ńňđ. 2
(âńĺăî 2)


variety of other investment vehicles are all traded on these exchanges. The two
key types of securities exchanges are the organized exchange and the over-the-
counter exchange. In addition, important markets exist outside the United States.

Organized Securities Exchanges Organized securities exchanges are tangi-
organized securities exchanges
Tangible organizations that act ble organizations that act as secondary markets where outstanding securities are
as secondary markets where resold. Organized exchanges account for about 46 percent of the total dollar vol-
outstanding securities are
ume of domestic shares traded. The best-known organized exchanges are the
New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX),
both headquartered in New York City. There are also regional exchanges, such
as the Chicago Stock Exchange and the Pacific Stock Exchange.
Most exchanges are modeled after the New York Stock Exchange, which
accounts for about 93 percent of the total annual dollar volume of shares traded
on organized U.S. exchanges. In order for a firm’s securities to be listed for trad-
ing on an organized exchange, a firm must file an application for listing and meet
a number of requirements. For example, to be eligible for listing on the NYSE, a
firm must have at least 2,000 stockholders owning 100 or more shares; a mini-
mum of 1.1 million shares of publicly held stock; pretax earnings of at least $6.5
million over the previous 3 years, with no loss in the previous 2 years; and a min-
imum of $100 million in stockholders’ equity. Clearly, only large, widely held
firms are candidates for NYSE listing.
To make transactions on the “floor” of the New York Stock Exchange, an
individual or firm must own a “seat” on the exchange. There are a total of 1,366
seats on the NYSE, most of which are owned by brokerage firms. Trading is car-
ried out on the floor of the exchange through an auction process. The goal of trad-
ing is to fill buy orders at the lowest price and to fill sell orders at the highest price,
thereby giving both purchasers and sellers the best possible deal.
Once placed, an order to buy or sell can be executed in minutes, thanks to
sophisticated telecommunication devices. New Internet-based brokerage systems
enable investors to place their buy and sell orders electronically. Information on
publicly traded securities is reported in various media, both print, such as the Wall
Street Journal, and electronic, such as MSN Money Central Investor (www.

The Over-the-Counter Exchange The over-the-counter (OTC) exchange is
over-the-counter (OTC) exchange
An intangible market for the an intangible market for the purchase and sale of securities not listed by the orga-
purchase and sale of securities
nized exchanges. OTC traders, known as dealers, are linked with the purchasers
not listed by the organized
and sellers of securities through the National Association of Securities Dealers
Automated Quotation (Nasdaq) system.
This sophisticated telecommunications network provides current bid and ask
prices on thousands of actively traded OTC securities. The bid price is the highest
price offered by a dealer to purchase a given security, and the ask price is the low-
est price at which the dealer is willing to sell the security. The dealer in effect adds
securities to his or her inventory by purchasing them at the bid price and sells
securities from the inventory at the ask price. The dealer expects to profit from
the spread between the bid and ask prices. Unlike the auction process on the
organized securities exchanges, the prices at which securities are traded in the
OTC market result from both competitive bids and negotiation.
24 PART 1 Introduction to Managerial Finance

Unlike the organized exchanges, the OTC handles both outstanding securi-
ties and new public issues, making it both a secondary and a primary market. The
OTC accounts for about 54 percent of the total dollar volume of domestic shares

International Capital Markets Although U.S. capital markets are by far the
world’s largest, there are important debt and equity markets outside the United
States. In the Eurobond market, corporations and governments typically issue
Eurobond market
The market in which corpora- bonds denominated in dollars and sell them to investors located outside the
tions and governments typically
United States. A U.S. corporation might, for example, issue dollar-denominated
issue bonds denominated in
bonds that would be purchased by investors in Belgium, Germany, or Switzerland.
dollars and sell them to investors
Through the Eurobond market, issuing firms and governments can tap a much
located outside the United
larger pool of investors than would be generally available in the local market.
The foreign bond market is another international market for long-term debt
securities. A foreign bond is a bond issued by a foreign corporation or govern-
foreign bond
Bond that is issued by a foreign ment that is denominated in the investor’s home currency and sold in the
corporation or government and is investor’s home market. A bond issued by a U.S. company that is denominated in
denominated in the investor’s
Swiss francs and sold in Switzerland is an example of a foreign bond. Although
home currency and sold in the
the foreign bond market is much smaller than the Eurobond market, many issuers
investor’s home market.
have found this to be an attractive way of tapping debt markets in Germany,
Japan, Switzerland, and the United States.
Finally, the international equity market allows corporations to sell blocks of
international equity market
A market that allows corpora- shares to investors in a number of different countries simultaneously. This mar-
tions to sell blocks of shares to
ket enables corporations to raise far larger amounts of capital than they could
investors in a number of different
raise in any single national market. International equity sales have also proven to
countries simultaneously.
be indispensable to governments that have sold state-owned companies to private
investors during recent years.

The Role of Securities Exchanges
Securities exchanges create continuous liquid markets in which firms can obtain
needed financing. They also create efficient markets that allocate funds to their
efficient market
A market that allocates funds to most productive uses. This is especially true for securities that are actively traded
their most productive uses as a
on major exchanges, where the competition among wealth-maximizing investors
result of competition among
determines and publicizes prices that are believed to be close to their true value.
wealth-maximizing investors that
The price of an individual security is determined by the demand for and supply of
determines and publicizes prices
the security. The competitive market created by the major securities exchanges
that are believed to be close to
their true value. provides a forum in which share price is continuously adjusted to changing
demand and supply.

Review Questions

1–18 Who are the key participants in the transactions of financial institutions?
Who are net suppliers and who are net demanders?
1–19 What role do financial markets play in our economy? What are primary
and secondary markets? What relationship exists between financial insti-
tutions and financial markets?
1–20 What is the money market? How does it work?
CHAPTER 1 The Role and Environment of Managerial Finance

1–21 What is the Eurocurrency market? What is the London Interbank Offered
Rate (LIBOR) and how is it used in this market?
1–22 What is the capital market? What are the primary securities traded in it?
1–23 What role do securities exchanges play in the capital market? How does
the over-the-counter exchange operate? How does it differ from the orga-
nized securities exchanges?
1–24 Briefly describe the international capital markets, particularly the
Eurobond market and the international equity market.
1–25 What are efficient markets? What determines the price of an individual
security in such a market?

Business Taxes

Taxes are a fact of life, and businesses, like individuals, must pay taxes on
income. The income of sole proprietorships and partnerships is taxed as the
income of the individual owners; corporate income is subject to corporate taxes.
Regardless of their legal form, all businesses can earn two types of income: ordi-
nary and capital gains. Under current law, these two types of income are treated
differently in the taxation of individuals; they are not treated differently for enti-
ties subject to corporate taxes. Frequent amendments in the tax code, such as the
Economic Growth and Tax Relief Reconciliation Act of 2001 (reflected in the
following discussions), make it likely that these rates will change before the next
edition of this text is published. Emphasis here is given to corporate taxation.

Ordinary Income
The ordinary income of a corporation is income earned through the sale of goods
ordinary income
Income earned through the sale or services. Ordinary income is currently taxed subject to the rates depicted in the
of a firm’s goods or services. corporate tax rate schedule in Table 1.3.

TABLE 1.3 Corporate Tax Rate Schedule

Tax calculation

Range of taxable income Base tax (Marginal rate amount over base bracket)

$ 0 to $ 50,000 $ 0 (15% amount over $ 0)
50,000 to 75,000 7,500 (25 amount over 50,000)
75,000 to 100,000 13,750 (34 amount over 75,000)
100,000 to 22,250 (39 amount over 100,000)
335,000 to 10,000,000 113,900 (34 amount over 335,000)
Over $10,000,000 3,400,000 (35 amount over 10,000,000)
aBecause corporations with taxable income in excess of $100,000 must increase their tax by the lesser of
$11,750 or 5% of the taxable income in excess of $100,000, they will end up paying a 39% tax on taxable
income between $100,000 and $335,000. The 5% surtax that raises the tax rate from 34% to 39% causes all
corporations with taxable income between $335,000 and $10,000,000 to have an average tax rate of 34%.
26 PART 1 Introduction to Managerial Finance

Western Manufacturing, Inc., a small manufacturer of kitchen knives, has before-
tax earnings of $250,000. The tax on these earnings can be found by using the
tax rate schedule in Table 1.3:
Total taxes due $22,250 [0.39 ($250,000 $100,000)]
$22,250 (0.39 $150,000)
$22,250 $58,500 $80,750
From a financial point of view, it is important to understand the difference
between average and marginal tax rates, the treatment of interest and dividend
income, and the effects of tax deductibility.

Average Versus Marginal Tax Rates
The average tax rate paid on the firm’s ordinary income can be calculated by
average tax rate
A firm’s taxes divided by its dividing its taxes by its taxable income. For firms with taxable income of
taxable income. $10,000,000 or less, the average tax rate ranges from 15 to 34 percent, reaching
34 percent when taxable income equals or exceeds $335,000. For firms with
taxable income in excess of $10,000,000, the average tax rate ranges between 34
and 35 percent. The average tax rate paid by Western Manufacturing, Inc., in the
preceding example was 32.3 percent ($80,750 $250,000). As a corporation’s
taxable income increases, its average tax rate approaches and finally reaches 34
percent. It remains at that level up to $10,000,000 of taxable income, beyond
which it rises toward but never reaches 35 percent.
The marginal tax rate represents the rate at which additional income is taxed.
marginal tax rate
The rate at which additional In the current corporate tax structure, the marginal tax rate on income up to
income is taxed. $50,000 is 15 percent; from $50,000 to $75,000 it is 25 percent; and so on, as
shown in Table 1.3. Western Manufacturing’s marginal tax rate is currently 39
percent because its next dollar of taxable income (bringing its before-tax earnings
to $250,001) would be taxed at that rate. To simplify calculations in the text, a
fixed 40 percent tax rate is assumed to be applicable to ordinary corporate income.

If Western Manufacturing’s earnings go up to $300,000, the marginal tax rate on
the additional $50,000 of income will be 39 percent. the company will therefore
have to pay additional taxes of $19,500 (.39 $50,000). Total taxes on the
$300,000, then, will be $100,250 ($80,750 $19,500). To check this figure
using the tax rate schedule in Table 1.3, we would get a total tax liability of
$22,500 [.39 ($300,000 $100,000)] $22,250 $78,000 $100,250—
the same value obtained by applying the marginal tax rate to the added income
and adjusting the known tax liability.

The average tax rate tends to be most useful in evaluating taxes historically,
and the marginal tax rate is more frequently used in financial decision making.
Given our focus on financial decision making, the tax rates used throughout this
text are assumed to represent marginal tax rates.
double taxation
Interest and Dividend Income
Occurs when the already once-
taxed earnings of a corporation
In the process of determining taxable income, any interest received by the corpo-
are distributed as cash dividends
ration is included as ordinary income. Dividends, on the other hand, are treated
to stockholders, who must pay
differently. This different treatment moderates the effect of double taxation,
taxes on them.
CHAPTER 1 The Role and Environment of Managerial Finance

which occurs when the already once-taxed earnings of a corporation are distrib-
uted as cash dividends to stockholders, who must pay taxes on them. Therefore,
dividends that the firm receives on common and preferred stock held in other cor-
porations, and representing less than 20 percent ownership in them, are subject
to a 70 percent exclusion for tax purposes.4
Because of the dividend exclusion, only 30 percent of these intercorporate
intercorporate dividends
Dividends received by one dividends are included as ordinary income. The tax law provides this exclusion to
corporation on common and avoid triple taxation. Triple taxation would occur if the first and second corpora-
preferred stock held in other
tions were taxed on income before the second corporation paid dividends to its
shareholders, who must then include the dividends in their taxable incomes. The
dividend exclusion in effect eliminates most of the potential tax liability from the
dividends received by the second and any subsequent corporations.

Checker Industries, a major manufacturer of molds for the plastics industry, dur-
ing the year just ended received $100,000 in interest on bonds it held and
$100,000 in dividends on common stock it owned in other corporations. The
firm is subject to a 40% marginal tax rate and is eligible for a 70% exclusion on
its intercorporate dividend receipts. The after-tax income realized by Checker
from each of these sources of investment income is found as follows:

Interest income Dividend income

(1) Before-tax amount $100,000 $100,000
Less: Applicable exclusion 0 (0.70 $100,000) 70,000
Taxable amount $100,000 $ 30,000
(2) Tax (40%) 40,000 12,000
After-tax amount [(1) (2)] $ 60,000 $ 88,000

As a result of the 70% dividend exclusion, the after-tax amount is greater for the
dividend income than for the interest income. Clearly, the dividend exclusion
enhances the attractiveness of stock investments relative to bond investments
made by one corporation in another.

Tax-Deductible Expenses
In calculating their taxes, corporations are allowed to deduct operating
expenses, as well as interest expense. The tax deductibility of these expenses
reduces their after-tax cost. The following example illustrates the benefit of tax

Two companies, Debt Co. and No Debt Co., both expect in the coming year to
have earnings before interest and taxes of $200,000. Debt Co. during the year

4. The exclusion is 80% if the corporation owns between 20 and 80% of the stock in the corporation paying it divi-
dends; 100% of the dividends received are excluded if it owns more than 80% of the corporation paying it divi-
dends. For convenience, we are assuming here that the ownership interest in the dividend-paying corporation is less
than 20%.
28 PART 1 Introduction to Managerial Finance

will have to pay $30,000 in interest. No Debt Co. has no debt and therefore will
have no interest expense. Calculation of the earnings after taxes for these two
firms is as follows:

Debt Co. No Debt Co.

Earnings before interest and taxes $200,000 $200,000
Less: Interest expense 30,000 0
Earnings before taxes $170,000 $200,000
Less: Taxes (40%) 68,000 80,000
Earnings after taxes $102,000 $120,000

Difference in earnings after taxes $18,000

Whereas Debt Co. had $30,000 more interest expense than No Debt Co., Debt
Co.’s earnings after taxes are only $18,000 less than those of No Debt Co.
($102,000 for Debt Co. versus $120,000 for No Debt Co.). This difference is
attributable to the fact that Debt Co.’s $30,000 interest expense deduction pro-
vided a tax savings of $12,000 ($68,000 for Debt Co. versus $80,000 for No
Debt Co.). This amount can be calculated directly by multiplying the tax rate by
the amount of interest expense (0.40 $30,000 $12,000). Similarly, the
$18,000 after-tax cost of the interest expense can be calculated directly by multi-
plying one minus the tax rate by the amount of interest expense [(1 0.40)
$30,000 $18,000].

The tax deductibility of certain expenses reduces their actual (after-tax) cost
to the profitable firm. Note that both for accounting and tax purposes interest is
a tax-deductible expense, whereas dividends are not. Because dividends are not
tax deductible, their after-tax cost is equal to the amount of the dividend. Thus a
$30,000 cash dividend has an after-tax cost of $30,000.

Capital Gains
If a firm sells a capital asset (such as stock held as an investment) for more than
its initial purchase price, the difference between the sale price and the purchase
price is called a capital gain. For corporations, capital gains are added to ordinary
capital gain
The amount by which the sale corporate income and taxed at the regular corporate rates, with a maximum mar-
price of an asset exceeds the ginal tax rate of 39 percent.5 To simplify the computations presented in the text,
asset’s initial purchase price.
as for ordinary income, a fixed 40 percent tax rate is assumed to be applicable to
corporate capital gains.

Loos Company, a manufacturer of pharmaceuticals, has pretax operating earn-
ings of $500,000 and has just sold for $40,000 an asset that was purchased 2
years ago for $36,000. Because the asset was sold for more than its initial pur-

5. The Omnibus Budget Reconciliation Act of 1993 included a provision that allows the capital gains tax to be
halved on gains resulting from investments made after January 1, 1993, in startup firms with a value of less than $50
million that have been held for at least 5 years. This special provision, which is intended to help startup firms, is
ignored throughout this text.
CHAPTER 1 The Role and Environment of Managerial Finance

chase price, there is a capital gain of $4,000 ($40,000 sale price $36,000 initial
purchase price). The corporation’s taxable income will total $504,000 ($500,000
ordinary income plus $4,000 capital gain). Because this total is above $335,000,
the capital gain will be taxed at the 34% rate (see Table 1.3), resulting in a tax of
$1,360 (0.34 $4,000).

Review Questions

1–26 Describe the tax treatment of ordinary income and that of capital gains.
What is the difference between the average tax rate and the marginal tax
1–27 Why might the intercorporate dividend exclusion make corporate stock
investments by one corporation in another more attractive than bond
1–28 What benefit results from the tax deductibility of certain corporate

Using This Text
The organization of this textbook links the firm’s activities to its value, as deter-
mined in the securities markets. The activities of the financial manager are
described in the five parts of the book. Each major decision area is presented in
terms of both return and risk factors and their potential impact on owners’
wealth. Coverage of international events and topics is integrated into the chapter
The text has been developed around a group of learning goals—six per chap-
ter. Mastery of these goals results in a broad understanding of managerial finance.
These goals have been carefully integrated into a learning system. Each chapter
begins with a numbered list of learning goals. Next to each major text heading is a
“toolbox,” which notes by number the specific learning goal(s) addressed in that
section. At the end of each section of the chapter (positioned before the next
major heading) are review questions that test your understanding of the material
in that section. At the end of each chapter, the chapter summaries, self-test prob-
lems, and problems are also keyed by number to each chapter’s learning goals. By
linking all elements to the learning goals, the integrated learning system facilitates
your mastery of the goals.
Also keyed to various parts of the text is the PMF Brief CD-ROM Software,
a disk for use with IBM PCs and compatible microcomputers. The disk contains
three different sets of routines:

1. The PMF Brief Tutor is a user-friendly program that extends self-testing
opportunities in the more quantitative chapters beyond those included in the
end-of-chapter materials. It gives immediate feedback with detailed solutions
and provides tutorial assistance (including text references). Text discussions
and end-of-chapter problems with which the PMF Brief Tutor can be used
are marked with a .
30 PART 1 Introduction to Managerial Finance

2. The PMF Brief Problem-Solver can be used as an aid in performing many of
the routine financial calculations presented in the book. A disk symbol, ,
identifies those text discussions and end-of-chapter problems that can be
solved with the PMF Brief Problem-Solver.
3. The PMF Brief Excel Spreadsheet Templates can be used with Microsoft
Excel to input data and carry out “what-if” types of analyses in selected
chapters. These problems are marked by the symbol .

A detailed discussion of how to use the PMF Brief CD-ROM Software—the
Tutor, the Problem-Solver, and the Excel Spreadsheet Templates—is included in
Appendix D at the back of this book.
Each chapter ends with a case that integrates the chapter materials. Where
applicable, the symbols for the PMF Brief Problem-Solver and/or the PMF Brief
Tutor identify case questions that can be solved with the aid of these programs.
The chapter-end cases can be used to synthesize and apply related concepts and

Chapter 1 established the primary goal of the firm—to maximize the wealth of the owners
for whom the firm is being operated. For public companies, which are the focus of this text,
value at any time is reflected in the stock price. Therefore, management should act only on
those alternatives or opportunities that are expected to create value for owners by increasing
the stock price. Doing this requires management to consider the returns (magnitude and tim-
ing of cash flows) and the risk of each proposed action and their combined impact on value.

agerial finance is concerned with the duties of the fi-
Define finance, the major areas of finance
nancial manager in the business firm. It offers nu-
and the opportunities available in this field, and
merous career opportunities, as shown in Table 1.2.
the legal forms of business organization. Finance,
The recent trend toward globalization of business
the art and science of managing money, affects the
activity has created new demands and opportunities
lives of every person and every organization. Major
in managerial finance.
opportunities in financial services exist within bank-
The legal forms of business organization are the
ing and related institutions, personal financial plan-
sole proprietorship, the partnership, and the corpo-
ning, investments, real estate, and insurance. Man-
CHAPTER 1 The Role and Environment of Managerial Finance

ration. The corporation is dominant in terms of prevent or minimize agency problems. Firms incur
business receipts and profits, and its owners are its agency costs to monitor managers’ actions and pro-
common and preferred stockholders. Stockholders vide incentives for them to act in the best interests
expect to earn a return by receiving dividends or by of owners. Stock options and performance plans are
realizing gains through increases in share price. The examples of such agency costs.
key strengths and weaknesses of the common legal
forms of business organization are summarized in Understand the relationship between financial
Table 1.1. institutions and markets, and the role and
operations of the money and capital markets.
Describe the managerial finance function and Financial institutions serve as intermediaries by
its relationship to economics and accounting. channeling into loans or investments the savings of
All areas of responsibility within a firm interact individuals, businesses, and governments. The
with finance personnel and procedures. In large financial markets are forums in which suppliers and
firms, the managerial finance function might be demanders of funds can transact business directly.
handled by a separate department headed by the Financial institutions actively participate in the
vice president of finance (CFO), to whom the trea- financial markets as both suppliers and demanders
surer and controller report. The financial manager of funds.
must understand the economic environment and re- In the money market, marketable securities
lies heavily on the economic principle of marginal (short-term debt instruments) are traded, typically
analysis to make financial decisions. Financial man- through large New York banks and government
agers use accounting but concentrate on cash flows securities dealers. The Eurocurrency market is the
and decision making. international equivalent of the domestic money
Identify the primary activities of the financial In the capital market, transactions in long-term
manager within the firm. The primary activities debt (bonds) and equity (common and preferred
of the financial manager, in addition to ongoing in- stock) are made. The organized securities exchanges
volvement in financial analysis and planning, are provide secondary markets for securities. The over-
making investment decisions and making financing the-counter exchange, a telecommunications net-
decisions. work, offers a secondary market for securities and is
a primary market in which new public issues are
Explain why wealth maximization, rather than sold. Important debt and equity markets—the
profit maximization, is the firm’s goal and how Eurobond market and the international equity mar-
the agency issue is related to it. The goal of the fi- ket—exist outside of the United States. The securi-
nancial manager is to maximize the owners’ wealth, ties exchanges create continuous liquid markets for
as evidenced by stock price. Profit maximization ig- needed financing and allocate funds to their most
nores the timing of returns, does not directly con- productive uses.
sider cash flows, and ignores risk, so it is an inap-
propriate goal. Both return and risk must be Discuss the fundamentals of business taxation
assessed by the financial manager who is evaluating of ordinary income and capital gains. Corpo-
decision alternatives. The wealth-maximizing ac- rate income is subject to corporate taxes. Corporate
tions of financial managers should also reflect the tax rates are applicable to both ordinary income
interests of stakeholders, groups who have a direct (after deduction of allowable expenses) and capital
economic link to the firm. Positive ethical practices gains. The average tax rate paid by a corporation
help the firm and its managers to achieve the firm’s ranges from 15 to nearly 35 percent. (For conve-
goal of owner wealth maximization. nience, we assume a 40 percent marginal tax rate in
An agency problem results when managers, as this book.) Corporate taxpayers can reduce their
agents for owners, place personal goals ahead of taxes through certain provisions in the tax code
corporate goals. Market forces, in the firm of share- such as intercorporate dividend exclusions and tax-
holder activism and the threat of takeover, tend to deductible expenses.
32 PART 1 Introduction to Managerial Finance

SELF-TEST PROBLEM (Solution in Appendix B)
ST 1–1 Corporate taxes Montgomery Enterprises, Inc., had operating earnings of
$280,000 for the year just ended. During the year the firm sold stock that it held
in another company for $180,000, which was $30,000 above its original pur-
chase price of $150,000, paid 1 year earlier.
a. What is the amount, if any, of capital gains realized during the year?
b. How much total taxable income did the firm earn during the year?
c. Use the corporate tax rate schedule given in Table 1.3 to calculate the firm’s
total taxes due.
d. Calculate both the average tax rate and the marginal tax rate on the basis of
your findings.

1–1 Liability comparisons Merideth Harper has invested $25,000 in Southwest
Development Company. The firm has recently declared bankruptcy and has
$60,000 in unpaid debts. Explain the nature of payments, if any, by Ms. Harper
in each of the following situations.
a. Southwest Development Company is a sole proprietorship owned by Ms.
b. Southwest Development Company is a 50–50 partnership of Ms. Harper and
Christopher Black.
c. Southwest Development Company is a corporation.

1–2 Accrual income versus cash flow for a period Thomas Book Sales, Inc., sup-
plies textbooks to college and university bookstores. The books are shipped with
a proviso that they must be paid for within 30 days but can be returned for a full
refund credit within 90 days. In 2003, Thomas shipped and billed book titles
totaling $760,000. Collections, net of return credits, during the year totaled
$690,000. The company spent $300,000 acquiring the books that it shipped.
a. Using accrual accounting and the preceding values, show the firm’s net profit
for the past year.
b. Using cash accounting and the preceding values, show the firm’s net cash
flow for the past year.
c. Which of these statements is more useful to the financial manager? Why?

1–3 Identifying agency problems, costs, and resolutions Explain why each of the
following situations is an agency problem and what costs to the firm might
result from it. Suggest how the problem might be dealt with short of firing the
individual(s) involved.
a. The front desk receptionist routinely takes an extra 20 minutes of lunch to
run personal errands.
b. Division managers are padding cost estimates in order to show short-term
efficiency gains when the costs come in lower than the estimates.
c. The firm’s chief executive officer has secret talks with a competitor about the
possibility of a merger in which (s)he would become the CEO of the com-
bined firms.
CHAPTER 1 The Role and Environment of Managerial Finance

d. A branch manager lays off experienced full-time employees and staffs cus-
tomer service positions with part-time or temporary workers to lower
employment costs and raise this year’s branch profit. The manager’s bonus is
based on profitability.

1–4 Corporate taxes Tantor Supply, Inc., is a small corporation acting as the exclu-
sive distributor of a major line of sporting goods. During 2003 the firm earned
$92,500 before taxes.
a. Calculate the firm’s tax liability using the corporate tax rate schedule given in
Table 1.3.
b. How much are Tantor Supply’s 2003 after-tax earnings?
c. What was the firm’s average tax rate, based on your findings in part a?
d. What is the firm’s marginal tax rate, based on your findings in part a?

1–5 Average corporate tax rates Using the corporate tax rate schedule given in
Table 1.3, perform the following:
a. Calculate the tax liability, after-tax earnings, and average tax rates for the
following levels of corporate earnings before taxes: $10,000; $80,000;
$300,000; $500,000; $1.5 million; $10 million; and $15 million.
b. Plot the average tax rates (measured on the y axis) against the pretax income
levels (measured on the x axis). What generalization can be made concerning
the relationship between these variables?

1–6 Marginal corporate tax rates Using the corporate tax rate schedule given in
Table 1.3, perform the following:
a. Find the marginal tax rate for the following levels of corporate earnings
before taxes: $15,000; $60,000; $90,000; $200,000; $400,000; $1 million;
and $20 million.
b. Plot the marginal tax rates (measured on the y axis) against the pretax
income levels (measured on the x axis). Explain the relationship between
these variables.

1–7 Interest versus dividend income During the year just ended, Shering
Distributors, Inc., had pretax earnings from operations of $490,000. In addi-
tion, during the year it received $20,000 in income from interest on bonds it
held in Zig Manufacturing and received $20,000 in income from dividends on
its 5% common stock holding in Tank Industries, Inc. Shering is in the 40%
tax bracket and is eligible for a 70% dividend exclusion on its Tank Industries
a. Calculate the firm’s tax on its operating earnings only.
b. Find the tax and the after-tax amount attributable to the interest income
from Zig Manufacturing bonds.
c. Find the tax and the after-tax amount attributable to the dividend income
from the Tank Industries, Inc., common stock.
d. Compare, contrast, and discuss the after-tax amounts resulting from the
interest income and dividend income calculated in parts b and c.
e. What is the firm’s total tax liability for the year?

1–8 Interest versus dividend expense Michaels Corporation expects earnings before
interest and taxes to be $40,000 for this period. Assuming an ordinary tax rate
34 PART 1 Introduction to Managerial Finance

of 40%, compute the firm’s earnings after taxes and earnings available for com-
mon stockholders (earnings after taxes and preferred stock dividends, if any)
under the following conditions:
a. The firm pays $10,000 in interest.
b. The firm pays $10,000 in preferred stock dividends.

1–9 Capital gains taxes Perkins Manufacturing is considering the sale of two non-
depreciable assets, X and Y. Asset X was purchased for $2,000 and will be sold
today for $2,250. Asset Y was purchased for $30,000 and will be sold today for
$35,000. The firm is subject to a 40% tax rate on capital gains.
a. Calculate the amount of capital gain, if any, realized on each of the assets.
b. Calculate the tax on the sale of each asset.

1–10 Capital gains taxes The following table contains purchase and sale prices for
the nondepreciable capital assets of a major corporation. The firm paid taxes of
40% on capital gains.

Asset Purchase price Sale price

A $ 3,000 $ 3,400
B 12,000 12,000
C 62,000 80,000
D 41,000 45,000
E 16,500 18,000

a. Determine the amount of capital gain realized on each of the five assets.
b. Calculate the amount of tax paid on each of the assets.

CHAPTER 1 CASE Assessing the Goal of Sports Products, Inc.

L oren Seguara and Dale Johnson both work for Sports Products, Inc., a major
producer of boating equipment and accessories. Loren works as a clerical
assistant in the Accounting Department, and Dale works as a packager in the
Shipping Department. During their lunch break one day, they began talking
about the company. Dale complained that he had always worked hard trying not
to waste packing materials and efficiently and cost-effectively performing his
job. In spite of his efforts and those of his co-workers in the department, the
firm’s stock price had declined nearly $2 per share over the past 9 months.
Loren indicated that she shared Dale’s frustration, particularly because the firm’s
profits had been rising. Neither could understand why the firm’s stock price was
falling as profits rose.
Loren indicated that she had seen documents describing the firm’s profit-
sharing plan under which all managers were partially compensated on the basis
of the firm’s profits. She suggested that maybe it was profit that was important
to management, because it directly affected their pay. Dale said, “That doesn’t
make sense, because the stockholders own the firm. Shouldn’t management do
what’s best for stockholders? Something’s wrong!” Loren responded, “Well,
CHAPTER 1 The Role and Environment of Managerial Finance

maybe that explains why the company hasn’t concerned itself with the stock
price. Look, the only profits that stockholders receive are in the form of cash
dividends, and this firm has never paid dividends during its 20-year history. We
as stockholders therefore don’t directly benefit from profits. The only way we
benefit is for the stock price to rise.” Dale chimed in, “That probably explains
why the firm is being sued by state and federal environmental officials for dump-
ing pollutants in the adjacent stream. Why spend money for pollution control? It
increases costs, lowers profits, and therefore lowers management’s earnings!”
Loren and Dale realized that the lunch break had ended and they must
quickly return to work. Before leaving, they decided to meet the next day to con-
tinue their discussion.

a. What should the management of Sports Products, Inc., pursue as its overrid-
ing goal? Why?
b. Does the firm appear to have an agency problem? Explain.
c. Evaluate the firm’s approach to pollution control. Does it seem to be ethical?
Why might incurring the expense to control pollution be in the best interests
of the firm’s owners in spite of its negative impact on profits?
d. On the basis of the information provided, what specific recommendations
would you offer the firm?

WEB EXERCISE At the Careers in Finance Web site, www.careers-in-finance.com, you will find
WW information on career opportunities in seven different areas of finance. First
click on Corporate Finance in the Areas to Explore section and use the various
subsections to answer the following questions:

1. What are the primary responsibilities of the financial manager?
2. Summarize the types of skills a financial manager needs.
3. Describe the key job areas in corporate finance.
4. What are the salary ranges for the following positions in corporate finance:
rookie financial analyst, credit manager, chief financial officer? How do
these compare to salaries at General Motors or PepsiCo?

Now return to the home page and click on either Commercial Banking or Invest-
ment Banking.

5. How do careers in the area you chose (commercial banking or investment
banking) compare to careers in corporate finance in terms of skills required,
responsibilities, and salaries?

Remember to check the book’s Web site at
for additional resources, including additional Web exercises.


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