# Corporate Finance - Final Exam QUESTIONS

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### Which one of the following best defines the variance of an investment's annual returns over a number of years? A. The average squared difference between the arithmetic and the geometric average annual returns. B. The squared summation of the differences between the actual returns and the average geometric return. C. The average difference between the annual returns and the average return for the period. D. The difference between the arithmetic average and the geometric average return for the period. E. The average squared difference between the actual returns and the arithmetic average return.

The average squared difference between the actual returns and the arithmetic average return.

volatility

### Which one of the following is defined by its mean and its standard deviation? A. arithmetic nominal return B. geometric real return C. normal distribution D. variance E. risk premium

normal distribution

geometric

I and III only

### The real rate of return on a stock is approximately equal to the nominal rate of return: A. multiplied by (1 + inflation rate). B. plus the inflation rate. C. minus the inflation rate. D. divided by (1 + inflation rate). E. divided by (1- inflation rate).

minus the inflation rate.

### 7. Which one of the following statements is correct? A. The greater the volatility of returns, the greater the risk premium. B. The lower the volatility of returns, the greater the risk premium. C. The lower the average return, the greater the risk premium. D. The risk premium is unrelated to the average rate of return. E. The risk premium is not affected by the volatility of returns.

A. The greater the volatility of returns, the greater the risk premium.

II and III only

### Estimates of the rate of return on a security based on a historical arithmetic average will probably tend to _____ the expected return for the long-term while estimates using the historical geometric average will probably tend to _____ the expected return for the short-term.

overestimate; underestimate

III and IV only

beta

### Which one of the following is a positively sloped linear function that is created when expected returns are graphed against security betas? A. reward-to-risk matrix B. portfolio weight graph C. normal distribution D. security market line E. market real returns

security market line

### Which one of the following is the formula that explains the relationship between the expected return on a security and the level of that security's systematic risk? A. capital asset pricing model B. time value of money equation C. unsystematic risk equation D. market performance equation E. expected risk formula

capital asset pricing model

total

### The expected return on a portfolio considers which of the following factors? I. percentage of the portfolio invested in each individual security II. projected states of the economy III. the performance of each security given various economic states IV. probability of occurrence for each state of the economy

I, II, III, and IV

### Which one of the following is an example of systematic risk? A. investors panic causing security prices around the globe to fall precipitously B. a flood washes away a firm's warehouse C. a city imposes an additional one percent sales tax on all products D. a toymaker has to recall its top-selling toy E. corn prices increase due to increased demand for alternative fuels

investors panic causing security prices around the globe to fall precipitously

### Unsystematic risk A. can be effectively eliminated by portfolio diversification. B. is compensated for by the risk premium. C. is measured by beta. D. is measured by standard deviation. E. is related to the overall economy.

can be effectively eliminated by portfolio diversification.

### The primary purpose of portfolio diversification is to: A. increase returns and risks. B. eliminate all risks. C. eliminate asset-specific risk. D. eliminate systematic risk. E. lower both returns and risks.

eliminate asset-specific risk.

beta.

### Total risk is measured by _____ and systematic risk is measured by _____. A. beta; alpha B. beta; standard deviation C. alpha; beta D. standard deviation; beta E. standard deviation; variance

standard deviation; beta

is underpriced.

### The market risk premium is computed by: A. adding the risk-free rate of return to the inflation rate. B. adding the risk-free rate of return to the market rate of return. C. subtracting the risk-free rate of return from the inflation rate. D. subtracting the risk-free rate of return from the market rate of return. E. multiplying the risk-free rate of return by a beta of 1.0.

subtracting the risk-free rate of return from the market rate of return.

### According to CAPM, the amount of reward an investor receives for bearing the risk of an individual security depends upon the: A. amount of total risk assumed and the market risk premium. B. market risk premium and the amount of systematic risk inherent in the security. C. risk free rate, the market rate of return, and the standard deviation of the security. D. beta of the security and the market rate of return. E. standard deviation of the security and the risk-free rate of return.

market risk premium and the amount of systematic risk inherent in the security.

### Which one of the following should earn the most risk premium based on CAPM? A. diversified portfolio with returns similar to the overall market B. stock with a beta of 1.38 C. stock with a beta of 0.74 D. U.S. Treasury bill E. portfolio with a beta of 1.01

stock with a beta of 1.38

cost of equity

cost of debt.

### The average of a firm's cost of equity and aftertax cost of debt that is weighted based on the firm's capital structure is called the: A. reward to risk ratio. B. weighted capital gains rate. C. structured cost of capital. D. subjective cost of capital. E. weighted average cost of capital.

weighted average cost of capital.

### A firm's cost of capital: A. will decrease as the risk level of the firm increases. B. for a specific project is primarily dependent upon the source of the funds used for the project. C. is independent of the firm's capital structure. D. should be applied as the discount rate for any project considered by the firm. E. depends upon how the funds raised are going to be spent.

depends upon how the funds raised are going to be spent.

### Which one of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure. A. This model considers a firm's rate of growth. B. The model applies only to non-dividend paying firms. C. The model is dependent upon a reliable estimate of the market risk premium. D. The model generally produces the same cost of equity as the dividend growth model. E. This approach generally produces a cost of equity that equals the firm's overall cost of capital.

The model is dependent upon a reliable estimate of the market risk premium.

### The pre-tax cost of debt: A. is based on the current yield to maturity of the firm's outstanding bonds. B. is equal to the coupon rate on the latest bonds issued by a firm. C. is equivalent to the average current yield on all of a firm's outstanding bonds. D. is based on the original yield to maturity on the latest bonds issued by a firm. E. has to be estimated as it cannot be directly observed in the market.

is based on the current yield to maturity of the firm's outstanding bonds.

II and III only

### The cost of preferred stock is computed the same as the: A. pre-tax cost of debt. B. return on an annuity. C. aftertax cost of debt. D. return on a perpetuity. E. cost of an irregular growth common stock.

return on a perpetuity.

### The capital structure weights used in computing the weighted average cost of capital: A. are based on the book values of total debt and total equity. B. are based on the market value of the firm's debt and equity securities. C. are computed using the book value of the long-term debt and the book value of equity. D. remain constant over time unless the firm issues new securities. E. are restricted to the firm's debt and common stock.

are based on the market value of the firm's debt and equity securities.

### If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to: I. reject some positive net present value projects. II. accept some negative net present value projects. III. favor high risk projects over low risk projects. IV. increase its overall level of risk over time.

I, II, III, and IV

### The flotation cost for a firm is computed as: A. the arithmetic average of the flotation costs of both debt and equity. B. the weighted average of the flotation costs associated with each form of financing. C. the geometric average of the flotation costs associated with each form of financing. D. one-half of the flotation cost of debt plus one-half of the flotation cost of equity. E. a weighted average based on the book values of the firm's debt and equity.

the weighted average of the flotation costs associated with each form of financing.

### Incorporating flotation costs into the analysis of a project will: A. cause the project to be improperly evaluated. B. increase the net present value of the project. C. increase the project's rate of return. D. increase the initial cash outflow of the project. E. have no effect on the present value of the project.

increase the initial cash outflow of the project.

venture capital

### What is an issue of securities that is offered for sale to the general public on a direct cash basis called? A. best efforts underwriting B. firm commitment underwriting C. general cash offer D. rights offer E. herring offer

general cash offer

rights offer

### Soup Galore is a partnership that was formed three years ago for the purpose of creating, producing, and distributing healthy soups in a dried form. The firm has been extremely successful thus far and has decided to incorporate and offer shares of stock to the general public. What is this type of an equity offering called? A. venture capital offering B. shelf offering C. private placement D. seasoned equity offering E. initial public offering

initial public offering

### What is a seasoned equity offering? A. an offering of shares by shareholders for repurchase by the issuer B. shares of stock that have been recommended for purchase by the SEC C. equity securities held by a firm's founder that are being offered for sale to the general public D. sale of newly issued equity shares by a firm that is currently publicly owned E. a set number of equity shares that are issued and offered to the public annually

sale of newly issued equity shares by a firm that is currently publicly owned

underwriter.

### Denver Liquid Wholesalers recently offered 50,000 new shares of stock for sale. The underwriters sold a total of 53,000 shares to the public. The additional 3,000 shares were purchased in accordance with which one of the following? A. Green shoe provision B. Red herring provision C. quiet provision D. lockup agreement E. post-issue agreement

Green shoe provision

dilution.

### A group of five private investors recently loaned \$6 million to Henderson Hardware for ten years at 9 percent interest. This loan is best described as a: A. private placement. B. debt SEO. C. notes payable. D. debt IPO. E. term loan.

private placement.

### Pearson Electric recently registered 250,000 shares of stock under SEC Rule 415. The firm plans to sell 150,000 shares this year and the remaining 100,000 shares next year. What type of registration was this? A. standby registration B. shelf registration C. Regulation A registration D. Regulation Q registration E. private placement registration

shelf registration

### Which of the following should be considered when selecting a venture capitalist? I. level of involvement II. past experiences III. termination of funding IV. financial strength

I, II, III, and IV

### The Securities and Exchange Commission: A. verifies the accuracy of the information contained in the prospectus. B. verifies the accuracy of the information contained in the red herring. C. examines the registration statement during the Green Shoe period. D. is concerned only that an issue complies with all rules and regulations. E. determines the final offer price once they have approved the registration statement.

is concerned only that an issue complies with all rules and regulations.

### With firm commitment underwriting, the issuing firm: A. is unsure of the total amount of funds it will receive until after the offering is completed. B. is unsure of the number of shares it will actually issue until after the offering is completed. C. knows exactly how many shares will be purchased by the general public during the offer period. D. retains the financial risk associated with unsold shares. E. knows up-front the amount of money it will receive from the stock offering.

knows up-front the amount of money it will receive from the stock offering.

### A firm should select the capital structure that: A. produces the highest cost of capital. B. maximizes the value of the firm. C. minimizes taxes. D. is fully unlevered. E. equates the value of debt with the value of equity.

maximizes the value of the firm.

all-equity firm.

### By definition, which of the following costs are included in the term "financial distress costs"? I. direct bankruptcy costs II. indirect bankruptcy costs III. direct costs related to being financially distressed, but not bankrupt IV. indirect costs related to being financially distressed, but not bankrupt

I, II, III, and IV

### The proposition that a firm borrows up to the point where the marginal benefit of the interest tax shield derived from increased debt is just equal to the marginal expense of the resulting increase in financial distress costs is called: A. the static theory of capital structure. B. M&M Proposition I. C. M&M Proposition II. D. the capital asset pricing model. E. the open markets theorem.

the static theory of capital structure.

### The optimal capital structure has been achieved when the: A. debt-equity ratio is equal to 1. B. weight of equity is equal to the weight of debt. C. cost of equity is maximized given a pre-tax cost of debt. D. debt-equity ratio is such that the cost of debt exceeds the cost of equity. E. debt-equity ratio results in the lowest possible weighted average cost of capital.

debt-equity ratio results in the lowest possible weighted average cost of capital.

### Which one of the following statements is correct concerning the relationship between a levered and an unlevered capital structure? Assume there are no taxes.

At the break-even point, there is no advantage to debt.

### Which of the following statements related to financial risk are correct? I. Financial risk is the risk associated with the use of debt financing. II. As financial risk increases so too does the cost of equity. III. Financial risk is wholly dependent upon the financial policy of a firm. IV. Financial risk is the risk that is inherent in a firm's operations.

I, II, and III only

Tc x D.

### The interest tax shield is a key reason why: A. the required rate of return on assets rises when debt is added to the capital structure. B. the value of an unlevered firm is equal to the value of a levered firm. C. the net cost of debt to a firm is generally less than the cost of equity. D. the cost of debt is equal to the cost of equity for a levered firm. E. firms prefer equity financing over debt financing.

the net cost of debt to a firm is generally less than the cost of equity.

### The optimal capital structure: A. will be the same for all firms in the same industry. B. will remain constant over time unless the firm changes its primary operations. C. will vary over time as taxes and market conditions change. D. places more emphasis on operations than on financing. E. is unaffected by changes in the financial markets.

will vary over time as taxes and market conditions change.

clientele effect

stock repurchase

stock dividend

### Which one of the following statements related to cash dividends is correct? A. Extra cash dividends cannot be repeated in the future. B. A dividend is never a liability until it has been declared. C. If a firm has paid regular quarterly dividends for at least five consecutive years it is legally obligated to continue doing so. D. Regular cash dividends reduce paid-in capital. E. The dividend yield expresses the annual dividend as a percentage of net income.

A dividend is never a liability until it has been declared.

### All else equal, the market value of a stock will tend to decrease by roughly the aftertax value of the dividend on the: A. dividend declaration date. B. ex-dividend date. C. date of record. D. date of payment. E. day after the date of payment.

ex-dividend date.

### Which one of the following favors a low dividend policy? A. the tax on capital gains is deferred until the gain is realized B. few, if any, positive net present value projects are available to a firm C. a majority of the shareholders has a low relevant tax rate D. a majority of the shareholders has better investment opportunities with similar risks E. corporate tax rates exceed personal tax rates

the tax on capital gains is deferred until the gain is realized

### Which of the following shareholders tend to favor a high dividend policy? I. retired individuals II. endowment funds III. corporate investors IV. investors with high dividend tax rates but low capital gains tax rates

I, II, and III only

### Which one of the following statements is correct? A. Firms prefer to cut dividend payments rather than borrow money to fund a short- term cash need. B. Share repurchases tend to increase agency costs. C. Maintaining a steady dividend is a key goal of most dividend-paying firms. D. Tax rates are the key factor in determining a firm's dividend policy. E. Stock prices tend to ignore expected changes in dividend payments.

C. Maintaining a steady dividend is a key goal of most dividend-paying firms.

### Stock splits can be used to: A. adjust the market price of a stock such that it falls within a preferred trading range. B. decrease the excess cash held by a firm thereby lowering agency costs. C. increase both the number of shares outstanding and the market price per share. D. increase the total equity of a firm. E. adjust the debt-equity ratio.

adjust the market price of a stock such that it falls within a preferred trading range.

operating cycle.

cash cycle.

II and IV only

I and III only

### A flexible short-term financial policy: A. increases a firm's need for long-term financing. B. minimizes net working capital. C. avoids bad debts by only selling items for cash. D. maximizes fixed assets and minimizes current assets. E. is most appropriate for a firm with relatively high carrying costs and relatively low shortage costs.

increases a firm's need for long-term financing.

### The optimal investment in current assets for an operating firm occurs at the point where: A. both shortage costs and carrying costs equal zero. B. shortage costs are equal to zero. C. carrying costs are equal to zero. D. carrying costs exceed shortage costs. E. the total costs of holding current assets is minimized.

the total costs of holding current assets is minimized.

### A cumulative cash deficit indicates a firm: A. has at least a short-term need for external funding. B. is facing long-term financial distress. C. will go out of business within the year. D. is capable of funding all of its needs internally. E. is using its cash wisely.

has at least a short-term need for external funding.

### A firm's overall cost of equity is: A. is generally less that the firm's WACC given a leveraged firm. B. unaffected by changes in the market risk premium. C. highly dependent upon the growth rate and risk level of the firm. D. generally less than the firm's aftertax cost of debt. E. inversely related to changes in the firm's tax rate.

highly dependent upon the growth rate and risk level of the firm.

Example: