Deck 18: How Managerial Incentives Affects Financial Decisions

Question 1

Explain the trade-off between diversification and control.

Answer 1

An individual investor who wishes to obtain enough shares to control management would generally have to hold an undiversified portfolio.Although the investor would benefit by getting management to make value-maximizing decisions,he or she would bear significant costs by holding an undiversified portfolio.Hence,investors face a trade-off between diversification and control.The undiversified investor,however,shares the benefits of control (the higher share price)with other shareholders,but must bear alone the cost of having an undiversified portfolio.Firms with concentrated ownership are likely to be better monitored and thus better managed.

Question 2

_____ refers to transforming an existing division into a new company by distributing shares of the new company to the firm's existing shareholders.

A)Carve-out
B)Greenshoe
C)Vertical integration
D)Spin-off

Answer 2

D

Question 3

Which of the following is a reason why it is difficult for investors to interpret the relation between value creation and management ownership concentration using market-to-book value ratio?

A)The market value to its book value is a subjective measure of value creation.
B)The market-to-book ratio is affected the volatility in book values.
C)The market-to-book ratio measures more than management effectiveness.
D)The market-to-book ratio is only an indicator of market-wide risk.

Answer 3

C

Question 4

In a typical agency problem observed in firms,_____.

A)suppliers are considered as the principals and competitors as the agents.
B)suppliers are considered as the principals and employees as the agents.
C)debt holders are considered as the principals and shareholders as the agents.
D)shareholders are considered as the principals and management as the agents.

Question 5

Which of the following is true of the trade-off between diversification and management control?

A)Firms with concentrated ownership are likely to be poorly monitored and thus poorly managed.
B)An undiversified investor does not share the benefits of control with other shareholders,but must bear alone the cost of having an undiversified portfolio.
C)An individual investor who wishes to obtain enough shares to control management would generally have to hold an undiversified portfolio.
D)The concentration of ownership is solely based on the costs of bearing firm-specific risk and not on management efficiency.

Question 6

Closed-end mutual funds are:

A)privately traded mutual funds with a fixed number of shares that can be bought and redeemed directly from the fund at their net asset values.
B)publicly traded mutual funds with a fixed number of shares that can be bought and sold on the open market.
C)publicly traded mutual funds with an unlimited number of shares that can be bought and redeemed directly from the fund at their net asset values.
D)privately traded mutual funds with an unlimited number of shares that can be bought and sold only to large hedge funds.

Question 7

Which of the following is true of leverage on firms?

A)Shareholders prefer a lower leverage ratio than that preferred by management.
B)The firms that are more strongly influenced by shareholders have higher leverage ratios.
C)A small debt obligation limits management's ability to use corporate resources in ways that do not benefit investors.
D)If the leverage ratio is lower,the firm's systematic risk will also be lower

Question 8

How is bank financing helpful in monitoring management?

Question 9

Based on the studies by Donaldson and Lorsch (1983),which of the following are the three separate constituencies the top executives of a firm represent?

A)Investors; customers and suppliers; and employees
B)Equity holders; debt holders; suppliers and employees
C)Regulatory bodies; equity holders; suppliers and employees
D)Equity holders; debt holders; suppliers and employees

Question 10

Which of the following types of financial institutions are most effective in monitoring corporate management?

A)Exchange-traded funds
B)Hedge funds
C)Mutual funds
D)Pension funds

Question 11

Which of the following can higher market valuations,in general,be associated with?

A)Greater investor protection
B)Weaker corporate governance codes
C)Unstable political activity
D)Inactive equity markets

Question 12

Which of the following is true of the effect of management shareholdings on share prices?

A)The top managers of regulated public companies have an incentive to hold a larger fraction of the firms they work for.
B)Management incentive to hold shares is not related to risk aversion but to risk tolerance limit.
C)Holding a large number of shares tells investors that the management is unsure about the firm's prospects and the management is waiting for the right opportunity to sell the shares.
D)Management may obtain a better price for their shares if they commit to holding a larger fraction of the firm's outstanding shares.

Question 13

Which of the following is a way in which a self-interested manager distorts the firm's investment decisions?

A)If the manager only prefers projects that minimize overall risk
B)If the manager only prefers projects that reduce human capital requirements
C)If the manager relies on multiple capital budgeting and investment analysis tools
D)If the manager only prefers projects that enhance his overall control

Question 14

Why is it easier to measure the value created by managers in the case of closed-end mutual funds?

Question 15

What is agency problem?

Question 16

A proxy fight refers to:

A)the acquisition of a public company whose shares are listed on a stock exchange with proxy buying.
B)the conflict of interest between the members who are delegated with proxy voting power and the original owners.
C)an anti-takeover arrangement in which the target company will sell significantly discounted stock to a friendly third party.
D)organizing shareholders setting out to oust the incumbent board of directors by electing a new board.

Question 17

Which of the following an excellent measure of the value created by the fund's managers in the case of closed-end mutual funds?

A)The ratio of the share price of the closed-end mutual fund to the share price of a similar open-end mutual fund
B)The ratio of the share price of the closed-end mutual fund to the net asset value per share of the portfolio it holds
C)The ratio of the share price of the closed-end mutual fund to the share price of a comparable market index
D)The ratio of the share price of the closed-end mutual fund to the share price of a stock with comparable risk

Question 18

Which of the following is true when the managers have flexibility in investment decisions?

A)Uncertainty in management effectiveness increases as the level of flexibility in investment decisions increases.
B)When there is very little uncertainty,the outside shareholders must not limit the managers' flexibility.
C)The costs of discretion are greater when the interests of managers and shareholders do not coincide.
D)Flexible investment designs cannot add value to a firm,since flexibility decreases a firm's operating options.

Question 19

A manager may prefer less than the optimal level of debt,because:

A)there will be a decrease in the influence of equity holders in the daily decision making process.
B)it may decrease the overall return on investment.
C)additional debt increases the risk of bankruptcy and limits a manager's discretion.
D)additional debt decreases the tax-benefits though it decreases the cost of borrowing.