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Solution Manual For Corporate Finance The Core, 5th Edition by Jonathan Berk, Peter DeMarzo Chapter 1-19
Solution Manual For Corporate Finance The Core, 5th Edition by Jonathan Berk, Peter DeMarzo Chapter 1-19
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SOLUTIONS MANUAL FORCorporate Finance:
The Core
Fifth Edition
Jonathan Berk
Stanford University
Peter DeMarzo
Stanford University
ISBN-10: 978-0-13-499824-4
ISBN: 0-13-499824-3
iii
,Contents
Chapter 1 The Corporation and Financial Markets 1
Chapter 2 Introduction to Financial Statement Analysis 5
Chapter 3 Financial Decision Making and the Law of One Price 21
Chapter 4 The Time Value of Money 31
Chapter 5 Interest Rates 59
Chapter 6 Valuing Bonds 79
Chapter 7 Investment Decision Rules 97
Chapter 8 Fundamentals of Capital Budgeting 117
Chapter 9 Valuing Stocks 135
Chapter 10 Capital Markets and the Pricing of Risk 147
Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 161
Chapter 12 Estimating the Cost of Capital 181
Chapter 13 Investor Behavior and Capital Market Efficiency 191
Chapter 14 Capital Structure in a Perfect Market 201
Chapter 15 Debt and Taxes 211
Chapter 16 Financial Distress, Managerial Incentives, and Information 221
Chapter 17 Payout Policy 237
Chapter 18 Capital Budgeting and Valuation with Leverage 249
Chapter 19 Valuation and Financial Modeling: A Case Study 269
,Sure! I’ll expand on the topics related to "Taxation of Business Entities," providing a more detailed exploration. This overview will cover fundamental concepts, applications, and implications relevant to the study of business taxation.---### Overview of Business
Entities#### 1. Types of Business EntitiesBusiness entities can be categorized based on ownership structure and tax treatment. Understanding these types is crucial for determining tax obligations and benefits.- **Sole Proprietorships**: - Owned by a single individual, this
is the simplest form of business entity. Income is reported on the owner’s personal tax return (Form 1040, Schedule C), which simplifies tax filing but also means personal liability for debts and obligations.- **Partnerships**: - Consisting of two or more individuals,
partnerships do not pay federal income taxes. Instead, they are considered pass-through entities, meaning income is taxed at the partners' individual rates. Form 1065 is used to report partnership income, while partners receive Schedule K-1 to report their share on their
returns.- **Corporations**: - Corporations are separate legal entities that provide limited liability protection to their owners (shareholders). C-Corporations face double taxation: once at the corporate level on profits and again at the individual level when dividends are
distributed. S-Corporations, on the other hand, are pass-through entities but have restrictions on ownership and number of shareholders.- **Limited Liability Companies (LLCs)**: - LLCs combine the flexibility of partnerships with the liability protection of
corporations. An LLC can choose to be taxed as a sole proprietorship, partnership, or corporation, allowing for strategic tax planning. ### 2. Tax Implications of Each Entity TypeUnderstanding the tax implications of each entity type is critical for effective business
planning.- **Sole Proprietorships**: - Income is taxed at the owner’s individual tax rate. All profits and losses are reported on the owner’s tax return. This simplicity, however, can expose owners to significant personal risk.- **Partnerships**: - Each partner reports their
share of income and losses on their personal returns, allowing for loss deductions. Partners are also subject to self-employment taxes on their share of the income, which can significantly impact tax liability.- **Corporations**: - C-Corporations are taxed at the corporate
tax rate (currently 21%). Dividends are taxed again at the shareholder level. S-Corporations avoid double taxation, but there are restrictions on the number and type of shareholders.- **Limited Liability Companies (LLCs)**: - By default, single-member LLCs are treated
as sole proprietorships for tax purposes, while multi-member LLCs are treated as partnerships. However, they can elect to be taxed as a corporation if beneficial.### Key Tax Concepts#### 1. Income RecognitionIncome recognition is a fundamental principle in taxation,
determining when income must be reported.- **Cash vs. Accrual Accounting**: - Businesses can choose between cash and accrual methods. Cash accounting recognizes income when received and expenses when paid, making it straightforward. Accrual accounting
recognizes income when earned and expenses when incurred, aligning revenue with the period it relates to, but can complicate cash flow management.#### 2. DeductionsDeductions reduce taxable income, directly impacting tax liability.- **Ordinary and Necessary
Expenses**: - The IRS allows deductions for expenses that are ordinary (common in the industry) and necessary (helpful and appropriate for the business). Common deductions include rent, utilities, salaries, and professional fees.- **Limits on Deductions**: - Certain
expenses, such as meals and entertainment, have specific limits (e.g., meals are typically only 50% deductible). Understanding these limits is vital for effective tax planning.#### 3. Tax CreditsTax credits directly reduce the tax liability, providing a dollar-for-dollar reduction
of taxes owed.- **Types of Tax Credits**: - Examples include the Research and Development (R&D) tax credit, which encourages innovation, and the Work Opportunity Tax Credit (WOTC) for hiring individuals from certain target groups.### Specific Business Entity
Taxation#### 1.
Chapter 1
The Corporation
1-1. What is the most important difference between a corporation and all other organizational forms?
A corporation is a legal entity separate from its owners.
1-2. What does the phrase limited liability mean in a corporate context?
Owners’ liability is limited to the amount they invested in the firm. Stockholders are not responsible for
any encumbrances of the firm; in particular, they cannot be required to pay back any debts incurred by
the firm.
1-3. Which organizational forms give their owners limited liability?
Corporations and limited liability companies give owners limited liability. Limited partnerships provide
limited liability for the limited partners, but not for the general partners.
1-4. What are the main advantages and disadvantages of organizing a firm as a corporation?
Advantages: Limited liability, liquidity, infinite life
Disadvantages: Double taxation, separation of ownership and control
1-5. Explain the difference between an S corporation and a C corporation.
C corporations must pay corporate income taxes; S corporations do not pay corporate taxes, but must pass
through the income to shareholders to whom it is taxable. S corporations are also limited to 100
shareholders and cannot have corporate or foreign stockholders.
1-6. You are a shareholder in a C corporation. The corporation earns $2 per share before taxes. Once it
has paid taxes it will distribute the rest of its earnings to you as a dividend. The corporate tax rate
is 40% and the personal tax rate on (both dividend and non-dividend) income is 30%. How much is
left for you after all taxes are paid?
First, the corporation pays the taxes. After taxes, $2 (1 0.4) $1.20 is left to pay dividends. Once the
, iv Berk/DeMarzo, Corporate Finance, Fourth Edition
dividend is paid, personal tax must be paid, which leaves $1.20 (1 0.3) $0.84 . So, after all the taxes
are paid, you are left with 84¢.
1-7. Repeat Problem 6 assuming the corporation is an S corporation.
An S corporation does not pay corporate income tax. So it distributes $2 to its stockholders. These
stockholders must then pay personal income tax on the distribution. So they are left with
$2 (1 0.3) $1.40 .
1-8. You have decided to form a new start-up company developing applications for the iPhone. Give
examples of the three distinct types of financial decisions you will need to make.
As the manager of an iPhone applications developer, you will make three types of financial decisions.
i. You will make investment decisions, such as determining which type of iPhone application projects
will offer your company a positive NPV and that your company, therefore, should develop.
ii. You will make the decision on how to fund your iPhone application investments and what mix of
debt and equity your company will have.
iii. You will be responsible for the cash management of your company, ensuring that your company has
the necessary funds to make investments, pay interest on loans, and pay your employees.
Sure! I’ll expand on the topics related to "Taxation of Business Entities," providing a more detailed exploration. This overview will cover fundamental concepts, applications, and implications relevant to the study of business taxation.---### Overview of Business
Entities#### 1. Types of Business EntitiesBusiness entities can be categorized based on ownership structure and tax treatment. Understanding these types is crucial for determining tax obligations and benefits.- **Sole Proprietorships**: - Owned by a single individual, this
is the simplest form of business entity. Income is reported on the owner’s personal tax return (Form 1040, Schedule C), which simplifies tax filing but also means personal liability for debts and obligations.- **Partnerships**: - Consisting of two or more individuals,
partnerships do not pay federal income taxes. Instead, they are considered pass-through entities, meaning income is taxed at the partners' individual rates. Form 1065 is used to report partnership income, while partners receive Schedule K-1 to report their share on their
returns.- **Corporations**: - Corporations are separate legal entities that provide limited liability protection to their owners (shareholders). C-Corporations face double taxation: once at the corporate level on profits and again at the individual level when dividends are
distributed. S-Corporations, on the other hand, are pass-through entities but have restrictions on ownership and number of shareholders.- **Limited Liability Companies (LLCs)**: - LLCs combine the flexibility of partnerships with the liability protection of
corporations. An LLC can choose to be taxed as a sole proprietorship, partnership, or corporation, allowing for strategic tax planning. ### 2. Tax Implications of Each Entity TypeUnderstanding the tax implications of each entity type is critical for effective business
planning.- **Sole Proprietorships**: - Income is taxed at the owner’s individual tax rate. All profits and losses are reported on the owner’s tax return. This simplicity, however, can expose owners to significant personal risk.- **Partnerships**: - Each partner reports their
share of income and losses on their personal returns, allowing for loss deductions. Partners are also subject to self-employment taxes on their share of the income, which can significantly impact tax liability.- **Corporations**: - C-Corporations are taxed at the corporate
tax rate (currently 21%). Dividends are taxed again at the shareholder level. S-Corporations avoid double taxation, but there are restrictions on the number and type of shareholders.- **Limited Liability Companies (LLCs)**: - By default, single-member LLCs are treated
as sole proprietorships for tax purposes, while multi-member LLCs are treated as partnerships. However, they can elect to be taxed as a corporation if beneficial.### Key Tax Concepts#### 1. Income RecognitionIncome recognition is a fundamental principle in taxation,
determining when income must be reported.- **Cash vs. Accrual Accounting**: - Businesses can choose between cash and accrual methods. Cash accounting recognizes income when received and expenses when paid, making it straightforward. Accrual accounting
recognizes income when earned and expenses when incurred, aligning revenue with the period it relates to, but can complicate cash flow management.#### 2. DeductionsDeductions reduce taxable income, directly impacting tax liability.- **Ordinary and Necessary
Expenses**: - The IRS allows deductions for expenses that are ordinary (common in the industry) and necessary (helpful and appropriate for the business). Common deductions include rent, utilities, salaries, and professional fees.- **Limits on Deductions**: - Certain
expenses, such as meals and entertainment, have specific limits (e.g., meals are typically only 50% deductible). Understanding these limits is vital for effective tax planning.#### 3. Tax CreditsTax credits directly reduce the tax liability, providing a dollar-for-dollar reduction
of taxes owed.- **Types of Tax Credits**: - Examples include the Research and Development (R&D) tax credit, which encourages innovation, and the Work Opportunity Tax Credit (WOTC) for hiring individuals from certain target groups.### Specific Business Entity
Taxation#### 1.
1-9. When a pharmaceutical company develops a new drug, it often receives patent protection for that
medication, allowing it to charge a higher price. Explain how this public policy of providing patent
protection might help align the corporation’s interests with society’s interests.
Without patent protection, the developer of the drug would be forced to lower prices to compete with
generic manufacturers. Because this price competition would lower expected future profits, the developer
would be willing to spend much less in R&D to develop the drug initially, and drug innovation would be
curtailed.
Alternatively, by allowing the drug’s developer to earn higher profits that are commensurate with the
value of the drug to society, drug developers will find it in their best interests to spend more on R&D, and
drug innovation is enhanced. Thus, patent protection can align the corporation’s and society’s interests
and provide for more efficient spending on drug R&D.
1-10. Corporate managers work for the owners of the corporation. Consequently, they should make
decisions that are in the interests of the owners, rather than their own. What strategies are
available to shareholders to help ensure that managers are motivated to act this way?
Shareholders can do the following.
i. Ensure that employees are paid with company stock and/or stock options.
ii. Ensure that underperforming managers are fired.
iii. Write contracts that ensure that the interests of the managers and shareholders are closely aligned.
iv. Mount hostile takeovers.
1-11. Suppose you are considering renting an apartment. You, the renter, can be viewed as an agent
while the company that owns the apartment can be viewed as the principal. What principal-agent
conflicts do you anticipate? Suppose instead that you work for the apartment company. What
features would you put into the lease agreement that would give the renter incentives to take good
care of the apartment?
The agent (renter) will not take the same care of the apartment as the principal (owner) because the renter
does not share in the costs of repairing damage to the apartment. To mitigate this problem, having the
renter pay a deposit should motivate the renter to keep damages to a minimum. The deposit forces the
renter to share in the costs of repairing any problems that they cause.
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