BUAD 3040: Chapter 1 Cengage

Business Ethics

A company's attitude and conduct toward its employees, customers, community, and stockholders.

Sarbanes-Oxley Act

A law passed by Congress that requires the CEO and CFO to certify that their firm's financial statements are accurate.

Corporation

A legal entity created by a state, separate and distinct from its owners and managers, having unlimited life, easy transferability of ownership, and limited liability.

Limited Liability Company (LLC)

A popular type of organization that is a hybrid between a partnership and a corporation.

S Corporation

A special designation that allows small businesses that meet qualifications to be taxed as if they were a proprietorship or a partnership rather than a corporation.

Financial Management

Also called corporate finance, focuses on decisions about acquiring assets, raising capital, and running the firm so as to maximize its value.

Intrinsic Value

An estimate of a stock's "true" value based on accurate risk and return data. The intrinsic value can be estimated, but not measured precisely.

Marginal Investor

An investor whose views determine the actual stock price.

Proprietorship

An unincorporated business owned by one individual.

Partnership

An unincorporated business owned by two or more persons.

a. True value.

Another word for intrinsic value is: a. True value. b. Exchange rate neutral. c. Fair market price. d. Nominal price.

2. Corporations generally find it easier to raise large amounts of capital.

Bethany is planning to start a business. Why might she choose to operate her business as a corporation rather than as a proprietorship or a partnership? 1. Corporations generally face fewer regulations. 2. Corporations generally find it easier to raise large amounts of capital. 3. Corporate investors are exposed to unlimited liability. 4. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation. 5. A smaller amount of a corporation's income is generally subject to federal taxes.

3. Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers.

Calistoga Combines is a publicly-owned firm. In order to best serve shareholders, its' primary operating goal should be to: 1. Minimize the firm's risks because most stockholders dislike risk. In turn, this will maximize the firm's stock price. 2. Since it is impossible to measure a stock's intrinsic value, the text states that it is better for managers to attempt to maximize the current stock price than its intrinsic value. 3. Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers. 4. Maximize the firm's expected EPS, which must also maximize the firm's price per share. 5. Maximize managers' own interests, which are by definition consistent with maximizing shareholders' wealth.

1. The use of covenants in bond agreements that limit the firm's use of additional debt and constrain managers' actions.

If you sat on the board of directors of Tyng Corporation, which of the following actions would you recommend to reduce potential conflicts of interest between Tyng's stockholders and bondholders? 1. The use of covenants in bond agreements that limit the firm's use of additional debt and constrain managers' actions. 2. Abolishing the Securities and Exchange Commission. 3. Financing risky projects with additional debt. 4. The threat of hostile takeovers. 5. Compensating managers with stock options.

2. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.

Imagine that you are the chairman of the board of a large corporation. Which of the following mechanisms do you think the board should choose to adopt to motivate top-level managers to act in the best interests of stockholders? 1. Elect a board of directors that allows managers greater freedom of action. 2. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries. 3. Eliminate a requirement that members of the board of directors have a substantial investment in the firm's stock. 4. Take actions that reduce the possibility of a hostile takeover. 5. Decrease the use of restrictive covenants in bond agreements.

Corporate Raiders

Individuals who target corporations for takeover because they are undervalued.

d. Efficient.

Intrinsic value is equal to market value when markets are: a. In the money. b. In equilibrium. c. At the margin. d. Efficient.

Investments

Involve decisions concerning stocks and bonds and include security analysis, portfolio theory, and market analysis.

2. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.

Of the following actions, which one is most likely to reduce conflicts of interest between managers and stockholders? 1. Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firm's stock. 2. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover. 3. Pay managers large cash salaries and give them no stock options. 4. Beef up the restrictive covenants in the firm's debt agreements. 5. For a firm that compensates managers with stock options, reduce the time before options are vested (i.e., the time before options can be exercised and the shares that are received can be sold).

2. The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash.

Of the following policy changes, which would be the most likely to REDUCE potential conflicts of interest between stockholders and managers? 1. Congress passes a law that severely restricts hostile takeovers. 2. The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash. 3. A firm's compensation system is changed so that managers receive larger cash salaries and no long-term options to buy stock. 4. The company's outside marketing firm is given a lucrative year-by-year consulting contract with the company. 5. The company changes the way executive stock options are handled, with all options vesting after one year rather than having 20% of the options awarded vest every two years over a 10-year period.

Capital Markets

Relate to the markets where interest rates and stock and bond prices are determined.

Limited Liability Partnership (LLP)

Similar to an LLC but used for professional firms in the fields of accounting, law, and architecture. It provides personal asset protection from business debts and liabilities but is taxed as a partnership.

2. Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders).

The Gabriel Corporation has asked you, a consultant, to recommend an action that is likely to reduce potential conflicts between stockholders and bondholders. Which action do you propose? 1. The firm begins to use only long-term debt (e.g., debt that matures in 30 years or more) rather than debt that matures in less than one year. 2. Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders). 3. Compensating managers with more stock options and less cash income. 4. A government regulation that banned the use of convertible bonds. 5. The passage of laws that make it harder for hostile takeovers to succeed.

Hostile Takeover

The acquisition of a company over the opposition of its management.

Stockholder Wealth Maximization

The primary financial goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm's common stock.

Shareholder Wealth Maximization

The primary financial goal of a corporation

Equilibrium

The situation in which the actual market price equals the intrinsic value, so investors are indifferent between buying and selling a stock.

Market Price

The stock value based on perceived but possibly incorrect information as seen by the marginal investor.

True

True or False: As a result of financial scandals occurring during the past decade, there has been a strong push to improve business ethics.

False

True or False: Conflicts between stockholders and debtholders arise because stockholders are less willing than debtholders to take on risky projects because stockholders are more "at risk" of losing their investment.

True

True or False: Finance prepares students for jobs in banking, investments, insurance, corporations, and government. It is important for all business students, no matter what their major is, to understand finance concepts. In addition, finance is useful to all individuals regardless of their jobs as we encounter finance in our everyday lives, such as decisions regarding consumer loans and mortgages.

True

True or False: If a company practices "good business ethics," then it will treat its customers, employees, and stockholders "fairly," and this will cause it to have a good reputation. Such behavior may increase costs and thus hurt profits in the short run, but this is often offset by long-run benefits in the form of customer loyalty, more dedicated employees, and stockholders who will support management in the event of a downturn in the business.

True

True or False: If a firm's managers narrowly focused on creating shareholder value, but in the process the company was unresponsive to its employees and customers, hostile to its local community, and indifferent to the effects its actions had on the environment; then in all likelihood society would impose a wide range of costs on the company, and this would ultimately lead to a reduction in shareholder value.

False

True or False: If a lower level person in a firm does something illegal, like "cooking the books" to understate costs and thereby increase profits above the correct profits because he or she was told to do so by a superior, the lower level person cannot be prosecuted but the superior can be prosecuted.

True

True or False: Imagine that a firm's board of directors wants to maximize value for all of its stockholders in general, as opposed to some specific stockholders. A smart solution would be to design an executive compensation system that aims to build the firm's long-term value.

True

True or False: In most corporations, the CFO is outranked by the CEO.

True

True or False: In most corporations, the CFO ranks under the CEO.

False

True or False: Managers always attempt to maximize the long-run value of their firms' stocks, or the stocks' intrinsic values. This is exactly what stockholders desire. Thus, conflicts between stockholders and managers are not possible.

True

True or False: Managers should try to forecast the effects of different decisions on the firm's intrinsic value and then take actions designed to maximize this value. Management should provide information that helps investors make better estimates of the firm's intrinsic value, which will keep the stock price closer to the equilibrium level. However, there are times when management cannot divulge the true situation because doing so would provide information that helps its competitors.

False

True or False: Maximizing expected EPS will maximize shareholder value.

True

True or False: Maximizing the firm's expected profits for the current year does not necessarily maximize the stockholders' wealth for the current year.

False

True or False: Maximizing the stock price on a specific target date will maximize shareholder value.

False

True or False: Stocks have market prices, and they also have intrinsic values. If the market price is below the intrinsic value as estimated by marginal investors, and if the intrinsic value remains stable in the future, then there will be a tendency for the stock's price to fall over time.

True

True or False: The board of directors is the highest ranking body in a corporation. The members of the board are elected by the shareholders, and the chairperson of the board is the highest ranking member of the board. The CEO generally reports to the board and its chairperson, and the board generally has the authority to remove the CEO.

False

True or False: The chairperson of the board and the CEO are one and the same.

True

True or False: The chief executive officer (or CEO) is the top executive officer, and he or she reports to the board. The chairperson of the board often also serves as the CEO. Most firms also have a chief operating officer (COO) and a chief financial officer (CFO). The COO is often designated as the firm's president and directs the firm's operations. The CFO is in charge of accounting, financing, credit policy, decisions regarding asset acquisitions, and investor relations.

False

True or False: The primary financial objective of the firm is to maximize EPS.

True

True or False: There are factors that influence stock price over which managers have virtually no control.

False

True or False: There are many types of unethical business behavior. One example is where executives provide information that they know is incorrect to banks and to stockholders. It is illegal to provide such information to banks, but it is not illegal to provide it to stockholders because they are the owners of the firm, not outsiders.

1. Due to legal considerations related to ownership transfers and limited liability, which affect the ability to attract capital, most business (measured by dollar sales) is conducted by corporations in spite of large corporations' less favorable tax treatment.

Which is TRUE about business organizations? 1. Due to legal considerations related to ownership transfers and limited liability, which affect the ability to attract capital, most business (measured by dollar sales) is conducted by corporations in spite of large corporations' less favorable tax treatment. 2. Large corporations are taxed more favorably than proprietorships. 3. Corporate stockholders are exposed to unlimited liability. 4. Most businesses (by number and total dollar sales) are organized as proprietorships or partnerships because it is easier to set up and operate one of these forms rather than as a corporation. However, if the business gets very large, it becomes advantageous to convert to a corporation, primarily because corporations have important tax advantages over proprietorships and partnerships. 5. Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority of international businesses (in terms of the number of businesses) are organized as corporations, all governed by the same legal statutes.

a. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.

Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and managers? a. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover. b. Pay managers large cash salaries and give them no stock options. c. For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can be exercised and the shares that are received can be sold. d. Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firm's stock. e. Beef up the restrictive covenants in the firm's debt agreements.

e. All the above are stakeholders in a corporation.

Which of the following are stakeholders in a corporation? a. A corporation's shareholders b. A corporation's employees c. A corporation's customers d. A corporation's vendors e. All the above are stakeholders in a corporation.

5. All of the above encourage management to act in stockholders' best interests.

Which of the following factors tend to encourage management to act in their stockholders' best interests? 1. A reasonable compensation package sufficient to attract and retain able managers. 2. Threat of a hostile takeover. 3. Direct intervention by shareholders. 4. Firing managers who do not perform well. 5. All of the above encourage management to act in stockholders' best interests.

d. All of these help keep management focused on stockholders' interests as reflected in maximizing the long-run stock price.

Which of the following helps ensure that managers operate in their stockholders' interests rather than their own personal interests? a. The threat of firing by the board of directors. b. The threat of a hostile takeover possibly resulting in top managers losing their jobs. If the stock price is below its intrinsic value, this threat is magnified. c. Compensation packages designed to provide incentives for management to maximize the long-run stock price. d. All of these help keep management focused on stockholders' interests as reflected in maximizing the long-run stock price.

a. More favorable tax treatment.

Which of the following is NOT an advantage of the corporate form of organization versus partnerships and proprietorships? a. More favorable tax treatment. b. Ability to attract large amounts of capital. c. Ease of transferring ownership among investors. d. Limited liability. e. Liquidity of investors' holdings in the business.

d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.

Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders? a. Elect a board of directors that allows managers greater freedom of action. b. Take actions that reduce the possibility of a hostile takeover. c. Decrease the use of restrictive covenants in bond agreements. d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries. e. Eliminate a requirement that members of the board of directors have a substantial investment in the firm's stock.

2. Exposure to taxation of corporate earnings and stockholder dividend income.

Which of the following represents a significant disadvantage to the corporate form of organization? 1. Difficulty in transferring ownership. 2. Exposure to taxation of corporate earnings and stockholder dividend income. 3. Degree of liability to which corporate owners and managers are exposed. 4. Level of difficulty corporations' face in obtaining large amounts of capital in financial markets. 5. All of the above are disadvantages to the corporate form of organization.

5. The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds, rather than by small individual investors, rises from 10% to 80%.

Which of the following situations would most likely encourage a firm's managers to make decisions that are in the best interests of stockholders? 1. The firm's board of directors gives the firm's managers greater freedom to take whatever actions they think best without obtaining board approval. 2. The percentage of executive compensation that comes in the form of cash is increased and the percentage coming from long-term stock options is reduced. 3. The state legislature passes a law that makes it more difficult to successfully complete a hostile takeover. 4. The firm's founder, who is also the president and chairperson of the board, sells 85% of her shares. 5. The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds, rather than by small individual investors, rises from 10% to 80%.

5. A significant risk in starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt. This problem would be avoided if you formed a corporation to operate the business.

Which of the following statements about business organizations is CORRECT? 1. It's unlikely for a firm to be organized as a corporation when it requires a lot of capital. 2. Tax advantages of incorporation offset the corporate shareholders' exposure to unlimited liability. 3. It is generally easier to transfer one's ownership interest in a partnership than in a corporation. 4. If a corporation elects to be taxed as a P corporation, then both it and its stockholders can avoid all federal taxes. This provision was put into the Federal Tax Code in order to encourage the formation of small businesses. 5. A significant risk in starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt. This problem would be avoided if you formed a corporation to operate the business.

1. If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted.

Which of the following statements about legal and ethical issues is CORRECT? 1. If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted. 2. Ethical behavior is not influenced by training and auditing procedures. People are either ethical or they are not, and this is what determines ethical behavior in business. 3. Ethics is not an important consideration in business and in business schools. 4. There are many types of unethical business behavior. One example is when executives provide information that they know is incorrect to outsiders. It is illegal to provide such information to federally regulated banks, but it is not illegal to provide it to stockholders. 5. If a lower level person in a firm does something illegal, like "cooking the books," to understate costs and thereby artificially increase profits because he or she was ordered to do so by a superior, the lower level person cannot be prosecuted but the superior can be prosecuted.

4. Partnerships have more difficulty attracting large amounts of capital than corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying and selling) of partnership interests.

Which of the following statements accurately describes business organizations? 1. A major disadvantage of a partnership relative to a corporation is the fact that federal income taxes must be paid by the partners rather than by the firm itself. 2. In a typical partnership, liability for other partners' misdeeds is limited to the amount of a particular partner's investment in the business. 3. In a limited partnership, the limited partners have voting control, while the general partner has operating control over the business, and the limited partners are individually responsible, on a pro rata basis, for the firm's debts in the event of bankruptcy. 4. Partnerships have more difficulty attracting large amounts of capital than corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying and selling) of partnership interests. 5. A slow-growth company, with little need for new capital, would be more likely to organize as a corporation than would a faster growing company.

c. The board of directors is the highest ranking body in a corporation, and the chairman of the board is the highest ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but he or she can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person.

Which of the following statements is CORRECT? a. The CFO generally reports to the firm's chief accounting officer, who is normally the controller. b. By law in most states, the chairman of the board must also be the CEO. c. The board of directors is the highest ranking body in a corporation, and the chairman of the board is the highest ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but he or she can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person. d. The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he or she is not responsible for the validity of the financial statements, as the controller and the auditors have that responsibility. e. In most corporations, the CFO ranks above the CEO.

a. The threat of takeovers tends to reduce potential conflicts between stockholders and managers.

Which of the following statements is CORRECT? a. The threat of takeovers tends to reduce potential conflicts between stockholders and managers. b. Managerial compensation plans cannot be used to reduce potential conflicts between stockholders and managers. c. The creation of the Securities and Exchange Commission (SEC) has eliminated conflicts between managers and stockholders. d. One of the ways in which firms can mitigate or reduce potential conflicts between bondholders and stockholders is by increasing the amount of debt in the firm's capital structure. e. The threat of takeover generally increases potential conflicts between stockholders and managers.

2. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.

Which of the following statements reflects the position of most people in business? 1. A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation. 2. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. 3. It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior. 4. Whistleblowers are generally promoted more rapidly than other employees because of the courage it takes to blow the whistle. 5. Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees.

b. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation.

With which of the following statements would most people in business agree? a. Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring and firing employees. b. Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. c. It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior. d. "Whistle blowers," because of the courage it takes to blow the whistle, are generally promoted more rapidly than other employees. e. A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation.