Review Questions 1
Textbook Page Questions
25 2, 3, 4
26 11, 12
2. A firm might cut its labour force dramatically, which could reduce immediate expenses and
increase profits in the short term. Over the long term, however, the firm might not be able to
serve its customers properly or it might alienate its remaining workers; if so, future profits will
decrease, and the stock price will decrease in anticipation of these problems.
Similarly, a firm can boost profits over the short term by using less costly materials even if this
reduces the quality of the product. Once customers catch on, sales will decrease and profits
will fall in the future. The stock price will fall.
The moral of these examples is that, because stock prices reflect present and future profitability,
the firm should not necessarily sacrifice future prospects for short-term gains.
3. The key advantage of separating ownership and management in a large corporation is that
it gives the corporation permanence. The corporation continues to exist if managers are
replaced or if stockholders sell their ownership interests to other investors. The
corporation’s permanence is an essential characteristic in allowing corporations to obtain
the large amounts of financing required by many business entities.
Both public and private corporations are distinct legal entity, separate from its owners (i.e.,
its shareholders). The key difference between public and private corporations is the rules
governing the sale of their common shares. The common shares of a public corporation are
listed for trading on a stock exchange and investors can freely buy and sell the
corporation’s shares at the current stock price. The common shares of private corporations
are not listed for trading on a stock exchange. Shareholders of private corporations must
negotiate directly with potential buyers and are subject to resale restrictions.
4. A sole proprietorship is easy to set up with a minimum of legal work. The business itself is not
taxed. For tax purposes, the income of the proprietorship is treated as the income of the
proprietor. The main disadvantages of a proprietorship are the proprietor’s unlimited liability
for the debts of the firm, and difficulty in raising large amounts of financing as the business
A partnership has the same tax advantage as the proprietorship. The partnership per se does
not pay taxes. The partnership files a tax return, but all of the partnership income is allocated
to the partners and treated as personal income. Also, it is fairly easy to set up a partnership.
Because there can be many partners, a partnership can raise capital more easily than a proprietorship. However, like sole proprietors, partners have unlimited liability for the debts of
the firm. In fact, each partner has unlimited liability for all the business’s de