Principles of Finance Study Guide
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Course Introduction
Principles of Finance introduces students to the fundamental concepts and tools used in the field of finance. The course covers essential topics such as the time value of money, risk and return, financial statement analysis, capital budgeting, and the functioning of financial markets. Emphasis is placed on understanding how individuals, businesses, and organizations make investment and financing decisions, as well as the ethical and regulatory considerations involved. By the end of the course, students will have a foundational knowledge of financial principles that will help inform sound financial decision-making in both personal and professional settings.
Recommended Textbook
Corporate Finance 2nd Edition by Jonathan Berk
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Page 2
Chapter 1: The Corporation
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Q1) An investment is said to be liquid if the investment
A) has large day to day fluctuations in price.
B) has a large bid-ask spread.
C) can easily be converted into cash.
D) is traded on a stock exchange.
Answer: C
Q2) The distinguishing feature of a corporation is that
A) their is no legal difference between the corporation and its owners.
B) it is a legally defined, artificial being, separate from its owners.
C) it spreads liability for its corporate obligations to all shareholders.
D) provides limited liability only to small shareholders.
Answer: B
Q3) The Principal-Agent Problem arises
A) because managers have little incentive to work in the interest of shareholders when this means working against their own self-interest.
B) because of the separation of ownership and control in a corporation.
C) Both A and B
D) None of the above
Answer: C
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Chapter 2: Introduction to Financial Statement Analysis
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Q1) The firm's equity multiplier measures
A) the value of assets held per dollar of shareholder equity.
B) the return the firm has earned on its past investments.
C) the firm's ability to sell a product for more than the cost of producing it.
D) how efficiently the firm is utilizing its assets to generate sales.
Answer: A
Q2) On the balance sheet,short-term debt appears
A) in the Stockholders' Equity section.
B) in the Operating Expenses section.
C) in the Current Assets section.
D) in the Current Liabilities section.
Answer: D
Q3) Perrigo's market capitalization is closest to:
A) $952.16 million
B) $3,580.14 million
C) $4,168.06 million
D) $4,425.15 million
Answer: B
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Chapter 3: Arbitrage and Financial Decision Making
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Q1) Suppose a risky security pays an average cash flow of $100 in one year.The risk-free rate is 5%,and the expected return on the market index is 13%.If the returns on this security are high when the economy is strong and low when the economy is weak,but the returns vary by only half as much as the market index,then the price for this risky security is closest to:
A) $88
B) $92
C) $93
D) $95
Answer: B
Q2) If the risk-free rate of interest (r<sub>f</sub>)is 6%,then you should be indifferent between receiving $250 today or
A) $235.85 in one year.
B) $250.00 in one year.
C) $265.00 in one year.
D) None of the above
Answer: C
Q3) The price per share of the ETF in a normal market is:
Answer: Value of ETF = = 2 × 121.57 + 3 × 36.59 + 3 × 3.15 = $362.36
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Page 5
Chapter 4: The Time Value of Money
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Q1) You are considering investing in a zero coupon bond that will pay you its face value of $1000 in ten years.If the bond is currently selling for $485.20,then the IRR for investing in this bond is closest to:
A) 12%
B) 8.0%
C) 7.5%
D) 10%
Q2) Draw a timeline detailing the cash flows from investment "A."
Q3) Which of the following statements is false?
A) The difference between an annuity and a perpetuity is that an annuity ends after some fixed number of payments.
B) Most car loans, mortgages, and some bonds are annuities.
C) A growing perpetuity is a cash flow stream that occurs at regular intervals and grows at a constant rate forever.
D) An annuity is a stream of N equal cash flows paid at irregular intervals.
Q4) Draw a timeline detailing the cash flows from investment "B."
Q5) In terms of present value,how much will Joe receive for selling the family business?
Q6) The future value at retirement (age 65)of your savings is:
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Chapter 5: Interest Rates
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Q1) Wesley Mouch's auto loan requires monthly payments and has an effect annual rate of 6.43%.The APR on this auto loan is closest to:
A) 6.00%
B) 6.25%
C) 6.50%
D) 6.62%
Q2) The amount of your original loan is closest to:
A) $14,808
B) $22,212
C) $32,000
D) $37,020
Q3) Which alternative offers you the lowest effective rate of return?
A) Investment A
B) Investment B
C) Investment C
D) Investment D
Q4) Should you purchase the delivery truck or lease it? Why?
Q5) After examining the yield curve,what predictions do you have about interest rates in the future? About future economic growth and the overall state of the economy?
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Chapter 6: Investment Decision Rules
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Q1) Assuming that your capital is constrained,which investment tool should you use to determine the correct investment decisions?
A) Profitability Index
B) Incremental IRR
C) NPV
D) IRR
Q2) The payback period for this project is closest to:
A) 2.1 years
B) 3.0 years
C) 2 years
D) 2.2 years
Q3) Calculate the IRR for the snow board project and use it to determine he maximum deviation allowable in the cost of capital estimate that leaves the investment decision unchanged.The maximum deviation allowable is closest to:
A) 11.0%
B) 0.0%
C) 2.5%
D) 1.0%
Q4) If the discount rate for project B is 15%,then what is the NPV for project B?
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Chapter 7: Fundamentals of Capital Budgeting
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Q1) Which of the following statements is false?
A) The simplest method used to calculate depreciation is the straight-line method.
B) A sunk cost is any unrecoverable cost for which the firm is already liable.
C) Unlevered Net Income = EBIT × <sub>c</sub>.
D) The decision to continue or abandon should be based only on the incremental costs and benefits of the project going forward.
Q2) Assuming that Casa Grande Farms depreciates these tractors using MACRS depreciation method for three-year property starting immediately,then the annual depreciation tax shield in year 2 is closest to:
A) 20,785
B) 27,991
C) 84,000
D) 180,000
Q3) What is sensitivity analysis?
Q4) What is a sunk cost? Should it be included in the incremental cash flows for a project? Why or why not?
Q5) Epiphany is worried about the reliability of the sales forecast.How sensitive is the project's NPV to a 10% change in sales.
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Chapter 8: Valuing Bonds
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Q1) Suppose that when these bonds were issued,Luther received a price of $972.42 for each bond.What is the likely rating that Luther's bonds received?
A) AA
B) BBB
C) B
D) A
Q2) Which of the following statements is false?
A) If the bond trades at a discount, and investor who buys the bond will earn a return both from receiving the coupons and from receiving a face value that exceeds the price paid for the bond.
B) Most coupon bond issuers choose a coupon rate so that the bonds will initially trade at, or very near to, par.
C) Coupon bonds always trade for a discount.
D) At any point in time, changes in market interest rates affect a bond's yield to maturity and its price.
Q3) Explain why the expected return of a corporate bind does not equal its yield to maturity?
Q4) What is the relationship between a bond's price and its yield to maturity?
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Page 10
Chapter 9: Valuing Stocks
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Q1) Suppose you plan on purchasing Von Bora stock in one year,right after the $1.40 dividend is paid.You then plan on selling your stock at the end of year two,right after the $1.50 dividend is paid.The total return that you will receive on your investment is closest to:
A) 9.50%
B) 10.75%
C) 10.25%
D) 10.00%
Q2) Which of the following statements is false?
A) There are two potential sources of cash flows from owning a stock.
B) An investor will be willing to pay a price today for a share of stock up to the point that this transaction has a zero NPV.
C) An investor might generate cash by choosing to sell the shares at some future date.
D) Because the cash flows from stock are known with certainty, we can discount them using the risk-free interest rate.
Q3) What are some implicit assumptions that are made when valuing a firm using multiples based on comparable firms?
Q4) Calculate the enterprise value for DM Corporation.
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Page 11
Chapter 10: Capital Markets and the Pricing of Risk
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Q1) What is the Beta for a type I firm?
A) 1.0
B) 0.75
C) 0.0
D) 1.5
Q2) Do expected returns for individual stocks increase proportionately with volatility?
Q3) Which of the following investments offered the lowest overall return over the past eighty years?
A) Small stocks
B) Treasury Bills
C) S&P 500
D) Corporate bonds
Q4) If the risk-free rate is 5% and the expected return of investing in Merck is 11.3%,then the expected return on the market must be:
A) 8.0%
B) 10.0%
C) 10.4%
D) 12.0%
Q5) What is the market portfolio?
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Chapter 11: Optimal Portfolio Choice and the Capital Asset Pricing Model
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Q1) The expected return on the precious metals fund is closest to:
A) -3%
B) 4%
C) 1%
D) 10%
Q2) Which of the following statements is false?
A) When an investor chooses her optimal portfolio, she will do so by finding the tangent line using the risk-free rate that corresponds to her investment horizon.
B) If the market portfolio is not efficient, savvy investors who recognize that the market portfolio is not optimal will push prices and expected returns back into balance.
C) Even though different investors may research different stocks, their information will not impact the market portfolio since there is no way to share this information with other investors.
D) In the real world borrowers pay higher interest rates than savers receive.
Q3) Calculate the variance on a portfolio that is made up of equal investments in Stock Y and Stock Z stock.
Q4) Calculate the covariance between Stock Y's and Stock Z's returns.
Q5) Calculate the correlation between Stock Y's and Stock Z's returns.
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Chapter 12: The Capital Asset Pricing Model
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Q1) Luther Industries has a market capitalization of $23 billion,no debt,and $4 billion in cash.If Luther's estimated equity beta is 1.32,then the beta of Luther's underlying business enterprise is closest to:
A) 1.09
B) 1.32
C) 1.48
D) 1.60
Q2) The overall value of Wyatt Oil (in $ millions)is closest to:
A) 7.0%
B) 8.5%
C) 10.0%
D) 14.0%
Q3) Using the average historical excess returns for both Wyatt Oil and the Market portfolio,your estimate of Wyatt Oil's Beta is closest to:
A) 0.75
B) 0.84
C) 1.00
D) 1.19
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Chapter 13: Investor Behavior and Capital Market Efficiency
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Q1) If the risk-free rate is 3% and the market risk premium is 5%,then the CAPM's predicted expected return for Wyatt Oil is closest to:
A) 8.5%
B) 9.0%
C) 9.5%
D) 10.0%
Q2) A stock's ________ measures the stock's return relative to that predicted based on its beta,at the time of some event.
A) excessive abnormal return
B) cumulative average return
C) excessive predicted return
D) cumulative abnormal return
Q3) When all investors correctly interpret and use their own information,as well as information that can be inferred from market prices or the trades of others,they are said to have
A) sensation seeking expectations.
B) positive expectations.
C) rational expectations.
D) confident expectations.
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Page 15
Chapter 14: Capital Structure in a Perfect Market
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Q1) Suppose that to raise the funds for the initial investment the firm borrows $40,000 at the risk free rate and issues new equity to cover the remainder.In this situation,the cost of capital for the firm's levered equity is closest to:
A) 23%
B) 25%
C) 15%
D) 18%
Q2) The unlevered beta for Blinkin is closest to:
A) 0.95
B) 1.10
C) 1.00
D) 0.90
Q3) The number of shares that Galt must issue is closest to:
A) 15 million
B) 25 million
C) 30 million
D) 40 million
Q4) What is a market value balance sheet and how does it differ from a book value balance sheet?
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Chapter 15: Debt and Taxes
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Q1) If Flagstaff currently maintains a debt to equity ratio of 1,then the value of Flagstaff's interest tax shield is closest to:
A) $10 million
B) $18 million
C) $11 million
D) $24 million
Q2) Nielson Motors has no debt,and maintains a policy of holding $80 million in excess cash reserves,invested in risk free treasury securities currently yielding 3%.If Nielson is in the 35% marginal tax bracket,the cost of permanently maintaining this $80 million reserve is closest to:
A) $0.85 million
B) $1.6 million
C) $24.0 million
D) $28.0 million
Q3) The interest rate tax shield for Kroger in 2004 is closest to:
A) $268 million
B) $393 million
C) $211 million
D) $94 million
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Page 17
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Q1) Assuming perfect capital markets,the share price for BBB after this announcement is closest to:
A) $11.40
B) $10.85
C) $10.00
D) $8.60
Q2) Which of the following statements is false?
A) Creditors often place restrictions on the actions that the firm can take. Such restrictions are referred to as debt covenants.
B) Covenants are often designed to prevent management from exploiting debt holders, so they may help to reduce agency costs.
C) Agency costs are smallest for long-term debt.
D) Covenants may limit the firm's ability to pay large dividends or the types of investments that the firm can make.
Q3) The total debt overhang associated with accepting project 1,is closest to:
A) $0 million
B) $12.5 million
C) $14.4 million
D) $22.5 million
Page 18
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Chapter 17: Payout Policy
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Q1) The effective tax disadvantage for retaining cash in 2002 is closest to:
A) 15.00%
B) 14.75%
C) 30.00%
D) 35.00%
Q2) The effective dividend tax rate for a buy and hold individual investor in 1999 is closest to:
A) 25%
B) 0%
C) 20%
D) 40%
Q3) The effective dividend tax rate in 1989 is closest to:
A) 0%
B) 20%
C) 25%
D) 30%
Q4) Calculate the effective tax disadvantage for retaining cash in 1999,2001,and 2005.
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19
Chapter 18: Capital Budgeting and Valuation With Leverage
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Q1) Based upon the three comparable firms,calculate that most appropriate unlevered cost of capital for Aardvark to use on this new product.
Q2) Consider the following equation for the Project WACC with a fixed debt schedule: R<sub>wacc</sub> = r<sub>U</sub> - d <sub>c</sub>[rD + f(r<sub>U</sub>r<sub>D</sub>)]
The term f in this equations represents
A) the annual adjustment percentage to the amount of debt.
B) a measure of the permanence of the debt level.
C) the dollar amount of debt outstanding.
D) the debt-to-value ratio.
Q3) The unlevered value of Aardvark's new project is closest to:
A) $205
B) $100
C) $164
D) $202
Q4) Galt's WACC is closest to:
A) 6.0%
B) 9.6%
C) 10.3%
D) 10.7%
Page 20
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Chapter 19: Valuation and Financial Modeling: a Case Study
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Q1) If the risk-free rate of interest is 6% and the market risk premium has historically averaged 5%,then the cost of capital for Nike is closest to:
A) 14.7%
B) 10.2%
C) 9.1%
D) 13.5%
Q2) If Ideko's future expected growth rate is 5% and its WACC is 9%,then the continuation value in 2010 is closest to:
A) 164,200
B) 278,775
C) 280,450
D) 303,425
E) 482,850
Q3) Assuming that Ideko has a EBITDA multiple of 9.4,then the continuation unlevered P/E ratio of Ideko in 2010 is closest to:
A) 17.2
B) 16.4
C) 14.5
D) 19.4
21
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Chapter 20: Financial Options
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Q1) Using options to reduce risk is called
A) speculation.
B) a naked position.
C) hedging.
D) a covered position.
Q2) The writer of a call option has
A) the obligation to sell a security for a given price.
B) the obligation to buy a security for a given price.
C) the right to sell a security for a given price.
D) the right to buy a security for a given price.
Q3) With a(n)________,the buyer pays a premium to the seller and receives a payment from the seller to make up for the loss if the underlying bond defaults.
A) equity option swap
B) credit default swap
C) risk-free swap
D) interest rate swap
Q4) Describe the conditions when it would be optimal to exercise an American Call and an American Put option prior to their expiration.
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Chapter 21: Option Valuation
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Q1) The Black-Scholes value of a one-year European put option on Taggart stock with a strike price of $50 is closest to:
A) $1.45
B) $3.15
C) $4.75
D) $9.50
Q2) Using the binomial pricing model,the calculated price of a one-year put option on KD stock with a strike price of $20 is closest to:
A) -7.7
B) 2.4
C) 4.6
D) -1.8
Q3) Luther Industries does not pay dividend and is currently trading at $25 per share.The current risk-free rate of interest is 5%.Calculate the price of a call option on Luther Industries with a strike price of $30 that expires in 75 days when N(d<sub>1</sub>)= .639 and N(d<sub>2</sub>)= .454.
Q4) Using the binomial pricing model,calculate the price of a two-year call option on Kinston stock with a strike price of $9.
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Page 23
Chapter 22: Real Options
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Q1) The constant annuity payment over the life of a project that is equivalent to receiving the NPV today is the
A) annualized annuity.
B) independent annual benefit.
C) equivalent annual profitability.
D) equivalent annual benefit.
Q2) Which of the following is not a real option?
A) A stock option
B) An abandonment option
C) An investment timing option
D) An expansion option
Q3) Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately.Assuming that the probability of high or low demand is still 50%,the NPV of the Kinston Industries Mountain Bike Project is closest to:
A) $0
B) $90,000
C) -$45,000
D) $1,000,000
Q4) Describe the two factors that affect the value of an investment timing option?
Page 24
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Chapter 23: The Mechanics of Raising Equity Capital
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Q1) The amount of money the underwriter will earn on this transaction is closest to:
A) $4 million
B) $6 million
C) $9 million
D) $15 million
Q2) Which of the following statements is false?
A) The one advantage of a cash offer is that the underwriter takes on a larger role and, therefore, can credibly certify the issue's quality.
B) SEO underwriting fees average about 5% of the proceeds of the issue and, as with IPOs, the variation across issues of different sizes is relatively small.
C) As with IPOs, evidence suggests that companies over perform following a seasoned offering.
D) Often the value destroyed by the price decline can be a significant fraction of the new money raised with a SEO.
Q3) How much money did Luther raise?
Q4) When referring to IPOs,what is book building?
Q5) Based upon the price/earnings ratio,what would be a reasonable value for KD?
Q6) What will the proceeds from the IPO be if Luther is selling 1.1 million shares?
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Chapter 24: Debt Financing
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Q1) Which of the following statements is false?
A) Almost all bonds that are issued today are registered bonds.
B) The trust company represents the bondholders and makes sure that the terms of the indenture are enforced.
C) For private placements, the prospectus must include an indenture, a formal contract between the bond issuer and a trust company.
D) In the case of default, the trust company represents the bondholders' interests.
Q2) Treasury securities that are pure discount bonds with original maturities ranging from a few days to 26 weeks are called
A) TIPS.
B) Treasury bonds.
C) Treasury notes.
D) Treasury bills.
Q3) Which of the following does not issue asset-backed securities?
A) Government National Mortgage Association
B) Federal National Mortgage Association
C) Student Loan Marketing Association
D) Federal Reserve
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Chapter 25: Leasing
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Q1) What will Luther's balance sheet look like if they acquire the new fleet of delivery trucks using an operating lease?
Q2) Which of the following statements is false?
A) Lease payments are a fixed obligation of the firm.
B) The risk of the lease payments is no greater than the risk of secured debt, so it is reasonable to discount the lease payments at the firm's secured borrowing rate.
C) If a firm purchases a piece of equipment, the expense is a capital expenditure. Therefore, the purchase price can be depreciated over time, generating a depreciation tax shield.
D) If the equipment is leased and the lease is a non-tax lease, there is no capital expenditure, but the lease payments are an operating expense.
Q3) A lease where the lessee has the option to purchase the asset at the end of the lease for a set price that is set upfront in the lease contract is called a A) fixed price lease.
B) $1.00 out lease.
C) fair market value lease.
D) fair market value cap lease.
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Page 27
Chapter 26: Working Capital Management
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Q1) Kinston Industries has an average accounts payable balance of $220,000.Its annual cost of goods sold is $5,475,000,and it receives terms of 2/10,net 30 from its suppliers.Kinston chooses to forgo this discount.Is Kinston managing its accounts payables well?
Q2) Describe "just-in-time" inventory management.
Q3) The percentage of Wyatt's receivables that are current is closest to:
A) 32.1%
B) 38.3%
C) 42.2% D) 61.7%
Q4) KT Enterprises would like to construct and operate a new ice skating rink.In addition to the capital expenditures on the rink,management estimates that the project will require an investment today of $220,000 in net working capital.The firm will recover the investment in net working capital fifteen years from today,when management anticipates closing the rink.The discount rate for this type of cash flow is 8% per year.Calculate the present value of the cost of working capital for the ice skating rink.
Q5) Calculate the number of days in Luther's Operating Cycle.
Q6) What is a compensating balance?
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Chapter 27: Short-Term Financial Planning
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Q1) Which of the following statements is false?
A) Financing part or all of the permanent working capital with short-term debt is known as an aggressive financing policy.
B) When the yield curve is downward sloping, the interest rate on short-term debt is lower than the rate on long-term debt. In that case, short-term debt may appear cheaper than long-term debt.
C) The value of short-term debt is less sensitive to the firm's credit quality than long-term debt; therefore, its value will be less affected by management's actions or information.
D) Permanent working capital is the amount that a firm must keep invested in its short-term assets to support its continuing operations.
Q2) When a company analyzes its short-term financing needs,it typically examines cash flows at
A) monthly intervals.
B) yearly intervals.
C) quarterly intervals.
D) weekly intervals.
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Chapter 28: Mergers and Acquisitions
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Q1) If Wal-Mart and Target were to merge,this would be an example of a ________ merger.
A) conglomerate
B) vertical
C) horizontal
D) diagonal
Q2) If Martin pays no premium to acquire Luther,what will the earnings per share be after the merger?
Q3) A rights offering that gives existing target shareholders the right to buy shares in either the target or the acquirer at a deeply discounted price once certain conditions are met is called a
A) golden parachute.
B) poison pill.
C) classified board.
D) white knight.
Q4) What is a white knight?
Q5) Assume that Martin pays no premium to acquire Luther.Calculate Martin's price-earnings (P/E)ratio both pre and post merger.
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Chapter 29: Corporate Governance
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Q1) Which of the following is/are not corporate monitors?
A) Security analysts
B) Lenders
C) Securities and Exchange Commission
D) All of the above are monitors.
Q2) What is the role of takeovers in corporate governance?
Q3) Which of the following statements is false?
A) In many other countries, the central conflict is between what are called "controlling shareholders" and "minority shareholders."
B) Controlling shareholders can make decisions that benefit them disproportionately relative to the minority shareholders, such as employing family members rather than the most talented managers or establishing contracts favorable to other family controlled firms.
C) As recent events and corporate scandals have shown, investor protection in the United States is generally seen as substandard when compared to the developed economies in the world.
D) Much of the focus in the United States is on the agency conflict between shareholders, who own the majority of a firm but are a dispersed group, and managers, who own little of the firm and must be monitored.
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Page 31
Chapter 30: Risk Management
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Q1) Like most foreign exchange rates,the dollar/euro rate is a floating rate,which means it changes constantly depending on the quantity supplied and demanded for each currency in the market.The supply and demand for each currency is driven directly by all of the following factors except
A) relative inflation.
B) firms trading goods.
C) investors trading securities.
D) the actions of central banks in each country.
Q2) The Century 22 fund has invested in a portfolio of mortgaged backed securities that has a current market value of $245 million.The duration of this portfolio of mortgaged back securities is 14.7 years.The fund has borrowed to purchase these securities,and the current value of its liabilities (i.e.,the current value of the bonds Century 22 has issued)is $160 million.The duration of these liabilities is 5.4 years.What is the initial duration of the equity for the Century 22 fund?
Q3) What is the actuarially fair cost of full insurance?
Q4) 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?
Q5) What are some of the disadvantages of long-term supply contracts?
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Chapter 31: International Corporate Finance
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Q1) Which of the following statements is false?
A) Many countries regulate or limit capital inflows or outflows, and many do not allow their currencies to be freely converted into dollars, thereby creating capital market segmentation.
B) The existence of internationally integrated capital markets makes many decisions in international corporate finance more complicated but potentially more lucrative for a firm that is well positioned to exploit the market segmentation.
C) Political, legal, social, and cultural characteristics that differ across countries may require compensation in the form of a country risk premium.
D) Swaps allow firms to mitigate their exchange rate risk exposure between assets and liabilities, while still making investments and raising funds in the most attractive locales.
Q2) The amount of the taxes paid in dollars for the Irish operations is closest to:
A) $20.5 million
B) $5.1 million
C) $29.5 million
D) $50.0 million
Q3) What is the pound present value of the project?
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