Chapter 1 Warm-Up Exercises

Warm-up Exercises
(Principles of managerial finance, Gitman, 14th edition)

E1–1 Allie and Austin have operated a small florist business from their garage at home as an
informal business for the last three years. After some deliberation, they have decided to make their
business formal. They approach you, as a management consultant, to assist them in selecting the
most appropriate form of business organization.
You have established that both would like to minimize their tax liability. Advise Allie and Austin on
the most appropriate legal form of business organization based on this requirement. Provide a
brief outline of the strengths and weaknesses of the legal form of business organization
recommended. What other legal form of business organization would you recommend they
consider? What would be the motivation behind this recommendation?
E1–2 As chief financial officer, it is your responsibility to weigh the financial pros and cons of the
many investment opportunities developed by your company’s research and development division.
You are currently evaluating two competing 15-year projects that differ in several ways. Relative to
your firm’s current EPS, the first project is expected to generate above-average EPS during the
first 5 years, average
EPS during the second five years, and then below-average EPS during the last
5 years. The second project is expected to generate below-average EPS during the first 5 years,
average EPS during the second 5 years, and then well-above-average EPS during the last 5
years.
Is the choice obvious if you expect that the second investment will result in a larger overall
earnings increase? Given the goal of the firm, what issues will you consider before making a final
decision?
E1–3 The end-of-year parties at Yearling, Inc., are known for their extravagance. Management
provides the best food and entertainment to thank the employees for their hard work. During the
planning for this year’s bash, a disagreement broke out between the treasurer’s staff and the
controller’s staff. The treasurer’s staff contended that the firm was running low on cash and might
have trouble paying its bills over the coming months; they requested that cuts be made to the
budget for the party. The controller’s staff believed that any cuts were unwarranted, as the firm
continued to be very profitable.
Can both sides be correct? Explain your answer.
E1–4 You have been made treasurer for a day at AIMCO, Inc. AIMCO develops technology for
video conferencing. A manager of the satellite division has asked you to authorize a capital
expenditure in the amount of $10,000. The manager states that this expenditure is necessary to
continue a long-running project designed to use satellites to allow video conferencing anywhere on
the planet. The manager admits that the satellite concept has been surpassed by recent
technological advances in telephony, but he believes that AIMCO should continue the project
because $2.5 million has already been spent over the past 15 years on this project. Although the
project has little chance to be viable, the manager believes that it would be a shame to waste the
money and time already spent.
Use marginal cost–benefit analysis to make your decision regarding whether you should authorize
the $10,000 expenditure to continue the project.
E1–5 Recently, some branches of Donut Shop, Inc., have dropped the practice of allowing
employees to accept tips. Customers who once said, “Keep the change,” now have to get used to
waiting for their nickels. Management even instituted a policy of requiring that the change be
thrown out if a customer drives off without it. As a frequent customer who gets coffee and
doughnuts for the office, you notice that the lines are longer and that more mistakes are being
made in your order.
Explain why tips could be viewed as similar to stock options and why the delays and incorrect
orders could represent a case of agency costs. If tips are gone forever, how could Donut Shop
reduce these agency costs?
Answers to Warm-Up Exercises

E1-1. Comparison of advantages and disadvantages of a partnership versus incorporation.
Answer: Partnerships as each partner is taxed on his/her personal tax return.
Strengths:
• Can raise more funds than sole proprietorships
• Borrowing power enhanced by more owners
• More available brain power and managerial skill
• Income included and taxed on partner’s personal tax return
Weaknesses:
• Owners have unlimited liability and may have to cover debts of other partners
• Partnership is dissolved when a partner dies
• Difficult to liquidate or transfer partnership
E1-2 Timings of cash flows
Answer: Based on the information provided, the choice is not obvious. Even though the second
project is expected to provide the larger overall increase in earnings and, therefore, is the more
profitable project, the goal of the firm is to maximize value so timing, cash flow, and risk have to be
considered to determine which project is superior. Although it is often the case that profit
maximization leads to value maximization, it is definitely not always the case.
E1-3. Cash flow vs. accrued profits

Answer: It is not unusual for a firm to be profitable yet experience a cash crunch. The most
common cause is when expenses have a shorter due date than expected revenue. In such cases,
the firm must arrange short-term financing to meet its debt obligations before the revenue arrives.
If the forthcoming cash crunch is not a new situation for this firm, management should probably
consider going ahead with the year-end party if it is important for employee morale and the future
success of the firm, as long as adequate short-term funding can be arranged. On the other hand, if
the firm has not experienced such a cash crunch before, there may be larger problems looming
ahead, and it would be unseemly to spend cash on a party that would be better spent meeting the
debt obligations of the firm.
E1-4. Sunk costs

Answer: Marginal cost-benefit analysis ignores sunk costs, so the $2.5 million dollars is irrelevant
to the current decision that must be made. At this point there are two questions that must be
answered. First, will the $10,000 additional investment generate a PV of expected revenue that will
exceed the $10,000 investment? In other words, will the project generate a positive net present
value? If it does, the project must be considered further to see if it is the best use of capital. If the
firm has a need to ration capital, the project must then be compared to other projects competing
for the limited capital to see if it is viable. The fact that the project’s technology has been
surpassed by new technology does not immediately disqualify the project because new technology
does not ensure a positive cost-benefit result. In this case, a small $10,000 investment might avoid
a heavy expenditure in new technology.
Depending upon the industry, however, failure to keep up with competitors can be devastating.
The key may well lie in the description “the project has little chance to be viable,” which
indicates that approving the $10,000 is likely to be throwing good money after bad.
E1-5. Agency costs

Answer: Agency costs are the costs borne by stockholders to maintain a governance structure
that ensures against dishonest acts of management and gives managers the financial incentive to
maximize share price. One example of agency costs is stock options, which are used to provide an
incentive for managers to work diligently for the benefit of the firm. Tips are similar to stock options
in that they are offered as rewards for good service much as stock options are used to reward
managers, presumably based on their good performance—which subsequently leads to a higher
stock price. The Donut Shop, Inc., example does not represent a clear case of agency costs
because it is the management itself that has instituted the “No tips” policy and the employees
have responded with reduced performance. By banning tips, the management has created a
situation where an agency cost may be necessary to provide an incentive for employees to resume
their former level of performance.
One solution that may work for Donut Shop, Inc., is to institute a profit-sharing plan that reaches
down to the employee level where the slowdown and inefficiency are occurring. A profit-sharing
plan is designed to motivate the employees and could alleviate the aggravation caused by the no-
tip policy but must be clearly identified as the replacement to tipping in order to be effective. A
profit-sharing plan is usually viewed by the employees as a reward for good performance but does
not have the immediacy of the positive effect that an employee gets from a tip.
It is unclear from the case whether the new no-tip policy is a company-wide policy or simply the
actions of a few branch managers. However, the real solution here is to recognize that the no-tip
policy has created an unnecessary backlash that can be alleviated by reversing management’s
position without incurring the additional costs of revising the current employee benefit plan and
paying out a portion of corporate profits.

Chapter 1 Warm-Up Exercises

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Chapter 1 Warm-Up Exercises

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Warm-up Exercises

(Principles of managerial finance, Gitman, 14th edition)

Answers to Warm-Up Exercises

E1-3. Cash flow vs. accrued profits

E1-4. Sunk costs

E1-5. Agency costs

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