Tutorial 1

1. What are the differences between sole proprietorship and corporation (comparing the
strengths and weaknesses)?
Solution:
Sole proprietorship Corporation
Definition A business owned by one person An artificial being created by law (often
and operated for his or her profit. called a “legal entity”).
Strengths Strengths
 Owner receives all profits  Owners have limited liability, which
 Easy and inexpensive to form, and to guarantees that they cannot lose more
dissolve than they invested
 Any business profits are belonged to the  Can achieve large size via sale of
owner and are taxed only once as part of ownership (stock)
personal tax return  Ownership (stock) is readily transferable
 Independence, hence it is relatively easy  Long life of firm
to make decisions and there is no scope  Has better access to financing
for disagreement between owners.
Weaknesses Weaknesses
 Unlimited personal liability for business  Tax generally higher, because corporate
debts, total wealth can be taken to income is taxed, and dividends paid to
satisfy debts owners are also taxed.
 Difficulty in raising funds for expansion  More expensive to organize than other
because lenders are usually reluctant to business forms
lend large amount to individual.  Subject to greater government regulation
 Limited life as if a sole proprietorship is
not sold, then it will cease to exist when
the owner dies

2. Compare and contrast the terms “stockholder” and “stakeholder.”

Solution:
A stockholder owns part of a company and is entitled to income in the form of dividends.
Stockholders also elect directors who run the company.
Stakeholders are groups of people who have an interest in how the firm is run. These include
stockholders, employees, management, creditors and customers among others. Each group is
interested in the firm’s operation and profitability for its own reasons.
The stockholders are stakeholders, but all stakeholders aren’t stockholders.

3. Is the shareholder wealth maximization goal a short or long-term goal? Explain your
answer.
Solution:
The goal of shareholder wealth maximization is a long-term goal. Shareholder wealth is a
function of all the future returns to the shareholders.
Hence, in making decisions that maximize shareholder wealth, management must consider
the long-run impact on the firm and not just focus on short-run (i.e., current period) effects.

For example, a firm could increase short-run earnings and dividends by eliminating all
research and development expenditures. However, this decision would reduce long-run
earnings and dividends, and hence shareholder wealth, because the firm would be unable to
develop new products to produce and sell.

4.. Can there be a difference between profit maximization and shareholder-wealth

maximization?
Solution:
Define the Shareholder Wealth Maximization?
Stockholder wealth maximization is the appropriate goal for management decisions. The risk
and timing associated with expected earnings per share and cash flows are considered in
order to maximize the price of the firm’s common stock.

5. Why is profit maximization, by itself, is an inappropriate goal?

Solution:
The problem with a profit maximization goal is that it fails to take account of risk, the timing
of the cash flow is not considered, and profit measurement is a very inexact process. Thus, it
is an inappropriate goal.
Profit maximization and maximizing shareholder wealth could conflict.
For example, a company could accept very high return (and also very high-risk projects) that
does not return enough to compensate for the high risk.
Profits, or net income, are accounting numbers and therefore subject to manipulation.
It would be possible to show positive profits when shareholder wealth was actually being
decreased.

6. Which of the two should be the goal of the firm and its management?
Solution:
The shareholders wealth maximization should be the goal of a firm and its management.

5. What are some of the ways in which manager-shareholder conflicts (agency problem) may
be controlled?
Solution:
There exist several mechanisms to control manager-shareholder conflicts. Properly designed
compensation contracts that give managers an ownership stake in the form through a stock
grant or option grants can reduce manager-shareholder conflicts. By giving managers an
ownership stake in the form they are likely to undertake business decisions that align with
shareholder interests.
An effective board of directors can also minimize potential management-shareholder
conflicts. The board of directors has the ultimate authority to hire and fire top management so
a strong board would deter management from engaging in actions that are detrimental to
shareholders. Generally a strong board requires that a majority of the board be independent,
that is, they must not be current or former officers of the company and must not have any
business dealings with the company.
Finally, the threat of takeovers also acts as an effective deterrent to management-shareholder
conflicts. Firms suffering from severe management-shareholder conflicts will be undervalued
making it a target for a potential acquirer (for example, another firm) who can replace the
management with a more effective one and profit from the resulting gain in shareholder
value.

6. What are agency costs or agency problems or agency conflict? Why do these tend to
increase in severity as a corporation grows larger?
Solution:
Agency costs are the costs of monitoring the firm to make sure that managers act in
shareholders interests, bonding or the efforts that managers take to assure shareholders that
they are acting in their best interest, and residual loss, losses because managers did not make
decisions in the best interests of shareholders.
Agency problem or Agency conflict refers to any time a decision is made that does not
maximize shareholder wealth, when there is a conflict between parties concerned with a firm.
The primary agency conflicts are between
managers and shareholders and
shareholders and bondholders, but there can also be conflicts between
top management and operating management,
managers and employees, and
stockholders and customers, suppliers,
the government and the community.
For example, managers may want excessive benefits, such as a fleet of company planes that
maximize their person satisfaction, but conflict with maximizing shareholder wealth.
These tend to increase as the firm grows larger because there is a larger, more diverse body of
shareholders to satisfy. When there is one owner/manager, by definition whatever choices
he/she makes will maximize shareholder wealth. This becomes more difficult as the number
of shareholders increases.
7. What issue does agency theory examine? Why is it important in a public corporation rather
than in a private corporation?

Agency theory examines the relationship between the owners of the firm and the managers of
the firm. In privately owned firms, management and the owners are usually the same people.
Management operates the firm to satisfy its own goals, needs, financial requirements and the
like. As a company moves from private to public ownership, management now represents all
owners. This places management in the agency position of making decisions in the best
interest of all shareholders.

8. Why are institutional investors important in today's business world?

Because institutional investors such as pension funds and mutual funds own a large percentage
of major U.S. companies, they are having more to say about the way publicly owned companies
are managed. As a group, they have the ability to vote large blocks of shares for the election of
a board of directors, which is supposed to run the company in an efficient, competitive manner.
The threat of being able to replace poor performing boards of directors makes institutional
investors quite influential. Since these institutions, like pension funds and mutual funds,
represent individual workers and investors, they have a responsibility to see that the firm is
managed in an efficient and ethical way.

Tutorial 1_MCQ answer

1) At its most basic level, the function of financial intermediaries is to ________.

A) track and report interest rates
B) move money from lenders to borrowers and back again
C) report all financial transactions to the federal government
D) effect a transfer of wealth in society
Answer: B
Diff: 1
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.

2) Which of the following is NOT an example of a financial transaction?

A) Your parents use their credit card to pay this term's college tuition.
B) You use the ATM to withdraw British pounds so you can fly to London.
C) Your roommate lends you $20 and you repay it in one week.
D) All of the above are financial transactions.
Answer: D
Diff: 2
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.

3) The movement of money from lender to borrower and back again is known as ________.
A) the circle of life
B) corporate finance
C) the cycle of money
D) money laundering
Answer: C
Diff: 1
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.
Hmwrk Questions: * Taken from "Prepping for Exams" questions at the end of the chapter.
4) The common objective of borrowing and lending is to ________.
A) make all parties better off
B) gain a profit at the other's expense
C) make a firm or individual appear more liquid than is really the case
D) thwart regulatory authority
Answer: A
Diff: 1
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.

5) Which of the following is NOT a function of a financial intermediary in the

lending/borrowing process?
A) To help establish terms of the lending/borrowing agreement
B) To match the borrower and the lender
C) To bear the risk that the borrower will not repay
D) All of the above are functions of a financial intermediary.
Answer: D
Diff: 1
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.

6) You place $500 into your checking account at First Bank and earn 1% APR on your
deposit. Your professor borrows money at a rate of 8% from the same bank for a tuition loan
for her son. Which of the following statements is true?
A) The bank is criminally liable to you for paying an interest rate lower than the expected
rate of inflation.
B) You and your professor have an obvious conflict of interest because you have accounts at
the same financial institution.
C) You benefit from earning interest on your deposit, safety for your funds, and having a
recognizable means for paying for your financial obligations without having to hold cash.
D) Your professor is the only party to be made worse off by this example because she is the
only party paying net interest.
Answer: C
Explanation: C) Both you and your professor are using services typically provided by banks.
There is no conflict of interest.
Diff: 2
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.
7) The basic function of financial intermediaries is to move advice from lenders to borrowers
and back to lenders.
Answer: FALSE
Explanation: The basic function of financial intermediaries is to move MONEY from lenders
to borrowers and back to lenders.
Diff: 1
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.

8) In the lending/borrowing process, a financial intermediary function is to bear the risk that
the borrower will not repay.
Answer: TRUE
Diff: 1
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.

9) All financial transactions have a buyer and a seller.

Answer: TRUE
Diff: 1
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.

10) Give three examples of a financial transaction.

Answer: (1) Your parents use their credit card to pay some of your college expenses.
(2) You use the ATM to withdraw funds so you can buy your best friend a birthday gift.
(3) Your roommate lends you $20 and you repay it back when you get your next pay check.
Diff: 2
Topic: 1.1 The Cycle of Money
AACSB: 3 Analytical Thinking
LO: 1.1 Describe the cycle of money, the participants in the cycle, and the common
objective of borrowing and lending.
1.2 Overview of Finance Areas

1) Which of the following best identifies the four main areas of finance?
A) Exchange rate management, investments, financial institutions and markets, international
finance
B) Corporate finance, investments, capital structure, international finance
C) Corporate finance, investments, financial institutions and markets, international finance
D) Corporate finance, capital budgeting, financial institutions and markets, regulation
Answer: C
Explanation: C) Exchange rate management, capital structure, and capital budgeting are
activities within the functional areas of finance.
Diff: 2
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

2) Of the following, which is NOT one of the four main areas of finance?
A) International finance
B) Corporate finance
C) Investments
D) All are considered main areas of finance.
Answer: D
Diff: 1
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

3) The set of financial activities that support the OPERATIONS of a business is best
described by which main area of finance?
A) Corporate finance
B) Investments
C) Financial institutions and markets
D) International finance
Answer: A
Diff: 1
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

4) ________ is the area of finance concerned with activities such as borrowing funds to
finance projects such as plant expansions or new product launches.
A) Working capital management
B) International finance
C) Investments
D) Corporate finance
Answer: D
Diff: 2
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

5) ________ is the area of finance concerned with activities such as repayment of borrowed
funds through dividends or interest payments.
A) Investments
B) Corporate finance
C) Capital budgeting
D) International finance
Answer: B
Diff: 1
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

6) ________ is the area of finance concerned with the activities of buying and selling
financial assets such as stocks and bonds.
A) Investments
B) Corporate finance
C) International finance
D) Financial markets and institutions
Answer: A
Diff: 1
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.
Hmwrk Questions: * Taken from "Prepping for Exams" questions at the end of the chapter.

7) Which of the following is NOT typically thought of as an investment activity?

A) Accurately pricing financial assets
B) The process of buying and selling financial assets
C) Repaying borrowed funds
D) Negotiating the rules and regulations of financial transactions
Answer: C
Diff: 2
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

8) The organized financial intermediaries and the forums that promote the cycle of money is
a good definition of which of the following main areas of finance?
A) Corporate finance
B) Investments
C) Financial institutions and markets
D) International finance
Answer: C
Diff: 1
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

9) Financial institutions and markets

A) are the organized financial intermediaries and the forums that promote the cycle of
money.
B) compose the set of financial activities that support the operations of a business.
C) are the activities centered on the purchase and sale of financial assets.
D) are concerned only with the addition of a multinational element to all finance activities.
Answer: A
Diff: 1
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

10) Of the following, which is NOT an example of a financial intermediary?

A) Commercial bank
B) Insurance company
C) Investment bank
D) All of the above are financial intermediaries.
Answer: D
Diff: 2
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

11) Of the following, which is NOT an activity engaged in by a financial intermediary?

A) Matching borrowers and lenders
B) Bearing risk
C) Managing retirement portfolios for large classes of employees
D) All of the above are activities of financial intermediaries.
Answer: D
Diff: 2
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

12) "Concern with the multinational elements of financial activities" best describes which of
the four main areas of finance?
A) Investments
B) International finance
C) Corporate finance
D) Financial institutions and markets
Answer: B
Diff: 1
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

13) Which of the following is a reason why expertise in international finance is important?
A) The process of assessing risk among many countries is more difficult than assessing risk
for a single country.
B) Financial regulatory rules and requirements differ from country to country.
C) Changes in economic conditions impact the relative values of currency among countries.
D) All of the above are reasons for gaining expertise in international finance.
Answer: D
Diff: 1
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each represents.

14) Which of the following is NOT an activity of a financial institution or market?

A) Bringing together buyers and sellers of financial assets
B) Providing a market for the transaction of financial assets
C) Providing information to buyers and/or sellers of financial assets
D) All are activities of financial institutions.
Answer: D
Diff: 1
Topic: 1.2 Overview of Finance Areas
AACSB: 3 Analytical Thinking
LO: 1.2 Distinguish the four main areas of finance and briefly explain the financial activities
that each