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True/False and Multiple Choice Finance Problem Set

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1. The money market is usually thought of as dealing with long-term debt instruments issued by firms with excellent credit ratings.

2. For a firm to have its securities listed on an exchange, it must meet certain requirements.
These usually include measures of profitability, size, market value, and public ownership.

3. When fixed expenses increase relative to sales, it indicates that there is not enough productive
capacity to absorb an increase in sales.

4. The more frequent the compounding periods in a year, the higher the future value.

5. In measuring cash flows we are interested only in the incremental or differential after-tax cash flows that are attributed to the investment proposal being evaluated.

6. Additional cash needed to fill increased working capital requirements should be included in the initial cost of a product when analyzing an investment.

7. The weighted average cost of capital is the minimum required return that must be earned on additional investment if firm value is to remain unchanged.

8. The weighted cost of capital assumes that the company maintains a constant dividend payout ratio.

9. In most instances, as the amount of debt rises, the common stockholders will decrease their required rate of return.

10. The objective of hedging strategy is to have a zero net asset position in a foreign currency.

Multiple Choice

11. Which of the following is not an advantage of a private placement (as compared to a public offering)?
a. Greater financing flexibility
b. Lower flotation costs
c. Lower interest costs
d. Quicker availability of funds

12. The demand for funds by the federal government puts upward pressure on interest rates causing private investors to be pushed out of the financial markets. This is called:
a. the big squeeze.
b. the efficient market hypothesis.
c. the crowding out effect.
d. liquidity preference.
e. government intervention.

13. The opportunity cost is defined as the:
a. rate of return based on historical costs.
b. rate of return available to an investor for a given level of risk.
c. cost associated with the acquisition of investments.
d. future value of the purchase price.

14. The percent-of-sales method can be used to forecast:
a. expenses.
b. assets.
c. liabilities.
d. all of the above.

15. Which of the following statements about the percent-of-sales method of financial forecasting is true?
a. It is the least commonly used method of financial forecasting.
b. It is a much more precise method of financial forecasting than a cash budget would be.
c. It involves estimating the level of an expense, asset, or liability for a future period as a percent of the forecast for sales revenues.
d. It projects all liabilities as a fixed percentage of sales.

16. Which of the following will increase cumulative borrowing in the cash budget?
a. Decreasing the average collection period
b. Increasing purchases
c. Decreasing depreciation expense
d. Both a and c
e. All of the above

17. A company collects 60% of its sales during the month of the sale, 30% one month after the sale, and 10% two months after the sale. The company expects sales of $10,000 in August, $20,000 in September, $30,000 in October, and $40,000 in November. How much money is expected to be collected in October?
a. $25,000
b. $15,000
c. $35,000
d. None of the above

18. The present value of a perpetuity decreases when the _______ decreases.
a. number of investment periods
b. annual discount rate
c. perpetuity payment
d. both b and c

19. Which of the following would decrease free cash flows? A decrease in:
a. depreciation expense.
b. interest expense.
c. incremental sales.
d. both a & c.
e. all of the above.

20. Exchange rate risk:
a. arises from the fact that the spot exchange rate on a future date is a random variable.
b. applies only to certain types of international businesses.
c. has been phased out due to recent international legislation.
d. both a and b.

Problems (Please remember to show your calculations)

21. The treasurer for Brookdale Clothing must decide how much money the company needs to borrow in July. The balance sheet for June 30, 2004 is presented below:

Brookdale Clothing Balance Sheet
June 30, 2004
Cash $75,000 Accounts payable $ 400,000
Marketable securities 100,000 Long-term debt 300,000
Accounts receivable 300,000 Common stock 100,000
Inventory 250,000 Retained earnings 200,000
Total current assets 725,000 Total liabilities and
Fixed assets 275,000 stockholder's equity $1,000,000
Total assets $1,000,000

The company expects sales of $250,000 for July. The company has observed that 25% of its sales is for cash and that the remaining 75% is collected in the following month. The company plans to purchase $400,000 of new clothing. Usually 40% of purchases is for cash and the remaining 60% of purchases is paid in the following month. Salaries are $100,000 per month, lease payments are $50,000 per month, and depreciation charges are $20,000 per month. The company plans to purchase a new building for $200,000 in July and sell its marketable securities for $100,000. If the company must maintain a minimum cash balance of $50,000, how much money must the company borrow in July?

22. How does the risk-return tradeoff relate to the time value of money and the multinational firm?

23. You are planning to deposit $10,000 today into a bank account. Five years from today you expect to withdraw $7,500. If the account pays 5% interest per year, how much will remain in the account eight years from today?

24. What is the value (price) of a bond that pays $400 semiannually for 10 years and returns $10,000 at the end of 10 years? The market discount rate is 10% paid semiannually.

25. Frank Zanca is considering three different investments that his broker has offered to him. The different cash flows are as follows:

End of Year A B C
1 300 400
2 300
3 300
4 300 300 600
5 300
6 300
7 300
8 300 600

Because Frank has enough savings for only one investment, his broker has proposed the third alternative to be, according to his expertise, the best in town. However, Frank questions his broker and wants to eliminate the present value of each investment. Assuming a 15% discount rate, what is Frank's best alternative?

26. Combs, Inc. is issuing new common stock at a market price of $22. Dividends last year were $1.15 per share and are expected to grow at a rate of 7%. Flotation costs will be 5% of the market price. What is Combs, Inc.'s cost of external equity?

27. Company K is considering two mutually exclusive projects. The cash flows of the projects are as follows:
Year Project A Project B
0 -$2,000 -$2,000
1 $500
2 $500
3 $500
4 $500
5 $500
6 $500
7 $500 $5,650
a. Compute the NPV and IRR for the above two projects, assuming a 13%
required rate of return.
b. Discuss the ranking conflict.
c. Which of these two projects should be chosen?

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The solution provides a solution for various problems including net present value computation, cash budgeting, internal rate of return estimation, bond valuation, opportunity cost etc.

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Financial Management Questions- Short answers and Multiple Choice

Short Answer

1. What is the difference between stock price maximization and profit maximization? Under what conditions might profit maximization not lead to stock price maximization?

2. Assume that you are serving on the board of directors of a medium-sized corporation and that you are responsible for establishing the compensation policies of senior management. You believe that the company's CEO is very talented, but your concerns is that she is always looking for a better job and may want to boost the company's short-run performance (perhaps at the expense of long-run profitability) to make herself more marketable to other corporations. What effect would these concerns have on the compensation policy you put in place

3. What is free cash flow? Why is it the most important measure of cash flow?

4. If you were starting a business, what tax considerations might cause you to prefer to set it up as a proprietorship or a partnership rather than as a corporation?

5. How does inflation distort ratio analysis comparisons, both for one company over time (trend analysis) and when different companies are compared? Are only balance sheet items of both balance sheet and income statement items affected?

6. Over the past year, my company has realized an increase in its current ratio and a drop in its total assets turnover ratio. However, the company's sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes?

7. If investors' aversion to risk increased, would the risk premium on a high-beta stock increase more or less than that on a low-beta stock? Explain.

8. If a company's beta were to double, would its expected return double?



1. If a firm's managers want to maximize stock price it is in their best interests to operate efficient, low-cost plants, develop new and safe products that consumers want, and maintain good relationships with customers, suppliers, creditors, and the communities in which they operate.

a. True
b. False

2. An agency relationship exists when one or more persons hire another person to perform some service but withhold decision-making authority from that person.

a. True
b. False

3. Financial Managers and accountants perform the same functions in a firm.

a. True
b. False

4. Which of the following statements is true?

a. One of the benefits of incorporating your business is that you become entitled to receive unlimited liability.
b. Sole proprietorships are subject to more regulations than corporations.
c. Sole proprietorships do not have to pay corporate tax.
d. All of the above are correct.
e. None of the answers above is correct.

5. Which of the following actions are likely to reduce the agency problem between stockholders and managers?

a. Congress passes a law that severely restricts hostile takeovers.
b. A manager receives a lower salary but receives additional shares of the company's stock.
c. The board of directors has become more vigilant in its oversight of the company's management.
d. Statements b and c are correct.
e. All of the statements above are correct.

6. The annual report contains four basic financial statements: the income statement; balance sheet; statement of cash flows; and statement of retained earnings.

a. True
b. False

7. Taxes, payment patterns, and reporting considerations, as well as credit sales and non-cash costs, are reasons why operating cash flows can differ from accounting profits.

a. True
b. False

8. Net operating working capital is equal to the operating current assets minus the operating current liabilities.

a. True
b. False

9. Which of the following statements is most correct?

a. Indexing tax brackets reduces the extent of "bracket creep."
b. Bonds issued by a municipality such as the city of Miami would carry a lower interest rate than bonds with the same risk and maturity issued by a private corporation such as Florida Power & Light.
c. Our federal tax laws tend to encourage corporations to finance with debt rather than with equity securities.
d. Our federal tax laws encourage the managers of corporations with surplus cash to invest it in stocks rather than in bonds. However, other factors may offset tax considerations.
e. All of the statements above are true.

10. Which of the following best describes free cash flow?

a. Free cash flow is the amount of cash flow available for distribution to all investors after all necessary investments in operating capital have been made.
b. Free cash flow is the amount of cash flow available for distribution to shareholders after all necessary investments in operating capital have been made.
c. Free cash flow is the net change in the cash account on the balance sheet.
d. Free cash flow is equal to net income plus depreciation.
e. Free cash flow is equal to the cash flow from non-taxable transactions.

11. The current ratio and inventory turnover ratio measure the liquidity of a firm. The current ratio measures the relationship of a firm's current assets to its current liabilities and the inventory turnover ratio measures how rapidly a firm turns its inventory back into a "quick" asset or cash.

a. True
b. False

12. The degree to which the managers of a firm attempt to magnify the returns to owners' capital through the use of financial leverage is captured in debt management ratios.

a. True
b. False

13. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operations.

a. True
b. False

14. Determining whether a firm's financial position is improving or deteriorating requires analysis of more than one set of financial statements. Trend analysis is one method of measuring a firm's performance over time.

a. True
b. False

15. Which of the following statements is most correct about Economic Value Added (EVA)?

a. If a company has no debt, its EVA equals its net income.
b. If a company has positive ROE, its EVA must also be positive.
c. A company's EVA will be positive whenever the cost of equity exceeds the ROE.
d. All of the statements above are correct.
e. None of the statements above is correct.

16. 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.

17. Which of the following statements is most correct?

a. Many large firms operate different divisions in different industries, and this makes it hard to develop a meaningful set of industry benchmarks for these types of firms.
b. Financial ratios should be interpreted with caution because there exist seasonal and accounting differences that can reduce their comparability.
c. Financial ratios should be interpreted with caution because it may be difficult to say with certainty what is a "good" value. For example, in the case of the current ratio, a "good" value is neither high nor low.
d. Ratio analysis facilitates comparisons by standardizing numbers.
e. All of the statements above are correct.

18. If we develop a weighted average of the possible return outcomes, multiplying each outcome or "state" by its respective probability of occurrence for a particular stock, we can construct a payoff matrix of expected returns.

a. True
b. False

19. The tighter the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation.

a. True
b. False

20. If investors become more averse to risk, the slope of the Security Market Line (SML) will increase.

a. True
b. False

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