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MULTIPLE CHOICE

 

  1. Which of the following actions is consistent with social responsibility but is necessarily inconsistent with stockholder wealth maximization?

a. Investing in a smokestack "scrubber" to reduce the firm's air pollution as mandated by law.

b. Voluntarily installing expensive machinery to treat effluent discharge which is currently being dumped into a river where it is ruining the drinking water of the community where the plant is located.

c. Investing in a smokestack filter to reduce sulphur-dioxide emissions in order to reduce the current tax being levied on the firm by the state for its pollution.

d. Making a large corporate donation to the local community in order to fund a recreation complex which will be used by the community and the firm's employees.

e. Each of the actions above is consistent with social responsibility and none is necessarily inconsistent with stockholder wealth maximization.

 

  2. Which of the following statements is most correct?

a. The ability of firms to engage in socially beneficial projects that involve voluntary costs is constrained by competition and the need of firms to attract capital at low cost.

b. The actions that maximize a firm's stock price are inconsistent with maximizing social welfare.

c. The concepts of social responsibility and ethical responsibility on the part of corporations are completely different and neither is relevant in maximizing stock price.

d. In a competitive market, if a group of firms do not spend resources making social welfare improvements, but another group does, in general, this will not affect the second group's ability to attract capital.

e. If government did not mandate socially responsible corporate actions, such as those relating to product safety and fair hiring practices, most firms in competitive markets would still pursue such policies voluntarily.

 

  3. Which of the following statements is most correct?

a. Other things held constant, it is generally safer to invest money in a proprietorship than in a partnership or a corporation.

b. According to the text, law firms and accounting firms must be organized as proprietorships or partnerships; these businesses do not have the option of incorporating.

c. If you are planning to start a business, which you will run as the sole employee, and if you expect the business to earn $1,000,000 per year before taxes, you can minimize federal income taxes by setting up the business as a corporation because corporations are not subject to double taxation while proprietorships are.

d. According to the text, "agency problems" tend to increase as the percentage of a corporation's stock owned by its managers increases.

e. Maximizing the income statement item "net income" is not the best goal for a corporation whose managers are interested in maximizing the economic welfare of the firm's stockholders.

  

  4. Which of the following statements is most correct?

a. A major disadvantage of a regular partnership or a corporation as a form of business is the fact that they do not offer their owners limited liability, whereas proprietorships do.

b. The major advantages of the "S" corporation are that owners enjoy the protection of limited liability and they obtain some tax advantages, such as avoiding double taxation.

c. There are more partnerships and sole proprietorships than corporations in the U.S., and unincorporated businesses produce more goods and services than do corporations.

d. Because corporations enjoy the benefits of limited liability, easy transferability of ownership interest, unlimited life, and favorable tax status relative to the situation for partnerships and proprietorships, most large businesses choose to incorporate.

e. Since lawyers have the incorporation process so automated (e.g., word processors for drawing up the necessary papers), it is less expensive to form a corporation than to form a proprietorship or partnership.

 

  5. Which of the following statements is most correct?

a. 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.

b. 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.

c. Due to legal considerations related to ownership transfers and limited liability, most business (measured by dollar sales) is conducted by corporations.

d. Statements a, b, and c are correct.

e. All of the statements are false.

 

  6. Jane Doe, who has substantial personal wealth and income, is considering the possibility of opening a new business in the chemical waste management field. She will be the sole owner. 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 expects to realize substantial cash flows from dividends the firm will eventually pay out. Which of the legal forms of business organization would probably best suit her needs?

 a. Proprietorship, because of ease of entry.

b. Regular corporation, because of the limited liability.

c. Partnership, if she needs additional capital.

d. S corporation, to enjoy tax advantages and gain limited liability.

e. In this situation, the various forms of organization seem equally desirable.

 

  7. Which of the following statements is most correct?

 a. Corporations are taxed more favorably than sole proprietorships.

b. Corporations have unlimited liability.

c. Because of their size, large corporations face fewer regulations than smaller corporations and sole proprietorships.

d. Reducing the threat of corporate takeover increases the likelihood that managers will act in shareholders' interest.

e. Bond covenants are designed to reduce potential conflicts between stockholders and bondholders.

 

  8. Which of the following statements is most correct?

a. Agency conflicts between stockholders and managers are not really a problem when outsiders (i.e., non-managers) own shares in a corporation.

b. Managers may operate in the stockholders' best interests, or managers may operate in their own personal best interests. As long as managers stay within the law, there are no effective controls that stockholders can implement to control managerial decision making.

c. The agency conflicts between bondholders and stockholders can be reduced with the use of bond covenants.

d. An agency relationship exists when one or more persons hire another person to perform some service but withhold decision-making authority from that person.

e. All of the statements above are false.

 

  9. Which of the following statements is most correct?

a. Risk aversion implies that some securities will go unpurchased in the market even if a large risk premium is paid to investors.

b. When investors require higher rates of return for investments that demonstrate higher variability of returns, this is evidence of risk aversion.

c. Risk aversion implies a general dislike for risk, thus, the lower the expected return the higher the risk premium.

d. In comparing two firms that differ from each other only with respect to risk, the expected returns on the stock of the firms should be equal.

e. All of the statements above are false.

 

 10. Which of the following statements is false?

a. The coefficient of variation is a better measure of risk than the standard deviation if the expected returns of the securities being compared differ significantly.

b. Managers cannot act in the best interests of their shareholders unless they know their shareholders' average time preference for receiving their money and what risks a typical shareholder is prepared to assume.

c. Companies should deliberately increase their risk relative to the market only if the actions that increase the risk also increase the expected rate of return on the firm's assets by enough to completely compensate for the higher risk.

d. If the expected rate of return for a particular investment, as seen by the marginal investor, exceeds its required rate of return, we should soon observe an increase in demand for the investment, and the price will likely increase until a price is established that equates the expected return with the required return.

 

 11. Which of the following statements is most correct?

a. The expected return on a portfolio of financial assets is equal to the summation of the products of the expected returns of the individual assets multiplied by the probability of each return being realized.

b. When adding new securities to a portfolio, the higher or more positive the degree of correlation between the new securities and those already in the portfolio, the greater the benefits of the additional portfolio diversification.

c. In portfolio analysis, we rarely use ex post (historical) returns and standard deviations, because we are interested in ex ante (future) data.

d. Portfolio diversification reduces the variability of returns on each security held in the portfolio.

e. All of the statements above are false.

12. Which of the following statements is most correct?

a. A portfolio with a beta of minus 2 has the same degree of risk to its holder, relative to the market, as a portfolio with a beta of plus 2. However, the holder of either portfolio could lower his or her risk exposure by buying some "normal" stocks.

b. A stock with a beta of -1.0 has zero market risk.

c. It is possible for a stock to have a positive beta even in situations where the correlation between the returns on it and those on another stock are negative.

d. Diversifiable risk, which is measured by beta, can be lowered by adding more stocks to a portfolio.

e. Statements a and c are correct.

 

 13. Which of the following statements is most correct about a stock which has a beta = 1.2?

a. If the stock's beta doubles its expected return will double.

b. If expected inflation increases 3 percent, the stock's expected return will increase by 3 percent.

c. If the market risk premium increases by 3 percent the stock's expected return will increase by less than 3 percent.

d. Answers a, b, and c are correct.

e. Answers b and c are correct.

 

 14. Which of the following statements is most correct?

a. We would observe a downward shift in the required returns of all stocks if investors believed that there would be deflation in the economy.

b. If investors became more risk averse, then the new security market line would have a steeper slope.

c. If the beta of a company doubles, then the required rate of return will also double.

d. Both statements a and b are correct.

e. All of the statements above are correct.

 

 15. Assume that a new law is passed which restricts investors to holding only one asset. A risk-averse investor is considering two possible assets as the asset to be held in isolation. The assets' possible returns and related probabilities (i.e., the probability distributions) are as follows:

                  Asset X       Asset Y

                  P     k       P     k

                0.10   -3%    0.05   -3%

                0.10    2     0.10    2

                0.25    5     0.30    5

                0.25    8     0.30    8

                0.30   10     0.25   10

 

Which asset should be preferred?

a. Asset X, since its expected return is higher.

b. Asset Y, since its beta is probably lower.

c. Either one, since the expected returns are the same.

d. Asset X, since its standard deviation is lower.

e. Asset Y, since its coefficient of variation is lower and its expected return is higher.

 

 16. Given the following probability distribution, what is the expected return and the standard deviation of returns for Security J?

                     State     Pi     kJ

                       1       0.2    10%

                       2       0.6    15

                       3       0.2    20

a. 15%;  6.50%

b. 12%;  5.18%

c. 15%;  3.16%

d. 15%; 10.00%

e. 20%;  5.00%

 

 17. You are holding a stock which has a beta of 2.0 and is currently in equilibrium. The required return on the stock is 15 percent, and the return on an average stock is 10 percent. What would be the percentage change in the return on the stock, if the return on an average stock increased by 30 percent while the risk-free rate remained unchanged?

a. +20%

b. +30%

c. +40%

d. +50%

e. +60%

 

 18. Oakdale Furniture Inc. has a beta coefficient of 0.7 and a required rate of return of 15 percent. The market risk premium is currently 5 percent. If the inflation premium increases by 2 percentage points, and Oakdale acquires new assets which increase its beta by 50 percent, what will be Oakdale's new required rate of return?

a. 13.50%

b. 22.80%

c. 18.75%

d. 15.25%

e. 17.00%

 

 19. The following probability distributions of returns for two stocks have been estimated:

             Probability     Stock A     Stock B

                 0.3           12%          5%

                 0.4            8%          4%

                 0.3            6%          3%

 

What is the coefficient of variation for the stock that is less risky (assuming you use the coefficient of variation to rank riskiness).

a. 3.62

b. 0.28

c. 0.19

d. 0.66

e. 5.16

20. You have been scouring The Wall Street Journal looking for stocks that are "good values" and have calculated the expected returns for five stocks. Assume the risk-free rate (kRF) is 7 percent and the market risk premium (kM - kRF) is 2 percent. Which security would be the best investment? (Assume you must choose just one.)

  Expected Return    Beta

a.     9.01%         1.70

b.     7.06%         0.00

c.     5.04%        -0.67

d.     8.74%         0.87

e.    11.50%         2.50

 

ANSWER KEY

 

  1. e. Each of the actions above is consistent with social responsibility and none is necessarily inconsistent with stockholder wealth maximization.

  2. a. The ability of firms to engage in socially beneficial projects that involve voluntary costs is constrained by competition and the need of firms to attract capital at low cost.

  3. e. Maximizing the income statement item "net income" is not the best goal for a corporation whose managers are interested in maximizing the economic welfare of the firm's stockholders.

  4. b. The major advantages of the "S" corporation are that owners enjoy the protection of limited liability and they obtain some tax advantages, such as avoiding double taxation.

  5. c. Due to legal considerations related to ownership transfers and limited liability, most business (measured by dollar sales) is conducted by corporations.

  6. d. S corporation, to enjoy tax advantages and gain limited liability.

  7. e. Bond covenants are designed to reduce potential conflicts between stockholders and bondholders.

  8. c. The agency conflicts between bondholders and stockholders can be reduced with the use of bond covenants.

  9. b. When investors require higher rates of return for investments that demonstrate higher variability of returns, this is evidence of risk aversion.

10. b. Managers cannot act in the best interests of their shareholders unless they know their shareholders' average time preference for receiving their money and what risks a typical shareholder is prepared to assume.

11. e. All of the statements above are false.

12. e. Statements a and c are correct.

13. b. If expected inflation increases 3 percent, the stock's expected return will increase by 3 percent.

14. d. Both statements a and b are correct.

15.  e. Asset Y, since its coefficient of variation is lower and its

    expected return is higher.

16.  c. 15%;  3.16%

17.  c. +40%

18. c. 18.75%

19. c. 0.19

20. b.  7.06%            0.00