Finance Multiple Choice Questions (2015)

| November 24, 2016

Question
Schalheim Sisters Inc. has always paid out all of its earnings as dividends; hence, the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?
The market risk premium declines. The flotation costs associated with issuing new common stock increase. The company’s beta increases. Expected inflation increases. The flotation costs associated with issuing preferred stock increase.
Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?
A B C A project’s IRR increases as the WACC declines.

D E F A project’s NPV increases as the WACC declines.

G H I A project’s MIRR is unaffected by changes in the WACC.

J K L A project’s regular payback increases as the WACC declines.

M N O A project’s discounted payback increases as the WACC declines.
A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT?
The periodic interest rate is greater than 3%.

The periodic rate is less than 3%.

G H I The present value would be greater if the lump sum were discounted back for more periods.

J K L The present value of the $1,000 would be smaller if interest were compounded monthly rather than semiannually.

M N O The PV of the $1,000 lump sum has a higher present value than the PV of a 3-year, $333.33 ordinary annuity. Which of the following statements is CORRECT? One of the disadvantages of incorporating a business is that the owners then become subject to liabilities in the event the firm goes bankrupt.

Sole proprietorships are subject to more regulations than corporations.

In any type of partnership, every partner has the same rights, privileges, and liability exposure as every other partner.

Sole proprietorships and partnerships generally have a tax advantage over many corporations, especially large ones.

Corporations of all types are subject to the corporate income tax. A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio?
A B C Reduce the company’s days’ sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment.

D E F Use cash to repurchase some of the company’s own stock.

G H I Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year.

J K L Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.

M N O Use cash to increase inventory holdings. Aubey Aircraft recently announced that its net income increased sharply from the previous year, yet its net cash flow from operations declined. Which of the following could explain this performance?
A B C The company’s operating income declined.

D E F The company’s expenditures on fixed assets declined.

G H I The company’s cost of goods sold increased.

J K L The company’s depreciation and amortization expenses declined.

M N O The company’s interest expense increased.

A firm’s new president wants to strengthen the company’s financial position. Which of the following actions would make it financially stronger?

A B C Increase accounts receivable while holding sales constant.

D E F Increase EBIT while holding sales constant.

G H I Increase accounts payable while holding sales constant.

J K L Increase notes payable while holding sales constant.

M N O Increase inventories while holding sales constant. Other things held constant, which of the following actions would increase the amount of cash on a company’s balance sheet?
A B C The company repurchases common stock.

D E F The company pays a dividend.

G H I The company issues new common stock.

J K L The company gives customers more time to pay their bills.

M N O The company purchases a new piece of equipment. Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S’s undiscounted net cash flows total $20,000, while L’s total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project’s NPV is more sensitive to changes in the WACC?
A B C Project S.

D E F Project L.

G H I Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital.

J K L Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal.

M N O The solution cannot be determined because the problem gives us no information that can be used to determine the projects’ relative IRRs. Which of the following statements is CORRECT?
A B C If a security analyst saw that a firm’s days’ sales outstanding (DSO) was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength.

D E F If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days’ sales outstanding (DSO) will increase.

G H I There is no relationship between the days’ sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things.

J K L A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.

M N O If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days’ sales outstanding will decline. Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company’s marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?
A B C 0.57%

D E F 0.63%

G H I 0.70%

J K L 0.77%

M N O 0.85% Bosio Inc.’s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company’s cost of preferred stock for use in calculating the WACC?
A B C 8.72%

D E F 9.08%

G H I 9.44%

J K L 9.82%

M N O 10.22% Ellen now has $125. How much would she have after 8 years if she leaves it invested at 8.5% with annual compounding?
A B C $205.83

D E F $216.67

G H I $228.07

J K L $240.08

M N O $252.08 You are considering two mutually exclusive, equally risky, projects. Both have IRRs that exceed the WACC. Which of the following statements is CORRECT? Assume that the projects have normal cash flows, with one outflow followed by a series of inflows.
A B C If the two projects’ NPV profiles do not cross, then there will be a sharp conflict as to which one should be selected.

D E F If the cost of capital is greater than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects. The same project will rank higher by both criteria.

G H I If the cost of capital is less than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects. The same project will rank higher by both criteria.

J K L For a conflict to exist between NPV and IRR, the initial investment cost of one project must exceed the cost of the other.

M N O For a conflict to exist between NPV and IRR, one project must have an increasing stream of cash flows over time while the other has a decreasing stream. If both sets of cash flows are increasing or decreasing, then it would be impossible for a conflict to exist, even if one project is larger than the other.
A company is choosing between two projects. The larger project has an initial cost of $100,000, annual cash flows of $30,000 for 5 years, and an IRR of 15.24%. The smaller project has an initial cost of $50,000, annual cash flows of $16,000 for 5 years, and an IRR of 16.63%. The projects are equally risky. Which of the following statements is CORRECT?
A B C Since the smaller project has the higher IRR, the two projects’ NPV profiles cannot cross, and the smaller project’s NPV will be higher at all positive values of WACC.

D E F Since the smaller project has the higher IRR, the two projects’ NPV profiles will cross, and the larger project will look better based on the NPV at all positive values of WACC.

G H I If the company uses the NPV method, it will tend to favor smaller, shorter-term projects over larger, longer-term projects, regardless of how high or low the WACC is.

J K L Since the smaller project has the higher IRR but the larger project has the higher NPV at a zero discount rate, the two projects’ NPV profiles will cross, and the larger project will have the higher NPV if the WACC is less than the crossover rate.

M N O Since the smaller project has the higher IRR and the larger NPV at a zero discount rate, the two projects’ NPV profiles will cross, and the smaller project will look better if the WACC is less than the crossover rate. The CFO of Shalit Industries plans to have the company issue $300 million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur?
A B C The company’s taxable income would fall.

D E F The company’s interest expense would remain constant.

G H I The company would have less common equity than before.

J K L The company’s net income would increase.

M N O The company would have to pay less taxes.

You deposit $1,000 today in a savings account that pays 3.5% interest, compounded annually. How much will your account be worth at the end of 25 years?
A B C $2,245.08

D E F $2,363.24

G H I $2,481.41

J K L $2,605.48

M N O $2,735.75 Which of the following statements is CORRECT?
A B C The use of debt financing will tend to lower the basic earning power ratio, other things held constant.

D E F A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure.

G H I If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE.

J K L Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favorable basis than income from stock.

M N O All else equal, increasing the debt ratio will increase the ROA.

To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm’s tax rate is 40%, what is the component cost of debt for use in the WACC calculation?
A B C 4.35%

D E F 4.58%

G H I 4.83%

J K L 5.08%

M N O 5.33% You observe that a firm’s ROE is above the industry average, but its profit margin and debt ratio are both below the industry average. Which of the following statements is CORRECT?
A B C Its total assets turnover must be above the industry average.

D E F Its return on assets must equal the industry average.

G H I Its TIE ratio must be below the industry average.

J K L Its total assets turnover must be below the industry average.

M N O Its total assets turnover must equal the industry average.

Which of the following statements is CORRECT?
A B C Capital market instruments include both long-term debt and common stocks.

D E F An example of a primary market transaction would be your uncle transferring 100 shares of Wal-Mart stock to you as a birthday gift.

G H I The NYSE does not exist as a physical location; rather, it represents a loose collection of dealers who trade stocks electronically.

J K L If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction.

M N O While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors.

Which of the following statements is CORRECT?
A B C Typically, a firm’s DPS should exceed its EPS.

D E F Typically, a firm’s EBIT should exceed its EBITDA.

G H I If a firm is more profitable than average (e.g., Google), we would normally expect to see its stock price exceed its book value per share.

J K L If a firm is more profitable than most other firms, we would normally expect to see its book value per share exceed its stock price, especially after several years of high inflation.

M N O The more depreciation a firm has in a given year, the higher its EPS, other things held constant. Which of the following statements is CORRECT?
A B C It is generally more expensive to form a proprietorship than a corporation because, with a proprietorship, extensive legal documents are required.

D E F Corporations face fewer regulations than sole proprietorships.

G H I One disadvantage of operating a business as a sole proprietorship is that the firm is subject to double taxation, at both the firm level and the owner level.

J K L One advantage of forming a corporation is that equity investors are usually exposed to less liability than in a regular partnership.

M N O If a regular partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business. Which of the following items cannot be found on a firm’s balance sheet under current liabilities?
A B C Accounts payable.

D E F Short-term notes payable to the bank.

G H I Accrued wages.

J K L Cost of goods sold.

M N O Accrued payroll taxes. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
A B C Long-term debt.

D E F Accounts payable.

G H I Retained earnings.

J K L Common stock.

M N O Preferred stock. Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L’s IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?
A B C If the WACC is 10%, both projects will have positive NPVs.

D E F If the WACC is 6%, Project S will have the higher NPV.

G H I If the WACC is 13%, Project S will have the lower NPV.

J K L If the WACC is 10%, both projects will have a negative NPV.

M N O Project S’s NPV is more sensitive to changes in WACC than Project L’s.

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Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method?
A B C Lacks an objective, market-determined benchmark for making decisions.

D E F Ignores cash flows beyond the payback period.

G H I Does not directly account for the time value of money.

J K L Does not provide any indication regarding a project’s liquidity or risk.

M N O Does not take account of differences in size among projects.

Which of the following statements is CORRECT? A B C It is usually easier to transfer ownership in a corporation than it is to transfer ownership in a sole proprietorship.

D E F Corporate shareholders are exposed to unlimited liability.

G H I Corporations generally face fewer regulations than sole proprietorships.

J K L Corporate shareholders are exposed to unlimited liability, and this factor may be compounded by the tax disadvantages of incorporation.

M N O Shareholders in a regular corporation (not an S corporation) pay higher taxes than owners of an otherwise identical proprietorship.

Suppose a State of New York bond will pay $1,000 ten years from now. If the going interest rate on these 10-year bonds is 5.5%, how much is the bond worth today?
A B C $585.43

D E F $614.70

G H I $645.44

J K L $677.71

M N O $711.59

Which of the following statements is CORRECT?
A B C Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt is an example of “window dressing.” Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is another example of “window dressing.”

D E F Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of “window dressing.”

G H I Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is an example of “window dressing.”

J K L Using some of the firm’s cash to reduce long-term debt is an example of “window dressing.”

M N O “Window dressing” is any action that improves a firm’s fundamental, long-run position and thus increases its intrinsic value.

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