Unit 8. Exam Investment Considerations for Small-Business Owners

Which one of the following is most likely to own preferred stocks? S corporation C corporation partnership

C corporation Preferred stocks are attractive to C corporations because C corporations can exclude 70% of the dividend income if they own less than 20% of the other corporation.

A good short-term investment for cash balances is a money market mutual fund. True False

True A money market mutual fund is a safe, short-term, liquid investment, which makes it an appropriate investment for cash management.

For tax purposes, S corporations are "conduits." True False

True For tax purposes, S corporations are "conduits" in that they pay no income taxes—corporate earnings flow through to shareholders instead.

XYZ, Inc., a C corporation, has $200,000 in taxable income this tax year. It distributes half to its shareholders in the form of cash dividends. As far as XYZ, Inc., is concerned, which one of the following amounts, if any, is subject to the corporate income tax? $0 (C corporations do not pay income tax.) $100,000 (This is $200,000 less the dividend distribution.) $150,000 (Half of corporate dividends are deductible.) $200,000 (None of the corporate dividends are deductible.)

$200,000 (None of the corporate dividends are deductible.) Since XYZ, Inc., has taxable income of $200,000, that is the amount subject to tax. Dividends are not deductible.

The Johnson brothers are owners of a large hardware store and are trying to estimate what their operation might be worth in a sale. A competing hardware store of slightly larger size was purchased recently by a new owner. The brothers have learned that the competing store, which typically reported annual net operating income of $200,000, sold for $950,000. Assume that these two businesses are roughly equivalent and that the Johnson brothers' store typically earns $150,000 in annual net operating income. Use the capitalization rate method to determine how much their hardware operation might be worth. $675,068 $712,500 $750,000

$712,500 $200,000 ÷ $950,000 = .2105 (the cap rate); $150,000 ÷ .2105 = $712,500

A simple cash flow statement can determine whether an owner's net worth in a business is increasing or decreasing. True False

False A simple cash flow statement can determine whether the cash position in a business is increasing or decreasing.

A typical owner of a personal service business accumulates significant business assets over time. True False

False A typical owner of a personal service business accumulates few, if any, business assets.

. Corporations cannot exclude any portion of dividend income from their taxable corporate income. True False

False Corporations can generally exclude 70% of dividend income from their taxable corporate income (if the dividend-receiving firm owns less than 20% of the other corporation).

Which one of the following statements is correct regarding a business valuation based on book value? It would be complicated to use book value. It could not be used with a closely held corporation. It might not be an accurate value.

It might not be an accurate value. It might be inaccurate since items are carried on a balance sheet at historic costs, which might not be an accurate current value for those items.

Money purchase plans require the employer to contribute a fixed percentage of compensation to employee accounts. are only permitted for companies with 100 or fewer employees. have a maximum contribution amount of $15,000.

Money purchase plans require the employer to contribute a fixed percentage of compensation to employee accounts. The requirement of an employer contribution equal to a fixed percentage of compensation is a characteristic of money purchase plans.

Jim Burnett acts as treasurer for a corporation that sets money for taxes aside in an escrow account on a monthly basis. Which one of the following would be the most appropriate way to invest this cash? preferred stock T-bills or certificates of deposit high-grade corporate bonds intermediate-term government bonds

T-bills or certificates of deposit T-bills or certificates of deposit are excellent choices for short-term investments.

A two-tiered portfolio of investments, as presented in the module, would consist of bonds and then stocks. bank certificates of deposit and then money market funds. Treasury bills and then short-term federal agency securities.

Treasury bills and then short-term federal agency securities. Safe, very liquid money in high-quality money market instruments such as Treasury bills provides a source of readily available funds, and the high-quality, liquid investments provide a possibility for somewhat higher returns with very limited risk, such as short-term federal agency securities.

"Key person" insurance is often used by small businesses. True False

True Key person insurance protects a business against the disruption that the loss of a key employee would bring about.

Life insurance is commonly used as a method of funding a buy-sell agreement. True False

True Life insurance is often used as a means to create the cash necessary to fulfill the obligation of either a corporation or the other shareholders to buy out the interests of a deceased shareholder in a closely held corporation.

Most small-business owners are inherently undiversified. True False

True Most small-business owners have much of their total assets tied up in their businesses, and therefore such business owners are inherently undiversified.

When a small business is started, the first source of funds is usually money invested by the owners and their relatives and friends. True False

True When a small business is started, the business's owners and their relatives and friends are usually the initial sources of funds

In general, a small, closely held business has more specific financial planning issues to address than a stable, ongoing small business does. True False

True With a small, closely held business, a greater number of issues (particularly in estate planning) need to be addressed so that the business can remain in the hands of family members.

With a profit sharing plan, the employer has a defined benefit plan. may contribute no more than 15% of covered payroll. need not make contributions each year, but must make substantial and recurring contributions.

all contributions to an employee's account are fully vested. The contributions to an employee's account under a SIMPLE plan are fully vested.

Which of the following are typical needs of an owner of a personal service business? establish an appropriate retirement plan provide an adequate estate for his or her survivors both a and b neither a nor b

both a and b The owner of a personal service business needs to establish an appropriate retirement plan and provide an adequate estate for his or her survivors.

With a SIMPLE plan all contributions to an employee's account are fully vested. the plan is subject to the nondiscrimination rules applicable to other qualified plans. an IRA must be established. the employee may not make elective contributions.

discounts future cash flows by a rate that is appropriate for the risk involved. Discounting future cash flows by a rate that is appropriate for the risk involved in order to get a present value is the essence of the present value method.

Phillip Zapata and his family own all the shares of a small corporation that manufactures specialty shoes. The firm employs 120 full-time workers. There is no market for the stock, but Phillip would like to be able to cash in some of his shares each year so that he can live better, have more money for daily expenses, and do some traveling. Which one of the following is the best solution to his liquidity problem? establish a SEP-IRA consider a public offering work out a redemption buy-sell agreement with family members establish an ESOP

establish an ESOP An ESOP would create a market for the company stock and thus allow Phillip to cash in some of his shares.

John Long is a sole proprietor, and he needs cash to invest in some new equipment. His banker suggests a home equity loan. His brother-in-law offers a loan at 8% over prime. Which one of the following would be the most appropriate financing method for John's investment professional to suggest? margin the stocks in his self-managed IRA buy government securities and use them as loan collateral margin the stocks in his personal account sell naked call options

margin the stocks in his personal account John can borrow up to 50% of the value of the stocks in his personal margin account.

Bill Dunston is the sole shareholder of Dunston Press, a small publishing company. All of the employees of Dunston Press are considerably younger than Bill, turnover is relatively high, and twelve of his twenty employees are part time. He is considering implementing a retirement plan for the company and wants to avoid fixed contribution obligations. He also wants to receive the maximum benefit possible. Which one of the following plans would be most appropriate, considering Bill wants to maximize contributions on his behalf relative to those of the other employees? money purchase pension plan salary reduction SEP plan cross-tested profit sharing plan age-weighted profit sharing plan

need not make contributions each year, but must make substantial and recurring contributions. One advantage of a profit sharing plan for the employer is that the employer need not make contributions each year.

The type of small business that typically has little or no wealth accumulating in the business itself is the personal service business. stable, ongoing small business. the small, closely held corporation.

personal service business. The value in a personal service business is based on the personal knowledge, customer relationships, and capabilities of the owner and is not based on the business itself.

Partnership income is taxed at the C corporation rate. personal tax rates of the individual partners. S corporation rate.

personal tax rates of the individual partners. Partnership income is taxed at the personal income tax rates of the individual partners, because it is taxed to the partners.

A life insurance death benefit can be used as an effective tool for all of the following except transferring a business upon the death of the owner. a source of retirement funds. providing operating liquidity to a business owner. paying the outstanding liabilities of an estate.

providing operating liquidity to a business owner. Life insurance is a poor choice for providing operating funds for a business because operating funds are needed on an ongoing basis and the cash value of any policy will eventually be depleted.

The present value method of business valuation subtracts liabilities from assets to get the net value of a firm. discounts future cash flows by a rate that is appropriate for the risk involved. divides net operating income by a cap rate.

providing operating liquidity to a business owner. Life insurance is a poor choice for providing operating funds for a business because operating funds are needed on an ongoing basis and the cash value of any policy will eventually be depleted.

When a small, growing business becomes established and needs permanent capital, it usually resorts to selling equity to outsiders. getting a business loan from a bank. soliciting funds from the owners and their family members.

selling equity to outsiders. Equity ownership sold to outsiders is a source of capital that is used after the owner taps his own sources of funds.

If venture capitalists provide early capital to a business, they usually cash out when the business first obtains loans from a bank. the owners invest their capital. shares of stock are sold to the public.

shares of stock are sold to the public. Venture capitalists usually cash out their positions in a company when shares of stock are sold to the public.

Which one of the following currently is the most common form of business organization? sole proprietorship partnership C corporation

sole proprietorship The sole proprietorship is the most common form of business organization. In 2009, more than 72% of U.S. businesses filed income tax returns indicating they were sole proprietorships.