3 CHAPTER FINANCIAL STATEMENTS, CASH FLOW, AND TAXES True/False Easy: (3.1) Annual
report Answer: a EASY . 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
(3.1) Annual report and expectations Answer: a EASY . The primary reason the annual report is
important in finance is that it is used by investors when they form expectations about the firm's future
earnings and dividends, and the riskiness of those cash flows. a. True b. False (3.2) Retained earnings
versus cash Answer: b EASY . Consider the balance sheet of Wilkes Industries as shown below. Because
Wilkes has $800,000 of retained earnings, the company would be able to pay cash to buy an asset with a
cost of $200,000. Cash $ 50,000 Accounts payable $ 100,000 Inventory 200,000 Accruals 100,000
Accounts receivable 250,000 Total CL $ 200,000 Total CA $ 500,000 Debt 200,000 Net fixed assets $
900,000 Common stock 200,000 Retained earnings 800,000 Total assets $1,400,000 Total L & E
$1,400,000 a. True b. False (3.2) Balance sheet Answer: a EASY . On the balance sheet, total assets must
always equal total liabilities and equity. a. True b. False (3.2) Balance sheet: non-cash assets Answer: a
EASY . Assets other than cash are expected to produce cash over time, but the amount of cash they
eventually produce could be higher or lower than the values at which these assets are carried on the
books. a. True b. False (3.3) Income statement Answer: a EASY . The income statement shows the
difference between a firm's income and its costs--i.e., its profits--during a specified period of time.
However, not all reported income comes in the form or cash, and reported costs likewise may not
correctly reflect cash outlays. Therefore, there may be a substantial difference between a firm's reported
profits and its actual cash flow for the same period. a. True b. False (3.7) Net operating working capital
Answer: a EASY . Net operating working capital is equal to operating current assets minus operating
current liabilities. a. True b. False (3.7) Total net operating capital Answer: b EASY . Total net operating
capital is equal to net fixed assets. a. True b. False (3.7) Net operating profit after taxes (NOPAT)
Answer: a EASY . Net operating profit after taxes (NOPAT) is the amount of net income a company
would generate from its operations if it had no interest income or interest expense. a. True b. False (3.9)
Federal income taxes: interest income Answer: b EASY . The fact that 70% of the interest income
received by a corporation is excluded from its taxable income encourages firms to use more debt
financing than they would in the absence of this tax law provision. a. True b. False (3.9) Federal income
taxes: interest expense Answer: b EASY . If the tax laws were changed so that $0.50 out of every $1.00 of
interest paid by a corporation was allowed as a tax-deductible expense, this would probably encourage
companies to use more debt financing than they presently do, other things held constant. a. True b. False
(3.9) Federal income taxes: int expense and dividends Answer: b EASY . The interest and dividends paid
by a corporation are considered to be deductible operating expenses, hence they decrease the firm's tax
liability. a. True b. False (Comp: 3.2,3.3) Financial statements Answer: b EASY . The balance sheet is a
financial statement that measures the flow of funds into and out of various accounts over time, while the
income statement measures the firm's financial position at a point in time. a. True b. False Medium: (3.4)
Retained earnings Answer: b MEDIUM . Its retained earnings is the actual cash that the firm has
generated through operations less the cash that has been paid out to stockholders as dividends. Retained
earnings are kept in cash or near cash accounts and, thus, these cash accounts, when added together, will
always be equal to the firm's total retained earnings. a. True b. False (3.4) Retained earnings Answer: a
MEDIUM . The retained earnings account on the balance sheet does not represent cash. Rather, it
represents part of stockholders' claims against the firm's existing assets. This implies that retained
earnings are in fact stockholders' reinvested earnings. a. True b. False (3.5) Cash flow and net income
Answer: b MEDIUM . In accounting, emphasis is placed on determining net income in accordance with
generally accepted accounting principles. In finance, the primary emphasis is also on net income because
that is what investors use to value the firm. However, a secondary financial consideration is cash flow,
because cash is needed to operate the business. a. True b. False (3.6) Statement of cash flows Answer: a
MEDIUM . To estimate the cash flow from operations, depreciation must be added back to net income
because it is a non-cash charge that has been deducted from revenue. a. True b. False (3.7) Future cash
flows Answer: b MEDIUM . The current cash flow from existing assets is highly relevant to the investor.
However, since the value of the firm depends primarily upon its growth opportunities, profit projections
from those opportunities are the only relevant future flows with which investors are concerned. a. True b.
False (3.9) Federal income taxes: int exp and dividends Answer: a MEDIUM . Interest paid by a
corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This
treatment, other things held constant, tends to encourage the use of debt financing by corporations. a.
True b. False (Comp: 3.1-3.3,3.6) Financial stmts: time dimension Answer: a MEDIUM . The time
dimension is important in financial statement analysis. The balance sheet shows the firm's financial
position at a given point in time, the income statement shows results over a period of time, and the
statement of cash flows reflects changes in the firm's accounts over that period of time. a. True b. False
Multiple Choice: Conceptual Easy: (3.1) Financial statements Answer: b EASY . Which of the following
statements is CORRECT? a. The four most important financial statements provided in the annual report
are the balance sheet, income statement, cash budget, and the statement of retained earnings. b. The
balance sheet gives us a picture of the firms financial position at a point in time. c. The income statement
gives us a picture of the firms financial position at a point in time. d. The statement of cash flows tells us
how much cash the firm has in the form of currency and demand deposits. e. The statement of cash needs
tells us how much cash the firm will require during some future period, generally a month or a year. (3.2)
Balance sheet Answer: e EASY . Which of the following statements is CORRECT? a. The balance sheet
for a given year, say 2006, is designed to give us an idea of what happened to the firm during that year. b.
The balance sheet for a given year, say 2006, tells us how much money the company earned during that
year. c. The difference between the total assets reported on the balance sheet and the debts reported on
this statement tells us the current market value of the stockholders' equity, assuming the statements are
prepared in accordance with generally accepted accounting principles (GAAP). d. For most companies,
the market value of the stock equals the book value of the stock as reported on the balance sheet. e. A
typical industrial companys balance sheet lists the firm's assets that will be converted to cash first, and
then goes on down to list the firm's longest lived assets last. (3.2) Balance sheet Answer: c EASY . Other
things held constant, which of the following actions would increase the amount of cash on a companys
balance sheet? a. The company repurchases common stock. b. The company pays a dividend. c. The
company issues new common stock. d. The company gives customers more time to pay their bills. e. The
company purchases a new piece of equipment. (3.2) Current assets Answer: c EASY . Which of the
following items is NOT included in current assets? a. Accounts receivable. b. Inventory. c. Bonds. d.
Cash. e. Short-term, highly liquid, marketable securities. (3.2) Current liabilities Answer: d EASY .
Which of the following items cannot be found on a firms balance sheet under current liabilities? a.
Accounts payable. b. Short-term notes payable to the bank. c. Accrued wages. d. Cost of goods sold. e.
Accrued payroll taxes. (3.3) Income statement Answer: e EASY . Which of the following statements is
CORRECT? a. The focal point of the income statement is the cash account, because that account cannot
be manipulated by accounting tricks. b. The reported income of two otherwise identical firms cannot be
manipulated by different accounting procedures provided the firms follow Generally Accepted
Accounting Principles (GAAP). c. The reported income of two otherwise identical firms must be identical
if the firms are publicly owned, provided they follow procedures that are permitted by the Securities and
Exchange Commission (SEC). d. If a firm follows Generally Accepted Accounting Principles (GAAP),
then its reported net income will be identical to its reported net cash flow. e. The income statement for a
given year, say 2006, is designed to give us an idea of how much the firm earned during that year.
Medium: (3.2) Balance sheet Answer: c MEDIUM . Below are the 2005 and 2006 year-end balance
sheets for Wolken Enterprises: Assets: 2006 2005 Cash $ 200,000 $ 170,000 Accounts receivable
864,000 700,000 Inventories 2,000,000 1,400,000 Total current assets $ 3,064,000 $2,270,000 Net fixed
assets 6,000,000 5,600,000 Total assets $ 9,064,000 $7,870,000 Liabilities and equity: Accounts payable
$ 1,400,000 $1,090,000 Notes payable 1,600,000 1,800,000 Total current liabilities $ 3,000,000
$2,890,000 Long-term debt 2,400,000 2,400,000 Common stock 3,000,000 2,000,000 Retained earnings
664,000 580,000 Total common equity $ 3,664,000 $2,580,000 Total liabilities and equity $ 9,064,000
$7,870,000 Wolken has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year
non-callable, long-term debt in 2005. As of the end of 2006, none of the principal on this debt had been
repaid. Assume that the companys sales in 2005 and 2006 were the same. Which of the following
statements must be CORRECT? a. Wolken increased its short-term bank debt in 2006. b. Wolken issued
long-term debt in 2006. c. Wolken issued new common stock in 2006. d. Wolken repurchased some
common stock in 2006. e. Wolken had negative net income in 2006. (3.2) Balance sheet Answer: e
MEDIUM . On its 2007 balance sheet, Barngrover Books showed $510 million of retained earnings, and
exactly that same amount was shown the following year. Assuming that no earnings restatements were
issued, which of the following statements is CORRECT? a. If the company lost money in 2007, they must
have paid dividends. b. The company must have had zero net income in 2007. c. The company must have
paid out half of its earnings as dividends. d. The company must have paid no dividends in 2007. e.
Dividends could have been paid in 2007, but they would have had to equal the earnings for the year. (3.2)
Balance sheet Answer: b MEDIUM . Below is the common equity section (in millions) of Teweles
Technologys last two year-end balance sheets: 2006 2005 Common stock $2,000 $1,000 Retained
earnings 2,000 2,340 Total common equity $4,000 $3,340 Teweles has never paid a dividend to its
common stockholders. Which of the following statements is CORRECT? a. The companys net income in
2006 was higher than in 2005. b. Teweles issued common stock in 2006. c. The market price of Teweles'
stock doubled in 2006. d. Teweles had positive net income in both 2005 and 2006, but the companys net
income in 2006 was lower than it was in 2005. e. The company has more equity than debt on its balance
sheet. (3.3) EPS, DPS, BVPS, and stock price Answer: c MEDIUM . Which of the following statements
is CORRECT? a. Typically, a firms DPS should exceed its EPS. b. Typically, a firms EBIT should
exceed its EBITDA. c. If a firm is more profitable than average (e.g., Google), we would normally expect
to see its stock price exceed its book value per share. d. If a firm is more profitable than most other firms,
we would normally expect to see its book value per share exceed its stock price, especially after several
years of high inflation. e. The more depreciation a firm has in a given year, the higher its EPS, other
things held constant. (3.5) Depreciation, amortization, and net cash flow Answer: d MEDIUM . Which of
the following statements is CORRECT? a. The more depreciation a firm reports, the higher its tax bill,
other things held constant. b. People sometimes talk about the firms net cash flow, which is shown as the
lowest entry on the income statement, hence it is often called "the bottom line. c. Depreciation reduces a
firms cash balance, so an increase in depreciation would normally lead to a reduction in the firms net
cash flow. d. Net cash flow (NCF) is often defined as follows: Net Cash Flow = Net Income +
Depreciation and Amortization Charges. e. Depreciation and amortization are not cash charges, so neither
of them has an effect on a firms reported profits. (3.5) Changes in depreciation Answer: d MEDIUM .
Which of the following would be most likely to occur in the year after Congress, in an effort to increase
tax revenue, passed legislation that forced companies to depreciate equipment over longer lives? Assume
that sales, other operating costs, and tax rates are not affected, and assume that the same depreciation
method is used for tax and stockholder reporting purposes. a. Companies net operating profits after taxes
(NOPAT) would decline. b. Companies physical stocks of fixed assets would increase. c. Companies
net cash flows would increase. d. Companies cash positions would decline. e. Companies reported net
incomes would decline. (3.6) Net cash flow Answer: a MEDIUM . Which of the following factors could
explain why Dellva Energy had a negative net cash flow last year, even though the cash on its balance
sheet increased? a. The company sold a new issue of bonds. b. The company made a large investment in
new plant and equipment. c. The company paid a large dividend. d. The company had high amortization
expenses. e. The company repurchased 20% of its common stock. (3.6) Net cash flow Answer: b
MEDIUM . Analysts who follow Howe Industries recently noted that, relative to the previous year, the
companys operating net cash flow increased, yet cash as reported on the balance sheet decreased. Which
of the following factors could explain this situation? a. The company cut its dividend. b. The company
made a large investment in a profitable new plant. c. The company sold a division and received cash in
return. d. The company issued new common stock. e. The company issued new long-term debt. (3.6) Net
cash flow and net income Answer: a MEDIUM . A security analyst obtained the following information
from Prestopino Products financial statements: Retained earnings at the end of 2006 were $700,000, but
retained earnings at the end of 2007 had declined to $320,000. The company does not pay dividends.
The companys depreciation expense is its only non-cash expense; it has no amortization charges. The
company has no non-cash revenues. The companys net cash flow (NCF) for 2007 was $150,000. On
the basis of this information, which of the following statements is CORRECT? a. Prestopino had negative
net income in 2007. b. Prestopinos depreciation expense in 2007 was less than $150,000. c. Prestopino
had positive net income in 2007, but its income was less than its 2006 income. d. Prestopino's NCF in
2007 must be higher than its NCF in 2006. e. Prestopinos cash on the balance sheet at the end of 2007
must be lower than the cash it had on the balance sheet at the end of 2006. (3.6) Net cash flow and net
income Answer: d MEDIUM . Aubey Aircraft recently announced that its net income increased sharply
from the previous year, yet its net cash flow from operations declined. Which of the following could
explain this performance? a. The companys operating income declined. b. The companys expenditures
on fixed assets declined. c. The companys cost of goods sold increased. d. The companys depreciation
and amortization expenses declined. e. The companys interest expense increased. (3.6) Statement of cash
flows Answer: e MEDIUM . Which of the following statements is CORRECT? a. The statement of cash
flows reflects cash flows from operations, but it does not reflect the effects of buying or selling fixed
assets. b. The statement of cash flows shows where the firms cash is located; indeed, it provides a listing
of all banks and brokerage houses where cash is on deposit. c. The statement of cash flows reflects cash
flows from continuing operations, but it does not reflect the effects of changes in working capital. d. The
statement of cash flows reflects cash flows from operations and from borrowings, but it does not reflect
cash obtained by selling new common stock. e. The statement of cash flows shows how much the firms
cash--the total of currency, bank deposits, and short-term liquid securities (or cash equivalents)--increased
or decreased during a given year. (3.6) Statement of cash flows Answer: c MEDIUM . Which of the
following statements is CORRECT? a. In the statement of cash flows, a decrease in accounts receivable is
reported as a use of cash. b. Dividends do not show up in the statement of cash flows because dividends
are considered to be a financing activity, not an operating activity. c. In the statement of cash flows, a
decrease in accounts payable is reported as a use of cash. d. In the statement of cash flows, depreciation
charges are reported as a use of cash. e. In the statement of cash flows, a decrease in inventories is
reported as a use of cash. (3.7) Modifying acct data for managerial purposes Answer: b MEDIUM . For
managerial purposes, i.e., making decisions regarding the firm's operations, the standard financial
statements as prepared by accountants under Generally Accepted Accounting Principles (GAAP) are
often modified and used to create alternative data and metrics that provide a somewhat different picture of
a firm's operations. Related to these modifications, which of the following statements is CORRECT? a.
The standard statements make adjustments to reflect the effects of inflation on asset values, and these
adjustments are normally carried into any adjustment that managers make to the standard statements. b.
The standard statements focus on accounting income for the entire corporation, not cash flows, and the
two can be quite different during any given accounting period. However, for valuation purposes we need
to discount cash flows, not accounting income. Moreover, since many firms have a number of separate
divisions, and since division managers should be compensated on their divisions performance, not that of
the entire firm, information that focuses on the divisions is needed. These factors have led to the
development of information that is focused on cash flows and the operations of individual units. c. The
standard statements provide useful information on the firms individual operating units, but management
needs more information on the firms overall operations than the standard statements provide. d. The
standard statements focus on cash flows, but managers are less concerned with cash flows than with
accounting income as defined by GAAP. e. The best feature of standard statements is that, if they are
prepared under GAAP, the data are always consistent from firm to firm. Thus, under GAAP, there is no
room for accountants to adjust the results to make earnings look better. (3.7) Depreciation,
amortization, and free cash flow Answer: c MEDIUM . Which of the following statements is CORRECT?
a. Operating cash flow (OCF) is defined as follows: OCF = EBIT(1-T) - Depreciation and Amortization.
b. Changes in working capital have no effect on free cash flow. c. Free cash flow (FCF) is defined as
follows: FCF = EBIT(1 - T) + Depreciation and Amortization - Capital expenditures required to sustain
operations - Required changes in net operating working capital. d. Free cash flow (FCF) is defined as
follows: FCF = EBIT(1-T)+ Depreciation and Amortization + Capital expenditures. e. Operating cash
flow is the same as free cash flow (FCF). (3.8) MVA and EVA Answer: d MEDIUM . Which of the
following statements is CORRECT? a. The primary difference between EVA and accounting net income
is that when net income is calculated, a deduction is made to account for the cost of common equity,
whereas EVA represents net income before deducting the cost of the equity capital the firm uses. b. MVA
gives us an idea about how much value a firms management has added during the last year. c. MVA
stands for market value added, and it is defined as follows: MVA = (Shares outstanding)(Stock price) +
Book value of common equity. d. EVA stands for economic value added, and it is defined as follows:
EVA = EBIT(1-T) (Investor-supplied op. capital) x (A-T cost of capital). e. EVA gives us an idea about
how much value a firms management has added over the firms life. (3.9) Federal income tax system
Answer: b MEDIUM . Which of the following statements is CORRECT? a. Since companies can deduct
dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing,
and this causes companies debt ratios to be lower than they would be if interest and dividends were both
deductible. b. Interest paid to an individual is counted as income for tax purposes and taxed at the
individuals regular tax rate, which in 2006 could go up to 35%, but dividends received were taxed at a
maximum rate of 15%. c. The maximum federal tax rate on corporate income in 2006 was 50%. d.
Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either
by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the
debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from
income when calculating income for tax purposes. e. The maximum federal tax rate on personal income
in 2006 was 50%. (3.9) Federal income tax system Answer: c MEDIUM . Which of the following
statements is CORRECT? a. The income of certain small corporations that qualify under the Tax Code is
completely exempt from corporate income taxes. Thus, the federal government receives no tax revenue
from these businesses. b. All businesses, regardless of their legal form of organization, are taxed under
the Business Tax Provisions of the Internal Revenue Code. c. Small businesses that qualify under the Tax
Code can elect not to pay corporate taxes, but then their owners must report their pro rata shares of the
firms income as personal income and pay taxes on that income. d. Congress recently changed the tax
laws to make dividend income received by individuals exempt from income taxes. Prior to the enactment
of that law, corporate income was subject to double taxation, where the firm was first taxed on the income
and stockholders were taxed again on the income when it was paid to them as dividends. e. All
corporations other than non-profit corporations are subject to corporate income taxes, which are 15% for
the lowest amounts of income and 35% for the highest amounts of income. (Comp: 3.6,3.7) NCF, FCF,
and cash Answer: c MEDIUM . Last year, Tucker Technologies had (1) a negative net cash flow from
operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet.
Which of the following factors could explain this situation? a. The company had a sharp increase in its
inventories. b. The company had a sharp increase in its accrued liabilities. c. The company sold a new
issue of common stock. d. The company made a large capital investment early in the year. e. The
company had a sharp increase in its depreciation and amortization expenses. (Comp: 3.2,3.3,3.6,3.9)
Changes in depreciation Answer: e MEDIUM . Assume that Congress recently passed a provision that
will enable Bev's Beverages Inc. (BBI) to double its depreciation expense for the upcoming year but will
have no effect on its sales revenue or tax rate. Prior to the new provision, BBIs net income after taxes
was forecasted to be $4 million. Which of the following best describes the impact of the new provision on
BBIs financial statements versus the statements without the provision? Assume that the company uses
the same depreciation method for tax and stockholder reporting purposes. a. The provision will reduce the
companys net cash flow. b. The provision will increase the companys tax payments. c. Net fixed assets
on the balance sheet will increase. d. The provision will increase the companys net income. e. Net fixed
assets on the balance sheet will decrease. (Comp: 3.2,3.3,3.6,3.9) Changes in depreciation Answer: b
MEDIUM . The Nantell Corporation just purchased an expensive piece of equipment. Assume that the
firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a
provision that requires the company to depreciate the equipment on a straight-line basis over 7 years.
Other things held constant, which of the following will occur as a result of this Congressional action?
Assume that the company uses the same depreciation method for tax and stockholder reporting purposes.
a. Nantells taxable income will be lower. b. Nantells net fixed assets as shown on the balance sheet will
be higher at the end of the year. c. Nantells cash position will improve (increase). d. Nantells reported
net income after taxes for the year will be lower. e. Nantells tax liability for the year will be lower.
(Comp: 3.2,3.3,3.6) Changes in depreciation Answer: d MEDIUM . Assume that Pappas Company
commenced operations on January 1, 2007, and it was granted permission to use the same depreciation
calculations for shareholder reporting and income tax purposes. The company planned to depreciate its
fixed assets over 15 years, but in December 2007 management realized that the assets would last for only
10 years. The firm's accountants plan to report the 2007 financial statements based on this new
information. How would the new depreciation assumption affect the companys financial statements? a.
The firms reported net fixed assets would increase. b. The firms EBIT would increase. c. The firm's
reported 2007 earnings per share would increase. d. The firm's cash position in 2007 and 2008 would
increase. e. The firms net liabilities would increase. (Comp: 3.2,3.3,3.9) Changes in depreciation
Answer: c MEDIUM . A start-up firm is making an initial investment in new plant and equipment.
Assume that currently its equipment must be depreciated on a straight-line basis over 10 years, but
Congress is considering legislation that would require the firm to depreciate the equipment over 7 years.
If the legislation becomes law, which of the following would occur in the year following the change? a.
The firms operating income (EBIT) would increase. b. The firms taxable income would increase. c. The
firms net cash flow would increase. d. The firms tax payments would increase. e. The firms reported
net income would increase. (Comp: 3.1-3.3,3.6) Financial statements Answer: e MEDIUM . Which of the
following statements is CORRECT? a. Dividends paid reduce the net income that is reported on a
companys income statement. b. If a company uses some of its bank deposits to buy short-term, highly
liquid marketable securities, this will cause a decline in its current assets as shown on the balance sheet. c.
If a company issues new long-term bonds during the current year, this will increase its reported current
liabilities at the end of the year. d. Accounts receivable are reported as a current liability on the balance
sheet. e. If a company pays more in dividends than it generates in net income, its retained earnings as
reported on the balance sheet will decline from the previous year's balance. (Comp: 3.5,3.6,3.8) EVA, CF,
and net income Answer: d MEDIUM . Which of the following statements is CORRECT? a. One way to
increase EVA is to achieve the same level of operating income but with more investor-supplied capital. b.
If a firm reports positive net income, its EVA must also be positive. c. One drawback of EVA as a
performance measure is that it mistakenly assumes that equity capital is free. d. One way to increase EVA
is to generate the same level of operating income but with less investor-supplied capital. e. Actions that
increase reported net income will always increase net cash flow. (Comp: 3.2,3.3,3.6) Retained earnings
Answer: b MEDIUM . Which of the following statements is CORRECT? a. Since depreciation is a source
of funds, the more depreciation a company has, the larger its retained earnings will be, other things held
constant. b. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow
cash to make required payments. c. Common equity includes common stock and retained earnings, less
accumulated depreciation. d. The retained earnings account as shown on the balance sheet shows the
amount of cash that is available for paying dividends. e. If a firm reports a loss on its income statement,
then the retained earnings account as shown on the balance sheet will be negative. Medium/Hard: (Comp:
3.2,3.3,3.9) Changes in leverage Answer: d MEDIUM/HARD . The CFO of Shalit Industries plans to
have the company issue $300 million of new common stock and use the proceeds to pay off some of its
outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and
that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following
would occur? a. The companys taxable income would fall. b. The companys interest expense would
remain constant. c. The company would have less common equity than before. d. The companys net
income would increase. e. The company would have to pay less taxes. Hard: (3.6) Net cash flow Answer:
d HARD . Last year Roussakis Companys operations provided a negative net cash flow, yet the cash
shown on its balance sheet increased. Which of the following statements could explain the increase in
cash, assuming the companys financial statements were prepared under generally accepted accounting
principles? a. The company repurchased some of its common stock. b. The company dramatically
increased its capital expenditures. c. The company retired a large amount of its long-term debt. d. The
company sold some of its fixed assets. e. The company had high depreciation expenses. Multiple Choice:
Problems Easy: A good bit of relatively simple arithmetic is involved in some of these problems, and
although the calculations are simple, it will take students some time to set up the problem and do the
arithmetic. We allow for this when assigning problems for a timed test. Also, students must use a number
of definitions to answer some of the questions, and to avoid excessive memorization, we provide students
with a list of formulas and definitions for use on exams. (3.2) Balance sheet: market value vs. book value
Answer: a EASY . Tucker Electronic System's current balance sheet shows total common equity of
$3,125,000. The company has 125,000 shares of stock outstanding, and they sell at a price of $52.50 per
share. By how much do the firm's market and book values per share differ? a. $27.50 b. $28.88 c. $30.32
d. $31.83 e. $33.43 (3.2) Balance sheet: change in BVPS from RE addition Answer: b EASY . Hunter
Manufacturing Inc.'s December 31, 2006 balance sheet showed total common equity of $2,050,000 and
100,000 shares of stock outstanding. During 2007, Hunter had $250,000 of net income, and it paid out
$100,000 as dividends. What was the book value per share at 12/31/07, assuming that Hunter neither
issued nor retired any common stock during 2007? a. $20.90 b. $22.00 c. $23.10 d. $24.26 e. $25.47 (3.3)
Income statement: EBIT Answer: e EASY . Companies generate income from their "regular" operations
and from other sources like interest earned on the securities they hold, which is called non-operating
income. Lindley Textiles recently reported $12,500 of sales, $7,250 of operating costs other than
depreciation, and $1,000 of depreciation. The company had no amortization charges and no non-operating
income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state
income tax rate was 40%. How much was Lindley's operating income, or EBIT? a. $3,462 b. $3,644 c.
$3,836 d. $4,038 e. $4,250 (3.3) Income statement: taxable income Answer: b EASY . Frederickson
Office Supplies recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and
$1,250 of depreciation. The company had no amortization charges and no non-operating income. It had
$8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was
40%. How much was the firm's taxable income, or earnings before taxes (EBT)? a. $3,230.00 b.
$3,400.00 c. $3,570.00 d. $3,748.50 e. $3,935.93 (3.5) Net cash flow Answer: d EASY . JBS Inc. recently
reported net income of $4,750 and depreciation of $885. How much was its net cash flow, assuming it
had no amortization expense and sold none of its fixed assets. a. $4,831.31 b. $5,085.59 c. $5,353.25 d.
$5,635.00 e. $5,916.75 (3.7) Net operating working capital Answer: b EASY . Swinnerton Clothing
Company's balance sheet showed total current assets of $2,250, all of which were required in operations.
Its current liabilities consisted of $575 of accounts payable, $300 of 6% short-term notes payable to the
bank, and $145 of accrued wages and taxes. What was its net operating working capital that was financed
by investors? a. $1,454 b. $1,530 c. $1,607 d. $1,687 e. $1,771 (3.8) MVA Answer: e EASY . Over the
years, Janjigian Corporation's stockholders have provided $15,250 of capital, part when they purchased
new issues of stock and part when they allowed management to retain some of the firm's earnings. The
firm now has 1,000 shares of common stock outstanding, and it sells at a price of $42.00 per share. How
much value has Janjigian's management added to stockholder wealth over the years, i.e., what is
Janjigian's MVA? a. $21,788 b. $22,935 c. $24,142 d. $25,413 e. $26,750 Easy/Medium: (3.3) Income
statement: net after-tax income Answer: d EASY/MEDIUM . Meric Mining Inc. recently reported
$15,000 of sales, $7,500 of operating costs other than depreciation, and $1,200 of depreciation. The
company had no amortization charges, it had outstanding $6,500 of bonds that carry a 6.25% interest rate,
and its federal-plus-state income tax rate was 35%. How much was the firm's net income after taxes?
Meric uses the same depreciation expense for tax and stockholder reporting purposes. a. $3,284.55 b.
$3,457.42 c. $3,639.39 d. $3,830.94 e. $4,022.48 (3.4) Statement of retained earnings: dividends Answer:
c EASY/MEDIUM . On 12/31/07, Heaton Industries Inc. reported retained earnings of $675,000 on its
balance sheet, and it reported that it had $172,500 of net income during the year. On its previous balance
sheet, at 12/31/06, the company had reported $555,000 of retained earnings. No shares were repurchased
during 2007. How much in dividends did Heaton pay during 2007? a. $47,381 b. $49,875 c. $52,500 d.
$55,125 e. $57,881 (3.4) Statement of retained earnings: NI Answer: a EASY/MEDIUM . During 2007,
Bascom Bakery Inc. paid out $21,750 of common dividends. It ended the year with $187,500 of retained
earnings versus the prior years retained earnings of $132,250. How much net income did the firm earn
during the year? a. $77,000 b. $80,850 c. $84,893 d. $89,137 e. $93,594 (3.7) Total operating capital
Answer: d EASY/MEDIUM . NNR Inc.'s balance sheet showed total current assets of $1,875,000 plus
$4,225,000 of net fixed assets. All of these assets were required in operations. The firm's current
liabilities consisted of $475,000 of accounts payable, $375,000 of 6% short-term notes payable to the
bank, and $150,000 of accrued wages and taxes. Its remaining capital consisted of long-term debt and
common equity. What was NNR's total investor-provided operating capital? a. $4,694,128 b. $4,941,188
c. $5,201,250 d. $5,475,000 e. $5,748,750 Medium: (3.3) Income statement: change in net income
Answer: b MEDIUM . Last year Tiemann Technologies reported $10,500 of sales, $6,250 of operating
costs other than depreciation, and $1,300 of depreciation. The company had no amortization charges, it
had $5,000 of bonds that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%.
This year's data are expected to remain unchanged except for one item, depreciation, which is expected to
increase by $750. By how much will net after-tax income change as a result of the change in
depreciation? The company uses the same depreciation calculations for tax and stockholder reporting
purposes. a. -463.13 b. -487.50 c. -511.88 d. -537.47 e. -564.34 (3.7) Free cash flow Answer: b MEDIUM
. TSW Inc. had the following data for last year: Net income = $800; Net operating profit after taxes
(NOPAT) = $700; Total assets = $3,000; and Total operating capital = $2,000. Information for the justcompleted year is as follows: Net income = $1,000; Net operating profit after taxes (NOPAT) = $925;
Total assets = $2,600; and Total operating capital = $2,500. How much free cash flow did the firm
generate during the just-completed year? a. $383 b. $425 c. $468 d. $514 e. $566 (3.7) Net operating
working capital Answer: b MEDIUM . Rao Corporation has the following balance sheet. How much net
operating working capital does the firm have? Cash $ 10 Accounts payable $ 20 Short-term investments
Accruals 20 Accounts receivable 50 Notes payable 50 Inventory 40 Current liabilities $ 90 Current assets
$130 Long-term debt 0 Net fixed assets 100 Common equity 30 Retained earnings 50 Total assets $230
Total liab. & equity $230 a. $54.00 b. $60.00 c. $66.00 d. $72.60 e. $79.86 (3.7) Net operating profit after
taxes (NOPAT) Answer: e MEDIUM . Bae Inc. has the following income statement. How much net
operating profit after taxes (NOPAT) does the firm have? Sales $2,000.00 Costs 1,200.00 Depreciation
100.00 EBIT $ 700.00 Interest expense 200.00 EBT $ 500.00 Taxes (35%) 175.00 Net income $ 325.00
a. $370.60 b. $390.11 c. $410.64 d. $432.25 e. $455.00 (3.7) Net operating profit after (NOPAT)
Answer: taxes c MEDIUM . EP Enterprises has the following income statement. How much net operating profit
after taxes (NOPAT) does the firm have? Sales $1,800.00 Costs 1,400.00 Depreciation 250.00 EBIT $
150.00 Interest expense 70.00 EBT $ 80.00 Taxes (40%) 32.00 Net income $ 48.00 a. $81.23 b. $85.50 c.
$90.00 d. $94.50 e. $99.23 (3.7) Return on invested capital (ROIC) Answer: d MEDIUM . Tibbs Inc. had
the following data for the year ending 12/31/06: Net income = $300; Net operating profit after taxes
(NOPAT) = $400; Total assets = $2,500; Short-term investments = $200; Stockholders' equity = $1,800;
Total debt = $700; and Total operating capital = $2,300. What was its return on invested capital (ROIC)?
a. 14.91% b. 15.70% c. 16.52% d. 17.39% e. 18.26% (3.7) Total operating capital Answer: b MEDIUM .
Zumbahlen Inc. has the following balance sheet. How much total operating capital does the firm have?
Cash $ 20.00 Accounts payable $ 30.00 Short-term investments 50.00 Accruals 50.00 Accounts
receivable 20.00 Notes payable 30.00 Inventory 60.00 Current liabilities $110.00 Current assets $150.00
Long-term debt 70.00 Gross fixed assets $140.00 Common stock 30.00 Accumulated deprec. 40.00
Retained earnings 40.00 Net fixed assets $100.00 Total common equity $ 70.00 Total assets $250.00
Total liab. & equity $250.00 a. $114.00 b. $120.00 c. $126.00 d. $132.30 e. $138.92 (3.8) Economic
Value Added (EVA) Answer: e MEDIUM . Barnes Brothers has the following data for the year ending
12/31/07: Net income = $600; Net operating profit after taxes (NOPAT) = $700; Total assets = $2,500;
Short-term investments = $200; Stockholders' equity = $1,800; Total debt = $700; and Total operating
capital = $2,100. Barnes' weighted average cost of capital is 10%. What is its economic value added
(EVA)? a. $399.11 b. $420.11 c. $442.23 d. $465.50 e. $490.00 (Comp: 3.3,3.5) Income statement: net
cash flow Answer: e MEDIUM . Edwards Electronics recently reported $11,250 of sales, $5,500 of
operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization
charges, it had $3,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate
was 35%. How much was its net cash flow? a. $3,284.75 b. $3,457.63 c. $3,639.61 d. $3,831.17 e.
$4,032.81 (Comp: 3.3,3.7) Income statement: free cash flow Answer: a MEDIUM . Wells Water Systems
recently reported $8,250 of sales, $4,500 of operating costs other than depreciation, and $950 of
depreciation. The company had no amortization charges, it had $3,250 of outstanding bonds that carry a
6.75% interest rate, and its federal-plus-state income tax rate was 35%. In order to sustain its operations
and thus generate sales and cash flows in the future, the firm was required to spend $750 to buy new fixed
assets and to invest $250 in net operating working capital. How much free cash flow did Wells generate?
a. $1,770.00 b. $1,858.50 c. $1,951.43 d. $2,049.00 e. $2,151.45 Hard: (3.8) EVA Answer: c HARD .
HHH Inc. reported $12,500 of sales and $7,025 of operating costs (including depreciation). The company
had $18,750 of investor-supplied operating assets (or capital), the weighted average cost of that capital
(the WACC) was 9.5%, and the federal-plus-state income tax rate was 40%. What was HHH's Economic
Value Added (EVA), i.e., how much value did management add to stockholders' wealth during the year?
a. $1,357.13 b. $1,428.56 c. $1,503.75 d. $1,578.94 e. $1,657.88 (Comp: 3.3,3.7) Changes in net income
and NCF Answer: e HARD . Last year, Michelson Manufacturing reported $10,250 of sales, $3,500 of
operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization
charges, it had $3,500 of bonds outstanding that carry a 6.5% interest rate, and its federal-plus-state
income tax rate was 35%. This year's data are expected to remain unchanged except for one item,
depreciation, which is expected to increase by $725. By how much will the depreciation change cause the
firm's net after-tax income and its net cash flow to change? Note that the company uses the same
depreciation calculations for tax and stockholder reporting purposes. a. -$383.84; $206.68 b. -$404.04;
$217.56 c. -$425.30; $229.01 d. -$447.69; $241.06 e. -$471.25; $253.75 . (Comp: 3.3,3.7) Income stmt:
FCF vs. net income Answer: c HARD Bartling Energy Systems recently reported $9,250 of sales, $5,750
of operating costs other than depreciation, and $700 of depreciation. The company had no amortization
charges, it had $3,200 of outstanding bonds that carry a 5% interest rate, and its federal-plus-state income
tax rate was 35%. In order to sustain its operations and thus generate sales and cash flows in the future,
the firm was required to make $1,250 of capital expenditures on new fixed assets and to invest $300 in
net operating working capital. By how much did the firm's net income exceed its free cash flow? a.
$673.27 b. $708.70 c. $746.00 d. $783.30 e. $822.47 CHAPTER 3 ANSWERS AND SOLUTIONS
CHAPTER 1 AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL
ENVIRONMENT True/False Easy: 1. (1.2) Firm organization Answer: b EASY The form of
organization for a business is not an important issue, as this decision has very little effect on the income
and wealth of the firm's owners. a. b. True False 2. (1.2) Firm organization Answer: b EASY The major
advantage of a regular partnership or a corporation as a form of business organization is the fact that
both offer their owners limited liability, whereas proprietorships do not. a. b. True False 3. (1.2)
Partnership Answer: a EASY There are three primary disadvantages of a regular partnership: (1)
unlimited liability, (2) limited life of the organization, and (3) difficulty of transferring ownership. These
combine to make it difficult for partnerships to attract large amounts of capital and thus to grow to a very
large size. a. b. True False 4. (1.2) Proprietorship Answer: a EASY Two disadvantages of a proprietorship
are (1) the relative difficulty of raising new capital and (2) the owner's unlimited personal liability for the
business' debts. a. b. True False 5. (1.2) Limited liability Answer: a EASY One key value of limited
liability is that it lowers owners' risks and thereby enhances a firm's value. a. b. True False Chapter 1:
Overview True/False Page 1 6. (1.3) Value maximization Answer: b EASY If a firm's goal is to maximize
its earnings per share, this is the best way to maximize the price of the common stock and thus
shareholders' wealth. a. b. True False 7. (1.4) Financial intermediaries Answer: a EASY If Firm A's
business is to obtain savings from individuals and then invest them in financial assets issued by other
firms or individuals, Firm A is a financial intermediary. a. b. True False 8. (1.7) Financial markets
Answer: b EASY If an individual investor buys or sells a currently outstanding stock through a broker,
this is a primary market transaction. a. b. True False 9. (1.7) Financial markets Answer: a EASY
Recently, Hale Corporation announced the sale of 2.5 million newly issued shares of its stock at a price of
$21 per share. Hale sold the stock to an investment banker, who in turn sold it to individual and
institutional investors. This is a primary market transaction. a. b. True False 10. (1.10) Stock market
transactions Answer: a EASY One of the functions of NYSE specialists is to facilitate trading by keeping
an inventory of shares of the stocks in which they specialize, buying when investors want to sell and
selling when they want to buy. They change the bid and ask prices of the securities so as to keep supply
and demand in balance. a. b. True False Page 2 True/False Chapter 1: Overview Medium: 11. (1.2)
Partnership Answer: b MEDIUM The disadvantages associated with a proprietorship are similar to those
under a partnership. One exception relates to the more formal nature of the partnership agreement and
the commitment of all partners' personal assets. As a result, partnerships do not have difficulty raising
large amounts of capital. a. b. True False 12. (1.2) Proprietorship Answer: a MEDIUM The facts that a
proprietorship, as a business, pays no corporate income tax, and that it is easily and inexpensively
formed, are two key advantages to that form of business. a. b. True False Multiple Choice: Conceptual
Easy: 13. (1.2) Firm organization Which of the following statements is CORRECT? a. b. c. d. e.
Answer: d EASY One of the disadvantages of incorporating a business is that the owners then become
subject to liabilities in the event the firm goes bankrupt. Sole proprietorships are subject to more
regulations than corporations. In any type of partnership, every partner has the same rights, privileges,
and liability exposure as every other partner. Sole proprietorships and partnerships generally have a tax
advantage over many corporations, especially large ones. Corporations of all types are subject to the
corporate income tax. Answer: a EASY 14. (1.2) Firm organization Which of the following statements
is CORRECT? a. b. c. d. e. One of the disadvantages of a sole proprietorship is that the proprietor is
exposed to unlimited liability. It is generally easier to transfer ones ownership interest in a partnership
than in a corporation. One of the advantages of the corporate form of organization is that it avoids
double taxation. One of the advantages of a corporation from a social standpoint is that every stockholder
has equal voting rights, i.e., one person, one vote. Corporations of all types are subject to the corporate
income tax. Conceptual Questions Page 3 Chapter 1: Overview 15. (1.2) Firm organization Which of the
following statements is CORRECT? a. b. c. d. e. Answer: d EASY It is generally more expensive to form
a proprietorship than a corporation because, with a proprietorship, extensive legal documents are
required. Corporations face fewer regulations than sole proprietorships. One disadvantage of operating a
business as a sole proprietorship is that the firm is subject to double taxation, at both the firm level and
the owner level. One advantage of forming a corporation is that equity investors are usually exposed to
less liability than in a regular partnership. If a regular partnership goes bankrupt, each partner is
exposed to liabilities only up to the amount of his or her investment in the business. 16. (1.2) Firm
organization Answer: c EASY Cheers Inc. operates as a partnership. Now the partners have decided to
convert the business into a regular corporation. Which of the following statements is CORRECT? a. b. c.
d. e. Assuming Cheers is profitable, less of its income will be subject to federal income taxes. Cheers will
now be subject to fewer regulations. Cheers shareholders (the ex-partners) will now be exposed to less
liability. Cheers investors will be exposed to less liability, but they will find it more difficult to transfer
their ownership. Cheers will find it more difficult to raise additional capital. Answer: a EASY 17. (1.2)
Firm organization Which of the following statements is CORRECT? a. b. c. d. e. It is usually easier to
transfer ownership in a corporation than it is to transfer ownership in a sole proprietorship. Corporate
shareholders are exposed to unlimited liability. Corporations generally face fewer regulations than sole
proprietorships. Corporate shareholders are exposed to unlimited liability, and this factor may be
compounded by the tax disadvantages of incorporation. There is a tax disadvantage to incorporation, and
there is no way any corporation can escape this disadvantage, even if it is very small. Page 4 Conceptual
Questions Chapter 1: Overview 18. (1.2) Corporate form of organization Answer: c EASY Which of
the following could explain why a business might choose to operate as a corporation rather than as a sole
proprietorship or a partnership? a. b. c. d. e. Corporations generally find it relatively difficult to raise
large amounts of capital. Less of a corporations income is generally subjected to taxes than would be true
if the firm were a partnership. Corporate shareholders escape liability for the firm's debts, but this
factor may be offset by the tax disadvantages of the corporate form of organization. Corporate
investors are exposed to unlimited liability. Corporations generally face relatively few regulations. 19.
(1.4) Financial transactions Answer: c EASY You recently sold 100 shares of your new company, XYZ
Corporation, 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 statements best describes
this transaction? a. b. c. d. e. This This This This This is is is is is an an an an an example example
example example example of of of of of an exchange of physical assets. a primary market transaction. a
direct transfer of capital. a money market transaction. a derivatives market transaction. Answer: a EASY
20. (1.5) Interest rates Which of the following statements is CORRECT? a. b. c. d. e. If expected inflation
increases, interest rates are likely to increase. If individuals in general increase the percentage of their
income that they save, interest rates are likely to increase. If companies have fewer good investment
opportunities, interest rates are likely to increase. Interest rates on all debt securities tend to rise during
recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt
securities. Interest rates on long-term bonds are more volatile than rates on short-term debt securities like
T-bills. Chapter 1: Overview Conceptual Questions Page 5 21. (1.6) Hedge funds Which of the following
statements is CORRECT? a. b. c. d. e. Answer: e EASY Hedge funds are legal in Europe and Asia, but
they are not permitted to operate in the United States. Hedge funds have more in common with
commercial banks than with any other type of financial institution. Hedge funds have more in common
with investment banks than with any other type of financial institution. Hedge funds are legal in the
United States, but they are not permitted to operate in Europe or Asia. The justification for the "light"
regulation of hedge funds is that only sophisticated investors with high net worths and high incomes are
permitted to invest in these funds, and such investors supposedly can do the necessary due diligence on
their own rather than have it done by the SEC or some other regulator. Answer: d EASY 22. (1.7) Money
markets Money markets are markets for a. b. c. d. e. Foreign stocks. Consumer automobile loans. U.S.
stocks. Short-term debt securities. Long-term bonds. 23. (1.7) Financial markets Which of the following
is a primary market transaction? a. b. c. d. e. Answer: b EASY You sell 200 shares of IBM stock on the
NYSE through your broker. IBM issues 2,000,000 shares of new stock and sells them to the public
through an investment banker. 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. One financial institution buys
200,000 shares of IBM stock from another institution. An investment banker arranges the transaction.
You invest $10,000 in a mutual fund, which then uses the money to buy $10,000 of IBM shares on the
NYSE. Answer: e EASY 24. (1.7) Financial markets Which of the following statements is CORRECT? a.
b. c. d. e. If Disney issues additional shares of common stock through an investment banker, this would be
a secondary market transaction. If you purchased 100 shares of Disney stock from your brother-inlaw,
this would be an example of a primary market transaction. The IPO market is a subset of the secondary
market. Only institutions, and not individuals, can participate in derivatives market transactions. As they
are generally defined, money market transactions involve debt securities with maturities of less than one
year. Page 6 Conceptual Questions Chapter 1: Overview 25. (1.7) Financial markets Answer: c EASY
You recently sold to your brother 200 shares of Disney stock, and the transfer was made through a broker,
and the trade occurred on the NYSE. This is an example of: a. b. c. d. e. A futures market transaction. A
primary market transaction. A secondary market transaction. A money market transaction. An over-thecounter market transaction. Answer: a EASY 26. (Comp: 1.6-1.8) Financial markets Which of the
following statements is CORRECT? a. b. c. d. e. The New York Stock Exchange is an auction market
with a physical location. Capital market transactions involve only the purchase and sale of equity
securities, i.e., common stocks. If an investor sells shares of stock through a broker, then this would be a
primary market transaction. Consumer automobile loans are evidenced by legal documents called
"promissory notes," and these individual notes are traded in the money market. While the distinctions are
blurring as investment banks are today buying commercial banks, and vice versa, investment banks
generally specialize in lending money, whereas commercial banks generally help companies raise capital
from other parties. Answer: a EASY 27. (Comp: 1.6-1.8) Financial markets Which of the following
statements is CORRECT? a. b. c. d. e. Capital market instruments include both long-term debt and
common stocks. An example of a primary market transaction would be your uncle transferring 100 shares
of Wal-Mart stock to you as a birthday gift. The NYSE does not exist as a physical location; rather, it
represents a loose collection of dealers who trade stocks electronically. 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. 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. Chapter 1: Overview Conceptual Questions Page 7 28. (Comp: 1.6-1.8) Financial markets
Which of the following statements is CORRECT? a. b. c. d. e. Answer: e EASY While the distinctions
are blurring, investment banks generally specialize in lending money, whereas commercial banks
generally help companies raise capital from other parties. A liquid security is a security whose value is
derived from the price of some other underlying asset. Money market mutual funds usually invest most
of their money in a well-diversified portfolio of liquid common stocks. Money markets are markets for
long-term debt and common stocks. The NYSE operates as an auction market, whereas the Nasdaq is a
dealer market. Medium: 29. (1.2) Corporate form of organization Answer: a MEDIUM
One drawback of switching from a partnership to the corporate form of organization is the
following: a. b. c. d. e.
It subjects the firm to additional regulations.
It cannot affect the amount of the firm's operating income that goes to taxes.
It makes it more difficult for the firm to raise additional capital. It makes the firms investors subject to
greater potential personal liabilities.
It makes it more difficult for the firms investors to transfer their ownership interests.
Answer: c MEDIUM
30. (1.2) Corporate form of organization Which of the following statements is CORRECT? a. b. c. d. e.
A hostile takeover is the main method of transferring ownership interest in a corporation. Unlimited
liability and limited life are two key advantages of the corporate form over other forms of business
organization. A corporation is a legal entity that is generally created by a state, and it has a life and
existence that is separate from the lives of its individual owners and managers. Limited liability of its
stockholders is an advantage of the corporate form of organization, but corporations have more trouble
raising money in financial markets because of the complexity of this form of organization. Although its
stockholders are insulated by limited legal liability, the legal status of the corporation does not protect the
firms managers in the same way, i.e., bondholders can sue its managers if the firm defaults on its debt,
even if the default is the result of poor economic conditions. Page 8 Conceptual Questions Chapter 1:
Overview 31. (1.2) Partnership form of organization Which of the following statements is CORRECT?
a. b. Answer: b MEDIUM c. d. e. In a regular partnership, liability for other partners misdeeds is
limited to the amount of a particular partners investment in the business. Partnerships have more
difficulty attracting large amounts of capital than corporations because of such factors as unlimited
liability, the need to reorganize when a partner dies, and the illiquidity (difficulty buying and selling) of
partnership interests. A slow-growth company, with little need for new capital, would be more likely to
organize as a corporation than would a faster growing company. In a limited partnership, the limited
partners have voting control, while the general partner has operating control over the business. Also, the
limited partners are individually responsible, on a pro rata basis, for the firms debts in the event of
bankruptcy. A major disadvantage of all partnerships relative to all corporations is the fact that federal
income taxes must be paid by the partners rather than by the firm itself. Answer: d MEDIUM 32. (1.2)
Partnership form of organization Which of the following statements is CORRECT? a. b. c. d. e.
Corporations are at a disadvantage relative to partnerships because they have to file more reports to state
and federal agencies, including the Securities and Exchange Administration, even if they are not publicly
owned. In a regular partnership, liability for the firm's debts is limited to the amount a particular partner
has invested in the business. A fast-growth company would be more likely to set up as a partnership for
its business organization than would a slow-growth company. Partnerships have difficulty attracting
capital in part because of their unlimited liability, the lack of impermanence of the organization, and
difficulty in transferring ownership. A major disadvantage of a partnership relative to a corporation as a
form of business organization is the high cost and practical difficulty of its formation. Chapter 1:
Overview Conceptual Questions Page 9 33. (1.2) Firm organization Which of the following statements is
CORRECT? a. Answer: c MEDIUM b. c. d. e. Most businesses (by number and total dollar sales) are
organized as proprietorships or partnerships because it is easier to set up and operate in one of these
forms rather than as a corporation. However, if the business gets very large, it becomes advantageous to
convert to a corporation, primarily because corporations have important tax advantages over
proprietorships and partnerships. Due to limited liability, unlimited lives, and ease of ownership transfer,
the vast majority of U.S. businesses (in terms of number of businesses) are organized as corporations.
Due to legal considerations related to ownership transfers and limited liability, most business (measured
by dollar sales) is conducted by corporations in spite of large corporations often less favorable tax
treatment. Large corporations are taxed more favorably than sole proprietorships. Corporate stockholders
are exposed to unlimited liability. 34. (1.2) Firm organization Answer: b MEDIUM Jane Doe, who has
substantial personal wealth and income, is considering the possibility of starting a new business in the
chemical waste management field. She will be the sole owner, and she has enough funds to finance the
operation. The business will have a relatively high degree of risk, and it is expected that the firm will
incur losses for the first few years. However, the prospects for growth and positive future income look
good, and Jane plans to have the firm pay out all of its income as dividends to her once it is well
established. Which of the legal forms of business organization would probably best suit her needs? a. b.
c. d. e. Proprietorship, because of ease of entry. S corporation, to gain some tax advantages and also to
obtain limited liability. Partnership, but only if she needs additional capital. Regular corporation,
because of the limited liability. In this situation, the various forms of organization seem equally
desirable. Page 10 Conceptual Questions Chapter 1: Overview 35. (1.2) Corporate charter and bylaws
Which of the following statements is CORRECT? a. Answer: e MEDIUM b. c. d. e. The corporate
bylaws are a standard set of rules established by the state of incorporation. These rules are identical for all
corporations in the state, and their purpose is to ensure that the firms managers run the firm in
accordance with state laws. The corporate charter is a standard document prescribed by the state of
incorporation, and its purpose is to ensure that the firms managers run the firm in accordance with state
laws. Procedures for electing corporate directors are contained in bylaws, while the declaration of the
activities that the firm will pursue and the number of directors are included in the corporate charter.
Companies must establish a home office, or domicile, in a particular state, and that state must be the one
in which most of their business (sales, manufacturing, and so forth) is conducted. Attorney fees are
generally involved when a company develops its charter and bylaws, but since these documents are
voluntary, a new corporation can avoid these costs by deciding not to have either a charter or bylaws. The
corporate charter is concerned with things like what business the company will engage in, whereas the
bylaws are concerned with things like procedures for electing the board of directors. 36. (1.3) Business
ethics Answer: c MEDIUM With which of the following statements would most people in business
agree? a. b. c. A corporations short-run profits will almost always increase if the firm takes actions that
the government has determined are in the best interests of the nation. Firms and government agencies
almost always agree with one another regarding the restrictions that should be placed on hiring and firing
employees. Although peoples moral characters are probably developed before they get into a business
school, it is still useful for business schools to cover ethics, including giving students an idea about the
adverse consequences of unethical behavior to themselves, their firms, and the nation. It is not useful for a
large corporation to develop a formal set of rules defining ethical and unethical behavior. Such rules
generally can't be applied in many specific instances, so it is better to deal with ethical issues on a caseby-case basis. Whistle blowers, because of the courage it takes to blow the whistle, are generally
promoted more rapidly than other employees. d. e. Chapter 1: Overview Conceptual Questions Page 11
37. (1.3) Goal of firm Answer: a MEDIUM The primary operating goal of a publicly-owned firm
interested in serving its stockholders should be to a. b. c. d. e. Maximize the stock price per share over the
long run, which is the stocks intrinsic value. Maximize the firm's expected EPS. Minimize the chances of
losses. Maximize the firm's expected total income. Maximize the stock price on a specific target date.
Answer: d MEDIUM 38. (1.3) Corporate goals and control Which of the following statements is
CORRECT? a. b. c. d. e. The proper goal of the financial manager should be to attempt to maximize the
firms expected cash flows, because this will add the most to the wealth of the individual shareholders.
The financial manager should seek that combination of assets, liabilities, and capital that will generate the
largest expected projected after-tax income over the relevant time horizon, generally the coming year.
The riskiness inherent in a firms earnings per share (EPS) depends on the characteristics of the projects
the firm selects, and thus on the firms assets. However, EPS is not affected by the manner in which those
assets are financed. Potential agency problems can arise between stockholders and managers, because
managers hired as agents to act on behalf of the owners may instead make decisions favorable to
themselves rather than the stockholders. Large, publicly-owned firms like AT&T and GM are controlled
by their management teams. Ownership is generally widely dispersed, hence managers have great
freedom in how they manage the firm. Managers may operate in stockholders best interests, but they
may also operate in their own personal best interests. As long as managers stay within the law, there is no
way to either force or motivate them to act in the stockholders best interests. 39. (1.5) Security prices and
interest rates Answer: e MEDIUM Suppose the U.S. Treasury announces plans to issue $50 billion of new
bonds. Assuming the announcement was not expected, what effect, other things held constant, would that
have on bond prices and interest rates? a. b. c. d. e. Prices and interest rates would both rise. Prices would
rise and interest rates would decline. Prices and interest rates would both decline. There would be no
changes in either prices or interest rates. Prices would decline and interest rates would rise. Page 12
Conceptual Questions Chapter 1: Overview 40. (1.5) Interest rates Answer: d MEDIUM Which of the
following would be most likely to lead to higher interest rates on all debt securities in the economy? a. b.
c. d. e. Households start saving a larger percentage of their income. The economy moves from a boom to
a recession. The level of inflation begins to decline. Corporations step up their expansion plans and thus
increase their demand for capital. The Federal Reserve uses monetary policy in an attempt to stimulate the
economy. 41. (1.5) Interest rates Answer: e MEDIUM Which of the following factors would be most
likely to lead to an increase in interest rates in the economy? a. b. c. d. e. Households reduce their
consumption and increase their savings. The Federal Reserve decides to try to stimulate the economy.
There is a decrease in expected inflation. The economy falls into a recession. Most businesses decide to
modernize and expand their manufacturing capacity, and to install new equipment to reduce labor costs.
Answer: d MEDIUM 42. (Comp: 1.7,1.8,1.10) Financial transactions Which of the following statements
is CORRECT? a. b. c. d. e. If General Electric were to issue new stock this year it would be considered a
secondary market transaction since the company already has stock outstanding. Capital market
transactions only include preferred stock and common stock transactions. The distinguishing feature
between spot markets versus futures markets transactions is the maturity of the investments. That is, spot
market transactions involve securities that have maturities of less than one year, whereas futures markets
transactions involve securities with maturities greater than one year. Both Nasdaq "dealers" and NYSE
specialists hold inventories of stocks. An electronic communications network (ECN) is a physical
location exchange. Chapter 1: Overview Conceptual Questions Page 13 43. (Comp: 1.2,1.3)
Miscellaneous concepts Which of the following statements is CORRECT? a. Answer: c MEDIUM b. c. d.
e. Corporations generally are subject to fewer regulations and more favorable tax treatment than sole
proprietorships and partnerships. This is why corporations do most of the business in the United States.
Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize
shareholder value than are managers who do not face the threat of hostile takeovers. One advantage of the
corporate form of organization is that liability of the owners of the firm is limited to their investment in
the firm. Because of their simplified organization, it is easier for sole proprietorships and partnerships to
raise large amounts of outside capital than it is for corporations. Bond covenants are an effective way to
resolve conflicts between shareholders and managers. Answer: e MEDIUM 44. (Comp: 1.2,1.3)
Miscellaneous concepts Which of the following statements is CORRECT? a. b. c. d. e. A good goal for a
firms management is maximization of expected EPS. Most business in the U.S. is conducted by
corporations, and corporations popularity results primarily from their favorable tax treatment. Because
most stock ownership is concentrated in the hands of a relatively small segment of society, firms' actions
to maximize their stock prices have little benefit to society. Corporations and partnerships have an
advantage over proprietorships because a sole proprietor is exposed to unlimited liability, but the liability
of all investors in the other types of businesses is more limited. The potential exists for agency conflicts
between stockholders and managers. Page 14 Conceptual Questions Chapter 1: Overview 45. (Comp:
1.2,1.3) Miscellaneous concepts Which of the following statements is CORRECT? a. b. c. d. e. Answer: d
MEDIUM One disadvantage of operating as a corporation rather than as a partnership is that corporate
shareholders are exposed to more personal liability than partners. There is no good reason to expect a
firm's stockholders and bondholders to react differently to the types of new asset investments a firm
makes. Bondholders are generally more willing than stockholders to have managers invest in risky
projects with high potential returns as opposed to safer projects with lower expected returns. Stockholders
are generally more willing than bondholders to have managers invest in risky projects with high potential
returns as opposed to safer projects with lower expected returns. Relative to sole proprietorships,
corporations generally face fewer regulations, and this makes it easier for corporations to raise capital.
Medium/Hard: 46. (1.7) Ownership and going public Answer: b Which of the following statements is
NOT CORRECT? a. b. c. d. e. MEDIUM/HARD When a corporations shares are owned by a few
individuals and are not traded on public markets, we say that the firm is closely, or privately, held."
Going public establishes a firm's true intrinsic value, and it also insures that a highly liquid market will
always exist for the firms shares. When stock in a closely held corporation is offered to the public for the
first time, the transaction is called going public, and the market for such stock is called the new issue
market. Publicly owned companies have shares owned by investors who are not associated with
management, and public companies must register with and report to a regulatory agency such as the SEC.
It is possible for a firm to go public and yet not raise any additional new capital at the time. Chapter 1:
Overview Conceptual Questions Page 15 CHAPTER 1 ANSWERS AND SOLUTIONS 1. 2. 3. 4. 5. 6. 7.
8. 9. 10. 11. 12. 13. (1.2) Firm organization (1.2) Firm organization (1.2) Partnership (1.2)
Proprietorship (1.2) Limited liability (1.3) Value maximization (1.4) Financial intermediaries (1.7)
Financial markets (1.7) Financial markets (1.10) Stock market transactions (1.2) Partnership (1.2)
Proprietorship (1.2) Firm organization Answer: b Answer: b Answer: a Answer a Answer: a Answer: b
Answer a Answer: b Answer: a Answer: a Answer: b Answer: a Answer: d EASY EASY EASY EASY
EASY EASY EASY EASY EASY EASY MEDIUM MEDIUM EASY Sole proprietorships and
partnerships pay personal income tax, but they avoid the corporate income tax. Small corporations that
meet certain requirements can elect to be classified as S Corporations, and then the business is taxed as a
partnership. 14. 15. (1.2) Firm organization (1.2) Firm organization Answer: a Answer: d EASY
EASY Corporations have limited liability; however, they face more regulations than the other forms of
organization. 16. 17. (1.2) Firm organization (1.2) Firm organization Answer: c Answer: a EASY
EASY If ownership in a proprietorship or partnership is transferred, the basic documents under which
the firm operates must be rewritten, whereas for a corporation the seller simply sells shares to a buyer,
and the corporation records the transfer on its books. 18. 19. 20. (1.2) Corporate form of organization
(1.4) Financial transactions (1.5) Interest rates Answers Answer: c Answer: c Answer: a EASY EASY
EASY Page 16 Chapter 1: Overview 21. 22. 23. (1.6) Hedge funds (1.7) Money markets (1.7) Financial
markets Answer: e Answer: d Answer: b EASY EASY EASY Statement b is a primary market
transaction, since the money and the security pass directly between the issuing firm and the investor. 24.
25. (1.7) Financial markets (1.7) Financial markets Answer: e Answer: c EASY EASY It is a secondary
market transaction because the stock is transferred from one investor to another. 26. 27. 28. 29. 30. 31.
32. 33. 34. (Comp: 1.6-1.8) Financial markets (Comp: 1.6-1.8) Financial markets (Comp: 1.6-1.8)
Financial markets Answer: a Answer: a Answer: e Answer: a Answer: c Answer: b Answer: d Answer: c
Answer: b EASY EASY EASY MEDIUM MEDIUM MEDIUM MEDIUM MEDIUM MEDIUM (1.2)
Corporate form of organization (1.2) Corporate form of organization (1.2) Partnership form of
organization (1.2) Partnership form of organization (1.2) Firm organization (1.2) Firm organization
The S corporation would allow her to take early losses as deductions against her other income, hence save
some taxes. Then, when the firm became profitable, she would receive dividends and pay taxes on them,
but the firm itself would avoid corporate taxes and double taxation. 35. 36. (1.2) Corporate charter and
bylaws (1.3) Business ethics Answer: e Answer: c MEDIUM MEDIUM It is important to have a specific
set of rules that all employees are expected to follow. This helps constrain actions, and it is also important
to "prove" that the company is trying to do right if some employee does something wrong. 37. 38. 39. 40.
(1.3) Goal of firm (1.3) Corporate goals and control (1.5) Security prices and interest rates (1.5) Interest
rates Answer: a Answer: d Answer: e Answer: d MEDIUM MEDIUM MEDIUM MEDIUM Chapter 1:
Overview Answers Page 17 41. (1.5) Interest rates Answer: e MEDIUM An increase in the demand for
capital by businesses will increase interest rates in the economy. 42. 43. 44. 45. 46. (Comp: 1.7,1.8,1.10)
Financial transactions (Comp: 1.2,1.3) Miscellaneous concepts (Comp: 1.2,1.3) Miscellaneous concepts
(Comp: 1.2,1.3) Miscellaneous concepts (1.7) Ownership and going public Answer: d Answer: c Answer:
e Answer: d Answer: b MEDIUM MEDIUM MEDIUM MEDIUM MEDIUM/HARD Page 18 Answers
Chapter 1: Overview