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Finance3040 Quiz1 Practice Problem Chapter 1-4
Terms in this set (29)
Which of the following are financing decisions?
a. Intel decides to spend $1 billion to develop a new microprocessor.
b. Volkswagen borrows 350 million euros (€350 million) from Deutsche Bank.
c. BP constructs a pipeline to bring natural gas onshore from a production platform in the Gulf of Mexico.
d. Budweiser spends €200 million to launch a new brand of beer in European markets.
e. Pfizer issues new shares to buy a small biotech company.
D) b and e
Answer: D) b and e
(a), (c) and (d) are investment (capital budgeting) decisions.
(e) is both an investment (capital budgeting) and a financing decision.
Without knowing anything about the personal ethics of the owners, which company would you better trust to keep its word in a business deal?
a. Harry's Hardware has been in business for 50 years. Harry's grandchildren, now almost adults, plan to take over and operate the business. Hardware stores require considerable investment in customer relations to become established.
b. Victor's Videos just opened for business. It rents a storefront in a strip mall and has financed its inventory with a bank loan. Victor has little of his own money invested in the business. Video shops usually command little customer loyalty.
Answer: A) a
The opportunity cost for not honoring their own words is extremely high for Harry's Hardware; and hence the firm is highly trustworthy in keeping their words in a business deal.
Modern finance does not condone attempts to pump up stock price by unethical means. But there need be no conflict between ethics and value maximization. The surest route to maximum value starts with products and services that satisfy customers. A good reputation with customers, employees, and other stakeholders is also important for the firms' long-run profitability and value.
Which of the following would correctly differentiate general partners from limited partners in a limited partnership?
A) General partners have more job experience.
B) General partners have an ownership interest.
C) General partners are subject to double taxation.
D) General partners have unlimited personal liability.
Answer: D) General partners have unlimited personal liability.
General partners have unlimited personal liability.
In the case of a professional corporation, ________ has/have limited liability.
A) only the professionals.
B) only the business.
C) both the professionals and the business.
D) neither the professionals nor the business.
Answer: B) only the business.
In the case of a professional corporation, only the business (and not the professionals) has limited liability.
Corporations are distinct, permanent legal entities. They allow for separation of ownership and control, and they can continue operating without disruption even as ownership changes. They provide limited liability to their owners. On the other hand, they are subject to double taxation because they pay taxes on their profits and the shareholders are taxed again when they receive dividends or sell their shares at a profit.
A manager's compensation plan that offers financial incentives for increases in quarterly profitability may create agency problems in that:
A) the managers are not motivated by personal gain.
B) the board of directors may claim the credit.
C) short-term, not long-term profits become the focus.
D) all of the above.
Answer: C) short-term, not long-term profits become the focus.
A manager's compensation plan that offers financial incentives for increases in quarterly profitability may create agency problems in that short-term, not long-term profits become the focus. Managers can become short-sighted, too, under non-perfect incentive plans.
The minimum, acceptable rate of return on corporate investments is determined by:
A) investors in financial markets.
B) information from accounting statements.
C) the financial manager.
D) the senior managers of the company.
Answer: A) investors in financial markets.
The minimum, acceptable rate of return on corporate investments is determined by investors in financial markets.
The cost of capital is the minimum acceptable rate of return on capital investment. It's an opportunity cost, that is, a rate of return that investors could earn in financial markets. For a safe capital investment, the opportunity cost is the interest rate on safe debt securities, such as high-grade corporate bonds. For riskier capital investments, the opportunity cost is the expected rate of return on risky securities—investments in the stock market, for example.
While corporations provide shareholders returns from _______, capital markets provide returns to shareholders from ______.
A) capital gains; dividends
B) appreciation; capital gains
C) dividends; capital gains
D) earnings; capital appreciation
Answer: C) dividends; capital gains
While corporations provide shareholders returns from dividends, capital markets provide returns to shareholders from capital gains.
The common stock of publicly traded corporations is usually traded:
A) by the company placing orders to purchase outstanding shares.
B) by investors contacting other investors directly.
C) between directors of the corporation.
D) on an organized exchange or over-the-counter.
Answer: D) on an organized exchange or over-the-counter.
The common stock of publicly traded corporations is usually traded on an organized exchange or over-the-counter.
When shareholder A sells its Ford stock to shareholder B in the secondary market, such as on the New York Stock Exchange, how much money is received by Ford?
A) Ford will receive most of the funds, except for commissions.
B) Ford will receive nothing.
C) Ford will receive only the commissions on the sale of stock.
D) Ford will receive a portion of the funds for every stock traded on the secondary market.
Answer: B) Ford will receive nothing.
A new issue of shares increases both the amount of cash held by the company and the number of shares held by the public. Such an issue is known as a primary issue, and it is sold in the primary market. But in addition to helping companies raise new cash, financial markets also allow investors to trade securities among themselves. For example, Smith might decide to raise some cash by selling her Apple stock at the same time that Jones invests his spare cash in Apple. The result is simply a transfer of ownership from Smith to Jones, which has no effect on the company itself. Such purchases and sales of existing securities are known as secondary transactions, and they take place in the secondary market.
Which of the following statements are correct?
a. Corporations sell securities in the primary market. The securities are later traded in the secondary market.
The NYSE is a formal exchange that centralizes all trades. NASDAQ is an electronic network of traders.
c. The capital market is for long-term financing, the money market for short-term financing.
A) a, b and c
B) a and b
Answer: A) a, b and c
All three statements are correct.
Which of the following statements are true?
a. Financing for public corporations must flow through financial markets.
b. Financing for private corporations must flow through financial intermediaries.
c. The sale of policies is a source of financing for insurance companies.
d. All foreign exchange trading occurs on the floors of the FOREX exchanges in New York and London.
e. The opportunity cost of capital is the capital outlay required to undertake a real investment opportunity.
f. The cost of capital is an opportunity cost determined by expected rates of return in financial markets. The opportunity cost of capital for risky investments is normally higher than the firm's borrowing rate.
C) c and f
D) d, e and f
Answer: C) c and f
Correction of (a): Financing for public corporations may flow through financial markets or through financial intermediaries.
Correction of (b): Financing for private corporations may flow through financial intermediaries.
Correction of (d): Much foreign exchange trading occurs on the floors of the FOREX exchanges in New York and London.
Correction of (e): The cost of capital is the minimum acceptable rate of return for capital investment. Investment projects offering rates of return higher than the cost of capital add value to the firm. Projects offering rates of return less than the cost of capital actually subtract value and should not be undertaken.
Which of the following statements are incorrect?
a. The cost of capital is the minimum acceptable rate of return on capital investment.
b. The cost of capital is a sunk cost, that is, a rate of return that investors could earn in financial markets.
c. For a safe capital investment, the opportunity cost is the interest rate on safe debt securities, such as high-grade corporate bonds.
d. For riskier capital investments, the opportunity cost is the expected rate of return on risky securities.
C) a and c
D) b and d
Answer: B) b
Correction of (b): The cost of capital is the minimum acceptable rate of return on capital investment.
Which of the following financial intermediaries has shown a preference for investing in long-term financial assets?
A) Commercial banks
B) Insurance companies
C) Finance companies
D) Savings-and-loan associations
Answer: B) Insurance companies
In the United States, insurance companies are more important than banks for the long-term financing of business. They are massive investors in corporate stocks and bonds, and they often make long-term loans directly to corporations.
An increase in accounts receivable balance provides an increase in cash flow.
An increase in accounts receivable balance provides a decrease in cash flow.
In general, what is changing as you read down the left hand side of a balance sheet?
A) The assets are more fully depreciated.
B) The assets are growing in value.
C) The assets are increasing in maturity.
D) The assets are becoming less liquid.
Answer: D) The assets are becoming less liquid.
As we read down the left hand side of a balance sheet, the assets are becoming less liquid.
ABC Corp.'s balance sheet shows their long-term debt to be $10 million. The debt was issued with a 10% coupon rate, and the current market interest rate is 7%. Based on this information, the market value of this debt will most likely be:
A) less than $10 million.
B) more than $10 million.
C) equal to $10 million.
D) unknown without knowing the maturity of the debt.
Answer: B) more than $10 million.
Since the coupon rate is higher than the market interest rate (discount rate), the present value of the remaining cash flows looks good.
Which of the following statements is more likely if cash and marketable securities increase by $5,000 during a period in which cash provided by operations increases by $1,000 and cash used by investments decreases by $500?
A) Cash provided by financing decreases by $3,500.
B) Cash used by financing decreases by $1,000.
C) Long-term debt decreased by less than short-term debt increased.
D) Debt was reduced by more than cash dividends paid.
Answer: C) Long-term debt decreased by less than short-term debt increased.
Investments expenditure usually comes from long-term debt. Therefore it is likely that long-term debt will also decrease by $500 when investments decrease by $500. Financing for operations usually comes from short-term debt. Hence when cash provided by operations increases by $1,000, so does the short-term debt. Therefore long-term debt decreases by $500, which is less than the $1,000 increase of the short-term debt.
Which of the following categories of a statement of cash flows is affected by depreciation?
A) Cash flows from operations
B) Cash flows from noncash expenses
C) Cash flows from investments
D) Cash flows from financing
Answer: A) Cash flows from operations
The first section in a consolidated statement of cash flows, cash flowfrom operations, starts with net income but adjusts that figure for those parts of the income statement that do not involve cash coming in or going out. Therefore, it adds back the allowance for depreciation because depreciation is not a cash outflow, even though it is treated as an expense in the income statement. Any additions to current assets need to be subtracted from net income, since these absorb cash but do not show up in the income statement. Conversely, any additions to current liabilities need to be added to net income because these release cash.
Which of the following statements about regulatory responses to accounting malpractices are incorrect?
a. In response corporate accounting scandals, Congress passed the Sarbanes-Oxley Act in 2002. The act attempts to ensure that the firm's financial reports accurately represent its financial condition.
b. The Sarbanes-Oxley Act created the Public Company Accounting Oversight Board to oversee the auditing of public companies, requires CEOs and CFOs to personally sign off on the firm's financial statements, and requires independent financial experts to serve on the audit committee of the board of directors.
c. After the Sarbanes-Oxley Act is passed and enforced, accounting rules leave firms no leeway at all when preparing their financial statements.
D) a and b
Answer: C) c
Correction of (c): After the Sarbanes-Oxley Act is passed and enforced, accounting rules leave firms little leeway at all when preparing their financial statements.
Which of the following actions will increase a firm's current ratio if it is now less than 1.0?
A) Convert marketable securities to cash.
B) Pay accounts payable with cash.
C) Buy inventory with short term credit (i.e. accounts payable).
D) Sell inventory at cost.
Answer: C) Buy inventory with short term credit (i.e. accounts payable).
Buying inventory with short term credit will cause current asset and current liability to increase by the same amount and increase the firm's current ratio to closer to (but still less than) 1.
When Tri-C Corp. compares its ratios to industry averages, it has a higher current ratio, an average quick ratio, and a low inventory turnover. What might you assume about Tri-C?
A) Its cash balance is too low.
B) Its cost of goods sold is too low.
C) Its current liabilities are too low.
D) Its average inventory is too high.
Answer: D) Its average inventory is too high.
Since current ratio includes inventory but quick ratio excludes inventory in the numerator, high current ratio and average quick ratio reveal the fact of high inventory. Low inventory turnover, i.e., total assets over average inventory, also confirms the fact of high inventory.
What is the ROA of a firm with $150,000 in average receivables, which represents 60 days sales, average assets of $750,000, and a profit margin of 9%?
Answer: C) 10.95%
Average receivable is inventory at start of year. Then using Du Pont formula ROA.
Which of the following is correct for a firm with EPS of $2 per share and a 45% payout ratio?
A) 45% of earnings will be plowed back into the firm.
B) Dividends will equal $1.10 per share.
C) Book value per share of equity will increase by $1.10.
D) Retained earnings will be unchanged.
Answer: C) Book value per share of equity will increase by $1.10.
$2 x (1 - 45%) = $2 x .55 = $1.10 per share.
Which of the following would be most detrimental to a firm's current ratio if that ratio is currently 2.0?
A) Buy raw materials on credit.
B) Sell marketable securities at cost.
C) Pay off accounts payable with cash.
D) Pay off a portion of long-term debt with cash.
Answer: D) Pay off a portion of long-term debt with cash.
Paying off a portion of long-term debt with cash will cause the numerator of the current ratio to decrease.
Which of the following is correct for a firm with a debt-equity ratio of .45 if long-term debt equals 500 and equity equals 2,000? The firm has:
A) current liabilities that are valued at 400.
B) leases that are valued at 400.
C) retained earnings that are valued at 900.
D) preferred stock of 400.
Answer: B) leases that are valued at 400.
Debt-equit ratio=(long-term debt+value of leases)/equity
Which of the following is not correct regarding the standard measures (and their significance) of a firm's leverage, liquidity, efficiency, and profitability?
a. Leverage ratios measure the indebtedness of the firm. Liquidity ratios measure how easily the firm can obtain cash. Efficiency ratios measure how intensively the firm is using its assets. Profitability ratios measure the firm's return on its investments.
b. Be selective in your choice of these ratios. Different ratios often tell you similar things. Financial ratios crop up repeatedly in financial discussions and arrangements.
c. Banks and bondholders commonly place limits on the borrower's liquidity ratios.
d. Ratings agencies also look at leverage ratios when they decide how highly to rate the firm's bonds.
Answer: C) c
Banks and bondholders usually demand limits on debt ratios or interest coverage.
How does the Du Pont formula help identify the determinants of the firm's return on its assets and equity?
a. The formula states that the return on equity is the product of the firm's leverage ratio, asset turnover, operating profit margin, and debt burden.
b. The formula states that the return on assets is the product of the firm's asset turnover and operating profit margin.
C) both a and b are correct.
D) neither a nor b is correct.
Answer: C) both a and b are correct.
Which of the following is incorrect regarding potential pitfalls of ratio analysis based on accounting data?
a. Financial ratio analysis is useful if practiced mechanically. Financial ratios often provide answers, and they do help you ask the right questions.
b. Accounting data do not necessarily reflect market values properly, and so must be used with caution.
c. We need a benchmark for assessing a company's financial position.
d. We typically compare financial ratios with the company's ratios in earlier years and with the ratios of other firms in the same business.
Answer: A) a
Financial statement analysis will rarely be useful if done mechanically. Financial ratios do not provide final answers, although they should prompt the right questions. In addition, accounting entries do not always reflect current market values, and in rare cases accounting is not transparent, because unscrupulous managers make up good news and hide bad news in financial statements.
Which of the following is incorrect regarding assessing the firm's performance with market value added and economic value added?
a. The ratio of the market value of the firm's equity to its book value indicates how far the value of the shareholders' investment exceeds the money that they have contributed.
b. The difference between the market and book values is known as market value added and measures the number of dollars of value that the company has added.
c. Managers often compare the company's return on assets with the cost of capital to see whether the firm is earning the return that investors require. It is also useful to deduct the cost of the capital employed from the company's profits to see how much profit the company has earned after all costs. This measure is known as residual income, economic value added, or EVA.
d. Managers of divisions or plants are often judged and rewarded by their business's market value added.
Answer: D) d
Managers of divisions or plants are often judged and rewarded by their economic value added.
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