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Chapter 1

An Introduction to Financial Management

True/False

1. The goal of the firm should be the maximization of profit.

Difficulty: Easy

Keywords: goal of firm, profit maximization

1. The goal of profit maximization is equivalent to the goal of maximization of share value.

Difficulty: Easy

Keywords: goal of firm, profit maximization

1. One of the problems associated with profit maximization is that it ignores the timing of a project’s return.

Difficulty: Moderate

Keywords: goal of firm, profit maximization

1. Although maximization of the market value of a firm’s common stock is a valid objective of the firm, it is not without its drawbacks since the effects of financial structure decisions are not reflected in this term.

Difficulty: Moderate

Keywords: goal of firm, market value of stock

1. For the risk-averse financial manager, the more risky a given course of action, the higher the expected return must be.

Difficulty: Moderate

Keywords: risk-return tradeoff

1. The financial manager should examine available risk-return trade-offs and make his decision based upon the greatest expected return.

Difficulty: Moderate

Keywords: risk-return tradeoff

1. Only a few financial decisions involve some sort of risk-return tradeoff.

Difficulty: Easy

Keywords: risk-return tradeoff

1. The goal of profit maximization ignores the timing of profit.

Difficulty: Moderate

Keywords: goal of firm, profit maximization, timing of cash flows

1. The sole proprietorship can be described as the absence of any legal business structure.

Difficulty: Moderate

Keywords: sole proprietorship

1. In a general partnership, all partners have unlimited liability for the actions of any one partner when that partner is conducting business for the firm.

Difficulty: Moderate

Keywords: general partnership

1. The corporation is the best form of organization in terms of raising capital.

Difficulty: Easy

Keywords: corporation

1. There is no legal distinction made between the assets of the business and the personal assets of the owners in the limited partnership.

Difficulty: Moderate

Keywords: limited partnership

1. The owners of a corporation enjoy unlimited liability.

Difficulty: Easy

Keywords: corporation

1. General partners have unrestricted transferability of ownership, while limited partners must have the consent of all partners to transfer their ownership.

Difficulty: Moderate

Keywords: general partnership, limited partnership

1. Ultimate control in a corporation is vested in the board of directors.

Difficulty: Easy

Keywords: corporation, board of directors

1. There are a significant number of legal requirements to follow when establishing a sole proprietorship.

Difficulty: Easy

Keywords: sole proprietorship

1. Limited partners may actively manage the business.

Difficulty: Easy

Keywords: sole proprietorship

1. The life of a corporation is not dependent upon the status of the investors.

Difficulty: Easy

Keywords: corporation, limited life

1. A sole proprietorship is the most desirable business form in all circumstances.

Difficulty: Easy

Keywords: sole proprietorship

1. In a sole proprietorship, the owner is personally responsible without limitation for the liabilities incurred.

Difficulty: Easy

Keywords: sole proprietorship

1. In a limited partnership, at least one general partner must remain in the association; the privilege of limited liability still applies to this partner.

Difficulty: Moderate

Keywords: limited partnership

1. In a general partnership, there is a distinction between business and personal assets.

Difficulty: Easy

Keywords: general partnership

1. In order to maximize shareholder wealth, a firm must consider historical costs as an integral part of their decision-making.

Difficulty: Moderate

Keywords: goal of firm, maximizing shareholder wealth

1. Financial management is concerned with the maintenance and creation of wealth.

Difficulty: Moderate

Keywords: goal of firm, wealth creation

1. Shareholder wealth is measured by the market value of the firm’s common stock.

Difficulty: Easy

Keywords: goal of firm, shareholder wealth maximization

1. The agency problem arises due to the separation of ownership and control in a firm.

Difficulty: Easy

Keywords: agency problem

1. There is little, if any, difference between a business error and an ethical error.

Difficulty: Easy

Keywords: ethical behavior

1. For markets to be efficient, price adjustments to new information must be correct.

Difficulty: Moderate

Keywords: efficient markets, price adjustments to new information

1. Ethical dilemmas frequently exist in finance.

Difficulty: Easy

Keywords: ethical dilemmas

1. Even though diversification can eliminate risk, it also makes it more difficult to measure a project’s or an asset’s risk.

Difficulty: Moderate

Keywords: risk and diversification

Multiple Choice

1. Which of the following statements best represents what finance is about?
2. How political, social, and economic forces affect corporations
3. Maximizing profits
4. Creation and maintenance of economic wealth
5. Reducing risk

Difficulty: Easy

Keywords: what is finance?

1. The goal of the firm should be:
2. Maximization of profits.
3. Maximization of shareholder wealth.
4. Maximization of consumer satisfaction.
5. Maximization of sales.

Difficulty: Easy

Keywords: goal of firm, shareholder wealth maximization

1. Consider the following equally likely project outcomes:

Profit

X Y

Pessimistic prediction $ 0 $500

Expected outcome $ 500 $500

Optimistic prediction $1000 $500

1. Project Y has less uncertainty than Project X.
2. Project X has more variability than Project Y.
3. a and b.
4. Since Projects X and Y have the same expected outcomes of $500, investors will view them as identical in value.

Difficulty: Moderate

Keywords: uncertainty, variability of outcomes

1. Consider the timing of the profits of the following certain investment projects:

Profit

L S

Year 1 $ 0 $ 3000

Year 2 $ 3000 $ 0

1. Project S is preferred to Project L.
2. Project L is preferred to Project S.
3. Projects S and L are equally desirable.
4. A goal of profit maximization would favor Project S only.

Difficulty: Moderate

Keywords: profit maximization, timing of cash flows

1. Maximization of shareholder wealth as a goal is superior to profit maximization because:
2. it considers the time value of the money.
3. following the shareholder wealth maximization goal will ensure high stock prices.
4. it considers uncertainty.
5. a and c.

Difficulty: Moderate

Keywords: goal of firm, shareholder wealth maximization

1. Which of the following best describes the goal of the firm?
2. The maximization of the total market value of the firm’s common stock
3. Profit maximization
4. Risk minimization
5. None of the above

Difficulty: Easy

Keywords: goal of firm, maximizing stock price

1. Why is maximizing shareholder wealth a better goal than maximizing profits?
2. Maximizing shareholder wealth places greater emphasis on the short term.
3. Maximizing profits ignores the uncertainty that is related to expected profits.
4. Maximizing shareholder wealth gives superior consideration to the entire portfolio of shareholder investments.
5. Maximizing profits gives too much weight to the tax position of shareholders.

Difficulty: Moderate

Keywords: goal of firm, shareholder wealth maximization, profit maximization

1. Profit maximization does not adequately describe the goal of the firm because:
2. profit maximization does not require the consideration of risk.
3. profit maximization ignores the timing of a project’s return.
4. maximization of dividend payout ratio is a better description of the goal of the firm.
5. a and b.

Difficulty: Moderate

Keywords: goal of firm, profit maximization

1. Which of the following goals of the firm is equivalent to the maximization of shareholder wealth?
2. Profit maximization
3. Risk minimization
4. Maximization of the total market value of the firm’s common stock
5. None of the above

Difficulty: Easy

Keywords: goal of firm, maximization of stock price

1. In finance, we assume that investors are generally:
2. neutral to risk.
3. averse to risk.
4. fond of risk.
5. none of the above.

Difficulty: Easy

Keywords: risk-averse investors

1. Consider cash flows for Projects X and Y such as:

Project X Project Y

Year 1 $3000 $ 0

Year 2 $ 0 $3000

A rational person would prefer receiving cash flows sooner because:

1. the money can be reinvested.
2. the money is nice to have around.
3. the investor may be tired of a particular investment.
4. the investor is indifferent to either proposal.

Difficulty: Moderate

Keywords: time value of money

1. Which of the following is not an advantage of the sole proprietorship?
2. Limited liability
3. No time limit imposed on its existence
4. No legal requirements for starting the business
5. None of the above

Difficulty: Moderate

Keywords: sole proprietorship

1. What is the chief disadvantage of the sole proprietorship as a form of business organization when compared to the corporate form?
2. Sole proprietorships are subject to double taxation of profits.
3. The cost of formation.
4. Inadequate profit sharing.
5. Owners have unlimited liability.

Difficulty: Moderate

Keywords: sole proprietorship

1. Which of the following is not true for limited partnerships?
2. Limited partners can only manage the business.
3. One general partner must exist who has unlimited liability.
4. Only the name of general partners can appear in the name of the firm.
5. Limited partners may sell their interest in the company.

Difficulty: Moderate

Keywords: limited partnerships

1. The true owners of the corporation are the:
2. holders of debt issues of the firm.
3. preferred stockholders.
4. board of directors of the firm.
5. common stockholders.

Difficulty: Easy

Keywords: corporation, shareholders, ownership

1. In terms of organizational costs, which of the following sequences is correct, moving from lowest to highest cost?
2. General partnership, sole proprietorship, limited partnership, corporation
3. Sole proprietorship, general partnership, limited partnership, corporation
4. Corporation, limited partnership, general partnership, sole proprietorship
5. Sole proprietorship, general partnership, corporation, limited partnership

Difficulty: Moderate

Keywords: business forms, organizational costs

1. Assume that you are starting a business. Further assume that the business is expected to grow very quickly and a great deal of capital will be needed soon. What type of business organization would you choose?
2. Corporation
3. General Partnership
4. Sole proprietorship
5. Limited partnership

Difficulty: Easy

Keywords: business forms, corporation, raising capital

1. Coplon, Inc., an industrial firm, earned $180,000 in dividends in 1993 on their stock holding in the Finco Company. How much of the dividends are excluded from Coplon’s taxable income?
2. $27,000
3. None
4. $126,000
5. $153,000

Difficulty: Easy

Keywords: taxes in business decisions

1. Which one of the following categories of owners enjoys limited liability?
2. General partners in a limited partnership
3. Shareholders (common stock) of a corporation
4. Sole proprietors
5. Both a & b

Difficulty: Moderate

Keywords: business forms, liability, shareholder liability

1. Which of the following is a characteristic of a limited partnership?
2. It allows one or more partners to have limited liability.
3. It requires one or more of the partners to be a general partner to whom the privilege of limited liability does not apply.
4. It prohibits the limited partners from participating in the management of the partnership.
5. all of the above.

Difficulty: Moderate

Keywords: limited partnership

1. Which of the following categories of owners have limited liability?
2. General partners
3. Sole proprietors
4. Shareholders of a corporation
5. Both a and b

Difficulty: Moderate

Keywords: business forms, limited liability

1. Which of the statements below is true?
2. The sole proprietorship and the general partnership both feature unlimited liability.
3. It is very complicated (legally) to establish a corporation.
4. No legal criterion exists for a general partnership.
5. All of the above are true.

Difficulty: Moderate

Keywords: business forms, characteristics of business forms

1. Which of the following types of business forms is the most ideal in terms of attracting new capital?
2. Sole proprietorship
3. Limited partnership
4. General partnership
5. A public corporation

Difficulty: Easy

Keywords: business forms, raising capital

1. Which forms of organization are free of initial legal requirements?
2. Sole proprietorship
3. General partnership
4. Corporation
5. Both a and b

Difficulty: Easy

Keywords: business forms, legal requirements

1. For these types of organization, no distinction is made between business and personal assets.
2. Sole proprietorship
3. General partnership
4. Limited partnership
5. All of the above
6. Both a and b

Difficulty: Moderate

Keywords: business forms, business versus personal assets

1. Which of the following is a significant disadvantage of a general partnership?
2. The cost of forming it is high.
3. Each partner is fully responsible for the liabilities incurred by the partnership.
4. There is a risk associated with the industry in which it operates.
5. Forming the business is very complex.

Difficulty: Moderate

Keywords: business forms, general partnership

1. If managers are making decisions to maximize shareholder wealth, then they are primarily concerned with making decisions that should:
2. positively affect profits.
3. increase the market value of the firm’s common stock.
4. either increase or have no effect on the value of the firm’s common stock.
5. accomplish all of the above.

Difficulty: Moderate

Keywords: goal of firm, shareholder wealth maximization

1. Profit maximization is not an adequate goal of the firm when making financial decisions because:
2. it does not necessarily reflect shareholder wealth maximization.
3. it ignores the risk inherent in different projects that will generate the profits.
4. it ignores the timing of a project’s returns.
5. all of the above are correct.

Difficulty: Moderate

Keywords: goal of firm, profit maximization

1. Which of the following goals is in the best long-term interest of stockholders?
2. Profit maximization
3. Risk minimization
4. Maximizing of the market value of the existing shareholders’ common stock
5. Maximizing sales revenues

Difficulty: Moderate

Keywords: maximizing stock price

1. Which of the following factors enable a public corporation to grow to a greater extent, and perhaps at a faster rate, than a partnership or a proprietorship?
2. Unlimited liability of shareholders
3. Access to the capital markets
4. Limited life
5. Elimination of double taxation on corporate income
6. All of the above

Difficulty: Moderate

Keywords: corporation, raising capital

1. Which of the following should be considered when assessing the financial impact of business decisions?
2. The amount of projected earnings
3. The risk-return tradeoff
4. The timing of projected earnings; i.e., when they are expected to occur
5. The amount of the investment in a given project
6. All of the above

Difficulty: Easy

Keywords: financial impact of business decisions

1. Financial management is concerned with which of the following?
2. Creating economic wealth
3. Making investment decisions that optimize economic value
4. Making business decisions that optimize economic wealth
5. Raising capital that is needed for growth
6. All of the above

Difficulty: Easy

Keywords: focus of financial management

1. Which of the following forms of business organization is the dominant economic force in the United States?
2. The sole proprietorship
3. The general partnership
4. The limited partnership
5. The joint venture
6. The corporation

Difficulty: Moderate

Keywords: business forms, corporation

1. Which of the following reasons is most responsible for corporations being the most important form of business organization in the United States?
2. Corporations have limited life.
3. Stockholders have unlimited liability.
4. Corporations are subject to less government regulation than the other forms of business organization.
5. Corporations have the ability to raise larger sums of capital than the other forms of business organization.
6. Corporations are subjected to less taxation than the other forms of business organization.

Difficulty: Moderate

Keywords: business forms, corporation

1. If one security has a greater risk than another security, how will investors respond?
2. They will require a lower rate of return for the investment that has greater risk.
3. They would be indifferent regarding their expectation of rates of return for either investment.
4. They will require a higher rate of return for the investment that has greater risk.
5. None of the above.

Difficulty: Moderate

Keywords: efficient capital markets

1. How could you compensate an investor for taking on a significant amount of risk?
2. Increase the expected rate of return.
3. Raise more debt capital.
4. Offer stock at a higher price.
5. Increase sales.

Difficulty: Moderate

Keywords: risk-return tradeoff

1. If an investor had a choice of receiving $1,000 today, or $1,000 in five years, which would the average investor prefer?
2. $1,000 in five years because they are not good at saving money.
3. $1,000 today because it will be worth more than $1,000 received in five years.
4. $1,000 in five years because it will be worth more than $1,000 received today.
5. Investors would be indifferent to when they would receive the $1,000.
6. None of the above.

Difficulty: Moderate

Keywords: time value of money

1. Why do investors prefer receiving cash sooner rather than later, according to finance theory?
2. Incremental profits are greater than accounting profits.
3. Money received earlier can be reinvested and returns can be increased.
4. Tax considerations are important when investing.
5. Diversification leads to increased value.

Difficulty: Moderate

Keywords: time value of money

1. Which of the following would be most likely to align the interests of managers and shareholders?
2. Fixed but high salaries
3. Large bonuses
4. Stock options
5. All of the above
6. None of the above

Difficulty: Moderate

Keywords: agency problem, stock options

1. What does the agency problem refer to?
2. The conflict that exists between the board of directors and the employees of the firm
3. The problem associated with financial managers and Internal Revenue agents
4. The conflict that exists between stockbrokers and investors
5. The problem that results from potential conflicts of interest between the manager of a business and the stockholders
6. None of the above

Difficulty: Moderate

Keywords: agency problem

1. A limited liability company (LLC) is:
2. able to retain limited liability for owners.
3. taxed like a corporation.
4. a cross between a partnership and a corporation.
5. a and c.
6. all of the above.

Difficulty: Moderate

Keywords: business form, LLC

1. Purchasing a security of a company that is issuing their stock for the first time publicly would be considered:
2. a secondary market transaction.
3. an initial public offering.
4. a seasoned new issue.
5. both a and b.

Difficulty: Moderate

Keywords: financial markets

1. Investors choose to invest in higher risk investments because these investments offer higher:
2. expected returns.
3. inflation.
4. actual returns.
5. future consumption.

Difficulty: Moderate

Keywords: risk and return tradeoff

1. Foregoing the earning potential of a dollar today is referred to as the:
2. time value of money.
3. opportunity cost concept.
4. risk/return tradeoff.
5. creation of wealth.

Difficulty: Moderate

Keywords: opportunity cost

1. In measuring value, the focus should be on:
2. cash flow.
3. accounting profits.
4. time value of money.
5. earnings per share.

Difficulty: Moderate

Keywords: cash flow versus profits

1. Which of the following is true regarding accounting profits?
2. Received by the firm and reinvested
3. Reflects money in hand
4. Represents actual money received and paid out
5. Equals cash in the bank

Difficulty: Easy

Keywords: cash flow versus profits

1. Which of the following statements is true regarding competitive markets?
2. Large profits exist over the long run.
3. Product differentiation produces insulation for competitors.
4. Cost advantages attract new entrants.
5. Both b and c.

Difficulty: Moderate

Keywords: competitive markets

1. Which of the following decrease new competition in competitive markets?
2. Economies of scale
3. Proprietary technology
4. Product differentiation
5. Both a and b
6. All of the above

Difficulty: Moderate

Keywords: competitive markets

1. Cost advantages in competitive markets:
2. have the potential to create large profits.
3. deter new entrants from entering.
4. can be created by economies of scale.
5. all of the above.

Difficulty: Moderate

Keywords: competitive markets

1. Which of the following is a characteristic of an efficient market?
2. Small number of individuals.
3. Opportunities exist for investors to profit from publicly available information.
4. Security prices reflect fair value of the firm.
5. Immediate response occurs for new public information.

Difficulty: Moderate

Keywords: market efficiency

1. Diversification increases when ________ decreases.
2. variability
3. return
4. risk
5. a and c
6. all of the above

Difficulty: Moderate

Keywords: diversification

1. Difficulty in finding profitable projects is due to:
2. social responsibility.
3. competitive markets.
4. ethical dilemmas.
5. opportunity costs.

Difficulty: Moderate

Keywords: competitive markets

1. Corporations receive money from investors with:
2. initial public offerings.
3. seasoned new issues.
4. primary market transactions.
5. a and b.
6. all of the above.

Difficulty: Moderate

Keywords: financial markets

1. IBM issuing new shares of common stock would be classified as:
2. a new seasoned issue.
3. an initial public offering.
4. a secondary market transaction.
5. a and b.

Difficulty: Moderate

Keywords: financial markets

1. According to the agency problem, _________ represent the principals of a corporation.
2. shareholders
3. managers
4. employees
5. suppliers

Difficulty: Moderate

Keywords: agency problem

1. Investors prefer $1 today versus $1 in the future due to:
2. time value of money.
3. opportunity cost.
4. agency problems.
5. a and b.
6. all of the above.

Difficulty: Moderate

Keywords: time value of money, opportunity cost

1. Which of the following is true regarding an initial public offering?
2. The corporation gets proceeds from the investor.
3. Investors get proceeds from other investors.
4. The security is sold for the first time to the public.
5. Both a and c.
6. All of the above.

Difficulty: Moderate

Keywords: financial markets

1. Which of the following is not a principle of basic financial management?
2. Risk/return tradeoff
3. Incremental cash flow counts
4. Efficient capital markets
5. Profit is king

Difficulty: Moderate

Keywords: basic financial management principles

1. Which of the following statements is false?
2. All risk can be diversified away.
3. Measuring a project’s risk is difficult.
4. Projects should focus on incremental cash flows.
5. Taxes play a significant role in project analysis.

Difficulty: Moderate

Keywords: risk, incremental cash flow, projects and taxes

1. The opening of new international markets to the U.S. can be attributed to:
2. acceptance of a free market system by third world countries.
3. regulation of U.S. industries.
4. increase in information technology.
5. a and c.
6. all of the above.

Difficulty: Moderate

Keywords: global finance

Short-Answer Questions

1. Briefly discuss mechanisms that can be used to align the interests of shareholders and managers.

Difficulty: Moderate

Keywords: overcoming the agency problem

1. Briefly discuss why financial decision makers must focus on incremental cash flows when evaluating new projects.

Difficulty: Hard

Keywords: incremental cash flows, project valuation

1. Discuss the risk/return tradeoff and how it relates to finance.

Difficulty: Moderate

Keywords: risk/return tradeoff

1. Compare and contrast primary market and secondary market transactions as it relates to the flow of funds in the transactions.

Difficulty: Moderate

Keywords: primary market transactions, secondary market transactions

1. Discuss how new entrants are deterred from entering a competitive market.

Difficulty: Hard

Keywords: competitive markets

1. What is incremental cash flow and how is it used in project analysis?

Difficulty: Moderate

Keywords: incremental cash flow