Quiz 1

Why do all shareholders agree on the same goal for the financial​ manager? ​ (Select all the choices that​ apply.) A. All of the decisions by the financial manager are made within the context of the overriding goal of financial management—to maximize the wealth of the ​owners, the stockholders. B. All of the decisions by the financial manager are made within the context of the overriding goal of financial management—to maximize the wealth of the corporation. C. The stockholders have invested in the​ corporation, putting their money at risk to become the managers of the corporation. D. The stockholders have invested in the​ corporation, putting their money at risk to become the owners of the corporation.

A and D

You want to pool your resources with your best friend and start your own telecommunications firm. However, you are concerned about the risk this business poses to your accumulated personal wealth. To limit your exposure, you and your friend should organize the business: a. As a general partnership b. As a limited partnership c. As a sole proprietorship d. As a corporation or PLC e. As a real estate investment trust f. none of these.

As a corporation or PLC

TRUE/FALSE & EXPLAIN: The goal of a financial manager is to maximize earnings.

FALSE. The goal of the financial manager is to increase the value of the company (increase shareholder wealth). Maximizing earnings is not the same thing. First of all, earnings are not cash flows, but are accounting constructs instead. You can't buy anything with earnings, but you can buy things with cash flows. Second, which earnings should I maximize? I could maximize this year's earnings by not spending anything on future production, thus killing next year's earnings. How should I weight earnings in various years? Luckily, the computation of Net Present Value accounts for the size, timing, and risk of all future cash flows!

2. The fundamental goal of financial management should be: a. Maximize sales. b. Maximize the market value of the existing stock. c. Avoid financial distress. d. Maintain steady earnings growth. e. Maximize profits. f. none of these.

Maximize the market value of the existing stock

16. Identify the goal of a financial manager and justify that goal (why is it the correct goal?).

The goal of a financial manager is to maximize the wealth of the shareholders (they implement this by maximizing the value of the company's assets). It is the correct goal because shareholders are the owners of the firm. Their money is at risk.

Why must we convert accounting data (earnings and book values) when performing financial analysis? Explain.

We convert earnings to cash flows because investors care about cash flows. Earnings can be manipulated (both legally and illegally). Investments are made with cash, and therefore investors want cash in return. Book values are historical costs, which are backward-looking. Market values are forward looking and represent the true value of the asset to the firm.

1. The mixture of debt and equity used by the firm to finance its operations is called: a. working capital management. b. financial depreciation. c. agency cost analysis. d. capital budgeting. e. capital structure. f. none of these.

Capital structure

Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership? a. Corporations generally find it relatively difficult to raise large amounts of capital. b. Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership. c. Corporate shareholders escape liability for the firm's debts, although this factor may be somewhat offset by the tax disadvantages of the corporate form of organization. d. Corporate investors are exposed to unlimited liability. e. Corporations generally face relatively few regulations.

Corporate shareholders escape liability for the firm's debts, although this factor may be somewhat offset by the tax disadvantages of the corporate form of organization.

9. Name two primary differences between a partnership and a corporation. a. General partners have limited liability and are only taxed at the personal level b. Corporate shareholders have limited liability and are double taxed c. A partnership is double taxed and has joint and several liability d. A corporation has joint and several liability and is double taxed

Corporate shareholders have limited liability and are double taxed

Which of the following is considered one of the basic questions of corporate finance? I. Which projects or assets the firm should choose. II. At what rate of interest should a firm borrow. III. How the firm should structure the payment to its employees. IV. What mixture of debt and equity should the firm use to fund its operations. V. How should the firm manage its day-to-day cash levels.

I, IV, & V only

You are planning to borrow money to buy a Porsche. Which of the following is a core determinant of the interest rate the bank might charge you? I. Whether the bank has a branch in your home town. II. Expected inflation. III. The real, risk-free rate of interest. IV. The lender's assessment of your risk as a borrower. V. Your cousin recently missed a payment to the bank.

II, III, & IV only

For most financial managers, the correct and fundamental goal of financial management is to: a. Maximize sales. b. Maintain steady earnings growth. c. Avoid financial distress. d. Maximize the market value of the existing stock. e. Maximize profits. f. Maximize market share.

Maximize the market value of the existing stock.

12. The primary goal of a publicly-owned firm interested in serving its stockholders should be to a. Maximize the stock price per share over the long run, which is the stock's intrinsic value. b. Maximize the firm's expected EPS. c. Minimize the chances of losses. d. Maximize the firm's expected total income. e. Maximize the stock price on a specific target date.

Maximize the stock price per share over the long run, which is the stock's intrinsic value.

Limited liability is a big advantage of the corporate form of business... a. but the corporation's income is double taxed b. but it is hard to transfer ownership without disrupting the business c. but shareholders can be personally sued if something goes wrong. d. all of the above

but the corporation's income is double taxed

What are the advantages and disadvantages of corporations and limited companies?

• Advantages: o Unlimited life o Easy transfer of ownership o Limited liability o Ease of raising capital • Disadvantages: o Double taxation (Corporation tax and dividends) o Cost of set-up and report filing o Often higher agency costs than other corporate forms

You are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too​ high, but you will be the CEO of the​ combined, much larger company. You know that when the company gets​ bigger, your pay and prestige will increase. What is the nature of the agency conflict here and how is it related to ethical​ considerations? ​ (Select all the choices that​ apply.) A. There is an ethical dilemma when the CEO of a firm has incentives that are opposite to those of the shareholders. B. There is a legal issue when the CEO of a firm has incentives that are opposite to those of the shareholders. C. In this​ case, you​ (as the​ CEO) have an incentive to potentially overpay for another company​ (which would be damaging to your​ shareholders) because your pay and prestige will improve. D. In this​ case, you​ (as the​ CEO) have an incentive to potentially overpay for another company​ (which would be damaging to your​ shareholders) because the value of the combined company will improve.

A and C

Recall the last time you ate at an expensive restaurant where you paid the bill. Now think about the last time you ate at a similar​ restaurant, but your parents paid the bill. Did you order more food​ (or more expensive​ food) when your parents​ paid? Explain how this relates to the agency problem in corporations. ​ (Select all the choices that​ apply.) A. In both situations there may be a lack of interest in controlling costs if those costs are not borne directly by the person making the decision. B. Your situation could never lead to an agency problem since your parents would only want the best for you. C. While you may be faced with an agency problem​ (spending more when your parents are buying than you would if you were​ paying), corporate managers are seldom faced with such decisions. D. The agency problem leads an individual​ (in your​ case) and corporate managers​ (in the corporate​ setting) to put their own​ self-interest ahead of the interests of the shareholders​ (your parents in your​ case).

A and D

Why do we care so much about cash flows and market values in finance and not about earnings and book values?

Cash flows determine the value of the firm. A share of stock is only worth money because it is a claim to future cash flows, which can be consumed. Market values are forward-looking and estimate the value today of an asset based on its ability to generate cash flows now and into the future. Earnings are not cash flows—they start as cash flows and then make non-cash flow adjustments. Since they are only a poor representation of the underlying cash flows, in finance we instead focus on the cash flows themselves. Book values are historical and backward looking, often having nothing to do with the actual value of an asset or its ability to generate cash flows.

What are the main types of decisions that financial managers make? Explain which one you think is more critical to firm value.

From LN 1, we learned that the primary types of decisions that managers make is what projects to pick (capital budgeting decision - what to invest in), how to finance those investments (capital structure decision), and day-to-day cash management (working capital, or liquidity decision). We discussed in class that the investment (capital budgeting) decision is the most important one because it fundamentally determines what the firm does and what its cash flows will be. Financing simply determines how those cash flows will be split between bondholders and shareholders. Whereas investing decisions maximize the value today of the difference between the benefits and the costs, financing decisions tend to create less value, typically by minimizing costs.

The objective of a financial manager is to maximize the wealth of the shareholders (also known as maximizing the market value of the assets). Why is this a better objective than maximizing earnings? Why is it better than maximizing market share?

Maximizing earnings is an imprecise and misdirected goal. Earnings are the yearly accounting numbers created for tax purposes. They differ from cash flows due to things like depreciation expense. Shareholders care about cash flows, not earnings, so earnings are not the right numbers to maximize. Further, which earnings do we maximize? This year's or next year's? The value of the assets will appropriately reflect all of the future cash flows generated by those assets, not simply near-term earnings. Maximizing market share is only rarely the same as maximizing shareholders' wealth. I can maximize market share by giving the product away, but that won't make my shareholders any better off.

Which of the following statements is CORRECT? a. The financial manager's proper goal should be to attempt to maximize the firm's market share, since that will add the most to the individual shareholders' wealth. b. The financial manager should seek that combination of assets that will generate the largest expected projected after-tax income over the relevant time horizon, generally the coming year. c. One example of financial managers maximizing value is when they delay a large investment in a project so that the firm may maximize its near-term earnings per share (EPS). d. Potential agency problems can arise between managers and stockholders, because managers hired as agents to act on behalf of the owners may instead make decisions favorable to themselves rather than the stockholders.

Potential agency problems can arise between managers and stockholders, because managers hired as agents to act on behalf of the owners may instead make decisions favorable to themselves rather than the stockholders.

Identify and justify the goal of the financial manager.

The financial manager's goal is to maximize shareholder wealth. Why maximize the shareholders' wealth? Because it is the shareholders that own the company and it is their wealth most at risk. The financial manager is the caretaker of the shareholders' money (i.e., agent for the stockholders) and his/her job is to make decisions in the best interest of the owners. In general, an increase in stockholders' wealth means that value has been added to a firm's assets (and wealth of society has generally increased.) The way to do this is to make decisions (particularly investment decisions) that maximize the value of the firm, and therefore the value of ownership of that firm. To get full credit you needed to say something about the fact that the money the managers are working with belongs to the shareholders. This idea motivates why it is that managers should maximize shareholder wealth. The two italicized sentences above are sufficient for full credit.

What are the three key determinants of the value of most any asset? Explain.

We discussed these three key dimensions of performance or value: Level (or size) of cash flow: More value is preferred to less Timing of cash flow: The sooner cash is received the more value it has Risk of cash flow: Less risky cash flows are more valuable than riskier

Which of the following is NOT considered one of the basic questions of corporate finance? a. What long-term investments should the firm choose. b. At what rate of interest should a firm borrow. c. Where will the firm get the long-term financing to pay for its investments. d. What mixture of debt and equity should the firm use to fund its operations. e. How should the firm manage its working capital, i.e., its everyday financial activities.

b. At what rate of interest should a firm borrow.

Explain the determinants of a required rate of return (interest rate).

The required rate of return is comprised of: Real (risk-free) rate of interest, aka the basic time value of money: the price you charge, or compensation you require, even if you are certain to get your money back. Optional addition: Captures an economy's aggregated "time preference for consumption", which also depends on production opportunities. Expected inflation: You must include a component to cover the expected increase in prices (loss in value of your currency) over time. Risk: The riskier is the loan/investment, the higher the return you will require.