MBA 655 Quiz 1 to 8 with answers
Quiz Solutions – Quiz 1
Class,
The correct responses to the quiz are provided immediately after each question and are indicated by an asterisk *. A
solution is also provided when applicable.
Please note that the question order may be different and that the numerical problems may have different
numerical values for the input values. The solution provided illustrates how to solve the problem using the numbers
provided in the problems below.
Thanks,
Dr.S.
Quiz 1
Financial Principles & Chpt. 1 & Intro.
There are 10 questions, @ 1 point each for 10pts total.
1. Which of the following 2 basic financial principles together contributes the most toward making markets efficient?
Note that each answer (a,b,c, etc) has 2 basic financial principles listed together.
a. agency problem principle and options principle
b. self-interest behavior principle and two-sided transactions principle
c. options principle and cash is king principle
d. incremental benefits principle and time value of money principle
* b, people act in their own self interest and there are 2 sides of each transaction, thus together these principles tend to
make markets efficient
2. All of the following would tend to reduce the agency problem between owners (stockholders) and managers,
EXCEPT which one?
Managers tend to have more, as well as better, information about the firm than outside stockholders, because of
asymmetrical information relationships
The threat of takeover and potential firing of existing management
Bonus plans such as stock options for managers.
External audits of the firm's financial condition.
* a, page 19-20f
3. Shareholders can attempt to overcome managerial agency problems by:
a. incurring monitoring expenditures
b. relying on market discipline such as hostile takeovers
c. using specialized compensation contracts
d. incurring bonding costs
e. all of the above
* e, page 19-20f
4. Calculate the tax disadvantage to organizing a U.S. business as a corporate versus a sole proprietorship under the
following conditions:
Assume that all earnings will be paid out as cash dividends. Operating Income (operating profit before taxes) will be
$100 under both organizational forms. The effective corporate tax rate = Tc = 40%. The average personal tax rate for the
owners is 45% and assume that rate applies to the dividends (i.e. assume there is no cap on rate that dividends are taxed
at and thus they are taxed at the personal tax rate).ANSWER = 22
Corporate 100 – 40 = 60 AT
then less 45% = 33 AT to owners
while sole proprietorship = 100 - 45 = 55
Thus, net tax disadvantage = 55 – 33 = 22homework, page 22. Prob #1-1,
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,MBA 655 Quiz 1 to 8 with answers
Answer 1-1 from HW:
2|Page
,MBA 655 Quiz 1 to 8 with answers
a. If the firm is organized as a partnership, operating income will be taxed only once, so investors will receive
$500,000 X (1-0.35) = $325,000. If the firm is organized as a corporation, operating income will be taxed once at the
corporate level and again at the personal level, so investors will receive only $500,000x(1-0.35)(1-0.15) = $276,250. The
“corporate tax wedge” is thus $48,750, or 9.75 percentage points.
b. Using the pre-2003 tax rates, partnership investors would receive a net $307,000 of operating income, while
corporate stockholders would be able to keep only $199,550 of the $500,000 in operating income.*
5. Double taxation refers to:
a) interest being paid after corporate taxes are paid, and thus being taxed twice at the corporate level
b) interest being paid after corporate taxes are paid, and thus being taxed once at the corporate level and again at the
personal level when an investor receives the interest
c) dividends being paid after corporate taxes are paid, and thus being taxed twice at the corporate level
• dividends being paid after corporate taxes are paid, and thus being taxed once at the corporate level
and again at the personal level when an investor receives the dividend
d) none of the above
* d, p15
6. All of the following are advantages a corporation may have over a partnership or a proprietorship, except which one?
a) Limited liability.
b) Ease of transfer of ownership interest.
c) Unlimited life.
d) Elimination of double taxation.
e) Ability to raise capital.
* d, p13-14
7. The primary goal of a publicly-owned firm interested in serving its stockholders should be to
a) Maximize expected total corporate profit.
b) Maximize expected EPS.
c) Minimize the chances of losses.
d) Maximize the total stock value, i.e. owners’ wealth.
e) Maximize expected net income.
*d
8. The signaling principle in finance would suggest that when a firm announces a plan to repurchase outstanding shares
(stock), this action could be a signal that the firm's managers (insiders) believe the firm's shares are
a) over-valued in the market
b) under-valued in the market
c) neither of the above, as this action would not signal anything about management's sentiments with respect to the
stock price.
* b, “buy low, sell high” logic
This is a thought question regarding the implication of the signaling principle. As noted from the homework on the
signaling principle, the basic idea is that actions convey information. The intent is to address the implication of this idea
with the insiders’ (firm’s management) action to repurchase outstanding stock: would this action “suggest” the insiders
believe the shares are under-valued, over-valued, or that this action would have no suggestion of the insider’s perception
of firm value?
The answer is that the insider’s would NOT repurchase shares IF they believe the shares are overvalued – instead,
that believe would be an incentive to sell additional shares to raise funds (if there were some reasonable reasons to
raise funds via issuing stock).
The insider’s would have an incentive to repurchase stock when they believe the stock is undervalued, as they
would be buying it back for less than they believe the value really is, which would increase the wealth of the
remaining shareholders (thus would be consistent with increasing the value of the firm to the firm’s owners,
3|Page
, MBA 655 Quiz 1 to 8 with answers
which is the fundamental financial management goal). Thus, since they have an incentive to repurchase when they
believe the stock is undervalued, their actions of repurchasing would also be a signal that the stock is
undervalued.
9. According to the financial perspective, value (thus shareholder wealth) creation is based on:
the size of the cash flows of the firm
a) the timing & risk of the cash flows
b) the net income, aka profits, of the firm
c) both a & c
d) both a & b
* e, page 17, homework Other Key Concepts
10. According to the payoff diagram that illustrates the payoff (at liquidation of a firm) to bondholders and stockholders
as a function of the value of the firm,
a) bondholders would prefer more risk than stockholders, because bondholders’ payoff is flat as the firm value
increases beyond the debt level
b) stockholders would prefer more risk than bondholders, because stockholders’ payoff is flat as the firm value
increases beyond the debt level
c) stockholders would prefer more risk than bondholders, because their (stockholders) payoff increases dollar
for dollar as the firm value increases beyond the debt level
d) managers would prefer more risk than stockholders, because their (managers) payoff increases dollar for dollar as
the firm value increases beyond the debt level
*c, homework Other Key Concepts 2, PowerPoint Slide - Payoff Diagram implications. The payoff diagram is
copied pasted below and in the PPT resources online. As the diagram illustrates, the stockholders are the
“residual” claimants on the firm, which means they get “whatever is left over” after all the debt claims are paid,
and thus they get ALL the upside potential on riskier projects if the projects turn out well. On the downside, it is
as if they are “playing with other people’s money (OPM)” if the project turns out bad, as the stockholders enjoy
“limited liability” (meaning their payoff does NOT go negative – thus can only loose what they invested = limited
liability). Thus, stockholders get all the upside and are limited on the downside, thus they prefer riskier projects.
4|Page
Quiz Solutions – Quiz 1
Class,
The correct responses to the quiz are provided immediately after each question and are indicated by an asterisk *. A
solution is also provided when applicable.
Please note that the question order may be different and that the numerical problems may have different
numerical values for the input values. The solution provided illustrates how to solve the problem using the numbers
provided in the problems below.
Thanks,
Dr.S.
Quiz 1
Financial Principles & Chpt. 1 & Intro.
There are 10 questions, @ 1 point each for 10pts total.
1. Which of the following 2 basic financial principles together contributes the most toward making markets efficient?
Note that each answer (a,b,c, etc) has 2 basic financial principles listed together.
a. agency problem principle and options principle
b. self-interest behavior principle and two-sided transactions principle
c. options principle and cash is king principle
d. incremental benefits principle and time value of money principle
* b, people act in their own self interest and there are 2 sides of each transaction, thus together these principles tend to
make markets efficient
2. All of the following would tend to reduce the agency problem between owners (stockholders) and managers,
EXCEPT which one?
Managers tend to have more, as well as better, information about the firm than outside stockholders, because of
asymmetrical information relationships
The threat of takeover and potential firing of existing management
Bonus plans such as stock options for managers.
External audits of the firm's financial condition.
* a, page 19-20f
3. Shareholders can attempt to overcome managerial agency problems by:
a. incurring monitoring expenditures
b. relying on market discipline such as hostile takeovers
c. using specialized compensation contracts
d. incurring bonding costs
e. all of the above
* e, page 19-20f
4. Calculate the tax disadvantage to organizing a U.S. business as a corporate versus a sole proprietorship under the
following conditions:
Assume that all earnings will be paid out as cash dividends. Operating Income (operating profit before taxes) will be
$100 under both organizational forms. The effective corporate tax rate = Tc = 40%. The average personal tax rate for the
owners is 45% and assume that rate applies to the dividends (i.e. assume there is no cap on rate that dividends are taxed
at and thus they are taxed at the personal tax rate).ANSWER = 22
Corporate 100 – 40 = 60 AT
then less 45% = 33 AT to owners
while sole proprietorship = 100 - 45 = 55
Thus, net tax disadvantage = 55 – 33 = 22homework, page 22. Prob #1-1,
1|Page
,MBA 655 Quiz 1 to 8 with answers
Answer 1-1 from HW:
2|Page
,MBA 655 Quiz 1 to 8 with answers
a. If the firm is organized as a partnership, operating income will be taxed only once, so investors will receive
$500,000 X (1-0.35) = $325,000. If the firm is organized as a corporation, operating income will be taxed once at the
corporate level and again at the personal level, so investors will receive only $500,000x(1-0.35)(1-0.15) = $276,250. The
“corporate tax wedge” is thus $48,750, or 9.75 percentage points.
b. Using the pre-2003 tax rates, partnership investors would receive a net $307,000 of operating income, while
corporate stockholders would be able to keep only $199,550 of the $500,000 in operating income.*
5. Double taxation refers to:
a) interest being paid after corporate taxes are paid, and thus being taxed twice at the corporate level
b) interest being paid after corporate taxes are paid, and thus being taxed once at the corporate level and again at the
personal level when an investor receives the interest
c) dividends being paid after corporate taxes are paid, and thus being taxed twice at the corporate level
• dividends being paid after corporate taxes are paid, and thus being taxed once at the corporate level
and again at the personal level when an investor receives the dividend
d) none of the above
* d, p15
6. All of the following are advantages a corporation may have over a partnership or a proprietorship, except which one?
a) Limited liability.
b) Ease of transfer of ownership interest.
c) Unlimited life.
d) Elimination of double taxation.
e) Ability to raise capital.
* d, p13-14
7. The primary goal of a publicly-owned firm interested in serving its stockholders should be to
a) Maximize expected total corporate profit.
b) Maximize expected EPS.
c) Minimize the chances of losses.
d) Maximize the total stock value, i.e. owners’ wealth.
e) Maximize expected net income.
*d
8. The signaling principle in finance would suggest that when a firm announces a plan to repurchase outstanding shares
(stock), this action could be a signal that the firm's managers (insiders) believe the firm's shares are
a) over-valued in the market
b) under-valued in the market
c) neither of the above, as this action would not signal anything about management's sentiments with respect to the
stock price.
* b, “buy low, sell high” logic
This is a thought question regarding the implication of the signaling principle. As noted from the homework on the
signaling principle, the basic idea is that actions convey information. The intent is to address the implication of this idea
with the insiders’ (firm’s management) action to repurchase outstanding stock: would this action “suggest” the insiders
believe the shares are under-valued, over-valued, or that this action would have no suggestion of the insider’s perception
of firm value?
The answer is that the insider’s would NOT repurchase shares IF they believe the shares are overvalued – instead,
that believe would be an incentive to sell additional shares to raise funds (if there were some reasonable reasons to
raise funds via issuing stock).
The insider’s would have an incentive to repurchase stock when they believe the stock is undervalued, as they
would be buying it back for less than they believe the value really is, which would increase the wealth of the
remaining shareholders (thus would be consistent with increasing the value of the firm to the firm’s owners,
3|Page
, MBA 655 Quiz 1 to 8 with answers
which is the fundamental financial management goal). Thus, since they have an incentive to repurchase when they
believe the stock is undervalued, their actions of repurchasing would also be a signal that the stock is
undervalued.
9. According to the financial perspective, value (thus shareholder wealth) creation is based on:
the size of the cash flows of the firm
a) the timing & risk of the cash flows
b) the net income, aka profits, of the firm
c) both a & c
d) both a & b
* e, page 17, homework Other Key Concepts
10. According to the payoff diagram that illustrates the payoff (at liquidation of a firm) to bondholders and stockholders
as a function of the value of the firm,
a) bondholders would prefer more risk than stockholders, because bondholders’ payoff is flat as the firm value
increases beyond the debt level
b) stockholders would prefer more risk than bondholders, because stockholders’ payoff is flat as the firm value
increases beyond the debt level
c) stockholders would prefer more risk than bondholders, because their (stockholders) payoff increases dollar
for dollar as the firm value increases beyond the debt level
d) managers would prefer more risk than stockholders, because their (managers) payoff increases dollar for dollar as
the firm value increases beyond the debt level
*c, homework Other Key Concepts 2, PowerPoint Slide - Payoff Diagram implications. The payoff diagram is
copied pasted below and in the PPT resources online. As the diagram illustrates, the stockholders are the
“residual” claimants on the firm, which means they get “whatever is left over” after all the debt claims are paid,
and thus they get ALL the upside potential on riskier projects if the projects turn out well. On the downside, it is
as if they are “playing with other people’s money (OPM)” if the project turns out bad, as the stockholders enjoy
“limited liability” (meaning their payoff does NOT go negative – thus can only loose what they invested = limited
liability). Thus, stockholders get all the upside and are limited on the downside, thus they prefer riskier projects.
4|Page
