Bae300 Chapter 1- Self Test

Front 1

What are the three types of financial mgmt decisions? For each type of decision, give an example of a business transaction that would be relevant.

Back 1

Capital budgeting (deciding whether to expand a manufacturing plant),

capital structure (deciding
whether to issue new equity and use the proceeds to retire outstanding debt)

working capital management (modifying the firm’s credit collection policy with its customers).

Front 2

What are the four primary disadvantages of the sole proprietorship and partnership forms of biz organization? What benefits are there to these types of biz organizations as opposed to corporate form?

Back 2

Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to raise
capital funds. Some advantages: simpler, less regulation, the owners are also the managers,
sometimes personal tax rates are better than corporate tax rates.

Front 3

What is the primary disadvantage of the corporate form of organization? Name at least 2 advantages of corporate organizaton.

Back 3

The primary disadvantage of the corporate form is the double taxation to shareholders of distributed
earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to
raise capital, unlimited life, and so forth.

Front 4

In response to the Sarbanes-Oxley Act, many small firms in the U.S. have opted to "go dark" and delist their stock. Why might a company choose this route? What are the costs of "going dark"?

Back 4

In response to Sarbanes-Oxley, small firms have elected to go dark because of the costs of
compliance. The costs to comply with Sarbox can be several million dollars, which can be a large
percentage of a small firms profits. A major cost of going dark is less access to capital. Since the
firm is no longer publicly traded, it can no longer raise money in the public market. Although the
company will still have access to bank loans and the private equity market, the costs associated with
raising funds in these markets are usually higher than the costs of raising funds in the public market.

Front 5

In a large corporation, what are the two distinct groups that report to the CFO? Which group is the focus of corporate finance?

Back 5

The treasurer’s office and the controller’s office are the two primary organizational groups that
report directly to the chief financial officer. The controller’s office handles cost and financial
accounting, tax management, and management information systems, while the treasurer’s office is
responsible for cash and credit management, capital budgeting, and financial planning. Therefore,
the study of corporate finance is concentrated within the treasury group’s functions.

Front 6

What goal should always motivate the actions of a firm's financial manager?

Back 6

To maximize the current market value (share price) of the equity of the firm (whether it’s publicly traded or not).

Front 7

Who owns a corporation? Describe the process whereby the owners control the firm's management. What is the main reason that an agency relationship exists in the corporate form of an organization? In this context, what kinds of problems can arise?

Back 7

In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders
elect the directors of the corporation, who in turn appoint the firm’s management. This separation of
ownership from control in the corporate form of organization is what causes agency problems to
exist. Management may act in its own or someone else’s best interests, rather than those of the
shareholders. If such events occur, they may contradict the goal of maximizing the share price of the
equity of the firm.

Front 8

Is an IPO a primary market transaction or a secondary market transaction?

Back 8

A primary market transaction.

Front 9

What is an auction market? How do they differ from dealer markets? What kind of market is NASDAQ?

Back 9

In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to
match buyers and sellers of assets. Dealer markets like NASDAQ consist of dealers operating at
dispersed locales who buy and sell assets themselves, communicating with other dealers either
electronically or literally over-the-counter.

Front 10

What kinds of goals are appropriate for a non profit?

Back 10

Such organizations frequently pursue social or political missions, so many different goals are
conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and
services are offered at the lowest possible cost to society. A better approach might be to observe that
even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to
maximize the value of the equity.

Front 11

Evaluate the follow statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

Back 11

Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows,
both short-term and long-term. If this is correct, then the statement is false.

Front 12

Can our goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored?

Back 12

An argument can be made either way. At the one extreme, we could argue that in a market economy,
all of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal
behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we
could argue that these are non-economic phenomena and are best handled through the political
process. A classic (and highly relevant) thought question that illustrates this debate goes something
like this: “A firm has estimated that the cost of improving the safety of one of its products is $30
million. However, the firm believes that improving the safety of the product will only save $20
million in product liability claims. What should the firm do?”

Front 13

Would our goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country? Why or why not?

Back 13

The goal will be the same, but the best course of action toward that goal may be different because of
differing social, political, and economic institutions.

Front 14

Corporate ownership varies around the world. Historically individuals have owned the majority of shares in public corporations in the U.S.. In Germany and Japan, however, banks other large financial institutions, and other companies own most of the stock in public corporations. Do you think agency problems are likely to be more or less severe in Germany/Japan than in the U.S.? Why? In recent years, large financial institutions such as mutual funds and pension funds have been becoming the dominant owners of stock in the U.S., and these institutions are becoming more active in corporate affairs. What are the implications of this trend for agency problems and corporate control?

Back 14

We would expect agency problems to be less severe in other countries, primarily due to the relatively
small percentage of individual ownership. Fewer individual owners should reduce the number of
diverse opinions concerning corporate goals. The high percentage of institutional ownership might
lead to a higher degree of agreement between owners and managers on decisions concerning risky
projects. In addition, institutions may be better able to implement effective monitoring mechanisms
on managers than can individual owners, based on the institutions’ deeper resources and experiences
with their own management. The increase in institutional ownership of stock in the United States and
the growing activism of these large shareholder groups may lead to a reduction in agency problems
for U.S. corporations and a more efficient market for corporate control.

Front 15

Do CEOs receive too much compensation in the U.S.?

Back 15

How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest answer is
that there is a market for executives just as there is for all types of labor. Executive compensation is
the price that clears the market. The same is true for athletes and performers. Having said that, one
aspect of executive compensation deserves comment. A primary reason executive compensation has
grown so dramatically is that companies have increasingly moved to stock-based compensation.
Such movement is obviously consistent with the attempt to better align stockholder and management
interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes
argued that much of this reward is simply due to rising stock prices in general, not managerial
performance. Perhaps in the future, executive compensation will be designed to reward only
differential performance, i.e., stock price increases in excess of general market increases

Front 16

Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all outstanding stock. Your company's management immediately begins fighting off this hostile bid. Is management acting in the shareholders' best interests? Why or why not?

Back 16

The goal of management should be to maximize the share price for the current shareholders. If
management believes that it can improve the profitability of the firm so that the share price will
exceed $35, then they should fight the offer from the outside company. If management believes that
this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the
company, then they should still fight the offer. However, if the current management cannot increase
the value of the firm beyond the bid price, and no other higher bids come in, then management is not
acting in the interests of the shareholders by fighting the offer. Since current managers often lose
their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight
corporate takeovers in situations such as this.

Front 17

• Role of the financial manager in a large corporation

Back 17

Coordinate the activities of the treasurer and the controller. The controller handles financial accounting, tax payments, and management information systems. The treasurer's office is responsible for managing the firm's cash and credit, its financial planning, and it's capital expenditures.

Front 18

• Agency problem

Back 18

The possibility of conflict of interest between the stockholders and management of a firm.

Front 19

• Primary vs. secondary

Back 19

Primary - original sale of securities by governments and corporations. (corp or gov sell to buyer)

Secondary - those in which the securities are bought and sold after the original sale. (one owner sells to another)

Front 20

• Dealer vs. auction markets•

Back 20

Both secondary markets.

Dealer - over the counter market. brokers and agents match buyers and sellers.

Auction - has a physical location (dealer doesn't have to). Matches those who wish to buy or sell by it's nature. Dealers play limited role.

Front 21

What does liquidity measure? Explain the trade off a firm faces between high and low liquidity levels.

Back 21

Liquidity measures how quickly and easily an asset can be converted to cash without significant loss
in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in
meeting short-term creditor demands. However, since liquidity also has an opportunity cost
associated with it—namely that higher returns can generally be found by investing the cash into
productive assets—low liquidity levels are also desirable to the firm. It’s up to the firm’s financial
management staff to find a reasonable compromise between these opposing needs.

Front 22

Why might the revenue and cost figures shown on a standard income statement not be representative of the actual cash inflows/outflows that occurred during a period?

Back 22

The recognition and matching principles in financial accounting call for revenues, and the costs
associated with producing those revenues, to be “booked” when the revenue process is essentially
complete, not necessarily when the cash is collected or bills are paid. Note that this way is not
necessarily correct; it’s the way accountants have chosen to do it.

Front 23

In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value?

Back 23

Historical costs can be objectively and precisely measured whereas market values can be difficult to
estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff
between relevance (market values) and objectivity (book values).

Front 24

In comparing accounting net income and operating cash flow, name two items you typically find in net income that are not in operating cash flow. Explain what each is and why it is excluded in operating cash flow.

Back 24

Depreciation is a non-cash deduction that reflects adjustments
made in asset book values in
accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but
it’s a financing cost, not an operating cost.

Front 25

Under standard accounting rules, it is possible for a company's liabilities to exceed it's assets. When this occurs, the owners' equity is negative. Can this happen with market values? Why/not?

Back 25

Market values can never be negative. Imagine a share of stock selling for –$20. This would mean
that if you placed an order for 100 shares, you would get the stock along with a check for $2,000.
How many shares do you want to buy? More generally, because of corporate and individual
bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities
cannot exceed assets in market value.

Front 26

Suppose a company's cash flow from assets is negative for a particular period. Is this necessarily a good sign or a bad sign?

Back 26

For a successful company that is rapidly expanding, for example, capital outlays will be large,
possibly leading to negative cash flow from assets. In general, what matters is whether the money is
spent wisely, not whether cash flow from assets is positive or negative.

Front 27

Suppose a company's operating cash flow from assets is negative for several years running. Is this necessarily a good sign or a bad sign?

Back 27

It’s probably not a good sign for an established company, but it would be fairly ordinary for a startup,
so it depends.

Front 28

Could a company's change in NWC be negative in a given year? Explain how this might come about. What about net capital spending?

Back 28

For example, if a company were to become more efficient in inventory management, the amount of
inventory needed would decline. The same might be true if it becomes better at collecting its
receivables. In general, anything that leads to a decline in ending NWC relative to beginning would
have this effect. Negative net capital spending would mean more long-lived assets were liquidated
than purchased.

Front 29

Could a company's cash flow to stockholders be negative for a given year? Explain how this might come about. What about cash flow to creditors?

Back 29

If a company raises more money from selling stock than it pays in dividends in a particular period,
its cash flow to stockholders will be negative. If a company borrows more than it pays in interest, its
cash flow to creditors will be negative.

Front 30

Referring back to the Merrill Lynch example used at the beginning of the chapter, note that we suggested that Merrill Lynch's stockholders probably didn't suffer as a result of the reported loss. What do you think was the basis for our conclusion?

Back 30

The adjustments discussed were purely accounting changes; they had no cash flow or market value
consequences unless the new accounting information caused stockholders to revalue the derivatives.

Front 31

A firm's enterprise value is equal to the market value of its debt and equity, less the firm's holdings of cash and cash equivalents. This figure is particularly relevant to potential purchasers or the firm. Why?

Back 31

Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have
to take on the company's debt, but would pocket its cash. Enterprise value differs significantly from
simple market capitalization in several ways, and it may be a more accurate representation of a firm's
value. In a takeover, the value of a firm's debt would need to be paid by the buyer when taking over
a company. This enterprise value provides a much more accurate takeover valuation because it
includes debt in its value calculation.

Front 32

Companies often try to keep accounting earnings growing at a relatively steady pace, thereby avoiding large swings in earnings from period to period. They also try to meet earnings targets. To do so, they use a variety of tactics. The simplest way is to control the timing of accountings revenues/costs, which all firms can do at least to some extent. E.g., if earnings are looking too low this quarter, then some accounting costs can be deferred until next quarter. This practice is called earnings management. It is common, and it raises a lot of questions. Why do firms do it? Why are firms even allowed to do it under GAAP? Is it ethical? What are the implications for cash flow and shareholder wealth?

Back 32

In general, it appears that investors prefer companies that have a steady earning stream. If true, this
encourages companies to manage earnings. Under GAAP, there are numerous choices for the way a
company reports its financial statements. Although not the reason for the choices under GAAP, one
outcome is the ability of a company to manage earnings, which is not an ethical decision. Even
though earnings and cash flow are often related, earnings management should have little effect on
cash flow (except for tax implications). If the market is “fooled” and prefers steady earnings,
shareholder wealth can be increased, at least temporarily. However, given the questionable ethics of
this practice, the company (and shareholders) will lose value if the practice is discovered.

Front 33

The basic present value equation has four parts. What are they?

Back 33

The four parts are the present value (PV), the future value (FV), the discount rate (r), and the life of
the investment (t).

Front 34

What is compounding. What is discounting?

Back 34

Compounding refers to the growth of a dollar amount through time via reinvestment of interest
earned. It is also the process of determining the future value of an investment. Discounting is the
process of determining the value today of an amount to be received in the future.

Front 35

As you increase the lengths of time involved, what happens to future values? What happens to present values?

Back 35

Future values grow (assuming a positive rate of return); present values shrink.

Front 36

What happens to a future value if you increase the rate? What happens to a present value?

Back 36

The future value rises (assuming it’s positive); the present value falls.

Front 37

Is it unethical to advertise a future value without a disclaimer?

Back 37

It would appear to be both deceptive and unethical to run such an ad without a disclaimer or
explanation.

Front 38

Why would TMCC be willing to accept such a small amount today ($1163) in exchange for a promise to reapy about 9 times that amount ($10,000) in the future?

Back 38

It’s a reflection of the time value of money. TMCC gets to use the $1,163. If TMCC uses it wisely, it
will be worth more than $10,000 in thirty years.

Front 39

TMCC has the right to buy back the securities on the anniversary date at a price established when the securities were issued. What impact does this have on the desirability of this security as an investment?

Back 39

This will probably make the security less desirable. TMCC will only repurchase the security prior to
maturity if it is to its advantage, i.e. interest rates decline. Given the drop in interest rates needed to
make this viable for TMCC, it is unlikely the company will repurchase the security. This is an
example of a “call” feature. Such features are discussed at length in a later chapter.

Front 40

Would you be willing to pay $1,163 today in exchange for $10,000 in 30 years? What would be the key considerations in answering yes or no? Would your answer depend on who is making the promise to repay?

Back 40

The key considerations would be: (1) Is the rate of return implicit in the offer attractive relative to
other, similar risk investments? and (2) How risky is the investment; i.e., how certain are we that we
will actually get the $10,000? Thus, our answer does depend on who is making the promise to repay.

Front 41

Suppose that when TMCC offered the security for $1,163 the U.S. Treasury had offered an essentially identical security. Do you think it would have had a higher or lower price? Why?

Back 41

The Treasury security would have a somewhat higher price because the Treasury is the strongest of
all borrowers.

Front 42

The TMCC security is bought and sold on the NYSE. If you looked at the price today, do you think the price would exceed the $1,163 original price? Why? If you looked in the year 2015, do you think the price would be higher or lower than today's price? Why?

Back 42

The price would be higher because, as time passes, the price of the security will tend to rise toward
$10,000. This rise is just a reflection of the time value of money. As time passes, the time until
receipt of the $10,000 grows shorter, and the present value rises. In 2015, the price will probably be
higher for the same reason. We cannot be sure, however, because interest rates could be much
higher, or TMCC’s financial position could deteriorate. Either event would tend to depress the
security’s price.

Front 43

There are four pieces to an annuity present value. What are they?

Back 43

The four pieces are the present value (PV), the periodic cash flow (C), the discount rate (r), and the
number of payments, or the life of the annuity, t.

Front 44

As you increase the length of time involved, what happens to the present value of an annuity? What happens to the future?

Back 44

Assuming positive cash flows, both the present and the future values will rise.

Front 45

What happens to the future value of an annuity if you increase the rate? What happens to the present value?

Back 45

Assuming positive cash flows, the present value will fall and the future value will rise.

Front 46

What do you think about the Tri-State Megabucks lottery discussed in the chapter advertising a $500,000 prize when the lump sum option is $250,000? Is it deceptive advertising?

Back 46

It’s deceptive, but very common. The basic concept of time value of money is that a dollar today is
not worth the same as a dollar tomorrow. The deception is particularly irritating given that such
lotteries are usually government sponsored!

Front 47

If you were an athlete signing a contract, would you want a big signing bonus payable immediately and smaller payments in the future, or vice versa? How about looking at it from the team's perspective?

Back 47

If the total money is fixed, you want as much as possible as soon as possible. The team (or, more
accurately, the team owner) wants just the opposite.

Front 48

Suppose two athletes sign 10-year contracts for $80 million. In one case, we're told that the $80 million will be paid in 10 equal installments. In the other case, we're told that the money will be paid in 10 installments, but the installments will increase by 5% per year. who got the better deal?

Back 48

The better deal is the one with equal installments.