P1-1
John Bailey invested $50,000 in The Entertainment Company seven years ago. He is
concerned about the future of the firm as the profits have plummeted over the last four
years. The firm has $120,000 in outstanding debt and is considering declaring bankruptcy.
a. If John is the sole proprietor, describe the financial implication of the firm going
bankrupt.
Since john is a sole proprietor, he has unlimited liability. that is his total wealth can be taken to
satisfy debt.
b. If John and his brother, Peter, are partners with an equal partnership distribution,
describe the financial implication of the firm going bankrupt.
Both owners have unlimited liability. They may have to cover debts of another if one one them is
less financially sound partners.
c. If the firm is a corporation, describe the financial implication of the firm going
bankrupt.
Owners have limited liability which guarantees they can not lose more than they invested.
P1-2
The Motor Corporation sold vehicles for $500,000 to one specific dealer during the year. At
the financial year end, the dealer still owed The Motor Corporation $350,000. The cost of
the vehicles sold was $400,000, and this cost was incurred and paid by The Motor
Corporation.
a. Determine the net profit using the accrual basis of accounting.
Net profit = $(500,000-400,000) = $100,000
b. Determine the net cash flow using the cash basis of accounting.
Cash inflow = $(500000 -350000) = $150000
Cash outflows = $400000
This study source was downloaded by 100000841962933 from CourseHero.com on 02-23-2022 01:43:56 GMT -06:00
https://www.coursehero.com/file/76842942/Chapter-1theorydocx/
Net cash flows = $(150,000-400000) = -$250000
c. The accountant and financial manager need to present the results to the CEO of The
Motor Corporation. What will be their message regarding the performance of the
corporation?
Accountant: Firm made a profit of $100,000 on the deal and the accountant is satisfied.
Financial manager: Firm ran out of cash and financial manager is not satisfied.
P1-3
Cash flows Sheldon Smith spends many hours monitoring his personal cash flows every
month. Sheldon earns 5% on his short-term investments while paying prime plus 2%
(prime is 9%) on the mortgage. The cash inflows and outflows for the month of March are
as follows:
a. Determine Sheldon’s total cash inflows and cash outflows for the month of March.
Cash inflows = $(500+5500) = $6000
Cash outflows = $(1550+850+200+310) = $2910
b. What is Sheldon’s net cash flow for the month of March? Explain the meaning of the
term “net cash flow.”
Net cash flows =cash inflow – cash outflow
= $(6000 -2910) = $3090
Sheldon’s total cash inflow exceeds his total cash outflow by $3,090.
This study source was downloaded by 100000841962933 from CourseHero.com on 02-23-2022 01:43:56 GMT -06:00
https://www.coursehero.com/file/76842942/Chapter-1theorydocx/
c. What advice would you give Sheldon if there is a surplus of funds?
If there is a surplus of funds, Sheldon may invest the funds in some form of short-term
investment
d. What advice would you give Sheldon if there is a shortage of funds?
If there is a shortfall of funds, Sheldon will have to either borrow or withdraw the amount
required from his savings (short-term investments). Sheldon could also reduce his expenses by
spending less.
P1-4
Marginal cost-benefit analysis and the goal of the firm Wendy Winter needs to determine
whether or not the current warehouse system should be upgraded to a new system. The
new system would require an initial cash outlay of $250,000. The current system could be
sold for $55,000. The monetary benefit of the new system over the next five years is
$325,000 while the monetary benefit of the current system over the same period is $125,000.
Furthermore, it is expected that the firm’s stock price will increase if the new system is
implemented because it will make the firm more cost efficient and cost effective in the long
run.
a. Identify and describe the analysis Wendy should use to make the decision.
Marginal cost-benefit analysis – Economic principle that states that financial decisions should be
made and actions taken only when the added benefits exceed the added costs.
b. Calculate the marginal benefit of the proposed new warehouse system.
Marginal benefit =$(325000 - $125000) = $200,000
c. Calculate the marginal cost of the proposed new warehouse system.
Marginal cost = $(250,000 -55,000) = $195000
d. What should Wendy’s recommendation be to the firm regarding the new
This study source was downloaded by 100000841962933 from CourseHero.com on 02-23-2022 01:43:56 GMT -06:00
https://www.coursehero.com/file/76842942/Chapter-1theorydocx/
warehouse system? Explain your recommendation.
Wendy will recommend that new warehouse system should be boungth as the net benefit is
$5000 ($200,000 -$195,000)
e. If the new system is implemented, will the firm achieve the primary financial goal
of managers?
Yes, as the new system is expected to increase the stock price which will increase the shareholder
wealth
P1-5
You are the CEO of Nelson Corporation, and the current stock price is $27.80. Pollack
Enterprises announced today that it intends to buy Nelson Corporation. To obtain all the
stock of Nelson Corporation, Pollack Enterprises is willing to pay $38.60 per share. At a
meeting with your management, you realize that the management is not happy with the
offer, and is against the takeover. Therefore, with the full support of your management
team, you are fighting to prevent the takeover from Pollack Enterprises. Is the
management of Nelson Corporation acting in the best interest of the Nelson Corporation
stockholders? Explain your reasoning.
The goal of management is to increase the stock price to maximize the shareholder wealth. If the
management team believes that it can improve the profitability of the firm that the share price
will exceed $38.60, then management should fight the hostile takeover. If the management team
believes that the company B will actually pay more than $38.60 to acquire the company, then the
management team should still fight the offer. However, if the current management team cannot
increase the value of the firm beyond the bid price ($38.60), then the management team is not
acting in the interests of the stockholders by fighting the offer. Another aspect is that the current
management team often loses its job when the company is acquired by another company. Due to
this reason, the management team will use this as an incentive to fight takeover
This study source was downloaded by 100000841962933 from CourseHero.com on 02-23-2022 01:43:56 GMT -06:00
https://www.coursehero.com/file/76842942/Chapter-1theorydocx/
P1-6
Assume you own stock in a company, and you are in the process of selling the stock to
another investor. Since the transaction will occur between the buyer and the seller, the
company will receive no direct cash flows as a result of the sale. Why should the company’s
management care about the price you get for your shares if the company does not receive
any direct cash flow from the transaction?
The current market price of the stock of the company reflects, among other things, market
opinion about the quality of firm management. If the sale price is low, this indirectly reflects on
the reputation of the managers, as well as potentially impacting their standing in the employment
market. Alternatively, if the sale price is high, this indicates that the market believes current
management is increasing firm value, and therefore doing a good job. An increase in the selling
price would mean that shareholder wealth was maximized.
This study source was downloaded by 100000841962933 from CourseHero.com on 02-23-2022 01:43:56 GMT -06:00
https://www.coursehero.com/file/76842942/Chapter-1theorydocx/
Powered by TCPDF (www.tcpdf.org)