Principles of Finance Review
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Course Introduction
Principles of Finance provides students with a comprehensive understanding of the fundamental concepts and tools used in the field of finance. The course covers key topics such as the time value of money, risk and return, financial statement analysis, valuation of securities, capital budgeting, and the functioning of financial markets and institutions. Students will learn to apply theoretical frameworks to real-world financial decision-making, develop analytical skills in evaluating investment opportunities, and understand the role of finance in both corporate and personal contexts. This foundational course prepares students for advanced studies in finance and related disciplines.
Recommended Textbook Fundamentals of Corporate Finance 5th Canadian Edition by Richard A Brealey
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Chapter 1: Goals and Governance of the Firm
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Sample Questions
Q1) Ethical decision making by management has a payoff for shareholders in terms of:
A)Improved capital structure.
B)Enhanced reputation value.
C)Increased managerial benefits.
D)Higher dividend payments.
Answer: B
Q2) The duties of a corporate controller typically include the preparation of financial statements.
A)True
B)False
Answer: True
Q3) A common problem for closely held corporations is:
A)Lack of access to substantial amounts of capital.
B)That shareholders receive only one vote each.
C)The separation of ownership and management.
D)An abundance of agency problems.
Answer: A
Q4) Tabulate and compare the differences among corporations, proprietorships and partnerships.
Answer: 11ea68e2_3f58_e75c_935e_8d737f8a414d_TB1770_00
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Chapter 2: Financial Markets and Institutions
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Sample Questions
Q1) What are the functions of financial markets?
Answer: Financial markets help channel savings to corporate investment, and they help match up borrowers and lenders.They provide liquidity and diversification opportunities for investors.Trading in financial markets provides a wealth of useful information for the financial manager.
Q2) Why are secondary market transactions of importance to corporations?
Answer: Although corporations do not generate cash flows from secondary market transactions (other than those they initiate), it is the existence of secondary markets that made many investors comfortable enough to invest in their primary market offerings.In other words, if investors felt there would not be an organized, convenient market in which to alter their portfolio of securities, their original investment decisions might be quite different.Also, the secondary market acts as a form of "scorecard" for the decisions of management and the general prospects of the firm.Market values are, in most instances, much more important than book values, thus values in the secondary market give investors and analysts alike the ability to evaluate a firm.These evaluations will also affect future primary market offerings.
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Chapter 3: Accounting and Finance
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Sample Questions
Q1) Which of the following statements correctly compares international accounting standards?
A)The standards are becoming less similar over time
B)The standards are typically more lenient in Canada and the U.S.
C)The standards are typically stricter in Canada and the U.S.
D)Balance sheets differ, but income statements are similar in all countries
Answer: C
Q2) Calculate the cash inflows (outflows) from investing activities if total cash decreased by $40,000; cash inflows from operating activities were $14,000 and cash outflows from financing activities were $60,000.
A)Inflow of $5,000
B)Inflow of $6,000
C)Outflow of $5,000
D)Outflow of $6,000
Answer: B
Q3) What is the firm's net income?
Answer: 11ea68e2_3ec4_be07_935e_5d193c37b745_TB1770_00
Q4) What are the firm's earnings before interest and taxes?
Answer: 11ea68e2_3ec4_6fe6_935e_31662b342463_TB1770_00
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Chapter 4: Measuring Corporate Performance
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Q1) Which of the following will increase a firm's times interest earned ratio?
A)An increase in debt
B)A decrease in cost of goods sold
C)An increase in interest expense
D)A decrease in net income
Q2) A total debt ratio of 0.35:
A)Indicates that the firm is financed with 35 percent long-term debt
B)Would exist if a firm had liabilities of $700 and assets of $2,000
C)Indicates that 35 cents of every dollar of capital is in the form of short-term debt
D)Indicates that 35 cents of every dollar of capital is in the form of long-term debt
Q3) A company with long-term debt of 80, lease obligations of 20, total assets of 1,000, and total liabilities of 350 has a:
A)Total debt ratio of approximately .10
B)Total debt ratio of approximately .23
C)Long-term debt ratio of approximately .15
D)debt-to-equity ratio of approximately .15 Equity = 1000 - 350 = 650
Q4) Name five types of distortions caused by increasing prices that have an impact on the income statement.
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Chapter 5: The Time Value of Money
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Q1) Under which of the following conditions will a future value calculated with simple interest exceed a future value calculated with compound interest at the same rate?
A)The interest rate is very high
B)The investment period is very long
C)The compounding is annually
D)This is not possible with positive interest rates
Q2) Converting an annuity to an annuity due decreases the present value.
A)True
B)False
Q3) A stream of equal cash payments lasting forever is termed:
A)An annuity
B)An annuity due
C)An installment plan
D)A perpetuity
Q4) The more frequent the compounding, the higher the future value, other things being equal.
A)True
B)False
Q5) Discuss the statement, "Money has a time value."
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Chapter 6: Valuing Bonds
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Q1) What happens to the price of a three-year bond with an 8% coupon when interest rates change from 8% to 6%?
A)A price increase of $51.54
B)A price decrease of $51.54
C)A price increase of $53.47
D)No change in price Using the BAII Plus calculator:
Q2) What is meant by "default risk" in bonds, and how do investors respond to it?
Q3) Suppose a 20-year maturity bond currently selling for $1,050 is callable in 5 years at a call price of $1,060.If its yield to maturity is 8.25%, its yield to call is:
A)Less than 8.14%.
B)8.14%.
C)More than 8.14%
D)Could be any of these Using the BAII Plus calculator:
Q4) Current yield overstates the return of premium bonds since investors who buy a bond at a premium face a capital loss over the life of the bond.
A)True
B)False
Q5) Why do bonds exhibit interest rate risk?
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Chapter 7: Valuing Stocks
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Q1) The study of published financial information on a company in order to make investment decisions is known as:
A)Technical analysis
B)Fundamental analysis
C)Efficiency analysis
D)Random pricing analysis
Q2) The g in the constant-growth dividend model refers to:
A)The annual growth rate for dividends
B)The annual growth rate for stock price
C)Both 'a' and 'b' above
D)Neither 'a' nor 'b' above
Q3) The liquidation value of a firm is equal to the book value of the firm.
A)True
B)False
Q4) Security prices are said to follow a "random walk," which means that:
A)Stock selection for portfolio composition is unimportant
B)It is impossible to know whether stocks offer higher returns than bonds
C)Investment analysts are unnecessary
D)Successive price changes are unpredictable
Q5) How does competition among investors lead to efficient markets?
Page 9
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Chapter 8: Net Present Value and Other Investment Criteria
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Q1) Which of the following investment criteria takes the time value of money into consideration?
A)Payback period
B)Profitability index
C)Internal rate of return for borrowing projects
D)Payback period, profitability index and IRR
Q2) Both the NPV and the internal rate of return methods recognize that the timing of cash flows affects project value.
A)True
B)False
Q3) When we compare assets with different lives, we should select the machine that has the lowest equivalent annual annuity.
A)True
B)False
Q4) When managers select correctly from among mutually exclusive projects, they:
A)May give up rate of return for NPV
B)May give up NPV for rate of return
C)Have a tendency to select the largest project
D)Focus on payback method to avoid conflicting signals
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Chapter 9: Using Discounted Cash-Flow Analysis to Make Investment Decisions
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Q1) Allocations of overhead should not affect a project's incremental cash flows unless the:
A)Project actually increased overhead expenses
B)Overhead cannot be recovered at the end of the project
C)Overhead cannot be allocated to other projects
D)Accountant is required to allocate costs to this project
Q2) Calculate the present value of the depreciation tax shield for an asset with a three-year estimated life costing $100,000.The firm has a 35 percent tax rate and a 10 percent cost of capital.Its CCA is 30 percent declining balance with a half-year rule.Compare this present value to that calculated for straight-line depreciation with no salvage value in both cases.
Q3) Class 45 asset purchased for $68,000 at the start of Year 1; Sold at the end of year 3 for $4,000.Analyze what will transpire at the end of year 3.
Q4) The rationale for not including sunk costs in capital budgeting decisions is that they:
A)Are usually small in magnitude
B)Revert at the end of the investment
C)Have no incremental effect
D)Reduce the estimated NPV
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Chapter 10: Project Analysis
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Q1) When the level of fixed costs is decreased, the break-even level of revenues:
A)Will automatically decrease
B)Will automatically increase
C)May or may not be changed, depending on variable costs
D)Will remain unchanged, because fixed costs cannot be altered
Q2) The break-even level of sales represents the point where:
A)Fixed costs are covered
B)Variable costs are covered
C)Fixed costs and variable costs are covered
D)Fixed costs, variable costs, and depreciation are covered
Q3) An 8 year project is estimated to produce a product with the following information: selling price = $80 per unit; variable costs are $65 per unit; fixed costs are $20,000; required return is 10%; initial investment = $200,000.Calculate the Degree of operating leverage.
A)0.83
B)0.73
C)0.63
D)0.53
Q4) Confirm that the percentage change in profits equals DOL times the percentage change in sales.
Page 12
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Chapter 11: Introduction to Risk, Return, and the Opportunity
Cost
of Capital
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Q1) A stock that is considered to be a positive risk asset is added to a portfolio.As a result, the portfolio will:
A)Have lower average returns
B)Have a lower variance of returns
C)Have a higher volatility of returns
D)Have a lower correlation of returns with stock market indexes
Q2) Calculate the inflation rate, given a nominal rate of 10.2% and a real rate of 8.05%
A)2.99%
B)2.49%
C)1.99%
D)1.06%
Q3) A maturity premium is offered on long-term Treasury bonds due to:
A)The risk of changing interest rates
B)The risk of default
C)Their unique risk
D)Their systematic risk
Q4) Discuss the relationship between risk and return.
Q5) What is the difference between unique risk, which can be diversified away, and market risk, which cannot?
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Chapter 12: Risk, Return, and Capital Budgeting
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Q1) If you were willing to bet that the overall stock market was heading up on a sustained basis, it would be logical to invest in:
A)High Beta stocks
B)Low Beta stocks
C)Stocks with large amounts of unique risk
D)Stocks that plot below the security market line
Q2) As a project's Beta increases, the project's opportunity cost of capital increases. A)True
B)False
Q3) An analyst predicts two economic states next year.A boom economy has a 70% probability of occurring, while a recession has a 30% probability of occurrence.A portfolio contains two stocks L and U.Stock L has a 40% weighting in the portfolio, while stock U has a 60% weighting.Stock L is estimated to provide a 10% return in a boom economy and a 4% return in a recession.Stock U is estimated to provide a 5% return in a boom economy and a -8% return in a recession.Calculate the portfolio return.
Q4) Why is it important to make the distinction between company opportunity cost of capital and project opportunity cost of capital when evaluating projects?
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Chapter 13: The Weighted-Average Cost of Capital and Company Valuation
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Q1) How much will a firm need in cash flow before tax and interest to satisfy debt holders and equity holders if: the tax rate is 35%, there is $13 million in common stock requiring a 10% return, and $6 million in bonds requiring an 6% return?
A)$1,392,000
B)$1,488,000
C)$2,360,000
D)$2,480,000 Working backwards:
Q2) New projects should only be undertaken by firms if they have the same risk as existing assets.
A)True
B)False
Q3) What%age of value should be allocated to equity in WACC computations for a firm with $50 million in debt selling at 85% of par, $50 million in book value of equity, and $65 million in market value of equity?
A)50.0%
B)54.1%
C)56.5%
D)60.5%
Q4) Can WACC be used to value an entire business?
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Chapter 14: Introduction to Corporate Financing and Governance
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Q1) One way that investors contribute capital to the firm is by:
A)Plowing back money into retained earnings
B)Paying less than par value for the stock
C)Receiving dividends and reinvesting them on their own
D)Increasing the amount of treasury stock
Q2) To state that net equity issues have been negative recently in the North America indicates that:
A)More shares have been repurchased than newly issued
B)New shares have been sold at less than par value
C)Issuing stock has been a negative NPV transaction
D)Dividend payments have exceeded net income
Q3) When firms retain cash, they are generating funds internally by increasing shareholder investment.
A)True
B)False
Q4) A corporation's net worth is composed of the:
A)Book value of common equity
B)Par value plus additional paid-in capital
C)Retained earnings less treasury stock
D)Book value of common equity plus preferred stock
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Chapter 15: Venture Capital, Ipos, and Seasoned Offerings
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Q1) Companies making smaller security issues may prefer to issue them through:
A)A private placement because lower rates of return can be offered
B)A private placement because it is cheaper than a public issue
C)A public issue because it is cheaper than a private placement
D)A public issue because more exposure will be achieved
Q2) The allowance of POP registration in Canada is likely to have increased:
A)The cost of issuing new securities
B)The profits of venture capitalists
C)Competition among underwriters
D)The underpricing of securities
Q3) A firm's first offering of stock to the general public is known as:
A)first-stage financing
B)An IPO
C)A general cash offer
D)A seasoned offering
Q4) Second-stage financing occurs:
A)prior to the initial public offering
B)When company founders sell a portion of their shares
C)After the best efforts of the underwriters
D)When the IPO does not raise sufficient cash
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Chapter 16: Debt Policy
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Q1) Leverage will __________ shareholders' expected return and _________ their risk.
A)Increase; decrease
B)Decrease; increase
C)Increase; increase
D)Increase; do nothing to
Q2) Discuss how agency problems can develop between shareholders and bondholders when the firm is experiencing financial distress.
Q3) According to MM II, as a firm's debt-to-equity ratio decreases:
A)Its financial risk increases
B)Its operating risk increases
C)The required rate of return on equity increases
D)The required rate of return on equity decreases
Q4) Equity Inc.is currently an all-equity financed firm.It has 10,000 shares outstanding that sell for $20 each.The firm has an operating income of $30,000 and pays no taxes.The firm contemplates a restructuring that would issue $50,000 in 8% debt, which will be used to repurchase stock.Assuming that individuals have the same borrowing opportunities as corporations, explain how an investor can undo the leverage that is proposed by Equity Inc.Under these conditions, what is the value of restructuring to a firm?
Q5) Calculate the required return on the debt.
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Chapter 17: Payout Policy
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Q1) Following the time sequence described in Table 22.1, and using the information from Questions 57 through 63, what would the present value of cash flows be for leasing this $800,000 asset if the lessee's before tax cost of capital were 15%? Note that the asset is scrapped and alone in its pool at the time of disposition.
A)($24,555)
B)$3,456
C)$2,457
D)$1,743
Q2) A leveraged lease requires a situation where:
A)Lessee loaning part of the asset purchase to the lessor
B)Lessor selling ownership of the leased asset to others
C)Lessor borrows part of the asset's price
D)Lessor loans the lessee funds to maintain the asset
Q3) Leasing allows small lessors to "lend" cheaply because lease contracts and collateral come in standardized forms.
A)True
B)False
Q4) Provide a critique of two weak or dubious reasons for leasing.
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Chapter 18: Long-Term Financial Planning
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Q1) Which of the following processes would not be expected to have an effect on share price?
A)Dividend declaration and payment
B)Stock repurchase
C)Stock dividend
D)Stock split
Q2) How can a 10% dividend be "homemade" by an investor that owns 100 non-dividend-paying shares priced at $20 each?
A)Sell 10 shares and retain 90 shares priced at $18
B)Sell 10 shares and retain 90 shares priced at $20
C)Sell 10 shares and retain 90 shares priced at $22
D)Dividends can be homemade only by the company
Q3) Which of the following is not found in John Lintner's "stylized facts" of corporate dividend policies?
A)Firms have long-run target dividend payout ratios
B)Managers focus more on dividend absolute levels than on its changes
C)Dividend changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings
D)Managers are reluctant to make dividend changes that might have to be reversed
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Chapter 19: Short-Term Financial Planning
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Q1) When most of the elements of a financial plan are related to sales levels, the plan is:
A)Less likely to be effective
B)Using sales as a plug figure
C)A percentage of sales model
D)Not adjusted for inflation
Q2) If a firm with an asset base of $3 million recently added $150,000 to retained earnings after a dividend payment of $100,000, then its internal growth rate is:
A)1.67%
B)3.33%
C)5.00%
D)8.33%
Q3) Which of the following changes will decrease a firm's internal growth rate?
A)A decrease in dividends with a given net income
B)An increase in net income with a given dividend payout ratio
C)A decrease in the plowback ratio
D)A decrease in assets with a set dividend
Q4) Why is it uncommon to expect assets to change proportionately with sales?
Q5) What is the effect of growth on the need for external financing?
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Chapter 20: Working Capital Management
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Q1) The safety margin kept by the bank on loan against liquid assets is called:
A)A haircut
B)A line of credit
C)Factoring
D)Filed warehousing
Q2) Firms that continually invest in non-trivial amounts of marketable securities may be guilty of:
A)Excessive short-term borrowing
B)Not matching their sources and uses of cash
C)Incurring excessive shortage costs
D)Not maximizing shareholder returns
Q3) A line of credit would be considered:
A)An agreement to borrow up to a specific total amount on demand from a bank
B)A short-term unsecured loan with minimum interest expense
C)A secured loan to be amortized over three to five years
D)A long-term, permanent source of funding
Q4) CumChan has issued commercial paper with a face value of $250,000 that will mature in 60 days.The present market value of the paper is $242,000.Interest on the paper is, therefore:
Q5) How does long-term financing policy affect short-term financing requirements?
Page 22
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Chapter 21: Mergers, Acquisitions, and Corporate Control
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Q1) In order to maintain a zero-balance account, the firm transfers all collections to a single account.
A)True
B)False
Q2) Lock-box systems allow local banks to collect and process the firm's remittance from that area.
A)True
B)False
Q3) Thrifty Corp.is establishing a lock-box system to reduce time in the collection process.They anticipate saving two days of mail time and .75 days of processing time through the system.Six hundred payments are expected to be collected daily, at an average size of $200.The appropriate interest rate is 6 percent per year.What is the break-even charge per item that you could consider paying to a bank for providing this service?
Q4) An East Coast firm should establish a lock-box service on the West Coast:
A)If the firm has a large number of customers
B)If it has banking facilities in West Coast
C)If West Coast customers are currently mailing their cheques to an East Coast address
D)If West Coast banks are more efficient
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Chapter 22: International Financial Management
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Q1) Determine the annual effective rate of a customer that does not take advantage of credit terms of 3/15, n/30.
A)109.84%
B)69.84%
C)29.84%
D)9.84%
Q2) Commercial drafts are issued by a customer's bank.
A)True
B)False
Q3) With terms of 4/15, net 60, what is the implied interest rate for forgoing a cash discount and paying at the end of the period?
A)25.63%
B)28.19%
C)39.25%
D)61.15%
Q4) The more liberal the terms of the collection policy, the less the potential for bad debts and unprofitable sales.
A)True B)False
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Chapter 23: Options
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Q1) Which of the following is not a method of changing the management of a firm?
A)Proxy contest
B)Merger and acquisition
C)LBO
D)MBO
Q2) When a firm's management takes the firm private with the aid of substantial debt it is known as a(n):
A)Tender offer
B)Greenmail offer
C)MBO
D)Hostile takeover
Q3) The shares of an acquired firm typically trade for a higher value on the open market after an LBO.
A)True
B)False
Q4) When one firm merges with another, the:
A)Boards of directors will merge also
B)Merger must be approved by 75% of the shareholders of the target firm
C)Merger must be approved by at least 50% of the shareholders of the target firm
D)Target firm will cease to exist
25
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Chapter 24: Risk Management
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Q1) What are some simple strategies to protect the firm against exchange rate risk?
Q2) A firm intends to hedge against exchange loss, a large future payment that must be made in a foreign currency.Which of the following identifies the cost of such a hedge?
A)Difference between expected and current spot rates
B)Difference between expected and current forward rates
C)Difference between the forward premium and the forward discount
D)Difference between the forward rate and the expected future spot rate
Q3) How can companies use swaps to change the risk of securities that they have issued?
Q4) If the direct exchange rate between U.S.Dollars and pounds sterling is 1.50/1, how much should you be willing to pay to receive 350 pounds?
A)$175.00
B)$233.33
C)$367.50
D)$525.00
Q5) The nominal interest rate is the difference between real interest rate and inflation.
A)True
B)False
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Chapter 25: Conclusion
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Q1) The conversion ratio for a convertible bond equals the:
A)Ratio of bond value to stock price at conversion
B)Number of bonds necessary to convert into one share of stock
C)Number of shares of stock that can be exchanged for one bond
D)Floor value beneath which the bond price cannot fall
Q2) Which graph represents a selling a put option?
Q3) Three months back you bought for $4 a put option on a stock with an exercise price of $100.If the stock price at expiration of this option is $92, what is your return on investment?
A)200 percent
B)150 percent
C)100 percent
D)50 percent Proceeds = Stock price - Exercise price
100 - 92 = $8
Profits = proceeds - original investment = 8 - 4 = $4
Q4) Which graph represents a buying a put option?
Q5) Stock price volatility is beneficial to option holders.
A)True
B)False
27
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Chapter 26: What We Do and Do Not Know About Finance
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Sample Questions
Q1) Which of the following is not correct concerning forward contracts? Forward contracts:
A)Are not standardized
B)Do not set the price until the end of the contract
C)Are not traded on organized exchanges
D)Are not marked to market daily
Q2) PAWS Inc.has structured a currency swap through its bank.PAWS intends to use the funds to finance an expansion in its Irish operations.The terms are that PAWS will borrow $2 million at a 9 percent rate, with interest-only paid in the first two years and all principal repaid after three years.The bank will provide punts (Irish currency) at an exchange rate of Ir\(\le\)0.65/$and an interest rate of 12 percent.Illustrate the flows between PAWS and the bank during the three-year loan.
Q3) A farmer who sells a futures contract is betting that prices will _____ at the expiration of the contract.
A)Decrease
B)Increase
C)Remain constant
D)Guarantee high profits
Q4) Why do companies hedge to reduce risk?
To view all questions and flashcards with answers, click on the resource link above. Page 28