CHAPTER 1 AN OVERVIEW OF FINANCIAL MANAGEMENT

(Difficulty: E = Easy, M = Medium, and T = Tough)

True-False Easy:
(1.2) Goal of firm Answer: b Diff: E 1 . The proper goal of the financial manager should be to maximize the firm's expected profit, since this will add the most wealth to each of the individual shareholders (owners) of the firm. a. True b. False (1.2) Goal of firm Answer: b Diff: E 2 . If a firm has a single owner, we may say that the proper goal of a financial manager would be to maximize the firm's earnings per share. a. True b. False (1.2) Managerial incentives Answer: b Diff: E 3 . Executive stock options are shares of stock awarded to managers on the basis of corporate performance. a. True b. False (1.2) Social welfare and finance Answer: b Diff: E 4 . The goal of maximizing stock price is a detriment to society in that few of the actions that result in maximization of stock price also benefit society. a. True b. False (1.2) Social welfare and finance Answer: a Diff: E 5 . If a firm's managers want to maximize stock price it is in their best interests to operate efficient, low-cost plants, develop new and safe products that consumers want, and maintain good relationships with customers, suppliers, creditors, and the communities in which they operate. a. True b. False

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(1.3) Agency Answer: b Diff: E 6 . An agency relationship exists when one or more persons hire another person to perform some service but withhold decision-making authority from that person. a. True b. False (1.3) Agency Answer: b Diff: E 7 . If a firm's stock price falls during the year, this indicates that the firm's managers are not acting in shareholders' best interests. a. True b. False (1.3) Agency Answer: a Diff: E 8 . An agency problem exists between stockholders and managers. A second agency problem arises between stockholders and creditors. a. True b. False

Medium:
(1.2) Managerial incentives Answer: a Diff: M 9 . In a competitive marketplace, if managers deviate too far from making decisions that are consistent with stockholder wealth maximization, they risk being disciplined by the market. Part of this discipline involves the threat of being taken over by groups who are more aligned with stockholder interests. a. True b. False (1.3) Hostile takeovers Answer: b Diff: M 10 . A hostile takeover is a method of seizing control of a company and involves an action taken against the opposition of incumbent management. However, this action is typically motivated by a desire to control the firm's assets and is rarely motivated by a low share price. a. True b. False

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Chapter 1: An Overview of Financial Management

Multiple Choice: Conceptual Easy:

(1.2) Goal of firm Answer: d Diff: E 11 . The primary goal of a publicly-owned firm interested in serving its stockholders should be to a. b. c. d. e. Maximize Maximize Minimize Maximize Maximize expected total corporate profit. expected EPS. the chances of losses. the stock price per share. expected net income. Answer: d Diff: E

(1.3) Agency 12 . Which of the following statements is most correct?

a. Compensating managers with stock can reduce the agency problem between stockholders and managers. b. Restrictions are included in credit agreements to protect bondholders from the agency problem that exists between bondholders and stockholders. c. The threat of a takeover can reduce the agency problem between bondholders and stockholders. d. Statements a and b are correct. e. All of the statements above are correct. (1.3) Agency 13 . Which of the following work stockholders and bondholders? to reduce agency Answer: a conflicts Diff: E between

a. Including restrictive covenants in the companys bond contract. b. Providing managers with a large number of stock options. c. The passage of laws which make it easier for companies to resist hostile takeovers. d. Statements b and c are correct. e. All of the statements above are correct. (1.3) Agency Answer: d Diff: E 14 . Which of the following actions are likely to reduce the agency problem between stockholders and managers? a. Congress passes a law that severely restricts hostile takeovers. b. A manager receives a lower salary but receives additional shares of the companys stock. c. The board of directors has become more vigilant in its oversight of the companys management. d. Statements b and c are correct. e. All of the statements above are correct.

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(1.3) Agency Answer: b Diff: E 15 . Which of the following actions are likely to reduce agency conflicts between stockholders and managers? a. b. c. d. e. Paying managers a large fixed salary. Increasing the threat of corporate takeover. Placing restrictive covenants in debt agreements. All of the statements above are correct. Statements b and c are correct.

(1.3) Managerial incentives Answer: e Diff: E 16 . Which of the following mechanisms is used to motivate managers to act in the interests of shareholders? a. b. c. d. e. Bond covenants. The threat of a takeover. Executive stock options. Statements a and b are correct. Statements b and c are correct. Answer: a Diff: E

(1.5) Interest rates 17 . Which of the following statements is CORRECT?

a. If expected inflation increases, interest rates are likely to increase. b. If individuals in general increase the percentage of their income that they save, interest rates are likely to increase. c. If companies have fewer good investment opportunities, interest rates are likely to increase. d. Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities. e. Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills.

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Medium:
(1.2) Valuation 18 . Which of the following statements is most correct? Answer: e Diff: M

a. Free cash flows are called free because the cost of capital for these cash flows is zero. b. Stock is valuable only because it generates cash flows for the investor. c. Managers can affect firm value by changing the riskiness of its cash flows. d. (a) and (b) are correct. e. (b) and (c) are correct. (1.2) Fundamental value 19 . Which of the following statements is most correct? Answer: b Diff: M N

a. A firms fundamental value is its market value. b. A firms fundamental value is the present value of its future free cash flows. c. A firms market price is usually greater than its fundamental value. d. A firms fundamental value is usually greater than its market price. e. A firms fundamental value is its book value. (1.2) Goal of firm 20 . Which of the following statements is most correct? Answer: e Diff: M

a. Firms that try to maximize their stock values will tend to lay off employees to cut costs. b. Firms that try to maximize their stock values will raise the prices of their products, gouging customers and driving them away. c. Anti-pollution laws are unnecessary because firms will choose not to pollute because that is in their best interests. d. The government should allow monopolies to operate without regulation so that they may maximize their shareholders wealth. e. Newly-privatized firms generally hire more employees. (1.3) Agency 21 . Which of the following statements is most correct? Answer: c Diff: M

a. Agency conflicts between stockholders and managers are not really a problem when outsiders (i.e., non-managers) own shares in a corporation. b. Managers may operate in stockholders' best interests, or managers may operate in their own personal best interests. As long as managers stay within the law, there are no effective controls that stockholders can implement to control managerial decision making. c. The agency conflicts between bondholders and stockholders can be reduced with the use of bond covenants. d. An agency relationship exists when one or more persons hire another person to perform some service but withhold decision-making authority from that person. e. All of the statements above are false.

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(1.3) Agency 22 . Which of the following statements is most correct?

Answer: d

Diff: M

a. One of the ways in which firms can mitigate or reduce agency problems between bondholders and stockholders is by increasing the amount of debt in the capital structure. b. The threat of takeover is one way in which the agency problem between stockholders and managers can be alleviated. c. Managerial compensation can be structured to reduce agency problems between stockholders and managers. d. Statements b and c are correct. e. All of the statements above are correct. (1.3) Agency Answer: d 23 . Which of the following is an example of a moral hazard? Diff: M

a. A CEO is awarded $100,000 worth of executive stock options, which he exercises two years later for $1,000,000. b. A company borrows $1,000,000 for investment in equipment, but uses the money instead to repurchase stock. c. A company declares bankruptcy, but instead of being liquidated, it is reorganized and one set of bondholders who are owed $10 million accept $3 million in payment for the debt. d. A CEO orders the headquarters moved just so he can have a nicer office. e. A group of institutional stockholders votes to oust management. (1.3) Agency 24 . A moral hazard problem arises when: a. b. c. d. Answer: a Diff: M

An agent takes unobserved actions on his own behalf. A principal hires another individual to perform some service. Firms borrow money from bondholders. Stockholders have to incur costs to make managers act to maximize stock price. e. Managers are granted performance shares. (1.3) EVA 25 . Which of the following statements is most correct? a. b. c. d. e. EVA EVA EVA EVA EVA is is is is is a a a a a measure measure measure measure measure of of of of of the value added to customers. the value added to management. the firms true profitability. management compensation. stock price. Answer: c Diff: M

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(1.4) Transparency 26 . Which of the following statements is most correct?

Answer: b

Diff: M

a. A market is transparent when trading is inexpensive. b. A market is transparent when accurate information is available to all market participants. c. A transparent market has few regulations. d. A transparent market has many opportunities for trading on insider information. e. A market is transparent when everyone knows who the person is that they are trading with. (1.4) Sarbanes-Oxley 27 . Which of the following statements is most correct? Answer: d Diff: M

a. Sarbanes-Oxley requires the Securities Exchange Commission to audit public companies financial statements. b. Sarbanes-Oxley made it illegal for company executives to trade on insider information. c. Sarbanes-Oxley requires the Chairman of the Board of Directors to sign and certify the companys financial statements. d. Sarbanes-Oxley requires the CEO sign and certify the companys financial statements. e. Sarbanes-Oxley requires company executives to disclose their fraudulent activities in a timely and accurate manner. (1.4) Sarbanes-Oxley 28 . Which of the following statements is most correct? Answer: e Diff: M

a. Sarbanes-Oxley established a new Federal agency, the Public Company Auditing Board, to audit public companies financial statements. b. Sarbanes-Oxley prohibited investment banks from allowing their analysts to make recommendations on stocks the investment banks do business with. c. Sarbanes-Oxley requires that either the CEO or CFO hand-deliver the annual and quarterly financial statements to the SEC. d. Sarbanes-Oxley requires that auditors maintain extensive records to document that their consulting and auditing services for a given company are not conflicting. e. Sarbanes-Oxley prohibits auditors from providing consulting services to the companies they audit. (1.5) Security prices and interest rates Answer: e Diff: M 29 . Suppose the U.S. Treasury announces plans to issue $50 billion of new bonds. Assuming the announcement was not expected, what effect, other things held constant, would that have on bond prices and interest rates? a. b. c. d. e. Prices and interest rates would both rise. Prices would rise and interest rates would decline. Prices and interest rates would both decline. There would be no changes in either prices or interest rates. Prices would decline and interest rates would rise. Answer: d Diff: M Page 7

(1.5) Interest rates Chapter 1: An Overview of Financial Management

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Which of the following would be most likely to lead to higher interest rates on all debt securities in the economy? a. b. c. d. Households start saving a larger percentage of their income. The economy moves from a boom to a recession. The level of inflation begins to decline. Corporations step up their expansion plans and thus increase their demand for capital. e. The Federal Reserve uses monetary policy in an attempt to stimulate the economy.

(1.5) Interest rates Answer: e Diff: M 31 . Which of the following factors would be most likely to lead to an increase in interest rates in the economy? b. c. d. e. a. Households reduce their consumption and increase their savings. The Federal Reserve decides to try to stimulate the economy. There is a decrease in expected inflation. The economy falls into a recession. Most businesses decide to modernize and expand their manufacturing capacity, and to install new equipment to reduce labor costs.

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Chapter 1: An Overview of Financial Management

CHAPTER 1 ANSWERS AND SOLUTIONS

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1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

(1.2) Goal of firm (1.2) Goal of firm (1.2) Managerial incentives (1.2) Social welfare and finance (1.2) Social welfare and finance (1.3) Agency (1.3) Agency (1.3) Agency (1.2) Managerial incentives (1.3) Hostile takeovers (1.2) Goal of firm

Answer: b Answer: b Answer: b Answer: b Answer: a Answer: b Answer: b Answer: a Answer: a Answer: b Answer: d

Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: M Diff: M Diff: E

(1.3) Agency Answer: d Diff: E Both statements a and b are correct; therefore, statement d is the correct choice. The threat of a takeover alleviates the agency problem between managers and stockholders, not between bondholders and stockholders. (1.3) Agency Answer: a Diff: E Statement a is correct; the other statements are false. Restrictive covenants resolve differences between bondholders and stockholders. (1.3) Agency Answer: d Diff: E Statement a will serve to increase the agency problems by preventing takeovers. Both statements b and c will reduce agency problems. (1.3) Agency Answer: b Diff: E Statement b is true. Corporate takeovers are most likely to occur when a firm is underperforming. Managers who fear losing their jobs will try to maximize shareholder wealth. The other statements are false. Statement a will exacerbate agency conflict, while statement c reduces the agency conflict between stockholders and bondholders. (1.3) Managerial incentives Answer: e Diff: E Statements b and c are true; therefore, statement e is the correct choice. Statement a is false, bond covenants force managers to act in the interest of bondholders. (1.5) Interest rates Answer: a EASY

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(1.2) Valuation Answer: e Diff: M Statement e is true. Stock is valuable only to the extent that it generates cash flows for the investor, and managers can impact the value of the firm by changing the size, riskiness, or timing of its cash flows. (1.2) Fundamental value Answer: b Diff: M N Statement b is true. An investors intrinsic value for a stock is the value that he or she would put on the investment. The market price is determined by the marginal investor, hence the market price is the marginal investors intrinsic value for the stock.

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. (1.2) Goal of firm Answer: e Diff: M Statement e is correct. Generally the performance of firms that privatized improves, causing them to hire more employees as they grow.

are

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(1.3) Agency Answer: c Diff: M Statement c is true. Statement a is false because agency conflicts can and do occur when outsiders own shares in a corporation. Statement b is false. Even if managers stay within the law, the threat of firing and/or the threat of takeover may be used to keep managers interests aligned with those of the shareholders. Statement d is false because the conflict exists when the decision-making authority is delegated to that person. (1.3)Agency Answer: d Diff: M Statement d is most correct. Statement a is incorrect, because increasing the amount of debt can increase agency problems. . (1.3) Agency Answer: d Diff: M Statement d is correct. A moral hazard is an unobservable action the agent takes on his behalf to the detriment of the principal. In this case, the move is not necessary for the company. It is only to better the CEOs personal situation. . (1.3) Agency Answer: a Diff: M Statement a is correct. The definition of a moral hazard problem is when an agent undertakes unobservable actions on his own behalf to the detriment of the principal. . (1.3) EVA Answer: c Diff: M Statement c is correct. EVA, or Economic Value Added, is after-tax operating profit less the cost of all capital used by the firm. It is a measure of the firms true profitability. . (1.4) Transparency Answer: b Diff: M Statement b is correct. A market is transparent when reliable and accurate information is available to all market participants. . (1.4) Sarbanes-Oxley Answer: d Diff: M Statement d is correct. One of the provisions of the SOX law is that the CEO must sign and personally certify that the annual and quarterly statements are complete and accurate. . (1.4) Sarbanes-Oxley Answer: e Diff: M Statement e is correct. Accounting firms may provide auditing or consulting services to a company, but not both. This is to eliminate the conflict of interests that occurred when auditors were complicit in companies fraudulent activities. (1.5) Security prices and interest rates (1.5) Interest rates Answer: e Answer: d Diff: M Diff: M

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(1.5) Interest rates Answer: e Diff: M An increase in the demand for capital by businesses will increase interest rates in the economy.