Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual

Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition, Instructor’s Manual
ANSWERS TO QUESTIONS
1. The principal advantage of the corporate form of business organization is that the
corporation has limited liability. The owner of a small family restaurant might be required
to personally guarantee corporate borrowings or purchases anyway, so much of this
advantage might be eliminated. The wealthy individual has more at stake and unlimited
liability might cause, one failing business to bring down the other healthy businesses.
2. The liability is limited to the amount of the investment in both the limited partnership and in
the corporation. However, the limited partner generally does not have a role in selecting the
management or in influencing the direction of the enterprise. On a pro rata basis,
stockholders are able to select management and affect the direction of the enterprise. Also,
partnership income is taxable to the limited partners as personal income whereas corporate
income is not taxed unless distributed to the stockholders as dividends.
3. With both a sole proprietorship and partnership, a major drawback is the legal liability of
the owners. It extends beyond the financial resources of the business to the owners
personally. Fringe benefits are not deductible as an expense. Also, both forms of
organization lack the corporate feature of “unlimited life”. With the partnership there are
problems of control and management. The ownership is not liquid when it comes to
planning for individual estates. Decision making can be cumbersome. An LLC generally
lacks the feature of “unlimited life”, and complete transfer of an ownership interest is
usually subject to the approval of at least a majority of the other LLC members.
4. The chief beneficiaries are smaller companies where the first $75,000 in taxable income is a
large portion, if not all, of their total taxable income.
5. Accelerated depreciation is used up to the point it is advantageous to switch to straight line
depreciation. A one-half year convention is followed in the first year, which reduces the
cost recovery in that year from what would otherwise be the case. Additionally, a one-half
year convention is followed in the year following the asset class. This pushes out the
depreciation schedule, which is disadvantageous from a present value standpoint. The
double declining balance method is used for the first four asset classes, 3, 5, 7 and 10 years.
The asset category determines the project’s depreciable life.
6. The immunity from each other’s taxing power dates back to the early part of the 19th
century. It used to apply to salaries of government employees as well. The exemption is
historical, and it is hard to rationalize from the standpoint of economic/taxing efficiency.
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7. Personal tax rates are progressive up to a point, then become regressive.
8. With the differential taxation of ordinary income and capital gains, securities with a higher
likelihood of capital gains are tax advantaged. These include low dividend common stocks,
common stocks in general, discount bonds, real estate, and other investments of this sort.
9. Depreciation changes the timing of tax payments. The longer these payments can be
delayed, the better off the business is.
10. One advantage to S becoming a corporation occurs when investors have outside income
against which to use losses by the company. Even with no outside income, stockholders still
may find S to be advantageous. If dividends are paid, the stockholder under a S corporation
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