Financial management deals with the maintenance and creation of economic value or wealth.

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. Answer: Keywords: Financial Management AACSB: Reflective thinking skills 2) Each financial decision made by a corporate manager can be evaluated by its direct impact on the corporation's stock price. Answer: Keywords: Goal of the Firm AACSB: Reflective thinking skills 3) The fundamental goal of a business is to maximize the retained earnings available to the corporation's shareholders. Answer: Keywords: Goal of the Firm AACSB: Reflective thinking skills 4) Shareholder wealth maximization means maximizing the price of the existing common stock. Answer: Keywords: Shareholder Wealth, Goal of the Firm AACSB: Reflective thinking skills 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. Answer: Keywords: Goal of the firm, Shareholder Wealth Maximization AACSB: Reflective thinking skills 6) Corporate managers should accept investment projects that maximize profits int he short run because of the time value of money. Answer: Keywords: Goal of the Firm, Profits, Time Value of Money AACSB: Reflective thinking skills 7) The goal of the firm's financial managers should be the maximization of the total value of the firm's stock. Answer: Keywords: Goal of the Firm AACSB: Reflective thinking skills 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. Answer: Keywords: Goal of the Firm AACSB: Reflective thinking skills 9) One problem with maximization of shareholder wealth as a goal is that it ignores risk taken by the firm's financial decisions. Answer: Keywords: Goal of the Firm AACSB: Reflective thinking skills 10) The goal of profit maximization ignores the risk of financial decisions Answer: Keywords: Goal of the Firm AACSB: Reflective thinking skills 11) Only a firm's financial decisions affect its stock prices. Answer: Keywords: Determinants of Stock Price AACSB: Reflective thinking skills 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. Answer: Keywords: Determinants of Stock Price AACSB: Reflective thinking skills 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 Answer: Keywords: Goal of the Firm, Corporation AACSB: Reflective thinking skills 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. Answer: Keywords: Goal of the Firm, Maximize Shareholder Wealth AACSB: Reflective thinking skills 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. Answer: Keywords: Goal of the Firm AACSB: Analytic skills 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. Answer: Keywords: Goal of the firm, Shareholder Wealth Maximization AACSB: Reflective thinking skills 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. Answer: Keywords: Goal of the Firm, Maximize Shareholder Wealth AACSB: Reflective thinking skills 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 Answer: Keywords: Goal of the Firm, Maximize Shareholder Wealth AACSB: Reflective thinking skills 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. Answer: Keywords: Goal of the Firm, Maximize Shareholder Wealth AACSB: Reflective thinking skills 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? Answer: Underestimation of risk can lead managers to borrow excessively to fund more and more projects. High levels of debt require interest and principal payments which may become impossible to make if the company's cash flows are reduced, even for short periods of time. Overestimation of risk can also be problematic. Managers who take on too little risk may be passing up desirable projects that could increase shareholder wealth. The principle that risk requires a return does not mean that all risk is bad, but rather that additional risk is ok if additional expected returns are high enough. If all risk was bad, companies would go out of business and all investors would buy U.S. Treasury Bills. Keywords: Risk Requires a Return, Goal of the Firm AACSB: Reflective thinking skills 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? Answer: Managers are supposed to maximize shareholder value. Exxon's analysis of the costs of an oil spill versus the cost of improving their tankers seems to have been a reasonable one at the time it was undertaken. The social costs of killing birds and fish were expected to be low. The outrage at Exxon's conduct and the subsequent large fines will change the estimation of future costs for similar situations. Managers need to consider the impact of their decisions on their companies' cash flows. Socially undesirable activities may lead to boycotts, protests, lower sales, fines, etc. These costs must be included in their analyses. Society sets limits within which corporations must operate or the corporations, and their shareholders, will suffer. Therefore, acting in ethical and socially responsible ways is congruent with the goal of shareholder wealth maximization. Keywords: Goal of the Firm, Maximizing Shareholder Value, Ethical Responsibility, Cash Flow AACSB: Reflective thinking skills 1.2 Learning Objective 2 1) When making financial decisions, managers should always look at marginal, or incremental cash flows. Answer: Keywords: Marginal or Incremental Cash Flows AACSB: Reflective thinking skills 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. Answer: Keywords: Cash Flow, Time Value of Money AACSB: Reflective thinking skills 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. Answer: Keywords: Net Income, Risk, Timing of Cash Flow AACSB: Analytic skills 4) Profits represent money that can be spent, and as such, form the basis for determining the value of financial decisions. Answer: Keywords: Profits, Cash Flow AACSB: Reflective thinking skills 5) The root cause of agency problems is conflicts of interest. Answer: Keywords: Agency Problems, Conflicts of Interest AACSB: Reflective thinking skills 6) Investors will be indifferent between two investments if both investments have the same expected return. Answer: Keywords: Risk-Return Tradeoff AACSB: Reflective thinking skills 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. Answer: Keywords: Efficient Markets AACSB: Analytic skills 8) Giving the company's CEO stock options as part of his or her compensation package is an example of an agency cost. Answer: Keywords: Agency Costs AACSB: Reflective thinking skills 9) Cash flows and profits are synonymous; in other words, higher cash flows equal higher profits. Answer: Keywords: Cash Flow, Profit AACSB: Reflective thinking skills 10) Shareholder selection committees select potential board of director nominees ensuring that board members will monitor management sufficiently to protect shareholder interests. Answer: Keywords: Agency Problems, Board of Directors AACSB: Reflective thinking skills 11) Managers should not be concerned with business ethics because ethical behavior is inconsistent with the primary goal of maximizing shareholder value. Answer: Keywords: Ethics, Goal of the Firm AACSB: Ethical understanding and reasoning abilities 12) One of the problems associated with maximization of total current stock value is that it ignores the timing of a project's return. Answer: Keywords: Maximizing Shareholder Value, Timing of Returns AACSB: Reflective thinking skills 13) The risk-return tradeoff is seen in many areas of finance. Answer: Keywords: Risk, Return AACSB: Reflective thinking skills 14) The risk/return tradeoff implies that the return on a riskless asset must be zero. Answer: Keywords: Risk-Return Tradeoff AACSB: Reflective thinking skills 15) The sole proprietorship has no legal business structure separate from its owner. Answer: Keywords: Sole Proprietorship AACSB: Reflective thinking skills 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. Answer: Keywords: Efficient Markets AACSB: Reflective thinking skills 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. Answer: Keywords: Opportunity Cost, Time Value of Money AACSB: Reflective thinking skills 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. Answer: Keywords: Basic Principles of Finance AACSB: Reflective thinking skills 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. Answer: Keywords: Efficient Markets AACSB: Analytic skills 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. Answer: Keywords: Opportunity Cost AACSB: Analytic skills 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. Answer: Keywords: Time Value of Money, Cash Flows AACSB: Reflective thinking skills 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. Answer: Keywords: Time Value of Money, Cash Flows AACSB: Analytic skills 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. Answer: Keywords: Risk, Return AACSB: Reflective thinking skills 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. Answer: Keywords: Risk-Return Tradeoff AACSB: Reflective thinking skills 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. Answer: Keywords: Risk-Return Tradeoff AACSB: Analytic skills 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. Answer: Keywords: Risk-Return Tradeoff, Expected Return, Actual Return AACSB: Reflective thinking skills 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. Answer: Keywords: Time Value of Money AACSB: Analytic skills 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. Answer: Keywords: Cash Flow, Net Income AACSB: Analytic skills 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. Answer: Keywords: Efficient Markets AACSB: Analytic skills 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. Answer: Keywords: Agency Problems AACSB: Reflective thinking skills 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. Answer: Keywords: Five Principles of Finance AACSB: Reflective thinking skills 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 Answer: Keywords: Ethics, Maximizing Shareholder Value AACSB: Ethical understanding and reasoning abilities 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. Answer: Keywords: Risk-Return Tradeoff, Expected Return, Actual Return AACSB: Analytic skills 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. Answer: Keywords: Agency Problems, Stock Option, Incentive Compensation AACSB: Reflective thinking skills 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. Answer: Keywords: Time Value of Money, Cash Flows AACSB: Analytic skills 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. Answer: Keywords: Efficient Markets AACSB: Analytic skills 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 Answer: Keywords: After-Tax Incremental Cash Flows AACSB: Reflective thinking skills 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. Answer: Keywords: Stock Price Maximization, Efficient Markets AACSB: Analytic skills 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. Answer: Keywords: Stock Price, Cash Flow AACSB: Analytic skills 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. Answer: Keywords: Agency Problems AACSB: Analytic skills 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. Answer: Keywords: Agency Problems, Executive Compensation AACSB: Reflective thinking skills 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. Answer: Keywords: Risk Requires a Return AACSB: Reflective thinking skills 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. Answer: Keywords: Ethics AACSB: Ethical understanding and reasoning abilities 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. Answer: Keywords: Risk-Return Tradeoff AACSB: Reflective thinking skills 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 Answer: Keywords: Risk-Return Tradeoff AACSB: Reflective thinking skills 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 Answer: Keywords: Time Value of Money AACSB: Reflective thinking skills 47) Assume that an investor is offered a choice of a risk-free government bond or a high-risk corporate stock. Further assume that the expected return is the same for both. According to one of the axioms of finance, which investment would be chosen? A) the corporate stock B) the government bond C) neither, the investor would be indifferent D) none of the above Answer: Keywords: Risk-Return Tradeoff AACSB: Reflective thinking skills 48) Assume that an investor is offered a choice of a risk-free government bond that is expected to return 3.5% or a high-risk corporate stock. According to one of the principles of finance, what would induce the investor to purchase the corporate stock? A) a return that is substantially lower than 3.5% B) cash dividends C) a return that is substantially higher than 3.5% D) none of the above Answer: Keywords: Risk-Return Tradeoff AACSB: Reflective thinking skills 49) Assume that you went to Las Vegas and hit the jackpot for $5 million. Further assume that you were offered a choice to receive the $5 million today, or receive it in two years. According to one of the principles of finance, which would you take? A) The $5 million in two years because you would be afraid of spending it all right away. B) The $5 million in two years because it would be worth more than if you would receive it today. C) You would be indifferent as to when you would receive the $5 million. D) The $5 million today because it would be worth more than if you would receive it in two years. Answer: Keywords: Time Value of Money AACSB: Reflective thinking skills 50) Assume that you won the Lotta Dough Lotto jackpot for $20 million. Further assume that you were offered a choice to receive the $20 million today, or receive it in equal installments of $1 million per year for 20 years. According to one of the principles of finance, which would you take? A) The $20 million in equal installments of $1 million per year for 20 years because you would be afraid of spending it all right away. B) The $20 million today because it would be worth more than if you would receive it in equal installments of $1 million per year for 20 years. C) You would be indifferent as to when you would receive the $20 million since the total number of dollars received is the same either way. D) The $20 million in equal installments of $1 million per year for 20 years because it would be worth more than if you would receive it today. Answer: Keywords: Time Value of Money AACSB: Reflective thinking skills 51) Which of the following statements best represents the "Agency Problem?" A) Managers might attempt to benefit themselves in terms of salary and perquisites at the expense of shareholders. B) The agency problem results from the separation of management and the ownership of the firm. C) The agency problem may interfere with the implementation of maximizing shareholder wealth. D) all of the above Answer: Keywords: Agency Problems AACSB: Reflective thinking skills 52) Short-term United States Treasury Bills are widely used as proxies for risk-free assets, yet the returns on these T-bills are consistently greater than zero. Is this consistent with the concept of a risk-return tradeoff? Answer: Yes. Investors also require a return for delaying consumption as well as a return for taking on risk. Keywords: Risk-Return Tradeoff, Return for Delaying Consumption AACSB: Reflective thinking skills 53) John won the lottery on Monday and can take either $50,000 per year for 20 years, or $500,000 today. Bill won the same lottery on Tuesday and has the same options for receiving the cash. A well respected financial advisor is hired by both John and Bill. The advisor recommends that John take the $50,000 per year for 20 years but advises Bill to take the $500,000 up front payment. How is it possible to give different advice to two clients regarding the exact same cash flows? Answer: The time value of money is based on opportunity cost. If John and Bill have different opportunity costs for funds, they can each be making rational choices. For example, suppose Bill can earn 20% on the funds he receives by investing them in his business, but John expects to earn only 2% by investing the lottery winnings in a certificate of deposit. Bill will end up with more cash if he takes the $500,000 up front and invests it wisely, even though he is giving up $500,000 of future winnings. John, however, is better off taking the $50,000 per year, for a total of $1,000,000 over 20 years, because he would not be able to make up the lost $500,000 by earning only 2% per year. Keywords: Opportunity Cost, Time Value of Money AACSB: Reflective thinking skills 54) The manager of Golden Ray Corporation receives a bonus if company profits exceed $1,000,000 this year. During the final week of the year, the manager changes an accounting policy that will increase reported profits from $950,000 to $1,025,000, triggering his bonus. The change in profits of $75,000 will reverse itself in the next year, and the accounting change has no impact on Golden Ray's cash flow. Discuss the above situation as it relates to both an agency problem and efficient markets. Answer: n agency problem exists when a manager (agent) acts in his or her own self-interest rather than in the best interests of the shareholders (principals). In order to reduce agency problems, management activity may be monitored, such as through audits and performance reviews, and management compensation can be designed to align the interests of the managers with the interests of the shareholders. A bonus based on profits encourages the manager to focus on profits, rather than on shareholder value. A better compensation scheme may include direct stock ownership by managers, stock options for managers, or performance incentives based on the company's stock price. Given efficient markets, one would expect the increase in profits to have little effect on the company's stock price. Stock values are based on cash flows, not profits, and the stock market is not fooled by an accounting change that artificially increases short-term profits. In this case, the stock price could go down because the company has to pay higher compensation to the manager even though the company's cash flows have not increased. Keywords: Agency Problems, Efficient Markets, Incentive Alignment, Cash Flow Versus Profits AACSB: Reflective thinking skills 55) Your friend Ricky took a finance class and learned about the risk/return tradeoff. Wanting a high return, Ricky invested in a risky, start-up technology company. A year later the company went bankrupt and Ricky lost his entire investment. Ricky is furious with his finance professor for misleading him, claiming he was taught that higher return goes with higher risk. Explain how Ricky misinterpreted the risk/return tradeoff. Answer: The risk/return tradeoff deals with expected returns, not actual returns. For risk averse investors, higher expected returns are required before they will take on higher risks. However, higher expected returns do not always materialize. Risky projects sometimes result in lower actual returns. This is what makes them risky. Keywords: Risk/Return Tradeoff, Actual Return, Expected Return, Risk AACSB: Reflective thinking skills 56) The board of directors of Wireless, Inc. is considering two compensation plans for the CEO of the company. The first would pay the CEO a salary of $250,000 for the upcoming year. The second would pay the CEO a salary of $100,000 and provide the CEO with a stock option to buy 100,000 shares of stock for $11 per share. The current price per share of Wireless, Inc. stock is $10 per share. The stock option expires at the end of the year. Why might shareholders prefer the second payment plan? As part of your answer, calculate the breakeven point for the CEO to obtain the same compensation under option two as he or she would under option one. Answer: Shareholders may prefer the compensation package that includes stock options because the options give the CEO the incentive to maximize the price of the company's stock, thus benefiting the shareholders. A fixed salary, regardless of stock price performance, can lead to a CEO who is willing to do the minimum necessary to maintain the job, but who is not motivated to work extra hard for the shareholders. For every dollar the price of the stock exceeds $11 per share, the CEO will make an additional $100,000. Thus, if the share price increases to $12.50, the profit on the stock option [($12.50 - $11.00) × 100,000 shares] of $150,000 plus the fixed salary of $100,000 will equal the total compensation from option one of $250,000. Stock options help to align the incentives of managers with the goals of shareholders. Keywords: Agency Costs, Incentive Alignment, Stock Options AACSB: Reflective thinking skills 1.3 Learning Objective 3 1) A corporate treasurer is typically responsible for cash management, credit management, and raising capital. Answer: Keywords: Treasurer, Financial Managers AACSB: Reflective thinking skills 2) Determining how a firm should raise money to fund its long-term investments is referred to as capital structure decisions. Answer: Keywords: Capital Structure Decisions AACSB: Reflective thinking skills 3) The chief financial officer (CFO) is responsible for overseeing financial planning, corporate strategic planning, and controlling the firm's cash flow. Answer: Keywords: Chief Financial Officer AACSB: Reflective thinking skills 4) The financial manager most directly responsible for producing the company's financial statements and directing its cost accounting functions is the A) chief financial officer. B) controller. C) treasurer. D) vice president - financer. Answer: Keywords: Controller, Financial Managers AACSB: Reflective thinking skills 5) A corporate treasurer is typically responsible for each of the following duties except: A) cash management. B) credit management. C) capital expenditures. D) cost accounting. Answer: Keywords: Treasurer, Financial Managers AACSB: Reflective thinking skills 6) The three basic types of issues addressed by the study of finance are A) capital budgeting, capital structure decisions, and working capital management. B) capital budgeting, working capital management, and investment analysis. C) capital structure decisions, working capital management, and sustained profitability. D) capital budgeting, investment analysis, and cash management. Answer: Keywords: Capital Budgeting, Capital Structure, Working Capital Management AACSB: Reflective thinking skills 7) Cash and credit management are typically the responsibility of the A) Controller. B) Vice President of Production and Operations. C) Chief Executive Officer, or CEO. D) Treasurer. Answer: Keywords: Treasurer AACSB: Reflective thinking skills 8) Working capital management is concerned with A) how a firm can best manage its cash flows as they arise in its day-to-day operations. B) how a firm should raise money to fund its investments. C) what long-term investments a firm should undertake. D) managing a firms capital stock. Answer: Keywords: Working Capital Management AACSB: Reflective thinking skills 9) Capital budgeting is concerned with A) whether a company's assets should be financed with debt or equity. B) managing a firms cash budgeting procedures. C) what long-term investments a firm should undertake. D) planning sales of a corporation's equity capital. Answer: Keywords: Capital Budgeting AACSB: Reflective thinking skills 10) Determining the best way to raise money to fund a firm's long-term investments is called A) the capital budgeting decision. B) the portfolio decision. C) the money flow processing decision. D) the capital structure decision. Answer: Keywords: Capital Structure Decisions AACSB: Reflective thinking skills 11) Your friend, John, believes that since capital markets are efficient, he doesn't need to read the financial press or be involved in stock research before purchasing stocks for his portfolio. He simply throws darts at the stock pages and buys the stocks the darts hit. Is stock research and analysis important when buying and selling stocks in an efficient market? Answer: Yes! Efficient capital markets theory suggests that investors will not be able to outperform the market in the long-run using just publicly available information. This is due to the fact that market prices very quickly adjust to information. If an investor only knows what all other investors know, then he or she cannot use that information to earn abnormal returns. However, an uninformed investor can certainly underperform the market. Keywords: Efficient Capital Markets AACSB: Reflective thinking skills 1.4 Learning Objective 4 1) The sole proprietorship is for all practical purposes the absence of any formal legal business structure. Answer: Keywords: Sole Proprietorship, Legal Forms of Business AACSB: Reflective thinking skills 2) A general partnership, unlike a limited partnership, is an entity that legally functions separate and apart from its owners. Answer: Keywords: General Partnership, Limited Partnership, Legal Forms of Business AACSB: Reflective thinking skills 3) The best form of business entity to attract new capital is the sole proprietorship because investors only need to deal with one owner. Answer: Keywords: Legal Forms of Business, Sole Proprietorship AACSB: Reflective thinking skills 4) S-type corporations and limited liability companies are taxed like partnerships, but have the advantage of limited liability for their owners. Answer: Keywords: Legal Forms of Business, S-Corporation, Limited Liability Company AACSB: Reflective thinking skills 5) Limited liability companies are more flexible than S-type Corporations because limited liability companies operate under state laws. Answer: Keywords: Legal Forms of Business, S-Corporation, Limited Liability Company AACSB: Reflective thinking skills 6) A limited liability company (LLC) is taxed like a partnership but provides limited liability for its owners similar to a corporation. Answer: Keywords: Limited Liability Company, Partnership, Corporation, Limited Liability AACSB: Reflective thinking skills 7) Its ability to raise capital by selling stock makes the corporation the best form of organization in terms of raising capital. Answer: Keywords: Corporation, Advantages of Corpo