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.
