The correct answer for each question is indicated by a .

1
INCORRECT Which of the following are NOT capital budgeting decisions?
a. Intel decides to spend $1 billion to develop a new microprocessor.
b. Volkswagen borrows 350 million euros (350 million) from Deutsche Bank.
c. BP constructs a pipeline to bring natural gas onshore from a production
platform in the Gulf of Mexico.
d. Budweiser spends 200 million to launch a new brand of beer in European
markets.
e. Pfizer issues new shares to buy a small biotech company.

a
A)

b
B)

c
C)

a, c, d and e
D)

Feedback:
(b) is a financing decision.
(e) is both an investment (capital budgeting) and a financing decision.
Financial management can be broken down into (1) the investment, or
capital budgeting, decision and (2) the financing decision. The firm has to
decide (1) how much to invest and which real assets to invest in and (2) how
to raise the funds necessary to pay for those investments.

2
INCORRECT Which of the following are financing decisions?
a. Intel decides to spend $1 billion to develop a new microprocessor.
b. Volkswagen borrows 350 million euros (350 million) from Deutsche Bank.
c. BP constructs a pipeline to bring natural gas onshore from a production
platform in the Gulf of Mexico.
d. Budweiser spends 200 million to launch a new brand of beer in European
markets.
e. Pfizer issues new shares to buy a small biotech company.

a
A)

b
B)

c
C)

b and e
D)
 Feedback:
(a), (c) and (d) are investment (capital budgeting) decisions.
(e) is both an investment (capital budgeting) and a financing decision.

3
INCORRECT Which of the following are financial assets?
a. A patent.
b. A share of stock issued by Bank of New York.
c. A blast furnace in a steel-making factory.
d. A mortgage loan taken out to help pay for a new home.
e. After a successful advertising campaign, potential customers' belief that your
brand of potato chips is extra crispy.
f. An IOU ("I owe you") from your brother-in-law.

a, b and c
A)

b, d and e
B)

b, d and f
C)

a, b, c and d
D)

Feedback:
(b), (d) and (f) are financial assets.
(a) and (e) are real assets (intangible ones).
(c) is a real asset (a tangible one).
Real assets include all assets used in the production or sale of the firms'
products or services. Real assets can be tangible (plant and equipment, for
example) or intangible (patents or trademarks, for example). In contrast,
financial assets are claims (such as stocks or bonds) on the income
generated by real assets.

4 CORRECT
Which of the following are real assets?
a. A patent.
b. A share of stock issued by Bank of New York.
c. A blast furnace in a steel-making factory.
d. A mortgage loan taken out to help pay for a new home.
e. After a successful advertising campaign, potential customers' belief that your
brand of potato chips is extra crispy.
f. An IOU ("I owe you") from your brother-in-law.

a, c and e
A)

a, b, c and d
B)
 a, c, d and e
C)

b, c and f
D)

Feedback: (a), (c) and (e) are real assets. Among them, (a) and (e) are
intangible and (c) is tangible.

5
INCORRECT Fritz and Frieda went to business school together 10 years ago. They have just
been hired by a midsized corporation that wants to bring in new financial
managers. Fritz studied finance, with an emphasis on financial markets and
institutions. Frieda majored in accounting and became a CPA 5 years ago. Which
of the following is NOT a correct statement?

Fritz would more likely be the treasurer and Frieda the controller.
A)

The treasurer raises money from the credit and financial markets and
requires background in financial institutions.
B)

Both Fritz and Frieda are suitable for either the treasurer's or the
controller's position.
C)

The controller requires a background in accounting.

D)

Feedback:
(A), (B) and (D) are correct ones!
Almost all managers are involved to some degree in investment decisions,
but some managers specialize in finance, for example, the treasurer,
controller, and CFO. The treasurer is most directly responsible for raising
capital and maintaining relationships with banks and investors that hold the
firm's securities. The controller is responsible for preparing financial
statements and managing budgets. In large firms, a chief financial officer
who oversees both the treasurer and the controller will also be involved in
financial policymaking and corporate planning.

6
INCORRECT Without knowing anything about the personal ethics of the owners, which
company would you better trust to keep its word in a business deal?
a. Harry's Hardware has been in business for 50 years. Harry's grandchildren,
now almost adults, plan to take over and operate the business. Hardware stores
require considerable investment in customer relations to become established.
b. Victor's Videos just opened for business. It rents a storefront in a strip mall
and has financed its inventory with a bank loan. Victor has little of his own
money invested in the business. Video shops usually command little customer
loyalty.

a
A)
 b
B)

neither
C)

both
D)

Feedback:
The opportunity cost for not honoring their own words is extremely high for
Harry's Hardware; and hence the firm is highly trustworthy in keeping their
words in a business deal.

Modern finance does not condone attempts to pump up stock price by

unethical means. But there need be no conflict between ethics and value
maximization. The surest route to maximum value starts with products and
services that satisfy customers. A good reputation with customers,
employees, and other stakeholders is also important for the firms' long-run
profitability and value.

7
INCORRECT Which of the following would be considered an advantage of the sole
proprietorship form of organization?

Wide access to capital markets

A)

Unlimited liability
B)

A pool of expertise
C)

Profits taxed at only one level

D)

Feedback: Profits are taxed at only one level would be considered an

advantage of the sole proprietorship form of organization.

8 CORRECT
Which of the following would correctly differentiate general partners from limited
partners in a limited partnership?

General partners have more job experience.

A)

General partners have an ownership interest.

B)
General partners are subject to double taxation.
 C)

General partners have unlimited personal liability.

D)

Feedback: General partners have unlimited personal liability.

9
INCORRECT In the case of a professional corporation, ________ has/have limited liability.

only the professionals.

A)

only the business.

B)

both the professionals and the business.

C)

neither the professionals nor the business.

D)

Feedback:
In the case of a professional corporation, only the business (and not the
professionals) has limited liability.
Corporations are distinct, permanent legal entities. They allow for separation
of ownership and control, and they can continue operating without
disruption even as ownership changes. They provide limited liability to their
owners. On the other hand, they are subject to double taxation because they
pay taxes on their profits and the shareholders are taxed again when they
receive dividends or sell their shares at a profit.

10
CORRECT A board of directors is elected as a representative of the corporation's:

top management.
A)

stakeholders.
B)

shareholders.
C)

customers.
D)

Feedback: A board of directors is elected as a representative of the

corporation's shareholders.

11
INCORRECT Which of the following statements best distinguishes the difference between real
 and financial assets?

Real assets have less value than financial assets.

A)

Real assets are tangible; financial assets are not.

B)

Financial assets are a claim to the income generated by real assets.

C)

Financial assets appreciate in value; real assets depreciate in value.

D)

Feedback: Financial assets are a claim to the income generated by real

assets. Some real assets are tangible, some are intangible.

12
CORRECT Financial markets are used for trading:

both real assets and financial assets.

A)

the goods and services produced by a firm.

B)

securities, such as shares of IBM.

C)

the raw materials used in manufacturing.

D)

Feedback: Financial markets are used for trading securities, such as shares
of listed companies.

13
CORRECT Which of the following would be considered a capital budgeting decision?

Planning to issue common stock rather than issuing preferred stock

A)

A decision to expand into a new line of products, at a cost of $5 million

B)

Repurchasing shares of common stock

C)

Issuing debt in the form of long-term bonds

D)

Feedback: The rest are financing decisions.

14
CORRECT The overall goal of capital budgeting projects should be to:

decrease the firm's reliance upon debt.

A)

increase the firm's sales.

B)

increase the firm's outstanding shares of stock.

C)

increase the wealth of the firm's shareholders.

D)

Feedback: The overall goal of capital budgeting projects should be to

increase the wealth of the firm's shareholders.

15
INCORRECT The term "capital structure" refers to:

the manner in which a firm obtains its long-term sources of funding.

A)

the length of time needed to repay debt.

B)

whether the firm invests in capital budgeting projects.

C)

which specific assets the firm should invest in.

D)

Feedback: The term "capital structure" refers to the manner in which a firm
obtains its long-term sources of funding.

16
CORRECT Primary markets can be distinguished from secondary markets in that primary
markets sell:

lower valued shares.

A)

previously unsold shares.

B)

only the shares of large firms.

C)

shares with greater profit potential.

D)
 Feedback: Primary markets can be distinguished from secondary markets in
that primary markets sell previously unsold shares. Secondary markets host
the sale of seasoned shares from one shareholder to an investor.

17
INCORRECT A manager's compensation plan that offers financial incentives for increases in
quarterly profitability may create agency problems in that:

the managers are not motivated by personal gain.

A)

the board of directors may claim the credit.

B)

short-term, not long-term profits become the focus.

C)

investors desire stable profits.

D)

Feedback: A manager's compensation plan that offers financial incentives for

increases in quarterly profitability may create agency problems in that short-
term, not long-term profits become the focus. Managers can become short-
sighted, too, under non-perfect incentive plans.

18
CORRECT Which of the following statements is NOT correct?

Agency problems arise when managers and shareholders have different

objectives.
A)

Managers may empire-build with excessive investment and growth.

B)

Managers may be unduly risk averse, or they may try to take excessive
salaries or perquisites.
C)

Agency problems will not arise when managers and shareholders have
exactly the same objectives.
D)

Feedback:
Conflicts of interest between managers and stockholders can lead to agency
problems. These problems are kept in check by compensation plans that link
the well-being of employees to that of the firm; by monitoring of
management by the board of directors, security analysts, and creditors; and
by the threat of takeover.

19
CORRECT The liability of sole proprietors is limited to the amount of their investment in the
company.
True
 A)

False
B)

Feedback: Partners, like sole proprietors, face unlimited liability. If the

business runs into difficulties, each partner can be held responsible for all
the businesss debts. The moral: Know thy partner.

20
INCORRECT The corporate form of business organization is often accompanied by separation
of ownership and management.

True
A)

False
B)

Feedback: The corporate form of business organization is often accompanied

by separation of ownership and management.

21
INCORRECT Capital budgeting decisions are used to determine how to raise the cash
necessary for investments.

True
A)

False
B)
he Sarbanes-Oxley (SOX) Act of 2002 was an attempt to tighten corporate governance.

True
A)

False
B)

Feedback: Financial markets and institutions are supposed to move financing

to all firms that can invest at superior rates of return. Financing moves from
investors to firms only if investors are protected. This creates the need for a
system of corporate governance, so that financing can flow to the right firms
at the right times. Good corporate governance protects investors and thus
supports the development of financial markets and the financing required for
economic growth. Governance includes standards for accounting and
disclosure to investors, requirements for boards of directors, and legal
sanctions for fraud or self-dealing by management. The Sarbanes-Oxley
(SOX) Act of 2002 was an attempt to tighten corporate governance.

2 CORRECT
Financial markets provide financial managers both a source of long-term funds
and a place to temporarily store liquidity.
 True
A)

False
B)

Feedback: Financial markets and intermediaries provide financing for

business. They channel savings to real investment.Financial markets help
channel savings to corporate investment, and they help match up borrowers
and lenders. They provide liquidity and diversification opportunities for
investors. Trading in financial markets provides a wealth of useful
information for the financial manager.

3
INCORRECT The money market is the source for ______ financial assets, while the capital
market is the source for ______ financing.

investment; liquid
A)

short-term; long-term
B)

liquid; financial institution

C)

long-term; short-term
D)

Feedback: The money market is the source for short-term financial assets,
while the capital market is the source for long-term financing.

4
INCORRECT All but one of the following is an economic function of the financial system?

provides a payments system and liquidity for investors

A)

provides a secondary market for trading real assets

B)

provides a means to manage risk

C)

provides for the flow of savings to real investment

D)

Feedback:
Financial institutions carry out a number of similar functions but in different
ways. They channel savings to corporate investment, and theyserve as
intermediaries between borrowers and lenders. Banks also provide liquidity
for depositors and, of course, play a special role in the economy's payment
 systems. Insurance companies allow policyholders to pool risks.

5 CORRECT
The minimum, acceptable rate of return on corporate investments is determined
by:

investors in financial markets.

A)

information from accounting statements.

B)

the financial manager.

C)

the senior managers of the company.

D)

Feedback: The minimum, acceptable rate of return on corporate investments

is determined by investors in financial markets. The cost of capital is the
minimum acceptable rate of return on capital investment. It's an opportunity
cost, that is, a rate of return that investors could earn in financial markets.
For a safe capital investment, the opportunity cost is the interest rate on safe
debt securities, such as high-grade corporate bonds. For riskier capital
investments, the opportunity cost is the expected rate of return on risky
securities, investments in the stock market, for example.

6
INCORRECT All but one of the following is a service/product provided to corporations by
financial markets and institutions?

valuation of company
A)

contracts to manage risk

B)

financing
C)

real assets
D)

Feedback: Real assets are not a service/product provided to corporations by

financial markets and institutions. Mutual funds pool investor savings and
invest in portfolios of traded securities. Financial institutions such as banks
or insurance companies raise money in special ways, for example, by
accepting deposits or selling insurance policies. They not only invest in
securities but also lend directly to businesses. They provide various other
financial services.

7
INCORRECT While corporations provide shareholders returns from _______, capital markets
 provide returns to shareholders from ______.

capital gains; dividends

A)

appreciation; capital gains

B)

dividends; capital gains

C)

earnings; capital appreciation

D)

Feedback: While corporations provide shareholders returns from dividends,

capital markets provide returns to shareholders from capital gains.

8 CORRECT
Owners of mutual funds own ______ and are called _______.

deposits; depositors
A)

bonds; bondholders
B)

shares; shareholders
C)

IOU's of mutual funds; creditors

D)

Feedback: Owners of mutual funds own shares and are called shareholders.
Mutual funds raise money by selling shares to investors. The investors'
money is pooled and invested in a portfolio of securities. Investors can buy
or sell shares in mutual funds as they please, and initial investments are
often $3,000 or less. Vanguard's Explorer Fund, for example, held a portfolio
of about 1,300 stocks with a market value of about $12 billion at the end of
2007. An investor in Explorer can increase her stake in the fund's portfolio
by buying additional shares, and so gain a higher share of the portfolio's
subsequent dividends and priceappreciation. She can also sell her shares
back to the fund if she decides to cash out of her investment.

9
INCORRECT The first time a security is sold it is in the _______ market; subsequent trading
of the security is in the ______ market.

money; capital
A)

capital; money
B)
 banking; secondary
C)

primary; secondary
D)

Feedback: A new issue of shares increases both the amount of cash held by
the company and the number of shares held by the public. Such an issue is
known as a primary issue, and it is sold in the primary market. But in
addition to helping companies raise new cash, financial markets also allow
investors to trade securities among themselves. For example, Smith might
decide to raise some cash by selling her Apple stock at the same time that
Jones invests his spare cash in Apple. The result is simply a transfer of
ownership from Smith to Jones, which has no effect on the company itself.
Such purchases and sales of existing securities are known as secondary
transactions, and they take place in the secondary market.

10
INCORRECT The common stock of publicly traded corporations is usually traded:

by the company placing orders to purchase outstanding shares.

A)

by investors contacting other investors directly.

B)

between directors of the corporation.

C)

on an organized exchange or over-the-counter.

D)

Feedback: The common stock of publicly traded corporations is usually

traded on an organized exchange or over-the-counter.

11
CORRECT All but one of the following is known as a financial market?

foreign exchange market

A)

pension fund market

B)

money market
C)

fixed-income market
D)

Feedback:
Pension fund is an intermediary in the financial marets.
 Fixed-income market is the financial market for debt securities.

The markets for long-term debt and equity are called capital markets. A
firm's capital is its long-run financing. Short-term securities are traded in the
money markets. "Short-term" means less than 1 year. For example, large,
creditworthy corporations raise short-term financing by issues of commercial
paper, which are debt issues with maturities of at most 270 days.
Commercial paper is issued in the money market.

The financial manager regularly encounters other financial markets. Here are
three examples, with references to the chapters where they are discussed:

Foreign-exchange markets. Any corporation engaged in international trade

must be able to transfer money from dollars to other currencies, or vice
versa. Foreign exchange is traded over the counter through a network of the
largest international banks.
Commodities markets. Dozens of commodities are traded on organized
exchanges, such as the New York Mercantile Exchange or the Chicago Board
of Trade. You can buy or sell corn, wheat, cotton, fuel oil, natural gas,
copper, silver, platinum, and so on.
Markets for options and other derivatives. Derivatives are securities whose
payoffs depend on the prices of other securities or commodities. For
example, you can buy an option to purchase IBM shares at a fixed price on a
fixed future date. The option's payoff depends on the price of IBM shares on
that date. Commodities can be traded by a different kind of derivative
security called a futures contract.

A financial intermediary is an organization that raises money from investors

and provides financing for individuals, companies, and other organizations.
For corporations, intermediaries are important sources of financing.
Intermediaries are a stop on the road between savings and real
investment. Two important classes of intermediaries are mutual funds and
pension funds.

12
INCORRECT Financial markets evaluate the performance of publicly traded corporations

constantly.
A)

quarterly when financial statements are filed with the SEC.

B)

annually, when the annual report is issued.

C)

as requested by the managers of the corporations.

D)

Feedback: Financial markets evaluate the performance of publicly traded

corporations on a constant basis.
13
CORRECT As new information is available, financial markets

reflect this new information immediately in the prices of securities traded.

A)

publish this information.

B)

provide the information to financial intermediaries.

C)

decide how best to tell the public.

D)

Feedback: As new information is available, financial markets reflect this new

information immediately in the prices of securities traded.

14
INCORRECT When shareholder A sells its Ford stock to shareholder B in the secondary
market, such as on the New York Stock Exchange, how much money is received
by Ford?

Ford will receive most of the funds, except for commissions.

A)

Ford will receive nothing.

B)

Ford will receive only the commissions on the sale of stock.

C)

Ford will receive a portion of the funds for every stock traded on the
secondary market.
D)

Feedback:
A new issue of shares increases both the amount of cash held by the
company and the number of shares held by the public. Such an issue is
known as a primary issue, and it is sold in the primary market. But in
addition to helping companies raise new cash, financial markets also allow
investors to trade securities among themselves. For example, Smith might
decide to raise some cash by selling her Apple stock at the same time that
Jones invests his spare cash in Apple. The result is simply a transfer of
ownership from Smith to Jones, which has no effect on the company
itself. Such purchases and sales of existing securities are known as
secondary transactions, and they take place in the secondary market.

15
INCORRECT The most important service provided by mutual funds to mutual fund investors
is:
the opportunity to buy corporate securities at a discounted price.
 A)

high expenses and trading costs which increase the rate of return for
investors.
B)

diversification.
C)

a higher than average rate of return.

D)

Feedback: The most important service provided by mutual funds to mutual

fund investors is diversification. Mutual funds raise money by selling shares
to investors. The investors' money is pooled and invested in a portfolio of
securities. Investors can buy or sell shares in mutual funds as they please,
and initial investments are often $3,000 or less. Vanguard's Explorer Fund,
for example, held a portfolio of about 1,300 stocks with a market value of
about $12 billion at the end of 2007. An investor in Explorer can increase her
stake in the fund's portfolio by buying additional shares, and so gain a higher
share of the portfolio's subsequent dividends and price appreciation. She can
also sell her shares back to the fund if she decides to cash out of her
investment.

16
CORRECT Which of the following statements are correct?
a. Corporations sell securities in the primary market. The securities are later
traded in the secondary market.
b. The NYSE is a formal exchange that centralizes all trades. NASDAQ is an
electronic network of traders.
c. The capital market is for long-term financing, the money market for short-
term financing.

a, b and c.
A)

a and b.
B)

c.
C)

d.
D)

Feedback: All three statements are correct.

17
INCORRECT Which of the following statements are true?
a. Financing for public corporations may flow through financial markets or
through financial intermediaries.
b. Financing for private corporations may flow through financial intermediaries.
c. The sale of policies is a source of financing for insurance companies.
d. Much foreign exchange trading occurs on the floors of the FOREX exchanges
in New York and London.
e. The cost of capital is the minimum acceptable rate of return for capital
 investment. Investment projects offering rates of return higher than the cost of
capital add value to the firm. Projects offering rates of return less than the cost
of capital actually subtract value and should not be undertaken.
f. The cost of capital is an opportunity cost determined by expected rates of
return in financial markets. The opportunity cost of capital for risky investments
is normally higher than the firm's borrowing rate.

a.
A)

b.
B)

c and f.
C)

d, e and f.
D)

18
INCORRECT Which of the following statements are incorrect?
a. The cost of capital is the maximum acceptable rate of return on capital
investment.
b. The cost of capital is the minimum acceptable rate of return on capital
investment.
c. For a safe capital investment, the opportunity cost is the interest rate on safe
debt securities, such as high-grade corporate bonds.
d. For riskier capital investments, the opportunity cost is the expected rate of
return on risky securities.

a.
A)

b.
B)

a and c.
C)

b and d.
D)

19
INCORRECT Which of the following statements about financial institutions are correct?
a. Financial institutions carry out a number of similar functions but in different
ways.
b. They channel savings to corporate investment, and they serve as
intermediaries between borrowers and lenders.
c. Banks also provide liquidity for depositors and, of course, play a special role
in the economy's payments systems.
 d. Insurance companies allow policyholders to pool risks.

a.
A)

b and c.
B)

c.
C)

a, b, c and d.
D)

Feedback: All statements are correct.

20
CORRECT Which of the following financial intermediaries has shown a preference for
investing in long-term financial assets?

Commercial banks
A)

Insurance companies
B)

Finance companies
C)

Savings-and-loan associations
D)

If net income is positive, then cash flow from operations is positive also for that period.

True
A)

False
B)

Feedback:
The firm requires cash when it buys new plant and machinery or when it
pays interest to the bank and dividends to the shareholders. Therefore, the
financial manager needs to keep track of the cash that is coming in and
going out.
We have seen that the firm's cash flow can be quite different from its net
income. These differences can arise for at least two reasons:
1. The income statement does not recognize capital expenditures as
expenses in the year that the capital goods are paid for. Instead, it spreads
those expenses over time in the form of an annual deduction for
depreciation.
2. The income statement uses the accrual method of accounting, which
 means that revenues and expenses are recognized when sales are made,
rather than when the cash is received or paid out.

2 CORRECT
An increase in accounts receivable balance provides an increase in cash flow.

True
A)

False
B)

Feedback: An increase in accounts receivable balance provides a decrease in

cash flow.

3
INCORRECT Balance sheets have traditionally recorded amounts in terms of book values.

True
A)

False
B)

Feedback:
Thus in contrast to the balance sheet shown in the company's books, the
market-value balance sheet is forward-looking. It depends on the profits
that investors expect the assets to provide.
Is it surprising that market value exceeds book value? It shouldnt be. Firms
find it attractive to raise money to invest in various projects because they
believe the projects will be worth more than they cost. Otherwise, why
bother? You will usually find that shares of stock sell for more than the value
shown in the company's books.

4
INCORRECT In general, what is changing as you read down the left hand side of a balance
sheet?

The assets are more fully depreciated.

A)

The assets are growing in value.

B)

The assets are increasing in maturity.

C)

The assets are becoming less liquid.

D)

Feedback: As we read down the left hand side of a balance sheet, the assets
are becoming less liquid.
5
INCORRECT Which of the following items should not be included in a listing of current
assets?

Marketable securities
A)

Accounts payable
B)

Accounts receivable
C)

Inventories
D)

Feedback: Accounts payables are current liabilities, not current assets.

6
INCORRECT If the balance sheet of a firm indicates that total assets exceed current liabilities
plus shareholders' equity, then the firm has:

no retained earnings.
A)

long-term debt.
B)

no accumulated depreciation.
C)

current assets.
D)

Feedback: Note that Total Assets equals Total Liabilities plus Owners' Equity.
The difference must be in the form of long-term debts.

7 CORRECT
According to GAAP, assets and liabilities are typically recorded on the balance
sheet at:

historical cost.
A)

market value.
B)

salvage value.
C)
historical cost less depreciation.
 D)

Feedback: According to GAAP, assets and liabilities are typically recorded on

the balance sheet at historical cost less depreciation.

8
INCORRECT Which of the following is correct for a fully depreciated asset that still has some
salvage value?

Market value is zero.

A)

Market value is greater than book value.

B)

Book value is greater than market value.

C)

The relationship between market and book values is indeterminable.

D)

Feedback: For a fully depreciated asset, the book value of the asset is zero. If
the asset still has some salvage value, it's the market value that we are
talking about.

9
INCORRECT ABC Corp.'s balance sheet shows their long-term debt to be $10 million. The
debt was issued with a 10% coupon rate, and the current market interest rate is
7%. Based on this information, the market value of this debt will most likely be:

less than $10 million.

A)

more than $10 million.

B)

equal to $10 million.

C)

unknown without knowing the maturity of the debt.

D)

Feedback: Since the coupon rate is higher than the market interest rate
(discount rate), the present value of the remaining cash flows looks good.

10
INCORRECT Which of the following is more likely to be correct if market value of equity is
less than book value of equity?

Investors anticipate excellent earning potential.

A)
Investors anticipate low earning potential.
 B)

Assets have been fully depreciated.

C)

The company is bankrupt.

D)

Feedback: If market value of equity is less than book value of equity,

investors anticipate low earning potential.

11
CORRECT Calculate the EBIT for a firm with $4 million total revenues, $3.5 million cost of
goods sold, $500,000 depreciation expense, and $120,000 interest expense.

$500,000
A)

$380,000
B)

$0
C)

($120,000)
D)

Feedback:

Sales $4,000,000

Costs 3,500,000

Depreciation Expense 500,000

EBIT $0

12
INCORRECT The gathering of related revenues and expenses incurred the same period,
regardless of when they were collected or paid, is:

cash basis accounting.

A)

market value accounting.

B)
 book value accounting.
C)

accrual accounting.
D)

Feedback: Under the practice of accrual accounting, the accountant gathers

together all expenses that are associated with a sale and deducts them from
the revenues to calculate profit, even though the expenses may have
occurred in an earlier period.

13
INCORRECT Which of the following statements is more likely if cash and marketable
securities increase by $5,000 during a period in which cash provided by
operations increases by $1,000 and cash used by investments decreases by
$500?

Cash provided by financing decreases by $3,500.

A)

Cash used by financing decreases by $1,000.

B)

Long-term debt decreased by less than short-term debt increased.

C)

Debt was reduced by more than cash dividends paid.

D)

Feedback: Investments expenditure usually comes from long-term debt.

Therefore it is likely that long-term debt will also decrease by $500 when
investments decrease by $500. Financing for operations usually comes from
short-term debt. Hence when cash provided by operations increases by
$1,000, so does the short-term debt. Therefore long-term debt decreases by
$500, which is less than the $1,000 increase of the short-term debt.

14
INCORRECT What happens when moving from net income to cash flows from operations as
the result of an increase in inventory balances?

Cash flows increase.

A)

Cash flows decrease.

B)

Cash flows are unchanged.

C)

The change in cash flows cannot be determined.

D)
 Feedback: Cash flows have been used to reimburse the payables from
inventory increase.

15
INCORRECT Which of the following categories of a statement of cash flows is affected by the
payment of interest expense?

Cash flows from operations

A)

Cash flows from noncash expenses

B)

Cash flows from investments

C)

Cash flows from financing

D)

Feedback: The first section in a consolidated statement of cash flows, cash

flow from operations, starts with net income but adjusts that figure for those
parts of the income statement that do not involve cash coming in or going
out. Therefore, it adds back the allowance for depreciation because
depreciation is not a cash outflow, even though it is treated as an expense in
the income statement. Any additions to current assets need to be subtracted
from net income, since these absorb cash but do not show up in the income
statement. Conversely, any additions to current liabilities need to be added
to net income because these release cash.

16
INCORRECT Which of the following statements regarding financial statements are correct?
a. Investors and other stakeholders in the firm need regular financial
information to help them monitor the firm's progress. Accountants summarize
this information in a balance sheet, income statement, and statement of cash
flows.
b. The balance sheet provides a snapshot of the firm's assets and liabilities. The
assets consist of current assets that can be rapidly turned into cash and fixed
assets such as plant and machinery. The liabilities consist of current liabilities
that are due for payment within a year and long-term debts. The difference
between the assets and the liabilities represents the amount of the
shareholders' equity.
c. The income statement measures the profitability of the company during the
year. It shows the difference between revenues and expenses.
d. The statement of cash flows measures the sources and uses of cash during
the year. The change in the company's cash balance is the difference between
sources and uses.

a.
A)

a and b.
B)

a, b and c.
C)
 a, c and d.
D)

17
CORRECT Which of the following statements are incorrect regarding the differences
between book values and market values?
a. It is important to distinguish between the book values that are shown in the
company accounts and the market values of the assets and liabilities.
b. Book values are historical measures based on the original cost of an asset.
c. The assets in the balance sheet are shown at their historical cost less an
allowance for depreciation.
d. The figure for shareholders' equity measures the cash that shareholders have
contributed in the past or that the company has reinvested on their behalf.

a.
A)

b.
B)

c.
C)

none of the above.

D)

Feedback: All statements are correct.

18
INCORRECT Which of the following statements regarding accounting income and cash flow
are incorrect?
a. Accounting income is not the same as cash flow. For example, we need to add
back the depreciation expense to accounting net income to recover the true
cash flow.
b. Investment in fixed assets is not deducted immediately from income but is
instead spread over the expected life of the equipment.
c. The accountant records revenues when the sale is made, rather than when
the customer actually pays the bill, and at the same time deducts the production
costs even though those costs may have been incurred earlier.

a.
A)

b.
B)

c.
C)

a and b.
D)
19
INCORRECT Which of the following statements regarding the taxation of corporate and
personal income are incorrect?
a. For large companies the marginal rate of tax on income is 35 percent.
b. In calculating taxable income the company deducts an allowance for
depreciation and interest payments. It cannot deduct dividend payments to the
shareholders.
c. Individuals are also taxed on their income, which includes dividends and
interest on their investments.
d. Capital gains/loss will realize only when an investment is sold. If the selling
price is higher than the acquiring price of an investment, a capital gains
capitalizes and a capital gains tax realizes.

a and b.
A)

b.
B)

c and d.
C)

d.
D)

20
INCORRECT Which of the following statements about regulatory responses to accounting
malpractices are incorrect?
a. In response corporate accounting scandals, Congress passed the Sarbanes-
Oxley Act in 2002. The act attempts to ensure that the firm's financial reports
accurately represent its financial condition.
b. The Sarbanes-Oxley Act created the Public Company Accounting Oversight
Board to oversee the auditing of public companies, requires CEOs and CFOs to
personally sign off on the firm's financial statements, and requires independent
financial experts to serve on the audit committee of the board of directors.
c. After the Sarbanes-Oxley Act is passed and enforced, accounting rules leave
firms little leeway at all when preparing their financial statements.

a.
A)

b.
B)

c.
C)

a and b.
D)
The net working capital of a firm will decrease when accrued wages are paid with cash.

True
A)

False
B)

Feedback: Accrued wages are current liabilities which may be paid off by
cash, a current asset. Net working capital, i.e., current asset minus current
liabilities will stay the same in such cases.

2 CORRECT
The sum of the payout ratio and the plowback ratio will always equal 1.0.

True
A)

False
B)

Feedback:
Sustainable growth is the rate of growth that can be generated by reinvested
earnings at the firm's current level of profitability. It is the product of the
plowback ratio and return on equity (ROE). (The plowback ratio equals 1
minus the dividend payout ratio.) Of course, this growth rate is really
sustainable only if ROE and retention are maintained at current levels.

3
INCORRECT Lease obligations are included in certain leverage ratios because leases:

require the payment of interest.

A)

represent long-term fixed obligations.

B)

must be financed through a bank.

C)

are a measure of efficiency, just like debt.

D)

Feedback: Lease obligations are included in certain leverage ratios because

leases represent long-term fixed obligations.

4 CORRECT
A firm with no leases has a long-term debt ratio of 50%. This means that the
book value of equity:
 equals the book value of long-term debt.
A)

is less than the book value of long-term debt.

B)

is greater than the book value of long-term debt.

C)

is unknown in relation to the book value of long-term debt.

D)

Feedback: If a firm with no leases has a long-term debt ratio of 50%, the
book value of equity equals the book value of long-term debt, i.e., at 50%.

5
INCORRECT An asset's liquidity measures its:

potential for generating a profit.

A)

cash requirements.
B)

ease and cost of being converted to cash.

C)

proportion of debt financing.

D)

Feedback: An asset's liquidity measures its ease and cost of being converted
to cash.

6
INCORRECT Which of the following actions will increase a firm's current ratio if it is now less
than 1.0?

Convert marketable securities to cash.

A)

Pay accounts payable with cash.

B)

Buy inventory with short term credit (i.e. accounts payable).

C)

Sell inventory at cost.

D)

Feedback: Buying inventory with short term credit will cause current asset
and current liability to increase by the same amount and increase the firm's
 current ratio to closer to (but still less than) 1.

7
INCORRECT A times interest earned ratio of 5.0 indicates that the firm:

pays 5 times its earnings in interest expense.

A)

earns significantly more than its interest obligations.

B)

has interest expense equal to 5% of EBIT.

C)

has low tax liability.

D)

Feedback:
A times interest earned ratio of 5.0 indicates that the firm earns significantly
more than its interest obligations.

Times Interest Earned Ratio measures financial leverage is the extent to

which interest obligations are covered by earnings. Banks prefer to lend to
firms with earnings that cover interest payments with room to spare.
Interest coverage is measured by the ratio of earnings before interest and
taxes (EBIT) to interest payments.

8
INCORRECT Which of the following will allow your firm to achieve its targeted 16% ROA with
an asset turnover of 2.5?

A leverage ratio of .0667.

A)

A P/E ratio of 14.

B)

A profit margin of 15%.

C)

A profit margin of 6.4%.

D)

Feedback:
ROE = Profit margin x Asset turnover
.16 = Profit margin x 2.50
.064 = Profit margin

9
INCORRECT When Tri-C Corp. compares its ratios to industry averages, it has a higher
current ratio, an average quick ratio, and a low inventory turnover. What might
you assume about Tri-C?
 Its cash balance is too low.
A)

Its cost of goods sold is too low.

B)

Its current liabilities are too low.

C)

Its average inventory is too high.

D)

Feedback: Since current ratio includes inventory but quick ratio excludes
inventory in the numerator, high current ratio and average quick ratio reveal
the fact of high inventory. Low inventory turnover, i.e., total assets over
average inventory, also confirms the fact of high inventory.

10
INCORRECT Which of the following statements is most likely correct for a firm with an
average collection period of 90 days?

Its average daily sales are low.

A)

Its average daily sales are high.

B)

Its current ratio will be high.

C)

It is providing financing for approximately 25% of its annual sales.

D)

Feedback: By definition, average collection period equals sales over (average

receivables / 365).

11
INCORRECT What is the ROA of a firm with $150,000 in average receivables, which
represents 60 days sales, average assets of $750,000, and a profit margin of
9%?

7.50%
A)

9.00%
B)

10.95%
C)
16.70%.
 D)

Feedback:

12
INCORRECT Which of the following is most likely to result in a higher P/E ratio for a firm,
other things equal?

Lower growth rate in dividends.

A)

Reduction in the stock's required rate of return.

B)

Lower dividend yield.

C)

Lower stock price.

D)

Feedback: Reduction in the stock's required rate of return equals the lower
earnings per share, which causes the higher P/E ratio, i.e., price per share
over earnings per share.

13
INCORRECT What is the market price of a share of stock for a firm with 100,000 shares
outstanding, a book value of equity of $3,000,000, and a market/book ratio of
3.5?

$8.57
A)

$30.00
B)

$85.70
C)

$105.00
D)

Feedback:
14
INCORRECT The Board of Directors is dissatisfied with last year's ROE of 15%. If the profit
margin and asset turnover remain unchanged at 8% and 1.25 respectively, by
how much must the total debt ratio increase to achieve 20% ROE?

Total debt ratio must increase by .5.

A)

Total debt ratio must increase by 5.

B)

Total debt ratio must increase by 16.67%.

C)

Total debt ratio must increase by 33.3%.

D)

Feedback:
Last Year:
.15 = ROE = leverage ratio x asset turnover ratio x profit margin = leverage
ratio x 1.25 x 8%.
.15 = [1.25 x 8%] x leverage ratio.
This Year:
ROE = .20 = [1.25 x 8%] x this year's leverage ratio.
Therefore leverage ratio (assets / equity) must increase by [(.20 - .15) / .
15] x 100% or 33.3%.

15
INCORRECT Which of the following would be most detrimental to a firm's current ratio if that
ratio is currently 2.0?

Buy raw materials on credit.

A)

Sell marketable securities at cost.

B)

Pay off accounts payable with cash.

C)

Pay off a portion of long-term debt with cash.

D)

Feedback: Paying off a portion of long-term debt with cash will cause the
numerator of the current ratio to decrease.

16
INCORRECT Which of the following is correct for a firm with a debt-equity ratio of .45 if long-
term debt equals 500 and equity equals 2,000? The firm has:

current liabilities that are valued at 400.

A)

current assets that are valued at 400.

B)

retained earnings that are valued at 900.

C)

preferred stock of 400.

D)

Feedback:

17
INCORRECT Which of the following is not correct regarding the standard measures (and their
significance) of a firm's leverage, liquidity, efficiency, and profitability?
a. Leverage ratios measure the indebtedness of the firm. Liquidity ratios
measure how easily the firm can obtain cash. Efficiency ratios measure how
intensively the firm is using its assets. Profitability ratios measure the firm's
return on its investments.
b. Be selective in your choice of these ratios. Different ratios often tell you
similar things. Financial ratios crop up repeatedly in financial discussions and
arrangements.
c. Banks and bondholders commonly place limits on the borrower's liquidity
ratios.
d. Ratings agencies also look at leverage ratios when they decide how highly to
rate the firm's bonds.

a.
A)

b.
B)

c.
C)

d.
D)

Feedback: Banks and bondholders usually demand limits on debt ratios or

 interest coverage.

18
INCORRECT How does the Du Pont formula help identify the determinants of the firm's
return on its assets and equity?
a. The formula states that the return on equity is the product of the firm's
leverage ratio, asset turnover, operating profit margin, and debt burden.
b. The formula states that the return on assets is the product of the firm's asset
turnover and operating profit margin.

a.
A)

b.
B)

both a and b are correct.

C)

neither a nor b is correct.

D)

19
CORRECT Which of the following is incorrect regarding potential pitfalls of ratio analysis
based on accounting data?
a. Financial ratio analysis will rarely be useful if practiced mechanically. It
requires a large dose of good judgment. Financial ratios often provide answers,
and they do help you ask the right questions.
b. Accounting data do not necessarily reflect market values properly, and so
must be used with caution.
c. We need a benchmark for assessing a company's financial position.
d. We typically compare financial ratios with the company's ratios in earlier
years and with the ratios of other firms in the same business.

a.
A)

b.
B)

c.
C)

d.
D)

Feedback:
Financial statement analysis will rarely be useful if done mechanically.
Financial ratios do not provide final answers, although they should prompt
the right questions. In addition, accounting entries do not always reflect
current market values, and in rare cases accounting is not transparent,
because unscrupulous managers make up good news and hide bad news in
 financial statements.

20
INCORRECT Which of the following is incorrect regarding assessing the firm's performance
with market value added and economic value added?
a. The ratio of the market value of the firm's equity to its book value indicates
how far the value of the shareholders' investment exceeds the money that they
have contributed.
b. The difference between the market and book values is known as market value
added and measures the number of dollars of value that the company has
added.
c. Managers often compare the company's return on assets with the cost of
capital to see whether the firm is earning the return that investors require. It is
also useful to deduct the cost of the capital employed from the company's
profits to see how much profit the company has earned after all costs. This
measure is known as residual income, economic value added, or EVA.
d. Managers of divisions or plants are often judged and rewarded by their
business's market value added.

a.
A)

b.
B)

c.
C)

d.
D)

Feedback: Managers of divisions or plants are often judged and rewarded by

their economic value added.

The more frequent the compounding, the higher the future value, other
things equal.

True
A)

False
B)

2
INCORRECT For a given amount, the lower the discount rate, the less the present value.

True
A)
False
 B)

Feedback: For a given amount, the lower the discount rate, the more the
present value.

3 CORRECT
How much must be invested today in order to generate a five-year annuity of
$1,000 per year, with the first payment one year from today, at an interest rate
of 12%?

$3,604,78
A)

$3,746.25
B)

$4,037.35
C)

$4,604.78
D)

Feedback:

4
INCORRECT How much will accumulate in an account with an initial deposit of $100, and
which earns 10% interest compounded quarterly for three years?

$107.69
A)

$133.10
B)

$134.49
C)

$313.84
D)

Feedback:
FV = PV (1+r)n
100 (1.025)12 = 134.49

5
INCORRECT How much can be accumulated for retirement if $2,000 is deposited annually,
beginning one year from today, and the account earns 9% interest compounded
 annually for 40 years?

$ 87,200.00
A)

$675,764.89
B)

$736,583.73
C)

$802,876.27
D)

Feedback:

6
INCORRECT Under which of the following conditions will a future value calculated with simple
interest exceed a future value calculated with compound interest at the same
rate?

The interest rate is very high.

A)

The investment period is very long.

B)

The compounding is annually.

C)

This is not possible with positive interest rates.

D)

7
INCORRECT How much interest is earned in the third year on a $1,000 deposit that earns
7% interest compounded annually?

$ 70.00
A)

$ 80.14
B)
 $105.62
C)

$140.00
D)

Feedback:
100 x (1.07)2 = $1,144.90 after 2 years.
$1,144.90 x .07 = $80.14

8
INCORRECT How long must one wait (to the nearest year) for an initial investment of $1,000
to triple in value if the investment earns 8% compounded annually?

9
A)

15
B)

22
C)

25
D)

Feedback:
$3,000 = 1,000(1.08)n
3 = (1.08)n
14.27, or approx. 14 yrs. = N
Solved with financial calculator; can also be solved with tables or logarithms.

9 CORRECT
A credit card account that charges interest at the rate of 1.25% per month
would have an annually compounded rate of _______ and an APR of _______.

16.08%; 15.00%
A)

14.55%; 16.08%
B)

12.68%; 15.00%
C)

15.00%; 14.55%
D)

Feedback:
Annually compounded rate = (1.0125)12 1 = 16.08%
 APR = 1.25% x 12 = 15.0%

10
INCORRECT What is the APR on a loan that charges interest at the rate of 1.4% per month?

10.20%
A)

14.00%
B)

16.80%
C)

18.16%
D)

Feedback: 1.4% monthly x 12 = 16.8% APR

11
INCORRECT If the effective annual rate of interest is known to be 16.08% on a debt that has
quarterly payments, what is the annual percentage rate?

4.02%
A)

10.02%
B)

14.50%
C)

15.19%
D)

Feedback:
(1.1608).25=1 + quarterly rate
1.0380 - 1 = quarterly rate
.0380 = quarterly rate
.1519 = quarterly rate x 4

12
CORRECT If a borrower promises to pay you $1,900 nine years from now in return for a
loan of $1,000 today, what effective annual interest rate is being offered?

5.26%
A)

7.39%
B)
 9.00%
C)

10.00%
D)

Feedback:

13
INCORRECT What is the present value of your trust fund if it promises to pay you $50,000 on
your 30th birthday (7 years from today) and earns 10% compounded annually?

$25,000.00
A)

$25,657.91
B)

$28,223.70
C)

$29,411.76
D)

Feedback:

14
INCORRECT What is the present value of the following payment stream, discounted at 8%
annually: $1,000 at the end of year 1, $2,000 at the end of year 2, and $3,000
at the end of year 3?
$5,022.11
 A)

$5,144.03
B)

$5,423.87
C)

$5,520.00
D)

Feedback:

15
INCORRECT The present value of a perpetuity can be determined by:

Multiplying the payment by the interest rate.

A)

Dividing the interest rate by the payment.

B)

Multiplying the payment by the number of payments to be made.

C)

Dividing the payment by the interest rate.

D)

Feedback: The formula to use is: PV=C/r.

16
INCORRECT Which of the following statements regarding present and future values of
streams of cash payments are incorrect?
a. A level stream of cash payments that continues indefinitely is known as a
perpetuity; one that continues for a limited number of years is called an annuity.
b. The present value of a stream of cash flows is simply the sum of the present
value of each individual cash flow.
c. The future value of an annuity is the sum of the future value of each
individual cash flow.
d. Shortcut formulas make the calculations for perpetuities and annuities easy.

a.
A)

b.
B)
 c.
C)

d.
D)

17
INCORRECT Which of the following statements regarding real and nominal cash flows and
real and nominal interest rates are incorrect?
a. A dollar is a dollar, but the amount of goods that a dollar can buy is eroded by
inflation. If prices double, the real value of a dollar halves.
b. Financial managers and economists often find it helpful to reexpress future
cash flows in terms of real dollarsthat is, dollars of constant purchasing power.
c. We need to be careful to distinguish the nominal interest rate and the real
interest ratethat is, the rate at which the real value of the investment grows.
Discount nominal cash flows (that is, cash flows measured in current dollars) at
nominal interest rates. Discount real cash flows (cash flows measured in
constant dollars) at real interest rates.
d. It's not okay to mix and match nominal and real. Real cash flows must be
discounted at real interest rates; nominal cash flows must be discounted at
nominal interest rates.

a.
A)

b.
B)

c.
C)

d.
D)

18
INCORRECT Which of the following statements regarding interest rates quoted over different
time intervals are incorrect?
a. Interest rates for short time periods are often quoted as annual rates by
multiplying the perperiod rate by the number of periods in a year.
b. The annual percentage rates (APRs) do not recognize the effect of compound
interest, that is, they annualize assuming simple interest.
c. The effective annual rate annualizes using compound interest. It equals the
rate of interest per period compounded for the number of periods in a year.

a.
A)

b.
B)
 c.
C)

None of the above is incorrect.

D)

Feedback: All the above statements are correct.

19
INCORRECT Your car loan requires payments of $200 per month for the first year and
payments of $400 per month during the second year. The annual interest rate is
12% and payments begin in one month. What is the present value of this two-
year loan?

$6,246.34
A)

$6,389.78
B)

$6,428.57
C)

$6,753.05
D)

20
INCORRECT A perpetuity of $5,000 per year beginning today is said to offer a 15% interest
rate. What is its present value?

$33,333.33
A)

$37,681.16
B)

$38,333.33
C)

$65,217.39.
D)

Feedback:
Longer-term bond prices are more sensitive to changes in interest rates than are short-term bond
prices.

True
A)

False
B)

2 CORRECT
A Treasury bond's bid price will be lower than the ask price.

True
A)

False
B)

3
INCORRECT Which of the following presents the correct relationship? As the coupon rate of a
bond increases, the bond's:

face value increases.

A)

current price decreases.

B)

interest payments increase.

C)

maturity date is extended.

D)

Feedback: As the coupon rate of a bond increases, the bond's interest

payments increase. Note that the product of the coupon rate and the face
value determines the interest payment.

4 CORRECT
What happens when a bond's expected cash flows are discounted at a rate lower
than the bond's coupon rate?

The price of the bond increases.

A)

The coupon rate of the bond increases.

B)
 The par value of the bond decreases.
C)

The coupon payments will be adjusted to the new discount rate.

D)

Feedback: When the coupon rate is higher than the discount rate, the bond
can be sold at higher price then otherwise. The reason is obvious.

5
INCORRECT When an investor purchases a $1,000 par value U.S. Treasury bond that was
quoted at 97.16, the investor:

receives 97.5% of the stated coupon payments.

A)

receives $975 upon the maturity date of the bond.

B)

pays 97.5% of face value for the bond.

C)

pays $1,025 for the bond.

D)

Feedback: In percentage terms, 97.16 is actually 97% plus (16/32)%, or

97.5%

6
INCORRECT How much should you pay for a $1,000 bond with 10% coupon, annual
payments, and five years to maturity if the interest rate is 12%?

$ 927.90
A)

$ 981.40
B)

$1,000.00
C)

$1,075.82
D)

Feedback:
7
INCORRECT The current yield of a bond can be calculated by:

multiplying the price by the coupon rate.

A)

dividing the price by the annual coupon payments.

B)

dividing the price by the par value.

C)

dividing the annual coupon payments by the price.

D)

Feedback: By definition, the current yield of a bond is the ratio of annual

coupon payments over the price.

8
INCORRECT The discount rate that makes the present value of a bond's payments equal to
its price is termed the:

rate of return.
A)

yield to maturity.
B)

current yield.
C)

coupon rate.
D)

Feedback: The discount rate that makes the present value of a bond's
payments equal to its price is, by definition, the yield to maturity.

9
INCORRECT What is the coupon rate for a bond with three years until maturity, a price of
$1,053.46, and a yield to maturity of 6%?

6%
A)
 8%
B)

10%
C)

11%
D)

Feedback:

10
INCORRECT Which of the following factors will change when interest rates change?

The expected cash flows from a bond

A)

The present value of a bond's payments

B)

The coupon payment of a bond

C)

The maturity value of a bond

D)

Feedback: The present value of the cash flows is the sum of the respective
discounted future cash flows.

11
CORRECT What is the rate of return for an investor who pays $1,054.47 for a three-year
bond with a 7% coupon and sells the bond one year later for $1,037.19?

5.00%
A)

5.33%
B)
6.46%
 C)

7.00%
D)

Feedback:
Capital gains/loss = $1,037.19 - $1,054.47 = -$17.28
Rate of Return = ($70.00 - $17.28)/$1,054.47
= $52.72/$1,054.47
= 5%

12
CORRECT How does a bond dealer generate profits when trading bonds?

By maintaining bid prices lower than ask prices

A)

By maintaining bid prices higher than ask prices

B)

By retaining the bond's next coupon payment

C)

By lowering the bond's coupon rate

D)

Feedback: Bond dealers make a profit and living on the spread (net income),
or the difference between ask rate (revenue) and bid rate (cost).

13
INCORRECT The yield curve depicts the current relationship between:

bond yields and default risk.

A)

bond maturity and bond ratings.

B)

bond yields and maturity.

C)

promised yields and default premiums.

D)

Feedback: By definition, the yield curve depicts the current relationship

between bond yields and maturity.

14
INCORRECT Which of the following bonds would be likely to exhibit a greater degree of
interest-rate risk?
 A coupon-paying bond with 5 years until maturity.
A)

A coupon-paying bond with 20 years until maturity.

B)

A floating-rate bond with 20 years until maturity.

C)

A zero-coupon bond with 30 years until maturity.

D)

Feedback: Longer-term bonds exhibit greater degree of interest-rate risk. It

is even more so if the longer-term bonds have longer maturity and undergo a
more significant discount effect.

15
INCORRECT What is the yield to maturity (APR) of a bond with the following characteristics?
Coupon rate is 8% with semi-annual payments, current price is $960, three
years until maturity.

4.78%
A)

5.48%
B)

9.57%
C)

12.17%
D)

Feedback:

16
INCORRECT Which of the following statements regarding bonds are incorrect?
a. A bond is a long-term debt of a government or corporation.
b. When you own a bond, you receive a fixed interest payment each year until
the bond matures. This payment is known as the coupon.
c. The coupon rate is the annual coupon payment expressed as a fraction of the
bond's face value.
d. At maturity the bond's face value is repaid.
 a.
A)

b.
B)

c.
C)

d.
D)

17
INCORRECT Which of the following statements regarding bonds are incorrect?
a. In the United States most bonds have a face value of $1,000.
b. The current yield is the annual coupon payment expressed as a fraction of the
bond's price.
c. The yield to maturity measures the average rate of return to an investor who
purchases the bond and holds it until maturity, accounting for coupon income as
well as the difference between purchase price and face value.

a.
A)

b.
B)

c.
C)

b and c.
D)

18
INCORRECT Which of the following statements about bonds are incorrect?
a. Bonds are valued by discounting the coupon payments and the final
repayment by the yield to maturity on comparable bonds.
b. By definition of yield to maturity, the bond payments discounted at the bond's
yield to maturity equals the bond market transaction price.
c. You may also start with the bond price and ask what interest rate the bond
offers. The interest rate that equates the present value of bond payments to the
bond price is the yield to maturity.
d. Because present values are lower when discount rates are higher, price and
yield to maturity vary inversely.

a.
A)
 b.
B)

c.
C)

d.
D)

19
CORRECT Which of the following statements about bonds are incorrect?
Bond prices are subject to interest rate risk, rising when market interest rates
fall and falling when market rates rise.
a. Bond prices are subject to interest rate risk.
b. Long-term bonds exhibit more interest rate risk than short-term bonds. It is
exactly due to the more significant discounting of the future cash flows
associated with long-term bonds.
c. Bond prices rise when market interest rates fall and fall when market rates
rise.
d. Because present values are lower when discount rates are higher, price and
yield to maturity vary inversely.

a.
A)

b.
B)

c.
C)

d.
D)

20
INCORRECT Which of the following statements regarding bond ratings are incorrect?
a. Investors demand higher promised yields if there is a high probability that the
borrower will run into trouble and default.
b. Credit risk implies that the promised yield to maturity on the bond is higher
than the expected yield.
c. The additional yield investors require for bearing credit risk is called the
default premium.
d. Bond ratings measure the bond's credit risk.

a.
A)

b.
B)
 c.
C)

d.
D)
The correct answer for each question is indicated by a .

1
INCORRECT The dividend discount model does not hold for investors who have a preference
for capital gains.

True
A)

False
B)

Feedback: The dividend discount model also holds for investors who have a
preference for capital gains.

2
INCORRECT Stock value is always increased whenever earnings are plowed back into the
firm.

True
A)

False
B)

Feedback: Stock value is not always increased even when earnings are
plowed back into the firm.

3
INCORRECT Which of the following is a characteristic of secondary markets for common
stock?

Only low-priced shares are traded in these markets.

A)

Only high-risk shares are traded in these markets.

B)

Secondary markets are where corporations borrow funds.

C)

Secondary-market trades do not provide funds for corporations whose stock

is traded.
D)
4
INCORRECT What dividend yield would be reported in the financial press for a stock that
currently pays a $1 dividend per quarter and the most recent stock price was
$40?

2.5%
A)

4.0%
B)

10.0%
C)

15.0%
D)

Feedback:
$1 dividend per quarter = $4 annually.
$4/$40 = 10% dividend yield.

5
INCORRECT If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year, what is the
stock's current price?

$4.50
A)

$18.00
B)

$22.22
C)

$40.50
D)

Feedback:
P/E = 13.5X
Then P = 13.5 x $3
Price = $40.50

6
INCORRECT The book value of a firm's equity is determined by:

multiplying share price by shares outstanding.

A)

multiplying share price at issue by shares outstanding.

B)
 the difference between book values of assets and liabilities.
C)

the difference between market values of assets and liabilities.

D)

Feedback: The book value of a firm's equity is determined by the difference

between book values of assets and liabilities.

7
INCORRECT What is the current price of a share of stock for a firm with $5 million in balance-
sheet equity, 500,000 shares of stock outstanding, and a price/book value ratio
of 4?

$2.50
A)

$10.00
B)

$20.00
C)

$40.00
D)

Feedback:
book value per share = $5,000,000/500,000 = $10
If price/book value = 4
then price = $10 x 4 = $40

8
INCORRECT A firm's liquidation value is the amount:

necessary to repurchase all shares of common stock.

A)

realized from selling all assets and repaying debts.

B)

a purchaser would pay for the firm in bankruptcy.

C)

equal to the book value of equity.

D)

Feedback: A firm's liquidation value is the amount realized from selling all
assets and repaying debts.

9
A stock paying $5 in annual dividends sells now for $80 and has an expected
INCORRECT return of 14%. What might investors expect to pay for the stock one year from
now?

$82.20
A)

$86.20
B)

$87.20
C)

$91.20
D)

Feedback:

10
INCORRECT Which of the following statements is correct about a stock currently selling for
$50 per share that has a 16% expected return and a 10% expected capital
appreciation?

Its expected dividend exceeds the actual dividend.

A)

Its expected return will exceed the actual return.

B)

It is expected to pay $3 in annual dividends.

C)

It is expected to pay $8 in annual dividends.

D)

Feedback:
16% = expected dividend yield + 10%
6% = expected dividend yield
$50 share price x 6% = $3 expected dividend payment

11
INCORRECT The expected return on a common stock is composed of:
 dividend yield.
A)

capital appreciation.
B)

both dividend yield and capital appreciation.

C)

capital appreciation minus the dividend yield.

D)

Feedback: The expected return on a common stock is composed of both

dividend yield and capital appreciation.

12
INCORRECT How much should you pay for a share of stock that offers a constant growth rate
of 10%, requires a 16% rate of return, and is expected to sell for $50 one year
from now?

$42.00
A)

$45.00
B)

$45.45
C)

$47.00
D)

Feedback:
The easiest way to solve this problem is to realize:

Expected return = expected dividend yield

+ expected capital appreciation
Then:
.16 = .06 + expected capital appreciation
.10 = expected capital appreciation
And
P1 = 110% of Po
$50.00 = 1.1Po
$45.45 = Po

13
INCORRECT Common stock can be valued using the perpetuity valuation formula if the:

discount rate is expected to remain constant.

A)
 dividends are not expected to grow.
B)

growth rate in dividends is not constant.

C)

investor does not intend to sell the stock.

D)

Feedback: Common stock can be valued using the perpetuity valuation

formula if the dividends are not expected to grow.

14
INCORRECT What constant growth rate in dividends is expected for a stock valued at $32.00
if next year's dividend is forecast at $2.00 and the appropriate discount rate is
13%?

5.00%
A)

6.25%
B)

6.75%
C)

15.38%
D)

Feedback:

15
INCORRECT A payout ratio of 35% for a company indicates that:

35% of dividends are plowed back for growth.

A)

65% of dividends are plowed back for growth.

B)

65% of earnings are paid out as dividends.

C)
 35% of earnings are paid out as dividends.
D)

Feedback: A payout ratio of 35% for a company indicates that 35% of

earnings are paid out as dividends.

16
INCORRECT Which of the following statements is incorrect about efficient-market theory?
a. The weak form states that prices reflect all the information contained in the
past series of stock prices. In this case it is impossible to earn superior profits
simply by looking for past patterns in stock prices.
b. The semistrong form of the theory states that prices reflect all published
information, so it is impossible to make consistently superior returns just by
reading the newspaper, looking at the company's annual accounts, and so on.
c. The strong form states that stock prices effectively impound all available
information. This form tells us that private information is hard to come by,
because in pursuing it you are in competition with thousandsperhaps millions
of active and intelligent investors. The best you can do in this case is to assume
that securities are fairly priced.
d. The relationship between the information and the levels of market efficiency is
shown in the following Venn's diagram:

a.
A)

b.
B)

c.
C)

d.
D)

17
INCORRECT Which of the following statements is incorrect regarding the present value of a
 stock?
a. Stockholders generally expect to receive cash dividends and capital gains or
losses.
b. The rate of return that stockholders expect over the next year is defined as
the expected dividend per share DIV1 plus the expected increase in price (P1
P0), all divided by the price at the start of the year P0.
c. Unlike the fixed interest payments that the firm promises to bondholders, the
dividends that are paid to stockholders depend on the fortunes of the firm.
That's why a company's common stock is riskier than its debt.
d. The return that investors expect on any one stock is also the return that they
demand on all stocks subject to the same degree of risk. The present value of a
stock equals the present value of the forecast future dividends and future stock
price, using that expected return as the discount rate.

a.
A)

b.
B)

c.
C)

d.
D)

18
INCORRECT Which of the following statements are incorrect in interpreting price-earnings
ratios?
a. We can think of a share's value as the sum of two partsthe value of the
assets in place and the present value of growth opportunities, that is, of future
opportunities for the firm to invest in high-return projects.
b. The price-earnings (P/E) ratio reflects the market's assessment of the firm's
growth opportunities.

a.
A)

b.
B)

both a and b are incorrect.

C)

neither a nor b is incorrect.

D)

Feedback: Both statements are correct.

19
CORRECT Which of the following statements are incorrect regarding the expected rate of
return on a common stock?
 a. The present value of a share is equal to the stream of expected dividends per
share up to some horizon date plus the expected price at this date, all
discounted at the return that investors require.
b. If the horizon date is three-year away, we simply say that stock price equals
the present value of dividends per share for all three years, plus the present
value of the stock at the end of year three. This is the dividend discount model.
In summary, the value of a stock is the present value of the dividends it will pay
over the investor's horizon plus the present value of the expected stock price at
the end of that horizon.
c. If dividends are expected to grow forever at a constant rate g, then the
expected return on the stock is equal to the dividend yield (DIV 1/P0) plus the
expected rate of dividend growth. The value of the stock according to this
constant-growth dividend discount model is P0 = DIV1/(r g).

a.
A)

b.
B)

c.
C)

a and c.
D)

20
INCORRECT Which of the following statements are incorrect regarding applying the random
walk theory to stocks?
a. Successive stock prices are not related.
b. Successive stock price changes are not related.
c. Stock prices fluctuate above and below a normal long-run price.
d. The history of stock prices cannot be used to predict future returns to
investors.

a.
A)

b.
B)

c.
C)

a and c.
D)

Feedback:
Feedback on each choice:
a. False. The levels of successive stock prices are related. If a stock is selling
for $100 per share today, the best guess of its price tomorrow is $100.
b. True. Changes in stock prices are unrelated. Whether a stock price
increases or decreases today has no bearing on whether it will do so
tomorrow.
c. False. There is no such thing as a "normal" price. If there were, you could
make easy profits by buying shares selling below their normal prices (which
would tend to be rising back toward those normal levels) and selling shares
currently selling above their normal prices. Under a random walk, prices are
equally likely to rise or fall.
d. True. Under a random walk, prices are equally likely to over- or
underperform regardless of their past history.