FIN 3403 EXAM 1REVIEW QUESTIONS WITH
VERIFIED SOLUTIONS
Guiding principles of Finance
1. Maximization of Wealth
2. Time Value of Money
3. Risk and Return
4. Leverage
5. Diversification
maximization of wealth
the creation of as much wealth as possible with the available resources
not all firms maximize (non-profit)
Time Value of Money
the principle that a dollar received today is worth more than a dollar received in the future
Risk and Return
greater risk should equal greater return
leverage
Refers to the use of debt to fund investments
- Borrower must make fixed interest payments on debt...
- ...which increases risk!
If interest payment is missed, could be forced into bankruptcy
Diversification
Spreading out investments to reduce risk
the financial manager
In large corporations, the owners (stockholders) usually don't make the financial decisions!
- Hire managers to operate in their best interests (to maximize profits
Forms of Business Organization
Three different legal forms of business organization exist:
1. Sole Proprietorship
2. Partnership
3. Corporatio.
Sole Proprietorship
, Owned by a single individual
• Advantages: Simple to start, Less regulation, Owner keeps all profits
• Disadvantages: Owner has unlimited liability for business debts, All business income is taxed
as personal income, Life of company limited to owner's life, Equity limited to owner's personal
wealth, Ownership is difficult to transfer
best for companies with low startup costs, simple operations, and relatively low exposure to
liability
Examples:
• Housekeeper
• Photographer
• Personal Trainer
Partnerhsip
• Formed by two or more individuals or entities
• Advantages and disadvantages are basically the same as sole proprietorship
example: Morgan & Morgan
Corporation
Created as a distinct legal entity that can: borrow money, own property, sue and be sued, enter
into contracts, be a partner or limited partner in a partnership
Advantages: Ownership (stock) easy to transfer, Can raise money relatively easily, Unlimited
life, Limited liability for owners (stockholders)
Disadvantages, Double taxation: profits are taxed at the corporate level when earned and at the
personal level when paid out
Agency Problem
Agency Relationship: the relationship between stockholders
and management
- Because management wants to do things that maximize their own interests over the interests of
the owners, there is an agency problem.
Agency Costs
- the costs of the conflict of interest between
stockholders and management
- Indirect agency costs: lost opportunities
- Direct agency costs:
1. Corporate expenditures that benefits management but
VERIFIED SOLUTIONS
Guiding principles of Finance
1. Maximization of Wealth
2. Time Value of Money
3. Risk and Return
4. Leverage
5. Diversification
maximization of wealth
the creation of as much wealth as possible with the available resources
not all firms maximize (non-profit)
Time Value of Money
the principle that a dollar received today is worth more than a dollar received in the future
Risk and Return
greater risk should equal greater return
leverage
Refers to the use of debt to fund investments
- Borrower must make fixed interest payments on debt...
- ...which increases risk!
If interest payment is missed, could be forced into bankruptcy
Diversification
Spreading out investments to reduce risk
the financial manager
In large corporations, the owners (stockholders) usually don't make the financial decisions!
- Hire managers to operate in their best interests (to maximize profits
Forms of Business Organization
Three different legal forms of business organization exist:
1. Sole Proprietorship
2. Partnership
3. Corporatio.
Sole Proprietorship
, Owned by a single individual
• Advantages: Simple to start, Less regulation, Owner keeps all profits
• Disadvantages: Owner has unlimited liability for business debts, All business income is taxed
as personal income, Life of company limited to owner's life, Equity limited to owner's personal
wealth, Ownership is difficult to transfer
best for companies with low startup costs, simple operations, and relatively low exposure to
liability
Examples:
• Housekeeper
• Photographer
• Personal Trainer
Partnerhsip
• Formed by two or more individuals or entities
• Advantages and disadvantages are basically the same as sole proprietorship
example: Morgan & Morgan
Corporation
Created as a distinct legal entity that can: borrow money, own property, sue and be sued, enter
into contracts, be a partner or limited partner in a partnership
Advantages: Ownership (stock) easy to transfer, Can raise money relatively easily, Unlimited
life, Limited liability for owners (stockholders)
Disadvantages, Double taxation: profits are taxed at the corporate level when earned and at the
personal level when paid out
Agency Problem
Agency Relationship: the relationship between stockholders
and management
- Because management wants to do things that maximize their own interests over the interests of
the owners, there is an agency problem.
Agency Costs
- the costs of the conflict of interest between
stockholders and management
- Indirect agency costs: lost opportunities
- Direct agency costs:
1. Corporate expenditures that benefits management but
