Multiple choice questions

1. Which of the following is the primary goal of financial management?

a) Maximizing revenues

b) Maximizing shareholder wealth

c) Minimizing costs

d) Increasing market share

Answer: b) Maximizing shareholder wealth

Explanation: The primary goal of financial management is to maximize shareholder wealth, which is
typically reflected by increasing the value of the firm's stock.

2. Which of the following is a characteristic of capital markets?

a) Short-term instruments

b) Long-term securities like stocks and bonds

c) Trade in cash and equivalents

d) Instruments maturing in less than one year

Answer: b) Long-term securities like stocks and bonds

Explanation: Capital markets deal with long-term securities such as stocks and bonds, whereas money
markets focus on short-term instruments.

3. What is the key difference between primary and secondary markets?

a) In the primary market, new securities are issued, while in the secondary market, existing securities are
traded.

b) Both markets deal only with short-term securities.

c) Primary markets are more liquid than secondary markets.

d) Secondary markets involve only corporate bonds.

Answer: a) In the primary market, new securities are issued, while in the secondary market, existing
securities are traded.

Explanation: Primary markets are for issuing new securities, while secondary markets involve trading
existing securities between investors.
4. Which of the following is an example of a financial institution?

a) Stock exchange

b) Commercial bank

c) Supermarket

d) Tax office

Answer: b) Commercial bank

Explanation: Financial institutions include banks, insurance companies, and investment firms that
facilitate financial transactions.

5. In which market would you find Treasury bills and commercial paper being traded?

a) Capital market

b) Primary market

c) Money market

d) Secondary market

Answer: c) Money market

Explanation: The money market deals with short-term instruments like Treasury bills and commercial
paper.

6. Which of the following best describes a corporation?

a) A business owned and run by one individual

b) A legal entity separate from its owners

c) A business where owners have unlimited liability

d) A business primarily funded by debt

Answer: b) A legal entity separate from its owners

Explanation: A corporation is a separate legal entity, meaning its owners (shareholders) have limited
liability and are not personally responsible for the corporation’s debts.

7. Which of the following is an example of an investment decision?

a) Deciding to issue new shares

b) Deciding to buy new machinery for production

c) Paying dividends to shareholders

d) Borrowing money from a bank

Answer: b) Deciding to buy new machinery for production

Explanation: Investment decisions involve choosing projects or assets the company should invest in,
such as new equipment or facilities.

8. What is a key feature of the money market?

a) It is used for long-term financing.

b) It involves highly liquid, short-term debt instruments.

c) It trades in equities.

d) It is the place where companies raise long-term capital.

Answer: b) It involves highly liquid, short-term debt instruments.

Explanation: The money market deals with short-term, highly liquid instruments like Treasury bills and
certificates of deposit.

9. Which of the following financial management decisions is concerned with how to raise funds?

a) Investment decisions

b) Dividend decisions

c) Financing decisions

d) Budgeting decisions

Answer: c) Financing decisions

Explanation: Financing decisions involve determining how the firm will raise funds, whether through
debt, equity, or other means.

10. Which business organization type provides limited liability to its owners?

a) Sole proprietorship

b) Partnership

c) Corporation

d) General partnership

Answer: c) Corporation
Explanation: In a corporation, shareholders have limited liability, meaning they are not personally
responsible for the company's debts.

11. In which market do companies typically raise capital by selling new securities?

a) Secondary market

b) Primary market

c) Derivatives market

d) Foreign exchange market

Answer: b) Primary market

Explanation: The primary market is where companies issue new securities, such as stocks or bonds, to
raise capital.

12. Which of the following is a possible goal of a firm other than profit maximization?

a) Wealth maximization

b) Loss minimization

c) Revenue shrinking

d) Dividend reduction

Answer: a) Wealth maximization

Explanation: Wealth maximization focuses on increasing shareholder wealth and is often considered a
more sustainable long-term goal than profit maximization alone.

13. Which of the following financial institutions primarily deals with risk management and protection
against losses?

a) Commercial banks

b) Insurance companies

c) Investment banks

d) Credit unions

Answer: b) Insurance companies

Explanation: Insurance companies provide protection against risks, offering policies that help businesses
and individuals manage financial risks.
14. Cash flows to a firm come from which of the following sources?

a) Payments for expenses

b) Salaries paid to employees

c) Sales revenue and investments

d) Debt repayment

Answer: c) Sales revenue and investments

Explanation: Cash inflows to a firm typically come from revenue generated by sales and any investments
made into the business.

15. Which financial market provides a platform for trading existing securities between investors?

a) Primary market

b) Secondary market

c) Money market

d) Capital market

Answer: b) Secondary market

Explanation: The secondary market is where existing securities are traded between investors, such as on
stock exchanges.

Part 2

1. Which of the following statements best describes the agency problem?

A. A conflict of interest between management and shareholders

B. The inability of managers to make optimal financial decisions due to insufficient information

C. The conflict between shareholders and customers

D. The miscommunication between management and employees

Answer: A

Explanation: The agency problem refers to the conflict of interest between management (as agents) and
shareholders (as principals). Managers may act in ways that benefit themselves at the expense of
shareholders' value.
2. What is the primary reason that agency problems are more common in corporations than in sole
proprietorships?

A. Sole proprietors have less financial expertise.

B. Sole proprietors face fewer legal constraints.

C. Corporations separate ownership and management.

D. Corporations are subject to more regulations.

Answer: C

Explanation: In corporations, the separation of ownership and management creates the potential for
agency conflicts because managers (agents) may pursue their interests rather than the owners'
(shareholders').

3. Which of the following scenarios is an example of an indirect agency cost?

A. Payment of audit fees

B. Offering stock options to align interests

C. Managers avoiding risky but valuable investments to protect their jobs

D. Hiring external consultants to monitor management decisions

Answer: C

Explanation: Indirect agency costs result from suboptimal decisions by managers, such as avoiding
valuable risks to protect job security. This reduces potential shareholder wealth.

4. How do performance-based compensation plans reduce agency problems?

A. They increase managerial power within the company.

B. They reward managers based on shareholder satisfaction surveys.

C. They align the managers’ interests with those of shareholders.

D. They eliminate the need for corporate governance.

Answer: C

Explanation: Performance-based compensation plans, like bonuses or stock options, encourage

managers to maximize shareholder wealth since their rewards depend on financial performance.

5. Which of the following is a direct agency cost?

A. Losses from poor managerial decisions

B. Auditor fees paid to monitor management

C. Legal penalties from management's non-compliance

D. Decline in stock price due to poor governance

Answer: B

Explanation: Direct agency costs include expenses such as audit fees and performance bonuses that are
paid to monitor or align managerial behavior with shareholders' interests.

6. What is the role of the Board of Directors in reducing agency problems?

A. Setting up compensation plans for employees

B. Hiring external auditors to review customer complaints

C. Monitoring managers and aligning their actions with shareholders' goals

D. Increasing the company’s marketing budget

Answer: C

Explanation: The Board of Directors represents shareholders and oversees management to ensure their
actions align with the shareholders' interests.

7. Which of the following tools provides shareholders with a legal mechanism to remove poorly
performing managers?

A. Stock buybacks

B. Shareholder voting rights

C. Issuance of additional shares

D. Dividend declarations

Answer: B

Explanation: Shareholders can use their voting rights to elect or remove members of the Board of
Directors, who in turn can hire or fire managers.

8. What is the most likely consequence for a firm if its managers avoid risky but profitable projects?

A. The company’s stock price will rise steadily.

B. The firm may become a target for takeover.

C. Shareholders will increase dividends to offset losses.

D. The company will reduce its capital expenditure budget.

Answer: B

Explanation: When managers avoid profitable but risky projects, the firm becomes less efficient and
more attractive for a takeover, as new management may see the potential for profit.

9. Which of the following best explains the role of corporate governance in mitigating agency problems?

A. It allows managers to issue more debt for projects.

B. It provides legal and structural frameworks to align managers' actions with shareholders' interests.

C. It ensures higher dividend payouts to shareholders.

D. It reduces the firm’s exposure to international competition.

Answer: B

Explanation: Corporate governance establishes policies and frameworks, such as legal requirements and
board oversight, to align managerial behavior with shareholders' goals.

10. Which of the following is NOT a measure to reduce agency problems?

A. Designing performance-based compensation packages

B. Implementing internal controls and monitoring systems

C. Increasing the frequency of shareholder meetings

D. Removing the Board of Directors to reduce management interference

Answer: D

Explanation: Removing the Board of Directors would likely increase agency problems, as the board is
responsible for monitoring and aligning management's behavior with shareholders' interests.