Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 1 An Introduction to the Foundations of Financial Management
1.1 Learning Objective 1
1) Financial management deals with the maintenance and creation of economic value or wealth.
2) Each financial decision made by a corporate manager can be evaluated by its direct impact on
the corporation’s stock price.
3) The fundamental goal of a business is to maximize the retained earnings available to the
corporation’s shareholders.
4) Shareholder wealth maximization means maximizing the price of the existing common stock.
5) It is important to evaluate a corporate manager’s financial decision by measuring the effect the
decision should have on the corporation’s stock price if everything else were held constant.
6) Corporate managers should accept investment projects that maximize profits int he short run
because of the time value of money.
7) The goal of the firm’s financial managers should be the maximization of the total value of the
firm’s stock.
8) The payment of a dividend to current shareholders will have no impact on a corporation’s
share price because the cash paid is not available to future potential shareholders who may want
to buy the corporation’s stock.
9) One problem with maximization of shareholder wealth as a goal is that it ignores risk taken by
the firm’s financial decisions.
10) The goal of profit maximization ignores the risk of financial decisions
11) Only a firm’s financial decisions affect its stock prices.
12) Shareholders react to poor investment or dividend decisions by causing the total value of the
firm’s stock to fall, and they react to good decisions by bidding the price of the stock up.
13) The primary goal of a publicly owned corporation is to ________.
A) maximize dividends per share
B) maximize shareholder wealth
C) maximize earnings per share after taxes
D) minimize shareholder risk
14) Maximization of shareholder wealth
A) represents a zero sum game in which one corporation gains at the expense of others.
B) provides benefits to society as scarce resources are directed to their most productive use.
C) is not a practical goal since it cannot be measured effectively.
D) is achieved only if cash flows exceed accounting profits.
15) A financial manager is considering two projects, A and B. A is expected to add $2 million to
profits this year while B is expected to add $2 million to profits this year while B is expected to
add $1 million to profits this year. Which of the following statements is most correct?
A) The manager should select project A because it maximizes profits.
B) The manager should select the project that maximizes long-term profits, not just one year of
profits.
C) The manager should select project A or he is irrational.
D) The manager should select the project that causes the stock price to increase the most, which
could be A or B.
16) Shareholder wealth maximization means
A) maximizing earnings per share.
B) maximizing dividends per share.
C) maximizing the price of existing common stock.
D) maximizing stockholders equity.
17) The goal of the firm should be
A) maximization of profits (net income per share).
B) maximization of shareholder wealth.
C) maximization of market share.
D) maximization of sales.
18) Which of the following goals of the firm are synonymous (equivalent) to the maximization
of shareholder wealth?
A) profit maximization
B) risk minimization
C) maximization of the total market value of the firm’s common stock
D) none of the above
19) Which of the following is the most important goal that a corporation should strive for?
A) Maximize current profits.
B) Maximize market share.
C) Maximize revenue.
D) Maximize shareholder wealth.
20) One of the causes of the recent financial crisis in the United States has been excessive risk
taking due to underestimation of risk. HOw does this relate to financial leverage? Can
overestimation of risk also be detrimental?
21) Documents uncovered after the Exxon Valdez oil spill in Alaska revealed that Exxon could
have used double-hulled oil tankers that would have prevented the spill, but the cost of refitting
their fleet of single-hulled tankers was considered too high. Exxon determined that the cost of
cleaning up an oil spill would be less than the cost of refitting the ships, thus increasing
shareholder value. Several years after the oil spill, however, Exxon was fined billions of dollars
for the spill. How do the costs of the clean up and the fines pertain to a discussion of
maximizing shareholder value and ethical responsibility?
1.2 Learning Objective 2
1) When making financial decisions, managers should always look at marginal, or incremental
cash flows.
2) An investment project is acceptable if the total cash received over the life of the project
exceeds the total cash spent over the life of the project.
3) If two companies have the same net income and the same level of risk, they must also have the
same stock price or the market is not in equilibrium.
4) Profits represent money that can be spent, and as such, form the basis for determining the
value of financial decisions.
5) The root cause of agency problems is conflicts of interest.
6) Investors will be indifferent between two investments if both investments have the same
expected return.
7) If the stock market is efficient, then investors do not need to read the Wall Street Journal or
research companies before they select which stocks to buy because market prices already reflect
all publicly available information.
8) Giving the company’s CEO stock options as part of his or her compensation package is an
example of an agency cost.
9) Cash flows and profits are synonymous; in other words, higher cash flows equal higher
profits.
10) Shareholder selection committees select potential board of director nominees ensuring that
board members will monitor management sufficiently to protect shareholder interests.
11) Managers should not be concerned with business ethics because ethical behavior is
inconsistent with the primary goal of maximizing shareholder value.
12) One of the problems associated with maximization of total current stock value is that it
ignores the timing of a project’s return.
13) The risk-return tradeoff is seen in many areas of finance.
14) The risk/return tradeoff implies that the return on a riskless asset must be zero.
15) The sole proprietorship has no legal business structure separate from its owner.
16) An efficient market is one where the prices of the assets traded in that market fully reflect all
available information at any instant in time.
17) The opportunity cost of any choice you make is the highest-valued alternative that you had to
give up when you made the choice.
18) The five basic principles of finance include all of the following except:
A) Cash flow is what matters.
B) Money has a time value.
C) Risk requires a reward.
D) Incremental profits determine value.
19) Suppose XYZ Corporation is traded on the New York Stock Exchange. XYZ’s closing price
on Monday is $20 per share. After the market closes on Monday, XYZ makes a surprise
announcement that it has obtained a major new customer. XYZ’s stock will likely
A) open at $20 per share on Tuesday and then increase as more investors read the announcement
in the Wall Street Journal.
B) remain at $20 per share because in efficient markets the price already reflects all information.
C) open above $20 because the positive news will result in a higher valuation even though the
stock has not yet traded.
D) open below $20 because the surprise announcement creates more uncertainty.
20) A corporate manager decides to build a new store on a lot owned by the corporation that
could be sold to a local developer for $250,000. The lot was purchased for $50,000 twenty years
ago. When determining the value of the new store project,
A) the cost of the lot is zero since the corporation already owns it.
B) the opportunity cost of the lot is $250,000 and should be included in calculating the value of
the project.
C) the cost of the lot for valuation purposes is $50,000 because land does not depreciate.
D) the incremental cash flow should be the $50,000 original cost less accumulated amortization.
21) To measure value, the concept of time value of money is used
A) to determine the interest rate paid on corporate debt.
B) to bring the future benefits and costs of a project, measured by its expected profits, back to the
present.
C) to bring the future benefits and costs of a project, measured by its cash flows, back to the
present.
D) to ensure that expected future profits exceed current profits today.
22) A financial manager is evaluating a project which is expected to generate profits of $100,000
per year for the next 10 years. The project should be accepted if
A) the cost of the project is less than $1,000,000.
B) the cost of the project is less than the present value of $100,000 per year for 10 years.
C) this project’s expected profits are higher than any other projects the corporation has available.
D) the present value of the project’s cash inflows exceeds the present value of the project’s cash
outflows.
23) Investors want a return that satisfies the following expectations:
A) A return for delaying consumption
B) An additional return for taking on risk
C) An additional return for accepting dividends rather than capital gains
D) Both A and B.
24) The expected return on a riskless asset is greater than zero due to
A) an expected return for delaying consumption.
B) an expected return for opportunity costs.
C) an expected return for taxes.
D) irrational investors who believe risk is always present.
25) Joe, a risk-averse investor, is trying to choose between investment A and investment B. If
investment A is riskier than investment B and Joe selects investment A anyway, then
A) the actual return for investment A will be higher than the actual return for investment B.
B) the actual return for investment A will be higher than the expected return for investment B.
C) the expected return for investment A will be higher than the actual return for investment B.
D) the expected return for investment A will be higher than the expected return for investment B.
26) The principle of risk-return tradeoff means that
A) higher risk investments must earn higher returns.
B) an investor who takes more risk will earn a higher return.
C) a rational investor will only take on higher risk if he expects a higher return.
D) an investor who bought stock in a small corporation five years ago has more money than an
investor who bought U.S. Treasury bonds five years ago.
27) Project A is expected to generate positive cash flow of $1 million in 10 years while Project B
is expected to generate $500,000 in 5 years. Therefore,
A) Project A is preferred because shareholder value is based on cash flow.
B) Project B is preferred because its cash flow is expected to be received sooner than the cash
flow from Project A.
C) Both projects have equal value because they average $100,000 per year.
D) Project B may be preferred to Project A if the opportunity cost of money is high enough.
28) Company A reports sales of $100,000 and net income of $15,000. Company B reports sales
of $100,000 and net income of $10,000. Therefore,
A) Company A’s cash flow may be higher or lower than Company B’s cash flow even though A’s
net income is higher.
B) Company A’s cash flow is $5,000 more than Company B’s cash flow.
C) Company B is creating less value for its shareholders than Company A.
D) Company B’s accounts receivable must be higher than Company A’s accounts receivable.
29) Profits are down so the controller decides to change the corporation’s accounting policy
relating to inventory costing. The change will allow the corporation to report higher income and
higher assets, although the physical inventory has not changed. Which of the following
statements is most correct?
A) The stock price is likely to increase because income is higher.
B) The stock price is likely to be unaffected because the stock market is efficient.
C) The stock price is likely to decrease because reported inventory is higher.
D) If the stock price increases, the stock market is efficient.
30) All of the following statements about agency problems are true except:
A) Agency problems interfere with the goal of maximizing shareholder value.
B) Agency costs are paid by the managers who do not act in the shareholders’ best interest.
C) Agency problems result from the separation of management and the ownership of a firm.
D) The root cause of agency problems is conflicts of interest.
31) All of the following contributed to recent financial crises except:
A) Focusing on earnings instead of cash flow.
B) Focusing on the short run.
C) Relying on the efficiency of financial markets.
D) Excessive risk taking due to underestimation of risk.
32) A corporate financial manager trying to maximize shareholder value
A) is not concerned with ethics but rather with writing iron-clad contracts.
B) can safely ignore ethics as long as no laws are broken.
C) must behave ethically in order to stay out of jail.
D) is concerned with ethics because unethical behavior destroys trust, and businesses cannot
function without a certain degree of trust
33) John invested $1,000 in a risky investment and BIll invested $1,000 in a less risky
investment. One year later, Bill’s investment is worth $1,030. Which of the following statements
is most correct?
A) If John’s investment is worth less than $1,030, then John was irrational to invest in the risky
project.
B) John’s investment must be worth more than $1,030 because of the risk-return tradeoff, given
that John’s investment was more risky.
C) If John’s investment is worth more than $1,030, then Bill was irrational to invest in the less
risky investment.
D) The worth of John’s investment cannot be determined with the information given.
34) In order to reduce agency problems, managers may be provided compensation that includes:
A) a fixed salary so managers’ pay is not at risk, allowing managers to focus on the company’s
business.
B) a bonus based on the level of profit achieved during the year.
C) an option to buy the company’s stock.
D) incentive pay for achieving higher sales than last year.
35) An investor is considering two equally risky investments. Investment A is expected to return
$1,000 per year for the next 5 years. Investment B is expected to return $6,000 at the end of 5
years. Which of the following statements is most correct if both investments A and B have the
same cost?
A) A risk averse investor will select investment B because it is expected to provide the most cash
($6,000 > $5,000).
B) A risk averse investor will select investment A because it provides cash earlier than
investment B.
C) The investor will select investment A only if the cost is less than $1,000.
D) The investor may select investment A or investment B depending on the opportunity cost of
money.
36) The CEO of High Tech International decides to change an accounting method at the end of
the current year. The change results in reported profits increasing by 5%, but the company’s cash
flows are not changed. If capital markets are efficient, then
A) the stock price will not be affected by the accounting change.
B) the stock price will increase due to higher profits.
C) the stock price will increase only if the accounting change will also result in higher profits in
the next year.
D) the stock price will decrease because accounting method changes are not permitted under
generally accepted accounting principles.
37) When evaluating an investment project, which of the following best describes the financial
information needed by the decision maker?
A) after-tax accounting profits
B) after-tax incremental cash flows to the company as a whole
C) incremental cash flows before taxes so the decision will not be biased by a tax code that may
change in the future
D) pre-tax accounting profits adjusted for any accounting method changes
38) The CEO of JLI Corp. decided to expand into a new market in 2010. At the end of 2010,
JLI’s stock price had decreased 5% since the beginning of the year. Which of the following
statements is most correct?
A) The CEO made a poor decision to expand because the stock price decreased during the year.
B) The CEO made a poor decision to expand because the company’s profits for the year
obviously decreased, causing the drop in stock price.
C) The CEO’s decision may have been optimal, keeping the stock price from falling more than
5% for the year.
D) CEO decisions are irrelevant because the efficient market determines the value of a
company’s stock.
39) High Tech Corp. cut its research and development budget in 2010 by $4,000,000 in order to
improve its cash flow for the year. Which of the following statements is most correct?
A) The stock price will likely increase because the value of stock is based on reported cash flow.
B) The stock price may decrease because investors may predict that future cash flows will
decrease due to the lack of innovation and new products.
C) The change will have no impact on stock price because the company’s profits will not change
in 2010.
D) The stock price will increase only if reported profits in 2010 are also higher than profits
reported in 2009.
40) In which of the following cases will the agency problem between shareholders and managers
be the greatest?
A) 100% of the common stock is owned by the founder of the company who decided to retire
and hired a manager to run his business for him.
B) The Johnson family owns 50% of the common stock of the company. The other 50% is
owned by 5 mutual funds.
C) The common stock of the company is owned by many diverse shareholders, with no
shareholder owning more than 1% of the outstanding stock.
D) All top managers in the company own significant amounts of stock and stock options.
41) Executive compensation in the United States
A) is dominated by performance-based compensation that ensures fair and just pay for corporate
executives.
B) is dominated by performance-based compensation designed to reduce agency problems.
C) cannot be linked to stock prices as this would create a conflict of interest with existing
shareholders.
D) is well below levels in Europe and Asia.
42) The recent financial crises was exacerbated by
A) managers who overestimated risk and hence did not invest sufficient funds.
B) managers who underestimated the real risks of their decisions and borrowed excessively.
C) a lack of financial leverage that made U.S. firms less competitive in world markets.
D) extremely high interest rates in the United States that stifled investment.
43) Ethical behavior
A) is the fifth basic principles of finance.
B) cannot be a concern to managers who are expected to maximize shareholder value.
C) in the corporate world means not breaking any laws.
D) is essential in business because unethical behavior destroys trust and business relationships.
44) Investors generally don’t like risk. Therefore, a typical investor
A) will not be induced to take on any risk.
B) will only take on the least risk possible.
C) will only take on additional risk if he expects to be compensated in the form of additional
return.
D) will only accept a zero return if the risk is zero.
45) In finance, we assume that investors are generally
A) neutral to risk.
B) averse to risk.
C) fond of risk.
D) none of the above
46) Consider the after-tax cash flows for Project S and Project L:
Project S Project L
Year 1 $3000 0
Year 2 0 $3000
Project S Project L
Year 1 $3000 0
Year 2 0 $3000
A rational person would prefer ________.
A) Project S because the money can be reinvested sooner
B) Project L because they can avoid taxes by receiving cash flows later
C) information about profits instead of cash flows
D) neither investment over the other