Finance Theory
Textbook Exam Questions
Course Introduction
Finance Theory explores the fundamental principles underlying the financial decisions of individuals and organizations. The course covers topics such as risk and return, portfolio optimization, asset pricing models, capital structure, market efficiency, and the valuation of financial assets. Students learn to apply mathematical concepts and economic reasoning to analyze how financial markets operate, how securities are priced, and how firms make investment and financing decisions. Through a combination of theoretical frameworks and real-world applications, the course provides a comprehensive foundation for understanding the behavior of financial markets and the rationale behind key financial strategies.
Recommended Textbook
Corporate Finance A Focused Approach 6th Edition by Michael
C. Ehrhardt
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Chapter 1: An Overview of Financial Management and the Financial Environment
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Q1) Which of the following statements is CORRECT?
A) A good goal for a firm's management is maximization of expected EPS.
B) Most business in the U.S. is conducted by corporations, and corporations' popularity results primarily from their favorable tax treatment.
C) Because most stock ownership is concentrated in the hands of a relatively small segment of society, firms' actions to maximize their stock prices have little benefit to society.
D) Corporations and partnerships have an advantage over proprietorships because a sole proprietor is exposed to unlimited liability, but the liability of all investors in the other types of businesses is more limited.
E) The potential exists for agency conflicts between stockholders and managers.
Answer: E
Q2) The major advantage of a regular partnership or a corporation as a form of business organization is the fact that both offer their owners limited liability, whereas proprietorships do not.
A)True
B)False
Answer: False
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Page 3
Chapter 3: Analysis of Financial Statements
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Sample Questions
Q1) Orono Corp.'s sales last year were $435,000, its operating costs were $362,500, and its interest charges were $12,500. What was the firm's times interest earned (TIE) ratio?
A) 4.72
B) 4.97
C) 5.23
D) 5.51
E) 5.80
Answer: E
Q2) Bostian, Inc. has total assets of $625,000. Its total debt outstanding is $185,000. The Board of Directors has directed the CFO to move towards a debt-to-assets ratio of 55%. How much debt must the company add or subtract to achieve the target debt ratio?
A) $158,750
B) $166,688
C) $175,022
D) $183,773
E) $192,962
Answer: A
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Chapter 4: Time Value of Money
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Sample Questions
Q1) Suppose a State of North Carolina bond will pay $1,000 ten years from now. If the going interest rate on these 10-year bonds is 5.5%, how much is the bond worth today?
A) $585.43
B) $614.70
C) $645.44
D) $677.71
E) $711.59
Q2) What's the future value of $1,500 after 5 years if the appropriate interest rate is 6%, compounded semiannually?
A) $1,819
B) $1,915
C) $2,016
D) $2,117
E) $2,223
Q3) A time line is not meaningful unless all cash flows occur annually.
A)True B)False
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Chapter 5: Bonds, Bond Valuation, and Interest Rates
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Sample Questions
Q1) Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these securities cannot bankrupt a company, and this makes them safer from an investor's perspective than regular bonds.
A)True
B)False
Q2) A 25-year, $1,000 par value bond has an 8.5% annual coupon. The bond currently sells for $875. If the yield to maturity remains at its current rate, what will the price be 5 years from now?
A) $839.31
B) $860.83
C) $882.90
D) $904.97
E) $927.60
Q3) As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured.
A)True
B)False
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Chapter 6: Risk, Return, and the Capital Asset Pricing Model
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Q1) We would almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.
A)True
B)False
Q2) Portfolio AB was created by investing in a combination of Stocks A and B. Stock A has a beta of 1.2 and a standard deviation of 25%. Stock B has a beta of 1.4 and a standard deviation of 20%. Portfolio AB has a beta of 1.25 and a standard deviation of 18%. Which of the following statements is CORRECT?
A) Stock A has more market risk than Stock B but less stand-alone risk.
B) Portfolio AB has more money invested in Stock A than in Stock B.
C) Portfolio AB has the same amount of money invested in each of the two stocks.
D) Portfolio AB has more money invested in Stock B than in Stock A.
E) Stock A has more market risk than Portfolio AB.
Q3) The CAPM is a multi-period model that takes account of differences in securities' maturities, and it can be used to determine the required rate of return for any given level of systematic risk.
A)True
B)False
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Chapter 7: Stocks, Stock Valuation, and Stock Market
Equilibrium
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Q1) Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT?
A) If one stock has a higher dividend yield, it must also have a lower dividend growth rate.
B) If one stock has a higher dividend yield, it must also have a higher dividend growth rate.
C) The two stocks must have the same dividend growth rate.
D) The two stocks must have the same dividend yield.
E) The two stocks must have the same dividend per share.
Q2) Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT?
A) All common stocks, regardless of class, must have the same voting rights.
B) All firms have several classes of common stock.
C) All common stock, regardless of class, must pay the same dividend.
D) Some class or classes of common stock are entitled to more votes per share than other classes.
E) All common stocks fall into one of three classes: A, B, and C.
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Page 8
Chapter 8: Financial Options and Applications in Corporate Finance
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Q1) Since investors tend to dislike risk and like certainty, the more volatile a stock, the less valuable will be an option to purchase the stock, other things held constant.
A)True
B)False
Q2) Because of the time value of money, the longer before an option expires, the less valuable the option will be, other things held constant.
A)True
B)False
Q3) The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $55 sells for $7.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option?
A) $7.33
B) $7.71
C) $8.12
D) $8.55
E) $9.00
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9
Chapter 9: The Cost of Capital
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Q1) The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.
A)True
B)False
Q2) The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.
A)True
B)False
Q3) The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.
A)True
B)False
Q4) The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired.
A)True
B)False
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Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows
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Q1) A project's IRR is independent of the firm's cost of capital. In other words, a project's IRR doesn't change with a change in the firm's cost of capital.
A)True
B)False
Q2) The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault. A)True
B)False
Q3) Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life. Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs. Now suppose interest rates and money costs decline. Other things held constant, this change will cause L to become preferred to S.
A)True
B)False
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Chapter 11: Cash Flow Estimation and Risk Analysis
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Q1) Wansley Enterprises is considering a new project. The company has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that the proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT?
A) The proposed new project would increase the firm's corporate risk.
B) The proposed new project would increase the firm's market risk.
C) The proposed new project would not affect the firm's risk at all.
D) The proposed new project would have less stand-alone risk than the firm's typical project.
E) The proposed new project would have more stand-alone risk than the firm's typical project.
Q2) Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated.
A)True
B)False
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Chapter 12: Financial Planning and Forecasting Financial Statements
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Sample Questions
Q1) If Decker had a financing surplus, it could remedy the situation by
A) borrowing on its line of credit.
B) issuing more common stock.
C) reducing its dividend.
D) borrowing from its retained earnings
E) paying a special dividend
Q2) F. Marston, Inc. has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)?
A) A switch to a just-in-time inventory system and outsourcing production.
B) The company reduces its dividend payout ratio.
C) The company switches its materials purchases to a supplier that offers a longer credit period (with all other terms held equal).
D) The company discovers that it has excess capacity in its fixed assets.
E) A sharp increase in its forecasted sales.
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13
Chapter 13: Corporate Valuation, Value-Based Management and
Corporate Governance
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Q1) Two important issues in corporate governance are (1) the rules that cover the board's ability to fire the CEO and (2) the rules that cover the CEO's ability to remove members of the board.
A)True
B)False
Q2) The CEO of D'Amico Motors has been granted some stock options that have provisions similar to most other executive stock options. If D'Amico's stock underperforms the market, these options will necessarily be worthless.
A)True
B)False
Q3) ESOPs were originally designed to help improve worker productivity, but today they are also used to help prevent hostile takeovers.
A)True
B)False
Q4) A poison pill is also known as a corporate restructuring.
A)True
B)False
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Chapter 14: Distributions to Shareholders: Dividends and Repurchases
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Q1) Which of the following statements is correct?
A) An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional shares of common stock through investment bankers.
B) Stock repurchases tend to reduce financial leverage.
C) If a company declares a 2-for-1 stock split, its stock price should roughly double.
D) One advantage of adopting the residual dividend policy is that this makes it easier for corporations to meet the requirements of Modigliani and Miller's dividend clientele theory.
E) If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes.
Q2) Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders' wealth.
A)True
B)False
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Chapter 15: Capital Structure Decisions
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Q1) Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.
A)True
B)False
Q2) Refer to the data for Pennewell Publishing Inc. (PP). Assume that PP is considering changing from its original capital structure to a new capital structure with 35% debt and 65% equity. This results in a weighted average cost of capital equal to 9.4% and a new value of operations of $510,638. Assume PP raises $178,723 in new debt and purchases T-bills to hold until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?
A) $45.90
B) $48.12
C) $51.06
D) $53.33
E) $58.75
Q3) Whenever a firm borrows money, it is using financial leverage.
A)True
B)False
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Chapter 16: Working Capital Management
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Q1) Which of the following statements is CORRECT?
A) A conservative financing policy is one where the firm finances part of its fixed assets with short-term capital and all of its net working capital with short-term funds.
B) If a company receives trade credit under terms of 2/10 net 30, this implies that the company has 10 days of free trade credit.
C) One cannot tell if a firm uses a current asset financing policy that matches maturities, is conservative, or is aggressive without an examination of its cash budget.
D) If a firm has a relatively aggressive current asset financing policy vis-á-vis other firms in its industry, then its current ratio will probably be relatively high.
E) Accruals are an expensive but commonly used way to finance working capital.
Q2) For a firm that makes heavy use of net float, being able to forecast collections and disbursement check clearings is essential.
A)True
B)False
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Chapter 17: Multinational Financial Management
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Q1) A U.S.-based company, Stewart, Inc., arranged a 2-year, $1,000,000 loan to fund a project in Mexico. The loan is denominated in Mexican pesos, carries a 10.0% nominal rate, and requires equal semiannual payments. The exchange rate at the time of the loan was 5.75 pesos per dollar, but it dropped to 5.10 pesos per dollar before the first payment came due. The loan was not hedged in the foreign exchange market. Thus, Stewart must convert U.S. funds to Mexican pesos to make its payments. If the exchange rate remains at 5.10 pesos per dollar through the end of the loan period, what effective interest rate will Stewart end up paying on the loan?
A) 10.36%
B) 11.50%
C) 17.44%
D) 20.00%
E) 21.79%
Q2) A foreign currency will, on average, depreciate against the U.S. dollar at a percentage rate approximately equal to the amount by which its inflation rate exceeds that of the United States.
A)True
B)False
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