Chapter 01: An Overview of Financial Management
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.
Corporations have to do more reporting to state and federal agencies than other businesses.
1-3 Forms of Business Organization
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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.
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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.
Chapter 01: An Overview of Financial Management
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.
c
MODERATE
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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.
MODERATE
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45. Which of the following statements is CORRECT?
Chapter 01: An Overview of Financial Management
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.
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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.
Chapter 01: An Overview of Financial Management
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.
Corporate takeovers are most likely to occur when a firm is underperforming. Managers who
fear losing their jobs will try to maximize shareholder wealth.
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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.
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Chapter 01: An Overview of Financial Management
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.
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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.
Small stockholders have little clout with management, while large institutional investors are
better able to force managers to operate in stockholders’ interests.
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Chapter 01: An Overview of Financial Management
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.
conflicts between stockholders and bondholders. Adding covenants to bond agreements will
reduce conflicts between stockholders and bondholders.
1-6 Stockholder-Debtholder Conflicts
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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.
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Chapter 01: An Overview of Financial Management
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.
1-8 Business Ethics
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Business ethics
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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.
1-8 Business Ethics
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Chapter 01: An Overview of Financial Management
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.
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Comprehensive
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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.
e
MODERATE
Comprehensive
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Business ethics
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Chapter 01: An Overview of Financial Management
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.
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58. 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.
Most business in U.S. is conducted by corporations, and corporations’ popularity results primarily from their
favorable tax treatment.
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Chapter 01: An Overview of Financial Management
59. 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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60. 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.
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.
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.
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Chapter 01: An Overview of Financial Management
61. 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 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.
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.
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Comprehensive
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62. 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.
d.
One drawback of forming a corporation is that you lose the limited liability that you would otherwise receive
as a proprietor.
e.
Potential conflicts between stockholders and bondholders are increased if a firm’s bonds are convertible into
its common stock.
MODERATE
Comprehensive
Multiple Choice
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Chapter 01: An Overview of Financial Management
63. Which of the following statements is CORRECT?
a.
Corporations face few regulations and more favorable tax treatment than do 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 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.
e
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64. New Business is just being formed by 10 investors, each of whom will own 10% of the business. The firm is expected
to earn $500,000 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.
$11,050
b.
$12,266
c.
$10,056
d.
$9,282
e.
$11,713
a
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Chapter 01: An Overview of Financial Management
EASY
Problems
65. Assume that the corporate tax rate is 34% and the personal tax rate is 30%. 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.
22.61%
b.
23.80%
c.
21.90%
d.
23.56%
e.
28.56%
Chapter 01: An Overview of Financial Management
Difference
EASY
66. Charleston Corporation (CC) now operates as a “regular” corporation, but it is considering a switch to S Corporation
status. CC is owned by 100 stockholders who each hold 1% of the stock, and each faces a personal tax rate of 35%. The
firm earns $2,800,000 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.
$6,436
b.
$5,507
c.
$6,188
d.
$6,497
e.
$6,250
c
Chapter 01: An Overview of Financial Management