40 Multiple Choice Questions in Finance
1. Which of the following could explain why a business might choose to organize as a corporation rather than as a sole proprietorship or a partnership?
a. Corporations generally face fewer regulations.
b. Corporations generally face lower taxes.
c. Corporations generally find it easier to raise capital.
d. Corporations enjoy unlimited liability.
e. Statements c and d are correct.
2. Which of the following statements is most correct?
a. Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority of U.S. businesses (in terms of number of businesses) are organized as corporations.
b. Most businesses (by number and total dollar sales) are organized as proprietorships or partnerships because it is easier to set up and operate in one of these forms rather than
as a corporation. However, if the business gets very large, it becomes advantageous to convert to a corporation, primarily because corporations have important tax advantages over
proprietorships and partnerships.
c. Due to legal considerations related to ownership transfers and limited liability, most business (measured by dollar sales) is conducted by corporations.
d. Statements a, b, and c are correct.
e. All of the statements are false.
3. Harmeling Enterprises experienced a decline in net operating profit after taxes (NOPAT). Which of the following definitely cannot help explain this decline?
a. Sales revenues decreased.
b. Costs of goods sold increased.
c. Depreciation increased.
d. Interest expense increased.
e. Taxes increased.
4. Which of the following statements is most correct?
a. Cash flows and accounting profit are not at all related since no common elements are used in the calculation of either individual measure.
b. Accounting profits are more important than free cash flow.
c. High inflation can seriously distort firms' balance sheets, and
since inflation also affects depreciation and inventory costs, profits can also be affected.
d. When an action is taken at one point in time, but its full effects cannot be accurately measured until later, this has the potential to affect the firm's financial statements. However, as long as the firm keeps the same standard accounting period this timing problem can be avoided.
e. None of the statements above is correct.
5. Which of the following alternatives could potentially result in a net increase in a company's free cash flow for the current year?
a. Reducing the days-sales-outstanding ratio.
b. Increasing the number of years over which fixed assets are depreciated.
c. Decreasing the accounts payable balance.
d. All of the answers above are correct.
e. Answers a and b are correct.
6. You observe that a firm's profit margin is below the industry average, its debt ratio is below the industry average, and its return on equity exceeds the industry average. What can you conclude?
a. Return on assets is above the industry average.
b. Total assets turnover is above the industry average.
c. Total assets turnover is below the industry average.
d. Both statements a and b are correct.
e. None of the statements above is correct.
7. The percentage of sales method produces accurate results unless which of the following conditions is (are) present?
a. Fixed assets are "lumpy."
b. Strong economies of scale are present.
c. Excess capacity exists because of a temporary recession.
d. Answers a, b, and c all make the percentage of sales methodinaccurate.
e. Answers a and c make the percentage of sales method inaccurate, but, as the text explains, the assumption of increasing economies of scale is built into the percentage of sales method.
8. A firm has the following balance sheet:
Cash $ 20 Accounts payable $ 20
Accounts receivable 20 Notes payable 40
Inventory 20 Long-term debt 80
Fixed assets 180 Common stock 80
Retained earnings 20
Total assets $240 and equity $240
Sales for the year just ended were $400, and fixed assets were used at 80 percent of capacity, but its current assets were at optimal levels. Sales are expected to grow by 5 percent next year, the profit margin is 5 percent, and the dividend payout ratio is 60 percent.
How much additional funds (AFN) will be needed?
b. -$6.4 (Surplus)
d. -$4.6 (Surplus)
9. Which of the following statements is correct?
a. The New York Stock Exchange is an organized auction market.
b. Money markets include markets for consumer automobile loans.
c. If an investor sells shares of stock through a broker, then it would be a primary market ransaction.
d. Capital market transactions involve only the purchase and sale of equity securities.
e. None of the answers above is correct.
10. Your company has the following balance sheet (in millions of dollars):
Current assets $4.0 Accounts payable $0.8
Net fixed assets 4.0 Notes payable 1.0
Accrued wages and taxes 0.2
Total current liabilities $2.0
Long-term debt 1.5
Common equity 1.5
Retained earnings 3.0
Total assets $8.0 Total liabilities and equity $8.0 You have determined the following facts: (1) last year's sales were $10 million; (2) the company will pay out 40 percent of earnings as dividends; (3) a profit margin of 3 percent is projected; (4) fixed assets were used to full capacity; and (5) all assets as well as spontaneous liabilities as shown on the balance sheet are expected to grow proportionally with sales. Further, your boss estimates she will need to raise $2 million externally by issuing new debt or common stock next year. If the above assumptions hold, what rate
of sales growth is your boss expecting? (Hint: You can use the AFN equation to help answer this problem.)
11. Which of the following statements is most correct?
a. The slope of the security market line is beta.
b. A stock with a negative beta must have a negative required rate of return.
c. If a stock's beta doubles its required rate of return must double.
d. If a stock has a beta equal to 1.0, its required rate of return will be unaffected by changes in the market risk premium.
e. None of the above statements is correct.
12. Inflation, recession, and high interest rates are economic events which are characterized as
a. Company-specific risk that can be diversified away.
b. Market risk.
c. Systematic risk that can be diversified away.
d. Diversifiable risk.
e. Unsystematic risk that can be diversified away.
13. Which of the following statements is most correct?
a. An efficient portfolio is one that provides the highest expected
rate of return for a given amount of risk.
b. An efficient portfolio is one that has the lowest amount of risk for a given expected rate of return.
c. The set of efficient portfolios is the same whether or not a risk free asset is considered.
d. Both a and b are correct.
e. Both a and c are correct.
14. Which of the following statements is most correct?
a. The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.
b. The slope of the CML is (�� k - k M RF)/ bM .
c. All portfolios that lie on the CML to the right of ΦM are inefficient.
d. All portfolios that lie on the CML to the left of ΦM are inefficient.
e. None of the above statements are correct.
15. Which of the following investments has the highest effective return (EAR)? (Assume that all CDs are of equal risk.)
a. A bank CD which pays 10 percent interest quarterly.
b. A bank CD which pays 10 percent monthly.
c. A bank CD which pays 10.2 percent annually.
d. A bank CD which pays 10 percent semiannually.
e. A bank CD which pays 9.6 percent daily (on a 365-day basis).
16. Assume you are to receive a 20-year annuity with annual payments of $50. The first payment will be received at the end of Year 1, and the last payment will be received at the end of Year 20. You will invest each payment in an account that pays 10 percent. What will be the value in your account at the end of Year 30?
17. A 10-year corporate bond has an annual coupon payment of 9 percent. The bond is currently selling at par ($1,000). Which of the following statements is most correct?
a. The bond's yield to maturity is 9 percent.
b. The bond's current yield is 9 percent.
c. If the bond's yield to maturity remains constant, the bond's price will remain at par.
d. Both answers a and c are correct.
e. All of the answers above are correct.
18. Assume that all interest rates in the economy decline from 10 percent to 9 percent. Which of the following bonds will have the largest percentage increase in price?
a. A 10-year bond with a 10 percent coupon.
b. An 8-year bond with a 9 percent coupon.
c. A 10-year zero coupon bond.
d. A 1-year bond with a 15 percent coupon.
e. A 3-year bond with a 10 percent coupon.
19. Which of the following statements is most correct?
a. If a market is strong-form efficient this implies that the returns on bonds and stocks should be identical.
b. If a market is weak-form efficient this implies that all public information is rapidly incorporated into market prices.
c. If your uncle earns a return higher than the overall stock market, this means the stock market is inefficient.
d. Both answers a and b are correct.
e. None of the above answers is correct.
20. Which of the following statements is false?
a. When a corporation's shares are owned by a few individuals who are associated with or are the firm's management, we say that the firm is "closely held."
b. A publicly owned corporation is simply a company whose shares are held by the investing public, which may include other corporations and institutions as well as individuals.
c. Going public establishes a true market value for the firm and ensures that a liquid market will always exist for the firm's shares.
d. When stock in a closely held corporation is offered to the public for the first time the transaction is called "going public" and the market for such stock is called the new issue market.
e. It is possible for a firm to go public, and yet not raise any additional new capital.
21. Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting?
a. Long-term debt.
b. Common stock.
c. Short-term debt used to finance seasonal current assets.
d. Preferred stock.
e. All of the above are considered capital components for WACC and capital budgeting purposes.
22. In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute or controversy?
a. The expected rate of return on the market, kM.
b. The stock's beta coefficient, bi.
c. The risk-free rate, kRF.
d. The market risk premium (RPM).
e. All of the above are subject to dispute.
23. Which of the following is not a barrier to a hostile takeover?
a. Nonpecuniary benefits.
b. Targeted share repurchases.
c. Shareholder rights provision.
d. Restricted voting rights.
e. Poison pill.
24. A company forecasts free cash flow of $40 million in three years. It expects the free cash flow to grow at a constant rate of 5 percent thereafter. If the weighted average cost of capital is 10 percent and the cost of equity is 15 percent, what is the horizon value, to the nearest million?
a. $280 million
b. $400 million
c. $420 million
d. $800 million
e. $840 million
25. Which of the following statements is most correct?
a. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate while the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider the inflation premium.
e. The IRR method does not consider all relevant cash flows, and particularly cash flows beyond the payback period.
26. Using the corporate valuation model, the value of a company's operations is $750 million. The company's balance sheet shows $50 million in short-term investments that are unrelated to operations. The balance sheet also shows $100 million in accounts payable, $100 million in notes payable, $200 million in long-term debt, $40 million in common stock (par plus paid-in-capital), and $160 million in retained earnings. What is your best estimate for the market value
a. $200 million
b. $300 million
c. $400 million
d. $500 million
e. $600 million
27. When evaluating a new project, the firm should consider all of the following factors except:
a. Changes in working capital attributable to the project.
b. Previous expenditures associated with a market test to
determine the feasibility of the project, if the expenditures have been expensed for tax purposes.
c. The current market value of any equipment to be replaced.
d. The resulting difference in depreciation expense if the project involves replacement.
e. All of the statements above should be considered.
28. Which of the following statements is most correct?
a. The MIRR method will always arrive at the same conclusion as the NPV method.
b. The MIRR method can overcome the multiple IRR problem, while the NPV method cannot.
c. The MIRR method uses a more reasonable assumption about reinvestment rates than the IRR method.
d. Statements a and c are correct.
e. All of the above statements are correct.
29. The value of an option depends on the stock's price, the risk-free rate, and the
a. Exercise price.
b. Variability of the stock price.
c. Option's time to maturity.
d. All of the above.
e. None of the above.
30. Warnes Motors' stock is trading at $20 a share. Call options that expire in three months with an exercise price of $20 have a price of $1.50. Which of the following will occur if the stock price increases 10 percent to $22 a share?
a. The price of the call option will increase by $2.
b. The price of the call option will increase by more than $2.
c. The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10 percent.
d. The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10 percent.
e. The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10 percent.
31. Which of the following would increase the likelihood that a company would increase its debt ratio in its capital structure?
a. An increase in costs incurred when filing for bankruptcy.
b. An increase in the corporate tax rate.
c. An increase in the personal tax rate.
d. A decrease in the firm's business risk.
e. Statements b and d are correct.
32. Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A's basic earning power (BEP) exceeds its cost of debt financing (kd). Which of
the following statements is most correct?
a. Company A has a higher return on assets (ROA) than Company B.
b. Company A has a higher times interest earned (TIE) ratio than Company B.
c. Company A has a higher return on equity (ROE) than Company B, and its risk, as measured by the standard deviation of ROE, is also higher than Company B's.
d. Statements b and c are correct.
e. All of the statements above are correct.
33. The trade-off theory provides several insights to financial managers concerning optimal capital structure. Which of the following insights is false?
a. Other things equal, firms with large amounts of marketable fixed assets should use more debt financing than firms whose value stems mostly from intangible assets.
b. Other things equal, firms with high corporate tax rates should use less debt financing than firms with low tax rates.
c. Other things equal, firms with high business risk should use less debt financing than firms with low business risk.
The following information applies to the next problem.
The Kimberly Corporation is a zero growth firm with an expected EBIT of $100,000 and a corporate tax rate of 30 percent. Kimberly uses $500,000 of 12.0 percent debt financing, and the cost of equity to an unlevered firm in the same risk class is 16.0 percent.
34. What is the value of the firm according to MM with corporate taxes?
35. Which of the following would not have an influence on the optimal dividend policy?
a. The possibility of accelerating or delaying investment projects.
b. A strong shareholders' preference for current income versus capital gains.
c. Bond indenture constraints.
d. The costs associated with selling new common stock.
e. All of the statements above can have an effect on dividend policy.
36. Which of the following is not an advantage of going public?
a. It allows a firm's founders to diversify their holdings.
b. It increases the liquidity of the stock.
c. It establishes a value for the firm.
d. It makes it easier to raise new equity capital in the future.
e. All of the above are advantages of going public.
37. McGwire Company's pension fund projected that a significant number of its employees would take advantage of an early retirement program the company plans to offer in five years.
Anticipating the need to fund these pensions, the firm bought zero coupon U.S. Treasury Trust Certificates maturing in five years. When these instruments were originally issued, they were 12
percent coupon, 30-year U.S. Treasury bonds. The stripped Treasuries are currently priced to yield 10 percent. Their total maturity value is $6,000,000. What is their total cost (price) to
a. $ 553,776
38. Reading Railroad's common stock is currently priced at $30, and its 8 percent convertible debentures (issued at par, or $1,000) are priced at $850. Each debenture can be converted into 25 shares of common stock at any time before 2005. What is the conversion price, CP, and
the conversion value of the bond?
a. $25.00; $1,000
b. $25.00; $ 750
c. $40.00; $ 750
d. $40.00; $ 850
e. $40.00; $1,000
39. Which of the following is typically part of the cash budget?
a. Payments lag.
b. Payment for plant construction.
c. Cumulative cash.
d. All of the above.
e. Only answers a and c above.
40. Assume that Sunshine Products Inc. has an agreement with Shady Finance Company to factor its receivables. Shady charges a flat commission of 2 percent of the receivables factored, plus 6 percent a year interest on the outstanding balance. It also deducts a reserve of 10 percent for returned and damaged materials. Interest and commission are paid in advance. No interest is charged on the reserve or the commission. If the average level of outstanding receivables is $700,000, and if they are turned over 4 times a year (hence the commission is paid 4 times a year), then what is the effective quarterly interest rate charged by Shady for this arrangement?
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