FINANCE 3013 Final Chapters 1- 13, 23 QUIZZES

FINANCE 3013 Final Chapters 1- 13, 23 QUIZZES Quizzes 1.2 The Four Types of Firms P 1-1 (book/static) What is the most important difference between a corporation and all other organizational forms? An important difference among the types of corporate organizational forms is the way they are taxed. Shareholders of a corporation pay taxes twice. This system is sometimes referred to as double taxation. P 1-2 (book/static) What does the phrase limited liability mean in a corporate context? Owners' liability is limited to the amount they invested in the firm. Stockholders are not responsible for any encumbrances of the firm; in particular, they cannot be required to pay back to pay back any debts incurred by the firm. P 1-3 (book/static) Which organizational forms give their owners limited liability? Limited partnership for limited partners only. Corporation. P 1-4 (book/static) What are the main advantages and disadvantages of organizing a firm as a corporation? The advantages are: The life of the business can continue beyond the death of any of the owners. The liability of the owners is limited to the amount of their investment in the firm. There is no limit on the number of owners a corporation may have, thus allowing the corporation to raise substantial amounts of capital. The disadvantages are: Income to a corporation is subject to double taxation, once at the corporate level and again when received by the owners in the form of a dividend. The corporation is more complicated and more expensive to set up than other business entities. P 1-5 (book/static) Explain the difference between an S and a C corporation. The profits and losses of the S corporation are passed directly to shareholders and are not subject to corporate taxes, while the C corporation must first pay taxes on any profits before passing the after-tax profits on to shareholders. In addition, the S corporation can have no more than 100 shareholders, all of whom must be U.S. citizens or residents. The C corporation does not have any such restrictions on its shareholders. P 1-6 (similar to) You are a shareholder in a C corporation. The corporation earns $2.27 per share before taxes. Once it has paid taxes it will distribute the rest of its earnings to you as a dividend. Assume the corporate tax rate is 35% and the personal tax rate on (both dividend and non-dividend) income is 30%. How much is left for you after all taxes are paid? First, the corporation pays the taxes. After taxes, $2.27 x (1 - 0.35) = $1.48 is left to pay the dividends. Once the dividend is paid, personal tax must be paid, which leaves $1.48 x (1 - 0.30) = $1.04. So, after all the taxes are paid, you are left with $1.04. The amount that remains is $1.04 per share. P 1-7 (similar to) You are a shareholder in an S corporation. The corporation earns $2.23 per share before taxes. As a pass through entity, you will receive $2.23 for each share that you own. Your marginal tax rate is 30%. How much per share is left for you after all taxes are paid? An S corporation does not pay corporate income tax. So it distributes $2.23 to its stockholders. These stockholders must then pay personal income tax on the distribution. So they are left with $2.23 x (1 – 0.30) = $1.56 The amount that remains is $1.56 per share 1.3 The Financial Manager P 1-8 (book/static) What is the most important type of decision that the financial manager makes? The financial manager's most important job is to make the firm's investment decisions. P 1-9 (book/static) Why do all shareholders agree on the same goal for the financial manager? All of the decisions by the financial manager are made within the context of the overriding goal of financial management—to maximize the wealth of the owners, the stockholders. The stockholders have invested in the corporation, putting their money at risk to become the owners of the corporation. 1.4 The Financial Manager’s Place in the Corporation P 1-10 (book/static) Corporate managers work for the owners of the corporation. Consequently, they should make decisions that are in the interests of the owners, rather than in their own interests. What strategies are available to shareholders to help ensure that managers are motivated to act this way? Write contracts that ensure that the interests of the managers and shareholders are closely aligned. Ensure that employees are paid with company stock and/or stock options. Ensure that underperforming managers are fired. Mount hostile takeovers. P 1-11 (book/static) Recall the last time you ate at an expensive restaurant where you paid the bill. Now think about the last time you ate at a similar restaurant, but your parents paid the bill. Did you order more food (or more expensive food) when your parents paid? Explain how this relates to the agency problem in corporations. The agency problem leads an individual (in your case) and corporate managers (in the corporate setting) to put their own self-interest ahead of the interests of the shareholders (your parents in your case). In both situations there may be a lack of interest in controlling costs if those costs are not borne directly by the person making the decision. P 1-12 (book/static) Suppose you are considering renting an apartment. You, the renter, can be viewed as an agent while the company that owns the apartment can be viewed as the principal. What agency conflicts do you anticipate? Suppose, instead, that you work for the apartment company. What features would you put into the lease that would give the renter incentives to take good care of the apartment? The agent (renter) will not take the same care of the apartment as the principal (owner), because the renter does not share in the costs of fixing damages to the apartment. To mitigate this problem, having the renter pay a deposit should motivate the renter to keep damages to a minimum. The deposit forces the renter to share in the costs of fixing any problems that are caused by the renter. In addition, the provision in the lease for annual renewals allows an incentive for a long-term renter to maintain the leased apartment. P 1-13 (book/static) You are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too high, but you will be the CEO of the combined, much larger company. You know that when the company gets bigger, your pay and prestige will increase. What is the nature of the agency conflict here and how is it related to ethical considerations? There is an ethical dilemma when the CEO of a firm has incentives that are opposite to those of the shareholders. In this case, you (as the CEO) have an incentive to potentially overpay for another company (which would be damaging to your shareholders) because your pay and prestige will improve. 1.5 The Stock Market P 1-14 (book/static) You are a financial manager in a public corporation. One of your engineers says that they can increase the profit margin on your flagship product by using a lower quality vendor. However, the product is likely to fail more often and will generally not last as long. Will taking your engineer's suggestion necessarily make shareholders better off? Why or why not? Will taking your engineer's suggestion necessarily make shareholders better off? Why or why not? No, it will not necessarily make the shareholders better off. Even though you are reducing costs, which could increase cash flows in the short-term, you will deal with more costly warrant issues and with lost reputation with your customers, potentially leading them to buy from your competitors, which would reduce cash flows in the longrun. Making a less expensive, but lower quality product is not the same as maximizing the value of the shares (making your shareholders better off). P 1-15 (book/static) You sit on the board of a public corporation. Your CEO has proposed taking steps to offset the carbon impact of your company's manufacturing process. Doing so will add to the company's overall expenses. Your CEO argues, however, that this action will actually increase the stock price, maximizing shareholder wealth. Why might socially-responsible activities also be value-maximizing? Why might socially-responsible activities also be value-maximizing? Socially responsible actions are not necessarily at odds with shareholder wealth maximization. If potential customers value these actions highly, they will be more likely to purchase your products and may even be willing to pay more for them if doing so helps a social goal that is important to them. Further, some potential employees may value working for socially responsible firms, helping you attract the best talent. P 1-16 (book/static) What is the difference between a public and private corporation? The shares of a public corporation are traded on an exchange (or "over the counter" in an electronic trading system) while the shares of a private corporation are not traded on a public exchange. P 1-17 (book/static) What is the difference between a primary and a secondary market? The primary market refers to a corporation issuing new shares of stock and selling them to investors. After this initial transaction between the corporation and investors, the shares continue to trade in a secondary market between investors without the involvement of the corporation. P 1-18 (book/static) How are limit orders and market orders different? A limit order specifies a price that you are willing to buy or sell at. It will be executed when there is demand or supply at that price. A market order is to be executed immediately at the best outstanding limit order. P 1-19 (book/static) Explain why the bid-ask spread is a transaction cost. Investors always buy at the ask and sell at the bid. Since ask prices always exceed bid prices, investors “lose” this difference. It is one of the transaction costs. Since the market makers take the other side of the trade, they make this difference. P 1-20 (book/static) What are the tradeoffs in using a dark pool? Using a dark pool allows traders to not reveal their intentions, since limit order books are not visible. Additionally, using a dark pool allows traders to potentially trade at a better price. However, dark pools sacrifice the guarantee of immediacy since an order may not be filled. P 1-21 (book/static) The following quote on Yahoo! stock appeared on April 11, 2016, on Yahoo! Finance. If you wanted to buy Yahoo!, what price would you pay per share? How much would you receive per share if you wanted to sell Yahoo!? To buy the stock, the price you would pay per share is $36.79. If you sell the stock, the amount you would receive per share is $36.78. 1.6 Financial Institutions P 1-22 (book/static) What is the financial cycle? In the financial cycle, money flows from savers and investors to companies who use that money to fund growth through new products. Financial institutions connect the money with ideas and assist in returning the profits back to the investors. In the financial cycle, companies generate profits and wages and interest which then flow back to the savers and investors. P 1-23 (book/static) How do financial institutions help with risk-bearing? Insurance companies spread out risk by pooling premiums together from policy holders and pay the claims of those who have an accident, fire, medical need or die. This process spreads the financial risk of these events out across a large pool of policyholders and the investors in the insurance company. Mutual funds and pension funds take your savings and spread them out among the stocks and bonds of many different companies, limiting your exposure to any one company. Financial institutions not only assist with the risk-bearing of savers and investors, but must also be concerned about their own risk, spreading their loans out among a variety of clientele. P 1-24 (book/static) What role do investment banks play in the economy? Investment banks advise companies in major financial transactions such as buying or selling companies or divisions. Investment banks assist companies in raising capital by issue of stocks and bonds on behalf of corporate clients. P 1-25 (book/static) What are some of the similarities and differences among mutual funds, pension funds, and hedge funds? Pension funds, which are similar to mutual funds in that they buy stocks, bonds and other financial instruments on behalf of its investors, is primarily concerned with providing retirement income. Mutual funds allow investments to be accumulated and withdrawn for a variety of financial goals. Unlike mutual funds and pension funds which serve investors of all means, hedge funds are primarily designed for wealthy investors and endowments. Mutual funds, pension funds and hedge funds are all financial institutions involved with helping savers and investors reach their financial goals. Quiz: 1.3.3 | Check for Understanding Consider the following potential events that might have occurred to Global on December 30, 2016. For each one, indicate which line items in Global's balance sheet would be affected and by how much. Also indicate the change to Global's book value of equity a. Global used $20.9 million of its available cash to repay $20.9 million of its long-term debt. Long-term liabilities would decrease by $20.9 million, and cash would decrease by the same amount. The book value of equity would be unchanged. b. A warehouse fire destroyed $4.8 million worth of uninsured inventory. Inventory would decrease by $4.8 million, as would the book value of equity. c. Global used $4.9 million in cash and $4.7 million in new long-term debt to purchase a $9.6 million building. Long-term assets would increase by $9.6 million, cash would decrease by $4.9 million, and long-term liabilities would increase by $4.7 million. There would be no change to the book value of equity. d. A large customer owing $2.8 million for products it already received declared bankruptcy, leaving no possibility that Global would ever receive payment. Accounts receivable would decrease by $2.8 million, as would the book value of equity. e. Global's engineers discover a new manufacturing process that will cut the cost of its flagship product by more than 48%. This event would not affect the balance sheet. f. A key competitor announces a radical new pricing policy that will drastically undercut Global's prices. This event would not affect the balance sheet. Confirm that you can find the financial statements for Starbucks Corporation (SBUX) as of Sep 28, 2014 using the following sources: a. From the company's Web page (). (Hint:Search for "investor relations.") Cost of sales as shown in the income statement statement as of Sep 28, 2014 is: $6,858.8 million b. From the SEC Web site (). (Hint: Search for company filings in the EDGAR database.) Income before tax as shown in the income statement statement as of Sep 28, 2014 is: $3,159.7 million c. From the Yahoo! Finance Web site (). Total assets as shown in the balance sheet statement as of Sep 28, 2014 is: $10,752.9 million d. From at least one other source. (Hint: Enter "SBUX 10K" at .) Cash from operating activities as shown in the cash flow statement as of Sep 28, 2014 is: $607.8 million What was the change in Global's book value of equity from 2015 to 2016 according to Table 2.1? Does this imply that the market price of Global's shares increased in 2016? Explain. What was the change in Global's book value of equity from 2015 to 2016? Global's book value of equity changed by $1.1 million from 2015 to 2016. Does this imply that the market price of Global's shares increased in 2016? Explain. An increase in book value does not necessarily indicate an increase in Global's share price. There are many events that may affect Global's future profitability, and hence its share price, that do not show up on the balance sheet. The market value of a stock does not depend on the historical cost of the firm's assets, but on investors' expectation of the firm's future performance. See Table 2.5 showing financial statement data and stock price data for Mydeco Corp. Suppose Mydeco had purchased additional equipment for $11.6 million at the end of 2013, and this equipment was depreciated by $3.9 million per year in 2014, 2015, and 2016. Given Mydeco's tax rate of 35%, what impact would this additional purchase have had on Mydeco's net income in years ? (Assume the equipment is paid for out of cash and that Mydeco earns no interest on its cash balances.) Calculate the new net income below: What four financial statements can be found in a firm's 10-K filing? What checks are there on the accuracy of these statements? Every public company is required to produce quarterly and annual financial statements. Those statements are: The statement of financial position. The income statement. The statement of cash flows. The statement of stockholders' equity