Introduction to Corporate Finance, 2nd edition, authors Laurence Booth & W. Sean Cleary solutions manual and test bank
Chapter 2: Business (Corporate) Finance
Multiple Choice Questions
Section 2.1 – Types of Business Organizations
1 Which of the following is not a reason for incorporating a business?
A. Limited liability
B. Ownership is relatively easy to transfer
C. It is easier to from than a proprietorship
D. Corporate tax laws may allow tax deferral or avoidance
Answer: C Type: Concept Level of Difficulty: Easy LO: 2.1
2. Which of the following is not a form of business organization?
A. Corporation
B. Sole partnership
C. General partnership
D. Sole proprietorship
Answer: B Type: Definition Level of Difficulty: Easy LO: 2.1
3. If you are in a business that is faced with enormous risks of failure what type of ownership would you avoid?
A. Corporation
B. Sole partnership
C. General partnership
D. Sole proprietorship
Answer: D Type: Concept Level of Difficulty: Easy LO: 2.1
4. Which of the following is an advantage of a corporation over a sole proprietorship?
A. A corporation is easy to set up
B. Corporate tax laws are often less attractive than personal tax laws
C. Shareholders’ liability is limited to their investment in the corporation
D. In a sole proprietorship, it is easier to transfer ownership
Answer: C Type: Concept Level of Difficulty: Easy LO: 2.1
5. What was the reason for the increase in the number of income trusts in Canada?
A. Limited liability
B. Unlimited liability
C. Tax advantage
D. Transfer of ownership
Answer: C Type: Concept Level of Difficulty: Easy LO: 2.1
6. Which of the following is the most correct? ___________________ know their exposure is limited to the amount of capital they invest in the company.
A. Shareholders
B. Sole proprietors
C. General and limited partners
D. Limited partners and shareholders
Answer: D Type: Concept Level of Difficulty: Medium LO: 2.1
7. Which of the following is (are) true about a general partnership?
I Some of the partners have limited liability.
II Some of the partners may not be involved in the day-to-day operations.
III Some partners may receive a different percentage of the profits.
A. III only
B. I and III
C. II and III
D. I and II
Answer: C Type: Concept Level of Difficulty: Medium LO: 2.1
8. Beginning in 2011, in Canada, what will be the most appropriate type of organization for a business with large assets and revenue?
A. Trust
B. Corporation
C. General partnership
D. Sole proprietorship
Answer: B Type: Concept Level of Difficulty: Medium LO: 2.1
9. Which of the following businesses is most likely to be operated as a corporation?
A. A law firm
B. A mining company
C. An accounting firm
D. All of these are likely to be operated as a corporation.
Answer: B Type: Concept Level of Difficulty: Easy LO: 2.1
10. The main purpose of creating a trust is to:
I Separate ownership from control
II Avoid legal liability
III Avoid taxes
IV Improve a firm’s reputation
A. I, II, and III
B. I and IV
C. I and III
D. III and IV
Answer: C Type: Concept Level of Difficulty: Easy LO: 2.1
11. Which of the following is not an example of a trust?
A. A mutual fund
B. An estate
C. A royalty trust
D. A bank
Answer: D Type: Concept Level of Difficulty: Easy LO: 2.1
12. After 20 years of being the sole proprietor of Monteregie Lawn Care, Denis Seville is considering making a change. His business has grown substantially over the years and he now has approximately one hundred extremely loyal clients. Denis wants to retire and move to Florida. Unfortunately, Denis has no children to carry on his business and thus he is thinking of selling it to someone else. What is the main consideration Denis should have about selling his lawn care business?
A. Lawn care is seasonal and not many people would want to purchase his business.
B. No one can meet the needs of his clients as well as he can.
C. He will face some difficulty in selling because all the client relationships are personal and belong to him; he will have to explain the new situation to each client.
D. The new owner may not retain the same business name.
Answer: C Type: Concept Level of Difficulty: Medium LO: 2.1
13. Lucy Vale and Bob Fama, both accountants, have opened an accounting firm in Calgary together and business has been steadily increasing. Since they each have the same number of clients, Lucy and Bob decided to simply split any income equally between them. However, Lucy has recently made a grievous error in the financial statements of one of her clients, and that client is now considering suing Lucy and the firm. If Lucy and Bob had never created a formal partnership agreement since the inception of their firm, should Bob be at all concerned about the potential lawsuit? Choose the best answer from the following:
A. No. Since there was no formal partnership agreement made, Bob cannot be held responsible for Lucy’s error.
B. Yes. A legal agreement is not always required for someone to be considered a partner of a partnership. Thus, Bob may be held partially responsible for Lucy’s error in the event the client sues the firm.
C. No. It was Lucy’s client and she made the error. Bob was not involved.
D. Yes. Bob has just incurred substantial debt by purchasing a new home which was partially financed by his share of the firm’s earnings.
Answer: B Type: Concept Level of Difficulty: Medium LO: 2.1
Section 2.2 – The Goals of the Corporation
14. Which of the following should be the primary goal of a CEO in a publicly-traded company?
A. Maximize the profit margin
B. Avoid bankruptcy
C. Increase market share
D. Maximize the company’s share price
Answer: D Type: Concept Level of Difficulty: Easy LO: 2.2
15. Why is wealth different from profits?
A. Wealth is a personal issue, while profits are related to a business.
B. Profits include a deduction for expenses, and expenses are not relevant for wealth calculations.
C. Wealth reflects the value of all profits, both short- and long-term, while profits refer to economic profits only.
D. All of the above.
Answer: C Type: Concept Level of Difficulty: Medium LO: 2.2
16. What are externalities?
A. Valuable resources to a company that the firm does not pay or charge for.
B. Issues in the surrounding business environment of a firm which have no impact on the firm’s operations or policies.
C. Members of the board of directors who are not employed by the firm.
D. None of the above.
Answer: A Type: Definition Level of Difficulty: Easy LO: 2.2
17. Why are externalities a necessary consideration when conducting business, especially for large corporations?
A. Externalities always cost money, and those costs hurt a firm’s bottom line.
B. Forgetting to account for externalities is against tax laws in Canada.
C. The actions a large firm makes can have a significant impact on other firms, and those actions may not necessarily be in Canada’s best interests.
D. All of the above.
Answer: C Type: Concept Level of Difficulty: Medium LO: 2.2
18. Which of the following is/are considered a stakeholder in a mining company?
A. Bondholders
B. Customers
C. Provincial government
D. All of the above
Answer: D Type: Concept Level of Difficulty: Easy LO: 2.2
19. Which one of the following is not part of externalities?
A. Union pension costs and regulations
B. High borrowing rate
C. Labour regulations
D. Cost of carbon emissions
Answer: B Type: Concept Level of Difficulty: Medium LO: 2.2
20. Who, of the following, does not have a contractual claim on a company?
A. Employees
B. Shareholders
C. Local community
D. Customers
Answer: C Type: Concept Level of Difficulty: Medium LO: 2.2
21. What is the risk-return tradeoff?
A. A firm will only have returns when it takes on risk.
B. A firm can either have risk, or it can have returns, but not both.
C. The balancing of gain with risk.
D. A risky return is always preferred to a risk-free return.
Answer: C Type: Definition Level of Difficulty: Easy LO: 2.2
22. Which one of the following is not true about the board of directors?
A. It represents shareholders interests
B. It cannot ignore its stakeholders
C. It is involved with guiding the management of the company
D. Board of directors include members of the company’s management team.
Answer: B Type: Concept Level of Difficulty: Medium LO: 2.2
23. What is the main implication of the 1994 Dey Report?
A. Firms should pay attention to special interests or other stakeholders, not just shareholders.
B. Boards of directors are responsible only for ensuring management is maximizing revenue.
C. Boards of directors can ignore stakeholders and focus solely on shareholders while maintaining their contractual responsibilities.
D. Considerations for social welfare should be of utmost importance to firms.
Answer: C Type: Concept Level of Difficulty: Medium LO: 2.2
Section 2.3 – The Role of Management and Agency Issues
24. Which of the following is an example of an agency cost?
A. A company buys the latest computer equipment for its employees.
B. Senior management receives stock options enabling them to buy company stock at an exercise price well above the current stock price.
C. Managers can use the company float plane to fly to their cottages on weekends.
D. Sales reps are provided with company cars to use when visiting clients.
Answer: C Type: Concept Level of Difficulty: Easy LO: 2.3
25. Agency problems are best defined as:
A. difficulties arising in dealings with real estate agencies.
B. problems arising due to potential misalignment between the interests of owners, creditors, and managers.
C. problems arising due to the complete alignment of the interests of owners, creditors, and managers.
D. issues surrounding whether or not to outsource production to an external agency.
Answer: B Type: Definition Level of Difficulty: Easy LO: 2.4
26. Which one of the following is not an example of agency problem?
A. Management refusing a merger because of the possibility of major changes in management
B. Taking a high risk to increase the value of the stock options held by management.
C. Increasing the level of debt of the company to increase the return on equity value.
D. Distributing a low level of dividends to have enough cash for bonuses.
Answer: C Type: Concept Level of Difficulty: Difficult LO: 2.4
27. Which of the following will help shareholders mitigate agency problems? Shareholders can:
I Elect directors
II Challenge management through proxy fights
III Tender their shares to outsiders in a hostile takeover
IV Sell their shares on the stock market
A. I, II, and IV
B. II, III, and IV
C. I, II, and III
D. I, II, III, and IV
Answer: D Type: Concept Level of Difficulty: Medium LO: 2.3
28. Which of the following is true?
A. Managers can ignore the objective of shareholder wealth in the short-run in favour of other stakeholders’ interests, but not in the long run.
B. In 2000, BCE spun-off its ownership in Nortel, making this an example of a firm’s agency costs diminishing shareholder value.
C. A 1997 Canadian survey of Shareholder Value Measurement showed that a minority of companies with listed shares state maximizing firm value is a key corporate objective.
D. Without adequate financial performance, a firm can survive in a competitive environment.
Answer: A Type: Concept Level of Difficulty: Medium LO: 2.4
29. You are asked to watch over your brother and sister in exchange for a fee. You invited your friends over and you watched TV all night without paying attention to your siblings. What type agency problem is this?
A. Indirect
B. Direct
C. Moral hazard
D. None of the above
Answer: C Type: Concept Level of Difficulty: Medium LO: 2.4
30. Which of the following is true?
A. Management buying another business at a premium may be an example of an agency cost.
B. Sole proprietorships can be vulnerable to agency costs.
C. Stock options are an example of an agency cost.
D. Agency costs do not include expenses of monitoring and controlling the actions of management.
Answer: B Type: Concept Level of Difficulty: Hard LO: 2.4
31. A merger between Bank of Montreal and TD bank would be a potential
A. Agency problem
B. Too big to fail problem
C. Moral hazard
D. None of the above
Answer: B Type: Concept Level of Difficulty: Easy LO: 2.4
32. Of the following list, which represents a potential implication for agency issues when shareholders are dispersed?
A. More shareholders have a controlling say in what happens in the firm.
B. The likelihood of management pleasing all shareholders is greatly improved.
C. A firm’s chief executive officer (CEO) is better able to choose his or her friends to sit on the board of directors.
D. None of the above.
Answer: C Type: Concept Level of Difficulty: Medium LO: 2.4
33. Which one of the followings is not a criterion that managers prefer to be judged upon?
A. Return on Assets
B. Return on Equity
C. Share price
D. Market share
Answer: C Type: Concept Level of Difficulty: Easy LO: 2.3
34. Why do shareholders have a greater preference for risk than do managers?
A. Shareholders are always richer than managers, and can afford to take more risk.
B. Shareholders can diversify risk by holding many securities, while a manager’s career is tied up with the firm.
C. Because they are investing in the stock market, shareholders must naturally prefer taking more risk than managers.
D. Managers do not like risk because it hurts the value of the company.
Answer: B Type: Concept Level of Difficulty: Medium LO: 2.3
35. What is the main purpose behind share incentive plans?
A. The plans encourage managers to invest in the stock market.
B. The plans are meant to align the interests of management and shareholders.
C. The plans encourage managers to give shares as incentives for employees.
D. All of the above.
Answer: B Type: Concept Level of Difficulty: Easy LO: 2.3
36. Which one of the following is true?
A. Managers have the mandate to increase the market value of the company.
B. Managers do not always look after shareholders’ interests.
C. The Board of directors is legally responsible for all the company’s decisions.
D. All of the above
Answer: A Type: Concept Level of Difficulty: Medium LO: 2.3
37. Share incentive plans have not produced the desired results. Why?
A. The retooling of option grants and share incentive schemes
B. Compensation schemes are generally designed to reward management, not to provide incentives
C. Fraud
D. All of the above
Answer: D Type: Concept Level of Difficulty: Medium LO: 2.3
38. Which one of the following is not a way to improve the efficiency in Canadian wealth management?
A. Encourage takeovers
B. Limit management’s defence mechanisms with regards to takeovers
C. Hold managers personally accountable
D. Increase measures of corporate governance
Answer: B Type: Concept Level of Difficulty: Medium LO: 2.3
39. Which of the following is not a reason why the market for corporate control is the most effective mechanism to give managers the incentive to act like shareholders?
A. The government imposes significant lawsuits and penalties for managers not acting in the best interests of shareholders.
B. The threat of acquisition keeps managers focused on achieving good performance and a high stock price.
C. A low stock price makes a firm a good target for acquisition.
D. It allows the best managers the chance to manage assets.
Answer: A Type: Concept Level of Difficulty: Medium LO: 2.3
Section 2.4 – Corporate Finance
40. Which of the following is an example of a capital structure decision?
A. Issuing new shares
B. Buying a new factory
C. Reducing inventory levels
D. Increasing purchases on credit
Answer: A Type: Definition Level of Difficulty: Easy LO: 2.5
41. The framework for analyzing investment or asset decisions is known as:
A. income management analysis
B. capital budgeting analysis
C. capital aligning analysis
D. asset allocation analysis
Answer: B Type: Definition Level of Difficulty: Easy LO: 2.5
42. Capital budgeting refers to:
A. The decision to raise capital from the market
B. The decision to allocate assets of the firm for investment
C. The decision to budget the administrative expenses of the firm
D. The decision to budget compensation within the firm
Answer: B Type: Definition Level of Difficulty: Medium LO: 2.5
43. What does it mean to “go public”?
A. To sell goods and services to the public
B. To raise money from the stock market
C. To borrow money from the debt market
D. To do business with governmental firms
Answer: B Type: Definition Level of Difficulty: Medium LO: 2.5
44. If a controller is responsible for liquidity management, which of the following accounts is she not interested in?
A. Long-term debt
B. Cash
C. Accounts payable
D. Inventory
Answer: A Type: Concept Level of Difficulty: Medium LO: 2.5
45. Another term for the “paper” market is:
A. debt market
B. equity market
C. money market
D. options market
Answer: C Type: Definition Level of Difficulty: Easy LO: 2.5
46. Which of the following statements is not true?
A. Cash and cash equivalents are defined as: deposits in banks plus short-term investments.
B. A firm’s accounts receivable is debt owed to them by other firms.
C. Another term for accounts receivable is trade credit.
D. A firm’s mortgages would appear on the asset side of its balance sheet.
Answer: D Type: Definition Level of Difficulty: Easy LO: 2.5
47. Which one of the following is not part of financial management?
A. Deciding on sources of capital financing
B. Deciding on debt and equity
C. Deciding on buying property
D. Deciding on changing company image
Answer: D Type: Concept Level of Difficulty: Easy LO: 2.5
48. Which of the following is not a source of corporate financing?
A. Equity
B. Retained earnings
C. Bonds
D. Fixed capital
Answer: D Type: Definition Level of Difficulty: Medium LO: 2.5
Section 2.5 – Finance Careers and the Organization of the Finance Function
49. Typical duties of the financial manager include:
I Raising funds
II Product line evaluation
III Controlling the disbursement of funds
IV Dividend policy
V Auditing financial statements
VI Shareholder relations
VII Setting personnel policy
VIII Pricing of the company’s products
A. I, III, IV, V, and VI
B. I, III, IV, and VI
C. III, IV, VI, and VII
D. II, III, VI, and VIII
Answer: B Type: Concept Level of Difficulty: Hard LO: 2.6
50. Which of the following is the least important of the financial manager’s responsibilities?
A. Keep an up-to-date record on past operations
B. Contain costs and foster productivity improvements
C. Raise funds to support the ongoing operations and planned investments
D. Control the dispersal of funds to ensure efficiency and adequate returns
Answer: A Type: Concept Level of Difficulty: Medium LO: 2.6
51. All of the following are the responsibility of the controller except:
A. financial planning
B. liquidity management
C. mergers and acquisitions
D. dividend policy
Answer: D Type: Definition Level of Difficulty: Medium LO: 2.6
52. The primary objective of the financial manager is to:
A. maximize earnings
B. maximize dividend payments
C. maximize shareholder wealth
D. maximize revenue
Answer: C Type: Concept Level of Difficulty: Easy LO: 2.6
53. If you are working for a company and your job description includes accounting, budgeting, internal audit, systems management/MIS, and tax management, you are most likely a(n):
A. treasurer
B. tax accountant
C. auditor
D. controller
Answer: D Type: Concept Level of Difficulty: Easy LO: 2.6
54. In major financial institutions, people generally start out their careers as:
A. Consultants
B. Analysts
C. Account managers
D. Banking associates
Answer: B Type: Definition Level of Difficulty: Medium LO: 2.6
Practice Problems
55. Define the term finance. What are the three broad functional categories associated with finance?
Type: Definition Level of Difficulty: Easy LO: 2.5
Suggested answer:
Finance is the study of the management of funds. The three broad functional categories associated with finance are:
1. Making long-term investment decisions, also called capital budgeting decisions
2. Making long-term financing decisions, also called capital structure decisions
3. Managing day-to-day activities, also called working capital (or liquidity) management
56. Give three potential advantages that explain why corporations represent a small percentage of the total number of businesses in Canada, but dominate in terms of assets and dollar volumes of sales.
Type: Concept Level of Difficulty: Medium LO: 2.1
Suggested answer:
i) Limited liability: investors know that their exposure to loss is limited
ii) Transfer of ownership is relatively easy; investors can cash out at any time if they need cash or are unhappy with the direction in which the company is headed
iii) Corporate tax laws may be more attractive in some circumstances, allowing tax deferral or avoidance
In principle, the separation of ownership from control allows corporations to obtain the best available management team.
57. Give two reasons for the importance and scope of finance.
Type: Concept Level of Difficulty: Medium LO: 2.5
Suggested answer:
First, the scale of operations of business firms has expanded greatly in recent years. The growing significance of large corporations and the increasing size of investments highlight the importance of long-range financial planning.
Second, the widespread diversification of products and the global nature of today’s business environment have increased the complexity of managing a business. We now have multiproduct, multidivisional and multinational corporations.
58. Which is a better economic objective for financial managers: maximizing profit or maximizing share price? Why? Give three reasons.
Type: Concept Level of Difficulty: Medium LO: 2.2
Suggested answer:
Maximizing share price is a better economic objective for financial managers because simple profit maximization does not address the following three issues:
Profits versus Return on Capital – Profits have to be viewed in relation to the amount of capital invested. The wealth position of shareholders can suffer even when total profits increase.
Timing of cash flows – The time value of money has to be considered when comparing profits across different time periods. Identical dollar amounts received at two different points in time do not have the same economic value.
Risk – Any stream of anticipated profits is subject to risk. Given the same potential return, investors will prefer less risk, as they are risk adverse. Investors will demand a higher return, or a risk premium, in order to invest in risky securities.
The objective of share price maximization overcomes the shortcomings of profit maximization.
59. Explain the concept of “too big to fail” and how it relates the latest financial crisis.
Type: Concept Level of Difficulty: Medium LO: 2.4
Suggested answer:
The “too big to fail” argument relates to firms that employ a high number of people or are involved in a vital sector of the economy. The argument refers to the inability of society to lose firms that are important, and so society must do whatever is in its power to protect these large businesses. However, the issue becomes: how can we control the management of businesses that are important in the economy? The saving of AIG and other financial institutions during the last crisis shows the cost that the society pays as a result.
60. Describe what is meant by agency relationships, and outline the potential conflicts of interest that may arise.
Type: Definition Level of Difficulty: Medium LO: 2.4
Suggested answer:
One type of agency relationship arises when there is a separation of management from ownership, which results in management being hired to act as an agent on behalf of the owner. Potential conflicts of interest arise when actions that are in the best interest of shareholders do not coincide with those that are in management’s best interests.
Another type of agency relationship arises when a corporation finances its activities with both equity and debt. At times, shareholders (who control the decisions of the firm) have an incentive to invest in projects that are detrimental to bondholders. To eliminate the potential for such actions, bondholders put restrictive covenants in the debt contracts restricting the actions of management. These covenants may impair management’s ability to make value-maximizing decisions.
61. Do agency costs only occur in a corporation, or can you have agency costs in a sole proprietorship?
Type: Concept Level of Difficulty: Hard LO: 2.4
Suggested answer:
Agency costs primarily occur in corporations, but can also occur in other forms of business. Whenever an owner of a business hires another person to act on their behalf, there exists an agency relationship. Whenever there exists an agency relationship, there is a potential for conflicts of interest to arise, and therefore agency costs may be incurred.
62. Edna’s Edibles Inc. has after-tax profits of $10,000 per year and 5,000 shares outstanding. The management of Edna’s Edibles is considering starting a new product line. This new line requires management to raise more money by issuing 3,000 shares of new equity. If this new line increases total profits by $5,000, should Edna’s management proceed with the new line?
Type: Calculation Level of Difficulty: Medium LO: 2.5
Suggested answer:
Before introducing the new product line, earnings per share was $10,000 ÷ 5,000 or $2.00 per share.
The new product line will increase earnings to $15,000 ($10,000 + $5,000) and increase shares outstanding to 8,000 (5,000 + 3,000). The new earnings per share will be $15,000 ÷ 8,000 or $1.875 per share.
Thus, this new line will decrease shareholders’ wealth by diluting earnings. Therefore, management should not proceed with the new investment.
63. Frank Wood, the owner of Cozy Corner Cabinets (CCC) has just hired Joe Boss to manage his company. Instead of using a flat salary, the two men have agreed that Joe will be paid 15 percent of the profits at the end of each year. CCC currently has three project opportunities to choose from, and can only choose one of them. Project A will generate profits of $75,000 per year, and will increase the value of CCC by $145,000. Project B will generate profits of $63,000 per year, and will increase the value of CCC by $153,000. Project C will generate profits of $68,000 per year, and will increase the value of CCC by $138,000. Which project is Joe Boss likely to choose and why? As the owner of CCC, which project would Frank prefer?
Type: Calculation Level of Difficulty: Hard LO:2.5
Suggested answer:
Under Project A, Joe would receive 0.15 * $75,000 = $11,250 per year. Under Project B, Joe would receive 0.15 * $63,000 = $9,450. Under Project C, Joe would receive 0.15 * $68,000 = $10,200. Thus, since $11,250 > $10,200 > $9,450, Joe would choose Project A to maximize his income.
However, Frank would prefer that Project B be chosen as it results in the greatest increase in firm value for CCC ($153,000 > $145,000 > $138,000).
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