Chapter One
Financial Economics
This chapter contains 48 multiple choice questions, 20 short problems and 5 longer problems.
Multiple Choice
- The primary goal of corporate management is to ______shareholder wealth.
(a)minimize
(b)maximize
(c)leverage
(d)mitigate
Answer: (b)
- A ______stock market imposes ______discipline on managers to take actions to maximize the market value of the firm’s shares.
(a)competitive, strong
(b)dispersed, weak
(c)mature, no
(d)dispersed, strong
Answer: (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)household
Answer: (a)
4. ______is anything that has economic value.
(a)A partnership
(b)An asset
(c)A balance sheet
(d)An income statement
Answer: (b)
5. A household’s wealth or net worth is measured by the value of its ______minus its ______.
(a)liabilities; assets
(b)assets; liabilities
(c)stocks; bonds
(d)bonds; liabilities
Answer: (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 finance
Answer: (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; variable
Answer: (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 planning
Answer: (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 firm
Answer: (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 corporations
Answer: (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 Billy’s net worth.
(a)$135,000
(b)$123,000
(c)$497,000
(d)$37,000
Answer: (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 Marlowe’s net worth.
(a)$58,000
(b)$123,000
(c)$22,000
(d)$37,000
Answer: (c)
13. An advantage of the corporate form of ownership is ______.
(a)no liability
(b)unlimited liability
(c)limited liability
(d)CEO liability
Answer: (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 above
Answer: (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 gathering
Answer: (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 planning
Answer: (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 premiums
Answer: (c)
18. A problem with using the profit maximization criterion is ______.
(a)deciding which period’s 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 firm’s production technology
(b)the wealth, preferences, and other investment opportunities of the owners
(c)the historic costs of the firm’s infrastructure
(d)the firm’s ability to meet its projected goals
Answer: (b)
20. One place to look for a statement of the goals of a corporation’s top managers is the ______.
(a)balance sheet
(b)income statement
(c)annual report
(d)bankruptcy filing
Answer: (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 inexpensive
Answer: (a)
22. Management’s 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 prices
Answer: (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)Shareholders
Answer: (d)
24. ______is the founder of modern portfolio theory.
(a)Harry Markowitz
(b)Merton Miller
(c)William Sharpe
(d)Bill Gates
Answer: (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, GmbH
Answer: (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, LTD
Answer: (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; accountants
Answer: (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 liability
Answer: (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 firm’s 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 above
Answer: (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 disapproval
Answer: (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 directors
Answer: (c)
33. All of the following departments typically report to the chief financial officer (CFO) except:
(a)marketing
(b)financial planning
(c)treasury
(d)control
Answer: (a)
34. The treasurer’s job includes managing all of the following except:
(a)the firm’s 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 acquisitions
Answer: (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 expenditures
Answer: (c)
- 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)
- 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)
- 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 above
Answer: (d)
- The controller’s 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 above
Answer: (b)
- The basic unit of analysis in capital budgeting is the ______.
(a)financing project
(b)investment project
(c)strategic project
(d)variable project
Answer: (b)
- 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 above
Answer: (d)
- Preferred stock, bonds, and convertible securities are also known as ______.
(a)nonmarketable claims
(b)standardized securities
(c)variable securities
(d)covenants
Answer: (b)
- The basic unit of analysis in capital structure decisions is the ______.
(a)firm as a whole
(b)investment project
(c)firm’s personnel
(d)financial system
Answer: (a)
- 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 mix
Answer: (d)
- Which of the following is not a financial function of a corporation?
(a)investor relations
(b)tax administration
(c)provision of capital
(d)regulatory legislation
Answer: (d)
- 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 above
Answer: (a)
- 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 executives
Answer: (b)
- 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 Oscar’s net worth.
(a)$3.12 million
(b)$5.28 million
(c)$7.28 million
(d)$8.4 million
Answer: (b)
Short Problems
- 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.
- 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.
- 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.
- 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 Siggy’s 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)
= $39,000
- 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 period’s 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?
- 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 Kecia's 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
= $11,000
- 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.
- 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 firm’s 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.
- 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 firm’s current shareholders by maximizing market value. If managers fail to maximize the market value of the firm’s shares, the firm will be vulnerable to a takeover in which the managers may lose their jobs.
- 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.
- 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 firm’s 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 corporation’s various business units. The controller will also be involved with preparation of financial statements for use by shareholders, creditors and regulatory authorities.
- 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.
- 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.
- 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 company’s monies and securities; credit and collection management; management of pension funds; management of investments and custodial responsibilities.
- 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.
- 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 another advantage of the corporate form. In this case, if the corporation fails to pay its debts, the creditors can seize the assets of the corporation but have no recourse to the personal assets of the shareholders.
- Briefly outline the process of capital budgeting.
Answer: The process of capital budgeting includes identifying ideas for new investment projects, evaluating them, deciding which ones to undertake, and then implementing them.
- Briefly discuss the process of working capital management.
Answer: Working capital management refers to the day-to-day financial affairs of the business, such as whether to extend credit to customers or demand cash on delivery or managing cash flow.
Longer Problems
- Describe the four basic types of financial decisions faced by householders.
Answer: Investment decisions – whether to invest in stocks or bonds
Consumption/Savings Decisions – how much to save for one’s retirement or a child’s education
Risk management decisions – whether to buy disability insurance
Financing decisions – what type of loan to adopt in order to finance the purchase of a home or