Chapter 2 review questions

Question 1

which statement about trusts is CORRECT? a. compared with corporations, trusts provide greater tax advantages b. compared with corporations, trusts provide fewer tax advantages c. income usually passes through trusts, with corporate tax paid by the unitholders d. unitholders do not pay tax on the income received

Answer 1

A a trust has more tax advantages than a corporation because income passes through trusts without any corporate tax to the unit owners. unit holders pay tax on the income received. it avoid the double taxation of a corporation.

Question 2

which of the following is the main concern from the Point of view of a company’s shareholders a. IRR of all divisions when investment is analyzed b. preservation of the firm where risk is concerned c. accounting return on investment when performance is appraise d. market prices when performance is appraised

Answer 2

d market prices are the main concern of shareholders

Question 3

which statement about the areas of disagreement between managers and shareholders is INCORRECT? a. Performance appraisal: managers use market prices while shareholders use accounting numbers like return on investment or cash b. investment analysis: managers use the internal rate of return of the best division while shareholders use weighted average cost of capital c. the order of financing: managers prefer retentions to debt and prefer debt to new equity while shareholders prefer debt first d. Risk concern: managers’ main concern is the preservation of the firm while shareholders main concern is their portfolios

Answer 3

a

Question 4

which of the following is NOT a concern related to capital budgeting a. the percentage of debt financing in the capital structure b. whether or not to replace old equipment to boost output c. whether to purchase or lease machinery d. inventory level

Answer 4

a

Question 5

who is the person in charge of the pure finance job (cash and credit management, risk management, etc) in a company?

Answer 5

generally the treasurer does finance-related activities while the controller and accountant do the accounting-related activities

Question 6

which of the following responsibilities doe NOT usually belong to the controller? a. compliance b. credit management c. tax management d. budgeting

Answer 6

b the treasure would usually have the responsibility of credit management

Question 7

Trustco income fund is an income trust whose units trade on the TSX. On October 31, 20066, just before the government of Canada announced new taxes for businesses organized as trusts, the price of each Trustco unit was $15.12. The firm had been making regular payments to its unitholders at a rate of $1.03 per year; this means that unitholders were getting a yield (or return) of 6.8 percent per year. the day after the gov’s announcement, the unit price fell to $12.26, but there was no immediate change in the payments to unitholders. what was the yield on trustco units on NOv 1, 2006?

Answer 7

The fall in the unit price was mirrored by an increase in the yield. the new yield was 1.03/12.26 = 8.4% per year

Question 8

List the 4 areas of conflict of interest between shareholders and managers

Answer 8

1. Performance Appraisal:

Managers - use accounting numbers like the reuturn on investmetn or cash while

shareholders use market prices.

2. Investment Analysis:

Managers - use the IRR of the best division

Shareholders - use the external WACC

3. The order of Financing:

Managers - prefer retentions to debt and prefer debt to equity

Shareholders - prefer debt first

4. Risk Concern:

Managers - are concerned with the preservaton of the firm

Shareholders - are concerned about their portfolio

Question 9

Describe the compensation structure of top Canadian executives.

Answer 9

straight salary

annual bonus

share receitps or options

other

notice that in all cases, stratight salarly compensation is relatively low copared with the total package. annual bonuses are generally somewhat larger, but hte largest component by far in most cases is share compensation. this comes in two forms:

1. grants of restricted stock awarded under incentive plans and
2. stock optons, for which if the company’s stock price goes above a certain level, the executive gets the right to buy the stock at a fixed lower price

Question 10

what is behind the stock option plan of executives? in reality, does it acheive this objective?

Answer 10

the idea behind a stock option plan is simply to have the best interest of CEOs and senior managers conicide with those of shareholders.

but the actual impact is doubtful.

in reality, when a company’s stock falls and makes existing options worthless, new ones are granted to continue to provide incentive for managers.

additionally, some comapnies were investigated by regulatory instiutions on “back dating” stock option issue. the fraud was that senior managers would get the compensation committee to award them stock optonsand then date them to an earlier period when the comapny’s tock price was low. Effectively, this meant tha ton th eapproval date, the stock was already worth a large amoutn of money, so there was little incentive vlaue to the grant.

Question 11

List the basic areas of capital budgeting

Answer 11

1. how does a firm decide to expand its existing buildings or to construct or buy another building?
2. How does a firm decide to replace machinery and equipment? just because it still works, does this mean that hte firm should still use it?
3. How does a firm decide whether to buy or lease machinery and equipment?
4. How much stock or inventory should a firm carry? should it keep stocks to meet every contingency or perhaps use JIT methods to reduce the investment?

Question 13

List the basic areas of financial management

Answer 13

1. how do firms decide to extend credit to customers to purchase their product?
2. how do firms manage their cash? this is a non-interst-bearing asset, so it seems that it should be minimized, but corporationshave considerable amoutns of money on deposit at banks.
3. how do firms manage any temporary suprlus cash?
4. who do firms take minority stakes in other firms, or more generally, how do they decide to buy 100% or less of another firm? tthis question leads us into corporate acquisition and valuation.

Question 14

List the basic questions related to corproate finance

Answer 14

1. how does a firm decide how to raise money thorugh debt or equity?
2. in terms of equity how does it raise the equity? through retained earnings or through issuing new equity?
3. How does a firm deicde to go public and issue shares to the general public versus remaining a non-traded private company?
4. if it decides to issue debt, what determines whether this is bank debt or bonds issued ot the public debt markets?
5. what determines whether firms access the short-term moeny market versus borrowing form a bank?

Question 15

Summarize the main responsiblities of the finance functions (including CFO, traeasurer and conroller) in a non-financail companay

Answer 15

1. CFO (most senior person) or in more traditonal companies the VP of finance
2. under the CFO, two main finance jobs:
   - treasurer - forecasting, pension management, cpaital budgting, cash management, credit management, financing, and risk managmeent

- controller

• focuses on accounting issues such as compliance, tax management, internal auditing and budgeting

Question 16

List the major jobs available in the financial industry

Answer 16

analysts, associates, managers, account managers, banking associates, security analysts, sales and trading people, private bankers, retail bankers, financial and investment analysts, portfolio managers, fixed income or equity traders, corporate finance associates and consultants. With financial innovations, more jobs are created.