978-0134083285 Chapter 1 Part 1

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Foundations of Finance, 9e (Keown/Martin/Petty)

Chapter 1 An Introduction to the Foundations of Financial Management

Learning Objective 1.1

1) Financial management deals with the maintenance and creation of economic value or wealth.

Keywords: Financial Management

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

2) Each financial decision made by a corporate manager can be evaluated by its direct impact on the

corporation’s stock price.

Keywords: Goal of the Firm

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

3) The fundamental goal of a business is to maximize the retained earnings available to the corporation’s

shareholders.

Keywords: Goal of the Firm

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

4) Shareholder wealth maximization means maximizing the price of the existing common stock.

Keywords: Shareholder Wealth, Goal of the Firm

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

5) It is important to evaluate a corporate manager’s financial decision by measuring the effect the decision

should have on the corporation’s stock price if everything else were held constant.

Keywords: Goal of the Firm, Maximize Shareholder Wealth

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

6) Corporate managers should accept investment projects that maximize profits in the short run because

of the time value of money.

Keywords: Goal of the Firm, Profits, Time Value of Money

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

7) The goal of the firm‘s financial managers should be the maximization of the total value of the firm’s

stock.

Keywords: Goal of the Firm

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

8) The payment of a dividend to current shareholders will have no impact on a corporation’s share price

because the cash paid is not available to future potential shareholders who may want to buy the

corporation’s stock.

Keywords: Goal of the Firm

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

9) One problem with maximization of shareholder wealth as a goal is that it ignores risk taken by the

firm’s financial decisions.

Keywords: Goal of the Firm

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

10) The goal of profit maximization ignores the risk of financial decisions.

Keywords: Goal of the Firm

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

11) Only a firm‘s financial decisions affect its stock prices.

Keywords: Determinants of Stock Price

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

12) Shareholders react to poor investment or dividend decisions by causing the total value of the firm’s

stock to fall, and they react to good decisions by bidding the price of the stock up.

Keywords: Determinants of Stock Price

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

13) The primary goal of a publicly owned corporation is to ________.

A) maximize dividends per share

B) maximize shareholder wealth

C) maximize earnings per share after taxes

D) minimize shareholder risk

Keywords: Goal of the Firm, Corporation

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

14) Maximization of shareholder wealth

A) represents a zero sum game in which one corporation gains at the expense of others.

B) provides benefits to society as scarce resources are directed to their most productive use.

C) is not a practical goal since it cannot be measured effectively.

D) is achieved only if cash flows exceed accounting profits.

Keywords: Goal of the Firm, Maximize Shareholder Wealth

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

15) A financial manager is considering two projects, A and B. A is expected to add $2 million to profits

this year while B is expected to add $1 million to profits this year. Which of the following statements is

MOST correct?

A) The manager should select project A because it maximizes profits.

B) The manager should select the project that maximizes long-term profits, not just one year of profits.

C) The manager should select project A or he is irrational.

D) The manager should select the project that causes the stock price to increase the most, which could be

A or B.

Keywords: Goal of the Firm

Learning Obj.: L.O. 1.1

AACSB: Analytical Thinking

16) Shareholder wealth maximization means

A) maximizing earnings per share.

B) maximizing dividends per share.

C) maximizing the price of existing common stock.

D) maximizing stockholders equity.

Keywords: Goal of the Firm, Maximize Shareholder Wealth

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

17) The goal of the firm should be

A) maximization of profits (net income per share).

B) maximization of shareholder wealth.

C) maximization of market share.

D) maximization of sales.

Keywords: Goal of the Firm, Maximize Shareholder Wealth

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

18) Which of the following goals of the firm are synonymous (equivalent) to the maximization of

shareholder wealth?

A) profit maximization

B) risk minimization

C) maximization of the total market value of the firm‘s common stock

D) none of the above

Keywords: Goal of the Firm, Maximize Shareholder Wealth

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

19) Which of the following is the most important goal that a corporation should strive for?

A) maximize current profits

B) maximize market share

C) maximize revenue

D) maximize shareholder wealth

Keywords: Goal of the Firm, Maximize Shareholder Wealth

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

20) One of the causes of the recent financial crisis in the United States has been excessive risk taking due

to underestimation of risk. How does this relate to shareholder wealth maximization and financial

leverage? Can overestimation of risk also be detrimental?

Keywords: Risk Requires a Return, Goal of the Firm

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

21) Documents uncovered after the Exxon Valdez oil spill in Alaska revealed that Exxon could have used

double-hulled oil tankers that would have prevented the spill, but the cost of refitting their fleet of single–

hulled tankers was considered too high. Exxon determined that the cost of cleaning up an oil spill would

be less than the cost of refitting the ships, thus increasing shareholder value. Several years after the oil

spill, however, Exxon was fined billions of dollars for the spill. How do the costs of the cleanup and the

fines pertain to a discussion of maximizing shareholder value and ethical responsibility?

Keywords: Goal of the Firm, Maximizing Shareholder Value, Ethical Responsibility, Cash Flow

Learning Obj.: L.O. 1.1

AACSB: Reflective Thinking

Learning Objective 1.2

1) When making financial decisions, managers should always look at marginal, or incremental cash

flows.

Keywords: Marginal or Incremental Cash Flows

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

2) An investment project is acceptable if the total cash received over the life of the project exceeds the total

cash spent over the life of the project.

Keywords: Cash Flow, Time Value of Money

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

3) If two companies have the same net income and the same level of risk, they must also have the same

stock price or the market is not in equilibrium.

Keywords: Net Income, Risk, Timing of Cash Flow

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

4) Profits represent money that can be spent, and as such, form the basis for determining the value of

financial decisions.

Keywords: Profits, Cash Flow

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

5) The root cause of agency problems is conflicts of interest.

Keywords: Agency Problems, Conflicts of Interest

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

6) Investors will be indifferent between two investments if both investments have the same expected

return.

Keywords: Risk-Return Trade-off

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

7) If the stock market is efficient, then investors do not need to read the Wall Street Journal or research

companies before they select which stocks to buy because market prices already reflect all publicly

available information.

Keywords: Efficient Markets

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

8) Giving the company‘s CEO stock options as part of his or her compensation package is an example of

an agency cost.

Keywords: Agency Costs

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

9) Cash flows and profits are synonymous; in other words, higher cash flows equal higher profits.

Keywords: Cash Flow, Profit

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

10) Shareholder selection committees select potential board of director nominees ensuring that board

members will monitor management sufficiently to protect shareholder interests.

Keywords: Agency Problems, Board of Directors

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

11) Managers should not be concerned with business ethics because ethical behavior is inconsistent with

the primary goal of maximizing shareholder value.

Keywords: Ethics, Goal of the Firm

Learning Obj.: L.O. 1.2

AACSB: Ethical understanding and reasoning

12) One of the problems associated with maximization of total current stock value is that it ignores the

timing of a project‘s return.

Keywords: Maximizing Shareholder Value, Timing of Returns

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

13) The risk-return trade-off is seen in many areas of finance.

Keywords: Risk, Return

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

14) The risk-return trade-off implies that the return on a riskless asset must be zero.

Keywords: Risk-Return Trade-off

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

15) The sole proprietorship has no legal business structure separate from its owner.

Keywords: Sole Proprietorship

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

16) An efficient market is one where the prices of the assets traded in that market fully reflect all available

information at any instant in time.

Keywords: Efficient Markets

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

17) The opportunity cost of any choice you make is the highest-valued alternative that you had to give up

when you made the choice.

Keywords: Opportunity Cost, Time Value of Money

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

18) Beginning in 2007 the United States experienced its most severe financial crisis since the

Great Depression of the 1930s.

Keywords: Current Assets, Temporary Sources of Financing

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

19) As of year-end 2012, the great economic recession in the United States that began in 2007 has NOT

officially ended.

Keywords: Current Global Financial Crisis

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

20) While many factors contributed to the financial crisis of 2007 and beyond, it is safe to say that real

estate loans were NOT much of a contributing factor.

Keywords: Current Global Financial Crisis

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

21) The purchase of a pool of mortgages is often financed through the sale of securities called mortgage-

backed securities, or MBS. This is a key part of the securitization process.

Keywords: Current Global Financial Crisis

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

22) Underemployment is a term used to describe hiring employees who work for a designated foreman or

team leader. In this sense they are employed under a specific individual.

Keywords: Current Global Financial Crisis

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

23) Fortunately, Europe was largely shielded from the economic recession that afflicted the world

economy in 2007. The European economies contracted less and have recovered much more rapidly than

their counterparts in the United States and China.

Keywords: Current Global Financial Crisis

Learning Obj.: L.O. 1.2

AACSB: Diverse and multicultural work environments

24) A homeowner that owes more on his/her mortgage than the home is worth is said to be “under

water.”

Keywords: Current Global Financial Crisis

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

25) The five basic principles of finance include all of the following EXCEPT

A) Cash flow is what matters.

B) Money has a time value.

C) Risk requires a reward.

D) Incremental profits determine value.

Keywords: Basic Principles of Finance

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

26) Suppose XYZ Corporation is traded on the New York Stock Exchange. XYZ’s closing price on Monday

is $20 per share. After the market closes on Monday, XYZ makes a surprise announcement that it has

obtained a major new customer. XYZ’s stock will likely

A) open at $20 per share on Tuesday and then increase as more investors read the announcement in the

Wall Street Journal.

B) remain at $20 per share because in efficient markets the price already reflects all information.

C) open above $20 because the positive news will result in a higher valuation even though the stock has

not yet traded.

D) open below $20 because the surprise announcement creates more uncertainty.

Keywords: Efficient Markets

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

27) A corporate manager decides to build a new store on a lot owned by the corporation that could be

sold to a local developer for $250,000. The lot was purchased for $50,000 twenty years ago. When

determining the value of the new store project,

A) the cost of the lot is zero since the corporation already owns it.

B) the opportunity cost of the lot is $250,000 and should be included in calculating the value of the

project.

C) the cost of the lot for valuation purposes is $50,000 because land does not depreciate.

D) the incremental cash flow should be the $50,000 original cost less accumulated amortization.

Keywords: Opportunity Cost

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

28) To measure value, the concept of time value of money is used

A) to determine the interest rate paid on corporate debt.

B) to bring the future benefits and costs of a project, measured by its expected profits, back to the present.

C) to bring the future benefits and costs of a project, measured by its cash flows, back to the present.

D) to ensure that expected future profits exceed current profits today.

Keywords: Time Value of Money, Cash Flows

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

29) A financial manager is evaluating a project which is expected to generate profits of $100,000 per year

for the next 10 years. The project should be accepted if

A) the cost of the project is less than $1,000,000.

B) the cost of the project is less than the present value of $100,000 per year for 10 years.

C) this project’s expected profits are higher than any other projects the corporation has available.

D) the present value of the project‘s cash inflows exceeds the present value of the project’s cash outflows.

Keywords: Time Value of Money, Cash Flows

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

30) Investors want a return that satisfies the following expectation(s):

A) A return for delaying consumption

B) An additional return for taking on risk

C) An additional return for accepting dividends rather than capital gains

D) Both A and B.

Keywords: Risk, Return

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking