homework help 37602
Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 1 An Introduction to the Foundations of Financial Management
1.1 Learning Objective 1
1) Financial management deals with the maintenance and creation of economic value or wealth.
Answer:
Keywords: Financial Management
AACSB: Reflective thinking skills
2) Each financial decision made by a corporate manager can be evaluated by its direct impact on the corporation’s stock price.
Answer:
Keywords: Goal of the Firm
AACSB: Reflective thinking skills
3) The fundamental goal of a business is to maximize the retained earnings available to the corporation’s shareholders.
Answer:
Keywords: Goal of the Firm
AACSB: Reflective thinking skills
4) Shareholder wealth maximization means maximizing the price of the existing common stock.
Answer:
Keywords: Shareholder Wealth, Goal of the Firm
AACSB: Reflective thinking skills
5) It is important to evaluate a corporate manager’s financial decision by measuring the effect the decision should have on the corporation’s stock price if everything else were held constant.
Answer:
Keywords: Goal of the firm, Shareholder Wealth Maximization
AACSB: Reflective thinking skills
6) Corporate managers should accept investment projects that maximize profits int he short run because of the time value of money.
Answer:
Keywords: Goal of the Firm, Profits, Time Value of Money
AACSB: Reflective thinking skills
7) The goal of the firm’s financial managers should be the maximization of the total value of the firm’s stock.
Answer:
Keywords: Goal of the Firm
AACSB: Reflective thinking skills
8) The payment of a dividend to current shareholders will have no impact on a corporation’s share price because the cash paid is not available to future potential shareholders who may want to buy the corporation’s stock.
Answer:
Keywords: Goal of the Firm
AACSB: Reflective thinking skills
9) One problem with maximization of shareholder wealth as a goal is that it ignores risk taken by the firm’s financial decisions.
Answer:
Keywords: Goal of the Firm
AACSB: Reflective thinking skills
10) The goal of profit maximization ignores the risk of financial decisions
Answer:
Keywords: Goal of the Firm
AACSB: Reflective thinking skills
11) Only a firm’s financial decisions affect its stock prices.
Answer:
Keywords: Determinants of Stock Price
AACSB: Reflective thinking skills
12) Shareholders react to poor investment or dividend decisions by causing the total value of the firm’s stock to fall, and they react to good decisions by bidding the price of the stock up.
Answer:
Keywords: Determinants of Stock Price
AACSB: Reflective thinking skills
13) The primary goal of a publicly owned corporation is to ________.
A) maximize dividends per share
B) maximize shareholder wealth
C) maximize earnings per share after taxes
D) minimize shareholder risk
Answer:
Keywords: Goal of the Firm, Corporation
AACSB: Reflective thinking skills
14) Maximization of shareholder wealth
A) represents a zero sum game in which one corporation gains at the expense of others.
B) provides benefits to society as scarce resources are directed to their most productive use.
C) is not a practical goal since it cannot be measured effectively.
D) is achieved only if cash flows exceed accounting profits.
Answer:
Keywords: Goal of the Firm, Maximize Shareholder Wealth
AACSB: Reflective thinking skills
15) A financial manager is considering two projects, A and B. A is expected to add $2 million to profits this year while B is expected to add $2 million to profits this year while B is expected to add $1 million to profits this year. Which of the following statements is most correct?
A) The manager should select project A because it maximizes profits.
B) The manager should select the project that maximizes long-term profits, not just one year of profits.
C) The manager should select project A or he is irrational.
D) The manager should select the project that causes the stock price to increase the most, which could be A or B.
Answer:
Keywords: Goal of the Firm
AACSB: Analytic skills
16) Shareholder wealth maximization means
A) maximizing earnings per share.
B) maximizing dividends per share.
C) maximizing the price of existing common stock.
D) maximizing stockholders equity.
Answer:
Keywords: Goal of the firm, Shareholder Wealth Maximization
AACSB: Reflective thinking skills
17) The goal of the firm should be
A) maximization of profits (net income per share).
B) maximization of shareholder wealth.
C) maximization of market share.
D) maximization of sales.
Answer:
Keywords: Goal of the Firm, Maximize Shareholder Wealth
AACSB: Reflective thinking skills
18) Which of the following goals of the firm are synonymous (equivalent) to the maximization of shareholder wealth?
A) profit maximization
B) risk minimization
C) maximization of the total market value of the firm’s common stock
D) none of the above
Answer:
Keywords: Goal of the Firm, Maximize Shareholder Wealth
AACSB: Reflective thinking skills
19) Which of the following is the most important goal that a corporation should strive for?
A) Maximize current profits.
B) Maximize market share.
C) Maximize revenue.
D) Maximize shareholder wealth.
Answer:
Keywords: Goal of the Firm, Maximize Shareholder Wealth
AACSB: Reflective thinking skills
20) One of the causes of the recent financial crisis in the United States has been excessive risk taking due to underestimation of risk. HOw does this relate to financial leverage? Can overestimation of risk also be detrimental?
Answer: Underestimation of risk can lead managers to borrow excessively to fund more and more projects. High levels of debt require interest and principal payments which may become impossible to make if the company’s cash flows are reduced, even for short periods of time. Overestimation of risk can also be problematic. Managers who take on too little risk may be passing up desirable projects that could increase shareholder wealth. The principle that risk requires a return does not mean that all risk is bad, but rather that additional risk is ok if additional expected returns are high enough. If all risk was bad, companies would go out of business and all investors would buy U.S. Treasury Bills.
Keywords: Risk Requires a Return, Goal of the Firm
AACSB: Reflective thinking skills
21) Documents uncovered after the Exxon Valdez oil spill in Alaska revealed that Exxon could have used double-hulled oil tankers that would have prevented the spill, but the cost of refitting their fleet of single-hulled tankers was considered too high. Exxon determined that the cost of cleaning up an oil spill would be less than the cost of refitting the ships, thus increasing shareholder value. Several years after the oil spill, however, Exxon was fined billions of dollars for the spill. How do the costs of the clean up and the fines pertain to a discussion of maximizing shareholder value and ethical responsibility?
Answer: Managers are supposed to maximize shareholder value. Exxon’s analysis of the costs of an oil spill versus the cost of improving their tankers seems to have been a reasonable one at the time it was undertaken. The social costs of killing birds and fish were expected to be low. The outrage at Exxon’s conduct and the subsequent large fines will change the estimation of future costs for similar situations. Managers need to consider the impact of their decisions on their companies’ cash flows. Socially undesirable activities may lead to boycotts, protests, lower sales, fines, etc. These costs must be included in their analyses. Society sets limits within which corporations must operate or the corporations, and their shareholders, will suffer. Therefore, acting in ethical and socially responsible ways is congruent with the goal of shareholder wealth maximization.
Keywords: Goal of the Firm, Maximizing Shareholder Value, Ethical Responsibility, Cash Flow
AACSB: Reflective thinking skills
1.2 Learning Objective 2
1) When making financial decisions, managers should always look at marginal, or incremental cash flows.
Answer:
Keywords: Marginal or Incremental Cash Flows
AACSB: Reflective thinking skills
2) An investment project is acceptable if the total cash received over the life of the project exceeds the total cash spent over the life of the project.
Answer:
Keywords: Cash Flow, Time Value of Money
AACSB: Reflective thinking skills
3) If two companies have the same net income and the same level of risk, they must also have the same stock price or the market is not in equilibrium.
Answer:
Keywords: Net Income, Risk, Timing of Cash Flow
AACSB: Analytic skills
4) Profits represent money that can be spent, and as such, form the basis for determining the value of financial decisions.
Answer:
Keywords: Profits, Cash Flow
AACSB: Reflective thinking skills
5) The root cause of agency problems is conflicts of interest.
Answer:
Keywords: Agency Problems, Conflicts of Interest
AACSB: Reflective thinking skills
6) Investors will be indifferent between two investments if both investments have the same expected return.
Answer:
Keywords: Risk-Return Tradeoff
AACSB: Reflective thinking skills
7) If the stock market is efficient, then investors do not need to read the Wall Street Journal or research companies before they select which stocks to buy because market prices already reflect all publicly available information.
Answer:
Keywords: Efficient Markets
AACSB: Analytic skills
8) Giving the company’s CEO stock options as part of his or her compensation package is an example of an agency cost.
Answer:
Keywords: Agency Costs
AACSB: Reflective thinking skills
9) Cash flows and profits are synonymous; in other words, higher cash flows equal higher profits.
Answer:
Keywords: Cash Flow, Profit
AACSB: Reflective thinking skills
10) Shareholder selection committees select potential board of director nominees ensuring that board members will monitor management sufficiently to protect shareholder interests.
Answer:
Keywords: Agency Problems, Board of Directors
AACSB: Reflective thinking skills
11) Managers should not be concerned with business ethics because ethical behavior is inconsistent with the primary goal of maximizing shareholder value.
Answer:
Keywords: Ethics, Goal of the Firm
AACSB: Ethical understanding and reasoning abilities
12) One of the problems associated with maximization of total current stock value is that it ignores the timing of a project’s return.
Answer:
Keywords: Maximizing Shareholder Value, Timing of Returns
AACSB: Reflective thinking skills
13) The risk-return tradeoff is seen in many areas of finance.
Answer:
Keywords: Risk, Return
AACSB: Reflective thinking skills
14) The risk/return tradeoff implies that the return on a riskless asset must be zero.
Answer:
Keywords: Risk-Return Tradeoff
AACSB: Reflective thinking skills
15) The sole proprietorship has no legal business structure separate from its owner.
Answer:
Keywords: Sole Proprietorship
AACSB: Reflective thinking skills
16) An efficient market is one where the prices of the assets traded in that market fully reflect all available information at any instant in time.
Answer:
Keywords: Efficient Markets
AACSB: Reflective thinking skills
17) The opportunity cost of any choice you make is the highest-valued alternative that you had to give up when you made the choice.
Answer:
Keywords: Opportunity Cost, Time Value of Money
AACSB: Reflective thinking skills
18) The five basic principles of finance include all of the following except:
A) Cash flow is what matters.
B) Money has a time value.
C) Risk requires a reward.
D) Incremental profits determine value.
Answer:
Keywords: Basic Principles of Finance
AACSB: Reflective thinking skills
19) Suppose XYZ Corporation is traded on the New York Stock Exchange. XYZ’s closing price on Monday is $20 per share. After the market closes on Monday, XYZ makes a surprise announcement that it has obtained a major new customer. XYZ’s stock will likely
A) open at $20 per share on Tuesday and then increase as more investors read the announcement in the Wall Street Journal.
B) remain at $20 per share because in efficient markets the price already reflects all information.
C) open above $20 because the positive news will result in a higher valuation even though the stock has not yet traded.
D) open below $20 because the surprise announcement creates more uncertainty.
Answer:
Keywords: Efficient Markets
AACSB: Analytic skills
20) A corporate manager decides to build a new store on a lot owned by the corporation that could be sold to a local developer for $250,000. The lot was purchased for $50,000 twenty years ago. When determining the value of the new store project,
A) the cost of the lot is zero since the corporation already owns it.
B) the opportunity cost of the lot is $250,000 and should be included in calculating the value of the project.
C) the cost of the lot for valuation purposes is $50,000 because land does not depreciate.
D) the incremental cash flow should be the $50,000 original cost less accumulated amortization.
Answer:
Keywords: Opportunity Cost
AACSB: Analytic skills
21) To measure value, the concept of time value of money is used
A) to determine the interest rate paid on corporate debt.
B) to bring the future benefits and costs of a project, measured by its expected profits, back to the present.
C) to bring the future benefits and costs of a project, measured by its cash flows, back to the present.
D) to ensure that expected future profits exceed current profits today.
Answer:
Keywords: Time Value of Money, Cash Flows
AACSB: Reflective thinking skills
22) A financial manager is evaluating a project which is expected to generate profits of $100,000 per year for the next 10 years. The project should be accepted if
A) the cost of the project is less than $1,000,000.
B) the cost of the project is less than the present value of $100,000 per year for 10 years.
C) this project’s expected profits are higher than any other projects the corporation has available.
D) the present value of the project’s cash inflows exceeds the present value of the project’s cash outflows.
Answer:
Keywords: Time Value of Money, Cash Flows
AACSB: Analytic skills
23) Investors want a return that satisfies the following expectations:
A) A return for delaying consumption
B) An additional return for taking on risk
C) An additional return for accepting dividends rather than capital gains
D) Both A and B.
Answer:
Keywords: Risk, Return
AACSB: Reflective thinking skills
24) The expected return on a riskless asset is greater than zero due to
A) an expected return for delaying consumption.
B) an expected return for opportunity costs.
C) an expected return for taxes.
D) irrational investors who believe risk is always present.
Answer:
Keywords: Risk-Return Tradeoff
AACSB: Reflective thinking skills
25) Joe, a risk-averse investor, is trying to choose between investment A and investment B. If investment A is riskier than investment B and Joe selects investment A anyway, then
A) the actual return for investment A will be higher than the actual return for investment B.
B) the actual return for investment A will be higher than the expected return for investment B.
C) the expected return for investment A will be higher than the actual return for investment B.
D) the expected return for investment A will be higher than the expected return for investment B.
Answer:
Keywords: Risk-Return Tradeoff
AACSB: Analytic skills
26) The principle of risk-return tradeoff means that
A) higher risk investments must earn higher returns.
B) an investor who takes more risk will earn a higher return.
C) a rational investor will only take on higher risk if he expects a higher return.
D) an investor who bought stock in a small corporation five years ago has more money than an investor who bought U.S. Treasury bonds five years ago.
Answer:
Keywords: Risk-Return Tradeoff, Expected Return, Actual Return
AACSB: Reflective thinking skills
27) Project A is expected to generate positive cash flow of $1 million in 10 years while Project B is expected to generate $500,000 in 5 years. Therefore,
A) Project A is preferred because shareholder value is based on cash flow.
B) Project B is preferred because its cash flow is expected to be received sooner than the cash flow from Project A.
C) Both projects have equal value because they average $100,000 per year.
D) Project B may be preferred to Project A if the opportunity cost of money is high enough.
Answer:
Keywords: Time Value of Money
AACSB: Analytic skills
28) Company A reports sales of $100,000 and net income of $15,000. Company B reports sales of $100,000 and net income of $10,000. Therefore,
A) Company A’s cash flow may be higher or lower than Company B’s cash flow even though A’s net income is higher.
B) Company A’s cash flow is $5,000 more than Company B’s cash flow.
C) Company B is creating less value for its shareholders than Company A.
D) Company B’s accounts receivable must be higher than Company A’s accounts receivable.
Answer:
Keywords: Cash Flow, Net Income
AACSB: Analytic skills
29) Profits are down so the controller decides to change the corporation’s accounting policy relating to inventory costing. The change will allow the corporation to report higher income and higher assets, although the physical inventory has not changed. Which of the following statements is most correct?
A) The stock price is likely to increase because income is higher.
B) The stock price is likely to be unaffected because the stock market is efficient.
C) The stock price is likely to decrease because reported inventory is higher.
D) If the stock price increases, the stock market is efficient.
Answer:
Keywords: Efficient Markets
AACSB: Analytic skills
30) All of the following statements about agency problems are true except:
A) Agency problems interfere with the goal of maximizing shareholder value.
B) Agency costs are paid by the managers who do not act in the shareholders’ best interest.
C) Agency problems result from the separation of management and the ownership of a firm.
D) The root cause of agency problems is conflicts of interest.
Answer:
Keywords: Agency Problems
AACSB: Reflective thinking skills
31) All of the following contributed to recent financial crises except:
A) Focusing on earnings instead of cash flow.
B) Focusing on the short run.
C) Relying on the efficiency of financial markets.
D) Excessive risk taking due to underestimation of risk.
Answer:
Keywords: Five Principles of Finance
AACSB: Reflective thinking skills
32) A corporate financial manager trying to maximize shareholder value
A) is not concerned with ethics but rather with writing iron-clad contracts.
B) can safely ignore ethics as long as no laws are broken.
C) must behave ethically in order to stay out of jail.
D) is concerned with ethics because unethical behavior destroys trust, and businesses cannot function without a certain degree of trust
Answer:
Keywords: Ethics, Maximizing Shareholder Value
AACSB: Ethical understanding and reasoning abilities
33) John invested $1,000 in a risky investment and BIll invested $1,000 in a less risky investment. One year later, Bill’s investment is worth $1,030. Which of the following statements is most correct?
A) If John’s investment is worth less than $1,030, then John was irrational to invest in the risky project.
B) John’s investment must be worth more than $1,030 because of the risk-return tradeoff, given that John’s investment was more risky.
C) If John’s investment is worth more than $1,030, then Bill was irrational to invest in the less risky investment.
D) The worth of John’s investment cannot be determined with the information given.
Answer:
Keywords: Risk-Return Tradeoff, Expected Return, Actual Return
AACSB: Analytic skills
34) In order to reduce agency problems, managers may be provided compensation that includes:
A) a fixed salary so managers’ pay is not at risk, allowing managers to focus on the company’s business.
B) a bonus based on the level of profit achieved during the year.
C) an option to buy the company’s stock.
D) incentive pay for achieving higher sales than last year.
Answer:
Keywords: Agency Problems, Stock Option, Incentive Compensation
AACSB: Reflective thinking skills
35) An investor is considering two equally risky investments. Investment A is expected to return $1,000 per year for the next 5 years. Investment B is expected to return $6,000 at the end of 5 years. Which of the following statements is most correct if both investments A and B have the same cost?
A) A risk averse investor will select investment B because it is expected to provide the most cash ($6,000 > $5,000).
B) A risk averse investor will select investment A because it provides cash earlier than investment B.
C) The investor will select investment A only if the cost is less than $1,000.
D) The investor may select investment A or investment B depending on the opportunity cost of money.
Answer:
Keywords: Time Value of Money, Cash Flows
AACSB: Analytic skills
36) The CEO of High Tech International decides to change an accounting method at the end of the current year. The change results in reported profits increasing by 5%, but the company’s cash flows are not changed. If capital markets are efficient, then
A) the stock price will not be affected by the accounting change.
B) the stock price will increase due to higher profits.
C) the stock price will increase only if the accounting change will also result in higher profits in the next year.
D) the stock price will decrease because accounting method changes are not permitted under generally accepted accounting principles.
Answer:
Keywords: Efficient Markets
AACSB: Analytic skills
37) When evaluating an investment project, which of the following best describes the financial information needed by the decision maker?
A) after-tax accounting profits
B) after-tax incremental cash flows to the company as a whole
C) incremental cash flows before taxes so the decision will not be biased by a tax code that may change in the future
D) pre-tax accounting profits adjusted for any accounting method changes
Answer:
Keywords: After-Tax Incremental Cash Flows
AACSB: Reflective thinking skills
38) The CEO of JLI Corp. decided to expand into a new market in 2010. At the end of 2010, JLI’s stock price had decreased 5% since the beginning of the year. Which of the following statements is most correct?
A) The CEO made a poor decision to expand because the stock price decreased during the year.
B) The CEO made a poor decision to expand because the company’s profits for the year obviously decreased, causing the drop in stock price.
C) The CEO’s decision may have been optimal, keeping the stock price from falling more than 5% for the year.
D) CEO decisions are irrelevant because the efficient market determines the value of a company’s stock.
Answer:
Keywords: Stock Price Maximization, Efficient Markets
AACSB: Analytic skills
39) High Tech Corp. cut its research and development budget in 2010 by $4,000,000 in order to improve its cash flow for the year. Which of the following statements is most correct?
A) The stock price will likely increase because the value of stock is based on reported cash flow.
B) The stock price may decrease because investors may predict that future cash flows will decrease due to the lack of innovation and new products.
C) The change will have no impact on stock price because the company’s profits will not change in 2010.
D) The stock price will increase only if reported profits in 2010 are also higher than profits reported in 2009.
Answer:
Keywords: Stock Price, Cash Flow
AACSB: Analytic skills
40) In which of the following cases will the agency problem between shareholders and managers be the greatest?
A) 100% of the common stock is owned by the founder of the company who decided to retire and hired a manager to run his business for him.
B) The Johnson family owns 50% of the common stock of the company. The other 50% is owned by 5 mutual funds.
C) The common stock of the company is owned by many diverse shareholders, with no shareholder owning more than 1% of the outstanding stock.
D) All top managers in the company own significant amounts of stock and stock options.
Answer:
Keywords: Agency Problems
AACSB: Analytic skills
41) Executive compensation in the United States
A) is dominated by performance-based compensation that ensures fair and just pay for corporate executives.
B) is dominated by performance-based compensation designed to reduce agency problems.
C) cannot be linked to stock prices as this would create a conflict of interest with existing shareholders.
D) is well below levels in Europe and Asia.
Answer:
Keywords: Agency Problems, Executive Compensation
AACSB: Reflective thinking skills
42) The recent financial crises was exacerbated by
A) managers who overestimated risk and hence did not invest sufficient funds.
B) managers who underestimated the real risks of their decisions and borrowed excessively.
C) a lack of financial leverage that made U.S. firms less competitive in world markets.
D) extremely high interest rates in the United States that stifled investment.
Answer:
Keywords: Risk Requires a Return
AACSB: Reflective thinking skills
43) Ethical behavior
A) is the fifth basic principles of finance.
B) cannot be a concern to managers who are expected to maximize shareholder value.
C) in the corporate world means not breaking any laws.
D) is essential in business because unethical behavior destroys trust and business relationships.
Answer:
Keywords: Ethics
AACSB: Ethical understanding and reasoning abilities
44) Investors generally don’t like risk. Therefore, a typical investor
A) will not be induced to take on any risk.
B) will only take on the least risk possible.
C) will only take on additional risk if he expects to be compensated in the form of additional return.
D) will only accept a zero return if the risk is zero.
Answer:
Keywords: Risk-Return Tradeoff
AACSB: Reflective thinking skills
45) In finance, we assume that investors are generally
A) neutral to risk.
B) averse to risk.
C) fond of risk.
D) none of the above
Answer:
Keywords: Risk-Return Tradeoff
AACSB: Reflective thinking skills
46) Consider the after-tax cash flows for Project S and Project L:
Project S Project L
Year 1 $3000 0
Year 2 0 $3000
Project S Project L
Year 1 $3000 0
Year 2 0 $3000
A rational person would prefer ________.
A) Project S because the money can be reinvested sooner
B) Project L because they can avoid taxes by receiving cash flows later
C) information about profits instead of cash flows
D) neither investment over the other
Answer:
Keywords: Time Value of Money
AACSB: Reflective thinking skills
47) Assume that an investor is offered a choice of a risk-free government bond or a high-risk corporate stock. Further assume that the expected return is the same for both. According to one of the axioms of finance, which investment would be chosen?
A) the corporate stock
B) the government bond
C) neither, the investor would be indifferent
D) none of the above
Answer:
Keywords: Risk-Return Tradeoff
AACSB: Reflective thinking skills
48) Assume that an investor is offered a choice of a risk-free government bond that is expected to return 3.5% or a high-risk corporate stock. According to one of the principles of finance, what would induce the investor to purchase the corporate stock?
A) a return that is substantially lower than 3.5%
B) cash dividends
C) a return that is substantially higher than 3.5%
D) none of the above
Answer:
Keywords: Risk-Return Tradeoff
AACSB: Reflective thinking skills
49) Assume that you went to Las Vegas and hit the jackpot for $5 million. Further assume that you were offered a choice to receive the $5 million today, or receive it in two years. According to one of the principles of finance, which would you take?
A) The $5 million in two years because you would be afraid of spending it all right away.
B) The $5 million in two years because it would be worth more than if you would receive it today.
C) You would be indifferent as to when you would receive the $5 million.
D) The $5 million today because it would be worth more than if you would receive it in two years.
Answer:
Keywords: Time Value of Money
AACSB: Reflective thinking skills
50) Assume that you won the Lotta Dough Lotto jackpot for $20 million. Further assume that you were offered a choice to receive the $20 million today, or receive it in equal installments of $1 million per year for 20 years. According to one of the principles of finance, which would you take?
A) The $20 million in equal installments of $1 million per year for 20 years because you would be afraid of spending it all right away.
B) The $20 million today because it would be worth more than if you would receive it in equal installments of $1 million per year for 20 years.
C) You would be indifferent as to when you would receive the $20 million since the total number of dollars received is the same either way.
D) The $20 million in equal installments of $1 million per year for 20 years because it would be worth more than if you would receive it today.
Answer:
Keywords: Time Value of Money
AACSB: Reflective thinking skills
51) Which of the following statements best represents the “Agency Problem?”
A) Managers might attempt to benefit themselves in terms of salary and perquisites at the expense of shareholders.
B) The agency problem resu
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