prashantsahni

Which of the following statements regarding stock options as management compensation is most accurate?

A) When a stock option is out of the money, the manager has an incentive to take greater risk. When it is in the money, its incentive effect is similar to that of stock compensation.

B) When a stock option is out of the money, the manager has an incentive to take greater risk and its incentive effect is similar to that of stock compensation.

C) When a stock option is in the money, the manager has an incentive to take greater risk and its incentive effect is similar to that of stock compensation.

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When stock options are out of the money, managers have an incentive to take greater risks. The reason is that the option is worthless when the firm’s stock price is less than the option exercise price. If the option is currently in the money, a stock option is similar to stock in terms of its incentive effect. The only difference is that the option will provide lower compensation (the stock price minus the exercise price) relative to an outright payment of stock.

prashantsahni

Suppose shareholders wish that the board directors undertook more risk. Which of the following would most likely achieve that goal?

A) The directors were paid with stock and their liability insurance was paid for.

B) The directors were paid with stock options and their liability insurance was their responsibility.

C) The directors were paid with stock options and their liability insurance was paid for.

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If board directors were paid in stock options, they would be encouraged to take more risk. If their liability insurance were paid for, then they would also have an incentive to take greater risk because they would not have to face the potential consequences of their decisions.

prashantsahni

Which of the following statements regarding management compensation is most accurate?

A) Stock-based compensation and bonuses are substitutes whereas explicit and implicit incentives are most often complements.

B) Stock-based compensation and bonuses are complements whereas explicit and implicit incentives are most often complements.

C) Stock-based compensation and bonuses are complements whereas explicit and implicit incentives are most often substitutes.

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Bonuses and stock-based compensation are complements because bonuses reflect the manager’s short-term success whereas stock-based compensation more reflects the manager’s longer-term successes. Implicit incentives are usually substitutes for explicit incentives because the stronger the implicit incentive, the lower the need is for explicit incentives.

prashantsahni

In which of the following situations is the board of directors most likely to become more effective?

A) The firm’s earnings have been increasing and the stock price has been consistently increasing.

B) The economy is in a recession and the firm’s stock price has been consistently declining.

C) The firm has sustained several quarters of losses and the firm’s stock price has been consistently declining.

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If the firm’s earnings have been consistently decreasing, the firm is likely nearing crisis. Boards become more active during periods of crisis or when the stock price declines. It is at these times when the personal relationship between managers and directors deteriorates and that boards find themselves in the public limelight.

prashantsahni

Which of the following would enable a Board of Directors to act in the best long-term interest of the shareholders?

A) A majority of the Board of Directors is comprised of independent members and the Chairman of the Board is also a former Chief Executive Officer of the firm.

B) A majority of the Board of Directors is comprised of independent members and the Board meets regularly outside the presence of management.

C) There are Board members who are closely aligned with a firm supplier and the Board meets regularly outside the presence of management.

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The Chairman of the Board, who is also the CEO or former CEO, may impair the Board members from expressing opinions contrary to management. Also, when Board members’ interests are closely aligned with a firm supplier, customer, pension advisor, etc., independence may be impaired.

prashantsahni

Which of the following prescriptions would least likely improve board of director effectiveness?

A) The board should have an independent chairman.

B) Directors should be subject to maximum equity positions.

C) Self-evaluations of boards should be performed.

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Directors should be required to hold a minimum amount of equity, not limited to a maximum of how much equity they can hold.

prashantsahni

In which of the following situations would an active investor be the least effective monitor of management? The active investor holds a:

A) small block of liquid stock.

B) large block of illiquid stock.

C) small block of illiquid stock.

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If the active investor holds a small block of stock, then they do not have as strong an incentive to monitor management as they would if they held more shares and hence had more at stake. If the stock were liquid, they would also be less likely to be an effective monitor of management because they can easily sell their shares if management misbehaves. If instead the stock was illiquid, the active investor would likely place pressure on management to change because they could not cash out as easily.

prashantsahni

Which of the following refers to the situation where an active investor does not own the majority of the firm’s shares but persuades other shareholders of her position?

A) The active investor has real control.

B) The active investor has contingent control.

C) The active investor has formal control.

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An active investor must have control to effectuate change. To have control, the shareholder must have either a majority of the firm’s shares (formal control) or be able to persuade other minority shareholders of her position (real control).

prashantsahni

Which of the following is least likely to limit active investor effectiveness?

A) Active investors are strictly monitored as to their performance.

B) Managers may become too focused on short-term performance.

C) Active investors may liquidate their shares.

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Active investors may not be effective monitors of management because active investors themselves are often unmonitored. Institutional (active) investors rarely face the same pressure that they apply to corporations. Their compensation is usually based on assets managed instead of performance, they are not subject to proxy fights, and they do not carry debt.

prashantsahni

Which of the following statements regarding bankruptcy as a mechanism for enforcing good corporate governance is most accurate?

A) Bankruptcy costs are substantial but bankruptcy does not discipline management to the extent expected.

B) Bankruptcy costs are comparatively minor but bankruptcy does not discipline management to the extent expected.

C) Bankruptcy costs are substantial and bankruptcy provides strong discipline against poor management.

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Bankruptcy costs are substantial and include both direct and indirect costs. Bankruptcy does not actually discipline management to the extent expected. Managers are often able to retain their positions during a firm’s bankruptcy.