Chapter 1: Introduction to Corporate Finance

Questions and Problems:

1.1 In the absence of agency problems, what is the primary goal of managers in a corporation? How
can managers achieve this goal?

In the absence of agency problems, managers act in the best interest of shareholders and make decisions
to maximize shareholders’ wealth. They create value from the capital budgeting,
financing, and liquidity activities. For example, managers create value by buying assets that
generate more cash than they cost.

1.2 Who owns a corporation? Describe the process whereby the owners control the firm’s
management. What is the main reason that an agency relationship exists in the corporate
form of organization? In this context, what kinds of problems can arise?
In the corporate form of ownership, the shareholders are the owners of the firm. The
shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This
separation of ownership from control in the corporate form of organization is what causes agency
problems to exist. Management may act in its own or someone else’s best interests, rather than those of
the shareholders. If such events occur, they may contradict the goal of maximizing shareholders’ wealth.

1.3 Corporate ownership varies around the world. Historically, individuals have owned the majority of
shares in public corporations in the United States. In Canada this is also the case, but ownership is
more often concentrated in the hands of a majority shareholder. In Germany and Japan, banks, other
financial institutions, and large companies own most of the shares in public corporations. How do
you think these ownership differences affect the severity of agency costs in different countries?
We would expect agency problems to be less severe in countries with a small percentage of individual
ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate
goals. The high percentage of institutional ownership might lead to a higher degree of agreement between
owners and managers on decisions concerning risky projects. In addition, institutions may be better able
to implement effective monitoring mechanisms on managers than can individual owners, based on the
institutions’ deeper resources and experiences with their own management. The increase in institutional
ownership of stock in the United States and the growing activism of these large shareholder groups may
lead to a reduction in agency problems for U.S. corporations and a more efficient market for corporate
control.

1.4 What are the major types of financial institutions and financial markets in Canada?

Canadian financial institutions include chartered banks and other depository institutions––trust companies
and credit unions as well as nondepository institutions––investment dealers, insurance companies,
pension funds and mutual funds.

Financial markets can be classified as either money markets or capital markets. Short–term debt
securities are bought and sold in money markets. Capital markets are the markets for long–term
debt and shares of stock, for example the TSX.

1.5 What are some major trends in Canadian financial markets? Explain how these trends affect the
practice of financial management in Canada.
Canadian Financial Markets, like all markets, are experiencing rapid globalization. The toolkit of
available financial management techniques has expanded in response to a need to control volatility risk
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and to track complex dealing in many countries. Computer technology improvements make new financial
engineering applications practical and create opportunities to combine different types of financial
institutions. Financial institutions pressure authorities to deregulate in a process called the regulatory
dialectic. Increased uncertainty during the COVID-19 pandemic and other disruptive events led Canadian
companies to delay their investments and to hold more cash for precautionary motives. Unfortunately,
several companies, particularly retailers, sought court protection from their creditors.

These trends have made financial management in Canada much more complex and technical. In the
face of increased global competition and disruptive shocks, the payoff for good financial
management is great with finance becoming important in corporate strategic planning.

Appendix 1A: Taxes

Questions and Problems:

1.A1 The average tax rate is total taxes paid divided by total taxable income whereas the marginal tax
rate is the extra tax payable on the next dollar earned.

1.A2 Personal investment income in the form of interest is taxed at the same rates as employment
income. Dividend income is initially taxed at the same rate as employment income but the dividend
tax credit reduces the effective tax rate on dividends for investors. Taxes on capital gains apply at
50 percent of the applicable marginal rate. However, before the 1994 Federal Budget, each
individual was entitled to receive a lifetime capital gains exemption of $100,000
net of any capital losses. From a corporate point of view, interest earned is fully taxable while
dividends on common shares of other Canadian corporations are received tax–free. As with
individuals, capital gains are taxed at 50 percent of the marginal rate.

1.A3 If the firm has an operating loss, it may be carried back to reduce net income in the three prior years
and carried forward for up to twenty years. In the case of capital losses, if capital losses exceed
capital gains, the net capital loss may be carried back to reduce taxable capital gains in three prior
years and carried forward indefinitely. An investment tax credit allows a qualified firm to subtract a
set percentage of an investment directly from taxes payable.

1.A4 a. Ontario
Corporation X: Taxes = .122 x $100,000 = $12,200
Corporation Y: Taxes = .265 x $1,000,000 = $265,000

b. The firms have different marginal tax rates. Firm X pays (0.122 x $10,000) = $1,220 more
and Firm Y, pays an additional (0.265 x $10,000) = $2,650.

1.A5
DIVIDENDS
Dividend $10,000.00
Gross up (38%) 3,800.00
Grossed–up dividends 13,800.00

Federal Tax (33%) 4,554.00

Less Federal Dividend Tax Credit (.150198 x $13,800) 2,072.73
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Federal Tax Payable 2,481.27

Provincial Tax (.1316 x $13,800) 1,816.08

Less Provincial Tax credit (.1  $13,800) 1,380.00
Provincial Tax Payable 436.08

Tax Payable 2,917.35

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 INTEREST
Interest $10,000.00

Federal Tax (33%) 3,300.00

Provincial Tax (13.16%) 1,316.00
Tax Payable $4,616.00

CAPITAL GAINS
Capital Gain $10,000.00

Federal Tax (.33 x $10,000 x 1/2) 1,650.00

Provincial Tax (.1316 x $10,000 x 1/2) 658.00
Tax Payable $2,308.00

After tax cash flow from Dividends = $10,000.00 – $2,917.35 = $7,082.65

After tax cash flow from Interest = $10,000.00 – $4,616.00 = $5,384.00
After tax cash flow from Capital Gains = $10,000.00 – $2,308 = $7,692.00

Total (after tax) Cash Flow = $20,158.65

Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual

© 2022 McGraw-Hill Education Ltd.
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