATED DATA:
Taxes as a corporation: 2014 2015 2016
Income before salary & taxes $90,000.0 $120,000.0 $150,000.0
Less salary -60,000.0 –60,000.0 -60,000.0
Taxable income, corporate 30,000.0 60,000.0 90,000.0
Taxes as a proprietorship:
Total income 90,000.0 120,000.0 150,000.0
Less exemptions & deductions -35,300.0 -35,300.0 -35,300.0
b. If earnings before salary and taxes double each year, the following would exist:
INPUT DATA: 2014 2015 2016
Business income $180,000 $240,000 $300,000
Itemized deductions $19,500 $19,500 $19,500
MODEL-GENERATED DATA:
Taxes as a corporation: 2014 2015 2016
Income before salary & taxes $180,000.0 $240,000.0 $300,000.0
Less salary -60,000.0 -60,000.0 -60,000.0
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Chapter 6 Principles of Finance 6e
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• What action do you think FET should take?
There are a variety of responses to this question. Some students will suggest that FET ignore the flaw,
because it doesn’t seem to occur very often. Remind these students that the new micro system will be
References:
It is well documented in the business press that Intel Corporation was embroiled in controversy over a flaw
in the Pentium computer chip it introduced in 1994. The cost of replacing the flawed chips that were installed
in computers resulted in a fourth-quarter profit in 1994 that was 37 percent lower than the previous year. In
addition, a number of lawsuits were filed accusing Intel of fraud, false advertising, and various violations of
state laws protecting consumers.
On the other hand, in part because of the controversy created by the Intel situation, in 1995, Advanced
Micro Devices, Inc. delayed the distribution of its new computer chip, which was intended to compete
directly with Intel’s Pentium chip, because it was felt technical corrections and additional testing were
needed.
You can find additional information concerning these two situations in articles that appear in The
Wall Street Journal at the end of 1994 and throughout 1995. The following articles might be assigned for
background material:
“Chip Shot: Computer Giants’ War Over Flaw in Pentium Jolts the PC Industry,” The Wall Street Journal,
December 3, 1994, p. A1+.
“AMD Will Delay Delivery of New Chips Aimed at Competing With Intel Pentium,” The Wall Street Journal,
April 11, 1995, p. B5.
Annick Jesdanun, “Experts Spot Security Flaw in Windows Vista Software,” The Tampa Tribune, December
27, 2006, Business 1+.