Chapter 1 Questions Foundations of Financial Management


What advantages does a sole proprietorship offer?

  • Simple decision making
  • Low organizational and operating costs


Major drawback of sole proprietorship?

  • Unlimited liability
  • Taxation is on owner as income


What form of partnership allows some partners to limit their liability?

  • A limited partnership one or more partners is designated a general partner with unlimited liability
  • Other partners have limited liability (for their initial contribution)
    • Prohibited from active management role
    • Real estate agents, doctors, lawyers, accountants


In a corporation which group has ultimate responsibility for protecting and managing stockholders interests?

  • The board of directors


What are the disadvantages of a corporation

  • Double taxation of dividends
    • Subchapter S corporation can circumvent this (only up to 35 stockholders)
  • Complex management requirements
  • Costly reporting and structural requirements


What is the issue for agency theory? Why is it important for public corporations but not private corporations?

  • Agency theory looks at relationship owners and managers.
    • Competing goals
  • In private corporations managers and owners are usually the same people.


Why are institutional investors so important now?

  • They own a large percentage of stock
  • They exercise voting rights and demand board seats


Why is profit maximization by itself an inappropriate goal?

  • The time value of money must be considered.  The timing of profits can have a big effect on the benefit to the business.
  • Profit is subject to many different measurements which can be manipulated.
  • Changes in profit may represent changes in risk which may cause future problems for the business.
  • Problems of inflation and currency movement also complicate things.


What is meant by “Maximization of investor wealth”?

  • Achieving the highest value for the business
    • Stock prices
    • Options for management.


When does insider trading occur?

  • Some trade in shares using information that is not available to the public.
    • Ala Drexel, Martha Stewart, Rene Rivkin.
  • The SEC protects the public from insider trading.


In terms of the life of the security, what is the difference between money and capital markets?

  • Money markets are short term
    • Treasury bills
    • Commercial paper to finance daily operations of corporations
    • Certificates of deposit (less than 1 year)
  • Capital markets have life of more than one year
    • Common stock
    • Preferred stock
    • Corporate and government bonds


What is the difference between a primary and a secondary market?

  • Raising new funds IPO etc is in the primary market new issue
  • When the public start trading them this is the secondary market
    • Secondary market has constantly changing prices.


Assuming you looking at many companies with equal risk, which ones will have the highest stock prices?

  • The one which has the highest expected profits.


What changes can take place under restructuring? In recent times what group of investors has forced restructuring to take place?

  • Changes to liabilities and equity on the balance sheet.
  • Selling and reinvesting from devisions
  • Changing management team and workforce.
  • Institutional investors force restructuring.