Chapter 1—The Scope of Corporate Finance
MULTIPLE CHOICE
1. __________ activities allow corporations to raise capital by selling stock to investors.
a.
NYSE
b.
Secondary market
c.
Primary market
d.
Money market
e.
Centralized Nasdaq
2. Jane purchased Ford shares for $a. Later, she sold them in the secondary market for $b. Who received
the profits from this sale?
a.
Jane
b.
the exchange on which Ford shares are traded
c.
the investor who purchased the shares at $b
d.
no new cash flow was generated, so there was no profit
e.
Ford
3. Which of the following would not interest a firm seeking longer-term financing?
a.
issuing corporate bonds
b.
borrowing from a commercial bank
c.
issuing notes
d.
issuing commercial paper
e.
none of the above
4. Which of the following would be considered an advantage of the sole proprietorship form of business
organization?
a.
unlimited life
b.
pooled expertise
c.
wide access to capital
d.
unlimited personal liability
e.
income taxed at only one level
5. Double taxation:
a.
occurs when governments tax profits at the corporate level and dividends at the personal
level.
b.
is the single greatest advantage of the corporate form of business.
c.
can mean savings in taxes if a given business activity is conducted through a corporation
rather than through a partnership.
d.
only occurs in corporations that have preferred stock outstanding.
e.
none of the above
6. Which of the following statements is false?
a.
The objective of profit maximization typically translates into maximizing earnings per
share.
b.
Profit maximization adequately deals with timing and risk.
c.
Profit maximization is not the proper objective for managers.
d.
Financial managers should not necessarily select projects with the highest expected
monetary return.
e.
none of the above
7. The primary goal of a publicly-owned corporation should be to:
a.
maximize total corporate revenue
b.
maximize the price per share
c.
minimize the chance of losses
d.
maximize earnings per share
e.
none of the above
8. Which of these groups would not be considered “stakeholders” of the firm?
a.
suppliers
b.
customers
c.
shareholders
d.
employees
e.
all of the above are considered “stakeholders”
9. Shareholders can attempt to overcome managerial agency problems by:
a.
incurring monitoring expenditures
b.
relying on market discipline such as hostile takeovers
c.
using specialized compensation contracts
d.
incurring bonding costs
e.
all of the above
10. Being legally organized as a __________ offers clear competitive advantages over other organizational
forms.
a.
partnership
b.
private company
c.
public corporation
d.
multinational consortium
e.
sole proprietor
11. Which of the following is a basic function of corporate finance?
a.
risk management
b.
corporate governance
c.
capital budgeting
d.
financial management
e.
all of the above
12. The __________ function focuses on raising capital to support a company’s operations and investment
programs.
a.
financing
b.
capital budget
c.
financial management
d.
corporate governance
e.
risk-management
13. U.S. and non-U.S. companies raise the bulk of the funding they require each year through
__________.
a.
selling equity
b.
selling debt
c.
internal funding
d.
external funding
e.
venture capitalists
14. The __________ function is arguably the single most important activity of the firm’s financial
manager.
a.
financing
b.
capital budgeting
c.
financial management
d.
corporate governance
e.
risk-management
15. Which of the following statements regarding financial markets and securities is the most accurate?
a.
Debt represents an ownership interest in the firm.
b.
Trades of securities in the secondary market raise additional funds for corporations.
c.
Trades in the primary market are between issuing corporations and investors.
d.
More stock than bond transactions occur in the primary market.
e.
U.S. security issuers account for only a small portion of worldwide issues.
16. The market for debt instruments maturing in one year or less is the:
a.
short-term debt market
b.
money market
c.
capital market
d.
primary market
e.
interest market
17. With which form of business organization do all owners enjoy limited liability?
a.
Sole Proprietorship
b.
Partnership
c.
Corporation
d.
Limited Partnership
e.
Venture Capitalist
18. Incentive compensation plans are designed to:
a.
motivate managers to do what is in the best interest of shareholders.
b.
overcome agency costs.
c.
tie management compensation to the stock price.
d.
typically give managers the right to purchase stock at a fixed price, usually the current
market price at the time the right is granted.
e.
all of the above.
19. A risk averse manager would
a.
Take on projects that maximize shareholder wealth
b.
Consistently accept projects that are above the firm’s level of risk
c.
Consistently accept projects that are well below the firm’s desired risk
d.
Only take risky projects
20. Which of the following activities would be considered the risk management?
a.
Purchasing derivative instruments such as forwards, futures, options, and swaps
b.
Matching the maturities of assets and liabilities
c.
Locating production plants in the same country as the firm’s customers
d.
All of the above could be risk management
21. Which of the following would may a firm ineligible for S Corporation status?
a.
The firm has 55 shareholders
b.
All the shareholders are people (as opposed to other corporations)
c.
The firm is a French corporation
d.
The firm plans to eventually go public
22. Large publicly-traded corporations are exposed to agency costs because
a.
The separation of ownership and control of the corporation
b.
The board of directors has outside members
c.
The high compensation of CEOs
d.
None of the above
23. The double taxation problem refers to:
a.
The problem of different tax rates on capital gains and ordinary income.
b.
The problem of higher tax rates for shareholders relative to partners.
c.
The problem of income from foreign customers taxed both in the foreign market and then
again as income in the US market.
d.
The problem of state and federal income taxes for corporations.
24. Professional-service firms (such as doctors or dentists) are likely set up as:
a.
Corporations, to gain limited liability
b.
Partnerships, to gain tax advantages
c.
S corporations, to gain easy valuation
d.
Limited liability companies, to gain tax and liability benefits
MATCHING
Match each corporate finance function with its related activities:
a.
corporate governance
b.
risk management
c.
capital budgeting
d.
financing
e.
financial management
1. Selecting projects based on perceived risk and expected return.
2. Raising capital.
3. Developing internal structures to maintain value-maximizing activity.
4. Managing internal cash flows and the mix of debt and equity financing.
5. Recognizing and managing exposures to insurable and uninsurable risk.
Match the following advantages and disadvantages with the proper business organization form:
a.
corporation
b.
partnership
c.
sole proprietorship
6. limited life
7. unlimited life
8. limited access to capital
9. unlimited access to capital
10. unlimited personal liability
11. limited liability
12. separate contracting
13. double taxation
14. ease of operation
Match the following descriptions to the proper terms:
a.
ignores the time value of money
b.
proper goal of the firm in modern finance
c.
considered part of the firm’s social responsibility
d.
manager’s concern with job security
e.
tie management’s compensation to performance
15. maximize shareholders’ wealth
16. focus on stakeholders
17. maximize profit
18. control agency costs
19. agency costs
SHORT ANSWER
1. Boots-R-Us Inc. is a large manufacturer located in a small town in Texas. Given the large differential
in labor costs between Texas and Mexico, this firm is considering closing all manufacturing operations
in Texas and relocating in Mexico. Suppose this relocation will unambiguously increase shareholder
wealth. Provide one reason related to corporate stakeholders suggesting why Boots-R-Us may decide
not to relocate to Mexico.
2. Why is capital budgeting considered the single most important activity of the firm’s financial manager?
3. Identify the three basic steps of the capital budgeting process.
4. Why must countries develop an effective system of corporate governance?
5. What is the focus of modern risk-management?
6. Explain why maximizing profits falls short of maximizing shareholders’ wealth.
7. Refer to Tax Liability. Is there a tax advantage?
8. Refer to Tax Liability. If the partnership were changed to an S corporation, is there a tax advantage?
9. Refer to Tax Liability. If the corporation elected to be an S corporation, is there a tax advantage?
10. What role does a financial intermediary provide in financial markets and how is their existence
economically viable?
11. What is an initial public offering (IPO)?
12. What is a venture capitalist?
13. What are the main advantages of the corporate form compared to other forms of business
organization?
14. Describe important features of limited partnerships.
15. How is status as a limited partnership likely to be desirable from a tax perspective in the early years of
a firm’s existence?
16. How would a firm operate if it were run in the best interests of its bondholders?
17. What is a bonding expenditure?
ESSAY
1. Discuss three problems with profit maximization as a goal of the firm.
2. Consider a firm that employs profit maximization as a goal. Discuss one example of how an
unscrupulous manager might behave such that her actions are to the detriment of stakeholders.
3. In the typical corporate form of organization shareholders elect the Board of Directors, which
subsequently “hires” managers. In a brief essay, discuss the importance of choosing an external Board
of Directors to oversee a firm’s management when separating ownership (shareholders) and control
(managers). Discuss the concerns of many shareholders with respect to ‘chummy’ Boards of Directors.
(Your discussion should recognize that management often has a strong say in the slate of board
candidates put forward for shareholder election.)
4. The accepted North American goal of the firm is often considered to be shareholder wealth
maximization (SWM). In Europe and other parts of the world, this goal is often relaxed to include the
well-being of many stakeholders including shareholders, bondholders, employees, suppliers, and other
related parties. This model is sometimes called the corporate wealth maximization (CWM) model.
(Related examples include Keiritsu in Japan, and Chaebol in Korea.)
Do you believe that the SWM or the CWM best describes actual business practices in your region?
Which model of behavior do you believe is inherently better?
5. The textbook states that ethical behavior is a necessary condition for shareholder wealth maximization.
Do you believe the goal of the firm is always consistent with ethical considerations? What would you
do if you could implement an unethical (and undetectable) action that would increase firm value?
6. What is the importance of ethics in corporate finance?
7. What is the job of the board of directors?
8. Why would a corporation elect to be treated as a Subchapter S corporation?
9. How do market forces constrain the opportunistic behavior of a firm’s manager?
10. What is the motivation to privatize state-owned enterprises?
11. Describe how a corporation finances its operations.
12. Why should the financial manager maximize shareholder wealth rather than profit?
13. Discuss the issue of double taxation using an example assuming earnings before taxes of $ear,
corporate tax rate of ctr% and personal tax rate of ptr%. Contrast the tax issue of the corporation
versus a partnership.
14. Discuss the agency problem and potential solutions for the problem.