Chapter 2: Business (Corporate) Finance

Multiple Choice Questions 1. Which of the following businesses is the least likely to be operated as a partnership? A. Accounting firms B. Doctors offices C. Dentists offices D. Steel foundry Level of difficulty: Medium Solution: D Most partnerships are formed in the professional services areas such as in accounting, investment banking, and medical professions. Factories (including a foundry) are the least likely to be operated as a partnership. 2. Which of the following statements is false? A. The limited liability partnership (LLP) is one of the two main partnership forms. B. Limited liability partnerships (LLP) are usually set up for tax reasons. C. In the limited and general partnerships form, the limited partners are passive investors. D. In the limited and general partnerships form, the general partner has unlimited liability. Level of difficulty: Difficult Solution: B The limited and general partnerships are generally formed for tax reasons. 3. Which of the following are the responsibilities of a corporation? A. Operate in the legal sense B. Act in the social interest C. Maximize the wealth of its shareholders D. All of the above Level of difficulty: Medium Solution: D All of the above are the responsibilities of a corporation. 4. Which of the following is the main concern from the point of view of a companys shareholders? A. IRR of the best division when investment is analyzed B. Preservation of the firm when risk is concerned C. Accounting return on investment when performance is appraised D. Market prices when performance is appraised Level of difficulty: Difficult Solution: D Market prices are the main concern of shareholders. 5. What is the most important purpose of share incentive plans? A. Compensate straight salary B. Align the interests of managers and shareholders C. Reward management
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D. Boost the share price Level of difficulty: Medium Solution: B 6. Which of the following is not a concern related to capital budgeting? A. The percentage of debt financing in the capital structure B. Whether or not to replace old equipment to boost output C. Whether to purchase or lease machinery D. Inventory level Level of difficulty: Medium Solution: A All except choice A are concerns of capital budgeting. 7. Who is the person in charge of the pure finance job (cash and credit management, risk management, etc.) in a company? A. Controller B. Treasurer C. Chief operating officer D. Accountant Level of difficulty: Easy Solution: B 8. Which of the following responsibilities does not usually belong to the controller? A. Compliance B. Credit management C. Tax management D. Budgeting Level of difficulty: Medium Solution: B Practice Problems 9. List and define the four major forms of a business organization. Level of difficulty: Easy Solution: The four major forms of a business organization are: i) Sole proprietorship a business owned and operated by one person ii) Partnership a business owned and operated by two or more people iii) Trust a legal organization where assets are owned and managed, or controlled by different parties iv) Corporation a business organized as a separate legal entity under corporation law, with ownership divided into transferable shares 10. Summarize the characteristics of the sole proprietorship. Level of difficulty: Easy

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Solution: A sole proprietorship is the easiest form of a business to set up. The owner is not separate from the business and therefore has unlimited liability. There is no continuity in a sole proprietorship. 11. State the main differences between corporations and sole proprietorships. Level of difficulty: Easy Solution: Unlike a sole proprietorship, a corporation is a distinct legal identity, which could be continued. Moreover, there is a very clear separation between ownership and control in the corporation, while in the sole proprietorship, ownership and control are usually not separated. Owners have limited liability in corporations versus unlimited liability in sole proprietorships. 12. List the main responsibilities of the treasurer and the controller. Level of difficulty: Easy Solution: The treasurer is responsible for forecasting, pension management, capital budgeting, cash management, credit management, financing, and risk management. The controller focuses on accounting issues, such as compliance, tax management, internal auditing, and budgeting. 13. State the statutory responsibilities of directors that are described in the Canada Business Corporations Act. Level of difficulty: Medium Solution: Every director and officer of a corporation in exercising their powers and discharging their duties shall: (a) Act honestly and in good faith with a view to the best interests of the corporation; and (b) Exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. 14. Provide an example of the conflicts of interest between shareholders and managers. Level of difficulty: Medium Solution: Shareholders focus more on short-term interest because they are well diversified and are able to absorb higher risk. On the other hand, a managers career is connected to the firm, so they are more conservative in taking risks. This conflict of interests between shareholders and managers may lead to conflicting corporate decisions. 15. Yellow Pages Income Fund is an Income Trust whose units trade on the Toronto Stock Exchange. On October 31, 2006, just before the Government of Canada announced new taxes for businesses organized as trusts, the price of each Yellow Pages unit was $15.12. The firm had been making regular payments to its owners at a rate of $1.03 per year; this means that the owners were getting a yield (or return) of 6.8 percent per year. The day after the governments announcement, the unit price fell to $12.26, but there was no immediate change in the payments to owners. What was the yield on Yellow Pages units on November 1, 2006? Topic: Types of Business Organizations Level of difficulty: Difficult Solution:
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The fall in the unit price was mirrored by an increase in the yield. The new yield was ($1.03/$12.26) = 8.4% per year. 16. Janice borrowed $100,000 from friends and family to start her company (a sole proprietorship). Recently, business has been poor, and Janice has decided to cease operations and liquidate the firm. She expects to obtain $108,000 from selling the assets of the company. How much money will the debt-holders receive, and how much will be left for Janice? Would these figures be different if the company had been a corporation? Topic: Limited Liability (Types of Business Organizations) Level of difficulty: Difficult Solution: When operating as a sole proprietorship, all of the assets of the company belong to the owner; the companys debts are also the owners debts. Janice will have to pay her friends and family (the debt-holders) the full $100,000 they are owed. This will leave her with $8,000. A corporation exists independently from its owners. The $108,000 obtained from selling the assets will first be used to pay the debt-holders what they are owed. Any remaining funds will be paid to Janice. Because the value of the assets is greater than the money owed to the debt-holders, the payments are the same as they were with the sole proprietorship. 17. Suppose Janice (see problem 16) only obtains $93,000 when she sells all the assets of the firm. How much money would the debt-holders receive if the business were a corporation? If it were a sole proprietorship? How much would Janice receive in each case? Topic: Limited Liability (Types of Business Organizations) Level of difficulty: Difficult Solution: The debt-holders will receive the entire $93,000 obtained from selling the assets. The remaining $7,000 that they were owed will not be paid because the company has no more funds. Furthermore, the limited liability of shareholders in a corporation means that the debtholders have no legal right to expect Janice to pay them the rest of the money. Nonetheless, Janice receives nothing from the asset sale. If the business were a sole proprietorship, the debt-holders would receive the $93,000 from the sale of assets. However, they would also have the right to force Janice to pay them the extra $7,000 they were owed. Janice would not only receive no money from the sale of the assets, she would have to pay the extra $7,000! 18. When you hired Dan to manage your business, you agreed to pay him a bonus of 10 percent of profits at the end of each year. The company now has a choice between two projects (it can only take on one of them). Project A will generate profits of $50,000 per year, and the detailed financial calculations show that it will increase the value of the firm by $123,100. Project B will generate profits of $40,000 per year, but will increase the firms value by $125,500. Which project is Dan likely to choose, and why? Which project would you, the owner of the firm, prefer? Topic: Agency Issues Level of difficulty: Difficult Solution:
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Dan is likely to prefer Project A because it will result in a $5,000 annual bonus for him, whereas Project B would provide only a $4,000 annual bonus. On the other hand, you would be better off choosing Project B as it creates more value. 19. As the CFO of your company, it falls to you to make the final decision on large expenditures. Recently, your controller has proposed purchasing a new computer system at a cost of $50,000. He believes the system will deliver savings of $60,000 in the accounting department, and could be useful to other departments as well. Your treasurer takes a decidedly different view of the proposal. She claims that the company will have to borrow money to buy the computer system, and this will cost $10,000 in interest. As well, she is concerned that the amount of savings promised by the controller wont materialize. Should you purchase the computer system? Topic: Corporate Finance and Finance Careers Level of Difficulty: Difficult Solution: The controllers numbers indicate that the computer system will add ($60,000 $50,000) = $10,000 of value to the firm. That would indicate that you should proceed with the purchase. In general, the corporate treasurer has responsibility for capital budgeting decisions of this sort, including estimating costs and savings, determining the need for financing, and considering any risks involved. In this case, the interest expense identified by the treasurer brings the net value created down to $0, so there is no net benefit to proceeding. Moreover, if the treasurers concerns about the level of savings pan out, this computer system could end up costing more than the value it creates. It would be best to heed the treasurer and not purchase the computer system.

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