FIN 401 Lecture Notes - Lecture 11: Canada Business Corporations Act, Agency Cost, W. M. Keck Observatory

1) The subarea of finance where you need to value uncertain cash flows occurring at different points in time is:

a. investments

b. corporate finance

c. capital markets

d. bank management.

e. all of the above subareas

2) Which of the following statements is correct?

a. One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership.

b. Corporations face fewer regulations than sole proprietorships.

c. One disadvantage of operating a business as a sole proprietor is that the firm is subject to double taxation, because taxes are levied at both the firm level and the Owner level.

d. It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents ace required.

e. If a partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business.

3) Which of the following statements is correct?

a. Corporations generally face fewer regulations than sole proprietorships.

b. Corporate shareholders are exposed to unlimited liability.

c. It is usually easier to transfer ownership in a corporation than in a partnership.

d. Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation.

e. Less of a corporation's income is generally subject to federal taxes.

4) The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to:

a. Maximize its expected total corporate income.

b. Maximize its expected EPS.

c. Minimize the chances of losses.

d. Maximize the stock price per share over the long run, which is the stock’s intrinsic value.

e. Maximize the stock price on a specific target date.

5) Which of the following is correct?

a. In most corporations, the CFO ranks above the CEO.

b. By Law in most states, the chairman of the board must also be the CEO.

c. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person.

d. The CFO generally reports to the firm's chief accounting officer, who is normally the controller.

e. The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he or she is not responsible for the validity of the financial statements, as the controller and the auditors have that responsibility.

6) The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to

a. Maximize managers' own interests, which are by definition consistent with maximizing shareholders' wealth.

b. Maximize the firm’s expected EPS, which must also maximize the firm’s price per share.

c. Minimize the firm’s risks because most stockholders dislike risk in turn, this will maximize the firm’s stock price.

d. Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers.

e. Since it is impossible to measure a stock's intrinsic value, the text states that it is better for managers to attempt to maximize the current stock price than its intrinsic value.

7) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and bondholders?

a. Compensating managers with stock options.

b. Financing risky projects with additional debt.

c. The threat of hostile takeovers.

d. The use of covenants in bond agreements that limit the firm’s use of additional debt and constrain managers' actions.

e. Abolishing the Security and Exchange Commission.

8) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and managers?

a. Pay managers large cash salaries and give them no stock options.

b. Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover.

c. Beef up the restrictive covenants in the firm’s debt agreements.

d. Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firm’s stock.

e. For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can be exercised and the shares that are received can be sold.

9) Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders?

a. Decrease the use of restrictive covenants in bond agreements.

b. Take actions that reduce the possibility of a hostile takeover.

c. Elect a board of directors tlta.t allows managers greater freedom of action.

d. Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.

e. Eliminate a requirement that members of the board of directors have a substantial investment in the firm’s stock.

10) Which of the following is correct?

a. Potential conflicts between stockholders and bondholders are increased if a firm's bonds are convertible into its common stock.

b. Because bankruptcy requires that corporate bondholders be paid in full before stockholders receive anything, bondholders generally prefer to see corporate managers invest in high risk/high return projects rather than low risk/low return projects.

c. There is no good reason to expect a firm’s stockholders and bondholders to react differently to the types of assets in which it invests.

d. Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

e. Bondholders should generally be happier titan stockholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns.

11) You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following best describes this transaction?

a. This is an example of a direct transfer of capital

b. This is an example of a primary market transaction.

c. This is an example of an exchange of physical assets.

d. This is an example of a money market transaction.

e. This is an example of a derivative market transaction.

12) Which of the following statements is correct?

a. The NYSE does not exist as a physical location. Rather it represents a loose collection of dealers who trade stock electronically.

b. An example of a primary market transaction would be your uncle transferring 100 shares of Walmart stock to you as a birthday gift.

c. Capital market instruments include both long-term debt and common stocks.

d. If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction.

e. While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors.

13) Which of the following is a primary market transaction?

a. You sell 200 shares of IBM stock on the NYSE through your broker.

b. You buy 200 shares of IBM stock from your brother. The trade is not made through a broker--you just give him cash and he gives you the stock.

c. IBM issues 2,000,000 shares of new stock and sells them to the public through an investment banker.

d. One financial institution buys 200,000 shares of IBM stock from another institution. An investment banker arranges the transaction.

e. IBM sells 2,000.000 shares of treasury stock to its employees when they exercise options that were granted in prior years.

14) Money Markets are markets for:

a. Foreign currencies.

b. Consumer automobile loans.

c. Common stocks.

d. Long-term bonds.

e. Short-term debt securities such as Treasury bills and commercial paper.

15) You recently sold 200 shares of Disney stock, and the transfer was made through a broker. This is an example of:

a. A money market transaction.

b. A primary market transaction.

c. A secondary market transaction.

d. A futures market transaction.

e. An over-the-counter market transaction.

16) Which of the following statements is correct?

a. Hedge funds are legal in Europe and Asia, but they are not permitted to operate in the United States.

b. Hedge funds are legal in the United States, but they are not permitted to operate in Europe or Asia.

c. Hedge funds have more in common with investment banks than with any other type of financial institution.

d. Hedge funds have more in common with commercial banks than with any other type of financial institution.

e. Hedge funds are not as highly regulated as most other types of financial institutions.

17) Which of the following factors statements is correct?

a. The New York Stock Exchange is an auction market, and it has a physical location.

b. Home mortgage loans are traded in the money market.

c. If an investor sells shares of stock through a broker, then it would be a primary market transaction.

d. Capital markets deal only with common stocks and other equity securities.

e. While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.

18) Which of the following statements is correct?

a. The term "IPO" stands for Introductory Price Offered, and it is the price at which shares of a new company are offered to the public.

b. IPO prices are generally established by the market, and buyers of the new stock must pay the price that prevails at the close of trading on the day the stock is offered to the public.

c. In a "Dutch auction," investors who want to buy shares in an IPO submit bids indicating how many shares they want to buy and the price they are willing to pay. The company determines how many shares it wants to sell. The highest price that enables the company to sell the desired number of shares is the price that all buyers must pay.

d. It is possible that the price set in an IPO is so high that investors will refuse to buy the number of shares that the company wants to sell. In this situation, the IPO is said to be oversubscribed.

e. It is possible that the price set in an IPO is so low that investors will want to buy more shares than the company wants to sell. In that case, the company will have to issue more shares than it wants to sell.

19) The stock market is thought to be efficient because:

a. There are many brokers working the exchange floors

b. Computers can make very fast calculations these days

c. There are many stock analysts following the same stocks

d. Stocks are available and are very inexpensive

e. Speed trading is now an acceptable trading technique

20) If the stock is priced correctly but with better management the firm could be worth even more, then the firm would be:

a. A potential target for a stock investor

b. A potential target for a private equity firm

c. A potential target for a bond fund

d. A potential target for the SEC

e. A potential target for share repurchases

The goal of the firm is to ____ because _____. Answer maximize shareholders' wealth; it considers all risks invest funds in real estate; the return is longer maximize shareholders' profit; it is a short term outlook closely matching management goals Mike is paying $8,000 a year on his mortgage at 6% nominal annual interest. He has 15 more years to make payments. He wants to sell his house today. The lowest [minimum] price he can sell the house without losing any money on the house would be about ___. Answer $120,000 $ 50,000 $77,698 $ 186,208 A firm's net income before tax, EBT [NIBT] (on the income statement) is affected by _____. Answer taxes interest dividends Common Stock as listed on the Balance Sheet could include which of the following? Answer A) retained earnings B) additional paid in capital over par value C) preferred capital Both A) and B) If an asset is sold for ___ than its basis, the tax effect would be ____. Answer A) more; capital gain and depreciation recapture B) less; depreciation recapture C) more; capital loss Both A) and B) The main reason for a firm to have assets is to _______. Answer generate revenue match the liabilities and equity both of the above be able to borrow money and pay its debts none of the above The only risk you would NOT have in loaning money to the United States Government (Uncle Sugar) is _____ risk. Answer liquidity maturity default A(n) ____ shows _____. Answer balance sheet; sources and uses of funds income statement; net income as of a specific date cash flow statement; how well the firm is doing relative to its competition You can compare dollars _____ because ______. Answer computed using equations; any math is always correct at any point in time; time is never a factor if they are at nominal value; that is when decisions are made only at the same point in time; dollars can be invested to earn interest There ___ a tax benefit to the company with paying preferred dividends because _______. Answer is; investors can write them off is not; investors declare them as income is; the company can use the payments as an expense is not; the company cannot use the payments as an expense XYZ issued a 6% coupon, $1,000 par, 30 year to maturity bond. It is now 6 years to maturity. What is the price of the bond if the yield to maturity [market interest rate] is 10%? Answer $1,000 $659.46 $825.79 $705.33 The valuation process can be described as ______. Answer calculating the present value of an expected future cash flow using the investor's required rate of return as the discount rate calculating the future value of an expected future cash flow using the investor's required rate of return as the discount rate amortizing the value of the asset over its holding period The ______ is the minimum required rate of return a firm must earn on its investments. Answer net present value opportunity cost of capital or weighted average cost of capital. internal rate of return gross profit margin The value of an asset is the _____ dollar price someone is willing to pay for it. Answer usual maximum minimum Companies use ____ in capital budgeting project analysis because ________. Answer accounting profit; that is the total net income after tax cash flow; that is what the owners would receive from the project and reinvest accounting profit; that is what the owners would receive from the project and reinvest after tax cash flow; that is the result of prudent accounting When borrowing money, you want to know the ____ interest rate because ____. Answer nominal; it is the easiest to find. effective; it is the true cost of borrowing risk free; that is what the government pays Fed funds; that is what you would pay the bank Cash available to pay out to the investors after the firm pays for new investments or additions to working capital is _____. Answer a statement of cash flows operating after tax cash flow free cash flow net income An organization that raises money from investors and provides financing for individuals and businesses is a ___. Answer factor federal government regulatory unit state government taxing authority financial intermediary Negatives/cons of the Net Present Value (NPV) technique include: Answer least conservative reinvestment assumption multiple rates of return for non-conventional cash flows all of the above none of the above A fixed exchange rate means a country _____. Answer can only use gold coins as money is limited in the amount of paper money it can print can print money as the economy demands Your company is considering an investment with the following expected cash flows: Initial Investment = $407,596 Operating Cash Flows = $73,428 per year Terminal Cash Flow = $11,872. The company's WACC is 11% for similar risk projects. The proposed project would have an expected life of 9 years. Your boss asks you to do the analysis. You would tell your boss this proposed project ___ because ____. Answer is acceptable; NPV is about $3,620 is acceptable; NPV is zero should be rejected; NPV is about -$5,660 [negative $5,660]. should be rejected; NPV is zero All ratios are ___ and a reason to analyze ratios is ____. Answer good; to continue to look productive good and bad; because seemingly good ratios can be masking something bad bad; to try to rework the numbers to have them look good basically irrelevant; there really is no need to analyze financial statements When analyzing financial statements, ratio analysis gives ____ and provides insight into ____. Answer very little useful information; practically nothing good practice in logical thinking; what has occurred and the logic behind it financiers something to do during slow periods; how the financier spends his time accountants a reason to provide financial statements; why accountants do what they do while at work Given: Economic State[i]: Good Average Expected Return[i]: 10% 8% Probability[i]: 30% 70% What is the Standard Deviation? Answer 3% 8.4% 0.92% 5.6% Chapter 9: XYZ has a projected project to install a new press. The expected cash revenue is $175,000 per year. Expected yearly expenses are: Operatinf costs of $50,000; Rental of $17,000; Utilities of $20,500; and Depreciation of $10,000. The tax rate is 35%. What is the expected After-Tax Operating Cash Flow for the first year? Answer $65,500 $60,375 $77,500 $97,500 A stock just paid a dividend of $1.60 per year. The dividend is expected to grow at 3% per year indefinately. Equally risky stocks offer expected rates of return of 8%. What should be the stock price? Answer 53.33 $16.00 $32.96 None of the above. A plot of the CAPM is the _____. Answer wrong thing to do Security Market Line a function showing how to calculate TVM All of the above. Derivatives are used to ___. Answer divide one number by another find old ways to do things hedge risk none of the above With the end of the Gold Standard in the 1970's, what new risk did business face in the international market? Answer Comjpetition Exchange rate Worker compensation Property taxes One of the positive aspects [pros] of a Floating Exchange Rate System is ____. Answer money can be printed as needed to support financial/economic growth no/reduced inflation economic growth is reduced as a result of reduced liquidity [lower money supply] business planning is more difficult A(n) ____ contract obligates the seller to execute the contract and the contract is executed. Answer backwards forward future option What policies did countries institute after the Great War that help lead to the Great Depression? Answer A. Mandatory military service B. Trade restrictions C. High tariffs D. Isolationism Only B., C. and D. All of the above

Over the past few years, the number of start-up companies attracted to either doing business themselves in the cloud, or specifically creating applications for others to use in the cloud, has grown significantly. A few but very promising enterprises have launched applications in “container” technology, which enables companies, programmers, or other enterprises to both launch and run applications solely in the cloud. There is still a lot of room in this emerging marketplace, and you are diving in. The product you’ve developed has a unique angle to tap into the local-grown/local-made/local-paid movement that’s also growing larger every day. Your initial market is your own small city, which operates independently but which is linked economically and via public safety provision to another small city sitting directly across a river separating the two. Once you’ve been able to launch your company in your city, you plan to approach the “sister city” leaders, then the county, state, and eventually go national. It’s too soon now, but your future plans entail an IPO offering to accomplish all this. Eventually, you hope to be able to re-imagine your product to go global. You have big plans, are close to being tapped out financially and you now need to plan for additional investors. Address the following considerations as they apply to your product launch. 1.Describe an agency relationship and how it may/will take shape for your small company. As the sole employee and investor in your startup, what agency conflicts might arise? 2.Six months have transpired, and you’ve been able to add two employees. In this new arrangement, what agency disputes might now develop that need to be addressed, and how might you address them? What resources do you need to use or consider? 3.Another three months have passed. You are now ready to expand to your sister city and you need more capital. You decide the wisest path is to sell some stock to outside investors, but you will maintain control over your company by holding onto the majority of the stock. In this new scenario, what type of agency conflict might occur? How can you address this in advance? 4.The IPO was a success, and you have a robust number of shareholders. With board support, you determine it is time to hire a financial manager to help your firm achieve current goals and set new ones appropriate to the firm’s growth strategy. What professional strengths and skills will an individual seeking this position need to possess? 5.Another consideration you feel you need to address at this point, now that your firm’s stock is publicly traded, is how to sustain the high ethical standards you’ve fostered thus far as you move into the firm’s future. What strategies can your management team implement to conduct your business with both personal and professional integrity? What steps can you take to ensure that ethical considerations for financial and other management decisions are embedded into the firm’s culture? 6.Congratulations - you are now at Year One, and everything is moving along faster than you anticipated. While this is great, you are at the point where you need to raise additional capital from outside lenders. With this decision, what type of agency costs might the company incur? How might a lender mitigate any agency costs? 7.Year Two rolls around. Your company has been able to expand beyond your local communities and into to localities and governments in half the counties of the state. The stakes are getting bigger and you welcome the idea of high-level input to ensure the company keeps growing and expanding. You cash out the majority of your stock and turn the company over to an elected board of directors. Neither you nor any other stockholders own a controlling interest (which is also the situation at most public companies). List six potential managerial behaviors the new board might take that could harm your company’s value, and what steps overall can put into place to avoid or mitigate these. 8.You are also aware from your prior career and from your research, that corporate governance can affect shareholder value. This greatly concerns you, as you still have lofty plans for your company’s growth and eventual global trajectory. Questions you’ve identified that need to be addressed at this stage include: a) What is corporate governance?; b) What five corporate governance provisions are internal to a firm and are under its control?; c) What characteristics of the board of directors usually lead to effective corporate governance?; d) What characteristics of the board of directors signal ineffective or problematic governance practices?; e) How can regulatory agencies and legal systems affect corporate governance? If there are differences in local versus national levels, expand upon these. 9.Lastly, one of your new board members is very concerned with “blockholders.” What is block ownership? How does it affect corporate governance? Explain the pros and cons.