Essentials of Entrepreneurship & Small Business Management, 6e (Scarborough)
Chapter 6 Franchising and the Entrepreneur
1) A franchise is a system of distribution in which semi-independent business owners pay ________ and ________ to a parent company in return for the right to become identified with its trademark, to sell its product or services, and often to use its business format and system.
- A) a percentage of sales; royalties
- B) upfront costs; incremental costs
- C) royalties; monthly consulting charges
- D) fees; royalties
Answer: D
Diff: 2 Page Ref: 160
AACSB: Analytic Skills
2) Franchises sales represent ________ percent of the United States’ gross domestic product.
- A) 1.4
- B) 2.4
- C) 4.4
- D) 6.4
Answer: C
Diff: 3 Page Ref: 160
AACSB: Analytic Skills
3) ________ franchising involves providing the franchisee with a complete business system, with an established name, the building layout and design, accounting systems, and other elements while ________ franchising allows the franchisee to use the franchiser’s trade name without distributing the products exclusively under the franchiser’s name.
- A) Product distribution; trade name
- B) Trade name; pure
- C) Pure; trade name
- D) Pure; product distribution
Answer: C
Diff: 3 Page Ref: 161
AACSB: Analytic Skills
4) McDonald’s is an example of a ________ franchise.
- A) conversion forms
- B) trade name
- C) product distribution
- D) pure
Answer: D
Diff: 2 Page Ref: 161
AACSB: Reflective Thinking
5) Benefits of involvement in a franchise experience include:
- A) management training and support.
- B) brand name appeal and standardization of goods and services.
- C) national advertising exposure and financial assistance.
- D) All of the above
Answer: D
Diff: 1 Page Ref: 162-163
AACSB: Analytic Skills
6) Which of the following is not a potential advantage of franchising for the franchisee?
- A) Management training and assistance
- B) National advertising program
- C) Centralized buying power
- D) Limited product line
Answer: D
Diff: 1 Page Ref: 162-163
AACSB: Analytic Skills
7) Franchisers generally do which of the following regarding financial assistance to franchisees?
- A) Provide direct financing.
- B) Assist in finding financing and occasionally provide direct assistance in a specific area.
- C) Waive royalty fees for franchisees not making an adequate profit.
- D) Franchisers provide no assistance because having or finding financing is a requirement for qualifying for a franchise.
Answer: B
Diff: 2 Page Ref: 164
AACSB: Analytic Skills
8) A significant advantage a franchisee has over an independent business is the participation in the franchisor’s ________ largely due to the ________ the franchise offers.
- A) centralized buying power: buying insight
- B) centralized buying power; brand protection
- C) centralized buying power: economies of scale
- D) economies of scale: territorial protection
Answer: C
Diff: 2 Page Ref: 166
AACSB: Analytic Skills
9) Some franchisors offer ________ to give existing franchisees the right to exclusive distribution of brand name goods or services within a particular geographic area.
- A) territorial protection
- B) exclusive rights
- C) guaranteed protection
- D) exclusivity
Answer: A
Diff: 2 Page Ref: 166
AACSB: Analytic Skills
10) The failure rate for franchises is:
- A) higher than the average rate for new businesses.
- B) no different from the rate for new businesses.
- C) lower than the average rate for new businesses.
- D) indeterminable because of the Right to Privacy Act.
Answer: C
Diff: 2 Page Ref: 167
AACSB: Analytic Skills
11) A recent study reports that the success rate of franchisees increases when a franchise system:
- A) requires franchisees to have prior industry experience.
- B) requires franchisees to actively manage their operations.
- C) has built a strong brand name with training programs to improve knowledge and skills.
- D) All of the above increase the rate of success.
Answer: D
Diff: 1 Page Ref: 167
AACSB: Analytic Skills
12) Franchise royalty fees typically range from ________ to ________ percent of a franchisee’s continuing sales.
- A) 1; 3
- B) 5; 9
- C) 3; 7
- D) 7; 12
Answer: C
Diff: 3 Page Ref: 168
AACSB: Analytic Skills
13) When it comes to purchasing products, equipment, and incurring other expenses, the franchiser:
- A) cannot require the franchisees to buy from the franchise company.
- B) can set prices franchisees pay for the products but cannot set the retail price the franchisees charge.
- C) is permitted to set the retail price for the franchisee.
- D) cannot require franchisees to buy from an “approved” supplier.
Answer: B
Diff: 2 Page Ref: 168-169
AACSB: Analytic Skills
14) Which of the following is not a potential disadvantage of a franchise?
- A) Unsatisfactory training program
- B) Limited product line
- C) Less freedom
- D) All of the above are potential disadvantages of a franchise.
Answer: D
Diff: 1 Page Ref: 167-170
AACSB: Reflective Thinking
15) A franchise myth is that:
- A) once the franchise is open, the franchisee has autonomy to run the business in what ever way he or she sees fit.
- B) the owner need to be hands on.
- C) the franchise will only expect to be paid when the franchisee is profitable.
- D) franchises fail at a rate higher that independently owned businesses.
Answer: A
Diff: 2 Page Ref: 170-171
AACSB: Analytic Skills
16) Which of the following is an indication of a dishonest franchiser?
- A) A high-pressure sale
- B) A “get-rich-quick” scheme
- C) Attempts to discourage you from getting an attorney to review the contract
- D) All of the above
Answer: D
Diff: 1 Page Ref: 171-172
AACSB: Analytic Skills
17) The FTC’s philosophy regarding the Franchise Disclosure Document (FDD) focuses on:
- A) catching and prosecuting abusers of franchise laws.
- B) verifying the accuracy of FDD information.
- C) providing information to prospective franchisees and helping them make wise decisions.
- D) licensing prospective franchisers.
Answer: C
Diff: 3 Page Ref: 171-172
AACSB: Analytic Skills
18) Which of the following should make a potential franchisee suspicious about a franchiser’s honesty?
- A) Claims that the franchise contract is a standard agreement and that there is no need to read it or have an attorney look it over
- B) An offer of direct financing of a specific element of the franchise package
- C) Not providing detailed operational information until 10 days before signing the contract
- D) Requiring franchisees to spend a certain percentage of profits on advertising
Answer: A
Diff: 2 Page Ref: 176-177
AACSB: Reflective Thinking
19) In addition to reading the franchiser’s FDD, it would be wise for the potential franchisee to seek a franchise that offers which of the following?
- A) A unique concept or marketing approach
- B) A registered trademark
- C) A positive relationship with franchisees
- D) All of the above
Answer: D
Diff: 1 Page Ref: 177-178
AACSB: Analytic Skills
20) Franchises have experienced three major growth waves since its beginning that include a focus on:
- A) rapid growth, the fast food, and specific market niches.
- B) stable growth, the service sector, and the food industry.
- C) rapid growth, the service sector, and specific market niches.
- D) predictable growth, the service sector, and specific market niches.
Answer: C
Diff: 3 Page Ref: 180
AACSB: Reflective Thinking
21) A study by the International Franchises Association reports that minorities own more than ________ percent of all franchises and women own ________ percent of franchises.
- A) 2;8
- B) 9;20
- C) 12.;25
- D) 19;25
Answer: D
Diff: 3 Page Ref: 180
AACSB: Multicultural & Diversity
22) ________ is an emerging international market for U.S. franchisers that is expected to realize the highest future growth rate.
- A) Europe
- B) Canada
- C) Japan
- D) China
Answer: D
Diff: 1 Page Ref: 182-183
AACSB: Multicultural & Diversity
23) One of the major trends in franchising is the ________ of American franchise systems.
- A) replication
- B) conversion
- C) internationalization
- D) reduction
Answer: C
Diff: 2 Page Ref: 181
AACSB: Multicultural & Diversity
24) In a ________ , a franchisee opens more than one unit in a broad territory within a specific time period.
- A) multiple-unit franchising
- B) master franchise
- C) conversion franchising
- D) piggyback franchising
Answer: A
Diff: 1 Page Ref: 180
AACSB: Analytic Skills
25) A method of franchising that gives the right to create a semi-independent organization in a particular territory is a:
- A) piggyback franchise.
- B) master franchise.
- C) product distribution franchise.
- D) conversion franchise.
Answer: B
Diff: 2 Page Ref: 183
AACSB: Analytic Skills
26) When the franchiser has the right to establish a semi-independent organization in a particular territory to recruit, sell, and support other franchises, it is known as a ________ franchise.
- A) multi-unit
- B) piggyback
- C) conversion
- D) master
Answer: D
Diff: 1 Page Ref: 183
AACSB: Analytic Skills
27) McDonald’s recently set up several small franchises in nontraditional locations such as a hospital, a college campus, an airport, a subway station, and a sports arena. These locations are based on the principle of:
- A) conversion franchising.
- B) intercept marketing.
- C) multi-unit franchising.
- D) piggyback franchising.
Answer: B
Diff: 2 Page Ref: 183
AACSB: Analytic Skills
28) Chris Jaffe, the owner of a small independent doughnut shop, is worried that a large doughnut franchise will open an outlet near her location and take away business. Taking a proactive approach, Jaffe contacts the franchise, and after a few months of negotiations, becomes a franchisee. Jaffe is an example of which trend in franchising?
- A) Piggyback
- B) Conversion
- C) Master
- D) Subfranchising
Answer: B
Diff: 2 Page Ref: 184
AACSB: Reflective Thinking
29) Establishing a Baskin-Robbins franchise inside a Blimpee’s franchise is an example of ________ franchising.
- A) multi-unit
- B) master
- C) piggyback
- D) diversionary
Answer: C
Diff: 1 Page Ref: 184
AACSB: Analytic Skills
30) A franchise is an arrangement in which semi-independent business owners pay fees and royalties to a parent company in return for the right to sell its products or services and often to use its business format and system.
Answer: TRUE
Diff: 1 Page Ref: 160
AACSB: Analytic Skills
31) Pure franchising involves the right to use all the elements of a fully integrated business operation.
Answer: TRUE
Diff: 1 Page Ref: 161
32) Trade name franchising is a system of franchising in which a franchisee purchases the right to use the franchisor’s trade name without distributing particular products under that name.
Answer: TRUE
Diff: 1 Page Ref: 161
AACSB: Analytic Skills
33) Pure franchising involves a system of franchising in which a franchisor sells a franchisee a complete business format and system.
Answer: TRUE
Diff: 1 Page Ref: 161
AACSB: Analytic Skills
34) Before entering a franchise contract, a potential investor should ask, “What can a franchise do for me that I cannot do for myself?”
Answer: TRUE
Diff: 1 Page Ref: 163
AACSB: Reflective Thinking
35) When a franchisee buys a franchise, he or she is purchasing the expertise and the business of the franchiser.
Answer: TRUE
Diff: 1 Page Ref: 163
AACSB: Analytic Skills
36) Quality is so important in franchising that most franchisers retain the right to terminate the franchise contract and to repurchase the outlet if a franchisee fails to maintain quality standards.
Answer: TRUE
Diff: 2 Page Ref: 164
AACSB: Reflective Thinking
37) A major advantage of a franchise contract is the national advertising campaign that most franchisers provide free of charge for their franchisees.
Answer: FALSE
Diff: 1 Page Ref: 164
AACSB: Analytic Skills
38) Examples of some benefits franchise systems offer include management training, brand appeal, standardization of goods and services, national advertising, proven business formats, centralized buying power, and site selection assistance.
Answer: TRUE
Diff: 2 Page Ref: 162-167
AACSB: Reflective Thinking
39) Most franchisers provide extensive financial help such as loans and low-rate financing for their franchises.
Answer: FALSE
Diff: 2 Page Ref: 165
AACSB: Analytic Skills
40) The failure rate for franchises is below that for other types of new businesses.
Answer: TRUE
Diff: 2 Page Ref: 167
AACSB: Analytic Skills
41) In addition to other fees, franchisees must also pay royalties but only on net profits; in other words, no profits, and no royalties.
Answer: FALSE
Diff: 2 Page Ref: 167-168
AACSB: Analytic Skills
42) It is illegal for a franchiser to require franchisees to purchase products only from “approved suppliers.”
Answer: FALSE
Diff: 2 Page Ref: 168-169
AACSB: Analytic Skills
43) Having an attorney review and evaluate a franchise contract is unnecessary since the FTC requires all franchisers to offer a “standard” franchise contract.
Answer: FALSE
Diff: 2 Page Ref: 169
AACSB: Reflective Thinking
44) The franchise contract defines the rights and the obligations of both parties and sets the guidelines that govern the franchise relationship.
Answer: TRUE
Diff: 1 Page Ref: 169
AACSB: Analytic Skills
45) Franchisees in fast-growing systems reap the benefits of the franchisor’s expanding reach, but they also may encounter the downside of a franchisor’s aggressive growth strategy; market saturation.
Answer: TRUE
Diff: 2 Page Ref: 170
AACSB: Reflective Thinking
46) By signing the franchise contract, a franchisee typically surrenders some freedom and autonomy in operating his or her business.
Answer: TRUE
Diff: 1 Page Ref: 170
AACSB: Reflective Thinking
47) The bigger the franchise, the more successful the franchisees will be.
Answer: FALSE
Diff: 2 Page Ref: 170, Table 6.1
AACSB: Reflective Thinking
48) Absentee franchise owners are consistently successful.
Answer: FALSE
Diff: 2 Page Ref: 171
AACSB: Reflective Thinking
49) The Franchise Disclosure Document (FDD) is a document that every franchiser is required by law to give prospective franchisees before any offer or sale of a franchise.
Answer: TRUE
Diff: 2 Page Ref: 172
AACSB: Analytic Skills
50) If a franchiser encourages you to sign without reading the agreement, or discourages you from “spending the money on an attorney,” this is a warning sign that the franchiser might be dishonest.
Answer: TRUE
Diff: 1 Page Ref: 176-177
AACSB: Reflective Thinking
51) The franchisee turnover rate is the rate at which franchisees leave a franchise system.
Answer: TRUE
Diff: 1 Page Ref: 177
AACSB: Analytic Skills
52) A good method for evaluating a franchiser’s reputation is to interview existing franchise owners about the operation.
Answer: TRUE
Diff: 1 Page Ref: 177
AACSB: Analytic Skills
53) One of the first lessons in franchising is, “Do your homework before you get out your checkbook.”
Answer: TRUE
Diff: 1 Page Ref: 178
AACSB: Reflective Thinking
54) Most franchisees are better educated, more sophisticated, have more business acumen, and are more financially secure than those of just 20 years ago.
Answer: TRUE
Diff: 2 Page Ref: 180
AACSB: Reflective Thinking
55) A multi-unit franchise gives the franchisee the right to open more than one franchise outlet in a territory within a specific time frame.
Answer: TRUE
Diff: 1 Page Ref: 180-181
AACSB: Analytic Skills
56) A master franchise gives a franchisee the right to create a semi-independent organization in a particular territory to recruit, sell, and support other franchisees.
Answer: TRUE
Diff: 1 Page Ref: 183
AACSB: Analytic Skills
57) Define franchising. Explain the three types of franchising. Which is the fastest-growing segment?
Answer: A system of distribution in which semi-independent business owners (franchisees) pay fees and royalties to a parent company (franchiser) in return for the right to become identified with its trademark, to sell its products or services, and often use its business format and system. The three types of franchising are:
- Tradename
- Product distribution
- Pure (business format)
Pure franchising outlets’ sales are growing at a faster rate.
Diff: 2 Page Ref: 161-162
AACSB: Reflective Thinking
58) Outline the benefits and drawbacks of buying a franchise.
Answer: Some of the primary benefits of franchising include:
- Management and training support
- Brand name appeal
- Standardized quality of goods and services
- National advertising programs
- Financial assistance
- Proven products and business formats
- Centralized buying power
- Site selection and territorial protection
- Greater chance for success
The drawbacks of franchising include:
- Franchise fees and profit sharing
- Strict adherence to standardized operations
- Restrictions on purchasing
- Limited product line
- Unsatisfactory training programs
- Market saturation
- Less freedom
Diff: 3 Page Ref: 162-170
AACSB: Reflective Thinking
59) What is the Franchise Disclosure Document? How can this document be of value to a potential franchisee?
Answer: The law requires franchisers to register and deliver a copy to perspective franchisees before any offer or sale of a franchise. The Franchise Disclosure Document, or FDD, establishes full disclosure guidelines for any company selling franchises, outlining 23 important pieces of information. The FDD can help potential franchisees avoid being defrauded by requiring that the franchiser disclose detailed information on their operation at the first personal meeting, or at least ten days before a franchise contract is signed, or before any money is paid.
Diff: 2 Page Ref: 172
AACSB: Analytic Skills
60) Outline the recommended procedure for buying a franchise.
Answer: The most effective steps to buying a franchise are:
- Evaluate yourself
- Research your market
- Consider your franchise options
- Get a copy of the franchiser’s FDD
- Talk to existing franchisees
- Ask the franchiser some tough questions
- Make your choice
Diff: 3 Page Ref: 174-178
AACSB: Reflective Thinking
61) What are some indicators that a potential franchisee might be dealing with a dishonest franchise? What steps can a potential franchisee take to avoid becoming a victim of a dishonest franchise?
Answer: Indicators of a potentially dishonest franchise may include:
- Claims that contract is standard and “you don’t need to read it”
- Failure to provide disclosure information
- Marginally successful or no prototype
- Oral promises of future earnings with no documentation
- High turnover rate
- Poor manual or none at all
- Unusual amount of litigation
- Attempt to discourage attorney advice
- High pressure sales
- Claiming to be exempt from federal laws
- Get-rich-quick schemes
- Reluctance to provide references
- Evasive or vague answers
Steps to take may be to:
- Do your research
- Ask for the franchiser’s FDD
- Investigate the franchise thoroughly
- Apply preparation, common sense, and patience
Diff: 3 Page Ref: 174-178
AACSB: Reflective Thinking
62) Explain the following franchise concepts and give an example of each: multiple-unit franchising, intercept marketing, conversion franchising, and master franchising.
Answer:
Multi-unit franchising is a method whereby a franchisee opens more than one unit within a specific time frame.
Example: An individual or family owning all the local McDonald’s.
Intercept marketing is the principle of putting a franchise’s products or services directly in the paths of potential customers, wherever they may be.
Example: Putting a scaled-down version of a Subway sandwich shop in a gas station convenience store.
Conversion franchising is a trend in which owners of independent businesses become franchisees to gain the advantage of name recognition.
Example: An Italian restaurant owner buys a franchise like the Olive Garden restaurant.
Master franchising is a method of franchising that gives the franchisee the right to create a semi-independent organization in a particular territory to recruit, sell, and support other franchisees.
Example: An individual fluent in Spanish works to recruit as many franchisees as possible in Spain.
Diff: 3 Page Ref: 180, 183-184
AACSB: Reflective Thinking
63) Explain three trends that are currently shaping the franchising industry.
Answer: These current trends may include:
- Minority ownership
- Multiple-unit franchising
- Internationalism of American franchise system
- Master franchising
- Smaller, nontraditional locations
- Conversion franchising
- Piggyback or combination or multi-branded franchising
- Franchises serving dual-career couples and aging baby boomers
Diff: 3 Page Ref: 180-184
AACSB: Multicultural & Diversity
Mini-Case 6-1: Pipe Dreams
Ralph Emerson thought he’d been a librarian long enough, and when the opportunity arose to open a small tobacco, pipe, and cigar shop in the newly renovated downtown business district, he was ready to act. Pipe Dreams is a franchiser of smoke shops, and was founded eight years ago by a noted tobacconist in New York City. The concept for the shops is simple, yet sophisticated. It is simple in the sense that the shops sell only tobacco-related products, but sophisticated in the breadth and quality of the inventory they carry. Each franchise, depending on size, is stocked with inventory selected by the company’s founder. The franchiser finances the shop’s initial inventory. The franchisee is expected to create a decor within predetermined standards that Pipe Dreams establishes. Each franchisee must attend a three-day workshop, outlining the fundamentals of tobacco blending, the merchandising of pipes and cigars, and the techniques of successful business operation.
The franchise contract requires the franchisee to contribute 1.5 percent of gross revenue to a national advertising campaign. According to the contract, Pipe Dreams will finance the required fixtures for the store for ten years. In addition, the franchiser supplies all inventory at very favorable prices because it purchases in large quantities.
Ralph knows he can buy tobacco products from a variety of wholesalers. He also has some ideas on what would make a tobacco shop successful in this town. Ralph knows that Pipe Dreams franchisees have had a high success rate in the past.
64) Help Ralph make a decision by outlining the advantages and the disadvantages of a franchise arrangement.
Answer: This chapter outlines the advantages and disadvantages of franchise arrangements. The case suggests that the Pipe Dreams franchise (like many franchises) offers the entrepreneur a greater chance of success than “starting from scratch.”
Diff: 2 Page Ref: 162-170
AACSB: Reflective Thinking
65) Assuming that Ralph has adequate capital, would you recommend that he invest in the franchise or open his own tobacco shop? Why?
Answer: Given Ralph’s lack of experience in business, generally, and in managing a tobacco shop, specifically, it probably is wise for him to take the franchise option. Once he learns the business and gets established, he could explore the possibility of terminating the franchise relationship.
Diff: 2 Page Ref: 162-170
AACSB: Reflective Thinking
Essentials of Entrepreneurship & Small Business Management, 6e (Scarborough)
Chapter 7 Buying an Existing Business
1) The due diligence process of analyzing and evaluating an existing business:
- A) may be just as time consuming as the development of a comprehensive business plan for a start-up.
- B) helps to determine if the company will generate sufficient cash to pay for itself and leave you with a suitable rate of return on your investment.
- C) helps to determine what the company’s potential for success is.
- D) All of the above
Answer: D
Diff: 1 Page Ref: 190
AACSB: Analytic Skills
2) When done correctly, the due diligence process will:
- A) reveal both the positive and negative aspects of an existing business.
- B) be time consuming and expensive.
- C) most often result in the purchase of the business.
- D) rarely prove to be beneficial.
Answer: A
Diff: 1 Page Ref: 190
AACSB: Analytic Skills
3) Advantages to buying an existing business that you do not have with a startup include:
- A) greater access to venture capital.
- B) the opportunity to participate in a national advertising campaign.
- C) inventory is in place and trade credit is established.
- D) easy implementation of innovations and changes from past policies.
Answer: C
Diff: 2 Page Ref: 191-192
AACSB: Reflective Thinking
4) Which of the following is a potential disadvantage of purchasing an existing business?
- A) The employees inherited with the business may not be suitable.
- B) The previous owner may have created ill will among the company’s customers.
- C) Equipment and facilities may be obsolete or inefficient.
- D) All of the above
Answer: D
Diff: 1 Page Ref: 192-195
AACSB: Reflective Thinking
5) When evaluating the assets of an existing business, the inventory:
- A) is always current and salable.
- B) usually appreciates over time, making the business a bargain.
- C) should be judged on the basis of its market value, not its book value.
- D) is usually stated honestly and does not need an independent audit.
Answer: C
Diff: 2 Page Ref: 194
AACSB: Analytic Skills
6) An entrepreneur who is considering purchasing a business is analyzing a company’s accounts receivable. The following table summarizes her findings.
Age of Accounts Amount Probability of Collection
0 – 30 days $12,000 .96
31 – 60 days $ 4,000 .87
61 – 90 days $ 2,500 .71
91 – 120 days $ 1,400 .65
121 + days $ 800 .24
How much should this potential buyer be willing to pay for these accounts receivable?
- A) Nothing ; a buyer should never purchase existing accounts receivable.
- B) $20,700
- C) $17,877
- D) Not enough information given to determine
Answer: C
Diff: 3 Page Ref: 194-195
AACSB: Analytic Skills
7) The first step an entrepreneur should take when buying an existing business is to:
- A) explore financing options.
- B) prepare a list of potential candidates.
- C) analyze his or her skills, abilities, and interests in an honest self-audit.
- D) contact existing business owners in the area and ask if their companies are for sale.
Answer: C
Diff: 2 Page Ref: 196
AACSB: Reflective Thinking
8) When acquiring a business, the buyer should:
- A) conduct a self-analysis of skills, abilities, and interests.
- B) prepare a list of potential candidates.
- C) investigate potential candidates and carefully evaluate them.
- D) All of the above
Answer: D
Diff: 1 Page Ref: 196-199
9) Which of the following statements concerning financing the purchase of an existing business is true?
- A) It is usually more difficult than securing financing for a start-up business.
- B) Usually, the business seller is not a good source of financing.
- C) The buyer should be able to make the payments on the loans out of the company’s cash flow.
- D) All of the above
Answer: C
Diff: 2 Page Ref: 198
AACSB: Analytic Skills
10) Which of the following statements concerning financing the purchase of an existing business is not true?
- A) The business seller usually is a good candidate for a source of financing.
- B) The deal should allow the buyer to make the loan payment out of the company’s cash flow.
- C) The buyer should wait until late in the purchase process to arrange financing to avoid processing fees in case the deal falls through.
- D) All of the above
Answer: C
Diff: 2 Page Ref: 198
AACSB: Reflective Thinking
11) Perhaps the ideal source of financing the purchase of an existing business is:
- A) a venture capitalist.
- B) the Small Business Administration.
- C) the seller of the business.
- D) an insurance company.
Answer: C
Diff: 2 Page Ref: 198
12) To ensure a smooth transition when buying an existing business, a buyer should:
- A) communicate with employees to reduce their uncertainty and anxiety.
- B) be honest with existing employees about upcoming changes and plans for the company’s future.
- C) consider asking the seller to stay on and serve as a consultant until the transition is complete.
- D) All of the above
Answer: D
Diff: 1 Page Ref: 199
AACSB: Communication
13) The most common reasons owners of small- and medium-sized businesses give for selling their businesses are:
- A) need for money and low return on investment.
- B) boredom and burnout.
- C) low return on investment and burnout.
- D) greater opportunities working for someone else and low return on investment.
Answer: B
Diff: 2 Page Ref: 200
AACSB: Analytic Skills
14) Important factors to investigate regarding the business to be purchased include:
- A) assessing the physical assets of the business.
- B) reviewing accounts receivable and business records.
- C) reviewing contractual arrangements and assessing intangible assets.
- D) All of the above
Answer: D
Diff: 1 Page Ref: 200-201
AACSB: Analytic Skills
15) Which of the following is a criterion for a bulk transfer?
- A) The seller must give the buyer a signed, sworn list of existing creditors.
- B) The buyer and the seller must prepare a list of the property included in the sale.
- C) The buyer must give notice of the sale to each creditor at least ten days before he takes possession of the goods or pays for them.
- D) All of the above
Answer: D
Diff: 2 Page Ref: 202
AACSB: Analytic Skills
16) Laurette has entered into a contract with Jackson to purchase his retail music shop. Jackson’s lease on the existing building (which is in an excellent location) has five years remaining. If Laurette wants the lease to be part of the business sale:
- A) she should include a clause in the sales contract in which Jackson agrees to assign to her his rights and obligations under that lease.
- B) she should notify the landlord of Jackson’s assignment of the lease agreement to her.
- C) A and B are correct.
- D) None of the above. Because Jackson does not actually own the building, he can transfer no rights to it to Laurette.
Answer: C
Diff: 3 Page Ref: 202-203
AACSB: Reflective Thinking
17) Generally, a seller of an existing business can assign any contractual right to the buyer unless:
- A) the contract specifically prohibits the assignment.
- B) the contract is personal in nature.
- C) A and B are correct.
- D) None of the above. Business sellers typically cannot assign any contractual rights to buyers.
Answer: C
Diff: 2 Page Ref: 202-203
AACSB: Analytic Skills
18) During the acquisition process, the potential buyer usually must sign a ________, which is an agreement to keep all conversations and information secret and legally binds the buyer from telling anyone any information the seller shares with her.
- A) covenant not to compete
- B) nondisclosure document
- C) letter of intent
- D) purchase agreement
Answer: A
Diff: 2 Page Ref: 203
AACSB: Analytic Skills
19) Which of the following is required for the covenant not to compete to be enforceable?
- A) Part of a business sale and reasonable in scope
- B) Approved by a court of law and reasonable in scope
- C) The assistance of an attorney and approved by a court of law
- D) The registration of the due-on-sale agreement
Answer: A
Diff: 3 Page Ref: 203
AACSB: Analytic Skills
20) The three main sources of potential legal liabilities for the buyer of an existing business include all but which of the following?
- A) Problems with the physical premises, such as hazardous materials
- B) Product liability claims
- C) Labor problems and disputes
- D) Errors and omissions
Answer: D
Diff: 2 Page Ref: 203-204
AACSB: Analytic Skills
21) A toy manufacturer is sued based on the claim of injuries caused by a product it makes. This is an example of a:
- A) product liability lawsuit.
- B) promissory estoppel lawsuit.
- C) restrictive covenant lawsuit.
- D) contingent liability lawsuit.
Answer: A
Diff: 1 Page Ref: 204
AACSB: Reflective Thinking
22) When evaluating the financial position of a business he or she is considering buying, an entrepreneur should examine:
- A) its income statements and balance sheets from the past three to five years.
- B) its income tax returns for the past three to five years.
- C) the owner’s compensation and that of relatives.
- D) All of the above
Answer: D
Diff: 2 Page Ref: 204-205
AACSB: Analytic Skills
23) In a business sale, a letter of intent:
- A) states that the buyer and the seller have reached a sufficient meeting of the minds to justify the time and expense of negotiating a final agreement.
- B) should contain a clause calling for “good faith negotiations” between the parties.
- C) addresses such issues as price, payment terms, a deadline for closing the deal, and others.
- D) All of the above
Answer: D
Diff: 1 Page Ref: 206, Figure 7.2
AACSB: Analytic Skills
24) During the acquisition process, the buyer and the seller sign a ________, which spells out the parties’ final deal and represents the details of the agreement that are the result of the negotiation process.
- A) covenant not to compete
- B) nondisclosure document
- C) letter of intent
- D) purchase agreement
Answer: D
Diff: 1 Page Ref: 206, Figure 7.2
AACSB: Analytic Skills
25) Which of the following statements about valuing a business is true?
- A) The balance sheet technique is the best way to value a business.
- B) Business valuation is partly art and partly science.
- C) Buyers should rely on the seller’s industry expertise and years of experience to determine what his company is worth.
- D) Business valuation processes are consistently misleading regarding the future earning potential of a business.
Answer: B
Diff: 2 Page Ref: 207
AACSB: Reflective Thinking
26) The main reason a buyer purchases an existing business is for:
- A) its future income and profits for earning potential.
- B) its customer base and access to those customers.
- C) its tangible assets and the ability to liquidate those assets.
- D) its goodwill.
Answer: A
Diff: 2 Page Ref: 208
AACSB: Reflective Thinking
27) A method of valuing a business based on the value of the company’s net worth is the:
- A) balance sheet technique.
- B) adjusted balance sheet technique.
- C) earnings approach.
- D) opportunity cost technique.
Answer: A
Diff: 2 Page Ref: 208
AACSB: Analytic Skills
28) A valuation method that is more realistic than the balance sheet technique because it adjusts book value to reflect actual market value is the:
- A) excess earnings method.
- B) market approach.
- C) capitalization method.
- D) adjusted balance sheet method.
Answer: D
Diff: 2 Page Ref: 208
AACSB: Analytic Skills
29) Which of the following valuation methods does not consider the future income-earning potential of a business?
- A) Balance sheet technique
- B) Excess-earnings method
- C) Discounted future earnings approach
- D) Market approach
Answer: A
Diff: 3 Page Ref: 208
AACSB: Analytic Skills
30) When valuing inventory for a business sale, the most common methods used are:
- A) first-in-first-out (FIFO) and last-in-first-out (LIFO).
- B) first-in-first-out (FIFO) and average costing.
- C) cost of last purchase and replacement value of inventory.
- D) cost of last purchase and average costing.
Answer: C
Diff: 2 Page Ref: 208-210
AACSB: Analytic Skills
31) Business valuations based on balance sheet methods suffer certain disadvantages, including:
- A) they are extremely complex and are difficult to calculate.
- B) they do not consider the future earning potential of the business.
- C) they fail to take into account what is usually the largest asset a company owns: inventory.
- D) All of the above
Answer: B
Diff: 3 Page Ref: 210
AACSB: Analytic Skills
Use the following information to answer the questions below.
Baubles and Bells, a small business, is up for sale. The book value of its assets is $397,650, and its liabilities have a book value of $148,500. After adjusting for market value, total assets are worth $386,475, and total liabilities are $153,600. The business is considered to be a “normal risk” venture. The new owner (if he buys) plans to draw a salary of $28,000. Estimated earnings for the upcoming year are $88,400. Complete net earnings estimates for the next five years are:
Pessimistic Most Likely Optimistic
Year 1 $82,000 $88,400 $90,500
Year 2 $85,000 $90,000 $93,000
Year 3 $88,000 $92,500 $95,500
Year 4 $91,000 $95,000 $97,000
Year 5 $94,000 $97,000 $98,500
32) Using the adjusted balance sheet technique, what is the business worth?
- A) $397,650
- B) $386,475
- C) $249,150
- D) $232,875
Answer: B
Diff: 3 Page Ref: 208-209
AACSB: Analytic Skills
33) The valuation approach that considers the value of goodwill is the:
- A) balance sheet technique.
- B) excess earnings method.
- C) discounted future earnings approach.
- D) market approach.
Answer: B
Diff: 1 Page Ref: 210
AACSB: Analytic Skills
34) Under the excess earnings method, what is the “extra earning power” of the business?
- A) $86,219
- B) $2,181
- C) $11,175
- D) Cannot be determined from the information given
Answer: B
Diff: 3 Page Ref: 210-211
AACSB: Analytic Skills
35) Using the excess earnings method, what is the company’s “goodwill”?
- A) $6,543
- B) $33,525
- C) $15,267
- D) Cannot be determined from the information given
Answer: A
Diff: 3 Page Ref: 210-211
AACSB: Analytic Skills
36) Which of the following is considered an opportunity cost of buying an existing business?
- A) The salary that could be earned working for someone else and the owner’s investment in the business
- B) Dividends
- C) The market value of tangible assets
- D) The salary that the business has paid to previous owners
Answer: A
Diff: 2 Page Ref: 210
AACSB: Reflective Thinking
37) The amount the seller of a business receives for “goodwill” is taxed as:
- A) a long-term capital gain.
- B) regular income.
- C) superlative income.
- D) None of the above
Answer: B
Diff: 2 Page Ref: 210-212
AACSB: Analytic Skills
38) The capitalized earnings approach determines the value of a business by capitalizing its expected profits using:
- A) the interest rate that could be earned on a similar risk investment.
- B) the prime interest rate.
- C) the normal rate of return.
- D) the prevailing return of inflation.
Answer: A
Diff: 2 Page Ref: 212-213
AACSB: Analytic Skills
39) If a business buyer estimates that 20 percent is a reasonable rate of return for an existing business expected to produce a profit of $27,000, its capitalized value would be:
- A) $5,400.
- B) $32,400.
- C) $135,000.
- D) $540,000.
Answer: C
Diff: 2 Page Ref: 213
AACSB: Analytic Skills
40) In the earnings methods of business valuation, the rate of return associated with a “normal risk” business is:
- A) 15 percent.
- B) 25 percent.
- C) 35 percent.
- D) 50 percent.
Answer: B
Diff: 2 Page Ref: 213
AACSB: Analytic Skills
41) Which method of business valuation relies on three forecasts of future earnings: optimistic, pessimistic, and most likely?
- A) Balance sheet technique
- B) Excess-earnings method
- C) Discounted future earnings
- D) Market approach
Answer: C
Diff: 2 Page Ref: 213-214
AACSB: Analytic Skills
42) The ________ approach to valuing a business assumes that a dollar earned in the future is worth less than that same dollar is today.
- A) balance sheet
- B) capitalized earnings
- C) adjusted balance sheet
- D) discounted future earnings
Answer: D
Diff: 2 Page Ref: 213-214
AACSB: Analytic Skills
43) Which of the following valuation techniques is best suited for determining the value of service businesses?
- A) Discounted future earnings approach
- B) Balance sheet technique
- C) Adjusted balance sheet technique
- D) Excess earnings approach
Answer: A
Diff: 2 Page Ref: 213-214
AACSB: Analytic Skills
44) The ________ approach to valuing a business uses the price-earnings ratios of similar businesses to establish the value of a company.
- A) balance sheet
- B) capitalized earnings
- C) discounted future earnings
- D) market
Answer: D
Diff: 2 Page Ref: 214-215
AACSB: Analytic Skills
45) Which of the following is a disadvantage of the market approach to valuing a business?
- A) Necessary comparisons between publicly traded and privately owned companies
- B) Unrepresentative earnings estimates
- C) Difficulty in finding similar companies for comparison
- D) All of the above
Answer: D
Diff: 2 Page Ref: 214-215
AACSB: Analytic Skills
46) Which of the following is a drawback of the market approach of evaluation?
- A) It does not consider current earnings.
- B) It may underrepresent earnings.
- C) Its reliability depends on the forecasts of future earnings.
- D) It overemphasizes the value of goodwill.
Answer: B
Diff: 2 Page Ref: 214-215
AACSB: Analytic Skills
47) You are considering purchasing Babcock Office Supply. You estimate that the company’s earnings next year will be $67,400. You have found three similar companies whose stock is publicly traded. Their P/E ratios are 6.8, 7.4, and 7.1. Using the market approach, you estimate Babcock Office Supply to be worth:
- A) $478,540.
- B) $9,493.
- C) $67,400.
- D) $498,760.
Answer: A
Diff: 3 Page Ref: 214-215
AACSB: Analytic Skills
48) A company’s P/E ratio is:
- A) the price of one share of its common stock divided by its earnings per share.
- B) its profits per share divided by its equity per share.
- C) its profits per share divided by its excess cash flow per share.
- D) None of the above
Answer: A
Diff: 1 Page Ref: 215
AACSB: Analytic Skills
49) Some business brokers differentiate between the types of buyers: ________ buyers see buying a business as a way to generate income and ________ buyers view the purchase as part of a larger picture to offer a long-term advantage.
- A) strategic; financial
- B) financial; strategic
- C) strategic; optimistic
- D) financial; passive
Answer: B
Diff: 2 Page Ref: 215-216
AACSB: Communication
50) Which of the following strategies would not be suitable for an entrepreneur who wants to surrender control of the company gradually?
- A) Forming a family limited partnership
- B) Restructuring the company
- C) Straight business sale
- D) Using a two-step sale
Answer: C
Diff: 2 Page Ref: 216
AACSB: Analytic Skills
51) Mitchell Schlimer, founder of the Let’s Talk Business Network, a support community for entrepreneurs, says that, initially, about ________ percent of small business owners who sell their companies to larger businesses remain with the acquiring company.
- A) 40
- B) 50
- C) 70
- D) 90
Answer: D
Diff: 2 Page Ref: 217
AACSB: Reflective Thinking
52) ________ gives owners the security of a sales contract but permits them to stay at the “helm” for several years.
- A) The two-step sale
- B) A controlled sale
- C) Company restructuring
- D) An ESOP
Answer: A
Diff: 1 Page Ref: 219
AACSB: Analytic Skills
53) A(n) ________ allows owners to “cash out” by selling their companies to their employees as gradually or as quickly as they choose.
- A) two-step sale
- B) controlled sale
- C) company restructuring
- D) ESOP
Answer: D
Diff: 1 Page Ref: 219-220
AACSB: Analytic Skills
