Course Questions Flashcards
Which area of finance deals with sources of funding and the capital structure of corporations and seeks to increase the value of a firm to its owners?
* Financial institutions
* Investments
* Business finance
* Real estate
Business finance
Correct! Business finance is the area of finance that deals with uses and sources of funding to increase the value of the firm.
What is the primary difference between finance and accounting?
* Accounting focuses on the future, while finance is generally backward-looking.
* Finance provides financial data to decision makers, and accounting involves making decisions using that data.
* Accounting involves investing and forecasting, while finance summarizes a company’s financial information.
*Finance focuses on the future, while accounting is generally backward-looking .
Finance focuses on the future, while accounting is generally backward-looking.
Correct! Finance is the management and allocation of capital with the objectives of investing, forecasting, budgeting, saving, lending, and borrowing.
Which subspecialty of finance primarily involves deciding which assets will create more wealth and earn positive returns?
* Financial institutions
* Capital structure.
* Investments
* Accounting
- Investments
Correct! Investments is the area of finance that seeks to create wealth in the future by deciding where to allocate money.
What is the primary goal of the financial manager of a firm?
* To maximize owner wealth
* To maximize the manager’s utility
* To minimize the asset holdings of the firm
* To minimize the costs of the firm
- To maximize owner wealth
Correct! The financial manager should make decisions based on the primary goal of maximizing owner wealth.
What should be the main question a firm asks when considering any investment decision?
* Do the benefits of this investment outweigh the costs?
* What is the best investment in the stock market?
* Will this investment add value to the firm?
* Will this investment help the company reduce costs?
- Do the benefits of this investment outweigh the costs?
Correct! For any investment, you should expect to receive a benefit worth at least as much as the initial cost.
What is the primary aim of personal finance goals?
* To create more wealth and returns on investments.
* To increase consumption of goods and services
* To maximize satisfaction from products purchased and services obtained.
* To maximize shareholders’ utility by increasing a firm’s value3
- To maximize satisfaction from products purchased and services obtained.
Correct! The objective of personal financial goals is to maximize one’s utility.
Which task does a financial manager perform when choosing to obtain a loan to purchase a piece of equipment for a new project?
* Making credit standard decisions
* Making financing decisions
* Making investment decisions
* Making inventory control decisions
Making investment decisions
Correct! The manager is deciding where to get the funds to support a new project, which means the manager is making a financing decision.
Which financial career focuses on investing capital into firms whose shares are not currently sold on any public stock exchange?
* Insurance
* Corporate finance
* Financial planning
* Private equity
- Private equity
Correct! Private equity deals with investments in firms that are privately held and whose ownership is not yet bought or sold on any public stock exchange.
Which task does a financial manager perform when assessing the costs and benefits of potential projects?
* Implementing financial policies
* Managing working capital
* Making investment decisions
* Making financing decisions
- Making investment decisions
Correct! Understanding how benefits weigh up against costs is the priority before moving forward with financing and managerial decisions.
What area of finance involves deciding which assets to invest in to create wealth in the future?
* Investment banking
* Investments
* Organizational finance
* Financial institutions
- Investments
Correct! Investments are an area of finance that involves deciding which assets to invest in to create wealth in the future.
What tool can you use to understand your overall personal cash flows?
Budgeting
Hannah is the financial manager of a firm. A project that she has recommended has been approved and will cost $5 million. Since the company does not have enough cash on reserve, Hannah must figure out how to raise enough money to start the project. She can choose whether to issue new bonds, new stocks, a mortgage loan, or some combination of those options. What task is Hannah performing in this scenario?
* Making an investment decision
* Making a financing decision
* Managing working capital
* Managing financial investments
- Making a financing decision
Correct! Since the project has already been approved, Hannah is trying to find a way to finance the investment and considering its capital structure.
Maria and Mateo are setting financial goals. They decide that they need to save $200 each month to reach their goal of taking their children to visit their grandparents in Spain next summer. What is the objective of setting such a goal?
* To set priorities in personal finances
* To make personal finances predictable
* To maximize individual utility
* To minimize personal expenses
- To maximize individual utility
Correct! While everyone has different personal financial goals, the objectives of such goals are to maximize individual utility.
Which professional works with individuals to help them achieve their financial goals?
* Commercial banker
* Corporate financial analyst
* Financial planner
* Private equity manager
- Financial planner
Correct! Professional financial planners work with individuals to help them achieve their financial goals.
Omar is about to purchase a new car for $30,000. He knows he wants to buy the car, but he is still trying to decide how to pay for it. He has barely over $30,000 in his bank account. He can either take out an auto loan from a bank or use a mix of cash and an auto loan.
In this scenario, what is Omar doing?
* Assessing a financial goal
* Investing to achieve a goal.
* Budgeting
* Financing a goal
Financing a goal
Correct! He has already decided to purchase the car and is now deciding on financing options.
What are the purposes of financial markets?
* To willingly take risk and capture returns
* To maintain fair, orderly, and efficient markets
* To provide liquidity and determine prices
* To affect the distribution of income for investors
- To provide liquidity and determine prices
Correct! The purposes of financial markets are to provide liquidity and to determine prices.
In which financial market are securities such as stocks and bonds are traded after their initial issuance?
* Secondary market
* Initial market
* Primary market
* Dealer market
- Secondary market
Correct! Financial securities are first sold in the primary financial market and then traded among investors in the secondary financial market.
What kind of market primarily allows institutions to borrow and lend in the short term?
* Capital market.
* Money market
* Futures and options markets
* Primary market
- Money market
Correct! Assets in money markets are typically highly liquid and intended for use within a year or less.
A local start-up company just hit its five-year anniversary and is planning an initial public offering sometime this year. To issue public stock, which market will the company use?
* Secondary market
* Futures and options market
* Primary market
* Dealer market
- Primary market
Correct! When a company issues stock for the first time to raise capital, shares must initially be sold through a primary market.
What is the primary role of financial institutions?
* To deal with financing, capital structuring, and investment decisions
* To provide liquidity when trading financial assets
* To provide financial information to the stakeholders of a business
* To conduct financial transactions such as investments, loans, and deposits
- To conduct financial transactions such as investments, loans, and deposits
Correct! Financial institutions conduct transactions to circulate money.
What is a depository institution?
* An institution that is a financial intermediary that raises capital on a contractual basis
* An institution that has a goal to maximize owner or shareholder wealth
* An institution that accepts and pays interest on deposits of money, as well as extends loans
* An institution that provides individuals and firms access to financial markets
An institution that accepts and pays interest on deposits of money, as well as extends loans
Correct! This is the definition of a depository institution. Examples include banks and credit unions.
Which financial institution ensures that a nation’s economy remains healthy by controlling the amount of money circulating in the economy?
* Commercial bank
* Credit union
* Central bank
* Mutual fund
- Central bank
Correct! Central banks control the supply of money in the economy.
How do insurance companies pay policyholders when a claim is made?
* They use returns from stocks and bonds.
* They raise premiums for everyone who filed a claim during the year.
* They withdraw funds from their corporate savings account.
* They withdraw funds from policyholders’ premium accounts.
- They use returns from stocks and bonds.
Correct! Insurance companies invest the money that they earn from premiums into stocks and bonds, and then the returns are used to fill claims.
Which type of financial institution deals mainly with providing for retirement through employers?
* Pension fund
* Credit union
* Investment bank
* Mutual fund
- Pension fund
Correct! Through employers, individuals can contribute to pension funds, which then invest their money in the market to provide retirement funds.
A large corporation is looking to merge with another large corporation. Which financial institution can help them do this?
* Private equity institution
* Investment bank
* Pension fund
* Central bank
Investment bank
Correct! Investment banks facilitate complex financial deals, like mergers.
Unemployment rate is which type of economic indicator?
* Lagging
* Concurrent
* Leading
* Coincident
- Lagging
Correct! Lagging indicators change after the economy changes.
The Federal Reserve sometimes adjusts the interest rate at which commercial banks can borrow from it. What is the purpose of adjusting the interest rate?
* To regulate inflation and unemployment.
* To increase the size of the Federal Reserve
* To reduce the amount of outstanding debt owed by U.S. citizens
* To obtain a positive return for its private investors
- To regulate inflation and unemployment
Correct! Regulating inflation and unemployment is the main objective of the Federal Reserve and central banks, and it is accomplished by adjusting the interest rate.
What would an inverted yield curve signal?
* It may indicate higher interest rates for long-term bonds.
* It may indicate that inflation is rising at an unsustainable rate.
* It may indicate that the unemployment rate is falling.
* It may indicate an economic downturn.
- It may indicate an economic downturn.
Correct! An inverted yield curve reflects the expectation that the economy will have low or negative growth in the future.
In what way are coincident indicators useful?
* They help investors know which sectors of the economy to invest in.
* They are used to predict future economic trends so that recessions can be avoided.
* They are useful in conjunction with GDP and personal income to predict the future health of the economy.
* They are analyzed during economic shifts to provide information about the current state of the economy.
- They are analyzed during economic shifts to provide information about the current state of the economy.
o Correct! Coincident indicators help analysts see the big picture of economic trends.
Which responsibility is a focus of the U.S. Securities and Exchange Commission?
* To protect investors
* To provide liquidity
* To raise interest rates
* To regulate inflation
- To protect investors
Which type of financial institution provides individuals and firms access to financial markets?
* Depository institutions
* Investment institutions
* Contractual savings institutions
* Credit institutions
- Investment institutions
Correct! Investment institutions provide both individuals and firms access to financial markets.
Which financial institution includes entities that receive money from institutional investors and wealthy individuals to buy troubled companies to improve them and earn returns by selling them or going public?
* Private equity
* Credit union
* Commercial bank
* Mutual fund
- Private equity
Correct! This is the role of a buyout private equity firm.
Yield curve is which type of economic indicator?
* Leading
* Concurrent
* Lagging
* Coincident
- Leading
Correct. Leading indicators change before the economy changes.
About a year ago, the short-term Treasury bill had 1.54% interest and the long-term Treasury note had 2.54% interest. This week, the 1-year Treasury bill has an interest rate of 3.13%, while the 10-year Treasury note has an interest rate of 2.28%. What does this information indicate about the future economy?
* It may indicate a decreasing unemployment rate along with higher wages.
* It may reflect an expectation that the economy will grow in the future along with higher inflation.
* It may indicate that the economy is in a steady state.
* It may indicate an economic downturn.
It may indicate an economic downturn.
Correct! Since the long-term Treasury interest rate is lower than the short-term rate, it has an inverted yield curve, which may indicate an economic downturn.
Which term reflects a person’s beliefs about right and wrong, good and bad, or just and unjust?
* Moral
* Legal
* Ethical
* Standard
- Moral
Correct! Moral reflects one’s beliefs about right and wrong, good and bad, or just and unjust.
What characterizes an ethical action?
* An ethical action is based on accepted standards of conduct.
* An ethical action will achieve the best outcome for the decision maker.
* An ethical action is based on what is right or wrong, whether or not society agrees.
* An ethical action takes into account other individuals’ values over the decision maker’s own.
- An ethical action is based on accepted standards of conduct.
Correct! An ethical action conforms to accepted standards of conduct.
Lucas is a financial advisor working for Bullzai, Inc. He is faced with a dilemma. Bullzai has started changing its practices in order to increase profit. As a financial advisor, he is now supposed to suggest to clients to invest in portfolios that will not do as well as the portfolios that Bullzai is invested in. This is an accepted practice done by other businesses in the industry, and it complies with all standards set by the government. However, Lucas knows that this practice is not in his clients’ best interest. What type of dilemma is Lucas facing?
* Legal
* Ethical
* Technical
* Moral
- Moral
Correct! This is not a legal issue because the new practice complies with the law, and it is not an ethical issue because it is a commonly accepted practice within the industry. It is a moral issue because it deals with Lucas’s own sense of right and wrong.
Which type of error would result in a set repercussion or penalty given by the government?
* Spiritual
* Ethical
* Legal
* Moral
- Legal
Correct! A legal error would result in a predetermined penalty by the government.
Nora is an investment manager, which means that she is paid to invest other people’s money. To meet her goal for the month, she is seeking to invest money from clients in an investment that is risky but potentially has a higher return. What about this situation represents an ethical dilemma?
* Nora is considering investing in a risky asset just to meet her monthly goal.
* Nora is not explaining to her clients the riskiness of the specific investment.
* Nora is not currently meeting her goal for the month.
* Nora is uncertain about the outcome of the investment opportunity.
- Nora is considering investing in a risky asset just to meet her monthly goal.
Correct! Nora is caught between the obligation to meet her goal and the obligation to keep her clients’ money safe. As an investment manager, she is obligated to do what is best for the client.
What are the effects of attempting to maximize shareholder value for a business in an unethical way?
* It often leads to employing more workers and boosting the economy.
* It often decreases vulnerability to long and expensive litigations.
* It often gives the business an opportunity to improve its branding and reputation.
* It often leads to decreased shareholder value for the business.
- It often leads to decreased shareholder value for the business.
Correct! Unethical behavior can lead to very costly results.
Endothon Company has decided to move its production from the United States to a foreign country. Which situation below would constitute an unethical action by the company?
* Saving money by paying inadequate wages to workers overseas
* Telling current employees about the decision early on
* Lowering costs while keeping prices the same for customers
* Monitoring public perception of the company
- Saving money by paying inadequate wages to workers overseas
Correct! Other countries may not have laws that protect workers, such as minimum wage laws.
Why would bondholders set bond contracts that are very strict to deter the company from taking on risky projects?
* Bondholders are primarily interested in maintaining the company’s current financial status.
* Bondholders are primarily interested in the company paying more dividends.
* Bondholders are primarily interested in making sure they will be paid back.
* Bondholders are primarily interested in maximizing shareholder wealth.
- Bondholders are primarily interested in making sure they will be paid back.
Correct! If a company takes on a riskier project, there is a higher probability of the project being unsuccessful, which means that the bondholders may put themselves at a higher risk of not receiving their loan back.
Which kind of projects are bondholders interested in?
* Safe projects with a higher chance of providing sufficient compensation
their investment.
* Projects that allow the company the most freedom in how it spends money
* Riskier projects that will increase the value of the company’s stocks and their own financial return
* Riskier projects that will provide higher returns
- Safe projects with a higher chance of providing sufficient compensation
Correct! Bondholders provide money for a company for a certain period of time and want companies to pay them back for their investment.
Which scenario is an example of an agency problem?
* The management team works overtime without pay to complete financial reports.
* A manager purchases a company car and allocates it as a company expense.
* An employee takes a potential client to dinner and pays for it using the company credit card.
* The owners of the company offer shares of the company to management.
- A manager purchases a company car and allocates it as a company expense.
Correct! This is a luxury that does not improve shareholder value and costs the company money.
How can agency costs be mitigated?
* Releasing managers who do not attempt to maximize immediate shareholder value
* Separating owners from management so their interests do not conflict
* Aligning managers’ interests with shareholders’ interests
* Creating a corporate hierarchy of several managers
- Aligning managers’ interests with shareholders’ interests
Correct! This is most commonly done by compensating management with shares of ownership in the company.
What is the third step in finding a solution to an ethical dilemma?
* Move forward with the course of action you have chosen
* Identify and define the problem
* Consider all stakeholders involved
* Consider alternative courses of action
- Consider all stakeholders involved
Correct! First, you should identify and define the problem. Second, consider alternative courses of action. Third, consider all stakeholders involved.
What does the term legal describe?
* An action that conforms to accepted standards of conduct that guide a person’s behavior.
* An action that reflects one’s beliefs about right and wrong, good and bad, or just and unjust.
* An action that is in accordance with the laws and rules set by an authority.
* An idea or thing used as a measure, norm, or model in comparative evaluations.
An action that is in accordance with the laws and rules set by an authority.
Correct! Legal means to follow the laws and rules set by an authority.
Jack is a personal financial advisor. He is with a new client, and the client is asking him what he recommends for her portfolio. Jack knows that his firm’s investment product performed well last year, but its performance changes from year to year—some years it is better than the market, and some years it is not. Also, the fee to invest in the product is higher than the fee to invest in a market index fund. If Jack sells his company’s investment product, the customer’s loyalty to the company is doubled. Which actions should Jack take?
* Give a personal recommendation of the company’s product while explaining its performance relative to the market over the past several years.
* Give the client a recommendation of the company’s product, and only offer more information about other products if she asks for it.
* After introducing the product, show the client data about the index fund from only the years that the index fund did poorly.
* Introduce the company’s product as the best choice available and offer to waive the fee to invest.
- Give a personal recommendation of the company’s product while explaining its performance relative to the market over the past several years.
Correct! Giving a recommendation to sell a product is fine, but you should never hide other information. Sharing information about index funds and comparing your product to others is a fair action to take for the client.
Why might a manager manipulate accounting procedures?
* To spend capital on wasteful projects
* To maximize shareholder wealth
* To restrict a firm from taking on risky projects
* To make the company’s performance look good
- To make the company’s performance look good
Correct! A manager might manipulate accounting procedures to inflate the earnings of a company, which would optimize bonuses and stock-price-related benefits for management.
Which situation is an example of an agency problem?
* Managers do not agree with employees on material supply issues.
* Owners prevent managers from maximizing profits.
* Managers follow their own interests instead of the owners’ interest.
* A firm fails to maximize long-term investment.
- Managers follow their own interests instead of the owners’ interest.
Correct! An agency problem occurs when the agent (a manager) does not act in the best interest of the owners.
A company is trying to finance a project with a mortgage loan from a bank. The company’s assessment of the project indicates that the company may experience several years of loss until the project becomes profitable. This means that the company might lose its ability to pay back the loan and the interest on the mortgage. What action might the bank take to protect its interest?
* Push the company to pay dividends to the shareholders.
* Let the company take the mortgage loan because of its long partnership with the bank.
* Let the company manipulate accounting procedures.
* Set a strict covenant that the company cannot easily achieve.
Set a strict covenant that the company cannot easily achieve.
Correct! By setting a strict covenant, there is a risk that the company may not meet its obligation, which would deter the company from taking on risky projects.
What are the main services offered by financial institutions?
* Accepting a wide variety of deposits, offering investment products, providing loans, and brokering financial transactions
* Evaluating sources of funding for a business project, the capital structure of a firm, or actions managers could take to increase the value of the firm.
* Deciding which assets to invest in to create wealth in the future.
* Soliciting charitable donations and then managing the distribution of these funds
- Accepting a wide variety of deposits, offering investment products, providing loans, and brokering financial transactions
Correct! Financial institutions such as banks, insurance companies, and mutual fund companies provide these services.
What is the main objective of personal financial goals?
* To maximize owner wealth
* To maximize individual utility
* To maximize stock investments
* To maximize charity donations
- To maximize individual utility
Correct! You set goals and act to increase your satisfaction or happiness by taking care of necessities and achieving priorities.
Which task does the financial manager of a firm perform that involves the issuance of new stocks and bonds?
* Deciding on accounting standards
* Making financing decisions
* Making investing decisions
* Managing working capital
- Making financing decisions
Correct! Once investment decisions are made, a financial manager considers different possibilities of financing sources for the investments. This may include issuing new stocks and bonds.
Why is understanding the definition of finance important in managing personal finances?
* It allows individuals to find an investment with the highest return possible.
* It helps individuals act ethically with regard to finances.
* It helps individuals understand legal issues related to finance.
* It helps individuals compare the costs and benefits of an action to determine whether to take that action.
- It helps individuals compare the costs and benefits of an action to determine whether to take that action.
Correct! Any financial decision should make sense in terms of its costs and benefits.
In which type of market would a company issue bonds or stocks for the first time?
* Secondary market
* Dealer market
* Money market
* Primary market
- Primary market
Correct! This is the purpose of a primary market.
Which type of financial institution is a mutual fund?
* Contractual institution
* Investment institution
* Federal institution
* Depository institution
- Investment institution
Correct! Investment institutions provide individuals and firms access to financial markets.
Which financial institution specializes in managing and administering retirement funds?
* Pension funds
* Mutual funds
* Private equity
* Investment banks
- Pension funds
Correct! Pension funds specialize in retirement funds.
Which type of economic indicator is the consumer price index?
* Forecasting indicator
* Lagging indicator
* Leading indicator
* Coincident indicator
- Lagging indicator
Correct! CPI usually changes after the economy as a whole changes.
What does the term ethical refer to?
* The accepted standards of conduct that guide a person’s behavior
* One’s beliefs about right and wrong, good and bad, or just and unjust
* An idea or thing used as a measure, norm, or model in comparative evaluations
* Following the laws and rules set by an authority
- The accepted standards of conduct that guide a person’s behavior
Correct! Ethical refers to the accepted standards of conduct that guide a person’s behavior.
A company’s officers and board of directors are selling their stocks in the firm at higher prices due to false accounting reports that made the stock seem more valuable than it truly was. Which ethical issue is occurring in this situation?
* Maximizing shareholder value
* Agency problem due to conflicting interests
* Conflict between work and personal affairs
* Pursuing individual interest over client interests
- Agency problem due to conflicting interests
Correct! Accounting manipulation by management in pursuit of higher stock-related compensation is an example of an agency problem.
What is the term for the percentage of the principal that a lender charges a borrower for the use of assets?
* Simple interest
* Compound interest
* Interest rate
* Inflation rate
- Interest rate
Correct! This is the definition of interest rate.
How is the interest rate expressed?
* As a percentage
* As a dollar amount
* As a fractional probability
* As a ratio
- As a percentage
Correct! Interest is the percentage of the principal that a lender receives or that a borrower pays to use the money.
What is the main purpose of charging interest?
* It funds private banking institutions.
* It allows financial analysts to accurately calculate the time value of money when evaluating a project.
* It is what makes trading assets such as vehicles and land possible.
* It allows borrowers to pay to use the assets of another entity to accomplish their own goals.
- It allows borrowers to pay to use the assets of another entity to accomplish their own goals.
Correct! Because the funds do not belong to borrowers, they must pay to use them. This payment is the interest rate.
What is a component of the required rate of return?
* Compound interest
* Hurdle rate
* Opportunity cost
* Simple interest
- Opportunity cost
Correct! The required rate of return is composed of opportunity cost, risk, and inflation.
Why would a long-term investment require a higher rate of return?
* Regulations require a higher rate of return on long-term investments.
* There is greater risk involved and a higher opportunity cost.
* There is less risk involved and a lower opportunity cost.
* Projects with longer lives always produce a very high return
- There is greater risk involved and a higher opportunity cost.
Correct! There is greater risk because you cannot ensure the return of your investment for a longer period of time, and there is a higher opportunity cost because you cannot use that money for other things for a longer period of time.
You just inherited $25,000 from a long-lost relative. You decide to put the money in a savings account for the time being. What would be considered an opportunity cost of putting the money in savings?
* Earning interest on the $25,000 you just put in savings
* The fees you must pay to your bank to hold the $25,000
* Buying a brand new car worth $25,000
* Having access to the money should you have some sort of financial emergency
- Buying a brand new car worth $25,000
Correct! Buying a new car would be considered an opportunity cost because it is something you are giving up by keeping the money in your savings account.
Five years ago, Ahmed decided he was going to save up to purchase a car with cash. The car he wants is priced at $15,000. He saved $245 a month in an account that gave him enough interest to have $15,000 in five years. Today, he pulled out $15,000 from his account to buy the car, but the price of the car is now $16,562. Which component of the required rate of return did Ahmed forget to consider?
* Risk
* Opportunity cost
* Interest rate
* Inflation
- Inflation
Correct! The price of the car simply went up by $1,562 due to inflation.
What is the compensation for risk given to investors called?
* Risk premium
* Opportunity cost
* Risk-free rate
* Real rate
- Risk premium
Correct! Risk premium is the compensation that investors take for the risk they must bear.
Which type of interest rate is the rate at which invested money grows for a certain period time?
* Real rate
* Nominal rate
* Risk-free rate
* Inflation rate
- Nominal rate
Correct! The nominal rate is the rate at which invested money grows for a certain period and is the interest rate most often used in your daily life.
Which component of an interest rate is an indicator of inflation and opportunity cost?
* Risk premium
* Risk-free rate
* Growth rate
* Purchasing power
- Risk-free rate
Correct! The risk-free rate describes the rate of return on an investment with no risk, so it just measures inflation and opportunity cost.
Why is built-in inflation linked to adaptive expectations?
Workers want higher wages to keep their standard of living as prices increase, which pushes the prices even higher.
Why does an increased demand for goods and services cause inflation?
An increase in demand often causes an insufficient supply in the market, which causes prices to go up until the demand is once again equal to the supply.
What happens to prices in a market in which there is inflation?
Prices rise.
What is the name for the interest rate expressed on an annual basis?
* Annual percentage rate
* Simple interest
* Real interest rate
* Compound interest
- Annual percentage rate
Correct! The APR is the annual interest rate that is charged for borrowing money or that is earned through investment, and it is calculated on an annual basis.
Why is the required rate of return also known as the hurdle rate?
* It is the minimum rate that a firm must surpass to accept a project.
* Investors have to overcome a certain level of risk to invest.
* The investors cannot invest their money elsewhere.
* It takes into account that the prices of goods and services will increase.
- It is the minimum rate that a firm must surpass to accept a project.
Correct! When a financial manager decides whether to invest in a certain project, the projected return needs to meet the minimum rate of return, or else the firm must “hurdle” the rate in order to accept the project.
What is the inflation rate?
* The rate at which the average price level of a basket of goods and services in an economy increases
* The rate at which invested money grows for a certain period of time
* The rate that is adjusted to remove the effects of increased prices of goods and services
* The rate of return that an investor will accept for investment
- The rate at which the average price level of a basket of goods and services in an economy increases
Correct! The rate at which the average price level of a basket of goods and services in an economy increases is the inflation rate.
What does the risk-free rate indicate?
* Risk
* Inflation and opportunity cost
* Opportunity cost and risk
* Inflation and risk
- Inflation and opportunity cost
Correct! The risk-free rate includes inflation and opportunity cost.
Suppose Sophia is considering a new stock investment for her retirement account. This stock has significant risk, but is quite popular in the market. Inflation for the next few years is expected to be 2–3% per year, and the current U.S. Treasury rates are about 2%. How should she use this information to decide what type of return she can expect from the stock?
* Based on the risk level, she should be willing to accept a return from the stock less than the current U.S. Treasury rates.
* Based on the inflation rate, she should expect this stock to provide a return higher than this for the associated risk.
* Based on the type of financial security, the company selling the stock should set the required return used to assess the stock.
* Based on the stock’s popularity, she should not consider the opportunity costs of other assets’ potential returns when setting the required rate.
- Based on the inflation rate, she should expect this stock to provide a return higher than this for the associated risk.
Correct! Since the inflation of 2–3% will reduce any nominal returns she receives by this amount, she would want a higher return to accommodate for the opportunity costs and risks associated with the investment.
What is the name for a series of equal payments made at the end of consecutive periods over a fixed length of time?
* Single sum
* Ordinary annuity
* Perpetuity
* Annuity due
Ordinary annuity
Correct! This is the definition of an ordinary annuity. The keys are “at the end of each period,” “fixed period,” and “equal payments.”
If you invest $10,000 today and then $5,000 each year for the next 5 years into an investment with an interest rate of 4%, you can withdraw $39,248.14 in 5 years. What does $39,248.14 represent?
* Future value
* Perpetuity
* Present value
* Annuity
- Future value
Correct. Future value measures the worth of relative past cash flows. The $39,248.14 is relative future to other cash flows.
What is the name for the concept that a dollar today is worth more than a dollar in the future?
* Time value of money
* Cost of capital
* Ordinary annuity
* Perpetuity
- Time value of money
Correct! The time value of money is the concept that today’s dollar is worth more than a dollar in the future.
You are considering purchasing a house for $250,000. You have two options to finance it. One is a 20-year mortgage with an interest rate of 3.5%, and the other is a 30-year mortgage with an interest rate of 3.5%. Which mortgage option requires you to pay more in total interest?
* Both are the same
* Cannot be determined
* A 30-year mortgage
* A 20-year mortgage
- A 30-year mortgage
Correct! Even though the interest rate is the same, the longer the loan is, the more interest you pay for the mortgage.
Why does the time value of money play an important role in financial decision-making?
* Because the time value of money helps you estimate cash flows received at different times so that you can sum up all the benefits and costs
* Because the time value of money helps you estimate the cost of capital of any project
* Because you do not need to consider inflation, opportunity cost, or risk for investments when using time value of money
* Because the benefits of investments received at different times are comparable only when you consider the time value of money
- Because the benefits of investments received at different times are comparable only when you consider the time value of money
Correct! With the time value of money, you can find today’s value of future cash flows to compare the costs and benefits of different investments.
You are calculating the present value of an annuity due of $5,000 a year for 20 years. The discount rate is 3%. What should be the “type” input variable of the PV function?
* 20
* 0.03
* 5000
* 1
- 1
Correct! The type is the cash flow type in the PV function. 1 = BEGIN, or an indication of an annuity due.
You are calculating the lump sum of money needed now in order to withdraw $10,000 a year over the next 5 years from an account that earns a 3% interest rate. Which Excel function should you use?
* PV function
* RATE function
* NPER function
* FV function
- PV function
Correct! Since you are looking for a relative past value of future cash flows, you should use the PV function in Excel.
You are calculating the lump sum of money needed now in order to withdraw $10,000 a year over the next 5 years from an account that earns a 3% interest rate. Which Excel function should you use?
* PV function
Correct! Since you are looking for a relative past value of future cash flows, you should use the PV function in Excel.
* RATE function
* NPER function
* FV function
Which Excel function should you use when you are finding a present value of uneven cash flows to find the PV in one step?
* IRR
* PV
* FV
* NPV
- NPV
Correct! You can use one NPV function to find the present value of uneven cash flows.
Twenty years ago, Mateo started an investment account with $2,000. He then invested $100 into the account every month at the end of each month. Today, he has $46,528 in the same account. What is the term for the $100 monthly cash flows?
* Annuity
* Perpetuity
* Future value
* Present value
- Annuity
Correct. The fixed amount of $100 given every month is an annuity.
Which statement correctly contextualizes what a return is?
A return is the gain or loss on an investment over some period of time.
What is an expected return?
A hypothesized estimate of future returns under different scenarios based on expectational data
Lolo invested $30,000 today in an account that gives 3% interest. Starting one year from today, she will be able to pull out little over $3,500 a year. What does the $30,000 represent?
* Perpetuity
* Present value
* Annuity
* Future value
- Present value
Correct. The $30,000 is invested before any cash flows, so it is a relative past cash flow. Therefore, this is the present value.
The word risk is used in many different contexts. How is risk defined in finance?
* The idea that accepting one project will result in forgoing projects with greater returns.
* The probability that the expected return will accurately calculate the realized return on a project.
* The uncertainty that one project will be more or less successful than another.
* The possibility that the realized or actual return will differ from the expected return
- The possibility that the realized or actual return will differ from the expected return
Correct! This is an appropriate definition of risk.
What makes market risk different from firm-specific risk?
* Market risk depends on internal systems within a company, and firm-specific risk is independent of internal systems.
* Market risk is caused by unexpected changes, and firm-specific risk is caused by expected changes.
* Market risk cannot be diversified away, and firm-specific risk can.
* Market risk is a factor in the risk-return relationship, and firm-specific risk is not.
- Market risk cannot be diversified away, and firm-specific risk can.
Correct! Market risk is inherent in the economy as a whole and therefore cannot be diversified away.
Which statement accurately describes firm-specific risk?
* Firm-specific risk can be defined as risk that results from factors at a certain point in the economy.
* Firm-specific risk is the risk associated with problems that companies may face because of lawsuits, labor problems, or management decisions, among other factors.
* Firm-specific risk is the risk associated with problems that companies may face because of changes in interest rates, changes in cash flows due to tax changes, and business cycle changes.
* Firm-specific risk can be defined as risk that can be diversified away by choosing the appropriate industry to invest in.
- Firm-specific risk is the risk associated with problems that companies may face because of lawsuits, labor problems, or management decisions, among other factors.
Correct! This is the appropriate definition of firm-specific risk.
Which type of risk can be reduced by adding a variety of different assets into a portfolio?
* No risk
* Interest rate risk
* Systematic risk
* Firm-specific risk
- Firm-specific risk
Correct! Firm-specific risk can be diversified away.
How is risk separation different from diversification?
* Risk separation involves dispersing assets geographically instead of concentrating them in one location.
* Risk separation involves dispersing resources across different investment vehicles within the same asset class.
* Risk separation involves dispersing resources geographically in one location instead of across several locations.
* Risk separation involves dispersing assets across economies instead of focusing them in one economy
- Risk separation involves dispersing assets geographically instead of concentrating them in one location.
Correct! This is the main difference between the two techniques.
Which situation is a real-life example of risk transfer?
* Buying home insurance—risk is transferred from the policyholder to the insurer
* Using your 401(k) investment to buy a home—risk is transferred from the 401(k) fund to the home
* Purchasing U.S. Treasury bonds—risk is transferred from the holder of the bond to the government
* Changing investment vehicles—risk is transferred from one asset to another
- Buying home insurance—risk is transferred from the policyholder to the insurer
Correct! This is a correct example of risk transfer.
In 1980, the inflation rate was 5% and a particular investment gave a return of 15%. In 2010, the inflation rate was 5% and the same investment gave a return of 12%. In which year did stockholders gain greater purchasing power and why?
1980 because the real rate was higher than in 2010
Which phrase accurately depicts what interest rate risk is?
An example of market risk where the value of a bond is affected by changes in interest rates
Why would a company or individual want to retain risk?
* Individuals retain risk because they are unable to transfer that risk to other entities.
* Both companies and individuals retain risk when they believe that the cost of pursuing an activity is less than the alternative.
* Both companies and individuals retain risk when they cannot afford the cost to reduce the risk.
* Companies never retain risk because they are already prone to so much market risk.
- Both companies and individuals retain risk when they believe that the cost of pursuing an activity is less than the alternative.
Correct! This is the correct reasoning behind risk retention.
Which statement correctly identifies the relationship between systematic risk and different types of firms?
* Luxury good providers have low systematic risk because as the market moves up and down, their level of risk will also move up and down but in a diminished way.
* Utility companies have high systematic risk because as the market moves up and down, more people will invest in their stocks and bonds.
* Utility companies have low systematic risk because as the market moves up and down, their level of risk will also move up and down but in a diminished way.
* Luxury companies have high systematic risk because as the market moves up and down, more people will invest in their stocks and bonds.
- Utility companies have low systematic risk because as the market moves up and down, their level of risk will also move up and down but in a diminished way.
Correct! Different firms have different levels of systematic risk.
How does the amount of time affect the risk associated with different investment vehicles?
* Corporate bonds are riskier over time because it is uncertain whether the company will be around that long.
* Time does not affect the level of risk associated with each investment vehicle.
* Stock investments are more risky over a shorter period of time than over a longer period of time.
* Treasury bills are more risky over a longer period of time than over a short period of time.
- Stock investments are more risky over a shorter period of time than over a longer period of time.
Correct! Time diversification refers to the idea that stock investments are more risky over a shorter period of time than over a longer period of time.
What tends to happen to the risk of an investment that offers a higher return?
* The risk is not affected when an investment has a higher return.
* The risk is higher for an investment with a higher return.
* The risk is lower for an investment with a higher return.
* The risk of a well-diversified portfolio with high returns is always higher than the highest-risk stock in the portfolio.
- The risk is higher for an investment with a higher return.
Correct! The higher the risk an investor takes, the higher the reward the investor is compensated with.
What makes the expected return subjective and different from other types of returns?
* The expected return is based on prices and cash flows.
* The expected return is the only return used to compare different investment decisions.
* The expected return is based on expectational data and the probability of different scenarios occurring.
* The expected return is subjective because it uses 360 days as a full year instead of 365 days.
- The expected return is based on expectational data and the probability of different scenarios occurring.
Correct. The expected return is calculated from hypothesized or “best-guess” estimates of future prices or returns in different scenarios.
A company that produces soap, shampoo, lotion, and other personal care products has recently taken a hit due to a competitor’s new product line. The company decides to reduce wages for its labor force to save money while the company focuses on building up its reputation again, but the company’s labor force goes on strike to protest the pay cuts. What type of risk does the strike represent?
* Idiosyncratic risk
* Systematic risk
* Market risk
* Non-diversifiable risk
- Idiosyncratic risk
Correct! Idiosyncratic risk is the same as firm-specific risk. Since the strike will most likely affect only this firm, it is a firm-specific risk.
Which description below correctly identifies one type of price risk?
* Default risk—depends on how much debt the firm has, which affects earnings and stock prices
* Financial risk—depends on the firm’s ability to pay back its debt payments and dividend payments
Incorrect. This describes a firm’s ability to avoid defaulting on its payments.
* Operating risk—depends on the effect of the firm’s operating decisions on its operating costs
* Business cycle risk—depends on how the firm is performing relative to its industry’s leaders
- Operating risk—depends on the effect of the firm’s operating decisions on its operating costs
Correct! This is the correct description of operating risk.
What is the name for the process of “spreading” money over many different assets?
* Spreading
* Correlation
* Diversification
* Minimization
- Diversification
Correct! The question stem is the definition of diversification.
What is default risk?
* A firm-specific risk that demonstrates the inverse relationship between the probability of default and the required rate of return
* A market-specific risk that affects both the bonds and stocks of a firm
* A firm-specific risk that comes from the probability of a loss resulting from a borrower’s failure to repay a contractual obligation
* A market-specific risk that comes from the probability of a loss resulting from a borrower’s failure to repay a contractual obligation
- A firm-specific risk that comes from the probability of a loss resulting from a borrower’s failure to repay a contractual obligation
Which type of interest rate includes interest on interest in addition to interest on the principal?
* Nominal interest rate
* Yield to maturity
* Simple interest
* Compound interest
- Compound interest
Correct. The compound interest is known as interests on interests and the principal instead of only on the principal.
What is the rate at which the average price level of particular goods and services in an economy increases over a period of time?
* Inflation rate
* Opportunity cost
* Nominal rate
* Real rate
- Inflation rate
Correct. The question stem is the definition of inflation rate.
You signed an apartment contract today. You are going to pay $1,500 at the beginning of each month for the next 12 months, starting today. What type of cash flows is this contract?
* Uneven cash flows
* An annuity due
* A perpetuity
* An ordinary annuity
- An annuity due
Correct. An annuity due is a series of equal payments made at the beginning of consecutive periods.
What is the term for the return over the entire period that an investor owns a financial security?
* Expected return
* Required rate of return
* Real return
* Holding period return
- Holding period return
Correct. This is the definition of holding period return.
What is used to measure total risk?
* Bond ratings
* Holding period return
* Standard deviation
* Beta
- Standard deviation
Correct. Standard deviation is used to measure the total risk of securities.
What is the term for the risk that changes in interest rates will impact the value of a bond?
* Interest rate risk
* Firm-specific risk
* Systematic risk
* Default risk
- Interest rate risk
Correct. This is the risk that changes in interest rates will impact the value of a bond.
Which statement below is an example of how ratios are used in the field of finance?
* Ratios are helpful only when comparing companies that are the same size and that use the same operational style.
* Ratio analysis is performed based on a strict set of rules governed by generally accepted accounting principles.
* A firm’s ratios are compared with those of a benchmark peer group to determine the firm’s relative strength and performance.
* A firm’s ratios may vary year over year, so they are not helpful for evaluating whether firm goals are met.
- A firm’s ratios are compared with those of a benchmark peer group to determine the firm’s relative strength and performance.
Correct! This is called cross-sectional analysis and is common in financial analysis.
Why are ratios considered flexible?
* Because they are not regulated and can be changed or invented according to a firm’s needs
* Because they are based on estimates and thus do not have to be exact
* Because they do not require historical financial data in order to analyze a firm
* Because there are five ratios that must always be calculated and then reported on public financial statements
- Because they are not regulated and can be changed or invented according to a firm’s needs
Correct! Because financial ratios are an internal management tool, they are not subject to external rules and regulations.
How might calculating financial ratios help shareholders?
* Ratios can be used to know what exactly is happening in a firm by answering questions about the firm.
* Ratios help shareholders audit firms to make sure they are in accordance with GAAP standards.
* Ratios allow shareholders to participate in management decisions.
* Ratios can be used to determine whether a firm is maximizing shareholder wealth.
- Ratios can be used to determine whether a firm is maximizing shareholder wealth.
Correct! Ratios are used to evaluate managerial actions so shareholders can determine how effectively and profitably managers are using their invested capital.
The firm Betsy’s Books conducts a financial analysis using ratios to know how it is performing in comparison to other similar firms. What is this process called?
* Maximization
* Benchmarking
* Equity valuation
* Auditing
- Benchmarking
Correct! Benchmarking allows management to see how firms differ from one another and evaluate their performance relative to each other.
What type of ratio is used to assess a firm’s ability to meet short-term obligations without raising external capital?
* Liquidity ratios
* Profitability ratios
* Market ratios
* Activity ratios
- Liquidity ratios
Correct! Liquidity ratios measure a firm’s ability to meet short-term obligations without raising external capital.
Why are several different types of ratios used to analyze a firm?
* Because other ratios must be calculated before the main ratio can be calculated
* Because certain types of ratios become obsolete as a firm innovates
* Because ratios are sometimes inaccurate, and firms have a greater chance of calculating an accurate ratio if they calculate multiple ratios
* Because different types of ratios are needed to get information about different parts of a firm
- Because different types of ratios are needed to get information about different parts of a firm
Correct! Using only one type of ratio in a full financial analysis of a firm would not tell you very much information about the firm. It is through the calculation of many ratios that an analyst will be able to see the bigger picture of the firm.
What do leverage ratios describe?
* How easily a firm can convert assets into cash
* What return shareholders will earn on their investment in a firm
* What proportions of equity and debt a firm uses to finance its assets
* How efficiently a firm is using its assets
- What proportions of equity and debt a firm uses to finance its assets
Correct! This information gives insight into the financial structure of a firm.
A firm has paid off its short-term loans more quickly in the past couple of years. What might this trend indicate about the firm’s financial ratios?
* Its activity ratio is increasing.
* Its leverage ratio is decreasing.
* Its liquidity ratio is increasing.
* Its profitability ratio is decreasing.
- Its liquidity ratio is increasing.
Correct! Liquidity is a measure of the ability of a firm to convert short-term assets into cash. Paying off short-term loans quickly is an indication that a firm is quite liquid, so the firm’s liquidity ratio would be increasing.
Which type of ratio is a current ratio?
* Solvency
* Market
* Activity
* Liquidity
- Liquidity
Correct! A current ratio is a liquidity ratio because it assesses whether a firm can meet short-term obligations.
What is the main difference between the current ratio and the quick ratio?
* The quick ratio includes accounts receivable in current liabilities, and the current ratio does not.
* The quick ratio is faster to calculate than the current ratio.
* The quick ratio is used for smaller companies, and the current ratio is used for larger companies.
* The current ratio includes inventory in current assets, and the quick ratio does not.
- The current ratio includes inventory in current assets, and the quick ratio does not.
Correct! Inventory is the least liquid of all current assets. By not including inventory, the quick ratio is a more stringent test of a firm’s ability to meet short-term obligations.
The firm Betsy’s Books has a market-to-book ratio of 1.2. What does this tell you about the firm?
* This firm is expected to grow in the future.
* This firm gets a 20% return on its assets.
* This firm is about to go out of business.
* This firm gets an 20% return on investment.
- This firm is expected to grow in the future.
Correct! The market-to-book ratio measures the growth prospects of a company. If the ratio is greater than 1, then the company is expected to grow.
What does the net margin measure?
* The percent of revenue that is retained as profit for the firm
* The percent earned on each dollar invested in the firm
* The percent of revenue remaining after COGS has been taken out of sales
* The percent of sales remaining after covering COGS and operating expenses
- The percent of revenue that is retained as profit for the firm
Correct! The net margin is net income divided by sales, which tells us how much a firm actually gets to keep after paying all its expenses.
Which of these measures is a component of return on equity?
* Net margin
* Operating margin
* Current ratio
* Fixed asset turnover
- Net margin
Correct! Net margin, total asset turnover, and leverage multiplier are the components of return on equity.
How can the DuPont framework help a company assess its return on equity?
* It allows the company to determine how its abilities to generate profits, manage assets, and use financing contribute to the return on equity.
* It breaks the cash flow of a company into the operating, investing, and financing aspects of the firm to help identify how each contribute to the firm’s profitability.
* It provides a cross-sectional analysis of the industry for the firm to be able to compare its return on equity to that of its competitors.
* It compares alternative ways of financing the firm with debt so the company can determine which will provide the highest return on equity.
- It allows the company to determine how its abilities to generate profits, manage assets, and use financing contribute to the return on equity.
Correct! The DuPont framework breaks the return on equity into each of these components using the profit margin, total asset turnover, and leverage ratio.
Which action increases the return on equity of a firm if all else remains constant?
* Decreasing the total asset turnover
* Decreasing profitability
* Increasing equity financing
* Increasing debt financing
- Increasing debt financing
Correct! Increasing debt financing increases the leverage multiplier, which means that the ROE increases.
What is a component of the DuPont framework?
* Current ratio
* Fixed asset turnover
* Times interest earned
* Return on assets
- Return on assets
Correct! ROE is ROA times leverage multiplier.
BigDog and SmallDog are two companies that have an identical return on equity. One difference between the two companies is that BigDog has 40% of assets financed by debt while SmallDog has 100% of assets financed by equity. What can you conclude about BigDog and SmallDog?
* SmallDog has a smaller ROE than BigDog.
* SmallDog has a higher ROA than BigDog.
* SmallDog has a smaller ROA than BigDog.
* SmallDog has a higher ROE than BigDog.
- SmallDog has a higher ROA than BigDog.
Correct! Since SmallDog has no debt, the leverage multiplier of SmallDog is smaller than that of BigDog. Since both companies have the same ROE, SmallDog must have a higher ROA.
What is one way that a firm can improve its return on equity?
* Improving loan relations by ensuring that it meets debt covenants
* Successfully cutting production costs to boost net margin
* Hiring more employees for the accounting department to implement a multiple check system
* Increasing the number of trainings it gives management
- Successfully cutting production costs to boost net margin
Correct! Increasing net margin increases the ROE.
Which actions, taken together, will certainly increase a firm’s ROE?
* Decreasing equity financing and increasing net margin
* Increasing total asset turnover and decreasing debt financing
* Increasing net margin and decreasing debt financing
* Decreasing equity financing and decreasing return on assets
- Decreasing equity financing and increasing net margin
Correct! Decreasing equity financing increases the leverage multiplier, therefore increasing ROE, and increasing net margin also increases ROE.
A company currently has a ratio of 1.5 but hopes to improve the ratio to 2 to align more with the industry benchmark. To achieve this goal, costs were cut in production through an investment in efficient equipment, and the company achieved a higher profit margin. If this continues, you are certain that the firm will achieve its goal in two years. What is this an example of?
* Flexibility
* Cross-sectional analysis
* Progress measurement
* Trend analysis
- Progress measurement
Correct! You are comparing the company’s ratio to the goal and checking how the company is progressing toward the goal.
For what purpose are market ratios used?
* To measure how well a company uses its assets to generate sales or cash
* To consider how a firm is financed
* To assess a firm’s ability to meet short-term obligations without raising external capital
* To evaluate the current share price of a public firm’s stock
To evaluate the current share price of a public firm’s stock
Correct! Market ratios are used to evaluate whether the current share of a public firm’s stock is correctly priced.
You are considering starting a new business to sell Widgets in your hometown. You can import the Widgets at a low cost, and you hope to be able to sell them for significantly more. Which ratio can help you calculate how much profit you will earn from the sale of each Widget? (Assume you are only considering the cost of the Widget, not any other operating costs.)
* Accounts receivable turnover
* Gross margin
* Fixed asset turnover
* Operating margin
- Gross margin
Correct! Gross margin tells you the percent of sales that become gross profit. The rest of the money earned from sales is used for the production of goods.
What allows an investor to determine which financial activities are contributing to changes in the return on equity?
* Cross-sectional analysis
* DuPont framework
* Flexibility
* Trend analysis
DuPont framework
Correct! Decomposing the DuPont framework enables analysis of fundamental performance to determine which financial activities are contributing to changes in the return on equity.
Knowing that you are taking this finance class, a friend asks you about two investment opportunities he is considering. He wants to know which of the firms is using its assets more efficiently to generate sales. Which set of information could help you determine this?
* Firm A has a leverage ratio of 3, and Firm B has a leverage ratio of 1.5.
* Firm A has an asset turnover of 4, and Firm B has an asset turnover of 2.5.
* Both firms have a return on assets of 5%, but Firm B has a higher profit margin.
* Firm A has a gross margin of 40%, and Firm B has a gross margin
- Firm A has an asset turnover of 4, and Firm B has an asset turnover of 2.5.
Correct! Asset turnover is an indicator of how well a firm uses its assets to generate sales. Since Firm A generates $4 of sales for every $1 of assets, it is using its assets more efficiently.
Why are ratios useful for analyzing and comparing company performance between firms of different sizes?
* They allow for performance evaluation.
* They provide standardization.
* They help us focus.
* They provide flexibility.
They provide standardization.
Correct! Ratios standardize financial data to make them comparable across firms, even those of distinctly different sizes.
You are the financial manager of a firm. The firm is small and is struggling to collect cash from accounts receivable. Also, due to the nature of industry, inventories are illiquid. To make sure that the firm has enough cash holdings for short-term obligations, you decide to create a new ratio of cash to short-term obligations. What is this scenario an example of?
* Trend analysis
* Cross-sectional analysis
* Flexibility
* Standardization
- Flexibility
Correct! Ratio analysis is flexible, so you can create a new ratio given the need of the firm.
Why are activity ratios also called efficiency ratios or asset use efficiency ratios?
* Because they consider how a firm’s assets are financed.
* Because they are used to directly judge how well management is doing at maximizing owner wealth.
* Because they measure how well a company uses its assets to generate sales or cash.
* Because they are used to evaluate the current value of a company.
- Because they measure how well a company uses its assets to generate sales or cash.
Correct. Activity ratios measure how well a company uses its assets to generate sales or cash.
What type of ratio is used to consider how a firm is financed and to assess a firm’s ability to pay interest and pay back long-term obligations?
* Profitability ratios
* Financing ratios
* Market ratios
* Activity ratios
- Financing ratios
Correct! Financing ratios consider how a firm is financed.
What does a net margin of 7% indicate?
* For every dollar of total assets, 7 cents are generated as sales.
* For every dollar of fixed assets, 7 cents are generated in sales.
* For every dollar of revenue, 7 cents remain for the equity holders after all other costs are covered.
* For every dollar of revenue, 7 cents remain for the debt holders and equity holders after all other costs are covered.
- For every dollar of revenue, 7 cents remain for the equity holders after all other costs are covered.
Correct! Net margin tells us the percentage of sales that will become net income, which is the amount remaining for the equity holders.
Firm A has an average collection period of 67 days, and the industry norm is 40 days. What can the firm do in order to be competitive with accounts receivable management in the industry?
* Tighten the credit standards for its customers.
* Pay suppliers more quickly.
* Pay suppliers more slowly.
* Loosen the credit standards for its customers.
Tighten the credit standards for its customers.
Correct! The credit standards are too loose, so the customers are not paying Firm A as quickly as they are paying other competitors in the industry. Tightening the credit standards would shorten the average collection period.
What is the difference between the current ratio and the quick ratio?
* Cash is excluded in the calculation of a quick ratio.
* Notes payable are excluded in the calculation of a quick ratio.
* Inventory is excluded in the calculation of the quick ratio.
* Accounts payable are excluded in the calculation of a quick ratio.
- Inventory is excluded in the calculation of the quick ratio.
Correct! Since inventory is the least liquid current asset, inventory is not included in the calculation.
Which term is used to describe the stock of a firm with market-to-book ratio of less than 1?
* Undervalued
* Value stock
* Growth stock
* Overvalued
- Value stock
Correct! An M/B ratio of less than 1 is considered a value stock.
What does inventory turnover assess?
* How well a firm can meet short-term obligations through sales
* The proportion of inventory financed by equity
* The inventory management of a firm
* How well a company is doing overall
- The inventory management of a firm
Correct! Inventory turnover tells us how well a firm is managing its inventory.
You are comparing the return on equity of Firm 1 and Firm 2. Both firms have an identical profit margin and asset turnover, but Firm 1 has an overall higher return on equity. What must be true?
* Firm 2 has a higher cost of sales relative to Firm 1.
* Firm 2 is not using its assets as efficiently as Firm 1 to generate sales.
* Firm 1 is using a higher proportion of debt to finance its operations.
* Firm 1 has a lower times interest earned because its return on equity is higher.
- Firm 1 is using a higher proportion of debt to finance its operations.
Correct! The third component of return on equity is the leverage multiplier. Since the firms’ profit margins and asset turnovers are the same, it must be the leverage multiplier that is different. Using a higher amount of debt would result in a larger leverage multiplier and an overall higher return on equity.
Which method of ratio analysis looks at a firm’s performance over time?
Trend analysis
You are a financial analyst of an investment bank, and you are doing research on equity. You are looking at a book publisher’s financial ratios in comparison to its competitors and the industry average. What is this an example of?
Cross-sectional analysis
Which type of ratio are suppliers interested in?
Which type of ratio are suppliers interested in?
Liquidity ratios
Which type of ratio are suppliers interested in?
Liquidity ratios
What is the ratio that tells you on average how long it takes for a firm to collect accounts receivable?
Average collection period
What does an average collection period of 70 tell you?
On average, a firm takes 70 days to collect accounts receivable.
What does high inventory turnover relative to the industry and competitors indicate?
The firm does not hold enough inventory and is making its customers wait longer to receive their purchased goods.
What is the difference between return on assets (ROA) and return on equity (ROE)?
ROE considers the capital structure of a company, while ROA does not.
MiniCo recently spun off of BigCo. Both companies have the same leverage and asset turnover ratios, but MiniCo is underperforming on its return on equity to shareholders. If MiniCo would like to improve its return on equity, which action would help?
Reduce costs to improve its overall profitability.
When evaluating a company’s performance, what can variances on a company’s cash budget indicate?
* Variances are expected and should never pose a concern for management.
* Variances show that expenses were necessarily greater than income for the budget horizon.
* Variances show that certain managers or divisions are not meeting targets.
* Variances are not useful for performance evaluation of certain managers or divisions.
- Variances show that certain managers or divisions are not meeting targets.
Correct! Cash budgets provide a basis for performance evaluation, and significant variance from predicted income, saving, and expense predictions indicates that management has not accurately assessed company operations.
What are three principles of budgeting that are important to know before beginning the budgeting process?
* Improve your credit score; understand the key areas of savings, income, and expenses; and categorize all expenses
* Know yourself, reduce variance in spending, and consult a certified financial advisor
* Keep records; develop savings, income, and expense strategies; and use a method that meets your needs and objectives
* Eliminate debt, evaluate your personal financial performance, and consult a certified financial advisor
- Keep records; develop savings, income, and expense strategies; and use a method that meets your needs and objectives
Correct! All three of these principles are included in the six principles of budgeting as discussed in the course. The other three principles are know yourself; understand the key areas of savings, income, and expenses; and eliminate consumer debt and minimize long-term debt.
How far into the future do cash budgets usually forecast?
* Between five and ten years
* Between one and two weeks
* Between one and three years
* Between one month and one year
- Between one month and one year
Correct! Cash budgets are not useful if they forecast less than one month, and it is not necessary for cash budgets to extend beyond one year in the future.
What are three principles of budgeting that are important to know before beginning the budgeting process?
* Improve your credit score; understand the key areas of savings, income, and expenses; and categorize all expenses
* Know yourself, reduce variance in spending, and consult a certified financial advisor
* Keep records; develop savings, income, and expense strategies; and use a method that meets your needs and objectives
* Eliminate debt, evaluate your personal financial performance, and consult a certified financial advisor
- Keep records; develop savings, income, and expense strategies; and use a method that meets your needs and objectives
Correct! All three of these principles are included in the six principles of budgeting as discussed in the course. The other three principles are know yourself; understand the key areas of savings, income, and expenses; and eliminate consumer debt and minimize long-term debt.
What are the three main uses of cash budgets?
* Cash budgets help companies know how much to invest in capital, aid in expense tracking, and predict when additional financing is needed.
* Cash budgets allow periodic performance evaluation, inform investors of changes in net income, and allow businesses to gain access to credit.
* Cash budgets show lenders how effective the management of a business is, allow for corrective action when needed, and increase a firm’s degree of leverage.
* Cash budgets are used to forecast future financial need, aid in performance evaluation, and show when corrective action is needed.
- Cash budgets are used to forecast future financial need, aid in performance evaluation, and show when corrective action is needed.
Correct! A good cash budget is used in these ways to help a firm operate more effectively and efficiently.
What is the correct order of the three steps necessary to create a cash budget?
* Determine cash receipts, estimate cash disbursements, create the cash budget
* Create the cash budget, determine cash receipts, estimate cash disbursements
* Evaluate income, create the cash budget, estimate cash disbursements
* Estimate cash disbursements, predict expenses, create the cash budget
- Determine cash receipts, estimate cash disbursements, create the cash budget
Correct! Doing these three things in this order can help you understand your business, understand the timing of cash flows, and keep track of borrowing requirements.
Why is “put $50 in a savings account each month for Christmas gifts” a better budgeting goal than “save money for Christmas gifts”?
* Because it is specific and measurable
* Because it demonstrates a knowledge of the correct steps of cash budgeting
* Because $50 is a realistic amount to save each month
* Because “save money for Christmas gifts” is unattainable
- Because it is specific and measurable
Correct! Effective financial goals provide a specific and concrete target to focus on.
Why would a monthly mortgage payment be considered a fixed expense?
* Because the bank changes the payment amount each month
* Because the payments vary based upon the cost of the house
* Because the payment is the same amount each month
* Because you have control over the amount you pay each month
- Because the payment is the same amount each month
Correct! A mortgage is a fixed expense, meaning that the payment amount is the same each month. Knowing which of your expenses are the same from month to month will help you budget more accurately.
Which action would help you make your budget more efficient?
* Every month, increase the allotted amounts for each category of your budget.
* Create only two categories for expenses: necessary and unnecessary.
* Reduce your payments toward savings so you have enough for monthly expenses.
* Compare your budgeted cash flows to your actual cash flows, and then revise the budget if necessary.
- Compare your budgeted cash flows to your actual cash flows, and then revise the budget if necessary.
Correct! This would allow you to keep your budget updated and effective so you can make the best use of your money.
Which item is an example of a cash receipt in a personal budget?
* A purchase of $53 for groceries and toiletries for the week
* A ski pass worth $65 that your roommate gives you in exchange for borrowing your car
* A payment of $125 for an annual doctor’s visit
* A graduation gift of $100 from your grandmother
- A graduation gift of $100 from your grandmother
Correct! Since this is money, or income, coming into your cash budget, it represents a cash receipt.
Which item represents an example of a cash disbursement a business might have this month?
* A rent check paid and cashed for the warehouse the company uses
* Interest earned on bank deposits held by the firm.
* A collection of accounts receivable on sales made last month
* A purchase of inventory on credit that will be paid off next month
- A rent check paid and cashed for the warehouse the company uses
Correct! Since this expense is being paid this month and the cash is being withdrawn from the company’s account, this represents an example of a cash disbursement.
What three things should be included in a cash budget for a business?
* Sales, expenses, and borrowing
* Cash receipts, cash disbursements, and borrowing
* Cash receipts, cash disbursements, and savings
* Income, expenses, and savings
- Cash receipts, cash disbursements, and borrowing
Correct! All three of these things affect cash flows in a business and should be included in a cash budget.
Which items are considered cash disbursements for a business?
* Cash sales and accounts receivable
* Raw materials, rent, administrative expenses, interest, and selling expenses
* Rent, accounts receivable, accounts payable, and raw materials
* Dividends, investments, cash sales, and tax liabilities
- Raw materials, rent, administrative expenses, interest, and selling expenses
Correct! These are common products or services that a firm pays cash for during a specified period in order to generate sales.
Why are sales not strictly considered to be the same thing as cash receipts?
* Sales are not liquid enough to be considered a form of cash flow.
* Sales include expenses outside of the cash budget.
* Sales are not measured on a monthly basis and thus cannot be included in a cash budget.
* Sales include both cash sales and credit sales.
- Sales include both cash sales and credit sales.
Correct! Sales made on credit are not considered a cash receipt until the time period in which they are collected.
In what situation might the software method of tracking be preferable to the spreadsheet method of tracking?
* When a person has a hard time remembering to record their cash flows and when they prefer to use a card to make purchases
* When a person needs cash flow information for tax purposes
* When a person has a lot of free time and likes to record each cash flow by hand
* When a person prefers to use cash to make purchases and is very good about remembering to track cash flows
- When a person has a hard time remembering to record their cash flows and when they prefer to use a card to make purchases
Correct! The software method is convenient for busy people who do not want to use cash or record cash flows by hand.
What is the main reason why it is important to track and record cash flows?
* Tracking cash flows is important because it is impossible to refinance a loan without tracking your income and expenses.
* Tracking your cash flows allows you to recognize where and how your money is spent so you can monitor your cash flows and revise your budget as needed.
* Tracking cash flows is the main process by which a person can calculate the return they are receiving on their investments.
* Tracking your cash flows allows you to increase your annual income by knowing your previous income.
- Tracking your cash flows allows you to recognize where and how your money is spent so you can monitor your cash flows and revise your budget as needed.
Correct! This is the first step in the budgeting process, and it is necessary in order to have an accurate budget going forward.
What is the purpose of monitoring your cash flows?
* Monitoring is the process by which firms prove to lenders that they have sufficient cash flow to pay back a short-term loan.
* Monitoring allows you to implement changes to your budget gradually in such a way that the changes go smoothly and efficiently.
* Monitoring is used to identify the degree to which a business is leveraged so that the business can determine when it will be most profitable to repay outstanding loans.
* Monitoring allows you to evaluate whether your actual cash flows are in line with your goals and to understand when correction or revision is needed.
- Monitoring allows you to evaluate whether your actual cash flows are in line with your goals and to understand when correction or revision is needed.
Correct! If a business did not monitor its budget, then tracking cash flows would be useless, and the business would not know if it was on track to reach its goals.
Which processes help you identify and fix problems in your budget?
* Monitoring your budget allows you to identify problems, and then gradual revision and implementation of new processes allow you to fix those problems.
* When you spend too much in a category of your budget, you have identified a problem, which you can fix by increasing the allotted amount in that category for next month.
* Revision allows you to identify problems in your budget, and then tracking allows you to fix those problems immediately so that you can then monitor progress.
* Tracking allows you to identify problems, and then subsequent monitoring allows you to fix those problems.
- Monitoring your budget allows you to identify problems, and then gradual revision and implementation of new processes allow you to fix those problems.
Correct! This assures that the budget is as effective as possible at helping you reach your financial goals.
W&H Company wants to create a cash budget to better manage its cash flows. The financial manager knows that the firm’s labor costs and materials costs are too high for the level of sales each month. The firm also needs to keep better track of its cash flows to assess its need for additional financing through short-term loans.
W&H Inc.’s labor costs each month are an example of which item in a cash budget?
* Cash disbursement
* Minimum cash need
* Cash receipt
* Net cash for the month
- Cash disbursement
Correct! This is a cash disbursement for the firm because it represents cash going out during the month to pay employees.
W&H Company wants to create a cash budget to better manage its cash flows. The financial manager knows that the firm’s labor costs and materials costs are too high for the level of sales each month. The firm also needs to keep better track of its cash flows to assess its need for additional financing through short-term loans.
After W&H Inc. has developed a cash budget, what should the company do in the following months?
* It should begin tracking its cash inflows and outflows.
* It should invest any profits in new capital.
* It should wait until the budgeted months are over and then make a new budget for the months following.
* It should monitor its actual cash flows and then revise the cash budget if needed.
- It should monitor its actual cash flows and then revise the cash budget if needed.
Correct! Monitoring and revising the cash budget will allow W&H Inc. to identify and fix any problems that may arise.
W&H Company wants to create a cash budget to better manage its cash flows. The financial manager knows that the firm’s labor costs and materials costs are too high for the level of sales each month. The firm also needs to keep better track of its cash flows to assess its need for additional financing through short-term loans.
Why would creating a cash budget be useful for W&H if the firm needs a loan from the bank or another short-term lender?
* Cash budgets help lenders identify a business’s investing strategy going forward, establishing confidence in future operations.
* Cash budgets include a detailed credit report of the business’s operations, which proves that the company can use borrowed funds responsibly.
* Cash budgets allow businesses to seek financing from multiple lenders at a time, increasing borrowing capabilities.
* Cash budgets increase the lender’s trust in a firm by demonstrating the firm’s ability to make profits and repay loans.
- Cash budgets increase the lender’s trust in a firm by demonstrating the firm’s ability to make profits and repay loans.
Correct! Cash budgets are detailed plans that show creditors that a firm will have enough cash from month to month to support its operations while staying within acceptable borrowing limits. A good cash budget allows creditors to feel secure in lending money to the firm.
How do the benefits of knowing the cash position for each period differ between businesses and individuals?
* Knowing the cash position allows businesses to recognize when short-term loans are needed, while it allows individuals to analyze progress toward their personal financial goals.
* Knowing the cash position allows individuals to recognize when short-term loans are needed, while it allows business to know when to repay their vendors.
* Knowing the cash position allows businesses to know how much to invest each month, while it allows individuals to know how much to save each month.
* Knowing the cash position allows businesses to evaluate long-term cash accumulation, while it allows individuals to analyze loan balances.
- Knowing the cash position allows businesses to recognize when short-term loans are needed, while it allows individuals to analyze progress toward their personal financial goals.
Correct! Individuals do not usually (and should not) need short-term loans.
What is the difference between tracking and monitoring cash flows?
* Monitoring is revising your budget, whereas tracking is identifying patterns and changes in your cash flows.
* Tracking involves using your monitoring record to verify cash flows against your goals, discover changes and patterns in cash flows, and understand when correction may be needed.
* Monitoring involves using your tracking record to evaluate cash flows against your target, identify patterns and changes in cash flows, and gauge when correction is needed.
* Tracking involves using envelopes or computer programs to record cash flows, whereas monitoring involves evaluating cash flows by hand.
- Monitoring involves using your tracking record to evaluate cash flows against your target, identify patterns and changes in cash flows, and gauge when correction is needed.
Correct! By accessing cash flow records and knowing the remaining balance in the budget throughout the month and year, you will be able to monitor your budget in a way that will help you reach your financial goals.
What role does financial forecasting play in the future success and growth of a firm?
* Financial forecasting supplements historical data with proposed investments or changes to allow for more accurate foresight.
* Financial forecasts are only moderately useful because predicting the future is impossible.
* Financial forecasts are much less important than cash budgets because cash budgeting is the only essential tool a firm needs to attain long-term success.
* Financial forecasting looks backward to provide historical data that informs future operations.
- Financial forecasting supplements historical data with proposed investments or changes to allow for more accurate foresight.
Correct! While understanding the past is key to moving forward, accounting for any proposals in your forecasts highlights where funding may be needed or where you might actually have more room to spend.
What is the goal of financial forecasting?
* To project sales so investors can adjust stock prices
* To provide a detailed map of a firm’s future
* To understand the implications of today’s decisions on tomorrow’s performance
* To project net income and dividends for a firm
- To understand the implications of today’s decisions on tomorrow’s performance
Correct! The goal of financial forecasting is to see the big picture of how financial decisions will affect future performance.
Which question is answered by financial forecasting?
* How will an increase in the firm’s tax rate affect the firm’s net income?
* What is the firm’s current market share?
* Which product will produce the most in sales over the next year?
* How much financing will the firm need in the future?
- How much financing will the firm need in the future?
Correct! Finance forecasting helps us determine how much financing is needed in the future given today’s business decisions and growth.
How does financial forecasting help with financial decision-making?
* It helps decision makers understand the impacts of today’s actions on the future performance of the firm.
* It helps managers understand what key assumptions to make for the future.
* It helps managers analyze how the firm has been performing over the past several years.
* It helps decision makers see a detailed map of the future performance of the firm.
- It helps decision makers understand the impacts of today’s actions on the future performance of the firm.
Correct! This is the purpose of financial forecasting.
What is one of the fundamental purposes of financial forecasting?
* To understand the link between asset requirements and industry
* To estimate how changes in cost structures or sales will impact the future cash flows and financing needs of the firm
* To ensure that the future period’s sales and costs will not exceed historical numbers
* To create accurate financial reports that summarize the company’s financial performance for the previous period
- To estimate how changes in cost structures or sales will impact the future cash flows and financing needs of the firm
Correct! A solid financial model will allow you to see how changes in cost structures or sales growth will impact the firm’s future cash flows, financing needs, and cash budgeting.
What are spontaneous accounts?
* Accounts that vary naturally with sales
* Accounts that are optional to include when creating a financial forecast
* Accounts that are left to management’s discretion
* Accounts that do not vary with sales
- Accounts that vary naturally with sales
Correct! By definition, when sales increase, the increase must be matched in another account, such as receivables
Which type of account changes with sales growth?
* Discretionary accounts
* Fixed assets accounts
* Spontaneous accounts
* Non-spontaneous accounts
- Spontaneous accounts
Correct! Spontaneous accounts vary naturally with sales.
If a company expects sales to grow by 10% next year, which account might also increase by 10%?
* General business insurance
* Training budget for senior employees
* Cost of goods sold
* Headquarters utilities
- Cost of goods sold
Correct! Cost of goods sold is a spontaneous account, so if sales go up, you would expect the cost of goods sold to increase by a similar percentage. Otherwise, the company would not be able to sell products.
When can the discretionary financing needed (DFN) be determined?
* After pro-forma financial statements are forecasted using the percent of sales method
* After total revenue, alone, is projected
* After total revenue and expenses are projected
* After total financing need is determined
- After pro-forma financial statements are forecasted using the percent of sales method
Correct! Once all the financial statements are projected according to a given set of assumptions, you can determine the financing required to fund the predicted growth in sales.
Which action decreases the discretionary financing needed (DFN)?
* Increasing the payback ratio
* Decreasing the net margin
* Decreasing the retention ratio
* Increasing the plowback ratio
- Increasing the plowback ratio
Correct! Increasing the plowback ratio increases projected owners’ equity and thus decreases DFN.
You are a financial manager of a company, and you have projected sales increase for next year of 8%. Which action would you take when you conduct financial forecasting using the percent of sales method?
* Leave the cash account constant in the projected financial statements.
* Change the notes payable account in proportion to sales growth.
* Change the long-term liabilities account in proportion to sales growth.
* Leave the notes payable account constant in the projected financial statements.
- Leave the notes payable account constant in the projected financial statements.
Correct! Notes payable is a discretionary account. Thus, you should leave it constant in the projected financial statements.
You are conducting financial forecasting for your firm given the projected sales. What are you doing if you are estimating changes in the balance sheet based on the predicted change in sales?
* Determining total financing need
* Projecting discretionary accounts
* Forecasting spontaneous accounts
* Calculating retained earnings
- Forecasting spontaneous accounts
Correct! Spontaneous accounts change in proportion to sales growth.
What is the sustainable growth rate (SGR)?
* The external financing needed to meet the projected growth
* Accounts that vary with the change in sales
* The growth rate that allows a firm to maintain its present financial ratios without issuing new equity
* Accounts that do not vary with sales but are up to management’s discretion
- The growth rate that allows a firm to maintain its present financial ratios without issuing new equity
Correct! The SGR is the growth rate that allows a firm to maintain its present financial ratios without issuing new equity.
How can a company reduce its discretionary financing needed (DFN)?
* Reduce retention of earnings.
* Reduce prices.
* Increase the net margin.
* Increase the dividend payout.
- Increase the net margin.
Correct! Increasing net margin increases the projected owners’ equity, thus reducing the DFN.
Which action increases a company’s sustainable growth rate (SGR)?
* Decreasing profitability
* Decreasing asset use efficiency
* Decreasing dividend payout
* Decreasing the leverage the company uses
- Decreasing dividend payout
Correct! Decreasing dividend payout increases earnings retention and thus increases the SGR.
Which account should be looked at first when examining capacity constraints to determine whether the discretionary financing needed (DFN) can be reduced?
* Long-term debt
* Notes payable
* Accounts receivable
* Fixed assets
- Fixed assets
Correct! You can recheck capacity analyses to verify whether the firm really needs as large of an increase in fixed assets as projected in the forecast.
How can a firm grow its fixed assets if it is expecting growth but has reached capacity with its fixed assets?
* Continue to invest in capital through small increments over time.
* Increase the net margin.
* Use the percent of sales method to forecast fixed assets.
* Invest a substantial amount of money at one time to increase capacity.
- Invest a substantial amount of money at one time to increase capacity.
Correct! Investments in fixed assets are capital-intensive, meaning they require large payments at one point in time.
What does the sales capacity equation tell you?
* How much the firm can grow without issuing new equity
* How much room a firm has to grow without additional investment in fixed assets
* The limit for a firm’s sales growth
* The minimum amount of fixed assets required to support current sales
- How much room a firm has to grow without additional investment in fixed assets
Correct! By using the ratio of actual sales to percent of capacity, you can determine how much sales growth the firm can support without needing to invest in further fixed assets.
What is discretionary financing needed (DFN)?
* The additional financing needed given a firm’s expected future growth
* The additional projected owners’ equity needed given a firm’s expected future growth
* The total projected assets needed given a firm’s expected future growth
* The total projected liabilities needed given a firm’s expected future growth
- The additional financing needed given a firm’s expected future growth
Correct! DFN is how much additional financing the firm will need given its expectations for future growth.
You are a financial manager of a company. The marketing department has informed you that the projected sales growth for the upcoming year is 10%. As you conduct financial forecasting, you keep the long-term liabilities the same amount as the previous year and will discuss this account with the other managers later. What type of account is long-term liabilities?
* Projected owners’ equity account
* Discretionary account
* Spontaneous account
* Projected asset account
- Discretionary account
Correct! Discretionary accounts do not vary automatically with sales but are left to the discretion of management. In this scenario, you kept the long-term liabilities account the same.
What does the discretionary financing needed (DFN) tell us?
* The total amount of owners’ equity that a firm is projected to have
* The total amount of investment needed for future years
* The total amount of liabilities that a firm is projected to have
* The total amount of funding that management will need to obtain through discretionary financing sources
- The total amount of funding that management will need to obtain through discretionary financing sources
Correct! DFN is the difference between the projected total assets and the projected total liabilities plus owners’ equity. Any discrepancy between the sources and uses of finance is extra financing that management must obtain.
Company ABC would like to continue to grow, but in order to maintain control of all decisions and ownership, it wants to avoid issuing new stock. Which calculation will show the company’s leadership the fastest that ABC can grow?
* Key growth indicator
* Discretionary financing needed
* Return on equity
* Sustainable growth rate
- Sustainable growth rate
Correct! Sustainable growth rate is defined as the rate at which a firm can grow without issuing new equity. It implies that the firm’s growth comes from the return on equity less any dividends.
What is the major purpose of financial forecasting?
* To show the company’s growth over the past several years
* To produce a short-term budget for a company or individual
* To inform a company how business decisions will impact future growth
* To make operational changes within a company
- To inform a company how business decisions will impact future growth
Correct. Financial forecasting helps decision makers understand how actions taken today can impact the firm’s future performance.
Jerry wants to begin budgeting his money. What are three principles that he should know before beginning the budgeting process?
Track expenses categorically, use the most updated method of budgeting, and eliminate consumer debt.
Keep records; understand the key areas of savings, expenses, and income; and eliminate consumer debt.
Know yourself; transfer long-term debt to short-term debt; and develop savings, expense, and income strategies.
Make eliminating consumer debt a priority, only use the budgeting strategies that are approved by GAAP, and track expenses categorically.
Keep records; understand the key areas of savings, expenses, and income; and eliminate consumer debt.
Correct! These are three of the six principles of budgeting. The other three are know yourself; develop savings, income, and expense strategies; and use a method that meets your needs and objectives.
What are the three things one must determine before making a personal budget?
Expenses, interest payments, and savings
Liabilities, income, and expenses
Tax liabilities, expenses, and income
Income, expenses, and savings
Income, expenses, and savings
Correct! Knowing these things allows you to create a statement that accurately reflects your cash flows from month to month.
A firm had sales of $100,000 this month. However, the firm received only $90,000 in cash from sales. Why would the firm receive $10,000 less cash than its monthly sales?
Because the firm did not make all sales on cash
Because the firm purchased inventory on credit this month
Because the firm paid cash for inventory purchased
Because the firm paid down $10,000 on a loan
Because the firm did not make all sales on cash
Correct! Some sales are made on credit rather than cash, and a portion of credit sales are collected in the following months after the sales.
What three things should an individual or company be doing so that their budget is effective and so that they are on track to meet their financial goals?
Revise the budget, categorize investments, and track income
Reduce variable costs, account for income, and monitor outstanding loans
Monitor cash flows, reduce variable costs, and track expenses
Track cash flows, monitor cash flows, and revise the budget
Track cash flows, monitor cash flows, and revise the budget
Correct! Doing these things helps you to use your money in the most efficient and effective way possible.
What is the envelope method of budgeting?
Using a spreadsheet to track both your digital and physical expenditures of cash during the month
Paying all expenses during the month by check through the physical mailing system to ensure that obligations are met in a timely manner
Withdrawing cash at the beginning of the period and then allowing only a certain amount to be available for each category of spending
Tracking your credit and debit expenditures by updating and categorizing purchases that appear on your bank statement
Withdrawing cash at the beginning of the period and then allowing only a certain amount to be available for each category of spending
Correct! The envelope method involves putting a specific portion of your budget in cash in each envelope and only spending this amount during the period.
What are long-term financial forecasts used for?
Cash budgeting
Making investment and financing decisions
Developing savings, income, and expense strategies
Determining short-term operating needs
Making investment and financing decisions
Correct! Whatever growth a firm anticipates must eventually be financed one way or another. Any investment in capital that exceeds what the firm retains from profit generates a discretionary financing need.
Which type of account does not vary with sales and is left to management’s discretion?
Fixed assets accounts
Accounts receivable accounts
Non-spontaneous accounts
Spontaneous accounts
Non-spontaneous accounts
Correct! Non-spontaneous, or discretionary, accounts do not vary automatically with sales but are left to the discretion of management.
Which account is a discretionary account?
Notes payable
Fixed assets
Cash
Accounts receivable
Notes payable
Correct! Notes payable does not vary with sales, and it is based on management discretion.
What is the rate at which a firm can grow without issuing new equity?
Internal rate of return
Retention rate
Sustainable growth rate
Discount rate
Sustainable growth rate
Correct! The sustainable growth rate is the growth rate that allows a firm to maintain its present financial ratios without issuing new equity.
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Why do fixed assets increase as a lump sum instead of in proportion to sales growth?
A firm needs more fixed assets only when the DFN is negative.
A firm purchases fixed assets in proportion to sales.
A firm must purchase an entire fixed asset rather than just the portion needed to increase production.
A firm will outsource production until it can use an entire production facility.
A firm must purchase an entire fixed asset rather than just the portion needed to increase production.
Correct!. A factory or a piece of equipment must be purchased as a whole.
What indicates to a firm that a project will increase shareholder wealth?
The project’s cash flows are projected far into the future.
The NPV is negative.
The project’s cash flows are projected closer to the present.
The NPV is positive.
The NPV is positive.
Correct! The NPV is an estimate of the dollar amount that would be added to the firm’s value as a result of the investment.
What part of the NPV calculation is very important but difficult to estimate?
The life of the project
The cost of capital
The initial outlay
The expected cash flows
The cost of capital
Correct! The cost of capital is affected by several things, such as different capital structures, timing of cash flows, and investment potential, which makes it difficult to calculate. An inaccurate prediction of the cost of capital may cause a firm to miss out on good projects or accept bad projects.
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What is an advantage of using the NPV method?
It calculates the dollar value that would be added to the firm by doing the project.
It tells the percent return on an investment.
It can be used to compare multiple projects when a firm faces capital constraints.
It does not consider the time value of money.
It calculates the dollar value that would be added to the firm by doing the project.
Correct! The NPV is expressed as a dollar amount, and the result of the NPV calculation is exactly how much value would be added to the firm from that specific project.
What is a disadvantage of using the NPV method?
It is not an effective way to compare projects with different time spans.
It often underestimates cash flows.
It is not an effective way to compare projects of different sizes.
It does not consider the time value of money.
It is not an effective way to compare projects of different sizes.
Correct! NPV should not be used to compare projects of different sizes.
Suppose Alice is trying to explain to her friend, who knows nothing about the time value of money, why she should invest in Alice’s new company. Which method of valuation should Alice use to convince her friend to invest?
Internal rate of return (IRR)
Cash budgeting
Debt-to-equity ratio
Net present value (NPV)
Internal rate of return (IRR)
Correct! The IRR is easy to interpret, which makes it ideal for communicating the potential of an investment decision.
Which NPV value indicates that the IRR has been reached?
-$100.00
$15.00
$99.99
$0.00
$0.00
Correct! The IRR is the rate of return that makes the NPV of a project equal to zero.
Why is the IRR a poor valuation method for a project with unconventional cash flows?
There are multiple sign changes in the calculation resulting in multiple IRRs, and it is impossible to tell which IRR is the correct one.
The IRR method can be used only to calculate projects that add value to a firm, and projects with unconventional cash flows never add value to a firm.
Projects with unconventional cash flows are only possible to evaluate using trial and error, which is not an acceptable way to calculate the IRR.
The hurdle rate is always too large for projects with unconventional cash flows.
There are multiple sign changes in the calculation resulting in multiple IRRs, and it is impossible to tell which IRR is the correct one.
Correct! Projects with unconventional cash flows must be valued using NPV.
A company called Bobby’s Books is considering purchasing a new bookbinding machine. The company calculates the hurdle rate of the project to be 9% and the IRR to be 11%. Should the company purchase the bookbinding machine?
No, because the hurdle rate is lower than the IRR.
No, because the old bookbinding machine still works.
Yes, because newer models of equipment are always profitable investments.
Yes, because the IRR exceeds the cost of capital.
Yes, because the IRR exceeds the cost of capital.
Correct! When the IRR of a project is greater than the hurdle rate (the required rate of return, or cost of capital), it indicates that the company should accept the project.
Which capital investment evaluation method is presented as a ratio?
Profitability index (PI)
Internal rate of return (IRR)
Quick ratio
Net present value (NPV)
Profitability index (PI)
Correct! The PI is the ratio of discounted benefits to discounted costs.
How does the PI aid in interpretation of the NPV?
It converts the NPV to a percentage, which is easier for management to understand.
It does not take into account the initial outlay of the project, which makes the NPV easier to understand in comparison.
It gives an idea of the return generated by a project.
It communicates the value that would be lost to the company if it rejected the project.
It gives an idea of the return generated by a project.
Correct! The PI scales different-sized projects so that their returns are comparable.
Should a firm accept a project that has a PI of 0.8? Why?
Yes, because the PI is less than the cost of capital.
No, because the PI is supposed to be represented as a dollar amount.
No, because the project would be generating cash inflows that are 20% short of the initial investment.
Yes, because the PI would generate cash flows that are 80% more than the initial investment.
No, because the project would be generating cash inflows that are 20% short of the initial investment.
Correct! As a rule, firms should accept only projects that have a PI greater than 1.
You calculate the PI of a project to be 1 but realize that some aspect of your calculation was incorrect and needs to be adjusted. Which adjustment to the PI estimation should cause you to reject the project?
The initial outlay estimation was inaccurate, and after you adjust it, the new initial outlay is lower than the original.
The cash flows were underestimated, so the adjusted annual cash flows are higher than the original ones.
The length of project was underestimated, so in the new estimation, the life of the project is a couple of years longer with positive cash flows.
The cost of capital was underestimated, so you adjust the cost of capital to be higher.
The cost of capital was underestimated, so you adjust the cost of capital to be higher.
Correct! Increasing the cost of capital decreases the PI. Therefore, the new PI will be less than 1, and you should reject the project.
Why might a firm prefer to raise capital through stocks instead of bonds?
Stocks provide a steady stream of income to a firm.
Stocks do not require a firm to give up any ownership.
Stocks do not require the firm to repay the par value to investors.
Stocks do not allow investors to have voting rights.
Stocks do not require the firm to repay the par value to investors.
Correct! Stocks are shares of ownership in a firm, so the value of the stock is not required to be returned to investors.
An investor just purchased a bond for $973 that has a par value of $1,000. What type of bond is this?
A preferred bond
A par bond
A discount bond
A premium bond
A discount bond
Correct! When the market price is less than the par price of a bond, you know that the YTM is currently higher than the coupon rate of that particular bond, so it is being sold at a discount.
In what way is preferred stock different from bonds?
Preferred stockholders do not have voting rights, but bondholders do.
Companies must pay preferred stockholders but not bondholders before common stockholders.
Companies are allowed to skip payments to preferred stockholders but not to bondholders.
Preferred stock payments are fixed, but bond payments are not.
Companies are allowed to skip payments to preferred stockholders but not to bondholders.
Correct! If companies skipped bond payments, they would go into default. Companies can skip payments for preferred stock. However, by skipping these payments, companies are not able to pay common stockholders and must pay dividends in arrears at some point.
Why might a firm seek capital investment?
To fulfill expected dividend payments
To pay off bondholders
To purchase long-term assets for future growth
To pay short-term loans
To purchase long-term assets for future growth
Correct! Firms need funding for projects that will increase shareholder wealth in the future.
Which method should you use to calculate a bond value?
The PV function in Excel
The constant growth model
The IRR method
The perpetuity model
The PV function in Excel
Correct! You should use the PV function in Excel given the rate, FV, nper, and rate input variables.
You are evaluating a common stock. What is a key assumption for this evaluation?
Coupon payments are made semiannually.
The growth rate is assumed to stay the same forever.
Dividends are fixed.
There is a maturity date.
The growth rate is assumed to stay the same forever.
Correct! Common stock valuation uses the constant growth model under the assumption that the growth rate is constant forever.
What is the name for the process of evaluating and planning for purchases of long-term assets?
Capital budgeting
The time value of money
The constant growth model
The perpetuity model
Capital budgeting
Correct! Capital budgeting is the process of evaluating and planning for purchases of long-term assets.
Why is it important to have an accurate, carefully calculated required rate of return as part of the NPV?
An inaccurate required rate estimate could cause a firm to reject good projects or accept bad projects.
An accurate required rate of return actually is not very important, as the required rate of return is only a minor part of the NPV calculation.
The SEC and GAAP require an accurate rate of return as part of their capital investment standards.
Lenders will provide a firm with funds to invest in a project only if the required rate of return is extremely accurate.
An inaccurate required rate estimate could cause a firm to reject good projects or accept bad projects.
Correct! While the required rate of return is the most difficult part of the NPV calculation to estimate, it is also the most important.
A company is trying to decide which of four projects to invest in.
Project 1 has an IRR of 14% and an NPV of $54,000.
Project 2 has an IRR of 11% and an NPV of $67,000.
Project 3 has an IRR of 9% and an NPV of $60,000.
Project 4 has an IRR of 13% and an NPV of $47,000.
If the company can do only one project, which project should it choose to add the greatest value to the firm?
Project 2
Project 3
Project 1
Project 4
Project 2
Correct! The project with the highest NPV will bring the most value to the company.
The company Betsy’s Wigs is considering three potential projects that are not mutually exclusive. The IRR, NPV, and PI for each project are listed in the table below. Use this information to rank the projects in the order in which Betsy’s Wigs should accept them to bring the most value to the firm.
Project IRR NPV PI
Project 1 23% $820 1.02
Project 2 18% $880 1.27
Project 3 21% $790 1.35
Project 2, Project 1, Project 3
Project 2, Project 3, Project 1
Project 3, Project 2, Project 1
Project 1, Project 3, Project 2
Project 3, Project 2, Project 1
Correct! The projects with the highest PIs should be accepted first.
The YTM of a bond went from 8% to 7%. What can be predicted about the price of the bond?
It will increase.
It will decrease.
It is not possible to predict what will happen to the bond price.
It will stay the same.
It will increase.
Correct! There is an inverse relationship between YTM and the price of a bond.
A potential project to expand the size of an apartment complex will cost $100,000. Its calculated net present value is $5,000. Given this information, which statement is correct?
The project should be rejected because it has a negative NPV.
The project should be rejected because it has a negative IRR.
The project should be accepted because it has a positive NPV.
The project should be accepted because it has a positive IRR.
The project should be accepted because it has a positive NPV.
Correct! Because the NPV is positive, the project should be accepted.
Why is it important to consider all relevant cash flows in an ideal evaluation method for capital investment?
If you can receive money earlier, you can reinvest the cash into different projects earlier.
A project’s cash flows may be uncertain.
Without considering every cash flow of a potential project, you do not know how the project will enhance the value of a firm.
The value of a cash flow today is different from the values of a cash flow of the same dollar amount in 10 years.
Without considering every cash flow of a potential project, you do not know how the project will enhance the value of a firm.
Correct! You need to include all the cash flows coming from a potential project to understand how
Talia is comparing four mutually exclusive projects. In order to choose the best project to optimize the goal of the firm, which capital budgeting method should Talia use?
Time value of money
Net present value (NPV)
Internal rate of return (IRR)
Profitability index (PI)
Net present value (NPV)
Correct! When you compare mutually exclusive projects, you should look at how much value is added by each project, because you can do only one of them. Therefore, you should use the NPV method to choose a project.
Alphabet Co. has $50,000 to spend on capital investment projects for the next year. It will do as many projects as it has cash for. Alphabet Co. calculates the potential incremental cash flows and costs of the projects as well as the NPV, IRR, and PI for each project. How should the company decide which projects to invest in if it wants to maximize the total amount of value created?
It should choose the projects with the highest costs until all capital has been used.
It should choose the projects with the highest IRRs until all capital has been used.
It should choose the projects with the highest PIs until all capital has been used.
It should choose the projects with the highest NPVs until all capital has been used.
It should choose the projects with the highest PIs until all capital has been used.
Correct! By choosing the projects with the highest PI, Alphabet Co. will be able to use its limited capital effectively to create the most overall value for the firm.
What is opportunity cost as it relates to the time value of money?
It is the opportunity you forgo to invest in other options due to the time scope of an investment.
It is the cost at the terminal stage of a project in a TVM model.
It is the lowered cost over time of money used for an investment.
It is the cost of having more investment options than one.
It is the opportunity you forgo to invest in other options due to the time scope of an investment.
Correct! Opportunity cost is the cost that you have to give up for something as a result of investing in something else.
Why is the timing of cash flows an important characteristic of capital investment?
Companies need to know if they will have enough cash inflows to pay off their debt expenses.
Companies are wary of inflation risks due to timing of cash flows.
Timing of cash flows is related to the sunk costs associated with those cash flows.
Timing of cash flows is related to the opportunity cost associated with those cash flows.
Timing of cash flows is related to the opportunity cost associated with those cash flows.
Correct! The cash flows of an investment need to be compared to the cash flows of other projects.
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You are considering four projects. The initial cost to start each project is $500,000, and the total cash inflows generated by each project are $600,000. Each project also has the same level of risk. The only difference between these four projects is the cash flow patterns.
Year 1 Year 2 Year 3
Project A $200,000 $200,000 $200,000
Project B $300,000 $200,000 $100,000
Project C $100,000 $200,000 $300,000
Project D $600,000 $300,000 -$300,000
Given the information above, which statement is correct about these four projects?
Project C should be chosen first given that this project takes the longest time to receive cash summing to $600,000.
Project D should be chosen first given that the project will receive cash to sum to $600,000 the most quickly.
Project A should be chosen first given that the estimated cash flows are steady.
All projects should yield the same amount of value for the firm.
Project D should be chosen first given that the project will receive cash to sum to $600,000 the most quickly.
Correct! Project D receives cash flows the most quickly of the four projects. Given the concept of the time value of money, Project D should generate the highest NPV.
Why is there always a cost for bringing funds into a business?
A business must compensate investors for the opportunity cost of investing in the business.
Investors need an investment vehicle to fight inflation.
A business must compensate investors for the risk that they are taking to invest in the business.
Investors will only choose the investment vehicle with the highest return.
A business must compensate investors for the risk that they are taking to invest in the business.
Correct! Investors need a reason to part with their money.
What is the relationship between the risk and the rate of return?
Investors must be incentivized with higher returns or else they will choose a risk-free asset.
Risk has no relationship to the rate of return but is related instead to the cost of capital.
The higher the risk investors have to take on, the higher return they require.
The rate of return describes the inherent risk of a project.
The higher the risk investors have to take on, the higher return they require.
Correct! Investors will take on more risk if there is potential for a higher return.
The rate of return describes the inherent risk of a project.
How can having more debt benefit a company?
It protects a company from having to buy more assets.
Debt is never beneficial for a company due to its increasing costs over time.
It allows management to retain more control over the company.
Interest expense on debts is paid before taxes are calculated.
Interest expense on debts is paid before taxes are calculated.
Correct! This describes the tax shield advantage of debt.
Which example demonstrates a financing decision in a firm?
How a company will fund its assets and operations—namely, what proportions of debt and equity the business will use
Whether a company should hire executive leadership from outside the company or promote managers from within
How a company will increase its sales for next year by attracting new customers
Whether a company should use a third-party public affairs firm to promote its new product
How a company will fund its assets and operations—namely, what proportions of debt and equity the business will use
Correct! This correctly characterizes a finance decision.
What are incremental cash flows?
Any additional cash flows, whether in or out of the firm, that are created as a result of accepting a project
All cash flows that the firm has that may be affected by accepting a new project
The sum of all positive and negative cash flows that create an incremental increase or decrease in revenue
The positive cash flows of a project discounted back to their present value
Any additional cash flows, whether in or out of the firm, that are created as a result of accepting a project
Correct! This is the correct definition of incremental cash flows.
How does allocated overhead affect the selection of capital investment projects?
Overhead is allocated to the various projects of the firm, but never capital investment projects.
Accountants are paid to allocate cash flows such as “overhead” to the various projects of a firm. Therefore, these cash flows are added to new projects during analysis.
These cash flows are not a direct result of a specific project but are a general cost to the firm.
Overhead represents costs from specific projects, so it tells us the overall impact of a project on a company.
These cash flows are not a direct result of a specific project but are a general cost to the firm.
Correct! These cash flows are irrelevant to your analysis.
How are non-incremental cash flows different from incidental cash flows?
All non-incremental cash flows should be included. It is unclear if a company will incur a cost regardless of whether it adopts a specific project, so that cost should be counted as a cost of the project.
Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Therefore, they must not be included in the analysis.
All incidental cash flows should be excluded. If a company will incur a cost regardless of whether it adopts a specific project, the cost should not be counted as a cost of the project.
Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Nevertheless, they must be included in the analysis.
Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Nevertheless, they must be included in the analysis.
Correct! Incidental cash flows are included in analysis and non-incremental cash flows are not.
How does cannibalization factor into capital investment decisions?
If your company is planning on launching a product, and that product is going to steal some of the sales of another of the company’s products, that loss of sales could be an incidental cost or revenue caused by the new product.
If your company is planning on launching a product, and that product is going to steal some of the sales of another company’s products, that could be an incidental cost or revenue caused by the new product.
If your company is planning on launching a product, and that product is going to harm the sales of another of your products, it is better not to compete with yourself and lose market shares.
If your company is planning on launching a product, and that product is going to diminish some of the company’s cash flows generated from another product, it is better not to harm your products’ reputations.
If your company is planning on launching a product, and that product is going to steal some of the sales of another of the company’s products, that loss of sales could be an incidental cost or revenue caused by the new product.
Correct! This is the correct definition of cannibalization.
A company is considering five projects that are not mutually exclusive. However, the company does not have enough money to do all of them. In order to prioritize projects that fit within the company’s budget, which capital budgeting method should be used?
Profitability index (PI)
Net present value (NPR)
Internal rate of return (IRR)
Comparing the initial outlay to start with the biggest project
Profitability index (PI)
Correct! The PI should be used first to compare the projects and then to rank them to maximize the value of the firm.
Which scenario is an example of an opportunity cost that is not associated with cash flows?
Daisy lost $50 playing poker. Because of this, she decides not to gamble again.
Albert decides to stay home and study for his test instead of going to the movies.
Charlie stays home all weekend. He did not have any other plans.
Bill wants ice cream now. However, he eats dinner first and then buys an ice cream cone.
Albert decides to stay home and study for his test instead of going to the movies.
Correct! The opportunity cost is going to the movies.
Which condition indicates that an investment will add value to a company?
The positive cash inflows of the project are greater than the negative cash outflows of the project.
The opportunity costs of the project outweigh the present value of current operations of the company.
The present value of the benefits of the investment outweigh the present value of the costs of the investment.
The future value of the benefits of the investment outweigh the future value of the costs of the investment.
The present value of the benefits of the investment outweigh the present value of the costs of the investment.
Correct! If the project provides more value than it costs, then mathematically it will add value to the company.
How do corporations and purchasers of financial securities view returns?
Corporations look at returns as the risk posed to stockholders and bondholders if a corporation isn’t able to make payments.
Purchasers of financial securities look at returns as the amount of money they require in order to lend or give their money to the corporation that issued those securities.
Purchasers of financial securities look at returns as the percentage that they as investors must receive to break even on the money they invested.
Corporations look at high returns as a cost to investors that prevents them from either lending to or investing in a corporation.
Purchasers of financial securities look at returns as the amount of money they require in order to lend or give their money to the corporation that issued those securities.
Correct! This is a correct description of returns from the viewpoint of investors.
What is an opportunity cost?
The difference between the cost of a project and its potential profit
The opportunities a company has and how to rank them
The cost that must be incurred to make a profit
The loss of the ability to use an asset toward the next best project once you have invested it in another project
The loss of the ability to use an asset toward the next best project once you have invested it in another project
Correct! The concept of opportunity cost is that because you use an asset to invest in one project, you lose the opportunity to use the same asset to do a different project.
What would an analyst predict for a potential investment with an NPV of zero?
The project would add value to the firm.
The project would earn exactly the rate of return required by the firm.
The project would take away value from the firm, but only a small amount.
The profitability index would also be equal to zero.
The project would earn exactly the rate of return required by the firm.
Correct! An NPV of zero indicates that a project will neither add nor take away value from a firm.
A financial analyst for the company Bobby’s Books has been asked to evaluate a potential investment using a method that considers the time value of money. Is there more than one way to do this?
Yes, the analyst could use both the NPV and the IRR.
Yes, the analyst could use the current ratio and could compare cost of capital rates.
No, the analyst could only use cash budgeting to evaluate the project.
No, there are no valuation methods that take into account the time value of money.
Yes, the analyst could use both the NPV and the IRR.
Correct! Both NPV and IRR take into account the time value of money.
If two projects are mutually exclusive, which decision-making criterion will help you make the best decision about which project to accept?
Profitability index (PI)
Net present value (NPV)
Initial outlay (IO)
Internal rate of return (IRR)
Net present value (NPV)
Correct! When only one project can be chosen, the PI is not useful because it does not indicate the dollar value that a project will add to or take away from a firm.
Why might a firm prefer to raise debt capital through bonds instead of stocks?
Bonds take advantage of upside potential.
Bonds have no expiration date.
Bonds do not require the firm to pay back its loan.
Bonds do not require a firm to give up any ownership
Bonds do not require a firm to give up any ownership.
Correct! This is attractive to a firm that needs funds for a project but wishes to maintain control.
Why is it appropriate to calculate the value of a bond in the same way that the present value of an annuity is calculated?
A bond is a fixed amount paid each period forever to compensate investors.
The cash flows that come from owning a bond grow at a constant rate every year, and the payments continue forever.
Even though bonds have a fixed length, the cash flows differ each year.
Bonds pay a coupon every six months, pay a constant coupon amount, and have a maturity date.
Bonds pay a coupon every six months, pay a constant coupon amount, and have a maturity date.
Correct! Bond cash flows are an annuity, a constant amount paid every period.
Why is it important to consider the cost of capital in an ideal evaluation method of capital investment?
Because the value of a cash flow today is different from the value of a cash flow of the same amount of in 10 years
Because cash flows for a project may be uncertain
Because it cannot be determined how a potential project enhances the firm’s value without considering every cash flow of the project
Because if you can receive money earlier, you can reinvest the cash into different projects earlier
Because cash flows for a project may be uncertain
Correct! This is the reason why you should consider the cost of capital.
What must be determined in order to compare the values of two projects with differently timed cash flows that does not need to be determined for projects with similarly timed cash flows?
Opportunity cost
Present value of the benefits
Future value of the benefits and future value of the costs
Positive cash inflows and negative cash outflows
Opportunity cost
Correct! Opportunity cost must be determined to analyze two such projects.
What is the disadvantage of debt financing?
The more debt a company takes on, the less equity it can raise.
Debt financing creates a tax shield disadvantage.
A company with high amounts of debt will have a shorter YTM for its bonds.
Debt financing does not actually achieve an optimal capital structure for a company.
Debt financing does not actually achieve an optimal capital structure for a company.
Correct! Debt creates a tax shield, but there should be a mixture of debt and equity in an optimal capital structure.
How do you factor sunk costs into capital investment analysis?
They can be added into our analysis, depending on management’s decision.
Sunk costs are subtracted from the opportunity cost and attributed to net cash flow.
For the purposes of analysis, sunk costs are irrelevant.
They are inputted as negative cash inflows along with the initial outlay.
For the purposes of analysis, sunk costs are irrelevant.
Correct! Sunk costs are costs that have already been incurred whether you choose to do a project or not
Beckingham Sports is an American sporting goods company. Based on a $400,000 market study and a $600,000 fee for consulting spent prior to the project, the firm can increase its annual operating cash flow by $3,000,000 by selling overseas. Because the firm was considering the expansion, it spent $2,000,000 to purchase a land for new factory and equipment. However, someone is making an offer to pay the company $3,000,000 for the land it purchased for the new factory. What is relevant to include in the company’s capital budgeting decision?
$2,000,000 spent to purchase the land
3,000,000 for the offer price of the land
$400,000 spent on the market study
$600,000 for the consulting
3,000,000 for the offer price of the land
Correct! If you do the project, you will miss the opportunity to sell the land for$3,000,000. This is an example of an opportunity cost.
Why is NPV the most reliable method for evaluating investments?
It is capable of considering cash flows without taking into account the time value of money, it is useful for comparing two projects of different sizes, and it is an infallible rule for accepting or rejecting capital projects.
It does not require you to estimate the cost of capital.
It makes it easy to estimate the cost of capital, it ignores risk, and it is better for tax purposes.
It considers the time value of money, it tells you the dollar value that the investment will add to the firm, and it takes risk into account.
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It considers the time value of money, it tells you the dollar value that the investment will add to the firm, and it takes risk into account.
Correct! These are the main advantages of the NPV, some of which are not included in other methods of valuation, which makes NPV the most reliable.
Suppose you are a manager at a firm. One of your financial analysts places a report on your desk of valuation calculations for some potential investment projects. When you look at the calculations later, you notice that the analyst did not indicate if she used the NPV or IRR method. However, you do notice that the results of the calculations are all percentages. What can you conclude?
The analyst used the IRR method.
The analyst used the NPV method.
The calculations are all wrong.
The calculations are incomplete.
The analyst used the IRR method.
Correct! IRR calculations are represented as percentages because they are rates of return.
You are considering a project that has a profitability index of 1. What does this mean?
The benefit outweighs the cost of the project by the exact same amount as the initial cost.
The project has a negative net present value.
The project has the internal rate of return equal to the cost of capital.
The project has a positive net present value.
The project has the internal rate of return equal to the cost of capital.
Correct! PI = 1 means that the break-even point is the estimated cost of capital; in other words, the cost of capital and the rate of return should be exactly the same.
You just purchased a bond for $1,000 that has a par value of $1,000. What type of bond is this?
A par bond
A preferred bond
A premium bond
A discount bond
A par bond
Correct! The market price of a par bond is the same as the par value.
Why is it appropriate to calculate the value of a preferred stock in the same way that you would find the present value of a perpetuity?
The cash flows that come from owning a preferred stock grow at a constant rate every year and continue forever.
Even though a preferred stock has a fixed length, the cash flows differ each year.
For a preferred stock, a fixed amount is paid forever to compensate the investors.
Preferred stocks pay a coupon every six months, the coupon amount is constant, and the stock has a maturity date.
For a preferred stock, a fixed amount is paid forever to compensate the investors.
Correct! This is the case for preferred stocks, which are a type of perpetuity.
Why is it important to consider the time value of money in an ideal evaluation method for capital investment?
Because each project has different amount of risk
Because the value of a cash flow today is different from the value of a cash flow of the same dollar amount in 10 years
Because a project’s cash flows may be uncertain
Because without considering every cash flow of a potential project, you do not know how the project would enhance the firm’s value
Because the value of a cash flow today is different from the value of a cash flow of the same dollar amount in 10 years
Correct! You cannot directly compare dollar amounts received at different times.
Which scenario correctly describes opportunity cost?
Buster buys a pizza and with the same amount of money he could have used to buy a hamburger and fries. There is no opportunity cost because they cost the same.
Caroline makes $25 an hour. Instead of working one night, she goes to a concert that costs $50 and lasts two hours. The opportunity cost of the concert is $50.
Alexandra decides to spend $50 on some new clothes instead of using that money to pay her electric bill. The opportunity cost is having the electricity turned off.
Donatello has a side business making sculptures in addition to his regular job. If he spends more time on his side business, the opportunity cost is the money he makes from selling his sculptures.
Alexandra decides to spend $50 on some new clothes instead of using that money to pay her electric bill. The opportunity cost is having the electricity turned off.
Correct! Because she bought new clothes, she did not pay her bills.
How does management choose between two projects that are seemingly the same?
Management can analyze the different inherent risks that change the cost of capital to the firm.
As stated in the reinvestment assumption, there cannot be two projects that are the same.
Management can analyze the effect each project will have on the firm’s overall capital structure.
If two projects are seemingly the same, it does not matter what choice management makes.
Management can analyze the different inherent risks that change the cost of capital to the firm.
Correct! Each project will have its own inherent risks.
Which term describes the reduction in sales of a company’s own products due to the introduction of another similar product?
Sunk costs
Interest cost
Cost of cannibalization
Opportunity cost
Cost of cannibalization
Correct! The cost of cannibalization is the reduction in sales of a company’s own products due to the introduction of another similar product.
Which item is considered a sunk cost?
The required training in order to operate new equipment
The consulting cost spent three months prior to the start of a project
The price of selling old equipment that will be replaced by new equipment
The shipping cost of a new machine for a project
The consulting cost spent three months prior to the start of a project
Correct! Since the cost was incurred before the start of the project, this is a sunk cost.
