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Financial Management- Short answers, Multiple Choice Qns

Short Answer

1. What is the difference between stock price maximization and profit maximization? Under what conditions might profit maximization not lead to stock price maximization?

2. Assume that you are serving on the board of directors of a medium-sized corporation and that you are responsible for establishing the compensation policies of senior management. You believe that the company's CEO is very talented, but your concerns is that she is always looking for a better job and may want to boost the company's short-run performance (perhaps at the expense of long-run profitability) to make herself more marketable to other corporations. What effect would these concerns have on the compensation policy you put in place

3. What is free cash flow? Why is it the most important measure of cash flow?

4. If you were starting a business, what tax considerations might cause you to prefer to set it up as a proprietorship or a partnership rather than as a corporation?

5. How does inflation distort ratio analysis comparisons, both for one company over time (trend analysis) and when different companies are compared? Are only balance sheet items of both balance sheet and income statement items affected?

6. Over the past year, my company has realized an increase in its current ratio and a drop in its total assets turnover ratio. However, the company's sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes?

7. If investors' aversion to risk increased, would the risk premium on a high-beta stock increase more or less than that on a low-beta stock? Explain.

8. If a company's beta were to double, would its expected return double?

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True/False

1. If a firm's managers want to maximize stock price it is in their best interests to operate efficient, low-cost plants, develop new and safe products that consumers want, and maintain good relationships with customers, suppliers, creditors, and the communities in which they operate.

a. True
b. False

2. An agency relationship exists when one or more persons hire another person to perform some service but withhold decision-making authority from that person.

a. True
b. False

3. Financial Managers and accountants perform the same functions in a firm.

a. True
b. False

4. Which of the following statements is true?

a. One of the benefits of incorporating your business is that you become entitled to receive unlimited liability.
b. Sole proprietorships are subject to more regulations than corporations.
c. Sole proprietorships do not have to pay corporate tax.
d. All of the above are correct.
e. None of the answers above is correct.

5. Which of the following actions are likely to reduce the agency problem between stockholders and managers?

a. Congress passes a law that severely restricts hostile takeovers.
b. A manager receives a lower salary but receives additional shares of the company's stock.
c. The board of directors has become more vigilant in its oversight of the company's management.
d. Statements b and c are correct.
e. All of the statements above are correct.

6. The annual report contains four basic financial statements: the income statement; balance sheet; statement of cash flows; and statement of retained earnings.

a. True
b. False

7. Taxes, payment patterns, and reporting considerations, as well as credit sales and non-cash costs, are reasons why operating cash flows can differ from accounting profits.

a. True
b. False

8. Net operating working capital is equal to the operating current assets minus the operating current liabilities.

a. True
b. False

9. Which of the following statements is most correct?

a. Indexing tax brackets reduces the extent of "bracket creep."
b. Bonds issued by a municipality such as the city of Miami would carry a lower interest rate than bonds with the same risk and maturity issued by a private corporation such as Florida Power & Light.
c. Our federal tax laws tend to encourage corporations to finance with debt rather than with equity securities.
d. Our federal tax laws encourage the managers of corporations with surplus cash to invest it in stocks rather than in bonds. However, other factors may offset tax considerations.
e. All of the statements above are true.

10. Which of the following best describes free cash flow?

a. Free cash flow is the amount of cash flow available for distribution to all investors after all necessary investments in operating capital have been made.
b. Free cash flow is the amount of cash flow available for distribution to shareholders after all necessary investments in operating capital have been made.
c. Free cash flow is the net change in the cash account on the balance sheet.
d. Free cash flow is equal to net income plus depreciation.
e. Free cash flow is equal to the cash flow from non-taxable transactions.

11. The current ratio and inventory turnover ratio measure the liquidity of a firm. The current ratio measures the relationship of a firm's current assets to its current liabilities and the inventory turnover ratio measures how rapidly a firm turns its inventory back into a "quick" asset or cash.

a. True
b. False

12. The degree to which the managers of a firm attempt to magnify the returns to owners' capital through the use of financial leverage is captured in debt management ratios.

a. True
b. False

13. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operations.

a. True
b. False

14. Determining whether a firm's financial position is improving or deteriorating requires analysis of more than one set of financial statements. Trend analysis is one method of measuring a firm's performance over time.

a. True
b. False

15. Which of the following statements is most correct about Economic Value Added (EVA)?

a. If a company has no debt, its EVA equals its net income.
b. If a company has positive ROE, its EVA must also be positive.
c. A company's EVA will be positive whenever the cost of equity exceeds the ROE.
d. All of the statements above are correct.
e. None of the statements above is correct.

16. Which of the following alternatives could potentially result in a net increase in a company's free cash flow for the current year?

a. Reducing the days-sales-outstanding ratio.
b. Increasing the number of years over which fixed assets are depreciated.
c. Decreasing the accounts payable balance.
d. All of the answers above are correct.
e. Answers a and b are correct.

17. Which of the following statements is most correct?

a. Many large firms operate different divisions in different industries, and this makes it hard to develop a meaningful set of industry benchmarks for these types of firms.
b. Financial ratios should be interpreted with caution because there exist seasonal and accounting differences that can reduce their comparability.
c. Financial ratios should be interpreted with caution because it may be difficult to say with certainty what is a "good" value. For example, in the case of the current ratio, a "good" value is neither high nor low.
d. Ratio analysis facilitates comparisons by standardizing numbers.
e. All of the statements above are correct.

18. If we develop a weighted average of the possible return outcomes, multiplying each outcome or "state" by its respective probability of occurrence for a particular stock, we can construct a payoff matrix of expected returns.

a. True
b. False

19. The tighter the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation.

a. True
b. False

20. If investors become more averse to risk, the slope of the Security Market Line (SML) will increase.

a. True
b. False

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Solution Preview

Short answer questions please.

1. What is the difference between stock price maximization and profit maximization? Under what conditions might profit maximization not lead to stock price maximization?

Stock price maximization is a long term goal. It requires that in order for stock prices to be maximized, managers take decisions that maximize stockholder wealth, that bondholders be fully protected from expropriation, that markets be efficient and that social costs be negligible. Companies, and consequently the stockholders, prosper when management makes decisions that will produce long term increases in earnings and consequently maximize stock prices.
In contrast Profit maximization is a short term goal. It is the maximization of the firm's net income

Profit maximization does not take into account (1) the timing of profits and (2) the riskiness of different operating plans. However, both of these factors are reflected in stock price maximization. Thus, profit maximization would not necessarily lead to stock price maximization.

For instance if the managers in order to achieve profit maximization impair the company's assets or goodwill which will reduce long term earnings then profit maximization would not lead to stock price maximization.

2. Assume that you are serving on the board of directors of a medium-sized corporation and that you are responsible for establishing the compensation policies of senior management. You believe that the company's CEO is very talented, but your concerns is that she is always looking for a better job and may want to boost the company's short-run performance (perhaps at the expense of long-run profitability) to make herself more marketable to other corporations. What effect would these concerns have on the compensation policy you put in place?

The structure of the compensation package for managers should be designed to meet two
primary objectives: 1) to attract and retain able managers and 2) to align managers' actions as closely as possible with the interests of stockholders

Therefore the compensation for the CEO would be structured in three parts taking the concerns into consideration:
(1) a specified annual salary to meet living expenses
(2) a bonus paid at the end of the year depending on the company's profitability and
(3) options to buy stock: In this option the number of shares will be dependent upon the company's actual performance and the executive's continued service.

3. What is free cash flow? Why is it the most important measure of cash flow?

Free cash flow is the surplus cash generated by a firm after meeting its investment requirement.

Free cash flow = Gross cash flow- Gross investment = Free cash flow from operations + Non operating cash flow.

Free cash flow reflects the cash flow available to all providers of capital. It is equal to:

After tax interest payment + Dividend + Decrease in debt + Share repurchases

Free cash flow is important because it is very difficult for companies to manipulate it the way they can manipulate earnings. Companies can push expenses around, can focus on EBIT, EBITA, EBITDA or other factors to make earnings look better. They can even try to treat some operational expenses as capital expenditures. But the full, truth shows up in free cash flow.

4. If you were starting a business, what tax considerations might cause you to prefer to set it up as a proprietorship or a partnership rather than as a corporation?

In a proprietorship and partnership only personal tax on profits is paid.
In corporations there is double taxation. Double taxation refers to the fact that corporate income is subject to an income tax, and then stockholders are subject to a further personal tax on dividends received. Thus there is corporate tax on profits as well as personal tax on dividends. Thus to avoid double taxation one may prefer to set it up as a proprietorship or a partnership rather than as a corporation.

5 How does inflation distort ratio analysis comparisons, both for one company over time (trend analysis) and when different companies are compared? Are only balance sheet items of both balance sheet and income statement items affected?

Financial ratios are used to compare one company to another and one company's performance in a particular year to its performance in another year (trend analysis).

Because Ratio Analysis is based upon accounting information, its effectiveness is limited by the distortions which arise in financial statements due to such things as Historical Cost Accounting and inflation. This is explained below:
Conventional accounting results in a mix of attributes being reflected in the asset section of the balance sheet:
Accounts receivable are reported at the net amount expected to be received in the future;
Short-term investments are reported at either cost or current market value;
Inventory is carried at the lower of cost and market value;
And
Property, plant and equipment are reported at cost less accumulated depreciation.
During a period of inflation, assets reported on the balance sheet at historical cost are understated in terms of their current value. Understated assets results in understated expenses (especially depreciation and cost of goods sold), which in turn results in overstated net income and overstated retained earnings.

A ratio is calculated by dividing one number by another. Financial ratios are calculated using information from a company's financial statement. If the information on values of short term assets, fixed assets, short term liabilities are stated differently in terms of historical and current costs then the ratios will be distorted.

This distortion can be both on the trend analysis and comparison across companies. On ...

Solution Summary

Answers and explanations to 8 short answer questions and 20 multiple choice questions

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