Part 1 The Financial Environment
CHAPTER 2
BUSINESS (CORPORATE) FINANCE
CHAPTER LEARNING OBJECTIVES
2.1 List the four forms of business organizations and describe the advantages and
disadvantages of each.
• Sole proprietorship: a business owned and operated by one person
Advantages: it is easy to set up
Disadvantages: the business is inseparable from the owner; there is unlimited legal liability;
net income is taxed at personal marginal tax rate; financing is limited to the resources of the
single owner
• Partnership: a business owned and operated by two or more people.
Advantages: it combines the financial resources and talents of its partners; liability is spread
• Trust: a legal organization in which assets are owned by one party and managed or
controlled by a different party
• Corporation: a business organized as a separate legal entity under corporate law, with
ownership divided into transferable shares
Advantages: ownership and control are separated; it has the potential to attract great
2.2 Describe the goals of the firm and the pressures exerted on corporations by various
stakeholders. Corporations are owned by the shareholders but managed by the executives.
2.3 Explain what agency costs are and how they affect the interests of management and
shareholders. Agency costs are the costs associated with the agency problem. There are two
2.4 Explain the importance of aligning the interests of management with the interests of
shareholders in a corporation. Management’s personal interest and compensation may
2.5 Identify the main corporate finance decisions involving the financial management of a
firm’s assets and its liabilities (corporate financing). Financial managers in corporations
2.6 List some finance jobs available with financial and non-financial companies.
• Finance jobs in corporations include chief financial officer, treasurer, and controller.
• Jobs in the investment industry include portfolio managers, brokers, traders, and analysts.
2 – 3 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
MULTIPLE CHOICE QUESTIONS
1. What is an advantage of forming a general partnership instead of a corporation?
a) It is easier for partnerships to access the debt and equity markets.
b) Partners have limited liability, where corporate shareholders do not.
c) Partnerships are easier to set up than corporations.
d) The partnership lives on, even when all partners have died.
2. Which of the situations listed below would be an example of a limited liability partnership?
a) Harun and Ahmed mow lawns together, sharing equipment and expenses. They share the work
equally.
b) Xi and Fung operate a delivery business. Xi handles the pickups and deliveries only, while
Fung handles only the financial and accounting tasks.
c) Jordan and Chris have a landscaping business, with unequal involvement. Jordan works in the
business full-time while Chris is involved half-time.
d) Sara, Morgan, and Sabina started an accounting practice. Sara and Morgan work actively as
accountants. Sabina’s involvement is as an investor in the firm only.
3. Which of the following is NOT a reason for incorporating a business?
a) There is limited liability.
b) Ownership is relatively easy to transfer.
c) It is easier to form than a proprietorship.
d) Corporate tax laws may allow tax deferral or avoidance.
4. Which of the following is NOT a form of business organization?
a) corporation
b) sole partnership
c) general partnership
d) sole proprietorship
5. If you are in a business that is faced with enormous risks of failure, what type of ownership
would you avoid?
a) corporation
b) sole partnership
c) general partnership
d) sole proprietorship
6. Which of the following is an advantage of a corporation over a sole proprietorship?
a) A corporation is easy to set up.
b) Corporate tax laws are often less attractive than personal tax laws.
c) Shareholders’ liability is limited to their investment in the corporation.
d) In a sole proprietorship, it is easier to transfer ownership.
7. What was the reason for the increase in the number of income trusts in Canada?
a) limited liability
b) unlimited liability
c) tax advantage
2 – 5 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
d) transfer of ownership
8. Which of the following is the most correct? ______ know their exposure is limited to the amount
of capital they invest in the company.
a) Employees
b) Sole proprietors
c) General partners
d) Limited partners and shareholders
9. Which of the following is (are) true about a general partnership?
I. Some of the partners have limited liability.
II. Some of the partners may not be involved in the day-to-day operations.
III. Some partners may receive a different percentage of the profits.
a) III only
b) I and III
c) II and III
d) I and II
10. Beginning in 2013, in Canada, what would be the most appropriate type of organization for a
business with large assets and revenue?
a) trust
b) corporation
c) general partnership
d) sole proprietorship
Business (Corporate) Finance 2 – 6
11. Which of the following businesses is most likely to be operated as a corporation?
a) a law firm
b) a mining company
c) an accounting firm
d) All of these are likely to be operated as a corporation.
12. The main purpose of creating a trust is to
I. separate ownership from control.
II. avoid legal liability.
III. avoid taxes.
IV. improve a firm’s reputation.
a) I, II, and III
b) I and IV
c) I and III
d) III and IV
13. Which of the following is NOT an example of a trust?
a) a mutual fund
b) an estate
c) a royalty trust
d) a bank
2 – 7 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
14. After 20 years of being the sole proprietor of Montere Lawn Care, Denis Seville is
considering making a change. His business has grown substantially over the years and he now
has approximately 100 extremely loyal clients. Denis wants to retire and move to Florida.
Unfortunately, Denis has no children to carry on his business and thus he is thinking of selling it
to someone else. What is the main consideration Denis should have about selling his lawn care
business?
a) He will face some difficulty in selling because all the client relationships are personal and belong
to him; he will have to explain the new situation to each client.
b) Lawn care is seasonal and not many people would want to purchase his business.
c) It is difficult to learn lawn care skills for potential buyers.
d) The new owner may not retain the same business name.
15. Lucy Vale and Bob Fama, both accountants, have opened an accounting firm in Calgary
together and business has been steadily increasing. Since they each have the same number of
clients, Lucy and Bob decided to simply split any income equally between them. However, Lucy
has recently made a grievous error in the financial statements of one of her clients, and that
client is now considering suing Lucy and the firm. If Lucy and Bob had never created a formal
partnership agreement since the inception of their firm, should Bob be at all concerned about
the potential lawsuit? Choose the best answer from the following:
a) No. Since there was no formal partnership agreement made, Bob cannot be held responsible
for Lucy’s error.
b) Yes. A legal agreement is not always required for someone to be considered a partner of a
partnership. Thus, Bob may be held partially responsible for Lucy’s error in the event the client
sues the firm.
c) No. It was Lucy’s client and she made the error. Bob was not involved.
d) Yes. Bob has just incurred substantial debt by purchasing a new home which was partially
financed by his share of the firm’s earnings.
16. A corporation’s board of directors should first and foremost be accountable to which group?
a) politicians (law makers)
b) senior managers
c) shareholders
d) suppliers
17. Which of the following should be the primary goal of a CEO in a publicly traded company?
a) Maximize the profit margin.
b) Avoid bankruptcy.
c) Increase market share.
d) Maximize the company’s share price.
18. How is wealth different from profits?
a) Wealth is a personal issue, while profits are related to a business.
b) Profits include a deduction for expenses, and expenses are not relevant for wealth calculations.
c) Wealth reflects the value of all profits, both short- and long-term, while profits refer to economic
profits only.
d) all of the above
19. What are externalities?
a) valuable resources to a company that the firm does not pay or charge for
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b) issues in the surrounding business environment of a firm that have no impact on the firm’s
operations or policies
c) members of the board of directors who are not employed by the firm
d) none of the above
20. Why are externalities a necessary consideration when conducting business, especially for
large corporations?
a) Externalities always cost money, and those costs hurt a firm’s bottom line.
b) Forgetting to account for externalities is against tax laws in Canada.
c) The actions a large firm makes can have a significant impact on other firms, and those actions
may not necessarily be in Canada’s best interests.
d) all of the above
21. Which of the following is/are considered a stakeholder in the Toronto Stock Exchange?
a) shareholders
b) listing companies
c) provincial government
d) all of the above
22. Which one of the following is NOT part of externalities?
a) union pension costs and regulations
b) high borrowing rate
c) labour regulations
d) cost of carbon emissions
Business (Corporate) Finance 2 – 10
23. Who, of the following, does NOT have a contractual claim on a company?
a) employees
b) shareholders
c) local community
d) customers
24. What is the risk-return trade-off?
a) A firm will only have returns when it takes on risk.
b) A firm can either have risk, or it can have returns, but not both.
c) The balancing of gain with risk.
d) A risky return is always preferred to a risk-free return.
25. Which one of the following is NOT true about the board of directors?
a) It represents shareholders’ interests.
b) It cannot ignore its stakeholders.
c) It is involved with guiding the management of the company.
d) Board of directors may include members of the company’s management team.
26. What is the main implication of the 1994 Dey Report?
a) Firms should pay attention to special interests or other stakeholders, not just shareholders.
b) Boards of directors are responsible only for ensuring management is maximizing revenue.
c) Boards of directors can ignore stakeholders and focus solely on shareholders while
maintaining their contractual responsibilities.
d) Considerations for social welfare should be of utmost importance to firms.
27. Which one of the following is NOT an example of the agency problem?
a) management refusing a merger because of the possibility of major changes in management
b) taking a high-risk project to increase the value of the stock options held by management
c) increasing the level of debt of the company to increase the return on equity value
d) distributing a low level of dividends to have enough cash for bonuses
28. Which of the following illustrates an agency problem?
a) The advertising agency that a company uses produces top quality materials and charges a
high price for its work.
b) A not-for-profit environmental agency stages a protest. This results in negative attention to a
company’s manufacturing methods.
c) A company’s board, in wanting to protect board member compensation, agrees with everything
company management suggests.
d) A hiring agency screens out potential applicants to a company’s job posting.
29. You are asked to watch over your brother and sister in exchange for a fee. You invited your
friends over and you watched TV all night without paying attention to your siblings. What type of
agency problem is this?
a) indirect
b) direct
c) moral hazard
d) none of the above
30. Which of the following is true?
a) Management buying another business at a premium may be an example of an agency cost.
b) Corporations are not vulnerable to agency costs.
c) Stock options are an example of an agency cost.
d) Agency costs do not include expenses of monitoring and controlling the actions of
management.
31. Of the following list, which represents a potential implication for agency issues when
shareholders are dispersed?
a) More shareholders have a controlling say in what happens in the firm.
b) The likelihood of management pleasing all shareholders is greatly improved.
c) A firm’s chief executive officer (CEO) is better able to choose his or her friends to sit on the
board of directors.
d) none of the above
32. Johan, a corporate manager, often takes significant business and financial risks because of
the company’s compensation structure, which provides him with a comfortable base salary and
large bonuses when the business does well. Johan does not suffer in any way when the company
performs poorly, even if the performance is a result of his decisions. What is the term that
describes this situation?
a) moral hazard
b) agency monitoring problem
c) asymmetric risk structure
d) stakeholder snubbing
33. Which of the following is true?
a) Managers can ignore the objective of shareholder wealth in the short run in favour of other
stakeholders’ interests, but not in the long run.
b) In 2000, BCE spun off its ownership in Nortel, making this an example of a firm’s agency costs
diminishing shareholder value.
c) A 1997 Canadian survey of Shareholder Value Measurement showed that a minority of
companies with listed shares state maximizing firm value is a key corporate objective.
d) Without adequate financial performance, a firm can survive in a competitive environment.
34. A merger between Bank of Montreal and TD Bank would be a potential
a) agency problem.
b) too-big-to–fail problem.
c) moral hazard.
d) none of the above
35. Which one of the following is true?
a) Managers have the mandate to increase the market value of the company.
b) Managers always look after shareholders’ interests.
c) The board of directors is legally responsible for all the company’s decisions.
d) all of the above
36. Which of the following is NOT a reason why the market for corporate control is the most
effective mechanism to give managers the incentive to act like shareholders?
a) The government imposes significant lawsuits and penalties for managers not acting in the best
interests of shareholders.
b) The threat of acquisition keeps managers focused on achieving good performance and a high
stock price.
c) A low stock price makes a firm a good target for acquisition.
d) It allows the best managers the chance to manage assets.
37. If shareholders are not happy with a company’s management, a proxy fight is one method
that can be used to attempt to remove managers. Which of the following is true, with regard to a
proxy fight?
a) A proxy fight is an inexpensive method for a shareholder with a small holding to have an impact.
b) If a large shareholder is unhappy they are more likely to launch a proxy fight than to sell shares.
c) Most proxy fights are successful.
d) Proxy fights can be very expensive and time consuming.