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48. Which of the following statements is CORRECT?
a. If a lower level person in a firm does something illegal, like
“cooking the books” to understate costs and thereby artificially
increase profits because he or she was ordered to do so by a superior,
the lower level person cannot be prosecuted but the superior can be
prosecuted.
b. There are many types of unethical business behavior. One example is
where executives provide information that they know is incorrect to
outsiders. It is illegal to provide such information to federally
regulated banks, but it is not illegal to provide it to stockholders
because they are the owners of the firm.
c. The bankruptcy of Enron Corporation, and the fraud committed by some
of its officers, was the focus of news stories, but it did not lead to
any important changes in business practices.
d. If someone deliberately understates costs and thereby causes reported
profits to increase, this can cause the price of the stock to rise
above its intrinsic value. The stock will probably fall in the
future. Both those who participated in the fraud and the firm itself
can be prosecuted.
e. Ethical behavior is not influenced by training and auditing
procedures. People are either ethical or they are not, and this is
what determines ethical behavior in business.
49. With which of the following statements would most people in business
agree?
a. A corporation’s short-run profits will almost always increase if the
firm takes actions that the government has determined are in the best
interests of the nation.
b. Firms and government agencies almost always agree with one another
regarding the restrictions that should be placed on hiring and firing
employees.
c. “Whistle blowers,” because of the courage it takes to blow the
whistle, are generally promoted more rapidly than other employees.
d. It is not useful for large corporations to develop a formal set of
rules defining ethical and unethical behavior.
e. Although people’s moral characters are probably developed before they
are admitted to a business school, it is still useful for business
schools to cover ethics, if only to give students an idea about the
adverse consequences of unethical behavior to themselves, their firms,
and the nation.
50. Which of the following actions would be most likely to reduce potential
conflicts of interest between stockholders and bondholders?
a. Compensating managers with stock options.
b. Financing risky projects with additional debt.
c. The threat of hostile takeovers.
d. The use of covenants in bond agreements that limit the firm’s use of
additional debt and constrain managers’ actions.
e. Abolishing the Security and Exchange Commission.
Chapter 1: Overview M/C Problems Page 13
51. Which of the following actions would be most likely to reduce potential
conflicts between stockholders and bondholders?
a. Including restrictive covenants in the company’s bond indenture (which
is the contract between the company and its bondholders).
b. Compensating managers with more stock options and less cash income.
c. The passage of laws that make it harder for hostile takeovers to
succeed.
d. A government regulation that banned the use of convertible bonds.
e. The firm begins to use only long-term debt, e.g., debt that matures in
30 years or more, rather than debt that matures in less than one year.
52. Which of the following actions would be most likely to reduce potential
conflicts of interest between stockholders and managers?
a. Pay managers large cash salaries and give them no stock options.
b. Change the corporation’s formal documents to make it easier for
outside investors to acquire a controlling interest in the firm
through a hostile takeover.
c. Beef up the restrictive covenants in the firm’s debt agreements.
d. Eliminate a requirement that members of the board of directors must
hold a high percentage of their personal wealth in the firm’s stock.
e. For a firm that compensates managers with stock options, reduce the
time before options are vested, i.e., the time before options can be
exercised and the shares that are received can be sold.
53. Which of the following actions would be likely to reduce potential
conflicts of interest between stockholders and managers?
a. Congress passes a law that severely restricts hostile takeovers.
b. A firm’s compensation system is changed so that managers receive
larger cash salaries but fewer long-term options to buy stock.
c. The company changes the way executive stock options are handled, with
all options vesting after 2 years rather than having 20% of the
options awarded vest every 2 years over a 10-year period.
d. The company’s outside auditing firm is given a lucrative year–by-year
consulting contract with the company.
e. The composition of the board of directors is changed from all inside
directors to all outside directors, and the directors are compensated
with stock rather than cash.
54. Which of the following mechanisms would be most likely to help motivate
managers to act in the best interests of shareholders?
a. Decrease the use of restrictive covenants in bond agreements.
b. Take actions that reduce the possibility of a hostile takeover.
c. Elect a board of directors that allows managers greater freedom of
action.
d. Increase the proportion of executive compensation that comes from
stock options and reduce the proportion that is paid as cash salaries.
Page 14 M/C Problems Chapter 1: Overview
e. Eliminate a requirement that members of the board of directors have a
substantial investment in the firm’s stock.
55. Which of the following actions would be likely to encourage a firm’s
managers to make decisions that are in the best interests of
shareholders?
a. The percentage of executive compensation that comes in the form of
cash is increased and the percentage coming from long-term stock
options is reduced.
b. The state legislature passes a law that makes it more difficult to
successfully complete a hostile takeover.
c. The percentage of the firm’s stock that is held by institutional
investors such as mutual funds, pension funds, and hedge funds rather
than by small individual investors rises from 10% to 80%.
d. The firm’s founder, who is also president and chairman of the board,
sells 90% of her shares.
e. The firm’s board of directors gives the firm’s managers greater
freedom to take whatever actions they think best without obtaining
board approval.
56. Which of the following statements is CORRECT?
a. One of the ways in which firms can mitigate or reduce potential
conflicts between bondholders and stockholders is by increasing the
amount of debt in the firm’s capital structure.
b. The threat of takeover generally increases potential conflicts between
stockholders and managers.
c. Managerial compensation plans cannot be used to reduce potential
conflicts between stockholders and managers.
d. The threat of takeovers tends to reduce potential conflicts between
stockholders and managers.
e. The creation of the Securities and Exchange Commission (SEC) has
eliminated conflicts between managers and stockholders.
57. Which of the following statements is CORRECT?
a. Corporations are taxed more favorably than sole proprietorships.
b. Corporations have unlimited liability.
c. Because of their size, large corporations face fewer regulations than
smaller corporations and sole proprietorships.
d. Reducing the threat of corporate takeover increases the likelihood
that managers will act in shareholders’ interests.
e. Bond covenants are designed to protect bondholders and to reduce
potential conflicts between stockholders and bondholders.
Chapter 1: Overview M/C Problems Page 15
58. Which of the following statements is CORRECT?
a. A good goal for a firm’s management is the maximization of expected
EPS.
b. Most business in the U.S. is conducted by corporations, and
corporations’ popularity results primarily from their favorable tax
treatment.
c. Conflicts can exist between stockholders and managers, but potential
conflicts are reduced by the possibility of hostile takeovers.
d. Corporations and partnerships have an advantage over proprietorships
because a sole proprietor is exposed to unlimited liability, but the
liability of all investors in the other types of businesses is more
limited.
e. For a stock to be in equilibrium, its intrinsic value must be greater
than the actual market price.
59. Which of the following statements is CORRECT?
a. One disadvantage of organizing a business as a corporation rather than
a partnership is that the equity investors in a corporation are
exposed to unlimited liability.
b. Using restrictive covenants in debt agreements is an effective way to
reduce conflicts between stockholders and managers.
c. Managers generally welcome hostile takeovers since the “raider”
generally offers a price for the stock that is higher than the price
before the takeover action started.
d. The managers of established, stable companies sometimes attempt to get
their state legislatures to impose rules that make it more difficult
for raiders to succeed with hostile takeovers.
e. The managers of established, stable companies sometimes attempt to get
their state legislatures to remove rules that make it more difficult
for raiders to succeed with hostile takeovers.
60. Which of the following statements is CORRECT?
a. Well designed bond covenants are useful for reducing potential
conflicts between stockholders and managers.
b. The bid price in a hostile takeover is generally above the price
before the takeover attempt is announced, because otherwise there
would be no incentive for the stockholders to sell to the hostile
bidder and the takeover attempt would probably fail.
c. Stockholders in general would be better off if managers never
disclosed favorable events and therefore caused the price of the
firm’s stock to sell at a price below its intrinsic value.
d. Takeovers are most likely to be attempted if the target firm’s stock
price is above its intrinsic value.
e. The efficiency of the U.S. economy would probably be increased if
hostile takeovers were absolutely forbidden.
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61. Which of the following statements is CORRECT?
a. Hostile takeovers are most likely to occur when a firm’s stock is
selling below its intrinsic value as a result of poor management.
b. The efficiency of the U.S. economy would probably be increased if
hostile takeovers were absolutely forbidden.
c. Hostile takeovers are most likely to occur when a firm’s stock sells
at a price above its intrinsic value because its management has been
issuing overly optimistic statements about its likely future
performance.
d. In general, it is more in bondholders’ interests than stockholders’
interests for a firm to shift its investment focus away from safe,
stable investments and into risky investments, especially those that
primarily involve research and development.
e. Stockholders in general would be better off if managers never
disclosed favorable events and therefore caused the price of the
firm’s stock to sell at a price below its intrinsic value.
62. Which of the following statements is CORRECT?
a. One disadvantage of operating as a corporation rather than as a
partnership is that corporate shareholders are exposed to more
personal liability than are partners.
b. Relative to sole proprietorships, corporations generally face fewer
regulations, and they also find it easier to raise capital.
c. There is no good reason to expect a firm‘s stockholders and
bondholders to react differently to the types of assets in which it
invests.
d. Stockholders should generally be happier than bondholders to have
managers invest in risky projects with high potential returns as
opposed to safe projects with lower expected returns.
e. Bondholders should generally be happier than stockholders to have
managers invest in risky projects with high potential returns as
opposed to safe projects with lower expected returns.
63. Which of the following statements is CORRECT?
a. Because bankruptcy requires that corporate bondholders be paid in full
before stockholders receive anything, bondholders generally prefer to
see corporate managers invest in high risk/high return projects rather
than low risk/low return projects.
b. Since bondholders receive fixed payments, they do not share in the
gains if risky projects turn out to be highly successful. However,
they do share in the losses if risky projects fail and drive the firm
into bankruptcy. Therefore, bondholders generally prefer to see
corporate managers invest in low risk/low return projects rather than
high risk/high return projects.
c. One advantage of operating a business as a corporation is that
stockholders can deduct their pro rata share of the taxes the firm
pays, thereby eliminating the double taxation investors would face in
a partnership.
Chapter 1: Overview M/C Problems Page 17
d. One drawback of forming a corporation is that you lose the limited
liability that you would otherwise receive as a sole proprietor.
e. Potential conflicts between stockholders and bondholders are increased
if a firm’s bonds are convertible into its common stock.
64. Which of the following statements is CORRECT?
a. Corporations face few regulations and more favorable tax treatment
than do sole proprietorships and partnerships.
b. Managers who face the threat of hostile takeovers are less likely to
pursue policies that maximize shareholder value compared to managers
who do not face the threat of hostile takeovers.
c. Bond covenants are an effective way to resolve conflicts between
shareholders and managers.
d. Because of their simplified organization, it is easier for sole
proprietors and partnerships to raise large amounts of outside capital
than it is for corporations.
e. One advantage to forming a corporation is that the owners of the firm
have limited liability.
Multiple Choice: Problems
65. New Business is just being formed by 10 investors, each of whom will own
10% of the business. The firm is expected to earn $1,000,000 before
taxes each year. The corporate tax rate is 34% and the personal tax rate
for the firm’s investors is 35%. The firm does not need to retain any
earnings, so all of its after-tax income will be paid out as dividends to
its investors. The investors will have to pay personal taxes on whatever
they receive. How much additional spendable income will each investor
have if the business is organized as a partnership rather than as a
corporation?
a. $20,384
b. $20,800
c. $21,225
d. $21,658
e. $22,100
66. Assume that the corporate tax rate is 34% and the personal tax rate is
35%. The founders of a newly formed business are debating between
setting up the firm as a partnership versus a corporation. The firm will
not need to retain any earnings, so all of its after-tax income will be
paid out to its investors, who will have to pay personal taxes on
whatever they receive. What is the difference in the percentage of the
firm’s pre-tax income that investors actually receive and can spend under
the corporate and partnership forms of organization?
a. 20.4%
b. 20.8%
Page 18 M/C Problems Chapter 1: Overview
c. 21.2%
d. 21.7%
e. 22.1%
67. Charleston Corporation (CC) now operates as a “regular” corporation, but
it is considering a switch to S Corporation status. CC is owned by five
stockholders who each hold 20% of the stock, and each faces a personal
tax rate of 35%. The firm earns $2,000,000 per year before taxes, and
since it has no need for retained earnings, it pays out all of its
earnings as dividends. Assume that the corporate tax rate is 34% and the
personal tax rate is 35%. How much more (or less) spendable income would
each stockholder have if the firm elected S Corporation status?
a. $86,632
b. $88,400
c. $90,168
d. $91,971
e. $93,811
CHAPTER 1
ANSWERS AND SOLUTIONS
Chapter 1: Overview Answers Page 21
