Principles of Finance Exam Practice Tests
Course Introduction
Principles of Finance introduces students to the foundational concepts and tools necessary to understand the role of finance in business and personal decision-making.
Topics covered include time value of money, risk and return, valuation of stocks and bonds, capital budgeting, financial statement analysis, and the functioning of financial markets. The course also explores how financial managers use these principles to evaluate investment opportunities, manage funding sources, and maximize firm value, providing a thorough grounding for further study in finance or related fields.
Recommended Textbook
Corporate Finance 10th Edition by Stephen A. Ross
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Page 2
Chapter 1: Introduction to Corporate Finance
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Q1) The process of planning and managing a firm's long-term investments is called:
A) working capital management.
B) financial depreciation.
C) agency cost analysis.
D) capital budgeting.
E) capital structurE.
Answer: D
Q2) The Securities Exchange Act of 1934 focuses on:
A) all stock transactions.
B) sales of existing securities.
C) issuance of new securities.
D) insider trading.
E) Federal Deposit Insurance Corporation (FDIC) insurancE.
Answer: D
Q3) What advantages does the corporate form of organization have over sole proprietorships or partnerships?
Answer: The advantages of the corporate form of organization over sole proprietorships and partnerships are the ease of transferring ownership,the owners' limited liability for business debts,the ability to raise more capital,and the opportunity of an unlimited life of the business.
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Chapter 2: Financial Statements and Cash Flow
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Q1) Which of the following is not included in the computation of operating cash flow?
A) Earnings before interest and taxes
B) Interest paid
C) Depreciation
D) Current taxes
E) All of these are included
Answer: B
Q2) Which of the following are included in current assets?
I. equipment
II. Inventory
III. accounts payable
IV. cash
A) II and IV only
B) I and III only
C) I, II, and IV only
D) III and IV only
E) II, III, and IV only
Answer: A
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Page 4
Chapter 3: Financial Statements Analysis and Financial Models
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Q1) Rosita's Resources paid $250 in interest and $130 in dividends last year. The times interest earned ratio is 3.8 and the depreciation expense is $80. What is the value of the cash coverage ratio?
A) 2.71
B) 3.64
C) 4.12
D) 5.78
E) 6.10
Answer: C
Q2) Frederico's has a profit margin of 6%,a return on assets of 8%,and an equity multiplier of 1.4. What is the return on equity?
A) 6.7%
B) 8.4%
C) 11.2%
D) 14.6%
E) 19.6%
Answer: C
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Page 5
Chapter 4: Discounted Cash Flow Valuation
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Q1) You borrow $149,000 to buy a house. The mortgage rate is 7.5% and the loan period is 30 years. Payments are made monthly. If you pay for the house according to the loan agreement,how much total interest will you pay?
A) $138,086
B) $218,161
C) $226,059
D) $287,086
E) $375,059
Q2) You are considering two savings options. Both options offer a 4% rate of return. The first option is to save $1,200,$1,500,and $2,000 a year over the next three years,respectively. The other option is to save one lump sum amount today. If you want to have the same balance in your savings at the end of the three years,regardless of the savings method you select,how much do you need to save today if you select the lump sum option?
A) $4,318.67
B) $4,491.42
C) $4,551.78
D) $4,607.23
E) $4,857.92
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Page 6
Chapter 5: Net Present Value and Other Investment Rules
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Q1) The discount rate that makes the net present value of an investment exactly equal to zero is called the:
A) external rate of return.
B) internal rate of return.
C) average accounting return.
D) profitability index.
E) equalizer.
Q2) An investment cost $10,000 with expected cash flows of $3,000 for 5 years. The discount rate is 15.2382%. The NPV is ______ and the IRR is ______ for the project.
A) $0; 15.2382%
B) $3.33; 27.2242%
C) $5,000; 0%
D) Can not answer without one or the other value as input.
E) None of these.
Q3) The IRR rule is said to be a special case of the NPV rule. Explain why this is so and why it has some limitations NPV does not?
Q4) List and briefly discuss the advantages and disadvantages of the internal rate of return (IRR) rule.
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Page 7
Chapter 6: Making Capital Investment Decisions
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Q1) Peter's Boats has sales of $760,000 and a profit margin of 5%. The annual depreciation expense is $80,000. What is the amount of the operating cash flow if the company has no long-term debt?
A) $34,000
B) $86,400
C) $118,000
D) $120,400
E) $123,900
Q2) A project will increase sales by $60,000 and cash expenses by $51,000. The project will cost $40,000 and will be depreciated using straight-line depreciation to a zero book value over the 4-year life of the project. The company has a marginal tax rate of 35%. What is the operating cash flow of the project using the tax shield approach?
A) $5,850
B) $8,650
C) $9,350
D) $9,700
E) $10,350
Q3) Explain the half year convention used in MACRS depreciation.
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Chapter 7: Risk Analysis, Real Options, and Capital Budgeting
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Sample Questions
Q1) Variable costs:
A) change in direct relationship to the quantity of output produced.
B) are constant in the short-run regardless of the quantity of output produced. C) are equal to the change in a variable when one more unit of output is produced. D) are subtracted from fixed costs to compute the contribution margin.
E) form the basis that is used to determine the degree of operating leverage employed by a firm.
Q2) Ryan Industries is considering a project with a discounted payback just equal to the project's life. The projections include a sales price of $12,variable cost per unit of $9,and fixed costs of $5,000. The operating cash flow is $8,000. What is the break-even quantity?
A) 1,900 units
B) 2,679 units
C) 3,250 units
D) 4,000 units
E) 4,333 units
Q3) What is the benefit of scenario analysis if it does not produce an accept or reject decision for a proposed project?
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Page 9
Chapter 8: Interest Rates and Bond Valuation
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Q1) A bond with a face value of $1,000 that sells for $1,000 in the market is called a _____ bond.
A) par value
B) discount
C) premium
D) zero coupon
E) floating rate
Q2) The Lo Sun Corporation offers a 6% bond with a current market price of $875.05. The yield to maturity is 7.34%. The face value is $1,000. Interest is paid semiannually. How many years is it until this bond matures?
A) 16 years
B) 18 years
C) 24 years
D) 30 years
E) 32 years
Q3) Explain why some bond investors are subject to liquidity risk,default risk,and/or taxability risk. How does each of these risks affect the yield of a bond?
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Chapter 9: Stock Valuation
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Q1) The common stock of Eddie's Engines,Inc. sells for $25.71 a share. The stock is expected to pay $1.80 per share next month when the annual dividend is distributed. Eddie's has established a pattern of increasing its dividends by 4% annually and expects to continue doing so. What is the market rate of return on this stock?
A) 7%
B) 9%
C) 11%
D) 13%
E) 15%
Q2) Payments made by a corporation to its shareholders,in the form of either cash,stock or payments in kind,are called:
A) retained earnings.
B) net income.
C) dividends.
D) redistributions.
E) infused equity.
Q3) What is the difference between the enterprise value to EBITDA ratio and the PE ratio?
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Chapter 10: Risk and Return: Lessons From Market History
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Q1) Which one of the following is a correct statement concerning risk premium?
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 rate of return, the greater the risk premium.
D) The risk premium is not correlated to the average rate of return.
E) The risk premium is not affected by the volatility of returns.
Q2) Little John Industries sold for $1.90 on January 1 and ended the year at a price of $2.50. In addition,the stock paid dividends of $0.20 per share. Calculate Little John's dividend yield,capital gains yield,and total rate of return for the year.
Q3) What are the arithmetic and geometric average returns for a stock with annual returns of 21%,8%,-32%,41%,and 5%?
A) 5.6%; 8.6%
B) 5.6%; 6.3%
C) 8.6%; 5.6%
D) 8.6%; 8.6%
E) 8.6%; 6.3%
Q4) You earned a total return of -5% on NoDotCom this year,earned -40% last year,and earned 30% two years ago. Calculate both the three-year holding period return and the average three year return.
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Chapter 11: Return and Risk: the Capital Asset Pricing Model
Capm
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Sample Questions
Q1) The total number of variance and covariance terms in a portfolio is N<sup>2</sup>. How many of these would be (including non-unique) covariances?
A) N
B) N<sup>2</sup>
C) N<sup>2</sup>- N
D) N<sup>2</sup>- N/2
E) None of these.
Q2) A portfolio has 25% of its funds invested in Security C and 75% of its funds invested in Security D. Security C has an expected return of 8% and a standard deviation of 6%. Security D has an expected return of 10% and a standard deviation of 10%. The securities have a coefficient of correlation of 0.6. Which of the following values is closest to portfolio return and variance?
A) .090; .0081
B) .095; .001675
C) .095; .0072
D) .100; .00849
E) Cannot calculate without the number of covariance terms.
Q3) Explain in words what beta is and why it is important.
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Chapter 12: An Alternative View of Risk and Return: The Arbitrage Pricing Theory
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Q1) The acronym APT stands for:
A) Arbitrage Pricing Techniques.
B) Absolute Profit Theory.
C) Arbitrage Pricing Theory.
D) Asset Pricing Theory.
E) Assured Price Techniques.
Q2) Assume that the single factor APT model applies and a portfolio exists such that 1/2 of the funds are invested in Security Q and the rest in the risk-free asset. Security Q has a beta of 1.8. The portfolio has a beta of:
A) 0.0.
B) 0.8.
C) 0.9.
D) 1.0.
E) 1.8.
Q3) The betas along with the factors in the APT adjust the expected return for:
A) calculation errors.
B) unsystematic risks.
C) spurious correlations of factors.
D) differences between actual and expected levels of factors.
E) All of
Page 14
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Chapter 13: Risk, Cost of Capital, and Valuation
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Q1) The Hold-n-Trade Co. is an all-equity financed firm. The beta is .9,the market risk premium is 7% and the risk-free rate is 5%. What is the expected return of Hold-n-Trade?
A) 8%
B) 8.5%
C) 9%
D) 11.3%
E) 12%
Q2) Explain the factors that determine beta and how an asset beta can differ from equity betas.
Q3) Firms whose revenues are strongly cyclical and whose operating leverage is high are likely to have:
A) low betas.
B) high betas.
C) zero betas.
D) negative betas.
E) None of these.
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Chapter 14: Efficient Capital Markets and Behavioral Challenges
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Q1) Valuable financing opportunities can be created by:
A) fooling investors.
B) reducing costs or increasing subsidies.
C) the creation of a new security.
D) fooling investors and reducing costs or increasing subsidies.
E) fooling investors; reducing costs or increasing subsidies; and the creation of a new security.
Q2) In the five years after the offering,______ underperform matched control groups.
A) initial public offerings
B) seasoned equity offerings
C) bond offerings
D) initial public offerings and seasoned equity offerings
E) initial public offerings; seasoned equity offerings; and bond offerings
Q3) An investor discovers that stock prices change drastically as a result of certain events. This finding is a violation of the:
A) moderate form of the efficient market hypothesis.
B) semistrong form of the efficient market hypothesis.
C) strong form of the efficient market hypothesis.
D) weak form of the efficient market hypothesis.
E) None of these.
Page 16
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Chapter 15: Long-Term Financing
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Q1) Shares of stock that have been repurchased by the corporation are called:
A) treasury stock.
B) undistributed capital stock.
C) retained equity.
D) capital surplus shares.
E) None of these.
Q2) James Yachts has 2,000 shares outstanding each with a par value of $0.07. If they are sold to shareholders at $7 each,what would the capital surplus be?
A) $10,000
B) $12,140
C) $13,250
D) $13.860
E) $14,000
Q3) The written agreement between a corporation and its bondholders is called:
A) the collateral agreement.
B) the deed.
C) the indenture.
D) the deed of conveyance.
E) None of these.
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Chapter 16: Capital Structure: Basic Concepts
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Q1) The capital structure chosen by a firm doesn't really matter because of:
A) taxes.
B) the interest tax shield.
C) the relationship between dividends and earnings per share.
D) the effects of leverage on the cost of equity.
E) homemade leveragE.
Q2) Gail's Dance Studio is currently an all equity firm that has 80,000 shares of stock outstanding with a market price of $42 a share. The current cost of equity is 12% and the tax rate is 34%. Gail is considering adding $1 million of debt with a coupon rate of 8% to her capital structure. The debt will be sold at par value. What is the levered value of the equity?
A) $2.4 million
B) $2.7 million
C) $3.3 million
D) $3.7 million
E) $3.9 million
Q3) Explain homemade leverage and why it matters.
Q4) Discuss Modigliani and Miller's Propositions I and II in a world with taxes. List the basic assumptions,results,and intuition of the model.
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Chapter 17: Capital Structure: Limits to the Use of Debt
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Q1) Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?
Q2) Issuing debt instead of new equity in a closely held firm more likely:
A) causes the owner-manager to work less hard and shirk their duties as they have less capital at risk.
B) causes the owner-manager to consume more perquisites because the cost is passed to the debtholders.
C) causes both more shirking and perquisite consumption since the government provides a tax shield on debt.
D) causes agency costs to fall as owner-managers do not need to worry about other shareholders.
E) causes the owner-manager to reduce shirking and perquisite consumption as the excess cash flow must be used to meet debt payments.
Q3) Describe some of the sources of business risk and financial risk. Do financial decision makers have the ability to "trade off" one type of risk for the other?
Q4) What are the advantages of a prepackaged bankruptcy for a firm? What are the disadvantages?
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Chapter 18: Valuation and Capital Budgeting for the Levered Firm
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Q1) The acceptance of a capital budgeting project is usually evaluated on its own merits. That is,capital budgeting decisions are treated separately from capital structure decisions. In reality,these decisions may be highly interwoven. This may result in:
A) firms rejecting positive NPV, all equity projects because changing to a capital structure with debt will always create negative NPV.
B) never considering capital budgeting projects on their own merits.
C) corporate financial managers first checking with their investment bankers to determine the best type of capital to raise before valuing the project.
D) firms accepting some negative NPV all equity projects because changing the capital structure adds enough positive leverage tax shield value to create a positive NPV.
E) firms never changing the capital structure because all capital budgeting decisions will be subsumed by capital structure decisions.
Q2) A loan of $10,000 is issued at 15% interest. Interest on the loan is to be repaid annually for 5 years,and the non-amortized principal is due at the end of the fifth year. Calculate the NPV of the loan if the company's tax rate is 34%.
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Page 20
Chapter 19: Dividends and Other Payouts
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Q1) Schaeffer Shippers announced on May 1,2009,that it will pay a dividend of $5.00 per share on June 15 to all holders on record as of May 31<sup>st</sup>. The firm's stock price is currently at $70 per share. Assume that all investors are in the 33% tax bracket. Given that the ex-dividend date is May 29,what should happen to Schaeffer's stock price on May 29?
Q2) The information content of a dividend increase generally signals that:
A) the firm has a one-time surplus of cash.
B) the firm has few, if any, net present value projects to pursue.
C) management believes that the future earnings of the firm will be strong.
D) the firm has more cash than it needs due to sales declines.
E) future dividends will be lower.
Q3) The last date on which you can purchase shares of stock and still receive the dividend is the date _____ business day(s) prior to the date of record.
A) zero
B) one C) three D) five E) seven
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Chapter 20: Raising Capital
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Q1) Types of dilution include:
A) dilution of percentage ownership
B) dilution of market share
C) dilution of book value and earnings per share
D) dilution of percentage ownership and dilution of book value and earnings per share
E) All of these
Q2) The LaPorte Corporation has a new rights offering that allows you to buy one share of stock with 3 rights and $20 per share. The stock is now selling ex-rights for $26. The price rights-on is:
A) $22.00.
B) $24.00.
C) $26.00.
D) $28.00.
E) impossible to determine without the cum-rights pricE.
Q3) Lamar Inc. is attempting to raise $5,000,000 in new equity with a rights offering. The subscription price for the 125,000 new shares will be $40 per share. The stock currently sells for $50 per share and there are 250,000 shares outstanding. What will the price per share be if all rights are exercised?
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Chapter 21: Leasing
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Q1) Some assets are leased more than others because:
A) the value of the asset under a lease is not highly affected by term of use or maintenance decisions.
B) a lease may be used to fool clients into "buying" high priced assets above market value.
C) leasing allows sellers to attract clients with low prices as the basis for setting the contract.
D) Both the value of the asset under a lease is not highly affected by term of use or maintenance decisions; and a lease may be used to fool clients into "buying" high priced assets above market value.
E) Both the value of the asset under a lease is not highly affected by term of use or maintenance decisions; and leasing allows sellers to attract clients with low prices as the basis for setting the contract.
Q2) The price or lease payment that the lessee sets as their bound is known as:
A) the present value of the tax shields.
B) the reservation payment, L<sub>MIN</sub>.
C) the present value of operating savings.
D) the reservation payment, L<sub>MAX</sub>.
E) None of these.
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Chapter 22: Options and Corporate Finance
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Q1) 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.
Q2) The owner of a call option has the:
A) right but not the obligation to buy a stock at a specified price on a specified date.
B) right but not the obligation to buy a stock at a specified price during a specified period of time.
C) obligation to buy a stock on a specified date but only at the specified price.
D) obligation to buy a stock sometime during a specified period of time at the specified price.
E) obligation to buy a stock at the lower of the exercise price or the market price on the expiration datE.
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Chapter 23: Options and Corporate Finance: Extensions and Applications
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Q1) Investing in a negative NPV project today is a feasible choice if:
A) there are future option alternatives.
B) investing is sequentially limited.
C) the discount rate is low.
D) Both there are future option alternatives and investing is sequentially limited.
E) Both there are future option alternatives and the discount rate is low.
Q2) An example of a special option is:
A) an executive stock option.
B) the embedded option in a start-up company.
C) the option in simple business contracts.
D) the option to shut down and reopen a project.
E) All of
Q3) Executives cannot exercise their options for a fixed period of time. This is the:
A) investing period.
B) freeze-out period.
C) valuation period.
D) guaranteed growth period.
E) strike period.
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Chapter 24: Warrants and Convertibles
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Q1) The exercise of warrants creates new shares which:
A) increases the total number of shares but does not affect share value.
B) increases the total number of shares which can reduce an individual share value.
C) does not change the number of shares outstanding, similar to options.
D) increases share value because cash is paid into the firm at the time of warrant exercise.
E) None of these.
Q2) 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 these.
Q3) Kida Consultants has 100,000 shares of stock outstanding. The firm's value net of debt is $2 million. Kida has 1,000 warrants outstanding with an exercise price of $18,where each warrant entitles the holder to purchase one share of stock. Calculate the gain from exercising a single warrant.
Q4) Why are warrants and convertibles issued?
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Chapter 25: Derivatives and Hedging Risk
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Q1) Duration is a measure of the:
A) yield to maturity of a bond.
B) coupon yield of a bond.
C) price of a bond.
D) effective maturity of a bond.
E) All of
Q2) On June 1,you contract to take delivery of 1 ounce of gold for $965. The agreement is good for any day up to July 1. Throughout June,the price of gold hit a low of $960 and hit a high of $990. The price settled on June 30 at $980,and on July 1<sup>st</sup> you settle your futures agreement at that price. Your net cash flow is:
A) -$20.
B) -$15.
C) -$5
D) $15.
E) $20.
Q3) Duration is defined as the weighted average time to maturity of a financial instrument. Explain how this knowledge can help protect against interest rate risk.
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Chapter 26: Short-Term Finance and Planning
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Q1) The length of time between the acquisition of inventory by a firm and the payment by the firm for that inventory is called the:
A) operating cycle.
B) inventory period.
C) accounts receivable period.
D) accounts payable period.
E) cash cyclE.
Q2) Which one of the following will decrease the operating cycle?
A) Paying accounts payable faster
B) Discontinuing the discount given for early payment of an accounts receivable
C) Decreasing the inventory turnover rate
D) Collecting accounts receivable faster
E) Increasing the accounts payable turnover rate
Q3) The most common means of financing a temporary cash deficit is a:
A) long-term secured bank loan.
B) short-term secured bank loan.
C) short-term issue of corporate bonds.
D) long-term unsecured bank loan.
E) short-term unsecured bank loan.
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Chapter 27: Cash Management
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Q1) Even though the dividend rate on an Adjustable-Rate Preferred Stock (ARPS) is floating to keep in line with interest rates,the instrument still suffers from risk such as:
A) a thin market causing potential principal risk and liquidity concerns.
B) the risk of downgrades from the narrow range of issuers.
C) the impact of tax law changes, which may reduce the after-tax value of the instrument.
D) All of these.
E) None of these.
Q2) Firms hold cash,in part,to satisfy compensating balances. Compensating balances are:
A) cash balances held at the firm in excess of its transactions needs.
B) cash balances held at the firm that are below that of its transactions needs.
C) cash balances held at the firm in excess of its cash inflows.
D) cash balances held at commercial banks to pay implicitly for bank services.
E) None of these.
Q3) Discuss the Check Clearing Act for the 21<sup>st</sup> Century,known as Check 21 and how it will impact floats.
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Chapter 28: Credit and Inventory Management
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Q1) Seasonal dating of accounts receivable:
A) is used by all firms that grant credit.
B) brings the receivable immediately due during the season of the product.
C) makes the effective date of the invoice on a specific date in or around the relevant season of the product.
D) All of these.
E) None of these.
Q2) In credit analysis of a customer,commonly used information includes the customer's:
A) financial statements.
B) credit report.
C) payment history with the firm.
D) All of these.
E) Both credit report and payment history with the firm.
Q3) The three components of credit policy are:
A) collection policy, credit analysis, and interest rate determination.
B) collection policy, credit analysis, and terms of the sale.
C) collection policy, interest rate determination, and repayment analysis.
D) credit analysis, repayment analysis, and terms of the sale.
E) interest rate determination, repayment analysis and terms of salE.
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Chapter 29: Mergers, Acquisitions, and Divestitures
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Q1) Firm A is acquiring Firm B for $25,000 in cash. Firm A has 2,000 shares of stock outstanding at a market value of $21 a share. Firm B has 1,200 shares of stock outstanding at a market price of $17 a share. Neither firm has any debt. The net present value of the acquisition is $1,500. What is the price per share of Firm A after the acquisition?
A) $21.00
B) $21.25
C) $21.75
D) $22.00
E) $22.50
Q2) A reason for acquisitions is synergy. Synergy includes:
A) revenue enhancements.
B) cost reductions.
C) lower taxes.
D) All of these.
E) None of these.
Q3) Discuss why AT&T purchased T-Mobile in 2011.
Q4) Sometimes the management of a target firm fights a takeover attempt even when that attempt appears to be in the best interest of the shareholders. Why would management take this stance?
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Chapter 30: Financial Distress
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Q1) Perhaps equally,if not more damaging are the indirect costs of financial distress. Some examples of indirect costs are:
A) loss of current customers.
B) loss of business reputation.
C) management consumed in survival and not on a strategic direction.
D) All of these.
E) Both loss of current customers and loss of business reputation.
Q2) Financial distress can involve which of the following:
A) asset restructuring.
B) financial restructuring.
C) liquidation.
D) All of these.
E) None of these.
Q3) Flow-based insolvency is:
A) a balance sheet measurement.
B) a negative equity position.
C) when operating cash flow is insufficient to meet current obligations.
D) inability to pay one's debts.
E) Both when operating cash flow is insufficient to meet current obligations and inability to pay one's debts.
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Chapter 31: International Corporate Finance
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Q1) The international Fisher effect says that _____ rates are equal across countries.
A) spot
B) one-year future
C) nominal
D) inflation
E) real
Q2) The changes in the relative economic conditions between countries are referred to as the:
A) international Fisher effect.
B) international exchange rate effect.
C) translation exposure to exchange rate risk.
D) long-run exposure to exchange rate risk.
E) the interest rate parity risk.
Q3) What is triangle arbitrage?
Using the U.S. dollar,the Canadian dollar,and the euro,construct an example in which triangle arbitrage exists,and then show how to exploit it.
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