Principles of Finance
Midterm Exam
Course Introduction
Principles of Finance introduces students to the fundamental concepts and tools used in financial decision-making within organizations. The course covers key topics such as financial statement analysis, time value of money, risk and return, asset valuation, capital budgeting, and the workings of financial markets and institutions. Through theoretical frameworks and practical applications, students learn how to assess financial performance, make investment decisions, manage corporate finances, and understand the broader economic factors affecting financial management. This foundation prepares students for more advanced finance courses and professional roles in the finance sector.
Recommended Textbook
Fundamentals of Corporate Finance 4th Edition Jonathan Berk
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Page 2
Chapter 1: Corporate Finance and the Financial Manager
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Q1) Over four-fifths of all U.S. business revenue is generated by which type of firm?
A) sole proprietorships
B) partnerships
C) limited partnerships
D) corporations
Answer: D
Q2) Corporations have come to dominate the business world through their ability to raise large amounts of capital by sale of ownership shares to anonymous outside investors.
A)True
B)False
Answer: True
Q3) Which of the following types of firms generate the most revenue in the United States?
A) S corporation
B) limited partnership
C) C corporation
D) limited liability company
Answer: C
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Page 3
Chapter 2: Introduction to Financial Statement Analysis
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Q1) Consider the above statement of cash flows. What were AOS Industries' major means of raising money in 2008?
A) from investment activities
B) by sale of stock
C) from its operations
D) by issuing debt
Answer: D
Q2) Refer to the balance sheet above. If on December 31, 2005 Luther has 8 million shares outstanding trading at $15 per share, then what is Luther's enterprise value?
Answer: Enterprise value = Market value of equity + Debt - Cash Market value of equity = 8 million × $15 = $120 million
Debt = Notes payable + Current maturities of long-term debt + Long-term debt
Debt = $9.6 + $36.9 + $168.9 = $215.4
Cash = $58.5
So, enterprise value = $120 + 215.4 - 58.5 = $276.90.
Q3) What role do external auditors play in a firm's financial reporting process?
Answer: As the name implies, external auditors act as third party monitors to a firm's financial reporting process.
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4
Chapter 3: Time Value of Money: an Introduction
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Q1) A U.S.-based manufacturer of sunscreen is contemplating using funds to purchase courtside advertising at major tennis matches such as the French Open and the Australian Open. Advertising at such well viewed international events will then raise the domestic sales of the manufacturers products. Which of the following factors is the most relevant when analyzing this decision?
A) the cost of the machine used to produce the sunscreen
B) the manufacturing process of the sunscreen
C) the cost of the existing advertising campaign
D) the cost of the courtside advertising at the tennis matches
Answer: D
Q2) You have a used CD store. At an estate sale, you can purchase 230 compact discs for $356.5. You believe you could sell the CDs for an average of $3.05 each. What is the net benefit of buying the CDs at the estate sale and selling them in your store?
A) $445
B) $545
C) $645
D) $345
Answer: D
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Chapter 4: Time Value of Money: Valuing Cash Flow
Streams
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Q1) An investment pays you $30,000 at the end of this year, and $15,000 at the end of each of the four following years. What is the present value (PV) of this investment, given that the interest rate is 5% per year?
A) $39,614
B) $63,382
C) $79,228
D) $95,074
Q2) Assume that you are 30 years old today, and that you are planning on retirement at age 65. You expect your salary to be $42,000 one year from now and you also expect your salary to increase at a rate of 5% per year as long as you work. To save for your retirement, you plan on making annual contributions to a retirement account. Your first contribution will be made on your 31st birthday and will be 8% of this year's salary. Likewise, you expect to deposit 8% of your salary each year until you reach age 65. Assume that the rate of interest is 9%. The present value (PV) (at age 30) of your retirement savings is closest to ________.
A) $61,303
B) $30,652
C) $42,912
D) $67,433
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Chapter 5: Interest Rates
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Q1) When there are large numbers of people looking to save their money and there is little demand for loans, one would expect interest rates to be high.
A)True
B)False
Q2) Liam had an extension built onto his home. He financed it for 48 months with a loan at 5.00% APR. His monthly payments were $770. How much was the loan amount for this extension?
A) $33,436
B) $40,123
C) $46,810
D) $53,497
Q3) The effective annual rate (EAR) for a savings account with a stated APR of 5% compounded daily is closest to ________.
A) 5.64%
B) 6.15%
C) 5.13%
D) 6.66%
Q4) Is it possible to analyze cash flows that occur in time intervals that are not exactly equal to a year?
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Chapter 6: Bonds
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Q1) Which of the following statements regarding bonds and their terms is FALSE?
A) Bonds are securities sold by governments and corporations to raise money from investors today in exchange for a promised future payment.
B) By convention, the coupon rate is expressed as an effective annual rate.
C) Bonds typically make two types of payments to their holders.
D) The time remaining until the repayment date is known as the term of the bond.
Q2) Which of the following bonds will be most sensitive to a change in interest rates if all bonds have the same initial yield to maturity?
A) a ten-year bond with a $1,000 face value whose coupon rate is 5.8% APR paid semiannually
B) a ten-year bond with a $1,000 face value whose coupon rate is 7.4% APR paid semiannually
C) a 20-year bond with a $1,000 face value whose coupon rate is 5.8% APR paid semiannually
D) a 20-year bond with a $1,000 face value whose coupon rate is 7.4% APR paid semiannually
Q3) Before it matures, the price of any bond is always less than its face value. A)True B)False
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Page 8
Chapter 7: Stock Valuation
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Q1) The ownership in a corporation is divided into shares of stock, which carry rights to a share in the profits of the firm through future dividend payments.
A)True
B)False
Q2) Luther Industries has a dividend yield of 4.5% and a cost of equity capital of 10%. Luther Industries' dividends are expected to grow at a constant rate indefinitely. The growth rate of Luther's dividends is closest to ________.
A) 5.5%
B) 14.5%
C) 11.0%
D) 5.0%
Q3) Which of the following is NOT a way that a firm can increase its dividend?
A) by increasing its retention rate
B) by decreasing its shares outstanding
C) by increasing its earnings (net income)
D) by increasing its dividend payout rate
Q4) How can the dividend-discount model handle changing growth rates?
Q5) What is a major assumption about growth rate in the dividend-discount model?
Q6) What role do dividends play in stock investing?
Page 9
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Chapter 8: Investment Decision Rules
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Q1) The Net Present Value rule implies that we should compare a project's net present value (NPV) to zero.
A)True
B)False
Q2) The payback rule is based on the idea that an opportunity that pays back its initial investment quickly is a worthwhile opportunity.
A)True
B)False
Q3) A security firm is offered $80,000 in one year for providing CCTV coverage of a property. The cost of providing this coverage to the security firm is $74,000, payable now, and the interest rate is 8.5%. Should the firm take the contract?
A) Yes, since net present value (NPV) is positive.
B) It does not matter whether the contract is taken or not, since NPV = 0.
C) Yes, since net present value (NPV) is negative.
D) No, since net present value (NPV) is negative.
Q4) What can you comment about the shape of the net present value (NPV) profile of a multiple IRR project?
Q5) What is the Net Present Value rule?
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Page 10
Chapter 9: Fundamentals of Capital Budgeting
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Q1) To evaluate a capital budgeting decision, it is sufficient to determine its consequences for the firm's earnings.
A)True
B)False
Q2) A company buys tracking software for its warehouse which, along with the computer system and ancillaries to run it, will cost $1.6 million. This purchase will be deducted over five years. It is expected that the software will reduce inventory by $10.7 million at the end of the first year after it is installed, though there will be an annual cost of $120,000 per year to run the system. If the company's marginal tax rate is 40%, how will the purchase of this item change the company's free cash flows in the first year?
A) $10.756 million
B) $10.380 million
C) $9.680 million
D) $11.832 million
Q3) Which of the following will cause the EBIT Break-Even for sales to increase?
A) a decrease in the sales price
B) a decrease in depreciation expense
C) a decrease in selling, general, and administrative expenses
D) a decrease in the number of units sold
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Page 11
Chapter 10: Stock Valuation: a Second Look
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Q1) In the method of comparables, the known values of a firm's cash flows are used to estimate the unknown cash flows of a similar firm.
A)True
B)False
Q2) Which of the following is the appropriate way to calculate the price of a share of a given company using the free cash flow valuation model?
A) P<sub>0</sub> = Div<sub>1</sub>/(r<sub>E</sub> - g)
B) P<sub>0</sub> = PV(Future Free Cash Flow of Firm) / (Shares Outstanding<sub>0</sub>)
C) P<sub>0</sub> = [Div<sub>1 </sub>/ (r<sub>E</sub> - g)] / (Shares Outstanding<sub>0</sub>)
D) P<sub>0</sub> = (V<sub>0</sub> + Cash<sub>0</sub> - Debt<sub>0</sub>) / (Shares Outstanding<sub>0</sub>)
Q3) Several methods should be used to provide an estimate of a stock's value since no single method provides a definitive value.
A)True
B)False
Q4) Which is the best valuation technique when using comparables?
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Page 12
Chapter 11: Risk and Return in Capital Markets
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Q1) There is an overall relationship between ________ and ________. Larger stocks have a lower volatility overall.
A) size, risk
B) mean, standard deviation
C) risk aversion, size
D) volatility, mean
Q2) Ford Motor Company had realized returns of 20%, 30%, 30%, and 20% over four quarters. What is the quarterly standard deviation of returns for Ford calculated from this sample?
A) 5.77%
B) 5.20%
C) 6.06%
D) 4.62%
Q3) Which of the following investments had the largest fluctuations overall return over the past eighty years?
A) small stocks
B) S&P 500
C) corporate bonds
D) Treasury bills
Q4) Is volatility a reasonable measure of risk when evaluating large portfolios?
Page 13
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Chapter 12: Systematic Risk and the Equity Risk Premium
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Q1) Correlation is the degree to which the returns of two stocks share common risks.
A)True
B)False
Q2) Which of the following statements is FALSE?
A) The risk premium of a security is equal to the market risk premium divided by the amount of market risk present in the security's returns measured by its beta with the market.
B) The beta of a portfolio is the weighted average beta of the securities in the portfolio.
C) There is a linear relationship between a stock's beta and its expected return.
D) A security with a negative beta has a negative correlation with the market, which means that this security tends to perform well when the rest of the market is doing poorly.
Q3) While we are using historic return to estimate a stock's beta, why can't we use historic data to forecast the expected return for the stock?
Q4) What role does the standard deviations of two assets play in computation of the expected return of the two asset portfolio?
Q5) Is it possible for a stock to have high total risk but low systematic risk?
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Page 14
Chapter 13: The Cost of Capital
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Q1) Assume General Motors has a weighted average cost of capital of 9%. GM is considering investing in a new plant that will save the company $20 million over each of the first two years, and then $10 million each year thereafter. If the investment is $100 million, what is the net present value (NPV) of the project?
A) $25.8 million
B) $31.6 million
C) $28.7 million
D) $27.3 million
Q2) Assume Lavender Corporation has a market value of $4 billion of equity and a market value of $19.8 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?
A) 0.10, 0.90
B) 0.832, 0.168
C) 0.168, 0.832
D) 0.90, 0.10
Q3) What is the assumption about leverage when using WACC to evaluate a project?
Q4) Among the two models Constant Dividend Growth Model (CDGM) and Capital Asset Pricing Model (CAPM), which is a better method for computation of the cost of equity?
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Page 15
Chapter 14: Raising Equity Capital
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Q1) Which of the following statements is FALSE?
A) Underwriters appear to use the information they acquire during the book-building stage to intentionally underprice the IPO, thereby reducing their exposure to losses.
B) The green shoe option restricts an underwriter to issue more stock at the IPO offer price.
C) The lead underwriter usually makes a market in the stock by matching buyers and sellers and assigns an analyst to cover it.
D) In most cases, the existing shareholders are subject to a 180-day lockup; they cannot sell their shares for 180 days after the IPO. Once the lockup period expires, they are free to sell their shares.
Q2) Which of the following statements concerning the volume and number of IPOs issued over time is most correct?
A) They are cyclical.
B) They tend to rise over time.
C) They tend to fall over time.
D) They remain approximately the same over time.
Q3) What are venture capital firms?
Q4) What are some of the advantages of going public?
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Page 16
Chapter 15: Debt Financing
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Q1) Clearview Corporation, a company that deals mainly with the financing and distribution of music, issues debt with a maturity of 15 years. In the case of bankruptcy, holders of this debt will have claim to the intellectual property of Clearview. Which of the following best describes this type of corporate debt?
A) a note
B) a debenture
C) a mortgage bond
D) an asset-backed bond
Q2) A company issues a callable (at par) five-year, 7% coupon bond with annual coupon payments. The bond can be called at par in one year after release or any time after that on a coupon payment date. On release, it has a price of $110 per $100 of face value. What is the yield to call of this bond when it is released?
A) 1.40%
B) 2.73%
C) 4.71%
D) 5.66%
Q3) What is yield to call?
Q4) What is an original issue discount bond?
Q5) What are bond covenants?
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Chapter 16: Capital Structure
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Q1) A firm has a market value of equity of $30,000. It borrows $7500 at 8%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?
A) 16.75%
B) 6.70%
C) 20.10%
D) 23.45%
Q2) Firms in industries such as real estate tend to have ________ distress costs because of a large proportion of tangible assets.
A) high
B) low
C) unexpected
D) varying
Q3) A project will give a one-time cash flow of $22,000 after one year. If the project risk requires a return of 10%, what is the levered value of the firm with perfect capital markets?
A) $20,000
B) $16,000
C) $24,000
D) more information needed
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Page 18
Chapter 17: Payout Policy
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Q1) Prada has nine million shares outstanding, generates free cash flows of $ 40 million each year and has a cost of capital of 10%. It also has $30 million of cash on hand. Prada wants to decide whether to repurchase stock or invest the cash in a project that generates free cash flows of $5 million each year. Should Prada invest or repurchase the shares?
A) indifferent between options
B) repurchase
C) invest
D) cannot say for sure
Q2) What are the different ways a firm can repurchase shares?
Q3) The WTC Corporation will pay a constant dividend of $4.20 per share, per year, in perpetuity. If all investors pay a 20% tax on dividends, there is no capital gains tax, and the cost of capital for investing in WTC stock is 14%, what is the price for a share of WTC stock?
A) $24.00
B) $19.20
C) $28.80
D) $48.00
Q4) What is the bird-in-the-hand fallacy in dividend theory under perfect capital markets?
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Chapter 18: Financial Modeling and Pro Forma Analysis
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Q1) Assuming that Ideko has an EBITDA multiple of 8.5, then the continuation enterprise value of Ideko in 2015 is closest to ________.
A) $152.812 million
B) $272.799 million
C) $301.173 million
D) $181.072 million
Q2) One of the shortcomings of the percent of sales method is that it does not account for the fact that capacity changes are lumpy and not incremental.
A)True
B)False
Q3) Forecasting a balance sheet with percent of sales method requires two passes-a first pass to determine financing needs and a second pass that shows the sources and amounts of financing.
A)True
B)False
Q4) What is net new financing?
Q5) How do we compute net new financing?
Q6) What is common starting point for forecasting?
Q7) Why is EBITDA multiple used for valuation rather than sales or earnings?
Page 20
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Chapter 19: Working Capital Management
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Q1) The difference between a firm's operating cycle and its cash cycle is ________.
A) its account receivable days
B) its accounts payable days
C) its inventory days
D) There is no difference between the cash and operating cycles.
Q2) Which of the following is the term used to describe debt issued by state and local government which has a maturity of one to six months?
A) certificates of deposit
B) banker's acceptances
C) commercial paper
D) short-term tax exempts
Q3) Genovese Fine Foods, a manufacturer of foodstuffs, buys durham wheat flour on credit on June 1. It processes this flour to make pasta on June 6 and pays cash for the flour on June 15. On June 22 it sells the pasta to a chain of supermarkets, and on July 3 receives cash payment for this sale. What is the length of the cash cycle in this case?
A) 8 days
B) 12 days
C) 18 days
D) 28 days
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Page 21
Chapter 20: Short-Term Financial Planning
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Q1) Which of the following statements is FALSE?
A) By relying on short-term debt, the firm exposes itself to funding risk, which is the risk of incurring financial distress costs if it cannot refinance its debt in a timely manner or at a reasonable rate.
B) An ultra-conservative policy would involve financing even some of the plant, property, and equipment with short-term sources of funds.
C) With a conservative financing policy, the firm would use short-term debt very sparingly to meet its peak seasonal needs.
D) Short-term debt can have lower agency and lemons costs than long-term debt, and an aggressive financing policy can benefit shareholders.
Q2) Which of the following best describes a bank loan arrangement where a bank agrees to lend a firm any amount up to a stated maximum in an informal agreement which does not legally bind the bank to provide the funds?
A) single, end-of-period payment loan
B) bridge loan
C) committed line of credit
D) uncommitted line of credit
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Page 22
Chapter 21: Option Applications and Corporate Finance
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Q1) Luther Industries is currently trading for $27 per share. The stock pays no dividends. A one-year European put option on Luther with a strike price of $30 is currently trading for $2.60. If the risk-free interest rate is 6% per year, then the price of a one-year European call option on Luther with a strike price of $30 will be closest to ________.
A) $1.30
B) $7.10
C) $2.60
D) $1.95
Q2) Suppose that a stock sells at a price of $40 on the expiration date. Compute the price of a call option if the option strike price is $20.
A) $20
B) $30
C) $40
D) $50
Q3) When is an option in-the-money?
Q4) What is the long position of an options contract?
Q5) When is an option out-the-money?
Q6) What is a call option?
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Chapter 22: Mergers and Acquisitions
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Q1) Mayo Corporation is currently trading at $30 per share. There are 10 million shares outstanding, and the company has no debt. You believe that the value of the company would increase by 50% if the management were replaced. How much would you gain from acquiring 50% of Mayo's shares by borrowing, attaching the debt to the company and replacing the management?
A) $150 million
B) $225 million
C) $300 million
D) $10 million
Q2) The merger of two companies in the same industry that make products required at different stages of the production cycle is called ________.
A) economies of scope
B) vertical integration
C) economies of scale
D) horizontal integration
Q3) Assume that Martin pays no premium to acquire Luther. Calculate Martin's price-earnings (P/E) ratio both pre and post merger.
Q4) What is a white knight?
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24
Chapter 23: International Corporate Finance
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Q1) Which of the following statements is FALSE?
A) In some countries, especially in the developing world, all investors do not have equal access to financial securities.
B) Firms may face differential access to markets if there is any kind of asymmetry with respect to information about them.
C) In some cases, a country's risk-free securities are internationally integrated but markets for a specific firm's securities are not.
D) When countries' capital markets are not integrated we call them disintegrated capital markets.
Q2) Consider the following equation: S × [(Foreign Cash Flow) / (1 + r<sub>FC</sub>] = (Forward Rate × Foreign Cash Flow) / (1 + r<sub>$</sub>)
The term r<sub>$</sub> in this equation is ________.
A) the dollar discount rate
B) the risk-free rate for a foreign investor
C) the risk-free rate for a U.S. investor
D) the foreign currency discount rate
Q3) What are the timings of the foreign exchange market?
Q4) What are internationally segmented capital markets?
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Page 25
Chapter 24: Leasing
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Q1) Which of the following is considered an unfair comparison?
A) FMV lease versus $1.00-out lease
B) $1.00-out lease versus true tax lease
C) lease versus buy
D) lease versus borrow
Q2) In the chapter, the lease versus buy decision was called an unfair comparison. Why? What is the correct comparison?
Q3) If Luther acquires the new fleet of delivery trucks using an operating lease, Luther's debt-to-equity ratio will be closest to ________.
A) 2.0
B) 1.5
C) 0.80
D) 0.66
Q4) Suppose that the bulldozer can be leased with a $1.00-out lease. The lease payments will be closest to ________.
A) 2,114
B) 1,825
C) 2,030
D) 2,103
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Chapter 25: Insurance and Risk Management
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Q1) In reality market imperfections exist that can raise the cost of insurance above the actuarially fair price and offset some of these benefits. These insurance market imperfections include all of the following EXCEPT ________.
A) adverse selection
B) agency costs
C) administrative and overhead costs
D) taxation of insurance payments
Q2) Assuming that your firm will purchase insurance, what is the minimum-size deductible that would leave your firm with an incentive to implement the new safety policies?
Q3) An operator of an oil well has a 0.5% chance of experiencing a catastrophic failure over the next year. This failure will cost the operator $500 million. If the risk-free rate is 2%, the expected return on the market is 8%, and the beta of the risk is 0, what is the actuarially fair insurance premium?
A) $2,450,980
B) $2,500,000
C) $2,550,000
D) $2,314,815
Q4) What is the actuarially fair cost of full insurance?
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Chapter 26: Corporate Governance
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Sample Questions
Q1) What are some of the negative effects of increasing the sensitivity of managerial pay to firm performance?
Q2) Which of the following statements is FALSE?
A) New SEC rules require firms to report option grants within two days of the grant date, which may help prevent further abuses.
B) Studies have found evidence that the practice of timing the release of information to maximize the value of CEO stock options is widespread.
C) Managers have an incentive to manipulate the release of financial forecasts so that good news comes out before options are granted and bad news is delayed until after the options are granted.
D) The factor contributing most to the climb in CEO total compensation for the 1990s was the sharp increase in the value of stock and options granted each year.
Q3) Describe the main requirements of the Sarbanes-Oxley Act of 2002.
Q4) What is the role of takeovers in corporate governance?
Q5) What is the difference between inside, gray, and outside directors?
Q6) What is corporate governance?
Q7) How does a pyramid structure work?
To view all questions and flashcards with answers, click on the resource link above. Page 28