Fundamentals of Corporate Finance

Third European Edition

Solutions Manual
Chapter 2

Basic

1. Partnerships Why are professional firms, such as accountants and lawyers, more
likely to have a partnership form rather than a sole ownership or limited company
structure?
Answer: Professional firms are more likely to choose a partnership corporate form
because it allows partners to maintain their sole proprietorship business model but
draw from the economies of scale that come from combining business operations.
That is, partners can keep and grow their own clients and have the benefit of paying
for a share of admin resources, overheads and assets.

2. Macro Governance Why do you think corporate behaviour in bank-based financial

systems would be different from that in market-based financial systems? How do
you think other differences in the macro environment can affect corporate
objectives?
Answer: Corporate behaviour in bank-based financial systems would be different
from market-based financial systems because of the nature of financing between the
two financial systems. In a bank based financial system, companies will strive to
meet the requirements set out by their chief financiers, which are banks. Banks, as a
major source of funding, will influence corporate risk taking behaviour and
encourage longer investment horizons. On the other hand, corporations in market
based environment must satisfy the needs of the investing public, who naturally
focus on share price performance.

3. Corporate Governance Principles In your opinion what is the most important issue
in corporate governance? Explain your answer.
Answer: Many issues are important in running a firm and your answer depends on
the type of firm you are discussing. Moreover, your role in a company would make
you feel one issue is more important than any other. For example, if you are a
minority shareholder, you would be concerned with how the majority or controlling
shareholders engage with management and whether they are able to abuse their
power. If you are an international investor, then country-level corporate governance
would be more important.

4. Corporate Governance Explain why the corporate governance of a sole

proprietorship should be different from that of a partnership, which in turn should
be different from that of a limited corporation.
Answer: In a sole proprietorship there is no real need for formal governance
structures since all business activities are concentrated on one individual. That is,
the stakeholders, the shareholders, and the managers are all one individual. In a
partnership, semi-formal corporate governance structures are present, such as a
Partnership Agreement or Partnership Deed. These are designed to ensure that each

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Fundamentals of Corporate Finance
Third European Edition

partner carries out his or her duties as expected. A limited corporation is a separate
legal entity that is different from a sole proprietorship and partnership.

5. Corporate Governance across the World Why is there no single code of corporate
governance applied to all the countries of the world? Would emerging-market firms
have different issues to consider?
Answer: While a corporation’s goal remains the same (maximization of share value),
different institutional, economic, legal, financial, and cultural characteristics means
that the corporate governance environment will vary across countries. Similarly,
corporate governance codes for emerging market firms should consider the real
issues in each country such as poor quality of law enforcement and limited ability to
obtain independent directors. Thus, corporate governance structures that are
borrowed from developed markets such as the US, UK, Japan, Germany and others
must be adjusted in a manner that suits the environment in emerging markets.

6. Sole Proprietorship Sole proprietorship is the most common type of business

throughout the world. Why do you think this is the case? What are the benefits of
sole proprietorships over other forms of business?
Answer: Sole proprietorships are the most common types of business throughout
the world because they are the simplest to set up. In many countries, you do not
need to complete any forms or registration to begin running a sole proprietorship.

7. Stakeholders Discuss what is meant by a stakeholder. In what ways are stakeholders

represented in two-tier board structures? How does this differ from companies with
a unitary board structure? Use real examples to illustrate your answer.
Answer: A stakeholder is any party which has an interest in the operations of the
company, either directly or indirectly. Examples include shareholders, employees,
creditors, customers, suppliers, normal citizens, etc. In a two tier board system, the
board structure is divided into two parts consisting of the supervisory and executive
board. The supervisory board is composed of outside shareholders and other
stakeholders, such as employee groups (trade unions) and banks (capital providers).
A good example of a supervisory board is DaimlerChrysler AG, which was comprised
of 20 members - half of which were elected by shareholders at the Annual Meeting.
The other half comprises members elected by the company’s employees who work
in Germany (Annual report, 2008). The supervisory board can hire or fire any
member of the executive board. The latter is composed of executive directors who
direct the day-to-day operations of the firm. In a unitary board, the executive and
non-executive directors sit on the same board and it is very rare for stakeholders
such as employees to be represented.

Intermediate

8. Agency Problems Who owns a corporation? Describe the process whereby the
owners control the firm’s management. What is the main reason why an agency

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Fundamentals of Corporate Finance
Third European Edition

relationship exists in the corporate form of organization? In this context, what kinds
of problem can arise?
Answer: 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.

9. Board Committees Explain why you think public listed companies have board
subcommittees like the remuneration committee, audit committee and risk
management committee? Why could this responsibility not simply be left to the
board of directors? Explain.
Answer: In large complex corporations, the sheer range of tasks and responsibilities
can be exceptionally large. The board of directors or executive board should be seen
as the apex of a corporation’s management structure. If other tasks are required by
the board that draw on specialized skills or experiences, or if an activity (such as
audit or remuneration) must be handled independently to ensure accountability,
then sub-committees will be formed.

10. Corporate Governance Is it possible to improve one aspect of corporate governance

in a firm but weaken another at the same time? Use an illustration to explain your
answer.
Answer: Yes, it is possible to improve one aspect of a corporate governance principle
and weaken another. For example, if you improve the rights of shareholders, it may
weaken the rights of other stakeholders such as employees and communities. Many
examples can be given here and lecturers should encourage students to come up
with their own solutions.

11. Government Ownership In recent years, governments have taken control of banks
through buying their shares. What impact does this have on the lending culture of
these banks? Is this consistent with shareholder maximization? Use an example to
illustrate your answer.
Answer: Governments have different objectives to shareholders. Whereas
shareholders wish to maximize the value of their own investment, governments are
more concerned with maximizing social welfare. This can sometimes contradict that
of shareholders. For example, several governments purchased the shares of
financially stricken banks in 2008. Shortly afterwards, they put pressure on the
banks to lend to smaller companies and give mortgages, even though the banks
themselves felt that the lending decisions were not value maximizing.

Challenge

12. Agency Problems Suppose you own equity in a company. The current share price is
£25. Another company has just announced that it wants to buy your company, and

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Third European Edition

will pay £35 per share to acquire all the outstanding shares. Your company’s
management immediately begins fighting off this hostile bid. Is management acting
in the shareholders’ best interests? Why or why not?
Answer: Clearly the bidder thinks that the £35 is money well spent and that your
firm has untapped value that the market does not appreciate. Managers have many
agendas, including job safety. However, it is also possible that they do not believe
that the bidding company will be good for the company over the longer term.
Chapter 22 on Mergers and Acquisitions covers a very similar situation when Ryanair
submitted a higher bid for Aer Lingus. In the end, the bid was unsuccessful because
the major shareholders did not believe that the takeover was good for the company.

13. Agency Problems and Corporate Ownership Corporate ownership varies around the
world. Historically, individuals have owned the majority of shares in public
corporations in the United States. In Germany and Japan, however, banks and other
large financial institutions own most of the equity in public corporations. Do you
think agency problems are likely to be more or less severe in Germany and Japan
than in the United States? Why? In recent years, large financial institutions such as
mutual funds and pension funds have been becoming the dominant owners of
shares in the United Kingdom, and these institutions are becoming more active in
corporate affairs. What are the implications of this trend for agency problems and
corporate control?
Answer: We would expect agency problems to be less severe in countries with a
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 equity in the United Kingdom and the growing activism of these large
shareholder groups may lead to a reduction in agency problems for U.K. corporations
and a more efficient market for corporate control.

14. Executive Compensation Critics have charged that compensation to top managers in
the banking sector is simply too high and should be cut back. Look at the financial
accounts of some banks in your region and determine the total pay of their chief
executive officers. Are such amounts excessive? In answering, it might be helpful to
recognize that superstar athletes such as Cristiano Ronaldo and Lionel Messi, top
entertainers such as Tom Cruise and Kate Winslet, as well as many others at the top
of their respective fields earn at least as much, if not a great deal more.
Answer: How much is too much? Who is worth more, Cristiano Ronaldo or Lionel
Messi? The simplest answer is that there is a market for executives just as there is
for all types of labour. Executive compensation is the price that clears the market.
The same is true for athletes and performers.

15. Corporate Governance around the World In the Middle East, many companies have
a Sharia Supervisory Board to which the board of directors report. Evaluate the

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Third European Edition

merits of such a governance structure and argue whether this approach to

governance could be extended to other areas where the supervisory board guides on
ethical, social or environmental matters.
Answer: Supervisory boards, like the Sharia board, can be of use when the objectives
of a firm are tied to social, environmental or ethical issues. The purpose of such a
board is to guide executives in making the correct decisions with respect to the
company’s remit. An example of a supervisory board that may work in a separate
area is that of football teams. In this situation, the supervisory board would consist
of fan representatives and they would guide the executive board on football
decisions. Other areas include firms with where public oversight is required, such as
the banking sector.

16. Institutional Shareholders Regulators have developed a number of new policies with
respect to institutional shareholder involvement in the running of firms. Review the
reasons why regulators would prefer more or less involvement of institutions in the
running of corporations. In addition, discuss the proposals that have been put
forward by regulators in your own country, and whether these are likely to be
effective.
Answer: Institutional shareholders are increasingly becoming instrumental in
demanding good corporate governance in companies in which they invest, (e.g.
NAPF in UK and CalPERS in US). The main reason why institutions are important in
corporate governance is because they are normally the largest shareholders in the
firm. As representatives of their investee base, they should take the role of owners
in monitoring firms. With respect to country specific regulations, the student should
review their own country’s corporate governance code and take a view on the
effectiveness of the code.

17. Codes of Corporate Governance Download a set of country codes from the
European Corporate Governance Institute website (www.ecgi.org) and identify any
differences and similarities between your chosen country and the US codes. What
are the main differences between your chosen country and the US’s governance
codes?
Answer: The student would be expected to carry out this research themselves.

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Fundamentals of Corporate Finance
Third European Edition

Mini Case Questions

Questions 1-3
Glindebourne Wines Limited

Three years ago, John and Beverly Glindebourne formed Glindebourne Wines Limited. The
company produced a full line of English wines, and its specialities included tonic wine, crazy
dog wine, Temeke Wine and Tyson Wine. The two formed the company as an outside
interest, and both continued to work at their existing jobs. John did all the wine growing and
Beverly handled the marketing and distribution. With good product quality and a sound
marketing plan, the company grew rapidly. Early this year, the company was featured in a
widely distributed entrepreneurial magazine and just a few months ago the company was
featured in Gourmet Wines, a leading speciality wine magazine. After the article appeared in
Gourmet Wines, sales exploded and the company began receiving orders from all over the
world.

Because of the increased sales, John left his other job, followed shortly by Beverly. The
company hired additional workers to meet demand. Unfortunately, the fast growth
experienced by the company led to cash flow and capacity problems. The company is
currently producing as many wines as possible with the assets it owns, but demand for its
wines is still growing. Further, the company has been approached by a national supermarket
chain with a proposal to put four of its wines in all of the chain's stores, and a national
restaurant chain has contacted the company about selling Glindebourne Wines in its
restaurants. The restaurant would sell the wines without a brand name.

John and Beverly have operated the company as a sole proprietorship. They have
approached you to help manage and direct the company's growth.

Question 1
If John and Beverly remain a sole proprietorship, what is their biggest risk if the business
does not succeed and the firm becomes bankrupt?
 There is no risk to them if they fail
 Limited Liability
 Unlimited liability
 Partial Liability

Explanation:

If John and Beverley remain a sole partnership, then as the owners of the firm they will have
an unlimited liability for business debts. This means that the debtors of their company can
go after both the business assets of Glindebourne Wines and personal assets in the event of
a bankruptcy.

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Fundamentals of Corporate Finance
Third European Edition

Question 2
If John and Beverly decide to become a corporation, what documents from the list below
would they need? Check all that apply.
 Memorandum of association
 Articles of incorporation
 A letter from a lawyer
 A credit rating
 A bank statement

Explanation:

If John and Beverley decide to become a corporation, they will need articles of incorporation
which contains information regarding the company name, business purpose, intended life
and number of shares. In addition to this, they will need a memorandum of association
which sets out the process for electing directors and other rules and procedures.

Question 3
If John and Beverly decide to set up a limited partnership but intend to pass the business
onto their children at some point in the future, is a limited partnership the best structure?

 Yes
 It doesn’t matter
 No

Explanation:

If John and Beverley decide transfer their business to their children in the future, a limited
partnership is not a good corporate structure, as the transfer of ownership in a partnership
is problematic and requires a new partnership to be formed.

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