Principles Managerial Solutions 1

Topics: Taxation, Progressive tax, Income tax Pages: 16 (1985 words) Published: February 6, 2013
Chapter 1


The Role and Environment of Managerial Finance


Agency Costs

Answer: Agency costs are the costs borne by stockholders to maintain a governance structure that ensures against dishonest acts of management, and gives managers the financial incentive to maximize share price. One example of agency costs is stock options, which are used to provide an incentive for managers to work diligently for the benefit of the firm. Tips are similar to stock options in that they are offered as rewards for good service much as stock options are used to reward managers, presumably based on their good performance—which subsequently leads to a higher stock price. The Donut Shop, Inc. example does not represent a clear case of agency costs because it is the management itself that has instituted the “No tips” policy and the employees have responded with reduced performance. By banning tips, the management has created a situation where an agency cost may be necessary to provide an incentive for employees to resume their former level of performance.

One solution that may work for Donut Shop, Inc. is to institute a profit-sharing plan that reaches down to the employee level where the slowdown and inefficiency are occurring. A profit-sharing plan is designed to motivate the employees and could alleviate the aggravation caused by the no-tip policy, but must be clearly identified as the replacement to tipping in order to be effective. A profit sharing plan is usually viewed by the employees as a reward for good performance, but does not have the immediacy of the positive effect that an employee gets from a tip.

It is unclear from the case whether the new no-tip policy is a company-wide policy or simply the actions of a few branch managers. However, the real solution here is to recognize that the no-tip policy has created an unnecessary backlash that can be alleviated by reversing management’s position without incurring the additional costs of revising the current employee benefit plan and paying out a portion of corporate profits.


Stock Dividends vs. Interest

Answer: While 100% of corporate interest income is taxed at ordinary income tax rates, only 30% of corporate dividend income is treated as taxable income. Based solely on the tax treatment of corporate dividend income versus interest income, Pruro, Inc. would have greater after-tax income if it chooses the Reston stock paying 5% dividends over the promissory note paying 5% interest.

T Solution to Problems

LG 1: Liability Comparisons
(a) Ms. Harper has unlimited liability.
(b) Ms. Harper has unlimited liability.
(c) Ms. Harper has limited liability, which guarantees that she cannot lose more than she invested.



Part 1

Introduction to Managerial Finance

LG 2, 4: Marginal cost-benefit analysis and the goal of the firm Intermediate
(a) Benefits from new robotics
Benefits from existing robotics
Marginal benefits


(b) Initial cash investment
Receipt from sale of old robotics
Marginal cost


(c) Marginal benefits
Marginal cost
Net benefits


(d) Ken should recommend that the company replace the old robotics with the new robotics. The net benefit to shareholders is positive which should make the shareholders better off. (e) Ken should consider more than just net benefits. He should incorporate the important points of timing, cash flow, and risk, three important factors to determining the true impact on shareholders’ wealth.


LG 2: Annual Income versus Cash Flow for a Period
(a) Sales
Cost of good sold
Net profit


(b) Cash Receipts
Cost of good sold
Net cash flow


(c) The cash flow statement is more useful to the financial manager. The accounting net income includes amounts that will not be collected and, as a result, do not...
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