SOLUTION MANUAL FOR FUNDAMENTALS OF CORPORATE
FINANCE CANADIAN EDITION, 4TH EDITION BY
JONATHAN BERK, PETER DEMARZO, DAVID A
STANGELAND
Chapter 1
Corporate Finance and the Financial Manager
Note: All problems in this chapter are available in MyLabFinance. An asterisk (*) indicates
problems with a higher level of difficulty.
1. A corporation is a legal entity separate from its owners. This means ownership shares in
the corporation can be freely traded. None of the other organizational forms share this
characteristic.
2. Owners’ liability is limited to the amount they invested in the firm. Stockholders are not
responsible for any encumbrances of the firm; in particular, they cannot be required to
pay back any debts incurred by the firm.
3. Corporations and limited liability companies. Limited partnerships provide limited
liability for the limited partners, but not for the general partners.
4. Advantages: Limited liability, liquidity, infinite life
Disadvantages: Double taxation, separation of ownership and control
5. Real estate corporations must pay corporate income taxes but REITs do not pay corporate
tax; instead, they must pass through substantially all of the income to the trust unit
holders to whom the income is taxable.
6. Excel Solution
Plan: First find the value remaining after corporate taxes. Then determine the remainder
after personal taxes.
Execute: First the corporation pays the taxes. After taxes, $2 × (1 – 0.34) = $1.32 per
share is left to pay dividends. Once the dividend is paid, personal tax on this must be paid
leaving $1.32 × (1 – 0.18) = $1.0824 per share.
Evaluate: After all the taxes are paid, you are left with $1.0824 per share.
7. Excel Solution
Plan: First find the value remaining after corporate taxes. Then determine the remainder
after personal taxes.
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, Execute: As a REIT, there is no corporate tax so the full $2 per share can be paid out to
you as a unit holder. You must then pay personal income tax on the distribution. So you
are left with $2 × (1 – 0.4) = $1.20 per share.
Evaluate: After all the taxes are paid, you are left with $1.20 per share.
8. The investment decision is the most important decision that a financial manager makes,
as the manager must decide how to put the owners’ money to its best use.
9. The goal of maximizing shareholder wealth is agreed upon by all shareholders because
all shareholders are better off when this goal is achieved.
10. Shareholders can do the following:
a. Ensure that employees are paid with company stock and/or stock options.
b. Ensure that underperforming managers are fired.
c. Write contracts that ensure that the interests of the managers and shareholders are
closely aligned.
d. Mount hostile takeovers.
11. When your parents pay for the meal, you benefit from the food but do not take on the cost
of the food. This is similar to the agency problem in corporations, when managers can
benefit from taking actions in their own personal interests using money that belongs to
shareholders.
12. The agent (renter) will not take the same care of the apartment as the principal (owner),
because the renter does not share in the costs of fixing damage to the apartment. To
mitigate this problem, having the renter pay a deposit would motivate the renter to keep
damages to a minimum. The deposit forces the renter to share in the costs of fixing any
problems that are caused by the renter.
13. There is an ethical dilemma when the CEO of a firm has opposite incentives to those of
the shareholders. In this case, you (as the CEO) have an incentive to potentially overpay
for another company (which would be damaging to your shareholders) because your pay
and prestige will improve.
*14. Plan: For each of parts (a) to (d) you must determine if your personal change in monetary
wealth more than offsets the value to you of losing your leisure time (valued at $51,000).
If it does, then you would decide to proceed with the new project.
Execute:
a. If you owned 100% of the company and the project were accepted, your personal
shares of stock would increase in value by 100% of $1 million = $1 million. This
would more than offset your personal cost of lost leisure; therefore, your decision
would be to proceed with the project.
b. If you owned 1% of the company and the project were accepted, your personal shares
of stock would increase in value by 1% of $1 million = $10,000. This would not be
, enough to offset your personal cost of lost leisure; therefore your decision would be
to reject the project.
c. If you owned 3% of the company and the project were accepted, your personal shares
of stock would increase in value by 3% of $1 million = $30,000. In addition, you
would receive a bonus of $25,000, so in total your monetary wealth would increase
by $55,000. This more than offsets your personal cost of lost leisure; therefore, your
decision would be to proceed with the project.
d. If you accept the project your monetary wealth would increase by $25,000 + 3% of
$X. For you to decide to accept the project, this must be greater than $51,000 (the
value of your lost leisure). Solving for X we get the following:
$25,000 0.03X $51,000
0.03X $26,000
X $866,666.67
Evaluate:
e. In part (a), you (as the CEO) are perfectly aligned with the owners of the company as
you actually own the whole company. Thus, you receive the full benefit of the
$1 million increase in equity value and this offsets the value to you of the lost leisure.
In part (b), your incentives are not aligned with shareholders because the project
should be accepted to maximize shareholder wealth, but you reject it because the
increase in your monetary wealth does not offset the cost of your extra effort and lost
leisure time. Here, the principal-agent problem results in a decision that is costly to
shareholders as a whole. In part (c), your incentives are aligned with shareholders as
you receive enough of a monetary benefit to offset your cost of lost leisure. In
part (d), though, we can see that the bonus scheme does not always solve the
principal-agent problem. Your incentives are aligned with all shareholders when the
project increases the equity value by an amount greater than $866,666.67. However,
if the increase in equity value is lower, you would decide to reject the project even
though accepting it would maximize shareholder wealth.
15. This will impact and hurt the customers. It will be a negative impact for the customers as
they will likely get sour milk. It will also be a negative impact for shareholders because,
in the long run, customers will realize that the supermarket sells sour milk and they will
switch supermarkets. Thus, the value today of the future income and cash flow streams
generated by the supermarket will drop because of the long-term loss of customers
caused by this strategy. This will negatively impact the current stock price as
stockholders anticipate these long-term negative effects.
*16. There are many considerations for you as CEO. One is the cost–benefit analysis of
constructing the SD project and reaping the savings in disposal costs—that should show
whether the SD project increases shareholder value. In addition, if your bonus is tied to
earnings, you may be tempted to accept the project because of your higher bonuses for
each of the next 10 years. There are other considerations, though. For example, is the SD
method legal? If not, then the company could face substantial fines and reputational
damage by using SD. Also, SD may leak into the ground water—that could further
damage SPB’s reputation, cause major lawsuits, and necessitate environmental clean-up
charges. These costs would affect the cost-benefit analysis for sure. For your personal
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