Australian School Of Business School Of Banking And Finance FINS1613: B USINESS F INANCE Semester 1, 2012 Tutorial Week 2: Introduction

and Types of Firms

C ONCEPT R EVIEW 1. Types of rms For the following questions, compare and contract the three main types of organisation forms: corporations, partnerships, and sole traders (sole proprietorships). (a) What are the advantages of sole traders and partnerships? What are the disadvantages of these forms? (b) What are the most important structural differences between the corporate form and the other forms of organisation? (c) Who are the owners of a corporation? What type of direct control do they have over the organisation? (d) What are the advantages of the corporate form of organisation for the shareholders? (e) What are the disadvantages of the corporate form? How do these disadvantages depend on the tax system? (f) Which forms can we assume have a value maximisation objective? Why? (g) Which forms may be able to exist when ownership changes? Why might the ability of a rm to persist through ownership changes impact rm value?

2. Agency costs (a) In 2009, Walmart, a major US retailer, enacted Project Impact in which the company remodeled its stores to improve the customer experience. The move was made in response to customer requests for a less cluttered in-store experience. However, the remodeling was unsuccessful as sales dropped by over $1.5 billion. Project Impact clearly did not maximize the value of Walmarts stock. Does the project represent an agency cost? (b) Berk, DeMarzo, Harford, Ford, and Finch, Question 1.12 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 conicts 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? N UMERICAL Q UESTIONS 1. Imputation taxation Complete the following table under an imputation tax system. Pre-tax earnings $420 - Corporate tax (25%) Dividend distributed to shareholder Tax-basis for shareholder Income tax liability (35%) Franking credit - Tax owed by shareholder After-tax dividend received by shareholder 2. Comparing rm structures Imagine you and a friend are starting a rm in a country where there is a classical tax system. However, it is not clear if the rm should be structured as a partnership or as a corporation. If you set it up as a partnership, you and your partner will each own half the rm. As a partnership, the business is expected to make $500,000 before taxes each year. If you set the rm up as a corporation, you will only own 20% of the rm with the remaining 80% owned by your partner and other entities. But, you expect that you will be able to run a larger business that makes $1,500,000 before taxes each year. The corporate tax rate is 30% and your income tax rate is 40%. (a) How much will you receive after taxes each year if you set up a partnership? (b) How much will you receive after taxes each year if you set up a corporation? (c) Which structure would you prefer if you only cared about your annual after-tax income? What if you are concerned about personal liability?

3. Addressing agency problems A common solution to agency problems between rm owners and CEOs is to give the CEO an ownership stake in the company. To see why this works, imagine a CEO that wants to y from Sydney to Perth for a vacation. The CEO is equally happy to (i) y by the companys private jet or (ii) to y rst class on Qantas. Assume that the private jet costs $50,000 and will be paid for by the company, while the $5,000 rst class ticket will be paid for by the CEO. Assume that the CEO will not get caught using the company jet for personal use. (a) Which option should the CEO choose? Why is this an agency cost? (b) Now assume the following. The CEO is given 25% of the companys equity. The corporate tax rate is 30% and the CEO pays income taxes at 45%. i. What kind of tax system is in place in Australia? ii. What is the after tax cost to the CEO of ying by the company jet? (Hint: If the CEO ies by the company jet, the dividends available to shareholders decrease by $50,000. As a shareholder, the CEO will receive 25% of all available dividends.) iii. What is the after tax cost to the CEO of ying by Qantas? iv. Which option should the CEO choose? Did the ownership stake in the company solve agency problems? Why? (c) Assume now that the CEO is the head of a company in the US and is ying from New York to Los Angeles. The fares for private jet and commercial air (Qantas) are the same as above. The CEO still owns 25% of company equity and the corporate tax and income tax rates are 30% and 45%, respectively. i. ii. iii. iv. What kind of tax system is in place in the U.S.? What is the after tax cost to the CEO of ying by the company jet? What is the after tax cost to the CEO of ying by Qantas? Which option should the CEO choose? Did the ownership stake in the company solve agency problems? Why? v. Is your answer different from part (b)? Why?