Test bank, financial, economics, 2nd edition, bodie

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Chapter One
Financial Economics
This chapter contains 48 multiple choice questions, 20 short problems and 5 longer problems.
Multiple Choice
1. The primary goal of corporate management is to ________ shareholder wealth.
(a) minimize
(b) maximize
(c) leverage
(d) mitigate
Answer: (b)
2. A ________ stock market imposes ________ discipline on managers to take actions to maximize the
market value of the firm’s shares.
(a)
(b)
(c)
(d)

competitive, strong
dispersed, weak
mature, no
dispersed, strong

Answer: (a)
3. The ________ form is especially well suited to the separation of ownership and management of firms
because it allows relatively frequent changes in owners by share transfer without affecting the operations
of the firm.
(a)
(b)
(c)
(d)

corporate
sole proprietorship
partnership
household

Answer: (a)
4. ________ is anything that has economic value.
(a)
(b)
(c)
(d)

A partnership
An asset
A balance sheet
An income statement

Answer: (b)

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5. A household’s wealth or net worth is measured by the value of its ________ minus its ________.
(a)
(b)
(c)
(d)

liabilities; assets
assets; liabilities
stocks; bonds
bonds; liabilities

Answer: (b)
6. The branch of finance dealing with financial decisions of firms is called ________ or ________.
(a)
(b)
(c)
(d)

investments; international finance
markets; institutions
business finance; institutions
business finance; corporate finance

Answer: (d)
7. Bonds promise ________ cash payments, while stocks pay the ________ value left over after all other
claimants have been paid.
(a)
(b)
(c)
(d)

variable; residual
residual; fixed
fixed; residual
fixed; variable

Answer: (c)
8. The day-to-day financial affairs of the firm are usually referred to as ________.
(a)
(b)
(c)
(d)

working capital management
capital structure
capital budgeting
strategic planning

Answer: (a)
9. A disadvantage of the sole proprietorship is the fact that the sole proprietor has ________.
(a)
(b)
(c)
(d)

limited liability for the debts of the firm
unlimited liability for the debts of the firm
expensive costs to establish the firm
limited authority over the day-to-day business decisions of the firm

Answer: (b)

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10. In the U.S. corporations with concentrated ownership are called ________ and corporations with
broadly dispersed ownership are called ________.
(a)
(b)
(c)
(d)

private corporations; public corporations
public corporations; private corporations
public corporations; monopolies
private corporations; state owned corporations

Answer: (a)
11. Billy owns a house worth $350,000 and has a $55,000 bank account. Billy owes $270,000 to the bank
on a home mortgage loan and has a $12,000 credit card debt outstanding. Calculate Billy’s net worth.
(a)
(b)
(c)
(d)

$135,000
$123,000
$497,000
$37,000

Answer: (b)
12. Marlowe owns a house worth $150,000, a car worth $25,000 and has an $18,000 bank account.
Marlowe owes $135,000 to the bank on a home mortgage loan, $18,000 on the car loan and has an
$18,000 credit card debt outstanding. Calculate Marlowe’s net worth.
(a)

(b)
(c)
(d)

$58,000
$123,000
$22,000
$37,000

Answer: (c)
13. An advantage of the corporate form of ownership is ________.
(a)
(b)
(c)
(d)

no liability
unlimited liability
limited liability
CEO liability

Answer: (c)

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14. In the corporate form, the separated structure creates the potential for ________ between owners and
managers.
(a)

(b)
(c)
(d)

a conflict of interest
increased transactional costs
stability in relations
none of the above

Answer: (a)
15. All of the following are reasons for having a separation of management and ownership of the firm
except:
(a)
(b)
(c)
(d)

the “going concern” effect favors the separated structure
professional managers may be found who possess a superior ability to run the business
it prevents the possibility of a conflict of interest between the owners and management
it allows for savings in the cost of information gathering

Answer: (c)
16. ________ involves the evaluation of costs and benefits spread out over time, and it is largely a
financial decision-making process.
(a)
(b)
(c)
(d)

Stock valuation
Bond valuation
Inventory costing
Strategic planning

Answer: (d)
17. Shareholder wealth maximization depends on all of the following except:
(a)
(b)
(c)
(d)

production technology
market interest rates
risk aversion
market risk premiums

Answer: (c)
18. A problem with using the profit maximization criterion is ________.
(a)
(b)
(c)
(d)

deciding which period’s profit is to be maximized
the definition of “maximize profits” is ambiguous
the failure to consider risk
all of the above

Answer: (d)

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19. The existence of a well functioning stock market facilitates the efficient separation of the ownership
and management of firms, since stock prices can be substituted for external information about ________.
(a)
(b)
(c)
(d)

the firm’s production technology
the wealth, preferences, and other investment opportunities of the owners
the historic costs of the firm’s infrastructure
the firm’s ability to meet its projected goals

Answer: (b)
20. One place to look for a statement of the goals of a corporation’s top managers is the ________.
(a)
(b)
(c)
(d)

balance sheet
income statement
annual report
bankruptcy filing

Answer: (c)
21. In the absence of a stock market, managers would require information that is ________ to obtain.

(a)
(b)
(c)
(d)

costly if not impossible
costless
readily available
time-consuming but inexpensive

Answer: (a)
22. Management’s task is made much easier when it can observe the ________ of its own and other firms’
shares.
(a)
(b)
(c)
(d)

book prices
market prices
historical prices
security prices

Answer: (b)

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23. ________ are entitled to a share of any of the distributions from the corporation such as cash

dividends.
(a)
(b)
(c)
(d)

Sole proprietors
General partners
Professional managers
Shareholders

Answer: (d)
24. ________ is the founder of modern portfolio theory.
(a)
(b)
(c)
(d)

Harry Markowitz
Merton Miller
William Sharpe
Bill Gates

Answer: (a)
25. In Germany, public corporations are identifiable by ________ after the company name, whereas
private companies are denoted by ________.
(a)
(b)
(c)
(d)

PLC, Inc.
GmbH, AG
AG, GmbH
SpA, GmbH

Answer: (c)
26. In the United Kingdom, public corporations are identifiable by ________ after the company name,
whereas private companies are denoted by ________.
(a)
(b)
(c)
(d)

Inc, PLC
LTD, PLC
AG, GmbH
PLC, LTD

Answer: (d)
27. Shareholders elect ________ who in turn select ________ to run the business.
(a)
(b)
(c)
(d)

a board of directors; a treasurer
a board of directors; managers
managers; a board of directors
a board of directors; accountants

Answer: (b)
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28. In a competitive stock market, ________ offer(s) another important mechanism for aligning the
incentives of managers with those of shareholders.
(a)
(b)
(c)
(d)

takeovers
increased taxes
liquidation
increased liability

Answer: (a)

29. If a raider is interested in making a profit through the takeover of a prospective firm, the only
expenses that need be incurred are ________.
(a)
(b)
(c)
(d)

the cost of identifying a mismanaged firm
the cost of acquiring the firm’s shares
physical capital

both (a) and (b)

Answer: (d)
30. The cost of identifying a mismanaged firm can be low if the raider is which of the following:
(a)
(b)
(c)
(d)

a supplier
a customer
a competitor
all of the above

Answer: (d)
31. Takeover mechanisms can most effectively be reduced by ________.
(a)
(b)
(c)
(d)

directives from the board of directors
media intervention
government policies
public disapproval

Answer: (c)

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32. The chief financial officer (CFO) of a corporation normally reports to the ________ of the company.
(a)
(b)
(c)
(d)

controller
treasurer
chief executive officer
chairman of the board of directors

Answer: (c)
33. All of the following departments typically report to the chief financial officer (CFO) except:
(a)
(b)
(c)
(d)

marketing
financial planning
treasury
control

Answer: (a)
34. The treasurer’s job includes managing all of the following except:
(a)
(b)
(c)

(d)

the firm’s exposure to currency and interest rate risks
the tax department
relations with the external investment community
the analysis of proposed mergers and acquisitions

Answer: (d)
35. The activities of the vice president for financial planning include all of the following except:
(a)
(b)
(c)
(d)

analyzing proposed mergers
analyzing proposed spin-offs
preparing internal reports comparing planned and actual costs
analyzing major capital expenditures

Answer: (c)
36. Which of the following statements is most correct?
(a) The shareholders of a corporation elect managers who in turn select a board of directors to
run the business.
(b) Partnerships do not pay corporate tax.
(c) A disadvantage of the corporation is unlimited liability.
(d) The government is powerless to discourage corporate takeovers.
Answer: (b)

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37. For a typical firm, which of the following statements is most correct?
(a) The CFO has three departments reporting to him: financial planning, treasury and control.
(b) The treasurer oversees the accounting and auditing activities of the firm.
(c) The controller has responsibility for managing the financing activities of the firm and for
working capital management.
(d) The CEO is a senior vice president with responsibility for all the financial functions in the
firm.
Answer: (a)
38. Which of the following are financial decisions a firm has to make?
(a)
(b)
(c)
(d)

financing decisions
capital budgeting decisions
working capital decisions
all of the above

Answer: (d)
39. The controller’s job includes responsibility for ________.
(a) relations with the external investment community
(b) preparation of financial statements for use by shareholders, creditors and regulatory
authorities
(c) analysis of proposed mergers, acquisitions and spin-offs
(d) all of the above
Answer: (b)
40. The basic unit of analysis in capital budgeting is the ________.

(a)
(b)
(c)
(d)

financing project
investment project
strategic project
variable project

Answer: (b)
41. The steps involved in any capital budgeting process include:
(a)
(b)
(c)
(d)

evaluating projects
deciding which projects to undertake
identifying ideas for new investment projects
all of the above

Answer: (d)
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42. Preferred stock, bonds, and convertible securities are also known as ________.
(a)
(b)

(c)
(d)

nonmarketable claims
standardized securities
variable securities
covenants

Answer: (b)
43. The basic unit of analysis in capital structure decisions is the ________.
(a)
(b)
(c)
(d)

firm as a whole
investment project
firm’s personnel
financial system

Answer: (a)
44. Which one of the following correctly orders the steps involved in capital structure decisions?
(a)
(b)
(c)
(d)

determining a feasible financing plan; identifying new ideas for investment projects
determining the optimal financing mix; determining a feasible financing plan
identifying ideas for investment projects; determining the optimal financing mix

determining a feasible financing plan; determining the optimal financing mix

Answer: (d)
45. Which of the following is not a financial function of a corporation?
(a)
(b)
(c)
(d)

investor relations
tax administration
provision of capital
regulatory legislation

Answer: (d)
46. Which of the following functions may be categorized as administration of funds?
(a)
(b)
(c)
(d)

custodial responsibilities
tax administration
internal auditing
all of the above

Answer: (a)

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47. Investor relations includes:
(a)
(b)
(c)
(d)

government reporting
establishment and maintenance of communications with company stockholders
relations with taxing agencies
consultation with and advice to other corporate executives

Answer: (b)
48. Oscar owns a boat worth $2 million, a house worth $5.5.million and has $900,000 in a bank account.
Oscar owes $1.1 million to the bank on the boat loan, $2 million on the home loan and has $20,000
credit card debt. Calculate Oscar’s net worth.
(a)
(b)
(c)
(d)

$3.12 million
$5.28 million
$7.28 million
$8.4 million

Answer: (b)
Short Problems
1. Give a brief definition of the financial system.

Answer: A financial system is defined as the set of markets and other institutions used for financial
contracting and the exchange of assets and risks.
2. List the markets that the financial system likely includes.
Answer: A financial system includes the markets for stocks, bonds and other financial instruments,
financial intermediaries, financial service firms and the regulatory bodies that govern all of these
institutions.
3. Briefly describe the distinction between physical capital and financial capital.
Answer: Physical capital includes items such as buildings, machinery and other intermediate products
used in the production process. Financial capital, however, includes stocks, bonds and loans used to
finance the acquisition of physical capital.
4. Give a brief description of the wide range of financial instruments and claims a firm can issue.
Answer: These include common stock, preferred stock, bonds and convertible securities (standardized
securities that can be traded in organized markets). Financial instruments and claims can also include
nonmarketable claims such as bank loans, employee stock options, leases and pension liabilities.

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5. Siggy owns a house worth $200,000, a car worth $25,000 and has an $18,000 bank account. He also
has furniture worth $4,000 and jewelry worth $10,000. However, Siggy owes $145,000 to the bank on
a home mortgage loan, $17,000 on the car loan, $40,000 on student loans and has an $16,000 credit
card debt outstanding. Calculate Siggy’s net worth.
Answer: Net Worth = Total Assets – Total Liabilities
= ($200,000 + $25,000 + $18,000 + $4,000 + $10,000) –
($145,000 + $17,000 + $40,000 + $16,000)
= $39,000
6. Briefly list the problems associated with profit maximization as the chief goal of corporate managers.
Answer: The profit-maximization criterion has two problems associated with it. The first is that it is
difficult to determine which period’s profit is to be maximized if the production process requires many

periods. Secondly, if either future revenues or expenses are uncertain, then what exactly is the meaning
of “maximize profits” if profits are described by a probability distribution?
7. Kecia owns a house worth $220,000, a car worth $20,000 and has a $13,000 bank account. She also
has furniture worth $8,000. However, Kecia owes $165,000 to the bank on a home mortgage loan,
$17,000 on the car loan, $50,000 on student loans and has an $18,000 credit card debt outstanding.
Calculate Kecia's net worth.
Answer: Net Worth = Total Assets – Total Liabilities
= ($220,000 + $20,000 + $13,000 + $8,000) –
($165,000 + $17,000 + $50,000 + $18,000)
= $261,000 - $250,000
= $11,000
8. Give an example of a potential conflict of interest that can arise between owners and managers of a
firm.
Answer: Managers being concerned with their own personal welfare may lead to concern about job
security in the long run. This concern about long run survival may cause managers to limit the risk
incurred by the firm and make other decisions not with the objective of shareholder wealth maximization.
9. What use does the existence of a stock market serve to the manager of a firm?
Answer: Observing its own and other firms’ market price of shares helps it make decisions about
maximizing the firm’s value to its shareholders. If there was not a stock market, then managers would be
required to obtain information that is costly, if not impossible, to obtain. This includes the wealth,
preferences and other investment opportunities of the owners.

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10. Outline the role of the takeover in aligning the incentives of managers with those of shareholders.
Answer: The threat of a takeover provides a strong incentive for current managers to act in the interests
of the firm’s current shareholders by maximizing market value. If managers fail to maximize the market
value of the firm’s shares, the firm will be vulnerable to a takeover in which the managers may lose their

jobs.
11. Outline the role of the chief financial officer (CFO) in a corporation.
Answer: The CFO is a senior vice president with responsibility for all the financial functions in the firm
and reports directly to the CEO. Three departments report to the CFO: financial planning, treasury, and
control.
12. Discuss the role of the treasurer in a corporation.
Answer: The treasurer has responsibility for managing the financing activities of the firm and for
working capital management. The treasurer is responsible for managing relations with the external
investor community, managing the firm’s exposure to currency and interest rate risks, and managing the
tax department.
13. Discuss the tasks performed by the controller of a corporation.
Answer: The controller oversees the accounting and auditing tasks of the firm. The controller is
responsible for the preparation of internal reports comparing planned and actual costs, revenues, and
profits from the corporation’s various business units. The controller will also be involved with
preparation of financial statements for use by shareholders, creditors and regulatory authorities.
14. Discuss why voting rights for shareholders are not adequate to compel managers to act in the best
interests of the shareholders.
Answer: Because a major benefit of the separated structure is that the owners can remain relatively
uninformed about the operations of the firm, it is not apparent how these owners could know whether
their firm is being mismanaged. The value of voting rights is further cast into doubt if ownership of the
firm is widely dispersed. If that is the situation, then the holdings of any single owner are likely to be so
small that he or she would not incur the expense to become informed and to convey this information to
the other owners.
15. Is it possible for government to reduce the effectiveness of the takeover mechanism?
Answer: Yes. It is possible for government policy to prevent the formation of monopolies in various
product markets – as in the case of the United States Department of Justice, which can take legal action
under the antitrust laws to prevent mergers and acquisitions that might reduce competition.

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16. In terms of the financial functions of a corporation, what responsibilities do administration of funds
entail?
Answer: Management of cash; maintenance of banking arrangements; receipt, custody and
disbursement of the company’s monies and securities; credit and collection management; management of
pension funds; management of investments and custodial responsibilities.
17. Discuss the liability a partnership faces.
Answer: Unless otherwise specified, all partners have unlimited liability as in the sole proprietorship.
However, it is possible to limit the liability for some partners called “limited partners”. At least one of
the partners, called the general partner, has unlimited liability for the debts of the firm.
18. Describe the advantages of the corporate form of business organization.
Answer: The corporate form of ownership has the advantage that ownership shares can usually be
transferred without disrupting the business. Limited liability is also another advantage of the corporate
form. In this case, if the corporation fails to pay its debts, the creditors can seize the assets of the
corporation but have no recourse to the personal assets of the shareholders.
19. Briefly outline the process of capital budgeting.
Answer: The process of capital budgeting includes identifying ideas for new investment projects,
evaluating them, deciding which ones to undertake, and then implementing them.
20. Briefly discuss the process of working capital management.
Answer: Working capital management refers to the day-to-day financial affairs of the business, such as
whether to extend credit to customers or demand cash on delivery or managing cash flow.

Longer Problems
1. Describe the four basic types of financial decisions faced by householders.
Answer: Investment decisions – whether to invest in stocks or bonds
Consumption/Savings Decisions – how much to save for one’s retirement or a child’s
education
Risk management decisions – whether to buy disability insurance
Financing decisions – what type of loan to adopt in order to finance the purchase of a home or

car.

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2. Give a brief description of each of the four main areas of financial decision-making in a business.
Answer:

Strategic Planning: Evaluating the costs and benefits associated with the firm’s business
line, which may change over time.
Capital Budgeting: Identifying ideas for new investment projects, evaluating them,
deciding which ones to undertake, and then implementing them.
Capital Structure: The initial step is deciding upon a feasible financing plan for the firm.
The next decision involves the optimal debt/equity mix to use.
Working Capital Management: The day-to-day affairs of the business. This includes
paying bills as they come due, collecting from customers, managing the firm’s cash flows
to ensure that operating cash flows deficits are financed and that cash flow surpluses are
efficiently invested to earn a good return.

3. Explain the five basic reasons for separating the management from the ownership of an enterprise.
Answer:
 Professional managers may be found who have a superior ability to run the business.
 To achieve the efficient scale of a business the resources of many households may have to be pooled.
 In an uncertain economic environment, owners will want to diversify their risks across many
firms.
 The separated structure allows for savings in the costs of information gathering.
 There is a “learning curve” or “going concern” effect, which favors to separated structure.
4. Discuss the types of decisions that firms must make.
Answer: Capital budgeting decisions – whether to build a new plant or produce a new product.

Financing decisions – how much equity and how much debt a firm should adopt in its capital
structure.
Working Capital decisions – whether credit should be extended to a customer or cash
demanded on delivery.
5. Outline the roles of the three departments that report to the Chief Financial Officer.
Answer: Treasury: This department is responsible for managing the financing activities
of the firm and for working capital management. This includes managing relations with the
external investment community, managing the firm’s exposure to currency and interest rate
risks, and managing the tax department.
Financial Planning: This department is responsible for analyzing major capital
expenditures such as proposals to enter new lines of business or to exit existing businesses.
This includes analyzing proposed mergers, acquisitions and spin-offs.
Controller: This department oversees the accounting and auditing activities of the firm.
Activities include preparation of financial statements for use by shareholders, creditors and
regulatory authorities, as well as the preparation of internal reports comparing planned and
actual costs, revenues, and profits from the corporation’s various business units.

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