Partnerships and Proprietorships Generally Have a Tax Advantage Over Corporations

1 1.) In most corporations, the CFO ranks under the CEO. a. True b.False Answer: True 2.) The Chairman of the Board must also be the CEO. a.True b.False Answer: False 3.) The board of directors is the highest-ranking body in a corporation, and the chairman of the board is the highest ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but he or she can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person. a.True b.False Answer: True 4.) Partnerships and proprietorships generally have a tax advantage over corporations. a.True b.False Answer: True 5.) A disadvantage of the corporate form of organization is that corporate stockholders are more exposed to personal liabilities in the event of bankruptcy than are investors in a typical partnership. a.True b.False Answer: False 6.) An advantage of the corporate form of organization is that corporations are generally less highly regulated than proprietorships and partnerships. a.True b.False Answer: False 7.) Some partners in a partnership may have different rights, privileges, and responsibilities than other partners. 1/28 a.True b.False Answer: True 8.) One advantage of the corporate form of organization is that it avoids double taxation. a.True b.False Answer: False 9.) It is generally harder to transfer one's ownership interest in a partnership than in a corporation. a.True b.False 1 2/28 2 Answer: True 10.) One danger of starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt. This problem would be avoided if you formed a corporation to operate the business. a.True b.False Answer: True 11.) If a corporation elects to be taxed as an S corporation, then it can avoid the corporate tax. However, its stockholders will have to pay personal taxes on the firm's net income. a.True b.False Answer: True 12.) If a corporation elects to be taxed as an S corporation, then both it and its stockholders can avoid all Federal taxes. This provision was put into the Federal Tax Code in order to encourage the formation of small businesses. a.True b.False Answer: False 13.) The more capital a firm is likely to require, the greater the probability that it will be organized as a corporation. a.True b.False Answer: True 14.) It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents are required. a.True b.False Answer: False 15.) One disadvantage of forming a corporation rather than a partnership is that this makes it more difficult for the firm's investors to transfer their ownership interests. a.True b.False Answer: False 16.) Organizing as a corporation makes it easier for the firm to raise capital. This is because corporations' stockholders are 3/28 not subject to personal liabilities if the firm goes bankrupt and also because it is easier to transfer shares of stock than partnership interests. a.True b.False Answer: True 17.) In order to maximize its shareholders' value, a firm's management must attempt to maximize the stock price in the long run, or the stock's "intrinsic value." a.True b.False Answer: True 2 4/28 3 18.) If management operates in a manner designed to maximize the firm's expected profits for the current year, this will also maximize the stockholders' wealth as of the current year. a.True b.False Answer: False 19.) In order to maximize its shareholders' value, a firm's management must attempt to maximize the expected EPS. a.True b.False Answer: False 20.) In order to maximize its shareholders' value, a firm's management must attempt to maximize the stock price on a specific target date. a.True b.False Answer: False 21.) As a result of financial scandals occurring during the past decade, there has been a strong push to improve business ethics. a.True b.False Answer: True 22.) There are many types of unethical business behavior. One example is where executives provide information that they know is incorrect to banks and to stockholders. It is illegal to provide such information to banks, but it is not illegal to provide it to stockholders because they are the owners of the firm, not outsiders. a.True b.False Answer: False 23.) A stock's market price would equal its intrinsic value if all investors had all the information that is available about the stock. In this case the stock's market price would equal its intrinsic value. a.True b.False Answer: True 24.) If a stock's market price is above its intrinsic value, then the stock can be thought of as being undervalued, and it would be a good buy. a.True b.False 5/28 Answer: False 25.) If a stock's intrinsic value is greater than its market price, then the stock is overvalued and should be sold. a.True b.False Answer: False 26.) For a stock to be in equilibrium as the book defines it, its market price should exceed its intrinsic value. a.True b.False Answer: False 3 6/28 4 27.) The term "marginal investor" means an investor who is active in the market and would tend to buy a stock if its price fell and sell it if it rose, barring any new information coming out about the stock. It is the "marginal investor" who determines the actual stock price. a.True b.False Answer: True 28.) Managers always attempt to maximize the long-run value of their firms' stocks, or the stocks' intrinsic values. This is exactly what stockholders desire. Thus, conflicts between stockholders and managers are not possible. a.True b.False Answer: False 29.) A hostile takeover is said to occur when another corporation or group of investors gains voting control over a firm and replaces the old managers. If the old managers were managing the firm inefficiently, then hostile takeovers can improve the economy. However, hostile takeovers are controversial, and legislative actions have been taken to make them more difficult to undertake. a.True b.False Answer: True 30.) If a lower level person in a firm does something illegal, like "cooking the books" to understate costs and thereby increase profits above the correct profits because he or she was told to do so by a superior, the lower level person cannot be prosecuted but the superior can be prosecuted. a.True b.False Answer: False 31.) If someone deliberately understates costs and thereby increases profits, this can cause the stock price to rise above its intrinsic value. The stock price will probably fall in the future. Also, those who participated in the fraud can be prosecuted, and the firm itself can be penalized. a.True b.False Answer: True 32.) If a firm's board of directors wants to maximize value for its stockholders in general (as opposed to some specific stockholders), it should design an executive compensation system whose focus is on the firm's long-term value. a.True b.False 7/28 Answer: True 33.) Which of the following statements is CORRECT? a.One of the disadvantages of incorporating your business is that you could become subject to the firm's liabilities in the event of bankruptcy. b.Proprietorships are subject to more regulations than corporations. c.In any partnership, every partner has the same rights, privileges, and liability exposure as every other partner. d.Corporations of all types are subject to the corporate income tax. e.Proprietorships and partnerships generally have a tax advantage over corporations. Answer: e. Proprietorships and partnerships generally have a tax advantage over corporations. 4 8/28 5 (Some corporations (S corporations) are able to avoid the corporate income tax. Proprietorships and partnerships pay personal income tax, but they avoid the corporate income tax.) 34.) Which of the following statements is CORRECT? a.One of the advantages of the corporate form of organization is that it avoids double taxation. b.It is easier to transfer one's ownership interest in a partnership than in a corporation. c.One of the disadvantages of a proprietorship is that the proprietor is exposed to unlimited liability. d.One of the advantages of a corporation from a social standpoint is that every stockholder has equal voting rights, i.e., "one person, one vote." e.Corporations of all types are subject to the corporate income tax. Answer: c. One of the disadvantages of a proprietorship is that the proprietor is exposed to unlimited liability. 35.) Which of the following statements is CORRECT? a.One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership. b.Corporations face fewer regulations than proprietorships. c.One disadvantage of operating a business as a proprietor is that the firm is subject to double taxation, because taxes are levied at both the firm level and the owner level. d.It is generally less expensive to form a corporation than a proprietorship because, with a proprietorship, extensive legal documents are required. e.If a partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business. Answer: a.One advantage of forming a corporation is that equity investors are usually exposed to less liability than they would be in a partnership. (Corporations have limited liability; however, they face more regulations than the other forms of organization. Proprietorships do not pay corporate taxes.) 36.) Relaxant Inc. operates as a partnership. Now the partners have decided to convert the business into a corporation. Which of the following statements is CORRECT? a.Relaxant's shareholders (the ex-partners) will now be exposed to less liability. b.The company will probably be subject to fewer regulations and required disclosures. c.Assuming the firm is profitable, none of its income will be subject to federal income taxes. d.The firm's investors will be exposed to less liability, but they will find it more difficult to transfer their ownership. e.The firm will find it more difficult to raise additional capital to support its growth. Answer: a.Relaxant's shareholders (the ex-partners) will now be exposed to less liability. 37.) Which of the following statements is CORRECT? a.Corporations generally face fewer regulations than proprietorships. b.Corporate shareholders are exposed to unlimited liability. c.It is usually easier to transfer ownership in a corporation than in a partnership. 9/28 d.Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation. e.There is a tax disadvantage to incorporation, and there is no way any corporation can escape this disadvantage, even if it is very small. Answer: c.It is usually easier to transfer ownership in a corporation than in a partnership. (If ownership in a proprietorship or partnership is transferred, the basic documents under which the firm operates must be rewritten, whereas for a corporation the seller simply sells shares to a buyer.) 38.) Which of the following could explain why a business might choose to operate as a corporation rather than as a proprietorship or a partnership? a.Corporations generally face fewer regulations. b.Less of a corporation's income is generally subject to federal taxes. c.Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation. 5 10/28 6 d.Corporate investors are exposed to unlimited liability. e.Corporations generally find it easier to raise large amounts of capital. Answer: e.Corporations generally find it easier to raise large amounts of capital. (Outsiders thinking about investing in a business are generally not willing to be subjected to unlimited liability, and they also want to be able to sell their shares should they choose to do so. Corporations provide these advantages; hence, firms that need large amounts of capital that must be raised in capital markets generally choose to incorporate.) 39.) The primary operating goal of a publicly-owned firm interested in serving its stockholders should be to a.Maximize its expected total corporate income. b.Maximize its expected EPS. c.Minimize the chances of losses. d.Maximize the stock price per share over the long run, which is the stock's intrinsic value. e.Maximize the stock price on a specific target date. Answer: d.Maximize the stock price per share over the long run, which is the stock's intrinsic value. 40.) Which of the following statements is CORRECT? a.In most corporations, the CFO ranks above the CEO. b.By law in most states, the chairman of the board must also be the CEO. c.The board of directors is the highest ranking body in a corporation, and the chairman of the board is the highest ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but he or she can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person. d.The CFO generally reports to the firm's chief accounting officer, who is normally the controller. e.The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he or she is not responsible for the validity of the financial statements, as the controller and the auditors have that responsibility. Answer: c.The board of directors is the highest ranking body in a corporation, and the chairman of the board is the highest ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but he or she can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person. 41.) Which of the following statements is CORRECT? a.One drawback of forming a corporation is that it generally subjects the firm to additional regulations. b.One drawback of forming a corporation is that it subjects the firm's investors to increased personal liabilities. c.One drawback of forming a corporation is that it makes it more difficult for the firm to raise capital. d.One advantage of forming a corporation is that it subjects the firm's investors to fewer taxes. e.One disadvantage of forming a corporation is that it is more difficult for the firm's investors to transfer their ownership interests. Answer: a.One drawback of forming a corporation is that it generally subjects the firm to additional regulations. 11/28 (Corporations have to do more reporting to state and federal agencies than other businesses.) 42.) Which of the following statements is CORRECT? a.If a corporation elects to be taxed as an S corporation, then both it and its stockholders can avoid all Federal taxes. This provision was put into the Federal Tax Code in order to encourage the formation of small businesses. b.The more capital a firm is likely to require, the smaller the probability that it will be organized as a corporation. c.It is generally easier to transfer one's ownership interest in a partnership than in a corporation. d.One danger of starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt. This problem would be avoided if you formed a corporation to operate the business. e.Corporate shareholders are exposed to unlimited liability, but this factor is offset by the tax advantages of incorporation. Answer: d.One danger of starting a proprietorship is that you may be exposed to personal liability if the business goes bankrupt. This problem would be avoided if you formed a corporation to operate the business. 6 12/28 7 43.) Which of the following statements is 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 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, which affect the ability to attract capital, most business (measured by dollar sales) is conducted by corporations in spite of large corporations' less favorable tax treatment. d.Large corporations are taxed more favorably than proprietorships. e.Corporate stockholders are exposed to unlimited liability. Answer: c.Due to legal considerations related to ownership transfers and limited liability, which affect the ability to attract capital, most business (measured by dollar sales) is conducted by corporations in spite of large corporations' less favorable tax treatment. 44.) Which of the following statements is CORRECT? a.A hostile takeover is the main method of transferring ownership interest in a corporation. b.A corporation is a legal entity created by a state, and it has a life and existence that is separate from the lives and existence of its owners and managers. c.Unlimited liability and limited life are two key advantages of the corporate form over other forms of business organization. d.Limited liability is an advantage of the corporate form of organization to its owners (stockholders), but corporations have more trouble raising money in financial markets because of the complexity of this form of organization. e.Although the stockholders of the corporation are insulated by limited legal liability, the legal status of the corporation does not protect the firm's managers in the same way, i.e., bondholders can sue the firm's managers if the firm defaults on its debt. Answer: b.A corporation is a legal entity created by a state, and it has a life and existence that is separate from the lives and existence of its owners and managers. 45.) Which of the following statements is CORRECT? a.In a typical partnership, liability for other partners' misdeeds is limited to the amount of a particular partner's investment in the business. b.In a limited partnership, the limited partners have voting control, while the general partner has operating control over the business, and the limited partners are individually responsible, on a pro rata basis, for the firm's debts in the event of bankruptcy. c.A slow-growth company, with little need for new capital, would be more likely to organize as a corporation than would a faster growing company. d.Partnerships have more attracting large amounts of capital than corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity ( buying and selling) of partnership interests. e.A major disadvantage of a partnership relative to a corporation is the fact that federal income taxes must be paid by the partners rather than by the firm itself. Answer: d.Partnerships have more attracting large amounts of capital than corporations because of such factors as unlimited liability, the need to reorganize when a partner dies, and the illiquidity ( buying and selling) of partnership interests. 13/28 46.) The primary operating goal of a publicly-owned firm trying to best serve its stockholders should be to a.Maximize managers' own interests, which are by definition consistent with maximizing shareholders' wealth. b.Maximize the firm's expected EPS, which must also maximize the firm's price per share. c.Minimize the firm's risks because most stockholders dislike risk. In turn, this will maximize the firm's stock price. d.Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers. e.Since it is impossible to measure a stock's intrinsic value, the text states that it is better for managers to attempt to maximize the current stock price than its intrinsic value. Answer: d.Use a well-structured managerial compensation package to reduce conflicts that may exist between stockholders and managers. 47.) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and managers? 7 14/28 8 a.Pay managers large cash salaries and give them no stock options. b.Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover. c.Beef up the restrictive covenants in the firm's debt agreements. d.Eliminate a requirement that members of the board of directors must hold a high percentage of their personal wealth in the firm's stock. e.For a firm that compensates managers with stock options, reduce the time before options are vested, i.e., the time before options can be exercised and the shares that are received can be sold. Answer: b.Change the corporation's formal documents to make it easier for outside investors to acquire a controlling interest in the firm through a hostile takeover. (Corporate takeovers are most likely to occur when a firm is underperforming. Managers who fear losing their jobs will try to maximize shareholder wealth.) 48.) Which of the following actions would be likely to reduce potential conflicts of interest between stockholders and managers? a.Congress passes a law that severely restricts hostile takeovers. b.A firm's compensation system is changed so that managers receive larger cash salaries but fewer long-term options to buy stock. c.The company changes the way executive stock options are handled, with all options vesting after 2 years rather than having 20% of the options awarded vest every 2 years over a 10-year period. d.The company's outside auditing firm is given a lucrative year-by-year consulting contract with the company. e.The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash. Answer: e.The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash. 49.) Which of the following mechanisms would be most likely to help motivate managers to act in the best interests of shareholders? a.Decrease the use of restrictive covenants in bond agreements. b.Take actions that reduce the possibility of a hostile takeover. c.Elect a board of directors that allows managers greater freedom of action. d.Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries. e.Eliminate a requirement that members of the board of directors have a substantial investment in the firm's stock. Answer: d.Increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries. 50.) Which of the following actions would be likely to encourage a firm's managers to make decisions that are in the best interests of shareholders? a.The percentage of executive compensation that comes in the form of cash is increased and the percentage coming from long-term stock options is reduced. b.The state legislature passes a law that makes it more difficult to successfully complete a hostile takeover. c.The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds 15/28 rather than by small individual investors rises from 10% to 80%. d.The firm's founder, who is also president and chairman of the board, sells 90% of her shares. e.The firm's board of directors gives the firm's managers greater freedom to take whatever actions they think best without obtaining board approval. Answer: c.The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds rather than by small individual investors rises from 10% to 80%. (Small stockholders have little clout with management, while large institutional investors are better able to force managers to operate in stockholders' interests.) 51.) Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and bondholders? a.Compensating managers with stock options. 8 16/28 9 b.Financing risky projects with additional debt. c.The threat of hostile takeovers. d.The use of covenants in bond agreements that limit the firm's use of additional debt and constrain managers' actions. e.Abolishing the Security and Exchange Commission. Answer: d.The use of covenants in bond agreements that limit the firm's use of additional debt and constrain managers' actions. (Stock options and the threat of takeovers reduce conflicts between managers and shareholders. Financing risky projects with additional debt increases the potential for conflicts between stockholders and bondholders. Adding covenants to bond agreements will reduce conflicts between stockholders and bondholders.) 52.) Which of the following actions would be most likely to reduce potential conflicts between stockholders and bondholders? a.Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders). b.Compensating managers with more stock options and less cash income. c.The passage of laws that make it harder for hostile takeovers to succeed. d.A Government regulation that banned the use of convertible bonds. e.The firm begins to use only long-term debt, e.g., debt that matures in 30 years or more, rather than debt that matures in less than one year. Answer: a.Including restrictive covenants in the company's bond indenture (which is the contract between the company and its bondholders). 53.) Which of the following statements is CORRECT? a.If a lower level person in a firm does something illegal, like "cooking the books" to understate costs and thereby artificially increase profits because he or she was ordered to do so by a superior, the lower level person cannot be prosecuted but the superior can be prosecuted. b.There are many types of unethical business behavior. One example is where executives provide information that they know is incorrect to outsiders. It is illegal to provide such information to federally regulated banks, but it is not illegal to provide it to stockholders because they are the owners of the firm. c.If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted. d.Ethical behavior is not influenced by training and auditing procedures. People are either ethical or they are not, and this is what determines ethical behavior in business. e.Ethics is not an important consideration in business and in business schools. Answer: c.If someone deliberately understates costs and thereby causes reported profits to increase, this can cause the stock price to rise above its intrinsic value. The stock will probably fall in the future. Both those who participated in the fraud and the firm itself can be prosecuted. 54.) With which of the following statements would most people in business agree? a.A corporation's short-run profits will almost always increase if the firm takes actions that the government has determined are in the best interests of the nation. b.Firms and government agencies almost always agree with one another regarding the restrictions that should be placed on hiring 17/28 and firing employees. c."Whistle blowers," because of the courage it takes to blow the whistle, are generally promoted more rapidly than other employees. d.It is not useful for large corporations to develop a formal set of rules defining ethical and unethical behavior. e.Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. Answer: e.Although people's moral characters are probably developed before they are admitted to a business school, it is still useful for business schools to cover ethics, if only to give students an idea about the adverse consequences of unethical behavior to themselves, their firms, and the nation. 55.) Which of the following statements is CORRECT? a.Corporations are taxed more favorably than proprietorships. 9 18/28 10 b.Corporations have unlimited liability. c.Because of their size, large corporations face fewer regulations than smaller corporations and proprietorships. d.Reducing the threat of corporate takeover increases the likelihood that managers will act in shareholders' interests. e.Bond covenants are designed to protect bondholders and to reduce potential conflicts between stockholders and bondholders. Answer: e.Bond covenants are designed to protect bondholders and to reduce potential conflicts between stockholders and bondholders. 56.) Which of the following statements is CORRECT? a.A good goal for a firm's management is the maximization of expected EPS. b.Most business in the U.S. is conducted by corporations, and corporations' popularity results primarily from their favorable tax treatment. c.Conflicts can exist between stockholders and managers, but potential conflicts are reduced by the possibility of hostile takeovers. d.Corporations and partnerships have an advantage over proprietorships because a proprietor is exposed to unlimited liability, but the liability of all investors in the other types of businesses is more limited. e.For a stock to be in equilibrium, its intrinsic value must be greater than the actual market price. Answer: c.Conflicts can exist between stockholders and managers, but potential conflicts are reduced by the possibility of hostile takeovers. 57.) Which of the following statements is CORRECT? a.One of the ways in which firms can mitigate or reduce potential conflicts between bondholders and stockholders is by increasing the amount of debt in the firm's capital structure. b.The threat of takeover generally increases potential conflicts between stockholders and managers. c.Managerial compensation plans cannot be used to reduce potential conflicts between stockholders and managers. d.The threat of takeovers tends to reduce potential conflicts between stockholders and managers. e.The creation of the Securities and Exchange Commission (SEC) has eliminated conflicts between managers and stockholders. Answer: d.The threat of takeovers tends to reduce potential conflicts between stockholders and managers. 58.) Which of the following statements is CORRECT? a.One disadvantage of organizing a business as a corporation rather than a partnership is that the equity investors in a corporation are exposed to unlimited liability. b.Using restrictive covenants in debt agreements is an effective way to reduce conflicts between stockholders and managers. c.Managers generally welcome hostile takeovers since the "raider" generally offers a price for the stock that is higher than the price before the takeover action started. d.The managers of established, stable companies sometimes attempt to get their state legislatures to ​impose rules that make it more difficult for raiders to succeed with hostile takeovers. e.Most business in U.S. is conducted by corporations, and corporations' popularity results primarily from their favorable tax treatment. Answer: d.The managers of established, stable companies sometimes attempt to get their state legislatures to ​impose rules that make it more difficult for raiders to succeed with hostile takeovers. 19/28 59.) Which of the following statements is CORRECT? a.Well-designed bond covenants are useful for reducing potential conflicts between stockholders and managers. b.The bid price in a hostile takeover is generally above the price before the takeover attempt is announced, because otherwise there would be no incentive for the stockholders to sell to the hostile bidder and the takeover attempt would probably fail. c.Stockholders in general would be better off if managers never disclosed favorable events and therefore caused the price of the firm's stock to sell at a price below its intrinsic value. d.Takeovers are most likely to be attempted if the target firm's stock price is above its intrinsic value. e.The efficiency of the U.S. economy would probably be increased if hostile takeovers were absolutely forbidden. Answer: b.The bid price in a hostile takeover is generally above the price before the takeover attempt is announced, because otherwise there would be no incentive for the stockholders to sell to the hostile bidder and the takeover attempt would probably fail. 60.) Which of the following statements is CORRECT? 10 20/28 11 a.Hostile takeovers are most likely to occur when a firm's stock is selling below its intrinsic value as a result of poor management. b.The efficiency of the U.S. economy would probably be increased if hostile takeovers were absolutely forbidden. c.The managers of established, stable companies sometimes attempt to get their state legislatures to remove rules that make it more difficult for raiders to succeed with hostile takeovers. d.In general, it is more in bondholders' interests than stockholders' interests for a firm to shift its investment focus away from safe, stable investments and into risky investments, especially those that primarily involve research and development. e.Stockholders in general would be better off if managers never disclosed favorable events and therefore caused the price of the firm's stock to sell at a price below its intrinsic value. Answer: a.Hostile takeovers are most likely to occur when a firm's stock is selling below its intrinsic value as a result of poor management. (If a firm's stock is undervalued relative to its potential, then someone can profit by taking the firm over and doing a better job running it.) 61.) Which of the following statements is CORRECT? a.One disadvantage of operating as a corporation rather than as a partnership is that corporate shareholders are exposed to more personal liability than are partners. b.Relative to proprietorships, corporations generally face fewer regulations, and they also find it easier to raise capital. c.There is no good reason to expect a firm's stockholders and bondholders to react differently to the types of assets in which it invests. d.Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns. e.Stockholders in general would be better off if managers never disclosed favorable events and therefore caused the price of the firm's stock to sell at a price below its intrinsic value. Answer: d.Stockholders should generally be happier than bondholders to have managers invest in risky projects with high potential returns as opposed to safe projects with lower expected returns. 62.) Which of the following statements is CORRECT? a.Because bankruptcy requires that corporate bondholders be paid in full before stockholders receive anything, bondholders generally prefer to see corporate managers invest in high risk/high return projects rather than low risk/low return projects. b.Since bondholders receive fixed payments, they do not share in the gains if risky projects turn out to be highly successful. However, they do share in the losses if risky projects fail and drive the firm into bankruptcy. Therefore, bondholders generally prefer to see corporate managers invest in low risk/low return projects rather than high risk/high return projects. c.One advantage of operating a business as a corporation is that stockholders can deduct their pro rata share of the taxes the firm pays, thereby eliminating the double taxation investors would face in a partnership. d.One drawback of forming a corporation is that you lose the limited liability that you would otherwise receive as a proprietor. e.Potential conflicts between stockholders and bondholders are increased if a firm's bonds are convertible into its common stock. Answer: b.Since bondholders receive fixed payments, they do not share in the gains if risky projects turn out to be highly successful. However, they do share in the losses if risky projects fail and drive the firm into bankruptcy. Therefore, bondholders generally prefer to see corporate managers invest in low risk/low return projects rather than high risk/high return projects. 21/28 63.) Which of the following statements is CORRECT? a.Corporations face few regulations and more favorable tax treatment than do proprietorships and partnerships. b.Managers who face the threat of hostile takeovers are less likely to pursue policies that maximize shareholder value compared to managers who do not face the threat of hostile takeovers. c.Bond covenants are an effective way to resolve conflicts between shareholders and managers. d.Because of their simplified organization, it is easier for proprietors and partnerships to raise large amounts of outside capital than it is for corporations. e.One advantage to forming a corporation is that the owners of the firm have limited liability. Answer: e.One advantage to forming a corporation is that the owners of the firm have limited liability. 64.) New Business is just being formed by 10 investors, each of whom will own 10% of the business. The firm is expected to earn $500,000 before taxes each year. The corporate tax rate is 34% and the personal tax rate for the firm's investors is 35%. The 11 22/28 12 firm does not need to retain any earnings, so all of its after-tax income will be paid out as dividends to its investors. The investors will have to pay personal taxes on whatever they receive. How much additional spendable income will each investor have if the business is organized as a partnership rather than as a corporation? a. $11,050 b. $12,266 c. $10,056 d. $9,282 e. $11,713 Answer: a. $11,050 Business income: $500,000 Corporate tax rate (TC): 34% Number of investors (N): 10 Personal tax rate (TP): 35% Corporation: Corporate taxes $ 170,000 Income after corporate tax, paid to investors (stockholders) as dividends 330,000 Tax on dividends 115,500 Spendable income $ 214,500 23/28 Partnership: Taxes paid by business $0 Income received by investors (partners) 500,000 Taxes paid by partners as personal income 175,000 Spendable income $ 325,000 Difference in spendable income: total gain from being a partnership 12 24/28 13 $ 110,500 Individual investor gain $ 11,050 65.) Assume that the corporate tax rate is 34% and the personal tax rate is 30%. The founders of a newly formed business are debating between setting up the firm as a partnership versus a corporation. The firm will not need to retain any earnings, so all of its after-tax income will be paid out to its investors, who will have to pay personal taxes on whatever they receive. What is the difference in the percentage of the firm's pre-tax income that investors actually receive and can spend under the corporate and partnership forms of organization ? a. 22.61% b. 23.80% c. 21.90% d. 23.56% e. 28.56% Answer: b. 23.80% Corporate tax rate (TC): 34% Personal tax rate (TP): 30% Corporation: Corporate net = Business pre-tax income (1 - TC) Investors' net = Corporate net (1 - TP) = Business pre-tax net (1 - TC) (1 - TP) ​ ​ ​ = Business pre-tax net×66%×70% 46.2% Partnership: The business pays no tax, but investors pay tax on business income. 25/28 Investors' net = Business pre-tax net (1 - TP) = Business pre-tax net (1 - TP) 70% ​ Difference 23.80% 66.) Charleston Corporation (CC) now operates as a "regular" corporation, but it is considering a switch to S Corporation status. CC is owned by 100 stockholders who each hold 1% of the stock, and each faces a personal tax rate of 35%. The firm earns $2,800,000 per year before taxes, and since it has no need for retained earnings, it pays out all of its earnings as dividends. Assume that the corporate tax rate is 34% and the personal tax rate is 35%. How much more (or less) spendable income would each stockholder have if the firm elected S Corporation status? 13 26/28 14 a. $6,436 b. $5,507 c. $6,188 d. $6,497 e. $6,250 Answer: c. $6,188 Business income: $2,800,000 Corporate tax rate (TC): 34% Number of investors (N): 100 Personal tax rate (TP): 35% Corporation: Corporate taxes $952,000 Income after corporate tax, paid to investors (stockholders) as dividends 1,848,000 ​ Tax on dividends 646,800 Spendable income, total $1,201,200 Spendable income, each (100 investors) $ 12,012 S Corporation: 27/28 Taxes paid by business $0 Income received by investors 2,800,000 Taxes paid by investors as personal income 980,000 Spendable income, total $1,820,000 Spendable income, each (100 investors) $ 18,200 Difference in spendable income: gain from being an S Corporation $ 6,188 14 28/28