Solutions Manual

to accompany

Introducing
Corporate Finance 2e
Diana Beal, Michelle Goyen
Abul Shamsuddin

Prepared by

Diana Beal

© John Wiley & Sons Australia, Ltd 2008

Chapter Two: Taxation and business structures

Questions

2.1 What is an ABN?

A discrete identifier of businesses registered with the ATO.

2.2 Why should suppliers of goods and services be sure to quote an ABN on
their invoices?

Because payers must deduct the highest rate of marginal tax from payments if the
ABN is not quoted and an exemption form (NAT 3346) is not submitted.

2.3 Why is the sole proprietorship so commonly used as the structure of

Australian businesses?

Easy to set up for new businesses, full personal control.

2.4 David Black Plumbing ceases trading with $20  000 owed to EZ Plumbing
Supplies. David Black, the sole owner of the defunct business, owns his
house and several flats. Who is legally liable for the $20  000, David Black
or EZ Plumbing?

David Black

2.5 Filcher Partners are lawyers who want to bring in a new full partner.
Explain how the finances might be arranged to achieve this.

Assets, including intangibles such as goodwill, are valued at market prices and
liabilities deducted to find the net market value of the business. This value is then
divided by the number of current partners to estimate value per partner. The new
partner is then charged a price of or near this amount. The business then has this extra
cash or other assets to enhance its total asset value.

2.6 Dana Stevens is an orthodontist in a suburban dental practice run as a

partnership. There are no professional employees, the only employees
being the two receptionists and the three dental assistants. Don draws a
wage fortnightly and always says he is the lowest paid employee in the
firm. Can this claim be correct? Why?

Don’s ‘wage’ is not wages but is really drawings as a partner. He is able to draw as
much or as little as he likes, and the record of the drawings is kept in his personal

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Introducing Corporate Finance 2e Solutions Manual

current account in the partnership books. The current account is increased by annual
profits and decreased by drawings
2.7 ‘A company cannot be sued; it is the board who are sued in the case of
negligence.’ Is this statement correct? Why?

Incorrect. An incorporated body can sue and be sued as a separate legal ‘person’.

2.8 Traders use trusts to minimise their income tax. Explain this statement
with an example.

Trusts may be formed by individuals and companies. Tax is paid sometimes directly
by a trust, or by the relevant individuals at marginal rates or by the relevant
companies at company rates. The advantage of the trust structure is that income may
be directed to the ‘person’ enjoying the lowest tax rate. For example, a trust with
$150 000 net income may direct, say, $30 000 to each of five beneficiaries and have a
total tax liability of $18 000 whereas directing $75 000 to two beneficiaries incurs a
total tax bill of $34 200 (2007–08 rates).

2.9 Most income received by resident individuals in Australia is assessable

income including legacies, lottery prizes and gambling wins. Is this true?
Explain.

Incorrect. Most income is assessable, but the three stated types of income are
generally not. Gambling wins are assessable only if the taxpayer is a professional
gambler.

2.10 Prime Paints suffered a fire and lost $180 000 worth of stock. $150 000
was claimed and received from its insurer. Is this assessable income?

Yes

2.11 The claiming of interest expenses as tax deductions has been a highly
litigated area. Explain the factors underlying this.

The ATO recognises expenses incurred in gaining income. Thus to be a legitimate

deduction, interest must be paid on debt incurred to gain income. Sometimes this is
straight-forward; other times it is unclear, especially in relation to timing of the
interest payments and with some modern innovative financing methods.

2.12 Explain the basis of CGT.

CGT is levied on capital gains made on the disposal of assets purchased after
19 September 1985.

2.13 What rate of tax is currently levied as CGT?

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 Chapter Two: Taxation and business structures

Marginal rates
2.14 GST is an unfair tax which disadvantages business. Do you agree? Why?

No. GST does not fall on business but business is used as the tax collectors.

2.15 Explain the theoretical basis for dividend imputation.

Dividend imputation was introduced to rid the taxation system of double taxation of
company profits, firstly in the hands of the company and then in the hands of
shareholders.

2.16 If a taxpayer receives a $700 fully franked dividend, she will pay tax on
$700.Is this correct?

No. At the 30% company tax rate, she will pay tax on $1000.

2.17 A taxpayer receives $2100 in fully franked dividends and has a 30%
marginal tax rate. What extra tax liability will the tax-payer have on the
dividends?

Nil. The franking credits are equal to the income tax.

2.18 John is happy to be told by his accountant that has $4500 in franking
credits. Explain to John what this means.

The $4500 is tax paid by the companies in which he holds shares and it is a credit to
his account with the ATO to be used to pay tax or to be refunded.

2.19 An Australian technology company lists in New York and has mainly
foreign shareholders. Should dividend imputation have much impact on
its decision-making with regard to future investments?

No. As most of its shareholders cannot use the franking credits, it should analyse its
future investment decisions on a tax-paid basis.

2.20 Australian Ginger is a small listed firm with only Australian individuals
as shareholders. Their projects manager insists all development proposals
should use PV analysis and take tax effects into consideration. Is he
correct? Why?

No. Australian shareholders can use the franking credits, so decision analyses should
ignore tax.

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Introducing Corporate Finance 2e Solutions Manual

Financial Problems

2.1 Steve Preston is a veterinary surgeon who has worked for 10 years with
other practitioners in a range of country practices. He now feels it is time to
‘go out on his own’. He finds a medium-sized country town with no
veterinarian and sets up a practice. His wife answers the phone, makes up
the accounts, pays the bills and keeps the financial records.
(a) Which business structure in your view is best for Steve to use?
(b) What are the advantages of this structure?
(c) What are the disadvantages of this structure?

(a) Partnership
(b) Easy to set up, use own names, full personal control, easy to expand or contract
partner numbers, split income for tax purposes
(c) Unlimited legal liability

2.2 Peter and Chris Dunn grow Australian native flowers for the cut-flower
trade. They export to South-east Asian countries and occasionally send
flowers to the Amsterdam markets. They employ their three sons and one
daughter in the firm and employ 10 casual pickers. Currently, the business
is structured as a partnership, just as they set it up 25 years ago when they
first started.
(a) Which business structure in your view should the Dunns use now?
(b) What are the advantages of this structure?
(c) What are the disadvantages of this structure?

(a) Retain partnership but bring in the four children as partners, instead of being
employees
(b) Easy to set up, use current trading name, full personal control, easy to expand or
contract partner numbers
(c) Unlimited legal liability

2.3 Which is the most appropriate business structure in each of the following
cases? Why?
(a) Chui starts a TV repair business and has no employees for the first
two years.
(b) Business turnover at Chui’s TV Repairs has grown. He has employed
a part-time technician and persuaded his wife to give up her
receptionist job to handle the front counter enquiries, phone calls and
the books.
(c) Chui’s turnover has grown to $1 million pa and he employs two
technicians.

(a) Sole trader. Easy to set up, use own name, full personal control
(b) Partnership. Easy to set up, use current trading name, full personal control, easy to
expand or contract partner numbers, split income for tax purposes

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 Chapter Two: Taxation and business structures

(c) Partnership still OK. May consider company to avail himself of limited legal
liability.
2.4 Dr Doug Desjardines is a research scientist who has just developed a
vaccine which, if shown to be effective in clinical trials, promises to
revolutionise the treatment of a highly infectious rhinovirus. Doug is
nearing the end of his research life and has $1 million in superannuation
and other assets of about $2 million. He needs large sums of capital to
develop the vaccine. Why form of business organisation would you
recommend to Doug? Why?

Company. Limited legal liability to protect his retirement assets, ease in obtaining
funding, either debt or equity

2.5 What is the difference between assessable income and taxable income?

Assessable income is income taken into account for taxation purposes. Taxable
income is assessable income less allowable deductions.

2.6 James Hardie Industries agreed to compensate victims of asbestos pollution

stemming from the mining of the raw materials and the manufacture and
use of asbestos-based products. The firm applied to the ATO for a ruling
allowing these payments to be deducted from current income.
(a) What is the immediate effect of deductibility?
(b) How is tax liability affected?
(c) If the payments were allowed as deductions, how then are the
Australian people as a whole involved in the compensation
arrangements?
(d) Give some arguments both for and against deductibility?
(a) Reduction of taxable income and tax payable
(b) Decreased
(c) Total taxation revenue is decreased so the Australian public are effectively
helping to pay the compensation.
(d) For: Tax was paid on the income from the sale of the products; compensation is
a cost of production, therefore should be deductible.
Against: Compensation is not a cost of current production and will not
contribute to current taxable income. The company should be punished and not
given a tax reduction for a past wrong.

2.7 Sunshine Fruits made $100 000 taxable income last year. What would be
the tax payable, disregarding the Medicare levy, to the government by
Sunshine if:
(a) Sunshine was structured as a sole proprietorship?
(b) Sunshine was structured as a partnership with two equal partners?
(c) Sunshine was structured as a partnership with three equal partners?
(d) Sunshine was structured as a partnership with four equal partners?
(e) Sunshine was structured as a partnership with five equal partners?
(f) Sunshine was structured as a company (company tax only)?

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Introducing Corporate Finance 2e Solutions Manual

(a) $27 100 (2007–08 rates)

(b) $19 200
(c) $13 800
(d) $11 400
(e) $10 500
(f) $30 000

2.8 Jane Winter lent $100 000 to her accountancy partnership at 5% interest,

the cash rate at the time.
(a) Can the partnership claim the interest as a tax deduction?
(b) Explain where the deduction and the interest income will appear in
the tax returns.

(a) yes
(b) Deduction in the partnership return will reduce taxable income transferred
to individual partners. Jane’s individual return will show the interest income in
assessable income.

2.9 Since the calculation of a CGT liability was simplified in September 1999, a
taxpayer making an assessable capital gain and paying the top marginal tax
rate of 45% plus 1.5% Medicare levy effectively pays only 23.25% on the
gain. Explain why the rate is not (0.5 × 45%) + 1.5% making 24%.

The discounted CG is added to taxable income, thus increasing taxable income by half
the CG. Effectively, income × 0.5 × 46.5% or income × 23.25%.

2.10 A gain on the sale of an individual’s main residence is CGT exempt.

Explain why you think Parliament enacted this provision.

Australians are keen home-owners (70% of the population) who desire the right to sell
their principal residence freely without taxation. Hence, the political cost of CGT on
the main residence would be high.

2.11 Tom bought an investment property in 2000 for $150  000 and sold it again
in April 2007 for $280 000. He had no other capital gains or losses in the
year and had $75 000 other taxable income. How much tax will he pay on
his gain?

The CG is $130 000 and discounted is $65 000. At 2007–08 rates, the marginal rate on
this gain is 40%. Tax is $52 000 plus Medicare levy of $1950.

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 Chapter Two: Taxation and business structures

2.12 Alpha Agents and Traders buys timber fence posts from a small-time
timber cutter (not registered for GST) at $10 each. Freight is another
$2 per post. Alpha adds 40% mark-up and the 10% GST. What is the
selling price per post?

Cost $16.80 + GST $1.68 = $18.48

2.13 Jim earns a salary of $60 000 and has legitimate deductions, mainly
donations, of $1000. He has investments and receives $5600 in fully
franked dividends.
(a) What would be his tax (and 1.5% Medicare levy) liability if the
dividends had been unfranked?
(b) By how much does his taxable income increase through receipt of
the franking credits?
(c) What is his net tax (including 1.5% Medicare levy) if the dividends
are fully franked?

(a) (2007–08 rates) 31.5% × 5600 = $1764

(b) $2400
(c) $2520 – $2400 = $120

2.14 Fernelli South Entertainments Ltd (FSE) is a company which provides

after-dinner speakers. Its total fee income last year was $9.8 million and
its disbursements to the speakers were $8.2 million. In addition, there
were $600 000 in tax-deductible expenses.
(a) What are FSE’s taxable income and tax liability for the year?
(b) FSE has a policy of paying out 80% of taxable income as dividends
and has one million issued shares. What is the dividend per share
and what amount will be the franking credit per share?
(c) What will be the balance in the franking credit account at FSE after
the dividend payment, if the balance at the start of the year was
$200 000?

(a) $1 million; $300 000

(b) 80 cents; 34.28 cents (assuming the company has carried over franking credits).
The 80% of taxable income payout policy is unsustainable, because 80% is more
than the net 70% of taxable income retained after paying income tax.)

2.15 IXL Ltd is a manufacturer which has carried forward past losses of
$5 million from 2005–06. It made a profit in 2006–07 and wrote off all the
past losses. Its taxable income was thus reduced and it paid only
$1.5 million in income tax. It had a nil balance in its franking credit
account at the start of 2006–07.
(a) What was its taxable income in 2006–07?
(b) The directors decide to distribute $7 million in dividends of $1 per
share. Can these dividends be fully franked?
(c) How much is the franking credit per share?

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Introducing Corporate Finance 2e Solutions Manual

(a) Taxable income = 1.5m/0.3 + 5m = $10 million

(b) No – need $3m to frank fully
(c) 15 cents

2.16 Percy Porcelain graduated from university with a degree in dentistry.

Within a few years he started his own practice, saved diligently and
invested well in shares and property. Percy always looked for tax-effective
investments as he hated paying the top marginal rate of tax. After
20 years of practice, he decided he was sick of gaping mouths, sold his
practice and took a job as investment manager with Holey Dollars Ltd, an
investment firm owned by a group of Brisbane dentists. Holey Dollars
specialised in direct venture-capital investments. To analyse potential
investments, Percy used present value techniques to select the most
rewarding projects to maximise shareholder wealth. He continued to use
post-tax data. Do you agree with his technique? If so, why? If not, why
not?

No. He should use pre-tax values as Holey Dollars is a company with Australian
shareholders who can use franking credits.

2.17 Kappakali Ltd is a listed company in the recreation and tourism sector. It
has a high cash flow and is considered to be highly profitable in its sector.
Its shareholders are both Australian resident and non-Australian
individuals and companies, with perhaps a predominance of Japanese
investors. It has never missed a dividend and has always paid full-franked
dividends. In analysing a future investment project in March 2008, should
Kappakali’s managers use pre-tax or after-tax cash flows? Why?

After-tax flows because its investors predominantly cannot use franking credits.

2.18 David Bowman, a resident of Brisbane, has an investment in Kappakali

(the company in problem 2.17) shares. He receives $4000 in dividends in
2007–08, making his taxable income $67 000. What rate of tax will he pay
on his Kappakali dividend?

30% on the grossed-up amount of $5714.

2.19 Jani Sun Tin also resident of Brisbane bought some Kappakali (the
company in problem 2.17) shares in 2005. Her 2008 dividend is $1540 and
her taxable income $19 500. What rate of tax will she pay on her
dividend?

15% on the grossed-up income of $2200

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 Chapter Two: Taxation and business structures

2.20 Scott Jenkins has retired and has only a low income. He qualifies for
several tax offsets so pays no income tax or Medicare levy at all. He has
however $2100 in fully franked dividends. Does he qualify for a refund
from the ATO? If so, for how much?

Yes; $900

© John Wiley and Sons Australia, Ltd 2008 2.9