Finance 3000: Ch. 1

Which of the following statements about business organizations is CORRECT?

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 reflects the position of most people in business?

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. (Compliance may hurt short-term profits, and companies rarely welcome new regulations, but having rules in place and ethics training helps people understand what is expected of them and reminds them of the consequences of their actions.)

Of the following actions, which one is most likely to reduce conflicts of interest between managers and stockholders?

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. ( Corporate takeovers are most likely to occur when a firm is underperforming. Managers who fear losing their jobs will try to maximize shareholder wealth.)

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?

Corporations generally find it easier to raise large amounts of capital. (Outsiders who are thinking about investing in a business are generally not willing to be subjected to unlimited liability, and they also want to be able to sell their shares should they choose to do so. Corporations provide these advantages; hence, firms that need large amounts of capital that must be raised in capital markets generally choose to incorporate.)

Which is TRUE about business organizations?

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. (The unfavorable tax treatment of corporations keeps most businesses, which are small, from incorporating. This is offset by ease of ownership transfer and limited liability, which are important to large businesses.)

Which of the following represents a significant disadvantage to the corporate form of organization?

Exposure to taxation of corporate earnings and stockholder dividend income. (Corporations' earnings are taxed, and then earnings paid out as dividends to shareholders are taxed again, generally at a rate of 15%.)

The chairperson of the board and the CEO are one and the same.

False

The primary financial objective of the firm is to maximize EPS.

False (The primary financial objective is stockholder wealth maximization, which is the maximization of stock price.)

Maximizing expected EPS will maximize shareholder value.

False (The primary operating goal should be to maximize the long-run stock price, or the intrinsic value.)

Maximizing the stock price on a specific target date will maximize shareholder value.

False (The primary operating goal should be to maximize the long-run stock price, or the intrinsic value.)

Which of the following factors tend to encourage management to act in their stockholders' best interests?

Firing managers who do not perform well. Direct intervention by shareholders. Threat of a hostile takeover. A reasonable compensation package sufficient to attract and retain able managers.

Which of the following statements about legal and ethical issues is CORRECT?

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.

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?

Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders). (Bondholders want to be paid. Financing risky projects with additional debt increases the potential for conflicts between stockholders and bondholders. Adding covenants to bond agreements will reduce conflicts between stockholders and bondholders.)

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 shareholders?

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 statements accurately describes business organizations?

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.

Of the following policy changes, which would be the most likely to REDUCE potential conflicts of interest between stockholders and managers?

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.

There are factors that influence stock price over which managers have virtually no control.

True (Managers have no control over factors such as (1) external constraints, (2) the general level of economic activity, (3) taxes, (4) interest rates, and (5) conditions in the stock market.)

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

True (Risky transactions that generate short-term profits sometimes fail, thus eliminating wealth.)

In most corporations, the CFO is outranked by the CEO.

True (The CFO generally reports to the CEO, who oversees all executives.)

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.

True (The board represents the shareholders, and the interests of shareholders may be very different from the interests of the CEO and other managers.)

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 (The primary operating goal should be to maximize the long-run stock price, or the intrinsic value.)

Calistoga Combines is a publicly-owned firm. In order to best serve shareholders, its' primary operating goal should be to:

Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers. (The goal of management should be to maximize long-run shareholder wealth, and good compensation packages can reduce a manager's incentives to focus on the short term instead.)