Chapter 1: Questions

Question 1

PQ1.1: Compare the 4 business structures that may be used by a company

Answer 1

• The business may be set up as a sole trader. This is only suitable if there is one owner.
• The business may be set up as a partnership. This approach is suitable when there is more
  than one owner. The partnership can be an ordinary partnership or a limited liability
  partnership.
• The business may be set up as a private limited or public limited company. A public limited
  company is likely to be quoted on the stock exchange with its shares regularly traded.
• The sole trader structure and ordinary partnership leave each owner’s personal wealth at risk if
  the business fails. Under the other structures each owner’s liability is limited to the money
  invested in the business.
• There is greater separation of ownership and control under a company, particularly a public
  limited company with the shareholders owning the business but not usually being involved in the
  day-to-day running of the business.

Question 2

PQ1.2: Describe the role fo the CFO and their principal goal

Answer 2

The CFO is responsible for deciding on:
* the resources that the company will need, and
* the projects the company should run …
… this is the investment or capital budgeting decision.
The principal aim of the CFO is to maximise shareholder wealth by undertaking profitable projects and ensuring funds are raised in an efficient way.

Question 3

PQ1.3: Describe the role of the treasurer

Answer 3

The Treasurer will be responsible for:
* raising new cash when it is needed, as part of the financing decision
* managing the company’s cash
* keeping good relations with those who are already lending the company money.

Question 4

PQ1.4: Explain the importance of the capital budgeting decision

Answer 4

The capital budgeting decision relates to the choices made by the company as to which assets to invest in.
It is an important decision since incorrect choices can be costly and will affect the future direction of the business.

Question 5

PQ1.5: Outline the two principal sources of finance likely to be used by companies when investing in assets

Answer 5

Companies are most likely to finance projects using long-term finance. The two main sources
are:
* equity, ie the shares (or stock) market
* the bond market, ie debt finance

Question 6

Q1.6: Explain, using examples, how and why the interests of different stakeholders in a company may be in conflict

Answer 6

There are many examples of potential conflicts of interest between key stakeholders in a company, for example:
* Lenders and shareholders
* * Lenders are primarily interested in ensuring their loan payments are met over the term of the loan, they do not want the company to take unnecessary risk …
* * … whereas shareholders are interested in maximising long-term profits and might be happy for risk to be taken on.
* Managers and shareholders
* * Managers may aim to increase the size of the company and hence their power and prestige, or boost short-term profits to benefit from any performancerelated bonuses to which they are entitled.
* * These objectives can conflict with the longer-term objectives of the shareholders.
* Employees and shareholders
* * Employees may be focused on improved salaries and other benefits, for example pensions …
… but the provision of these extra benefits would be costly and reduce the profits made for the shareholders.

Question 7

PQ1.7: Define the terms agency theory and agency costs.
Explain how agency costs arise in the relationship between a company’s management and employees

Answer 7

Agency theory considers the complex relationships and conflicting objectives between a principal and an agent of that principal. Where the interests of these two parties diverge then principal-agent problems arise.
(i)(b) Agency costs arise due to conflicts and costs in monitoring and trying to reduce the
principal-agent problems.
(ii) In this case the company’s management is the ‘principal’ and the employees are the ‘agents of the principal’.
The agency costs arise since employees may be interested in only working hard enough to secure their basic salary …
… whereas managers may be entitled to performance-related bonuses and therefore may wish to motivate the employees to work hard to maximise the company’s profits.

Question 8

PQ1.8: A new manager in a company has stated that a company’s only responsibilities are to its shareholders and lenders. Comment on this statement.

Answer 8

A company’s primary responsibilities may be to its shareholders and lenders, but the company also has wider responsibilities in relation to society as a whole.
The company needs to manage its operations:
* in an ethical way, eg in terms of how it sources rare materials
* with consideration of its customers, ie ensuring the products it sells are safe
* by ensuring fair treatment of employees, eg through employment contracts setting out reasonable terms and conditions.
Regulation may control some of these areas. The company will also wish to avoid reputational risk arising from failures in these areas.

Question 9

Explain why it is difficult for shareholders to be assured that directors are consistently working to serve their interests.

Answer 9

• Shareholders are the ‘principals’ who elect directors as ‘agents’ to make decisions on their behalf. The interests of the two parties may not however be aligned.
• Shareholders often plan to hold shares for a limited time. Their aim is to maximise the return on their shares over this time.
• The objectives of directors may differ. They may be more concerned with their total remuneration and with the security of their jobs.
• In addition, information asymmetries arise as the shareholders’ ability to monitor the actions of
  the directors is limited, ie not all information about the company’s performance and future plans
  will be in the public domain.