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.