Limited liability A means that there are tight limits on the damages that a

Limited liability a means that there are tight limits

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16.Limited liability: A)means that there are tight limits on the damages that a firm can be forced to pay due to lawsuits over product safety and so on.B)means that the owners of a firm cannot personally be held responsible for the obligations of the firm.C)is the major disadvantage of incorporation.D)is the major advantage of proprietorship. 17.Suppose a corporation purchases an asset for $100,000. Under straight-line depreciation, the corporation would be allowed to depreciate the asset over 5 years. Under accelerated straight-line depreciation, it would be allowed to depreciate the asset over 2 years. Now assume that the discount rate is 10%. What would the present discounted value of the tax deduction be under straight-line depreciation? 18.Which of the following is NOT a method to finance a firm's investment? Page 3
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19.If corporations bear at least some of the tax burden when profits are taxed, this means that workers are likely to bear some of the burden through: 20. Suppose that you are a bank executive and that two corporations have asked the bank, through you, to buy bonds to finance the respective investments that they'd like to make. The first firm is financed 90% through debt and 10% through equity, while the second firm is financed 50% through debt and 50% through equity. Except for the finance structure and its implications (if any), assume that there are no differences between the two firms. (a) Suppose that you are unable to determine whether the project the first firm wants you to finance is any better or worse than the project the second firm wants you to finance. Suppose also that you want to lend both corporations the money. Should you charge both of them the same interest rate? Explain. (b) Suppose that you were instead a firm manager. In which of the corporations would you rather be? Explain. Page 4
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Answer Key 1. B 2. A 3. C 4. Corporations can finance either by borrowing (through bonds) or by issuing equity (selling stock). In this case, the corporation should sell bonds, since corporations do not have to pay tax on income that is distributed to bondholders. In contrast, if the corporation were to finance through selling stock, then it would have to pay corporate taxes on the income before distributing it to you through either capital gains or dividends. 5. C 6. A 7. C 8. C 9. A 10. There are a number of specific answers, but they all come down to the key distinction between debt and equity: debt requires fixed payments but equity does not. If the firm doesn't make its interest payments, it defaults on its debts and can be forced into bankruptcy. The extra flexibility of equity can raise its value enough to offset its tax disadvantage. Equity finance can provide a buffer zone against the risk of bankruptcy;
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