EoCB_chap1 (2)

Question 1

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

Answer 1

The two basic sources of funds for all businesses are debt and equity.

Question 2

1.2 Management role: What is net working capital?

Answer 2

Networkingcapitalisthedifferencebetweenafirm’stotalcurrentassetsanditstotal
current liabilities.

Question 3

1.3 Cash flows: 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

1.4 Management role: What three major decisions are of most concern to financial managers?

Answer 4

Financial managers are most concerned with the capital budgeting decisions, the financing decisions, and the working capital management decisions.

Question 5

1.5 Cash flows: What is the appropriate decision rule for a firm considering undertaking a capital project? Give a real-life example.

Answer 5

A firm should undertake a capital project only if the value of its future cash flows exceeds the cost of the project. For example, a financial manager would not invest $10,000,000 in a new production line if the net present value of future cash flows from that line are expected to be only $9,000,000. That would be like throwing $1,000,000 away.

Question 6

1.6 Management role: What is a firm’s capital structure, and why is it important?

Answer 6

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 7

1.7 Management role: What are some of the working capital decisions that a financial manager faces?

Answer 7

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

Question 8

1.8 Organizational form: What are the common forms of business organization discussed in this chapter?

Answer 8

Solution: The common forms of business organization discussed are sole proprietorship, partnership, corporation, and limited liability company and partnership.

Question 9

1.9 Organizational form: What are the advantages and disadvantages of a sole proprietorship?

Answer 9

Advantages:
* It is the easiest business organization to start.
* It is the least regulated.
* Owners keep all the profits and do not have to share the decision-making
authority with anyone.
* All income is taxed as personal income, which is usually in a lower tax bracket
than corporate income.

Disadvantages:
* The proprietor has an unlimited liability for all business debt and financial obligations of the firm.
* The amount of capital that can be invested in the firm is limited by the proprietor’s wealth.
* It is difficult to transfer ownership (requires sale of the business).

Question 10

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

Answer 10

A partnership consists of two or more owners legally joined together to manage a business. The major disadvantage to partnerships is that all partners have unlimited liability for the organization’s debts and legal obligations no matter what stake they have in the business. One way to avoid this is to form a limited partnership in which only general partners have unlimited liability and limited partners are only responsible for business obligations up to the amount of capital they have invested in the partnership.

Question 11

1.11 Organizational form: Who are the owners in a corporation, and how is their ownership represented?

Answer 11

The owners of a corporation are its stockholders or shareholders, and the evidence of their ownership is represented by shares of common stock. Other types of ownership do exist and include preferred stock.

Question 12

1.12 Organizational form: Explain what is meant by stockholders’ limited liability.

Answer 12

Limitedliabilityforastockholdermeansthatthestockholder’slegalliabilityextends
only to the capital contributed or the amount invested.

Question 13

1.13 Organizational form: What is double taxation?

Answer 13

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 they receive dividends.

Question 14

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

Answer 14

Most large companies prefer to operate as public corporations because large amounts of capital can be raised in public markets at a relatively low cost.

Question 15

1.15 Finance function: What is the primary responsibility of the board of directors in a corporation?

Answer 15

The board of directors of a corporation is responsible for serving the interests of stockholders in managing the corporation. It is possible that the interest of managers may deviate from those of the stockholders. The board’s objective is to monitor and correct any management decisions that might not be in the best interest of the stockholders. For example, board duties include hiring and firing the CEO, setting CEO pay, and monitoring the investment decisions of managers.

Question 16

1.16 Finance function: 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 16

An independent CPA firm that performs an audit of a firm ensures that the financial numbers are reasonably accurate, that accounting principles have been adhered to year after year and not in a manner that distorts the firm’s performance, and that the accounting principles used are in accordance with generally accepted accounting principles (GAAP).

Question 17

1.17 Firm’s goal: What are some of the drawbacks to setting profit maximization as the main goal of a company?

Answer 17

• It is difficult to determine what is meant by “profit”.
• It does not address the size and timing of cash flows—it does not account for the
  time value of money.
• It ignores the uncertainty or risk of cash flows.

Question 18

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

Answer 18

The appropriate goal of financial managers should be to maximize the current value of the firm’s stock price. Managers’ decisions affect the stock price in many ways as the value of the stock is determined by the future cash flows the firm can generate. Managers can affect the cash flows by, for example, selecting what products or services to produce, what type of assets to purchase, or what advertising campaign to undertake.

Question 19

1.19 Firm’s goal: What are the major factors that affect a firm’s stock price?

Answer 19

The factors affecting the stock price include: characteristics, the economy, economic shocks, the business environment, expected cash flows, and current market conditions.

Question 20

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

Answer 20

Agency relationships develop when a principal hires an agent to perform some service or represent the firm. An agency conflict arises when the agent’s interests and behaviors are at odds with those of the principal. Agency conflicts can be reduced through the following three mechanisms: management compensation, control of the firm, and the board of directors.

Question 21

1.21 Firm’s goal: What can happen if a firm is poorly managed and its stock price falls substantially below its maximum potential price?

Answer 21

If the stock price falls below its maximum potential price, it attracts corporate raiders, who look for fundamentally sound but poorly managed companies they can buy, turn around, and sell for a handsome profit.

Question 22

1.22 Agency conflicts: What are some of the regulations that pertain to boards of directors that were put in place to reduce agency conflicts?

Answer 22

Some of the regulations include:
* The majority of board members must be outsiders.
* A separation of the CEO and chairman of the board positions is recommended.
* Firm is required to have a code of ethics approved by the board.

Question 23

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

Answer 23

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 weak ethics and 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 24

1.24 Agency conflicts: What are some ways to resolve a conflict of interest?

Answer 24

One way to resolve a conflict of interest is by complete disclosure. As long as both parties are aware of the fact that, for example, both parties in a contract negotiation are represented by the same firm, disclosure is sufficient. Another way to avoid a conflict of interest is for the company to remove itself from serving the interest of one of the parties. This is, for example, the case with accounting firms not being allowed to serve as consultants to companies for whom they perform audits.

Question 25

1.25 Information asymmetry: 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 25

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 and services they purchase, or charge higher prices for the goods and services they sell.

Question 26

1.26 Business ethics: What ethical conflict does insider trading present?

Answer 26

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 illegal because it puts one party at a significant disadvantage in trading. If insider
trading were allowed, capital transfers would be much more difficult.

Question 27

Sample Test Problems
1.1 Identify three fundamental types of decisions that financial managers make and identify which part of the balance sheet each of these decisions affects.

Answer 27

Solution:
1. Capital Budgeting Decisions – identifying the productive assets the firm should buy. These decisions affect long-term assets on the balance sheet.
2. Financing Decisions – determining how the firm should finance or pay for assets. These decisions affect long-term debt and stockholders’ equity on the balance sheet.
3. Working Capital Management Decisions – determining how day-to-day financial matters should be managed. These decisions affect current assets and current liabilities on the balance sheet.

Question 28

Sample Test Problems
1.2 Which of the following is/are advantages of the corporate form of organization?
a. Reduced start-up costs
b. Greater access to capital markets
c. Unlimited liability
d. Single taxation

Answer 28

Solution: b. (Shares in a corporation can be sold to raise capital from investors who are not involved in the business. This greatly increases the amount of capital that can be raised to fund the business.)

Question 29

Sample Test Problems
1.3 Why is stock value maximization superior to profit maximization as a goal for management?

Answer 29

Solution: Whileprofitmaximizationappearstobealogicalgoalatfirstglance,ithassome serious drawbacks. First, since accounting profit is the difference between revenues and expenses, it can be distorted by accounting decisions. Second, accounting profits are quite different from cash flows. Since cash flows are the focus of investors, they should also be the focus of managers. Third, profit maximization does not account for when cash flows actually occur. Finally, profit maximization as a goal ignores the risk involved in generating the cash flows.
Stock value maximization is superior to profit maximization because it overcomes all of the listed shortcomings of profit maximization. This is because the value of a firm’s stock is determined by the cash flows that the firm is expected to produce. It accounts for (1) the size of the expected cash flows, (2) the timing of the expected cash flows, and (3) the riskiness of the expected cash flows.

Question 30

Sample Test Problems
1.4 What are agency costs? Explain.

Answer 30

Solution: Agency costs are costs that result from an agency relationship in which there is a
conflict of interest between a principal and an agent. An agency relationship exists in a business when a firm’s managers (agents) are not also its owners (principals). Agency costs are incurred when managers act in ways that harm owners’ interests. The cost of mechanisms, such as audits, that help control agency conflicts are also agency costs.

Question 31

Sample Test Problems
1.5 Identify seven mechanisms that can help better align the goals of managers with those of stockholders.

Answer 31

Solution: Mechanisms that can help align the goals of managers with those of stockholders are as follows:
(1) the board of directors,
(2) management compensation,
(3) the managerial labor market,
(4) competition among managers,
(5) large stockholders,
(6) the takeover market, and
(7) the legal and regulatory environment.

Boards of directors that are independent from managers can help limit the extent to which managers are able to act solely in their own interest. Firms design compensation plans that are tied to firm performance in order to provide managers with incentives to make decisions consistent with the goal of stockholder value maximization. A third mechanism that helps align the goals of managers is the managerial labor market. It is difficult for poorly performing managers to find a good