Foundations of Finance: An Introduction

Answer: Underestimation of risk can lead managers to borrow excessively to fund more and more projects. High levels of debt require interest and principal payments which may become impossible to make if the company’s cash flows are reduced, even for short periods of time. Overestimation of risk can also be problematic. Managers who take on too little risk may be passing up desirable projects that could increase shareholder wealth. The principle that risk requires a return does not mean that all risk is bad, but rather hat additional risk is k if additional expected returns are high enough.

If all risk was bad, companies would go out of business and all investors would buy U. S. Treasury Bills. Dif. 2 Keywords: Risk Requires a Return, Goal of the Firm 21) Documents uncovered after the Exxon Valued oil spill in Alaska revealed that Exxon could have used double-hulled oil tankers that would have prevented the spill, but the cost of refitting their fleet of single-hulled tankers was considered too high. Exxon determined that the cost of cleaning up an oil spill would be less than the cost f refitting the ships, thus increasing shareholder value.

Several years after the oil spill, however, Exxon was fined billions of dollars for the spill. How do the costs of the clean up and the fines pertain to a discussion of maximizing shareholder value and ethical responsibility? Answer: Managers are supposed to maximize shareholder value. Oxen’s analysis of the costs of an oil spill versus the cost of improving their tankers seems to have been a reasonable one at the time it was undertaken. The social costs of killing birds and fish were expected to be low. The outrage at Oxen’s induct and the subsequent large fines will change the estimation of future costs for similar situations.

Managers need to consider the impact of their decisions on their companies’ cash flows. Socially undesirable activities may lead to boycotts, protests, limits within which corporations must operate or the corporations, and their shareholders, will suffer. Therefore, acting in ethical and socially responsible ways is congruent with the goal of shareholder wealth minimization. Dif 2 Keywords: Goal of the Firm, Maximizing Shareholder Value, Ethical Responsibility, Cash Flow CABS: Reflective thinking skills Learning Objective 2 1) When making financial decisions, managers should always look at marginal, or incremental cash flows.

Answer: TRUE Keywords: Marginal or Incremental Cash Flows 2) An investment project is acceptable if the total cash received over the life of the project exceeds the total cash spent over the life of the project. Answer: FALSE Keywords: Cash Flow, Time Value of Money 3) If two companies have the same net income and the same level of risk, they must also have the same stock price or the market is not in equilibrium. Answer: FALSE Keywords: Net Income, Risk, Timing of Cash Flow ) Profits represent money that can be spent, and as such, form the basis for determining the value of financial decisions.

Answer: FALSE Keywords: Profits, Cash Flow 5) The root cause of agency problems is conflicts of interest. Answer: TRUE Keywords: Agency Problems, Conflicts of Interest 6) Investors will be indifferent between two investments if both investments have the same expected return. Answer: FALSE Keywords: Risk-Return Tradeoff 7) If the stock market is efficient, then investors do not need to read the Wall Street Journal or research companies before they select which stocks to buy because market Keywords: Efficient Markets ) Giving the company’s CEO stock options as part of his or her compensation package is an example of an agency cost.

Answer: TRUE Keywords: Agency Costs 9) Cash flows and profits are synonymous; in other words, higher cash flows equal higher profits. Answer: FALSE Keywords: Cash Flow, Profit 10) Shareholder selection committees select potential board of director nominees ensuring that board members will monitor management sufficiently to protect shareholder interests. Answer: FALSE Keywords: Agency Problems, Board of Directors 1 1) Managers should not be concerned with business ethics because ethical behavior s inconsistent with the primary goal of maximizing shareholder value.

Answer: FALSE Keywords: Ethics, Goal of the Firm CABS: Ethical understanding and reasoning abilities 12) One of the problems associated with minimization of total current stock value is that it ignores the timing of a project’s return. Answer: FALSE Keywords: Maximizing Shareholder Value, Timing of Returns 13) The risk-return tradeoff is seen in many areas of finance. Answer: TRUE Keywords: Risk, Return 14) The risk/return tradeoff implies that the return on a rissoles asset must be zero. Answer: FALSE 5) The sole proprietorship has no legal business structure separate from its owner.

Answer: TRUE Keywords: Sole Proprietorship 16) An efficient market is one where the prices of the assets traded in that market fully reflect all available information at any instant in time. Answer: TRUE 17) The opportunity cost of any choice you make is the highest-valued alternative that you had to give up when you made the choice. Answer: FALSE Keywords: Opportunity Cost, Time Value of Money 18) Beginning in 2007 the United States experienced its most severe financial crisis since the Great Depression of the sass.

Keywords: Current Assets, Temporary Sources of Financing 19) As of year-end 2012, the great economic recession in the United States that began in 2007 has NOT officially ended. Answer: FALSE Keywords: Current Global Financial Crisis 20) While many factors contributed to the financial crisis of 2007 and beyond, it is safe to say that real estate loans were NOT much of a contributing factor. Answer: 21) The purchase of a pool of mortgages is often financed through the sale of securities called mortgage-backed securities, or MS.

This is a key part of the serialization process. Answer: TRUE signaled foreman or team leader. In this sense they are employed under a specific individual. Answer: FALSE 23) Fortunately, Europe was largely shielded from the economic recession that afflicted the world economy in 2007. The European economies contracted less and have recovered much more rapidly than their counterparts in the United States and China. Answer: FALSE CABS: Dynamics of the global economy 24) A homeowner that owes more on his/her mortgage than the home is worth is said to be “under water”.

Answer: TRUE 25) The five basic principles of finance include all of the following EXCEPT A) Cash flow s what matters. B) Money has a time value. C) Risk requires a reward. D) Incremental profits determine value. Keywords: Basic Principles of Finance 26) Suppose EX. Corporation is traded on the New York Stock Exchange. Ex.’s closing price on Monday is $20 per share. After the market closes on Monday, EX. makes a surprise announcement that it has obtained a major new customer. Ex.’s stock will likely A) open at $20 per share on Tuesday and then increase as more investors read the announcement in the Wall Street Journal.

B) remain at $20 per share because in efficient markets the price already reflects all information. C) open above $20 because the positive news will result in a higher valuation even though the stock has not yet traded. D) open below $20 because the surprise announcement creates more uncertainty. Answer: C 27) A corporate manager decides to build a new store on a lot owned by the purchased for $50,000 twenty years ago. When determining the value of the new store project A) the cost of the lot is zero since the corporation already owns it.

B) the opportunity cost of the lot is $250,000 and should be included in calculating the value of the project. C) the cost of the lot for valuation purposes is $50,000 because land goes not depreciate. D) the incremental cash flow should be the $50,000 original cost less accumulated amortization. Answer: B Keywords: Opportunity Cost 28) To measure value, the concept of time value of money is used A) to determine the interest rate paid on corporate debt. B) to bring the future benefits and costs of a project, measured by its expected profits, back to the present.

C) to bring the future benefits and costs off project, measured by its cash flows, back to the present. D) to ensure that expected future profits exceed current profits today. Answer: C Keywords: Time Value of Money, Cash Flows 9) A financial manager is evaluating a project which is expected to generate profits of $100,000 per year for the next 10 years. The project should be accepted if A) the cost of the project is less than $1 B) the cost of the project is less than the present value of $100,000 per year for 10 years.

C) this project’s expected profits are higher than any other projects the corporation has available. D) the present value of the project’s cash inflows exceeds the present value of the project’s cash outflows. Answer: D 30) Investors want a return that satisfies the following expectations: A) A return for laying consumption B) An additional return for taking on risk C) An additional return for accepting dividends rather than capital gains D) Both A and B. 31) The expected return on a rissoles asset is greater than zero due to A) an expected return for delaying consumption.

B) an expected return for opportunity costs. C) an expected return for taxes. Answer: A 32) Joe, a risk-averse investor, is trying to choose between investment A and investment B. If investment A is riskier than investment B and Joe selects investment A anyway, then A) the actual return for investment A will be higher than the actual turn for investment B. B) the actual return for investment A will be higher than the expected return for investment B. C) the expected return for investment A will be higher than the actual return for investment B.

D) the expected return for investment A will be higher than the expected return for investment B. Answer: D 33) The principle of risk-return tradeoff means that A) higher risk investments must earn higher returns. B) an investor who takes more risk will earn a higher return. C) a rational investor will only take on higher risk if he expects a higher return. D) an investor who bought tock in a small corporation five years ago has more money than an investor who bought U. S. Treasury bonds five years ago.