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Corporate Finance 7th Canadian Edition By Ross - Solution Manual
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, Chapter 1: Introduction to Corporate Finance1.1 An argument can be made either way. At the one extreme, we could argue that in a market
economy, all of these things are priced. There is thus an optimal level of, for example,
unethical and /or illegal behaviour, and the framework of stock valuation explicitly
includes these. At the other extreme, we could argue that these are non–economic
phenomena and are best handled through the political process.
Most studies find that socially responsible investment practices do not impact portfolio
returns and risk consistently. Major Canadian institutional investors pay careful attention
to corporate social responsibility in selecting investments but place financial
considerations first.
A classic (and highly relevant) thought question that illustrates this debate goes
something like this: “A firm has estimated that the cost of improving the safety of one of
its products is $30 million. However, the firm believes that improving the safety of the
product will only save $20 million in product liability claims. What should the firm
do?’’
1.2 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 the share price of the equity of the firm.
1.3 We would expect agency problems to be less severe in other countries, primarily due to
the relatively 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 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 TSE.
1.5 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 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.
,These trends have made financial management in Canada much more complex and
technical. In the face of increased global competition, the payoff for good financial
management is great with finance becoming important in corporate strategic planning.
, Appendix
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 seven 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 = (0.155)($100,000) = $15,500
Corporation Y: Taxes = (0.265)($1,000,000) = $265,000
b. The firms have different marginal tax rates. Firm X pays $1,550 more and Firm
Y, pays an additional $2,650.
1.A5
DIVIDENDS
Dividend $10,000.00
Gross up (38%) 3,800.00
Grossed–up dividends 13,800.00
Federal Tax (29%) 4,002.00
Less Federal Dividend Tax Credit (.150198 x (2,072.73)
$13,800)
Federal Tax Payable 1,929.27
Provincial Tax (.1316 of $13,800) 1,816.08
Less Provincial Tax credit (.064 $13,800) (883.20)
Provincial Tax Payable 932.88
Tax Payable 2,862.15
INTEREST
Interest $10,000.00
Federal Tax (29%) 2,900.00
Provincial Tax (13.16%) 1,316.00
Tax Payable $4,216.00
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