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
Chapter 1: An Overview of Financial Management
Page 1
(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
Page 2
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.
(1.3) Agency
12
.
Which of the following statements is most correct?
Answer: d
Diff: E
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 company’s 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 company’s stock.
c. The board of directors has become more vigilant in its oversight of
the company’s management.
d. Statements b and c are correct.
e. All of the statements above are correct.
Chapter 1: An Overview of Financial Management
Page 3
(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.
(1.5) Interest rates
17
.
Which of the following statements is CORRECT?
Answer: a
Diff: E
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.
Page 4
Chapter 1: An Overview of Financial Management
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 firm’s fundamental value is its market value.
b. A firm’s fundamental value is the present value of its future free
cash flows.
c. A firm’s market price is usually greater than its fundamental value.
d. A firm’s fundamental value is usually greater than its market price.
e. A firm’s 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.
Chapter 1: An Overview of Financial Management
Page 5
(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:
Answer: a
Diff: M
a.
b.
c.
d.
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.
Page 6
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
Answer: c
Diff: M
the value added to customers.
the value added to management.
the firm’s true profitability.
management compensation.
stock price.
Chapter 1: An Overview of Financial Management
(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 company’s financial statements.
d. Sarbanes-Oxley requires the CEO sign and certify the company’s
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.
(1.5) Interest rates
Chapter 1: An Overview of Financial Management
Answer: d
Diff: M
Page 7
30
.
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.
Page 8
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.
Chapter 1: An Overview of Financial Management
CHAPTER 1
ANSWERS AND SOLUTIONS
Chapter 1: An Overview of Financial Management
Page 9
1.
(1.2) Goal of firm
Answer: b
Diff: E
2.
(1.2) Goal of firm
Answer: b
Diff: E
3.
(1.2) Managerial incentives
Answer: b
Diff: E
4.
(1.2) Social welfare and finance
Answer: b
Diff: E
5.
(1.2) Social welfare and finance
Answer: a
Diff: E
6.
(1.3) Agency
Answer: b
Diff: E
7.
(1.3) Agency
Answer: b
Diff: E
8.
(1.3) Agency
Answer: a
Diff: E
9.
(1.2) Managerial incentives
Answer: a
Diff: M
10.
(1.3) Hostile takeovers
Answer: b
Diff: M
11.
(1.2) Goal of firm
Answer: d
Diff: E
12.
(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.
13.
(1.3) Agency
Answer: a Diff: E
Statement a is correct; the other statements are false.
Restrictive
covenants resolve differences between bondholders and stockholders.
14.
(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.
15.
(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.
16.
(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.
17.
(1.5) Interest rates
18.
(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.
19.
(1.2) Fundamental value
Answer: b Diff: M N
Statement b is true. An investor’s 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 investor’s
intrinsic value for the stock.
Answer: a
EASY
20
. (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
21.
(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.
22.
(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.
23
. (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 CEO’s
personal situation.
24
. (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.
25
. (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
firm’s true profitability.
26
. (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.
27
. (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.
28
. (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.
29.
(1.5) Security prices and interest rates
Answer: e
Diff: M
30.
(1.5) Interest rates
Answer: d
Diff: M
31.
(1.5) Interest rates
Answer: e Diff: M
An increase in the demand for capital by businesses will increase interest
rates in the economy.