Goals and Governance of the Corporation Problem Solutions
Q1. Which of the following are investment decisions, and which are financing decisions?
- Should we stock up with inventory ahead of the holiday season? Investment Decision
- Do we need a bank loan to help buy the inventory? Financing Decision
- Should we develop a new software package to manage our inventory? Investment Decision
- With a new automated inventory management system, it may be possible to sell off our Birdlip warehouse. Investment Decision
- With the savings we make from our new inventory system, it may be possible to increase our dividend. Financing Decision
- Alternatively, we can use the savings to repay some of our long-term debt. Financing Decision
Explanation: Investment decisions, typically called capital budgeting, relate to investments in tangible and intangible assets. Financing decisions relate to the raising of money through debt and equity. Repayment of that money as well as interest and dividends are also financing decisions.
f. On the surface, this may appear similar to a dividend decision, but in reality retiring debt is a change in capital structure and more closely aligned with a financing decision.
Q2. Which of the following are real assets, and which are financial?
- A share of stock – Financial asset
- A personal IOU – Financial asset
- A trademark – Real asset
- A truck – Real asset
- Undeveloped land – Real asset
- The balance in the firm’s checking account – Financial asset
- An experienced and hardworking sales force – Real asset
- A bank loan agreement – Financial asset
Q3. Which of the following statements always apply to corporations? (You may select more than one answer. Single click the box with the question mark to produce a check mark for a correct answer and double click the box with the question mark to empty the box for a wrong answer. Any boxes left with a question mark will be automatically graded as incorrect.)
- Unlimited liability
- Limited life
- Ownership can be transferred without affecting operations
- Managers can be fired with no effect on ownership.
Q4. Which of the following are correct descriptions of large corporations? (You may select more than one answer. Single click the box with the question mark to produce a check mark for a correct answer and double click the box with the question mark to empty the box for a wrong answer. Any boxes left with a question mark will be automatically graded as incorrect.)
- Managers no longer have the incentive to act in their own interests.
- The corporation survives even if managers are dismissed.
- Shareholders can sell their holdings without disrupting the business.
- Corporations, unlike sole proprietorships, do not pay tax; instead, shareholders are taxed on any dividends they receive.
Q5. Which of the following statements more accurately describes the treasurer than the controller? (You may select more than one answer.Single click the box with the question mark to produce a check mark for a correct answer and double click the box with the question mark to empty the box for a wrong answer. Any boxes left with a question mark will be automatically graded as incorrect.)
- Monitors capital expenditures to make sure that they are not misappropriated.
- Responsible for investing the firm’s spare cash.
- Responsible for arranging any issue of common stock.
- Responsible for the company’s tax affairs.
Q6. We claim that the goal of the firm is to maximize current market value. Could the following actions be consistent with that goal?
- The firm adds a cost-of-living adjustment to the pensions of is retired employees. Yes
- The firm reduces its dividend payment, choosing to reinvest more earnings in the business. Yes
- The firm buys a corporate jet for its executives. Yes
- The firm drills for oil in a remote jungle. The chance of finding oil is only 1 in 5. Yes
a. This action might appear, superficially, to be a grant to former employees and thus not consistent with value maximization. However, such “benevolent” actions might enhance the firm’s reputation as a good place to work, might result in greater loyalty on the part of current employees, and might contribute to the firm’s recruiting efforts. Therefore, from a broader perspective, the action may be value-maximizing.
b. The reduction in dividends, in order to allow increased reinvestment, can be consistent with maximization of current market value. If the firm has attractive investment opportunities, and wants to save the expenses associated with issuing new shares to the public, then it could make sense to reduce the dividend in order to free up capital for the additional investments.
c. The corporate jet would have to generate benefits in excess of its costs in order to be considered stock-price enhancing. Such benefits might include time savings for executives and greater convenience and flexibility in travel.
d. Although the drilling appears to be a bad bet, with a low probability of success, the project may be value-maximizing if a successful outcome (although unlikely) is potentially sufficiently profitable. A one-in-five chance of success is acceptable if the payoff conditional on finding an oil field is 10 times the costs of exploration.
Q7. Company A pays its managers a fixed salary. Company B ties compensation to the performance of the stock. Which company’s compensation would most help to mitigate conflicts of interest between managers and shareholders?
- Company A
- Company B
Explanation: Clear and comprehensive financial reports provide essential information to the numerous shareholders of large corporations, allowing the shareholders to monitor the performance of the corporation and its board of directors and management. The debacles at WorldCom and Enron were directly related to a lack of clear and comprehensive financial reports.
Q8. Read the following passage and choose the appropriate terms to complete the sentences.
Companies usually buy real assets. These include both tangible assets such as executive airplanes and intangible assets such as brand names. To pay for these assets, they sell financial assets such as bonds. The decision about which assets to buy is usually termed the capital budgeting or investment decision. The decision about how to raise the money is usually termed the financing decision.
Q9. Choose the type of company in each case that best fits the description.
- The business is owned by a small group of investors. Private Corporation
- The business does not pay income tax. Partnership
- The business has limited liability. Public corporation
- The business is owned by its shareholders. Public corporation
Q10. Is limited liability always an advantage for a corporation and its shareholders?
Explanation: Limited liability is generally advantageous to large corporations. Large corporations would not be able to obtain financing from thousands or even millions of shareholders if those shareholders were not protected by the fact that the corporation is a distinct legal entity, conferring the benefit of limited liability on its shareholders. On the other hand, lenders do not view limited liability as advantageous to them. In some situations, lenders are not willing to lend to a corporation without personal guarantees from shareholders, promising repayment of a loan in the event that the corporation does not have the financial resources to repay the loan. Typically, these situations involve small corporations, with only a few shareholders; often these corporations can obtain debt financing only if the shareholders provide these personal guarantees.
Q11. Read the following passage and choose the appropriate terms to complete the sentences.
Shareholders want managers to maximize the market value of their investments. The firm faces a trade-off. Either it can invest its cash in real assets or it can give the cash back to shareholders in the form of a dividend and they can invest it in financial assets. Shareholders want the company to invest in real assets only if the expected return is higher than they could earn for themselves. The return that shareholders could earn for themselves is therefore the opportunity cost of capital for the firm.