Consider going ahead with the year end party if it is

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consider going ahead with the year end party if it is important to 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 when it would be better spent meeting the debt obligations of the firm. E1-4. 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.
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12 Gitman • Principles of Managerial Finance, Twelfth Edition 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. E1-5. Stock dividends vs. interest Answer: While 100% of corporate interest income is taxed at ordinary income tax rates, only 30% of corporate dividend income is treated as taxable income. Based solely on the tax treatment of corporate dividend income versus interest income, Pruro, Inc. would have greater after-tax income if it chooses the Reston stock paying 5% dividends over the promissory note paying 5% interest.
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