Chapter 1: An Overview of Financial Management
Note that there is an overlap between the T/F and multiple-choice questions, as some of the T/F statements
are
used in multiple-choice questions.
Multiple Choice: True/False
1.
In most corporations, the CFO ranks under the CEO.
a.
True
b.
False
2.
The Chairman of the Board must also be the CEO.
a.
True
b.
False
3.
The board of directors is the highest ranking body in a corporation, and the chairman of the board is the highest
ranking individual. The CEO generally works under the board and its chairman, and the board generally has the
authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but he or
she
can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for
a person
to simultaneously serve as CEO and chairman of the board, though many corporate control experts
believe it is bad
to vest both offices in the same person.
a.
True
b.
False
4.
Partnerships and proprietorships generally have a tax advantage over corporations.
a.
True
b.
False
5.
A disadvantage of the corporate form of organization is that corporate stockholders are more exposed to
personal
liabilities in the event of bankruptcy than are investors in a typical partnership.
a.
True
b.
False
6.
An advantage of the corporate form of organization is that corporations are generally less highly regulated than
proprietorships and partnerships.
a.
True
b.
False
7.
Some partners in a partnership may have different rights, privileges, and responsibilities than other partners.
a.
True
b.
False
8.
One advantage of the corporate form of organization is that it avoids double taxation.
a.
True
b.
False
9.
It is generally harder to transfer one’s ownership interest in a partnership than in a corporation.
a.
True
b.
False
10.
One danger of starting a proprietorship is that you may be exposed to personal liability if the business goes
bankrupt.
This problem would be avoided if you formed a corporation to operate the business.
a.
True
b.
False
11.
If a corporation elects to be taxed as an S corporation, then it can avoid the corporate tax. However, its
stockholders
will have to pay personal taxes on the firm’s net income.
a.
True
b.
False
12.
If a corporation elects to be taxed as an S corporation, then both it and its stockholders can avoid all Federal
taxes.
This provision was put into the Federal Tax Code in order to encourage the formation of small
businesses.
a.
True
b.
False
13.
It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship,
extensive
legal documents are required.
a.
True
b.
False
14.
The more capital a firm is likely to require, the greater the probability that it will be organized as a corporation.
a.
True
b.
False
15.
One disadvantage of forming a corporation rather than a partnership is that this makes it more difficult for the
firm’s
investors to transfer their ownership interests.
a.
True
b.
False
16.
Organizing as a corporation makes it easier for the firm to raise capital. This is because corporations’
stockholders
are not subject to personal liabilities if the firm goes bankrupt and also because it is easier to
transfer shares of stock
than partnership interests.
a.
True
b.
False
17.
In order to maximize its shareholders’ value, a firm’s management must attempt to maximize the stock price in
the
long run, or the stock’s “intrinsic value.”
a.
True
b.
False
18.
If management operates in a manner designed to maximize the firm’s expected profits for the current year, this
will
also maximize the stockholders’ wealth as of the current year.
a.
True
b.
False
19.
In order to maximize its shareholders’ value, a firm’s management must attempt to maximize the expected
EPS.
a.
True
b.
False
20.
In order to maximize its shareholders’ value, a firm’s management must attempt to maximize the stock price on
a
specific target date.
a.
True
b.
False
21.
As a result of financial scandals occurring during the past decade, there has been a strong push to improve
business
ethics.
a.
True
b.
False
22.
There are many types of unethical business behavior. One example is where executives provide information
that
they know is incorrect to banks and to stockholders. It is illegal to provide such information to banks, but it
is not
illegal to provide it to stockholders because they are the owners of the firm, not outsiders.
a.
True
b.
False
23.
A stock’s market price would equal its intrinsic value if all investors had all the information that is available
about the
stock. In this case the stock’s market price would equal its intrinsic value.
a.
True
b.
False
24.
If a stock’s market price is above its intrinsic value, then the stock can be thought of as being undervalued, and
it
would be a good buy.
a.
True
b.
False
25.
If a stock’s intrinsic value is greater than its market price, then the stock is overvalued and should be sold.
a.
True
b.
False
26.
For a stock to be in equilibrium as the book defines it, its market price should exceed its intrinsic value.
a.
True
b.
False
27.
The term “marginal investor” means an investor who is active in the market and would tend to buy a stock if its
price
fell and sell it if it rose, barring any new information coming out about the stock. It is the “marginal
investor” who
determines the actual stock price.
a.
True
b.
False
28.
Managers always attempt to maximize the long-run value of their firms’ stocks, or the stocks’ intrinsic values.
This is
exactly what stockholders desire. Thus, conflicts between stockholders and managers are not possible.
a.
True
b.
False
29.
A hostile takeover is said to occur when another corporation or group of investors gains voting control over a
firm
and replaces the old managers. If the old managers were managing the firm inefficiently, then hostile
takeovers can
improve the economy. However, hostile takeovers are controversial, and legislative actions have
been taken to make
them more difficult to undertake.
a.
True
b.
False
30.
If a lower level person in a firm does something illegal, like “cooking the books,” to understate costs and
thereby
increase profits above the correct profits because he or she was told to do so by a superior, the lower
level person
cannot be prosecuted but the superior can be prosecuted.
a.
True
b.
False
31.
If someone deliberately understates costs and thereby increases profits, this can cause the stock price to rise
above
its intrinsic value. The stock price will probably fall in the future. Also, those who participated in the
fraud can be
prosecuted, and the firm itself can be penalized.
a.
True
b.
False
32.
If a firm’s board of directors wants to maximize value for its stockholders in general (as opposed to some
specific
stockholders), it should design an executive compensation system whose focus is on the firm’s long-
term value.
a.
True
b.
False
Multiple Choice: Conceptual
Please note that some of the answer choices, or answers that are very close, are used in different questions.
This has caused us no difficulties, but please take this into account when you make up exams.
33.
Which of the following statements is CORRECT?
a.
One of the disadvantages of incorporating your business is that you could become subject to the firm’s
liabilities in the event of bankruptcy.
b.
Proprietorships are subject to more regulations than corporations.
c.
In any partnership, every partner has the same rights, privileges, and liability exposure as every other
partner.
d.
Corporations of all types are subject to the corporate income tax.
e.
Proprietorships and partnerships generally have a tax advantage over corporations.
34.
Which of the following statements is CORRECT?
a.
One of the advantages of the corporate form of organization is that it avoids double taxation.
b.
It is easier to transfer one’s ownership interest in a partnership than in a corporation.
c.
One of the disadvantages of a proprietorship is that the proprietor is exposed to unlimited liability.
d.
One of the advantages of a corporation from a social standpoint is that every stockholder has equal voting
rights, i.e., “one person, one vote.”
e.
Corporations of all types are subject to the corporate income tax.
35.
Which of the following statements is CORRECT?
a.
One advantage of forming a corporation is that equity investors are usually exposed to less liability than they
would be in a partnership.
b.
Corporations face fewer regulations than proprietorships.
c.
One disadvantage of operating a business as a proprietor is that the firm is subject to double taxation,
because
taxes are levied at both the firm level and the owner level.
d.
It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship,
extensive legal documents are required.
e.
If a partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her
investment in the business.
36.
Relaxant Inc. operates as a partnership. Now the partners have decided to convert the business into a
corporation.
Which of the following statements is CORRECT?
a.
Relaxant’s shareholders (the ex-partners) will now be exposed to less liability.
b.
The company will probably be subject to fewer regulations and required disclosures.
c.
Assuming the firm is profitable, none of its income will be subject to federal income taxes.
d.
The firm’s investors will be exposed to less liability, but they will find it more difficult to transfer their
ownership.
e.
The firm will find it more difficult to raise additional capital to support its growth.
37.
Which of the following statements is CORRECT?
a.
Corporations generally face fewer regulations than proprietorships.
b.
Corporate shareholders are exposed to unlimited liability.
c.
It is usually easier to transfer ownership in a corporation than in a partnership.
d.
Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of
incorporation.
e.
There is a tax disadvantage to incorporation, and there is no way any corporation can escape this
disadvantage, even if it is very small.
38.
Which of the following could explain why a business might choose to operate as a corporation rather than as a
proprietorship or a partnership?
a.
Corporations generally face fewer regulations.
b.
Less of a corporation’s income is generally subject to federal taxes.
c.
Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of
incorporation.
d.
Corporate investors are exposed to unlimited liability.
e.
Corporations generally find it easier to raise large amounts of capital.
39.
The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to
a.
Maximize its expected total corporate income.
b.
Maximize its expected EPS.
c.
Minimize the chances of losses.
d.
Maximize the stock price per share over the long run, which is the stock’s intrinsic value.
e.
Maximize the stock price on a specific target date.
40.
Which of the following statements is CORRECT?
a.
In most corporations, the CFO ranks above the CEO.
b.
By law in most states, the chairman of the board must also be the CEO.
c.
The board of directors is the highest ranking body in a corporation, and the chairman of the board is the
highest ranking individual. The CEO generally works under the board and its chairman, and the board
generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove
the board, but he or she can endeavor to have the board voted out and a new board voted in should a conflict
arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many
corporate control experts believe it is bad to vest both offices in the same person.
d.
The CFO generally reports to the firm’s chief accounting officer, who is normally the controller.
e.
The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he
or she is not responsible for the validity of the financial statements, as the controller and the auditors have
that
responsibility.
41.
Which of the following statements is CORRECT?
a.
One drawback of forming a corporation is that it generally subjects the firm to additional regulations.
b.
One drawback of forming a corporation is that it subjects the firm’s investors to increased personal
liabilities.
c.
One drawback of forming a corporation is that it makes it more difficult for the firm to raise capital.
d.
One advantage of forming a corporation is that it subjects the firm’s investors to fewer taxes.
e.
One disadvantage of forming a corporation is that it is more difficult for the firm’s investors to transfer their
ownership interests.
42.
Which of the following statements is CORRECT?
a.
If a corporation elects to be taxed as an S corporation, then both it and its stockholders can avoid all Federal
taxes. This provision was put into the Federal Tax Code in order to encourage the formation of small
businesses.
b.
The more capital a firm is likely to require, the smaller the probability that it will be organized as a
corporation.
c.
It is generally easier to transfer one’s ownership interest in a partnership than in a corporation.
d.
One danger of starting a proprietorship is that you may be exposed to personal liability if the business goes
bankrupt. This problem would be avoided if you formed a corporation to operate the business.
e.
Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of
incorporation.
43.
Which of the following statements is CORRECT?
a.
Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority of U.S. businesses
(in
terms of number of businesses) are organized as corporations.
b.
Most businesses (by number and total dollar sales) are organized as proprietorships or partnerships because
it
is easier to set up and operate one of these forms rather than as a corporation. However, if the business
gets
very large, it becomes advantageous to convert to a corporation, primarily because corporations have
important tax advantages over proprietorships and partnerships.
c.
Due to legal considerations related to ownership transfers and limited liability, which affect the ability to
attract capital, most business (measured by dollar sales) is conducted by corporations in spite of large
corporations’ less favorable tax treatment.
d.
Large corporations are taxed more favorably than proprietorships.
e.
Corporate stockholders are exposed to unlimited liability.
44.
Which of the following statements is CORRECT?
a.
A hostile takeover is the main method of transferring ownership interest in a corporation.
b.
A corporation is a legal entity created by a state, and it has a life and existence that is separate from the lives
and existence of its owners and managers.
c.
Unlimited liability and limited life are two key advantages of the corporate form over other forms of
business
organization.
d.
Limited liability is an advantage of the corporate form of organization to its owners (stockholders), but
corporations have more trouble raising money in financial markets because of the complexity of this form of
organization.
e.
Although the stockholders of the corporation are insulated by limited legal liability, the legal status of the
corporation does not protect the firm’s managers in the same way, i.e., bondholders can sue the firm’s
managers if the firm defaults on its debt.
45.
Which of the following statements is CORRECT?
a.
In a typical partnership, liability for other partners’ misdeeds is limited to the amount of a particular
partner’s
investment in the business.
b.
In a limited partnership, the limited partners have voting control, while the general partner has operating
control over the business, and the limited partners are individually responsible, on a pro rata basis, for the
firm’s debts in the event of bankruptcy.
c.
A slow-growth company, with little need for new capital, would be more likely to organize as a corporation
than would a faster growing company.
d.
Partnerships have more difficulty attracting large amounts of capital than corporations because of such
factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying
and selling) of partnership interests.
e.
A major disadvantage of a partnership relative to a corporation is the fact that federal income taxes must be
paid by the partners rather than by the firm itself.
46.
The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to
a.
Maximize managers’ own interests, which are by definition consistent with maximizing shareholders’
wealth.
b.
Maximize the firm’s expected EPS, which must also maximize the firm’s price per share.
c.
Minimize the firm’s risks because most stockholders dislike risk. In turn, this will maximize the firm’s stock
price.
d.
Use a well-structured managerial compensation package to reduce conflicts that may exist between
stockholders and managers.
e.
Since it is impossible to measure a stock’s intrinsic value, the text states that it is better for managers to
attempt to maximize the current stock price than its intrinsic value.
47.
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.
48.
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.
49.
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.
e.
Eliminate a requirement that members of the board of directors have a substantial investment in the firm’s
stock.
50.
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.
51.
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.
52.
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.
53.
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.
If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the
stock price 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.
d.
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.
e.
Ethics is not an important consideration in business and in business schools.
54.
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.
55.
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.
56.
Which of the following statements is CORRECT?
a.
Corporations are taxed more favorably than proprietorships.
b.
Corporations have unlimited liability.
c.
Because of their size, large corporations face fewer regulations than smaller corporations and
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.
57.
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 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.