Chapter 1 The Scope of Corporate Finance 15
months of restatement of earnings and prevention of manager trading during pen-
sion blackout periods.
• Sections 301, 407, 307 and 501: “Gatekeeper” clauses – which guides those in
charge of SROs (Self Regulating Organizations) and auditing committees.
• Section 1107 (others have some mention of this also): Enhancing the tools of the
SEC and protection of the whistleblowers in organizations where unethical behav-
iors are being reported
Solutions to End-of-Chapter Problems
LEGAL FORMS OF BUSINESS ORGANIZATION
P1–1. a. Calculate the tax disadvantage to organizing a U.S. business today as a corporation, as
compared to a partnership, under the following conditions. Assume that all earnings will be
A1-1. a. If the firm is organized as a partnership, operating income will be taxed only once,
so investors will receive $500,000 x (1-0.35) = $325,000. If the firm is organized
b. Using the pre-2003 tax rates, partnership investors would receive $500,000 x (1–
P1-2. Calculate the tax disadvantage to organizing a U.S. business as a corporation versus as a
partnership under the following conditions. Assume that all earnings will be paid out as cash
dividends. Operating income (operating profit before taxes) will be $3,000,000 per year un-
16 Instructor’s Manual
A1-2. a.If the firm is organized as a partnership, operating income will be taxed only once, so
investors will receive $3,000,000 (1−0.35) = $2,100,000. If the firm is organized as a cor-
poration, operating income will be taxed once at the corporate level, leaving $3,000,000
THE CORPORATE FINANCIAL MANAGER’S GOALS
P1-3. Consider the following simple corporate example involving one stockholder and one man-
ager. There are two mutually exclusive projects in which the manager may invest and two
possible manager compensation plans that the stockholder may choose to employ. The man-
ager may be paid a flat $300,000 or receive 10 percent of corporate profits. The stockholder
receives all profits net of manager compensation. The probabilities and associated gross
profits associated with each project are given below:
Project #1
Project #2
Probability
Gross Profit
Probability
Gross Profit
33.33%
$0
50.0%
$600,000
a. Which project maximizes shareholder wealth? Which compensation plan does the man-
ager prefer if this project is chosen?
b. Which project will the manager choose under a flat compensation arrangement?
c. Which compensation plan aligns the interests of the stockholders and the manager so
that the manager will act in the best interest of the stockholders?
d. What do the answers tell you about structuring management pay contracts?
A1-3. Payoffs to Project #1
Probability
Gross
Profit
Manager’s
Flat Pay
Stockholders
Payoff
Manager’s
10% Payoff
Stockholders
Payoff
1/3
$ 0
$300,000
$ -300,000
$ 0
$ 0
Payoffs to Project #2
Probability
Gross
Profit
Manager’s
Flat Pay
Stockholders
Payoff
Manager’s
10% Payoff
Stockholders
Payoff
1/2
a. Project #1 has the higher expected gross profit and stockholder’s payoff, regardless
of the managerial compensation method. If Project #1 is chosen, the manager
would prefer the 10% payoff because it provides greater compensation ($400,000
vs. $300,000 flat compensation).
$675,000 for Project #2) and managers ($400,000 vs. $75,000 for Project #2).
THOMSON ONE Business School Edition:
Access financial information from the Thomson ONE – Business School Edition Web site for the
in the respective boxes and then click OK (or hit Enter). From the ensuing page, click Click Here
to Access Thomson ONE – Business School Edition Now! This opens up a new window that
gives you access to the Thomson ONE – Business School Edition database. You can retrieve a
company’s financial information by entering its ticker symbol (provided for each company in the
problem[s]) in the box below “Name/Symbol/Key.”
P1-4 Examine the insider activities of Johnson & Johnson (ticker symbol, JNJ). Under the Filings
tab, click on the Daily 144 List in the Insider Analytics box. Does there appear to be a preponder-
ance of proposed buying or selling of JNJ shares? Does this suggest that an agency problem exists?
Answer to MiniCase
Minicase: The Scope of Corporate Finance
The potential career paths for a person with expertise in finance are varied and exciting. Career
possibilities include the areas of corporate finance, commercial banking, investment banking, mon-
ey management, and consulting.
Assignment
Find descriptions for these and other finance-related careers on the following Web site:
http://www.wetfeet.com/asp/careerlist.asp
Think of ways that the skills described as being vital to success in this chapter can be applied in
each career listed. How will the ongoing trends of globalization and increased technological so-
phistication likely impact these jobs over the next decade?
Answer
The following information is from WetFeet, Incorporated (www.wetfeet.com). Some places in
1. Corporate Finance
Career Overview
If you work in private enterprise, your company measures its success at the end of the year by
comparing how much money it made to how much it spent. If it made more than it spent, it was a
good year. If it made less than it spent, it was a bad year—or the company was in an investment
phase. (In other words, like Amazon.com, it spent more than it made because the company and its
investors believed it would realize a profit in the near future.)
Chapter 1 The Scope of Corporate Finance 19
People who work in corporate finance and accounting are responsible for managing the mon-
ey—forecasting where it will come from, knowing where it is, and helping managers decide how to
spend it in ways that will ensure the greatest return.
What You’ll Do
Corporate finance includes two key functions: accounting and finance.
Accounting concerns itself with day-to-day operations. Accountants balance the books, track
expenses and revenue, execute payroll, and pay the bills. They also compile all the financial data
needed to issue a company’s financial statements in accordance with government regulations.
2. Commercial Banking
Industry Overview
Asked why he robbed banks, Willie Sutton replied, “Because that’s where the money is.” That was
in the ’30s, but even today, despite changes, a lot of the money is still in commercial banks. Most of
us maintain checking accounts at commercial banks and use their ATMs. The money we deposit in
20 Instructor’s Manual
as 7-Eleven stores in the American landscape. And thanks to the repeal of the Glass-Steagall Act,
which limited the businesses commercial banks could operate in, there’s the move among banks
into nontraditional businesses such as insurance products and securities.
Trends
Consolidation and New Jobs
For decades, banks profited by simply holding customers’ money and charging them check-writing
fees and interest on loans. Jobs were well defined and stable, and the paths to promotion were clear
Deregulation
The Glass-Steagall Act, passed by Congress in 1933, served as the backbone of banking regulation.
During the late ’90s, however, banks and other financial institutions found ways around the re-
Problem Loans and Lower Profits
Just so you know that it’s not all sweetness and light in the commercial banking industry: Bank-
ruptcies at companies like Enron and Kmart and the fact that most companies have been so con-
How It Breaks Down
As a job seeker, the most important distinction to keep in mind is between regional banks and the
Consumer or Retail Banking
This is what most people think of when they think of banking: A small to mid-sized branch with
tellers and platform officers—the men and women in suits sitting at the nice wooden desks with
Business or Corporate Banking
Many of the players in this group are the same ones in the consumer-banking business; others
you’ll find on Wall Street, not Main Street. At the highest level, the larger players (Wells Fargo,
Securities and Investments
Traditionally, this field has been the domain of a few Wall Street firms. However, as federal regu-
Nontraditional Options
Increasingly, a number of nonbank entities are offering opportunities to people interested in finan-
cial services. Players include credit card companies such as American Express, MasterCard, and
Job Prospects
Two of the major trends in banking in the past decade or more have been consolidation (e.g., the
acquisition of Bank One by J.P. Morgan Chase, or the takeover of FleetBoston by Bank of Ameri-
ca) and the increasing use of technology (e.g., online banking, or automated check processing).
Both of these trends have had and will continue to have a negative effect on job growth in the in-
dustry.
22 Instructor’s Manual
3. Investment Banking
Career Overview
You’ve heard about the legendary long hours, the big bonuses, and the megabillion-dollar deals.
What I-Banking Is
Traditionally, commercial banks and investment banks performed completely distinct functions.
When Joe on Main Street needed a loan to buy a car, he visited a commercial bank. When Sprint
needed to raise cash to fund an acquisition or build its fiber-optic network, it called on its invest-
ment bank. Paychecks and lifestyles reflected this division too, with investment bankers reveling in
their large bonuses and glamorous ways while commercial bankers worked nine-to-five and then
went home to their families. Today, as the laws requiring the separation of investment and com-
mercial banking are reformed, more and more firms are making sure they have a foot in both
camps, thus blurring the lines and the cultures.
Investment banking isn’t one specific service or function. It is an umbrella term for a range of
What You’ll Do
The intensely competitive, action-oriented, profit-hungry world of investment banking can seem
like a bigger-than-life place where deals are done and fortunes are made. In fact, it’s a great place
Chapter 1 The Scope of Corporate Finance 23
Who Does Well
You shouldn’t go into banking just for the money—the lifestyle is too demanding. To survive in
investment banking, much less to do well, you’ll need to like the work itself. And, quite honestly,
even if you love the work, an investment banking career can still be a tough road. If the market or
More Investment Banking
Industry Overview
The intensely competitive, action-oriented, profit-hungry world of investment banking can seem
like a bigger-than-life place where deals are done and fortunes are made. In fact, it’s a great place
to learn the ins and outs of corporate finance and pick up analytical skills that will remain useful
throughout your business career. But investment banking has a very steep learning curve, and
chances are you’ll start off in a job whose duties are more Working Girl than Wall Street.
Wall Street is filled with high-energy, hardworking young hotshots. Some are investment
So where do you begin, and how do you focus your job search? Let’s begin with an important
reminder: Investment banking isn’t one specific service or function. It is an umbrella term for a
range of activities: underwriting, selling, and trading securities (stocks and bonds); providing fi-
nancial advisory services, such as mergers and acquisition advice; and managing assets. Investment
banks offer these services to companies, governments, nonprofit institutions, and individuals.
Traditionally, commercial banks and investment banks performed completely distinct func-
4. Asset Management
24 Instructor’s Manual
Career Overview
If money makes the world go ’round, the Earth would grind to a screeching halt without the asset
management industry. Asset management is the business of making money with money—or at
What You’ll Do
Asset managers manage money—other people’s money (the return earned on these investments
is the marginal benefit, whereas the marginal cost is can oftentimes be viewed as the return on
any possible alternative investments), and gobs of it. Generally, they convert that money into as-
Who Does Well
As an asset manager, you can’t just bet your hunches. The profession requires excellent quantitative
and analytical skills—if you hated statistics, you may want to look for a career elsewhere. But asset
5. Mutual Funds & Brokerage
Industry Overview
When a large amount of money is needed for any enterprise, from building a factory to funding a
corporation to drilling wells in a new oil field, that money is raised from investors—usually a large
number of them. Commonly, the enterprise raises that money by either selling ownership shares in
Chapter 1 The Scope of Corporate Finance 25
6. Insurance
Industry Overview
If you want to impress your friends and family with a job full of glamour, sizzle, and prestige, in-
surance is the wrong game for you. But if you want to work in an industry where there’s always
going to be demand for your services, you’d have a hard time finding a better candidate than insur-
ance.
About 1,800 U.S. insurance companies offer personal and commercial product lines including
basic health/life and property/casualty protection as well as a long list of other coverage ranging
from automobiles to mortgages to insurance for insurance companies (known as reinsurance).
Trends
The Good News
The market swoon ended in 2003, with stock markets posting impressive returns on the year. This
is good news for anybody who trades in equities, of course, but it’s particularly good news for the
Terrorism and Insurance
In the wake of September 11, 2001, insurance companies were faced with tremendous claims. As a
result, reinsurers stopped writing terrorism policies in the United States. Primary insurers, as a re-
26 Instructor’s Manual
Deregulation
Deregulation is redefining who can offer insurance. Repeal, in late 1999, of the 1933 Glass-
Steagall Act (which formerly separated all arenas of financial services) promised a major facelift
Shift in Demand
The shape of the life insurance sector has morphed over the past generation. Nowadays, demand
goes beyond straightforward life insurance. Rather, the market is looking to the insurance industry
Consolidation
Continuing the trend that essentially began 30 years ago, insurance companies are responding to
global competition and the need for cost efficiency by forming strategic alliances, merging into
How It Breaks Down
Life and Health Insurance
The policies in this sector provide benefits packages that policyholders pay a premium to enjoy.
Health insurance has gone through some major overhauls, including the replacement of fixed-fee
Property and Casualty (P/C) Insurance
The focus in this sector is on protection for owners of cars, homes, and businesses from loss, dam-
Chapter 1 The Scope of Corporate Finance 27
Insurance Brokers
Brokers act as go-betweens, uniting buyers and sellers of insurance and creating the contracts that
Reinsurance
In the most simple terms, reinsurance is the insurance of insurance companies. Insurance compa-
Job Prospects
The insurance industry enjoys more demand for its products today than ever before. As the U.S.
population grows and the Baby Boomers reach old age, demand in areas like health insurance, auto
insurance, and homeowners insurance will be especially strong.
However, ongoing consolidation and technology advances make it unlikely that job opportuni-
7. Real Estate
Industry Overview
The real estate industry’s pared–down definition is land. However, it’s much more complicated
than that. The industry involves the buying, selling, renting, leasing, and management of com-
mercial, residential, agricultural, and other kinds of property (the return on any real estate in-
28 Instructor’s Manual
Job Prospects
Unlike much of the rest of the economy, the real estate industry has been doing quite well, with
many leading firms chalking up double-digit top-line growth in 2003. Though the robustness varies
8. Venture Capital
Industry Overview
Underneath their moneyed mystique, venture capitalists are essentially glorified middlemen, and
their modus operandi is easily explained. In a nutshell, a VC firm acts as a broker for institutional
or “limited partner” investors such as pension funds, universities, and high-net-worth individuals,
all of whom pay annual management fees to have their money invested in high-risk, high-potential-
yield start-up companies.
After amassing a certain sum from the limited partner investors—usually between $10 million
and $1 billion—the VC firm parcels out the fund to a portfolio of fledgling private companies, each