Chapter 1

Question 1

What are the two basic sources of funds for all businesses?

Answer 1

debt and equity

Question 2

What is net working capital?

Answer 2

Net working capital is the difference between a firm’s total current assets and its total current liabilities.

Question 3

Explain the difference between profitable and unprofitable firms.

Answer 3

A profitable firm is able to generate enough cash flows from productive assets to cover its operating expenses, taxes, and payments to creditors. Unprofitable firms fail to do this, and therefore they may be forced to declare bankruptcy.

Question 4

What three major decisions are of most concern to financial managers?

Answer 4

Capital budgeting, financing, and working capital

Question 5

What are agency costs?

Answer 5

The costs incurred because of conflicts of interests between a principal and an agent

Question 6

The major advantage of debt financing is:

Answer 6

Interest payments are tax deductible.

Question 7

Identify four of the seven mechanisms that can help better align the goals of managers with those of stockholders.

Answer 7

(1) board of directors, (2) management compensation, (3) managerial labor market, (4) other managers, (5) large stockholders, (6) the takeover market, and (7) the legal and regulatory environment.

Question 8

What is the appropriate decision rule for a firm considering undertaking a project? Give a real-life example.

Answer 8

A firm should undertake a capital project only if the value of its future cash flows exceeds the cost of the project.

Question 9

What is a firm’s capital structure, and why is it important?

Answer 9

Capital structure shows how a company is financed; it is the mix of debt and equity on the liability side of the balance sheet. It is important as it affects the risk and the value of the company. In general, companies with higher debt-to-equity proportions are riskier because debt comes with legal obligations to pay periodic payments to creditors and to repay the principal at the end.

Question 10

What are some of the working capital decisions that a financial manager faces?

Answer 10

The financial manager must make working capital decisions regarding the level of inventory to hold, the terms of granting credit (account receivables), and the firm’s policy on paying accounts payable.

Question 11

What are the advantages and disadvantages of a sole proprietorship?

Answer 11

Advantages: easiest business type to start; least regulated; owners have full control; all income is taxed as personal income. Disadvantages: unlimited liability of proprietor; initial capital limited to proprietor’s wealth; difficult to transfer ownership.

Question 12

What are the common forms of business organization discussed in this chapter?

Answer 12

Sole proprietorships, Partnerships, Corporations, and Limited Liability Companies

Question 13

What is a partnership, and what is the biggest disadvantage of this form of business organization? How can this disadvantage be avoided?

Answer 13

A partnership consists of two or more owners who have joined together legally to manage a business. A key disadvantage of a general partnership is that, like the proprietor in a sole proprietorship, all partners have unlimited liability. he problem of unlimited liability is avoided for some partners in a limited partnership because limited partners can generally only lose the amount of money that they have invested in the business.

Question 14

Who are the owners of a corporation, and how is their ownership represented?

Answer 14

The owners of a corporation are its stockholders, and the evidence of their ownership is represented by shares of common stock.

Question 15

Explain what is meant by stockholders’ limited liability.

Answer 15

The legal liability of an investor is limited to the amount of capital invested in the business

Question 16

What is double taxation?

Answer 16

Double taxation occurs when earnings are taxed twice. The owners of a C-corporation are subject to double taxation—first at the corporate level when the firm’s earnings are taxed and then again at a personal level when the dividends they receive are taxed.

Question 17

What is the form of business organization taken by most large companies and why?

Answer 17

Most lawyers, accountants, and doctors form what are known as limited liability partnerships. These formations combine the tax advantages of partnerships with the limited liability of corporations.

Question 18

What is the primary responsibility of the board of directors in a corporation?

Answer 18

The board of directors of a corporation is responsible for serving the interests of stockholders in managing the corporation. It is possible that the interests of managers may deviate from those of their stockholders. The board’s objective is to hire and monitor managers to ensure that they are acting in the best interests of the stockholders. Board duties include hiring and firing the CEO, setting CEO pay, and monitoring the investment decisions of managers.

Question 19

All public companies must hire a certified public accounting firm to perform an independent audit of their financial statements. What exactly does the term audit mean?

Answer 19

An examination of records or financial accounts to check their accuracy.

Question 20

What are some of the drawbacks to setting profit maximization as the main goal of a company?

Answer 20

Problems include: It is difficult to determine what is meant by profits; it does not address the size and timing of cash flows (it does not account for the time value of money); and it ignores the uncertainty (risk) of cash flows.

Question 21

What is the appropriate goal of financial managers? How do managers’ decisions affect how successful the firm is in achieving this goal?

Answer 21

Thus, an appropriate goal for management is to maximize the current value of the firm’s stock.

Question 22

What are the major factors that affect a firm’s stock price?

Answer 22

Factors that affect the stock price include: The characteristics of the firm, the economy, economic shocks, the business environment, expected cash flows, and current market conditions.

Question 23

What is an agency relationship, and what is an agency conflict? How can agency conflicts be reduced in a corporation?

Answer 23

An agency relationship arises whenever one party, called the principal, hires another party, called the agent, to perform some service on behalf of the principal. Agency conflicts are conflicts of interest between a principal and an agent

Question 24

What can happen if a firm is poorly managed and its stock price falls substantially below its maximum?

Answer 24

If a firm’s stock price falls sustainably below its maximum potential price, it might attract corporate raiders. These persons look for firms that are fundamentally sound but poorly managed, so that they can buy the firm, turn it around, and sell it for a profit.

Question 25

How can a lack of business ethics negatively affect the performance of an economy? Give an example.

Answer 25

A lack of business ethics can lead to corruption, which, in turn, creates inefficiencies in an economy, inhibits the growth of capital markets, and slows the rate of overall economic growth. For example, the Russian economy has had a relatively difficult time attracting foreign investment since the fall of the Soviet Union due, in part, to corruption in the business community and local and national governments. Lower foreign investment has led to slower overall economic growth than the country might otherwise have enjoyed.

Question 26

What are some ways to resolve a conflict of interest?

Answer 26

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Question 27

Describe what an information asymmetry is in a business transaction. Explain how the inequity associated with an information asymmetry might be, at least partially, solved through the market for goods or services.

Answer 27

An information asymmetry exists when one party to a business transaction possesses information that is not available to the other parties in the transaction. If the parties with less information understand their relative disadvantage, they are likely to pay lower prices for the goods or services they purchase, or charge higher prices for the goods and services that they sell.

Question 28

What ethical conflict does insider trading present?

Answer 28

Insider trading is an example of information asymmetry. The main idea is that investment decisions should be made on an even playing field. Insider trading is morally wrong and has also been made illegal.