FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
1) Consider the consumption of electricity in a leased office space as an agency problem.
Who is the principal?
a) The landlord, regardless of who pays the electricity bill, because he remains
the owner of the office.
b) The tenant, regardless of who pays the electricity bill, because he is the one
using the electricity.
c) The landlord, if he is paying the electricity bill.
d) None of the two, since this issue cannot be viewed as an agency problem.
e) None of the above is correct.
“Both the landlord and the tenant may be aware of the overall costs and benefits of energy-efficient investments,
but as long as the landlord pays for the equipment and the tenant pays the energy bills, the investment will not be
made. In this case, there is also little incentive for the tenant to make a capital efficiency investment with a usual
payback time of several years, and which in the end will revert to the landlord as property. Since energy
consumption is determined both by technology and by behavior, an opposite principal agent problem arises when
the energy bills are paid by the landlord, leaving the tenant with no incentive to moderate her energy use.” Mind
the Gap- Quantifying Principal-Agent Problems in Energy Efficiency" (2007).
FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
4) Which of the following is true?
a. Decision rights and knowledge must be separated to minimize agency costs
b. A legal system that protects ownership rights is critical to the efficient
functioning of firms and markets
c. When an agent doesn’t care about the future consequence of his actions
because he expects to leave the company in the short-term, we are facing a
free-rider problem.
d. More then one of the above options is true
e. None of the above options is true
a) is false regarding the role of knowledge; c) is false since it refers to the horizon problem; b) Is the only right
option.
2) Still referring to the consumption of electricity in a leased office space, suppose now
that the tenant pays the electricity bill. Who is now the principal?
a) Nothing changed with respect to the previous question and the landlord is the
principal, regardless of who pays the electricity bill, because he remains the
owner of the office.
b) Nothing changed with respect to the previous question and the tenant is the
principal,, regardless of who pays the electricity bill, because he is the one
using the electricity.
c) The tenant, since he is now paying the electricity bill.
d) None of the two, since now this issue cannot be viewed as an agency
problem.
e) None of the above is correct.
In a situation where the agent is consuming the energy and paying for the energy consumed, there is no agency
problem with to the landlord.
3) Suppose you do not pay your taxes. With respect to the national security issues you
are:
a. Inducing an adverse selection problem, since the armed forces cannot exclude
you out of their protection duties.
b. Incurring in an horizon problem, since in the long run you may need protection
from the state.
c. Incurring in a free riding problem, since you are benefiting from protection
but not paying for it.
d. More than one of the above are correct
e. None of the above is correct.
You are benefiting from the protection of the armed forces already, and not paying anything for it. a. is not true,
since this is not an adverse selection problem, because the armed forces already have the obligation to protect us.
5) An agent is compensated for an action perfectly observable by the principal, but the
outcome of this action is not perfectly observable by the principal.
a. There is an agency problem, because the principal does not know exactly what
the outcome of the agent’s actions is, despite the perfect observation of the
action.
b. There is a moral hazard problem, since there is a hidden information problem.
c. There is an adverse selection problem, since there is a hidden information
problem.
d. There in no agency problem.
e. There is an agency problem, but none of the previous descriptions applies to it.
The action is observable by the principal, there is no agency problem of any kind. There is uncertainty between the
action and the outcome, but nothing the agent can do about it.
6) Which of the following is true?
a. The difference between moral hazard and adverse selection is that moral
hazard refers to agency problems after a contract is established, whereas
adverse selection refers to agency problems before there is a contract
between the principal and the agent.
b. The difference between moral hard and adverse selection is that moral hazard
refers to hidden action problems, while adverse selection is a problem of
hidden information.
c. The difference between moral hard and adverse selection is that moral hazard
refers to hidden information problems, while adverse selection is a problem of
hidden action.
d. More than one of the above is true.
e. None of the above is true.
That is how we defined the difference between moral hard and adverse selection in class. You can have moral
hazard problems with hidden information as well.
7) Markets are a good control for agency problems.
I This is true, since the existence of external product markets promotes internal
efficiency and thus reduces agency problems.
II This is true, since the existence of an external labor market leads to agent’s efficiency,
since he suddenly faces a risk of being replaced.
1
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FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
a.
b.
c.
d.
Only I is true.
Only II is true.
I and II are true
Neither I nor II are true, but markets can be a good control for agency
problems.
e. Neither I nor II are true, since markets cannot be a good control for agency
problems.
FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
10) Which of the following is true?
a.
In an agency problem, when the agent is risk averse then the principal has to be
risk neutral.
b.
In an agency problem, the agent and the principal can both be risk averse.
c.
In an agency problem the agent always has to be more risk averse than the
principal.
d.
More than one of the above is true.
e.
None of the above is true.
The existence of the external product markets allows you to establish benchmarks and competitive alternatives to
having your agent slacking. The existence of an external labor market allows the principal to resort to agents that
may be more efficient or willing to work at lower salaries (if the outside workers’ reservation utility is lower than
our current agents). Knowing this the agent will have an incentive to work harder.
In agency problems we need the agent to be more risk averse than the principal, but they can both be risk averse.
8) With the recent credit crunch, many families conservatively decided to clear as much
as their debt as possible in anticipation of increases in interest rates, even if they had
to pay the contracted anticipation fees. This lowered the average quality of the
outstanding credit, as banks were left with riskier borrowers in comparison to the
original credit portfolio.
I This is the intensification of the adverse selection problem banks faced originally when
they constituted their credit portfolio, and were looking for the least risky borrowers to
constitute their credit portfolio.
II This is the result of a moral hazard problem where the agents (the conservative
families) deviated from their originally contracted behavior.
III This is the result of a moral hazard problem where the agents (the banks) deviated
from their originally contracted behavior.
a.
Statement I is the only true statement
b.
Statement II is the only true statement
c.
Statement III is the only true statement
d.
Statement I and one of the others is true.
e.
None of the statements is true.
It is the intensification of the adverse selection originally faced by the banks. Now they are left with the riskier
borrowers they so much would prefer to avoid originally.
After the contract was set, conservative families acted as contracted, paying the contracted anticipation fees. The
borrowers acted diligently (meaning they did not change to becoming risky families).
Statement III is false, since banks act as principals in this problem.
11) Adam is a risk averse individual, Nancy is risk neutral and Larry is risk loving:
a.
Adam is different than Larry, because Adam prefers more income to less.
b.
Adam is different than Larry, because Adam prefers less income to more.
c.
Adam is different than Larry, because Adam maximizes his utility at a constant
income.
d.
Adam is different than Larry, because Adam has to have a constant utility
regardless of income.
e.
None of the above is true.
Adam prefers more income to less, but so does Larry. Adam can be risk averse and still have a monotonically
increasing utility function, which meaning he does not have a constant utility nor does he maximize it for a given
income.
12) Regarding Nancy, who is a risk neutral person:
a.
Nancy extracts no utility from her income.
b.
Nancy extracts always the same utility regardless of her income.
c.
Nancy’s utility increases as her income increases.
d.
Nancy maximizes her utility at a constant income.
e.
None of the above is true.
Nancy’s utility is increasing with income at a constant pace, meaning her utility is linear and increasing.
13) In the agency problem we analyzed, when the agent was risk neutral:
a.
The principal had to be risk neutral too.
b.
The agent would end up purchasing the firm from a risk-averse principal.
c.
We would inevitably get to the first best solution.
d.
The problem would have no solution.
e.
None of the above is true.
9) Which of the following is true?
a.
Accounting information is the only way to mitigate the agency problems between
shareholders and managers.
b.
Accounting information plays no role in the relationship between shareholders
and managers.
c.
Accounting information was created, among other reasons, to help solve the
agency problem between shareholders and mangers.
d.
More than one of the above is true.
e.
None of the above is true.
In the agency problem we analyzed, when the agent was risk neutral, he would immediately end the agency
problem, by taking over the firm, if the principal was risk averse.
Accounting information is not the only way to mitigate agency, but it does play a role. It was created to help solve
this problem, by showing up as a monitoring mechanism to shareholders.
3
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FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
14) In the agency problem we analyzed, G(.) represents the utility function of the principal.
When the principal is risk neutral or risk averse, this is because:
a.
G’ > 0
b.
G’’> 0
c.
G’< 0
d.
G’’≤ 0
e.
G(X-S) = X – S
d. guarantees a concave utility function. A. applies to the principal’s utility function, but not because of his risk
aversion pattern.
FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
18) In the second best solution:
a.
The principal observes the agent’s choice of action
b.
The principal has no way to observe the agent’s choice of action
c.
μ>0 (the Lagrangean multiplier on the ICC) means that the principal wants to
motivate the agent more than the lowest possible level of effort
d.
More than one of the above sentences are true
e.
None of the above sentences is true
b. and c. are correct.
15) The compensation that the principal gives to the agent has:
a.
A positive impact on principal’s utility because it affects the actions chosen by the
agent and consequently the outcome.
b.
A negative impact since each dollar paid to the agent is one dollar less to the
principal, and a positive impact, since it has a positive impact in the agents
actions and in the outcome, in the principal’s utility
c.
Has not any impact on the principal’s utility
d.
A negative impact in the principal’s utility because it affects agents actions and
consequently the outcome.
e.
More than one of the above options is correct
The negative impact derives from the fact that this comes out of the principal’s pocket. The positive effect is the
reason he bothers paying a salary to the agent..
16) Which of the following sentences is correct:
a.
With the Individual Rationality Constraint principal must ensure that the
contract is attractive enough to offer an acceptable level of utility to the agent.
b.
The Individual Rationality Constraint represents the link between the actions
choice by the agent and the contract
c.
The Individual Rationality Constraint will ensure that the agent choose the actions
in accordance with the principal’s objectives
d.
More than one of the above sentences are true
e.
None of the above sentences is true
The IRC makes the contract attractive enough for the agent by ensuring that what is being offered has higher utility
than the next best employment opportunity.
17) In the first best solution, if the principal is risk neutral and the agent is risk averse, the
optimal contract implies that:
a.
The optimal risk sharing condition indicates that the agent will be paid a salary
given by the function s(x) = x-k
b.
The optimal risk sharing condition indicates that the agent will be paid a salary
given by a constant function s(x) = k
c.
The principal will bear all the risks.
d.
More than one of the above sentences are true
e.
None of the above sentences is true
19) A worker can exert two types of efforts, high or low, which results in an outcome x,
which is a normally distributed random variable. A principal gets to keep x, paying a
salary w to the worker. The principal does not observe the effort, but only observes
the outcome x.
If the worker exerts a high effort, then x is distributed with N(a, σ2). If she exerts a low
effort, than the outcome x is distributed with N(a/2, σ2/4). The principal is risk neutral
and the agent is risk averse.
a. This description configures a situation of a moving support, because the
probability distribution of the low effort has a completely different average
than the distribution for the high effort.
b. This description configures a situation of a moving support, because the
probability distribution of the low effort has a completely different variance
than the distribution for the high effort.
c. This description configures a situation of a moving support, because the
probability distribution of the low effort has a completely different average
and a different variance than the distribution for the high effort.
d. This description does not configure a situation of a moving support.
e. None of the above.
In Normal distributions the support goes from -∞ to +∞, no matter what the variance or expected value are.
20) Suppose the typical agency problem, but with an agent having n different levels of
effort. The next best employment opportunity offered to the agent gets her a utility of
U1. The principal is interested in having the agent choosing the highest effort level
(which is the one that delivers the maximal expected output). How many IRCs will this
problem have?
a. 1
b. 2
c. n
d. n-1
e. none of the above.
There is only one IRC, assuring the agent will prefer the contract to the next best alternative.
21) Still referring to the situation described in question 20), how many ICCs will this
problem have?
a. 1
b. 2
c. n
d. n-1
e. none of the above.
b. and c. are correct. By paying the agent a constant salary, the principal bears all the risk..
There are n-1 ICCs to make sure that the desired effort level supersedes all other n-1 possible effort levels.
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FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
22) Still referring to the situation described in question 20), but now suppose the agent
has m different employment opportunities outside this contract, all delivering the
same reservation utility U1. How many IRCs will this problem have?
a. 1
b. m
c. m-1
d. n-1
e. none of the above.
FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
27) According to the CMVM recommendations, the management body should:
a.
Include a sufficient number of non-executive directors, to follow and evaluate
the company management by the executives.
b.
Include at least 5 non-executive directors, to follow and evaluate the company
management by the executives.
c.
Not include any non-executive director
d.
Include at least 5 non-executive directors that are allowed to exercise voting
rights.
e.
More than one of the above option is correct
There is only one IRC, assuring the agent will prefer the contract to the next best alternative.
See CMVM recommendation 5-A: “Balance between executive and non-executive members”
23) Still referring to the situation described in question 20), but now suppose the agent
has m different employment opportunities outside this contract, delivering the
reservation utilities ranging between U1 and Um. How many IRCs will this problem
have?
a. 1
b. m
c. m-1
d. n-1
e. none of the above.
28) According to the CMVM recommendations, the compensation policy has to be
submitted to appreciation.
a.
Of the company’s CEO
b.
Of the corporate governance director
c.
Of the Annual General Meeting of Shareholders
d.
Of the CEO and executive directors
e.
More than one of the above option is correct
See CMVM recommendation 8-A: “Approval of the compensation policy”
There is only one IRC, assuring the agent will prefer the contract to the next best alternative.
29) Some accounting scandals as WorldCom and Enron were the first step for the creation
of one of the following law. Which one?
a.
Public Company Accounting Reform and Investor Protection
b.
Sarbanes-Oxley
c.
US Corporate Governance Law
d.
More than one of the above options is correct
e.
None of the above.
24) Companies should have a corporate governance framework that:
a.
Is consistent with the rule of law and clearly articulates the division of
responsibilities among different supervisory, regulatory and enforcement
authorities.
b.
Promotes transparent and efficient markets.
c.
Defines the shareholders’ rights
d.
More than one of the above is correct.
e.
None of the above option is correct
Examples given in class for the introduction to the Sarbanes-Oxley Act, which can also be known as the Public
Company Accounting Reform and Investor Protection Act.
Option a and b are correct. See Point I “Ensuring the basis for an effective corporate governance framework” of the
corporate governance class.
25) The corporate governance framework should:
a.
Define the rights of the stakeholders.
b.
Recognize the rights of stakeholders established by law or through mutual
agreements.
c.
Ensure the strategic guidance of the company.
d.
All the above options are correct.
e.
Options b and c are correct.
30) Which statement is true:
a.
The Sarbox restricts auditing companies from doing other kinds of business apart
from auditing with the same clients.
b.
The Sarbox is the reason for scandals as Enron and Peregrine Systems
c.
The Sarbox increased the number of auditors working for firms listed in NYSE
d.
The Sarbox allows auditors to work as consultants and, simultaneously, as auditors
for the same firm.
e.
None of the above options is correct
See Sarbox Title I: “Public Company Accounting Oversight Board (PCAOB)”
31) Which of the following statement is false?
a.
Simple Capital Structure means that there is no potential common stock
b.
Earnings per share indicates the income earned by each share of common stock
c.
The existence of a stock dividend will change the shareholders’ total investment
d.
Antidilutive securities should not be reported.
e.
All statements are true.
See Point IV “The role of stakeholders in corporate governance” and Point VI “The responsibilities of the board”.
26) In CMVM recommendations the exercise of voting rights:
a.
Should be restricted only if it is made by correspondence.
b.
Should be restricted only if it is made by representation.
c.
Should be restricted if it is made by correspondence or by representation.
d.
Should not be restricted in any case.
e.
None of the above option is correct.
A stock dividend or split does not change the shareholders’ total investment.
See CMVM recommendation 2: “Exercising voting rights”
7
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FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
32) The weighted average number of shares at the end of the year 2008 in the EA
Company was 6,000,000 shares. We know that on March 15 it was approved a 3:2
stock split. How many shares outstanding had the company at January 1st?
a.
4,500,000 shares outstanding.
b.
4,000,000 shares outstanding.
c.
6,000,000 shares outstanding.
d.
9,000,000 shares outstanding.
e.
None of the above options is correct
a.
b.
c.
d.
e.
Performance Evaluation
Questions Booklet
Final Exam
$1.22.
$1.25.
$1.34.
$1.42.
None of the above.
First, calculate basic EPS = 125,000/100,000= $1.25
Next, check if the convertible bonds are dilutive:
numerator impact = (1,000 x 1,000 x0.07) x (1 —0.4) = $42,000
denominator impact = (1,000 x 25) = 25,000 shares
per share impact = $42,000 /25,000 shares = $1.68
Since $1.68 is greater than the basic EPS of $1.25, the bonds are antidilutive. Thus, diluted EPS basic EPS = $1.25.
Weighted average number of shares at the end of the year = Shares outstanding at January 1st * stock split 6,000,000 = X * (3/2) X = 4,000,000 shares outstanding
33) The Hall Corporation had 100,000 shares of common stock outstanding at the
beginning of the year. Hall issued 30,000 shares of common stock on May 1. On July 1,
the company issued a 10% stock dividend. On September 1, Hall issued 1,000, 10%
bonds, each convertible into 21 shares of common stock. What is the weighted
average number of shares to be used in computing basic and diluted EPS, assuming the
convertible bonds are dilutive?
Average shares, basic
Average shares, dilutive
a.
130,000
b.
132,000
c.
132,000
d.
139,000
e. None of the above options is correct.
FCEE-Católica
132,000
139,000
146,000
146,000
36) An analyst has gathered the following information about a company:
• 50,000 common shares outstanding from the beginning of the year.
• Warrants outstanding all year on 50,000 shares, exercisable at $20 per share.
• The average price of the company’s stock for the year was $15 at which the
firm would be buying treasury stock.
How many shares should, be used in calculating the company’s diluted EPS?
a.
b.
c.
d.
e.
The new stock is weighted by 8 /12. The bonds are weighted by 4 / 12 and are not affected by the stock dividend.
Basic shares = [[100,000 x (12 / 12)] + [30,000 x (8 / 12)][ x 1,10 = 132,000
Diluted shares = 132,000 + [21,000 x (4 / 12)] = 139,000
16,667.
33,333.
50,000.
66,667
None of the above.
The warrants in this case are antidilutive. The average price per share of $15 is less than the exercise price of $20.
The year-end price per share is not relevant. The denominator consists of only the common stock for basic EPS.
34) Given the following information, how many shares should be used in computing
diluted EPS? The information refers to the entire year.
• 300,000 shares outstanding.
• 100,000 warrants exercisable at $50 per share.
• Average share price is $55 at which the firm would be buying treasury stock.
• Year-end share price is $60.
a.
9,091.
b.
90,909.
c.
309,091.
d.
390,909.
e.
None of the above options is correct.
37) Liquidity ratios:
a. Give the manager an idea of the company’s ability to meet long-term
obligations.
b. Give the manager an idea of the company’s ability to generate profitable sales
from asset base
c. Allow the manager to be sure about company’s ability to meet long-term
obligations.
d. Give the manager an idea of the company’s ability to meet short-term
liabilities.
e. None of the above options is correct
a) refers to the Solvency Ratios; b) refers to the Profitability Ratios; c) is wrong since any ratio give a sure answer to
managers. D) is the correct answer
Since the exercise price of the warrants is less than the average share price, the warrants are dilutive. Using the
treasury stock method to determine the denominator impact:
($55 —$50)/$55 x 100,000 shares = 9,091 shares
Thus, the denominator will increase by 9,091 shares to 309,091 shares. The question asks for the total, not just the
impact of the warrants.
35) An analyst gathered the following information about a company:
• 100,000 common shares outstanding from the beginning of the year.
• Earnings of$125,000.
• 1,000, 7% $1,000 par bonds convertible into 25 shares each, outstanding as of
the beginning of the year.
• The tax rate is 40%.
The company’s diluted EPS is closest to:
9
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38) With other variables remaining constant, if profit margin rises, ROE will:
a. fall
b. increase
c. remain the same
d. initially fall and then increase
e. none of the above
This becomes obvious in the DuPont analysis, as ROE=Profit Margin x Assets Turnover x Financial Leverage.
39) An analyst has gathered the following information about a company.
• The total asset turnover is 1.2.
• The after-tax profit margin is 10 percent.
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FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
• The financial leverage multiplier is 1.5.
Given this information, the company’s return on equity is:
a. 18%
b. 9%
c. 10%
d. 12%
e. None of the above or not enough data to calculate.
ROE=Profit Margin x Assets Turnover x Financial Leverage = 0.1 x 1.2 x 1.5 = 0.18.
40) According Bebchuk and Fried in Payment without Performance, which of the following
is true?
a. Managers should be rewarded for how well their firm performed, even when
their performance is economy-or industry-wide movements.
b. Managers should rather be rewarded for their performance on accounting
numbers measured in absolute change, than for stock price performance
relative to the peers.
c. Investors should encourage firms to adopt equity compensation plans that
filter out at least some of the gains in the stock price that are due to general
market or industry movements.
d. More than one of the above is true.
e. None of the above.
Option a. is not true, since managers should not be rewarded on economy-or industry wide movements. Option b.
is not true, since the measuring performance based on accounting numbers alone, falls into similar problems than
th
stock price alone. Option c is true and it is in slide 43 of the 6 session.
41) According to Bebchuk and Fried in Payment without Performance, board members
supposed to supervise managers often side with these managers. The following
statements are plausible reasons:
I. Board members are elected by the same shareholders that elect managers and are
therefore part of the same team. This is called collegiality and team spirit.
II. Board members are also due some compensation, which is mostly decided by the
managers.
a. Only I is a true reason for the board members siding with managers.
b. Only II is a true reason for the board members siding with managers.
c. Both statements are true.
d. Each statement contains one true reason for the board members siding with
managers, but the reason in statement I is not called collegiality or team spirit.
e. None of the above.
FCEE-Católica
Performance Evaluation
Questions Booklet
Final Exam
43) In Payment without Performance, we referred to:
a. Evidence that executive compensation goes up with the strength of the board
with respect to the CEO
b. Evidence that executive compensation goes up in the presence of a large
outside shareholder
c. Evidence that executive compensation goes up in the presence of
antitakeover provisions
d. More than one of the above is true
e. None of the above is true
They refer to evidence that exec comp goes down with the strength of the board; it goes down in the presence of a
large stakeholder, and it goes up in the presence of antitakeover provisions. So only c. is true.
44) According to Payment without Performance, the following are forms of disconnecting
payment from performance:
I.
Goodbye payments
II.
Golden hellos
III.
Base salary of the CEO.
a. All 3 statements are true
b. All but I is true
c. All but II is true
d. All but III is true
e. More than one of the statements are false.
th
Slides 28 and 29 of the 6 session. The base salary does not depend on the performance of the CEO it is a fixed
amount.
45) According to Payment without Performance, the need to place a dollar value on all
forms of compensation arises because of the authors describe as “Stealth
Compensation”. This characterizes all but one of the following:
a. pensions,
b. deferred compensation,
c. post-retirement perks,
d. consulting contracts
e. stock option plans.
Stock options plans are not part of what they call “stealth compensation”, since there is disclosure on this. Stock
options are (or should be) expensed, and even if they are not, there is information about them in the financial
statements. What the authors define as “stealth compensation” refers to payments, promises of payments and
other compensation forms for when the executives leave the company or retire, including the existing of consulting
contracts. See slide 37.
Statement II is true, as the compensation package for the board members is usually decided together at the same
time for all board members, mostly by the management., even if it is subject to posterior approval by the
shareholders. Statement I is also true and being part of the same team is called collegiality or team spirit.
42) According to Bebchuk and Fried in Payment without Performance, board members side
with the managers, when negotiating the compensation package at arm’s lenght. Who
were they supposed to side instead?
a. Shareholders.
b. Employees.
c. No one, they are supposed to be independent.
d. All firm stakeholders, including shareholders, suppliers, customers, employees.
e. None of the above.
The board members are there to represent the shareholders. If they are independent, they represent them all.
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Please use the first page to mark your answers. Information in this booklet will not be graded!
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Please use the first page to mark your answers. Information in this booklet will not be graded!