Solutions to Problems

P1-1. LG 1: Liability comparisons

Basic
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.

P1-2. LG 2, 4: Marginal cost-benefit analysis and the goal of the firm

Intermediate
a. Benefits from new robotics $560,000
Benefits from existing robotics 400,000
Marginal benefits $160,000

b. Initial cash investment $220,000

Receipt from sale of old robotics 70,000
Marginal cost $150,000

c. Marginal benefits $160,000

Marginal cost 150,000
Net benefits $ 10,000

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.

P1-3. LG 2: Annual income versus cash flow for a period

Basic
a. Sales $760,000
Cost of goods sold 300,000
Net profit $460,000

b. Cash receipts $690,000

Cost of goods sold 300,000
Net cash flow $390,000

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 contribute to the wealth of
the owners.
 Chapter 1 The Role and Environment of Managerial Finance 3

P1-4. LG 1: Personal finance: Cash flow statement

a. Total cash inflow: $450 + $4,500 = $4,950
Total cash outflow: $1,000 + $500 + $800 + $355 + $280 + $1,200 + $222 = $4,357
b. Net cash flow: $4,950 $4,357 = $593
c. If Jane is facing a shortage, she could cut back on some of her discretionary items, including
clothing, dining out, and gas (i.e., travel less).
d. If Jane has a surplus in August, she should compare these cash flows to those of other months
and verify that Augusts cash flows are typical.She may for instance, observe the existence
of large automobile insurance bills or tendency to spend more during the Christmas holiday
season. If she has such needs, Jane will want to save the $593 in a money market security,
where she is unlikely to face a decline in investment. If her August net cash flow is not needed
to pay anticipated bills, she should invest in a diversified portfolio.

P1-5. LG 4: Identifying agency problems, costs, and resolutions

Intermediate
a. In this case the employee is being compensated for unproductive time. The company must
pay someone to take her place during her absence. Installation of a time clock that must be
punched by the receptionist every time she leaves work and returns would result in either:
(1) her returning on time or (2) reducing the cost to the firm by reducing her pay for the
lost work.
b. The costs to the firm are in the form of opportunity costs. Money budgeted to cover the
inflated costs of this project proposal is not available to fund other projects that may help
to increase shareholder wealth. Make the management reward system based on how close the
managers estimates come to the actual cost rather than having them come in below cost.
c. The manager may negotiate a deal with the merging competitor that is extremely beneficial to
the executive and then sell the firm for less than its fair market value. A good way to reduce
the loss of shareholder wealth would be to open the firm up for purchase bids from other
firms once the manager makes it known that the firm is willing to merge. If the price offered
by the competitor is too low, other firms will up the price closer to its fair market value.
d. Generally part time or temporary workers are not as productive as full-time employees. These
workers have not been on the job as long to increase their work efficiency. Also, the better
employees generally need to be highly compensated for their skills. This manager is getting
rid of the highest cost employees to increase profits. One approach to reducing the problem
would be to give the manager performance shares if they meet certain stated goals.
Implementing a stock incentive plan tying management compensation to share price would
also encourage the manager to retain quality employees.

P1-6. LG 6: Corporate taxes

Basic
a. Firms tax liability on $92,500 (from Table 1.4):
Total taxes due = $13,750 + [0.34 ($92,500 $75,000)]
= $13,750 + (0.34 $17,500)
= $13,750 + $5,950
= $19,700
b. After-tax earnings: $92,500 $19,700 = $72,800
c. Average tax rate: $19,700 $92,500 = 21.3%
4 Gitman Principles of Managerial Finance, Brief Fifth Edition

d. Marginal tax rate: 34%

P1-7. LG 6: Average corporate tax rates

Basic
a. Tax calculations using Table 1.4:

$10,000: Tax liability: $10,000 0.15 = $1,500

After-tax earnings: $10,000 $1,500 = $8,500
Average tax rate: $1,500 $10,000 = 15%

$80,000: Tax liability: $13,750 + [0.34 (80,000 $75,000)]

$13,750 + (0.34 $5,000)
$13,750 + $1,700
$15,450 = Total tax
After-tax earnings: $80,000 $15,450 = $64,550
Average tax rate: $15,450 $80,000 = 19.3%

$300,000: Tax liability: $22,250 + [0.39 ($300,000 $100,000)]

$22,250 + (0.39 $200,000)
$22,250 + $78,000
$100,250 = Total tax
After-tax earnings: $300,000 $100,250 = $199,750
Average tax rate: $100,250 $300,000 = 33.4%

$500,000: Tax liability: $113,900 + [0.34 ($500,000 $335,000)]

$113,900 + (0.34 $165,000)
$113,900 + $56,100
$170,000 = Total tax
After-tax earnings: $500,000 $170,000 = $330,000
Average tax rate: $170,000 $500,000 = 34%

$1,500,000: Tax liability: $113,900 + [0.34 ($1,500,000 $335,000)]

$113,900 + (0.34 $1,165,000)
$113,900 + $396,100
$510,000 = Total tax
After-tax earnings: $1,500,000 $510,000 = $990,000
Average tax rate: $510,000 $1,500,000 = 34%
 Chapter 1 The Role and Environment of Managerial Finance 5

$10,000,000: Tax liability: $113,900 + [0.34 ($10,000,000 $335,000)]

$113,900 + (0.34 $9,665,000)
$113,900 + $3,286,100
$3,400,000 = Total tax
After-tax earnings: $10,000,000 $3,400,000 = $6,600,000
Average tax rate: $3,400,000 $10,000,000 = 34%

$20,000,000: Tax liability: $6,416,667 + [0.35 ($20,000,000 $18,333,333)]

$6,416,667 + (0.35 $1,666,667)
$6,416,667 + 583,333.45
$7,000,000.45 = Total tax
After-tax earnings: $20,000,000 $7,000,000.45 = $13,000,000
Average tax rate: $7,000,000 $20,000,000 = 35%

b.

As income increases, the rate reaches 35%.

P1-8. LG 6: Marginal corporate tax rates

Basic
a.

Tax Calculation
Pretax Amount Marginal
Income Base Tax + % Over Base = Tax Rate
$ 15,000 $ 0 + (0.15 15,000) = $ 2,250 15.0%
60,000 7,500 + (0.25 10,000) = 10,000 25.0%
90,000 13,750 + (0.34 15,000) = 18,850 34.0%
200,000 22,250 + (0.39 100,000) = 61,250 39.0%
400,000 113,900 + (0.34 65,000) = 136,000 34.0%
1,000,000 113,900 + (0.34 665,000) = 340,000 34.0%
20,000,000 6,416,667 + (0.35 1,666,666) = 700,000 35.0%
6 Gitman Principles of Managerial Finance, Brief Fifth Edition

b.

As income increases to $335,000, the marginal tax rate approaches and peaks at 39%. For
income in excess of $335,000, the marginal tax rate declines to 34%, and after $10 million
the marginal rate increases slightly to 35%.

P1-9. LG 6: Interest versus dividend income

Intermediate
a. Tax on operating earnings: $490,000 0.40 tax rate = $196,000
b. and c

(b) (c)
Interest Income Dividend Income
Before-tax amount $20,000 $20,000
Less: Applicable exclusion 0 14,000 (0.70 $20,000)
Taxable amount 20,000 6,000
Tax (40%) 8,000 2,400
After-tax amount 12,000 17,600

d. The after-tax amount of dividends received, $17,600, exceeds the after-tax amount of interest,
$12,000, due to the 70% corporate dividend exclusion. This increases the attractiveness of
stock investments by one corporation in another relative to bond investments.
e. Total tax liability:

Taxes on operating earnings (from (a)) $196,000

+ Taxes on interest income (from (b)) 8,000
+ Taxes on dividend income (from (c)) 2,400
Total tax liability $206,400
 Chapter 1 The Role and Environment of Managerial Finance 7

P1-10. LG 6: Interest versus dividend expense

Intermediate
a. EBIT $40,000
Less: Interest expense 10,000
Earnings before taxes $30,000
Less: Taxes (40%) 12,000
Earnings after taxes* $18,000
*
This is also earnings available to common stockholders.

b. EBIT $40,000
Less: Taxes (40%) 16,000
Earnings after taxes $24,000
Less: Preferred dividends 10,000
Earnings available for
common stockholders $14,000

P1-11. LG 6: Capital gains taxes

Basic
a. Capital gain:
Asset X = $2,250 $2,000 = $250
Asset Y = $35,000 $30,000 = $5,000
b. Tax on sale of asset:
Asset X = $250 0.40 = $100
Asset Y = $5,000 0.40 = $2,000

P1-12. LG 6: Capital gains taxes

Basic
(a) and (b)

Capital Gain Tax

Sale Price Purchase Price (1)(2) (3) 0.40
Asset (1) (2) (3) (4)
A $ 3,400 $ 3,000 $ 400 $ 60
B 12,000 12,000 0 0
C 80,000 62,000 18,000 7,200
D 45,000 41,000 4,000 1,600
E 18,000 16,500 1,500 600

P1-13. LG 4: Ethics problem

Intermediate
Maximizing shareholder wealth, or the stock price, involves carefully evaluating each decisions
impact on cash flow amount, timing, and risk. However, that statement includes nothing that
directly incorporates the ethical aspect of decisions. The phrase subject to ethical constraints
implies that there are ethical facets of business decisions that may or may not be a significant
part of a decisions cash flow projections. Think of all decisions being sifted through an ethical
filtersome decisions are unethical and do not make it through the filter, while others are ethical
and pass through the filter. Examples of ethical considerations that might enter into decisions
include not exaggerating product quality or durability, correcting environmental problems even
8 Gitman Principles of Managerial Finance, Brief Fifth Edition

though regulators or the general public would never know about them, and not exaggerating future
cash flow projections in order to get a lower interest rate on a bank loan or bond issue. Each of
these examples may decrease the size or delay the timing of cash inflows, or increase the riskiness
of future cash flowsthereby reducing the stock price relative to what it could have been had one
acted unethically. No doubt you have thought of other examples as well.

Case
Assessing the Goal of Sports Products, Inc.
1. Maximization of shareholder wealth, which means maximization of share price, should be the
primary goal of the firm. Unlike profit maximization, this goal considers timing, cash flows, and risk.
It also reflects the worth of the owners investment in the firm at any time. It is the value they can
realize should they decide to sell their shares.

2. Yes, there appears to be an agency problem. Although compensation for management is tied to
profits, it is not directly linked to share price. In addition, managements actions with regard to
pollution controls suggest a profit maximization focus, which would maximize their earnings,
rather than an attempt to maximize share price.

3. The firms approach to pollution control seems to be questionable ethically. While it is unclear
whether their acts were intentional or accidental, it is clear that they are violating the lawan illegal
act potentially leading to litigation costsand as a result are damaging the environment, an immoral
and unfair act that has potential negative consequences for society in general. Clearly, Sports
Products has not only broken the law but also established poor standards of conduct and moral
judgment.

4. From the information given there appears to be a weak corporate governance system. The fact
that management is able to measure and reward their performance on profits indicates that no one
is watching out for the shareholders. Loren and Dales concerns indicate that employees apparently
have an interest in the long-run success of the firm. Allowing the continuation of pollution violations
is also apparently escaping the interest and control ability of others who should be monitoring the
firm.

5. Some specific recommendations for the firm include:

Tie management, and possibly employee, compensation to share price or a performance-based
measure and make sure that all involved own stock and have a stake in the firm. Being
compensated partially on the basis of share price or another performance measure, and owning
stock in the firm will more closely link the wealth of managers and employees to the firms
performance.
Comply with all federal and state laws as well as accepted standards of conduct or moral
judgment.
Establish a corporate ethics policy, to be read and signed by all employees.
Set up a corporate governance system that has as its basis the oversight and welfare of all the
stakeholders in the firm.
(Other answers are, of course, possible.)
 Chapter 1 The Role and Environment of Managerial Finance 9

Spreadsheet Exercise
The answer to Chapter 1s Monsanto spreadsheet problem is located in the Instructors Resource Center
at www.prenhall.com/irc.

A Note on Web Exercises

A series of chapter-relevant assignments requiring Internet access can be found at the books Companion
Website at http://www.prenhall.com/gitman. In the course of completing the assignments students access
information about a firm, its industry, and the macro economy, and conduct analyses consistent with those
found in each respective chapter.