CHAPTER 1 AN OVERVIEW OF FINANCIAL MANAGEMENT Multiple Choice: Conceptual Firm organization Answer: d EASY . Which of the following statements is CORRECT? a. Sole proprietorships are subject to more regulations than corporations. b. In any partnership, every partner has the same rights, privileges, and liability exposure as every other partner. c. Corporations of all types are subject to the corporate income tax. d. Sole proprietorships and partnerships generally have a tax advantage over corporations. Firm organization Answer: a EASY . 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 in a partnership. b. Corporations face fewer regulations than sole proprietorships. c. One disadvantage of operating a business as a sole proprietor is that the firm is subject to double taxation, at both the firm level and the owner level. d. It is generally less expensive to form a proprietorship than a corporation because, with a proprietorship, extensive legal documents are required. Corporate form Answer: d EASY . Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership? a. Less of a corporation?s income is generally subject to taxes. b. Corporate shareholders are exposed to reduced liability, but this factor is offset by the tax advantages of incorporation. c. Corporate investors are exposed to unlimited liability. d. Corporations generally find it easier to raise capital. Goal of firm Answer: d MEDIUM . 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. Conflicts of interest Answer: d MEDIUM . Which of the following statements is CORRECT? a. Compensating managers with stock options will do nothing to help eliminate potential conflicts between stockholders and managers. b. Restrictions can be included in credit agreements, but these restrictions will do nothing to protect bondholders from conflicts of interest between them and the firm?s managers and stockholders. c. The threat of takeovers reduces conflict of interest problems, but only between bondholders and stockholders. d. Compensating managers with stock options can help reduce conflicts of interest between stockholders and managers, but if the options are all exercisable on a specific date in the near future, this can motivate managers to deceive stockholders. Conflicts of interest Answer: b MEDIUM . 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 but give them no stock options. b. Change the corporate charter so as to make it easier for outside investors to acquire a controlling interest in the firm. 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 received can be sold. Managerial incentives Answer: c MEDIUM . Which of the following actions would be likely to encourage a firm?s managers to make decisions that are in the best interest 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 60%. d. The firm?s founder, who is also president and chairman of the board, sells 90% of her shares. Miscellaneous concepts Answer: d MEDIUM . 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 agency conflicts between stockholders and managers. c. Managers generally welcome hostile takeovers since the company seeking to do the taking over generally offers a price for the stock that is higher than the price before the takeover action started. d. The entrenched 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. Miscellaneous concepts Answer: a MEDIUM . 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 because of its poor management. b. The efficiency of the U.S. economy would probably be increased if hostile takeovers were absolutely forbidden. c. Hostile takeovers are most likely to occur when a firm?s stock sells at a price above its intrinsic value because its management has been issuing overly optimistic statements about its likely future performance. 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 involve primarily research and development. Miscellaneous concepts Answer: d MEDIUM . 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 partners. b. Relative to sole proprietorships, corporations generally face fewer regulations, and they also find it easier to raise capital. c. Bondholders should generally be more willing than stockholders to have managers invest in risky projects with high potential returns as opposed to safer projects with lower expected returns. d. Stockholders should generally be more willing than bondholders to have managers invest in risky projects with high potential returns as opposed to safer projects with lower expected returns. . Firm organization Answer: d EASY Sole proprietorships and partnerships pay personal income tax, but they avoid the corporate income tax. . Firm organization Answer: a EASY Corporations have limited liability; however, they face more regulations than the other forms of organization. Sole proprietorships do not pay corporate taxes. . Corporate form Answer: d EASY Outsiders thinking about investing in a business are generally not willing to be subjected to unlimited liability, and they also want to be able to sell their shares should they choose to do so. Corporations provide these advantages, hence firms that need large amounts of capital that must be raised in capital markets generally choose to incorporate. . Goal of firm Answer: d MEDIUM The primary operating goal should be to maximize the long-run stock price, or the intrinsic value. . Conflicts of interest Answer: d MEDIUM If stock options align the interests of stockholders and managers, but if all of a manager?s options vest on a given date, that manager may attempt to make earnings look good on the vesting date so that he or she can sell the shares received at a high price. . Conflicts of interest Answer: b MEDIUM Corporate takeovers are most likely to occur when a firm is underperforming. Managers who fear losing their jobs will try to maximize shareholder wealth. . Managerial incentives Answer: c MEDIUM Small stockholders have little clout with management, while large institutional investors are better able to force managers to operate in stockholders? interests. . Miscellaneous concepts Answer: d MEDIUM . Miscellaneous concepts Answer: a MEDIUM If a firm?s stock is undervalued relative to its potential, then someone can profit by taking it over and doing a better job running it. . Miscellaneous concepts Answer: d MEDIUM Page PAGE 4 Chapter 1: An Overview of Financial Management Chapter 1: An Overview of Financial Management Page PAGE 3
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