Finance Final Exam 1

Q1. The cost of capital for an all-equity-financed company that pays no dividends
is zero.

 True
 False

Q2. Grandma’s Applesauce, Inc. has a 0.60 probability of a good year with
operating cash flow of $50,000; and 0.40 probability of a bad year with operating
cash flow of $30,000. The company has a debt of $35,000 with 8 percent interest
due next year. Assuming the company has no means of servicing its debt other
than operations, and a 0% tax rate, which of the following is true?

 Shareholders expected claim is $12,200

 Creditors expected claim is $37,800
 Creditors expected claim is $34,680
 None of the above

Q3. Which of the following are sources of funds in a statement of sources and uses?

I. Collection of accounts receivables

II. Reduction of long-term debt
III. Payment of dividends
IV. Reduction in the cash account

 I only
 II and III
 III and IV
 I and IV

Q4. The higher the opportunity cost of capital the higher the NPV.

 True
 False

Q5. A company has net income of $20,000 and a tax rate of 35 percent. Its total
debt is $25,000, with principal payments of $5,000 due at the end of each year and
an annual interest rate of 8%. What will be the company’s interest tax shield in the
upcoming year?
 $8750
 $700
 $9450
 $2450

Q6. An optimal current ratio should be greater than 1.0.

 True
 False

Q7. External funding needs are computed as:

 Projected total assets – (projected liabilities + projected net worth)

 Projected total assets – (actual liabilities + net worth)
 Projected current assets – (projected current liabilities + net worth)
 None of the above

Q8. The item that roughly divides “real” from “financial” activities on an income
statement is:

 EBIT
 Interest Expense
 SG&A Expense
 None of the above

Q9. GoodTimes, Inc. has asset turnover of 0.5 times, a net profit margin of 10% and
average total assets of $100, what is its net income (assuming no unusual items)?

 $50
 $500
 $5
 The answer cannot be determined with the information provided.

Q10. Analysis of a company’s financial statements: Below are simplified

versions of the balance sheet and income statement for Toys by Tom, Inc. Use this
information to answer the following question.

A 15% increase in inventory turns for Toys by Tom, Inc. would bring this ratio to
____, suggesting ________ in ________.

 109 days; a deterioration; profitability

 3.9 days; a deterioration; profitability
 4.8 times; an improvement; efficiency
 3.9 times; an improvement; efficiency

Q11. A company builds a new plant and finances its construction by issuing stock.
Which ratio is least likely to be affected, all else being equal?

 Current ratio
 Debt to equity ratio
 Debt to asset ratio
 Net fixed assets to total assets

Q12. Enterprise Free Cash Flows should include which of the following:

I. Capital expenditures
II. Financing costs
III. Taxes
IV. Working capital requirements

 I and IV
 I, II and IV
 I , III and IV
 I, II, III, IV

Q13. You are saving money for a down payment on a house. Suppose you want to
have total savings of $20,000 in 10 years time and you have currently $5,000. What
annual interest rate do you need to earn on your initial investment, assuming you
contribute no additional savings?
 10.0%
 18.5%
 12.5%
 15.0%

Q14. Which of the following ratios appears on a common-size balance sheet?

I. Debt to asset ratio

II. Net working capital to total assets
III. Net profit margin

 I , II, III
 I only
 I and III
 III only

Q15. The cost of debt is generally lower than the cost of equity.

 True
 False

Q16. What is the risk premium for a stock where

 the risk free rate is 5.1%;

 the equity market risk premium is 5.0%; and
 the beta of the stock is 1.2.

Ans:

 11.1%
 6.1%
 6.0%
 12.1%

Q17. A share repurchase is financially equivalent to a dividend.

 True
 False

Q18. The owners of a firm facing a high probability of bankruptcy prefer to invest
in ____ projects, because ______.
 safer; riskier projects make bankruptcy more likely
 no new; the firm is likely to go bankrupt anyway
 risky; the shareholders have little to lose and might win if successful
 risky; creditors prefer taking a gamble rather than having the company
default

Q19. In the CAPM, what does the parameter beta measure?

 Non-systematic (diversifiable) risk

 Systematic (non-diversifiable) risk
 Total risk
 Risk-adjusted stock returns

Q20. Common-size financial statements are constructed in order to:

 Adjust for inflation and risk

 Facilitate comparisons of different-sized companies
 To comply with SEC requirements
 All of the above

Q21. “Real” activities create cash for a business, while “financial” activities
distribute cash within the company.

 True
 False

Q22. A perpetuity is a stream of cash flows that lasts forever.

 True
 False

Q23. An increase in financial leverage generally results in a higher return on equity

(ROE).

 True
 False

Q24. Which of the following is commonly forecasted as a percent of sales:

 Common stock
 Gross profit
 Long-term debt
 Revolving credit

Q25. You are trying to decide whether to accept or reject a one-year project. The
project is estimated to generate $5,000 in incremental gross profit, which includes
$200 in depreciation. Incremental SG&A expense is $400. At a 35% tax rate, the
after-tax incremental cash flow is:

 $2990
 $3190
 $3250
 $3510

Q26. Which of the following expresses the value of a levered firm (VL) in the Static
Tradeoff model of optimal capital structure? [Note: VU denotes the value of the
unlevered firm; CFD denotes expected costs of financial distress; and PV denotes
present value.]

 VL = PV(Tax Shield) – PV(CFD)

 VL = VU + PV(Tax Shield) / PV(CFD)
 VL = VU + PV(Tax Shield) – PV(CFD)
 VL = VU + PV(Tax Shield)

Q27. A firm is all equity financed, with 10,000 outstanding shares with a market
value of $20 each. Its net income was $30,000, and it decides to pay a cash dividend
of $2,000. Calculate the value of each share after the dividend payout.

 $22.8
 $20.0
 $19.8
 Not enough information

Q28. Share repurchases and dividend payouts are most likely to differ in their

 effects on a firm’s capital structure

 effects on corporate taxes.
 effects on corporate cash flow.
 effects on shareholders’ personal taxes

Q29. Biases can and should always be eliminated in financial forecasts.

 True
 False
Q30. Which of the following actions, all else being equal, will increase the
sustainable growth rate?

 Increasing asset turnover

 Reducing dividend payout
 Increasing leverage
 All of the above

Q31. What is the present value of a growing perpetuity that makes a payment of
$100 in the first year, which thereafter grows at 3% per year? Apply a discount
rate of 7%.

 $2000
 $3500
 $2500
 $4000

Q32. A project with an internal rate of return greater than the cost of capital should
always be accepted.

 True
 False

Q33. In general, an increase in a liability is a source of funds.

 True
 False

Q34. The phenomenon of compounding connotes which of the following?

 Investment of principal for a prolonged period

 Interest earned over a prolonged period
 Earning income on previously earned income
 Rising interest rates over time

Q35. A company’s beta (from the CAPM) is affected by its capital structure.

 True
 False

Q36. The Pecking Order Theory of capital structure implies a unique optimum
capital structure.
 True
 False

Q37. A company’s return on assets should be greater than its return on equity.

 True
 False

Q38. Which is a commonly used proxy for the “risk-free rate”?

 The average historical interest rate on long-term government bonds

 The current market rate interest rate on a government-insured savings
account
 The current yield to maturity on a long-term government bond
 The rate of return on a low volatility stock

Q39. What is the expected return on a risky investment where

 the risk free rate is 5.1%;

 the investment’s beta is 1.4;
 the equity market risk premium is 5.0%; and
 the cost of debt is 4.5%.

Ans:

 10.8%
 9.6%
 12.1%
 9.2%

Q40. Analysis of a company’s financial statements: Below are simplified

versions of the balance sheet and income statement for Toys by Tom, Inc. Use this
information to answer the following question.

If sales in 2003 were $10,000, what is the compounded average growth rate?

 8.6%
 6.7%
 6.3%
 Not enough information available
Q41. A company has net working capital of $0, current liabilities of $25 and total
assets equal to $100. What is its current ratio?

 0.0
 1.0
 0.5
 4.0

Q42. The cash cycle measures the days required to produce finished goods or
delivered services.

 True
 False

Q43. Which of the following are equivalent under M&M proposition I?

 Maximizing firm value and maximizing firm profit

 Maximizing firm value and minimizing the cost of capital
 Minimizing firm’s cost of capital and minimizing firm’s debt burden
 Maximizing profit and minimizing taxes

Q44. The Static Tradeoff theory of capital structure implies that firms with higher
business risk should have lower leverage.

 True
 False
Q45. The beta for the market as a whole equals 1.0.

 True
 False

Q46. The sustainable growth rate is the maximum growth rate achievable over an
extended period of time.

 True
 False

Q47. Which of the following is correct?

I. Tax shields make debt financing more attractive, all else equal.
II. A firm’s debt ratio falls when it uses excess cash to pay dividends.
III. The cost of equity is low for firms that pay no dividends, all else equal.
IV. Bankruptcy costs decrease the benefits of debt financing all else equal.

 I and IV
 I, II and IV
 I, III and IV
 I, II, III and IV

Q48. The cash conversion cycle is calculated as:

 Days in Inventory + Collection Period

 Days in Inventory – Payables Period
 Days in Inventory + Collection Period – Payables Period
 None of the above

Q49. If you invest $2,000 today for three years at 5% interest paid annually, you
will earn a total of $_____ in interest. Assume you re-invest all interest.

 205.00
 300.00
 315.25
 500.00

Q50. The Pecking Order Theory of capital structure rests on an assumption of

 agency costs.
 barriers to entry.
 asymmetric information.
 tax shields and cost of financial distress

Finance Final Exam 2

Q1. Which information is NOT required when calculating the weighted average
cost of capital for a company with debt?

 Its capital structure ratios

 Its cost of debt
 Its current ratio
 Its tax rate

Q2. Common-size financial statements are constructed in order to:

 Adjust for inflation and risk

 Facilitate comparisons of different-sized companies
 To comply with SEC requirements
 All of the above

Q3. Which of the following liabilities form part of a company’s “real” activities?

I. Short-term debt
II. Accounts payable
III. Accrued operating expenses
IV. Long-term debt

 III only
 II and III
 I and IV
 I only

Q4. How is the cash conversion cycle calculated?

 Days in Inventory + Collection Period

 Days in Inventory – Payables Period
 Days in Inventory + Collection Period – Payables Period
 None of the above
Q5. Analysis of a company’s financial statements: Below are simplified versions
of the balance sheet and income statement for Toys by Tom, Inc. Use this
information to answer the following question.

What is Toys by Tom, Inc. return on assets (ROA)?

 6.9%
 0.86
 18%
 1.2

Q6. The Pecking Order Theory of capital structure implies a unique optimum
capital structure.

 True
 False

Q7. For a levered firm, EBIT is equivalent to:

 Net income
 Pro forma earnings
 Operating profit
 Net income before taxes

Q8. A company can shorten its cash cycle by:

 Reducing inventory turnover

 Reducing account payables
 Reducing days receivable
 None of the above

Q9. The owner of Grandma’s Applesauce is planning to retire after the coming
year. She has to repay a loan $50,000 plus 8 percent interest and must rely on cash
flow from operations to do so. Cash flow from operations is uncertain; there is a
70% probability it will equal $65,000, and a 30% probability it will equal $45,000.
Assuming a tax rate of 0%, what is the owner’s expected cash flow after debt
service?

 $9,000
 $5,000
 $11,000
 $7,700

Q10. As EBIT drops, the return on equity (ROE) of a levered firm drops ______ the
ROE of an otherwise identical unlevered firm.

 the same as
 relatively more than
 relatively less than
 more or less than (it cannot be determined)

Q11. Which of the following ratios uses sales in the denominator?

 Days in inventory
 Receivables turnover
 Cash ratio
 Average collection period

Q12. Which of the following is commonly used in preparing pro forma statements?

 Historical financial statements

 Projected sales
 Efficiency ratios
 All of the above

Q13. The sustainable growth rate is the maximum growth rate achievable over an
extended period of time.

 True
 False

Q14. The cost of debt is generally lower than the cost of equity.

 True
 False

Q15. It is possible for a company to grow faster than its sustainable growth rate.

 True
 False

Q16. A higher level of leverage generally reduces managerial discretion.

 True
 False

Q17. Leverage and liquidity generally rise or fall together.

 True
 False

Q18. What is the present value of a perpetuity of $100 given a discount rate of 5%?

 $2,000
 $3,000
 $1,500
 $500

Q19. In general, the reduction of an asset is a source of funds.

 True
 False

Q20. Analysis of a company’s financial statements: Below are simplified

versions of the balance sheet and income statement for Toys by Tom, Inc. Use this
information to answer the following question.

Toys by Tom, Inc. has a current ratio of ____, suggesting ________.

 9.6; reasonable ability to cover interest expense

 0.57; potential illiquidity
 0.21; potential collection problems
 1.75; reasonable liquidity

Q21. An increase in financial leverage generally results in a higher return on equity

(ROE).

 True
 False

Q22. Biases can and should always be eliminated in financial forecasts.

 True
 False

Q23. For a firm with an optimal capital structure, the weighted average cost of
capital (WACC) is:

 higher than the cost of equity

 lower than the cost of debt
 lower than the cost of unlevered equity
 independent of the capital structure

Q24. For which of the following generic businesses would you expect a
combination of high asset turnover and low profit margins?

 Supermarkets
 Banks
 Software developers
 Arlines

Q25. M&M’s Proposition I states that a company’s value is independent of its

capital structure.

 True
 False

Q26. Operating cash flow is generated by a company’s daily operations related to

production and sales of goods and/or services.

 True
 False

Q27. If you invest $2,000 today for three years at 5% interest paid annually, you
will earn a total of $______ in interest. Assume you re-invest all interest.

 205.00
 300.00
 315.25
 500.00

Q28. Scenario analysis is a way of testing forecasts by changing one assumption at

a time.

 True
 False

Q29. Which of the following is a example of indirect costs of bankruptcy?

 Court costs
 Attorney and advisor fees
 Lost sales due to customers and suppliers lost trust
 All of the above

Q30. Suppose a riskless project requires an initial investment of $10 and will
generate a one-time cash inflow of $30 two years later. Assuming a risk-free
interest rate of 5%, which of the following statements about the project is NOT
true?

 The net present value of the project is positive.

 The IRR is greater than 50 percent.
 The accounting rate of return on the project is positive.
 The payback period is less than 2 years.

Q31. If you borrow capital to start a business and the money is provided interest-
free, then your cost of capital is zero.

 True
 False

Q32. A company has a retention rate of 50%, sales of $25,000, beginning equity of
$50,000 and profit margins of 10%, an asset turnover ratio of .75 and debt of
$10,000. What is its sustainable growth rate?

 2.5%
 1.7%
 3.75%
 Not enough information given

Q33. Which items are necessary in calculating the net present value of a project?

I. Investment outlays
II. Discount rate
III. Incremental cash flow
IV. Time period for the project

 I, II and IV
 I, II and III
 II, III and IV
 All of the above

Q34. Shareholders prefer high risk projects when facing a high probability of
bankruptcy because

 high risk projects usually bring high rewards.

 shareholders have the residual claim on a company.
 creditors have the residual claim on a company, and therefore bear the
risk.
 there is a good chance the government will rescue them in bankruptcy.

Q35. Which of the following assumptions regarding investor behavior are required
by the CAPM?
I. Investors try to maximize their wealth
II. Investors consider only risk when making investments
III. Investors are risk averse
IV. Investors adopt a long-term perspective

 I and III
 I, II and III
 I and IV
 All of the above

Q36. The _________ states that the value of the firm is determined solely by the value
of its assets.

 Static Tradeoff Model

 M&M proposition I
 The Pecking Order Model
 Agency Theory

Q37. What are pro forma statements?

 Summaries of historical financial statements

 Government-mandated analyses of financial statements
 Projected statements used in financial planning
 Estimated tax liabilities

Q38. All else equal, when a company’s debt ratio rises, its beta falls.

 True
 False

Q39. Which of the following is not an assumption underlying M&M proposition I?

 No arbitrage
 No taxes
 Corporate investments are risk-free
 Symmetric information

Q40. The NPV rule, which says companies should invest in projects for which NPV
is greater than 0, depends on the assumption of value maximization.

 True
 False
Q41. A firm has $100 of average inventory, operating profit of $500 and sales of
$1,500. What will be its days in inventory?

 36.5 days
 24.3 days
 73.0 days
 Not enough information

Q42. The amount by which a project increases the value of the firm is given by the
project’s ______.

 accounting rate of return

 net present value (NPV)
 internal rate of return (IRR)
 present value

Q43. Which trait is commonly found in debt contracts?

 Seniority
 Covenants
 Callability
 All of the above

Q44. Which of the following are equivalent under M&M proposition I?

 Maximizing firm value and maximizing firm profit

 Maximizing firm value and minimizing the cost of capital
 Minimizing firm’s cost of capital and minimizing firm’s debt burden
 Maximizing profit and minimizing taxes

Q45. Compute the net present value of an investment with 5 years of annual cash
inflows of $100 and two cash outflows, one today of $100 and one at the beginning
of the second year of $50. Use a discount rate of 10 percent.

 $229.08
 $287.60
 $233.62
 $271.53

Q46. In the CAPM, what does the parameter beta measure?

 Non-systematic (diversifiable) risk

 Systematic (non-diversifiable) risk
 Total risk
 Risk-adjusted stock returns

Q47. Selecting investment projects according to rules based either on project NPV
or IRR results in maximizing firm value.

 True
 False

Q48. A dollar today is worth more than a dollar tomorrow.

 True
 False

Q49. Increasing a company’s leverage has no effect on its cost of equity.

 True
 False

Q50. Which of the following expresses the value of a levered firm (VL) in the Static
Tradeoff model of optimal capital structure? [Note: VU denotes the value of the
unlevered firm; CFD denotes expected costs of financial distress; and PV denotes
present value.]

 VL = PV(Tax Shield) – PV(CFD)

 VL = VU + PV(Tax Shield) / PV(CFD)
 VL = VU + PV(Tax Shield) – PV(CFD)
 VL = VU + PV(Tax Shield)