Corporate Finance Chapter 1 Solution

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Solutions to Textbook Answers Chapter 1 Introduction

Solutions to questions
1. Finance involves three main areas—corporate finance, financial institutions and markets, and investments—that are closely related and complementary. For example, in corporate finance the central issues are how to acquire and employ or invest funds. To acquire funds a financial manager must deal with financial institutions, so some knowledge of the operations of financial institutions and markets is essential. Similarly, corporate finance involves investments because decisions have to be made about which assets should be acquired by a business. Given the close relationship between these three areas of finance, it is impossible to discuss one of them without some discussion of the others. In investment decisions , managers consider the amount invested in the assets of the business and the composition of that investment. Managers of the business are therefore involved in the task of choosing, usually from a long list of available projects, those that are to be undertaken. In addition to decisions about the amount and composition of investments, managers have to decide how to finance them. These are financing decisions . This will involve generating funds internally or raising funds from sources external to the business. Financing decisions also involve dividend decisions because payment of dividends reduces the internally generated funds that are available. (a) A sole proprietorship is a business owned by one person. Many small service businesses, retail stores and professional practices are operated as sole proprietorships. Although the owner of a sole proprietorship is legally liable for its debts, the business should be regarded by the proprietor as a separate entity. (b) A partnership is a business owned by two or more people acting as partners. Partnerships are not separate legal entities and the partners are therefore personally liable for the debts of the partnership. From the viewpoint of managing the business, however, a partnership is treated as an entity separate from the partners. Many small service businesses, retail stores and professional practices are operated as partnerships. (c) A company is a separate legal entity formed under the Corporations Act 2001 . The owners of a company are called shareholders because their ownership interests are represented by shares in the company’s capital. Separate legal entity status enables a company to conduct its operations in its own name as a legal entity. Companies vary greatly in size and objectives —the Corporations Act distinguishes between public companies, which may invite members of the public to invest in them , and proprietary companies, which have no such intention. 1

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The advantages of a sole proprietorship structure include: (a) Control of the business rests with the owner, so it is relatively easy to make decisions and there is no scope for disagreements between owners. (b) A sole proprietorship is easy and inexpensive to both form and dissolve. Initially, the owner makes an investment in the business and may borrow money to supplement this investment. If it is decided to dissolve the business, the owner can simply cease operations, sell the assets, pay any amounts owing and keep any proceeds that remain. (c) A sole proprietorship is not treated as a separate entity for tax purposes. Any business profits belong to the owner and therefore are taxed only once as part of the owner’s assessable income for the year. The disadvantages of a sole proprietorship include: (a) A sole proprietorship is not a separate legal entity and therefore the owner has unlimited liability for debts incurred as a result of the business’s operations. In other words, all obligations of the business are personal obligations of the owner, so if the business fails and some of its debts are unpaid, then those to whom money is owed may be able to lay claim to the owner’s personal assets....
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