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Multiple Choice Questions in Finance

1. For accounting purposes, which of the following conditions would automatically cause a lease to be a capital lease?
a. The lessee can purchase the asset below fair market value at the end of the lease.
b. The lease transfers ownership of the asset to the lessee by the end of the lease.
c. The lease term is more than 75% of the asset's economic life.
d. The present value of the lease payments is more than 90% of the asset's market value at lease inception.
e. All of the above would lead to the lease being considered a capital lease.

2. Which of the following correctly state one of the criteria of a capital lease as set forth in FAS 13?
I. the lessee can purchase the asset at fair market value at the end of the lease term
II. the present value of the lease payments is at least 90 percent of the fair market value of the asset at the beginning of the lease term
III. the lease term is 60 percent or more of the estimated economic life of the asset
IV. the lease transfers ownership of the property to the lessee by the end of the lease term
a. I and II only
b. II and III only
c. III and IV only
d. II and IV only
e. I and III only

3. The WACC is not used in the lease versus purchase decision because:
a. the WACC was used in the decision to acquire the asset, this is only a financing decision.
b. the WACC is used only when a lease alone is considered and not a lease versus purchase.
c. the WACC does not include the lease cost of capital and therefore should not be used.
d. tax rates of the lessor may be different than the lessee and therefore the WACC is incorrect.
e. when a bank arranges a lease they do not consider the lessee's cost of capital.

4. A lease is likely to be most beneficial to both parties when:
a. the lessor's tax rate is lower than the lessee's.
b. the lessor's tax rate is higher than the lessee's.
c. the lessor's tax rate is equal to the lessee's.
d. a lease cannot be beneficial to both parties.
e. a lease always has zero NPV, so both parties always break even.

5. Debt displacement is associated with leases because:
a. all assets not purchased with equity use debt financing.
b. debt is always a cheaper source of financing and preferred to equity financing.
c. FAS 13 and the IRS mandate debt displacement.
d. lease financing is all debt and causes an imbalance in the optimal debt to equity ratio which reduces future debt financing.
e. None of the above.

6. To meet IRS guidelines for leasing, the lease should:
a. limit the lessee's right to issue debt or pay dividends while the lease is operative.
b. not limit the lessee's right to issue debt or pay dividends while the lease is operative.
c. pay a very high return to the lessor.
d. transfer ownership of the asset at the end of the lease at below fair market value.
e. be over 30 years.

7. The difference between an American call and a European call is that the American call:
a. has a fixed exercise price while the European exercise price can vary within a small range.
b. is a right to buy while a European call is an obligation to buy.
c. has an expiration date while the European call does not.
d. is written on 100 shares of the underlying security while the European call covers 1,000 shares.
e. can be exercised at any time up to the expiration date while the European call can only be exercised on the expiration date.

8. Which one of the following will cause the value of a call to decrease?
a. lowering the exercise price
b. increasing the time to expiration
c. increasing the risk-free rate
d. lowering the risk level of the underlying security
e. increasing the stock price

9. You own stock in a firm that has a pure discount loan due in six months. The loan has a face value of $50,000. The assets of the firm are currently worth $62,000. The stockholders in this firm basically own a _____ option on the assets of the firm with a strike price of:
a. put; $62,000.
b. put; $50,000.
c. warrant; $62,000.
d. call; $62,000.
e. call; $50,000.

10. You sold a put contract on EDF stock at an option price of $.40. The option had an exercise price of $20. The option was exercised. Today, EDF stock is selling for $19 a share. What is your total profit or loss on all of your transactions related to EDF stock assuming that you close out your positions in this stock today? Ignore transaction costs and taxes.
a. -$140
b. -$60
c. $40
d. $60
e. $140

11. Shareholders in a leveraged firm might wish to accept a negative net present value project if:
a. it increases the standard deviation of the returns on the firm's assets.
b. it lowers the variance of the returns on the firm's assets.
c. it lowers the risk level of the firm.
d. it diversifies the cash flows of the firm.
e. it decreases the risk that a firm will default on its debt.

12. Which of the following would harm the position of a warrant holder?
a. a 3 for 1 stock split
b. a large stock dividend of 20%
c. a large cash dividend
d. listing of the warrants on the NYSE
e. None of the above would harm the warrant holders.

13. Common announces a major expansion into Internet services. This announcement causes the price of Common stock to increase, but also causes an increase in price volatility of the stock. Which of the following correctly identifies the impact of these changes on the put option of Common?
a. Both changes cause the price of the put option to decrease.
b. Both changes cause the price of the put option to increase.
c. The greater uncertainty will cause the price of the put option to decrease. The higher price of the stock will cause the price of the put option to increase.
d. The greater uncertainty will cause the price of the put option to increase. The higher price of the stock will cause the price of the put option to decrease.
e. The greater uncertainty has no direct effect on the price of the put option. The higher price of the stock will cause the price of the put option to decrease.

14. The gain from exercising a warrant is similar to the gain from exercising a call option except:
a. the gain on a warrant is greater by the fraction of warrant shares divided by total shares.
b. the gain on a warrant is limited by the firm's value after being reduced by the debt of the firm.
c. the gain on a warrant is decreased by the fraction of original shares divided by total post exercise shares.
d. Both A and B.
e. Both B and C.

15. Myers has warrants outstanding that grant the holder the right to purchase two shares of stock at an exercise price of $22 a share. The stock of Myers is currently selling for $24.60 a share. What is the minimum value of one warrant?
a. $1.30
b. $2.60
c. $3.40
d. $4.80
e. $5.20

16. A convertible bond has an option value which is equal to:
a. the market value of the convertible bond minus the straight bond value.
b. The market value of the convertible bond minus the conversion value.
c. the market value of the convertible bond minus the conversion premium.
d. the market value of the convertible bond minus the maximum of the straight bond value or conversion value.
e. None of the above.

17. Transfer or expropriation of wealth from bondholders to stockholders is less likely to occur when:
a. subordinated straight debt is issued because there are other senior bondholders to protect them.
b. convertible debt is issued because the equity component will reduce these agency costs when value is shared.
c. convertible debt is issued because the holders can more readily sue when a high-risk project is under taken.
d. subordinated debt because monitoring is much easier with subordinated straight debt is issued.
e. None of the above.

18. Based on empirical studies, firms tend to call convertible bonds when the conversion value is:
a. less than the conversion price.
b. greater than the straight bond value.
c. greater than the call price.
d. less than the face value.
e. None of the above.

19. If the producer of a product has entered into a fixed price sale agreement for that output, the producer faces:
a. a nice steady profit because the output price is fixed.
b. an uncertain profit if the input prices are volatile. This risk can be reduced by a short hedge.
c. an uncertain profit if the input prices are volatile. This risk can be reduced by a long hedge.
d. a modest profit if the input prices are stable. This risk can be reduced by a long hedge.
e. a modest profit if the input prices are stable. This risk can be reduced by a short hedge.

20. To protect against interest rate risk, the mortgage banker should:
a. buy futures, as this position will hedge loses if rates rise.
b. sell futures, as this position will hedge losses if rates rise.
c. sell futures, as this position will add to his gains if rates rise.
d. buy futures, as this position will add to his gains if rates rise.
e. None of the above.

21. A bond manager who wishes to hold the bond with the greatest potential volatility would be wise to hold:
a. short-term, high-coupon bonds.
b. long-term, low-coupon bonds.
c. long-term, zero-coupon bonds.
d. short-term, zero-coupon bonds.
e. short-term, low-coupon bonds.

22. Interest rate and currency swaps allow one party to exchange a:
a. floating interest rate or currency value for a fixed value over the contract term.
b. fixed interest rate or currency value for a lower fixed value over the contract term.
c. floating interest rate or currency value for a lower floating value over the contract term.
d. fixed interest rate position for a currency position over the contract term.
e. None of the above.

23. The sale of stock in a wholly owned subsidiary via an initial public offering is referred to as a(n):
a. split-up.
b. equity carve-out.
c. countertender offer.
d. white knight transaction.
e. lockup transaction.

24. When evaluating an acquisition, you should:
a. concentrate on book values and ignore market values.
b. focus on the total cash flows of the merged firm.
c. apply the rate of return that is relevant to the incremental cash flows.
d. ignore any one-time acquisition fees or transaction costs.
e. ignore any potential changes in management.

25. A proposed acquisition may create synergy by:
I. increasing the market power of the combined firm.
II. improving the distribution network of the acquiring firm.
III. providing the combined firm with a strategic advantage.
IV. reducing the utilization of the acquiring firm's assets.
a. I and III only
b. II and III only
c. I and IV only
d. I, II, and III only
e. I, II, III, and IV

26. The purchase accounting method for mergers require that:
a. the excess of the purchase price over the fair market value of the target firm be recorded as a one-time expense on the income statement of the acquiring firm.
b. goodwill be amortized on a yearly basis.
c. the equity of the acquiring firm be reduced by the excess of the purchase price over the fair market value of the target firm.
d. the assets of the target firm be recorded at their fair market value on the balance sheet of the acquiring firm.
e. the excess amount paid for the target firm be recorded as a tangible asset on the books of the acquiring firm.

27. If a firm wants to take over another firm but feels the attempt to do so will be viewed as unfriendly it could decide to take a _____ approach to the acquisition.
a. crown jewel
b. shark repellent
c. bear hug
d. countertender offer
e. lockup

28. What is the absolute priority rule of the following claims once a corporation is determined to be bankrupt?
a. administrative expenses, wages claims, government tax claims, debtholder and then equityholder claims
b. administrative expenses, wages claims, government tax claims, equityholder and then debtholder claims
c. wage claims, administrative expenses, debtholder claims, government tax claims and equityholder claims
d. wage claims, administrative expenses, debtholder claims, equityholder claims and government tax claims
e. None of the above.

29. Equityholders may prefer a formal bankruptcy filing because:
a. the firm can issue debtor in possession debt.
b. they can delay pre-bankruptcy interest payments.
c. the lack of information about the length and magnitude of the cash flow problem favors equityholders.
d. All of the above.
e. None of the above.

30. The key intuition of a Z-score model like Altman's is that:
a. only publicly traded firms can be evaluated.
b. one will be just as well off by guessing on default rates.
c. all corporations will default at least once.
d. financial profiles of bankrupt and non-bankrupt firms are very different one year before bankruptcy.
e. privately traded firms have better financial information which are disclosed to lenders and need not rely on any efficient market notions.

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Please see the attached file:
1.         For accounting purposes, which of the following conditions would automatically cause a lease to be a capital lease?
a. The lessee can purchase the asset below fair market value at the end of the lease.
b. The lease transfers ownership of the asset to the lessee by the end of the lease.
c. The lease term is more than 75% of the asset's economic life.
d. The present value of the lease payments is more than 90% of the asset's market value at lease inception.
e. All of the above would lead to the lease being considered a capital lease.

Answer: e. All of the above would lead to the lease being considered a capital lease.

2.         Which of the following correctly state one of the criteria of a capital lease as set forth in FAS 13?
I. the lessee can purchase the asset at fair market value at the end of the lease term
II. the present value of the lease payments is at least 90 percent of the fair market value of the asset at the beginning of the lease term
III. the lease term is 60 percent or more of the estimated economic life of the asset
IV. the lease transfers ownership of the property to the lessee by the end of the lease term
a. I and II only
b. II and III only
c. III and IV only
d. II and IV only
e. I and III only

Answer: d. II and IV only

The four criteria as per FAS 13 for classification as a capital lease are:

1. Transfer of title: ownership of the asset is transferred to the lessee at the end of the lease term;
2. Bargain purchase option: the lease contains a bargain purchase option to buy the equipment at less than fair market value;.
3. the lease term equals or exceeds 75% of the asset's estimated useful life;
4. the present value of the lease payments equals or exceeds 90% of the total original cost of the equipment.

(source: http://en.wikipedia.org/wiki/Finance_lease)

I is incorrect as the asset has to be purchased at less than fair market value
III is incorrect as the lease term is 75 % or more than the estimated economic life

3.         The WACC is not used in the lease versus purchase decision because:
a. the WACC was used in the decision to acquire the asset, this is only a financing decision.
b. the WACC is used only when a lease alone is considered and not a lease versus purchase.
c. the WACC does not include the lease cost of capital and therefore should not be used.
d. tax rates of the lessor may be different than the lessee and therefore the WACC is incorrect.
e. when a bank arranges a lease they do not consider the lessee's cost of capital.

Answer: a. the WACC was used in the decision to acquire the asset, this is only a financing decision.

The decision is a choice between leasing the asset and boorowing and purchasing the asset. This is a financing decision. The evaluation is based on the premise that that the investment proposal has already been accepted. Leasing is the functional equivalent of debt financing - it is an alternative to borrowing and purchasing the asset. Therefore the appropriate discount rate is the after tax cost of debt.

4.         A lease is likely to be most beneficial to both parties when:
a. the lessor's tax rate is lower than the lessee's.
b. the lessor's tax rate is higher than the lessee's.
c. the lessor's tax rate is equal to the lessee's.
d. a lease cannot be beneficial to both parties.
e. a lease always has zero NPV, so both parties always break even.

Answer: b. the lessor's tax rate is higher than the lessee's.

Lessor with a higher tax rate purchases the asset and leases it to the lessee with the lower tax rate. The lessor obtains the tax benefits which are greater because of the higher tax rates. The lessee gains by sharing some of the tax benefits.

5 Debt displacement is associated with leases because:
a. all assets not purchased with equity use debt financing.
b. debt is always a cheaper source of financing and preferred to equity financing.
c. FAS 13 and the IRS mandate debt displacement.
d. lease financing is all debt and causes an imbalance in the optimal debt to equity ratio which reduces future debt financing.
e. None of the above.

Answer: d. lease financing is all debt and causes an imbalance in the optimal debt to equity ratio which reduces future debt financing.

"Debt displacement:"" The amount of debt capacity taken up by a company's leasing activities. The more capital a company uses to lease assets, the lower the company's debt capacity will be, meaning that the company will not be able to borrow as much money."" (source: http://www.investorwords.com/7108/debt_displacement.html)
Leasing is a substitute for debt. Therefore, it uses up a firm's debt capacity (Leases displace debt). If a firm leases its assets , it will not be able to use as much debt as it would have been able to do otherwise. "

6.         To meet IRS guidelines for leasing, the lease should:
a. limit the lessee's right to issue debt or pay dividends while the lease is operative.
b. not limit the lessee's right to issue debt or pay dividends while the lease is operative.
c. pay a very high return to the lessor.
d. transfer ownership of the asset at the end of the lease at below fair market value.
e. be over 30 years.

Answer: d. transfer ownership of the asset at the end of the lease at below fair market value.

Thiswill make it a sale and not a lease

IRS Guidelines: a lease will be treated as a conditional sale for Federal income tax purposes if one or more of the following conditions are present
(i) Portions of the periodic payments are made specifically applicable to an equity to be acquired by the lessee.

ii) The lessee will acquire title upon the payment of a stated amount of "rentals" which under the contract he is required to make.

(iii) The total amount which the lessee is required to pay for a relatively short period of use constitutes an inordinately large proportion of the total sum required to be paid to secure the transfer of the title.

(iv) The agreed "rental" payments materially exceed the current fair rental value. This may be indicative that the payment includes an element other than compensation for the use of property.

(v) The property may be acquired under a purchase option at a price which is nominal in relation to the value of the property at the time when the option may be exercised, as determined at the time of entering into the original agreement, or which is a relatively small amount when compared with the total payments which are required to be made.

(vi) Some portion of the periodic payments is specifically designated as interest or is otherwise readily recognizable as the equivalent of interest.

(Source: http://www.sgrlaw.com/resources/briefings/bond_practice/453/)

IRS guidelines ...

Solution Summary

Answers 30 multiple choice questions in Finance dealing with Leasing, Options, warrants, convertibles, mergers and acquisitions, interest rate and currency swaps, bankruptcy etc.

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