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Chapter One Financial EconomicsThis chapter contains 48 multiple choice questions, 20 short problems and 5 longer problems.Multiple Choice1. The primary goal of corporate management is to _ shareholder wealth.(a) minimize(b) maximize(c) leverage(d) mitigateAnswer: (b)2. A _ stock market imposes _ discipline on managers to take actions to maximize the market value of the firms shares.(a) competitive, strong(b) dispersed, weak(c) mature, no(d) dispersed, strongAnswer: (a)3. The _ form is especially well suited to the separation of ownership and management of firms because it allows relatively frequent changes in owners by share transfer without affecting the operations of the firm.(a) corporate(b) sole proprietorship(c) partnership(d) householdAnswer: (a)4. _ is anything that has economic value.(a) A partnership(b) An asset(c) A balance sheet(d) An income statementAnswer: (b)5. A households wealth or net worth is measured by the value of its _ minus its _.(a) liabilities; assets(b) assets; liabilities(c) stocks; bonds(d) bonds; liabilitiesAnswer: (b)6. The branch of finance dealing with financial decisions of firms is called _ or _.(a) investments; international finance(b) markets; institutions(c) business finance; institutions(d) business finance; corporate financeAnswer: (d)7. Bonds promise _ cash payments, while stocks pay the _ value left over after all other claimants have been paid.(a) variable; residual(b) residual; fixed(c) fixed; residual(d) fixed; variableAnswer: (c)8. The day-to-day financial affairs of the firm are usually referred to as _.(a) working capital management(b) capital structure(c) capital budgeting(d) strategic planningAnswer: (a)9. A disadvantage of the sole proprietorship is the fact that the sole proprietor has _.(a) limited liability for the debts of the firm(b) unlimited liability for the debts of the firm(c) expensive costs to establish the firm(d) limited authority over the day-to-day business decisions of the firmAnswer: (b)10. In the U.S. corporations with concentrated ownership are called _ and corporations with broadly dispersed ownership are called _.(a) private corporations; public corporations(b) public corporations; private corporations(c) public corporations; monopolies(d) private corporations; state owned corporationsAnswer: (a)11. Billy owns a house worth $350,000 and has a $55,000 bank account. Billy owes $270,000 to the bank on a home mortgage loan and has a $12,000 credit card debt outstanding. Calculate Billys net worth.(a) $135,000(b) $123,000(c) $497,000(d) $37,000Answer: (b)12. Marlowe owns a house worth $150,000, a car worth $25,000 and has an $18,000 bank account. Marlowe owes $135,000 to the bank on a home mortgage loan, $18,000 on the car loan and has an $18,000 credit card debt outstanding. Calculate Marlowes net worth.(a) $58,000(b) $123,000(c) $22,000(d) $37,000Answer: (c)13. An advantage of the corporate form of ownership is _.(a) no liability(b) unlimited liability(c) limited liability(d) CEO liabilityAnswer: (c)14. In the corporate form, the separated structure creates the potential for _ between owners and managers.(a) a conflict of interest(b) increased transactional costs(c) stability in relations(d) none of the aboveAnswer: (a)15. All of the following are reasons for having a separation of management and ownership of the firm except:(a) the going concern effect favors the separated structure(b) professional managers may be found who possess a superior ability to run the business(c) it prevents the possibility of a conflict of interest between the owners and management(d) it allows for savings in the cost of information gatheringAnswer: (c)16. _ involves the evaluation of costs and benefits spread out over time, and it is largely a financial decision-making process.(a) Stock valuation(b) Bond valuation(c) Inventory costing(d) Strategic planningAnswer: (d)17. Shareholder wealth maximization depends on all of the following except:(a) production technology(b) market interest rates(c) risk aversion(d) market risk premiumsAnswer: (c)18. A problem with using the profit maximization criterion is _.(a) deciding which periods profit is to be maximized(b) the definition of maximize profits is ambiguous(c) the failure to consider risk(d) all of the above Answer: (d) 19. The existence of a well functioning stock market facilitates the efficient separation of the ownership and management of firms, since stock prices can be substituted for external information about _.(a) the firms production technology(b) the wealth, preferences, and other investment opportunities of the owners(c) the historic costs of the firms infrastructure(d) the firms ability to meet its projected goalsAnswer: (b)20. One place to look for a statement of the goals of a corporations top managers is the _.(a) balance sheet(b) income statement(c) annual report(d) bankruptcy filingAnswer: (c)21. In the absence of a stock market, managers would require information that is _ to obtain.(a) costly if not impossible (b) costless(c) readily available(d) time-consuming but inexpensiveAnswer: (a)22. Managements task is made much easier when it can observe the _ of its own and other firms shares.(a) book prices(b) market prices(c) historical prices(d) security pricesAnswer: (b)23. _ are entitled to a share of any of the distributions from the corporation such as cash dividends.(a) Sole proprietors(b) General partners(c) Professional managers(d) ShareholdersAnswer: (d)24. _ is the founder of modern portfolio theory.(a) Harry Markowitz(b) Merton Miller(c) William Sharpe(d) Bill GatesAnswer: (a)25. In Germany, public corporations are identifiable by _ after the company name, whereas private companies are denoted by _.(a) PLC, Inc.(b) GmbH, AG(c) AG, GmbH(d) SpA, GmbHAnswer: (c)26. In the United Kingdom, public corporations are identifiable by _ after the company name, whereas private companies are denoted by _.(a) Inc, PLC(b) LTD, PLC(c) AG, GmbH(d) PLC, LTDAnswer: (d)27. Shareholders elect _ who in turn select _ to run the business.(a) a board of directors; a treasurer(b) a board of directors; managers(c) managers; a board of directors(d) a board of directors; accountantsAnswer: (b)28. In a competitive stock market, _ offer(s) another important mechanism for aligning the incentives of managers with those of shareholders.(a) takeovers(b) increased taxes(c) liquidation(d) increased liabilityAnswer: (a)29. If a raider is interested in making a profit through the takeover of a prospective firm, the only expenses that need be incurred are _.(a) the cost of identifying a mismanaged firm(b) the cost of acquiring the firms shares(c) physical capital(d) both (a) and (b)Answer: (d)30. The cost of identifying a mismanaged firm can be low if the raider is which of the following:(a) a supplier(b) a customer(c) a competitor(d) all of the aboveAnswer: (d)31. Takeover mechanisms can most effectively be reduced by _.(a) directives from the board of directors (b) media intervention(c) government policies(d) public disapprovalAnswer: (c)32. The chief financial officer (CFO) of a corporation normally reports to the _ of the company.(a) controller(b) treasurer(c) chief executive officer(d) chairman of the board of directorsAnswer: (c)33. All of the following departments typically report to the chief financial officer (CFO) except:(a) marketing(b) financial planning(c) treasury(d) controlAnswer: (a)34. The treasurers job includes managing all of the following except:(a) the firms exposure to currency and interest rate risks(b) the tax department(c) relations with the external investment community(d) the analysis of proposed mergers and acquisitionsAnswer: (d)35. The activities of the vice president for financial planning include all of the following except:(a) analyzing proposed mergers(b) analyzing proposed spin-offs(c) preparing internal reports comparing planned and actual costs(d) analyzing major capital expendituresAnswer: (c)36. Which of the following statements is most correct?(a) The shareholders of a corporation elect managers who in turn select a board of directors to run the business.(b) Partnerships do not pay corporate tax.(c) A disadvantage of the corporation is unlimited liability.(d) The government is powerless to discourage corporate takeovers.Answer: (b)37. For a typical firm, which of the following statements is most correct?(a) The CFO has three departments reporting to him: financial planning, treasury and control.(b) The treasurer oversees the accounting and auditing activities of the firm.(c) The controller has responsibility for managing the financing activities of the firm and for working capital management.(d) The CEO is a senior vice president with responsibility for all the financial functions in the firm.Answer: (a)38. Which of the following are financial decisions a firm has to make?(a) financing decisions(b) capital budgeting decisions(c) working capital decisions(d) all of the aboveAnswer: (d)39. The controllers job includes responsibility for _.(a) relations with the external investment community(b) preparation of financial statements for use by shareholders, creditors and regulatory authorities(c) analysis of proposed mergers, acquisitions and spin-offs(d) all of the aboveAnswer: (b)40. The basic unit of analysis in capital budgeting is the _.(a) financing project(b) investment project(c) strategic project(d) variable projectAnswer: (b)41. The steps involved in any capital budgeting process include:(a) evaluating projects(b) deciding which projects to undertake(c) identifying ideas for new investment projects(d) all of the aboveAnswer: (d)42. Preferred stock, bonds, and convertible securities are also known as _.(a) nonmarketable claims(b) standardized securities(c) variable securities(d) covenantsAnswer: (b)43. The basic unit of analysis in capital structure decisions is the _.(a) firm as a whole(b) investment project(c) firms personnel(d) financial systemAnswer: (a)44. Which one of the following correctly orders the steps involved in capital structure decisions?(a) determining a feasible financing plan; identifying new ideas for investment projects(b) determining the optimal financing mix; determining a feasible financing plan(c) identifying ideas for investment projects; determining the optimal financing mix(d) determining a feasible financing plan; determining the optimal financing mixAnswer: (d)45. Which of the following is not a financial function of a corporation?(a) investor relations(b) tax administration(c) provision of capital(d) regulatory legislationAnswer: (d)46. Which of the following functions may be categorized as administration of funds?(a) custodial responsibilities(b) tax administration(c) internal auditing(d) all of the aboveAnswer: (a)47. Investor relations includes:(a) government reporting(b) establishment and maintenance of communications with company stockholders(c) relations with taxing agencies(d) consultation with and advice to other corporate executivesAnswer: (b)48. Oscar owns a boat worth $2 million, a house worth $5.5.million and has $900,000 in a bank account. Oscar owes $1.1 million to the bank on the boat loan, $2 million on the home loan and has $20,000 credit card debt. Calculate Oscars net worth.(a) $3.12 million(b) $5.28 million(c) $7.28 million(d) $8.4 millionAnswer: (b)Short Problems1. Give a brief definition of the financial system.Answer: A financial system is defined as the set of markets and other institutions used for financial contracting and the exchange of assets and risks.2. List the markets that the financial system likely includes.Answer: A financial system includes the markets for stocks, bonds and other financial instruments, financial intermediaries, financial service firms and the regulatory bodies that govern all of these institutions.3. Briefly describe the distinction between physical capital and financial capital.Answer: Physical capital includes items such as buildings, machinery and other intermediate products used in the production process. Financial capital, however, includes stocks, bonds and loans used to finance the acquisition of physical capital.4. Give a brief description of the wide range of financial instruments and claims a firm can issue.Answer: These include common stock, preferred stock, bonds and convertible securities (standardized securities that can be traded in organized markets). Financial instruments and claims can also include nonmarketable claims such as bank loans, employee stock options, leases and pension liabilities.5. Siggy owns a house worth $200,000, a car worth $25,000 and has an $18,000 bank account. He also has furniture worth $4,000 and jewelry worth $10,000. However, Siggy owes $145,000 to the bank on a home mortgage loan, $17,000 on the car loan, $40,000 on student loans and has an $16,000 credit card debt outstanding. Calculate Siggys net worth.Answer: Net Worth = Total Assets Total Liabilities = ($200,000 + $25,000 + $18,000 + $4,000 + $10,000) ($145,000 + $17,000 + $40,000 + $16,000) = $39,0006. Briefly list the problems associated with profit maximization as the chief goal of corporate managers.Answer: The profit-maximization criterion has two problems associated with it. The first is that it is difficult to determine which periods profit is to be maximized if the production process requires many periods. Secondly, if either future revenues or expenses are uncertain, then what exactly is the meaning of maximize profits if profits are described by a probability distribution?7. Kecia owns a house worth $220,000, a car worth $20,000 and has a $13,000 bank account. She also has furniture worth $8,000. However, Kecia owes $165,000 to the bank on a home mortgage loan, $17,000 on the car loan, $50,000 on student loans and has an $18,000 credit card debt outstanding. Calculate Kecias net worth.Answer: Net Worth = Total Assets Total Liabilities = ($220,000 + $20,000 + $13,000 + $8,000) ($165,000 + $17,000 + $50,000 + $18,000)= $261,000 - $250,000= $11,0008. Give an example of a potential conflict of interest that can arise between owners and managers of a firm.Answer: Managers being concerned with their own personal welfare may lead to concern about job security in the long run. This concern about long run survival may cause managers to limit the risk incurred by the firm and make other decisions not with the objective of shareholder wealth maximization.9. What use does the existence of a stock market serve to the manager of a firm?Answer: Observing its own and other firms market price of shares helps it make decisions about maximizing the firms value to its shareholders. If there was not a stock market, then managers would be required to obtain information that is costly, if not impossible, to obtain. This includes the wealth, preferences and other investment opportunities of the owners. 10. Outline the role of the takeover in aligning the incentives of managers with those of shareholders.Answer: The threat of a takeover provides a strong incentive for current managers to act in the interests of the firms current shareholders by maximizing market value. If managers fail to maximize the market value of the firms shares, the firm will be vulnerable to a takeover in which the managers may lose their jobs.11. Outline the role of the chief financial officer (CFO) in a corporation.Answer: The CFO is a senior vice president with responsibility for all the financial functions in the firm and reports directly to the CEO. Three departments report to the CFO: financial planning, treasury, and control.12. Discuss the role of the treasurer in a corporation.Answer: The treasurer has responsibility for managing the financing activities of the firm and for working capital management. The treasurer is responsible for managing relations with the external investor community, managing the firms exposure to currency and interest rate risks, and managing the tax department.13. Discuss the tasks performed by the controller of a corporation.Answer: The controller oversees the accounting and auditing tasks of the firm. The controller is responsible for the preparation of internal reports comparing planned and actual costs, revenues, and profits from the corporations various business units. The controller will also be involved with preparation of financial statements for use by shareholders, creditors and regulatory authorities.14. Discuss why voting rights for shareholders are not adequate to compel managers to act in the best interests of the shareholders.Answer: Because a major benefit of the separated structure is that the owners can remain relatively uninformed about the operations of the firm, it is not apparent how these owners could know whether their firm is being mismanaged. The value of voting rights is further cast into doubt if ownership of the firm is widely dispersed. If that is the situation, then the holdings of any single owner are likely to be so small that he or she would not incur the expense to become informed and to convey this information to the other owners. 15. Is it possible for government to reduce the effectiveness of the takeover mechanism?Answer: Yes. It is possible for government policy to prevent the formation of monopolies in various product markets as in the case of the United States Department of Justice, which can take legal action under the antitrust laws to prevent mergers and acquisitions that might reduce competition.16. In terms of the financial functions of a corporation, what responsibilities do administration of funds entail?Answer: Management of cash; maintenance of banking arrangements; receipt, custody and disbursement of the companys monies and securities; credit and collection management; management of pension funds; management of investments and custodial responsibilities.17. Discuss the liability a partnership faces.Answer: Unless otherwise specified, all partners have unlimited liability as in the sole proprietorship. However, it is possible to limit the liability for some partners called limited partners. At least one of the partners, called the general partner, has unlimited liability for the debts of the firm.18. Describe the advantages of the corporate form of business organization.Answer: The corporate form of ownership has the advantage that ownership shares can usually be transferred without disrupting the business. Limited liability is also anothe
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