Sample Exam Questions and Answers

1 Sample Exam Questions and Answers 1. Which of the following statements is most correct? a. Proprietorship is generally not easily and inexpensively formed. b. Partnership has limited liability and limited life. c. Corporation has unlimited liability and limited life d. Unlike corporations, proprietorship earnings are subjected to double taxation e. The value of any business other than a very small one will be maximized if it is organized as a corporation. Correct Answer: e 2. Which of the following statements is normally not correct? a. The stock price maximization is the most important goal for most corporations. b. The management actions that maximize stock prices do not benefit society. c. Stock price is generally determined by a company s ability to generate cash flows now and in the future. d. Even though cash flows ultimately determine stockholder value, financial managers cannot ignore EPS, because earnings announcements send messages to investors. e. When conflicts arise between profits and ethics, sometimes the ethical considerations are so strong that they clearly dominate. Correct Answer: b 3. Which of the following statements is generally not correct? a. The information contained in an annual report is not used by investors to form expectations about future earnings and dividends. b. The retained earnings account is built over time as the firm reinvests a part of its earnings rather than paying all earnings out as dividends. c. While the balance sheet can be thought as a snapshot in time, the income statement reports on operations over a period of time. d. Operating capital is the amount of interest bearing debt, preferred stock, and common equity used to acquire the company s net operating assets, that is, net operating working capital plus net plant and equipment. e. Economic Value Added (EVA) shows the value added during a given year, whereas, Market Value Added (MVA) reflects performance over the company s entire life. CSE 8363 / NTU EF 720 - N Final Exam. 1

2 Correct Answer: a 4. Which of the following statements is normally not correct? a. Inventories are typically the least liquid of a firm s current assets. b. An industry average for a financial ratio is not a magic number that all firms should strive to maintain. c. The current ratio is not the best indicator of the extent to which the claims of short-term creditors are covered by assets that are expected to be converted to cash fairly quickly. d. Firms with low debt ratios are less risky, but they also forego the opportunity to leverage up their return on equity. e. P/E ratios are higher for firms with strong growth prospects. Correct Answer: c 5. Which of the following statements is normally not correct? a. Managers employ financial ratios to help analyze, control and thus improve their firms operations b. Firms frequently employ window dressing techniques to make their financial statements look stronger c. Ratio analysis conducted in a mechanical, unthinking manner is dangerous, but used intelligently and with good judgement, it can provide useful insights into a firm s operations. d. Du Pont equation shows how the profit margin, the total assets turnover, and the use of debt interact to determine the return on equity. e. Firms with low debt ratios are less risky, but they also forego the opportunity to leverage up their return on equity. Correct Answer: b 6. Which of the following statements is normally not correct? a. An inverted, or abnormal yield curve means that short-term interest rates are lower than the long-term rates. b. The pure expectations theory assumes that investors establish bond prices and interest rates strictly on the basis of expectations for interest rate. c. According to the liquidity preference theory, borrowers are willing to pay a higher rate, other things held constant, for long-term funds than for short-term funds. d. Bankruptcies increase dramatically when interest rates rise, primarily because many firms use too much short-term debt. e. Inflation has a major impact on interest rates because it erodes the purchasing power of the CSE 8363 / NTU EF 720 - N Final Exam. 2

3 dollar and lowers the real rate of return on investments. Correct Answer: a 7. Which of the following statements is normally not correct? a. Most corporate bonds contain a call provision, which gives the issuing corporation the right to call the bonds for redemption and the provision generally states that the company must pay the bondholders an amount greater than the par value if they are called. b. A call provision is valuable to the firm but it is potentially detrimental to investors. c. The interest earned on most municipal bonds is exempt from federal taxes, and also from state taxes if the holder is a resident of the issuing state. d. Because a stock s value is determined from expected dividends, it means that corporations can increase their stock prices by simply raising the current dividend. e. Preemptive rights give stockholders the right to purchase any new shares sold by the firm. It enables current stockholders to maintain control and protect against a dilution of value. Correct Answer: d 8. Which of the following statements is normally not correct? a. The Efficient Market Hypothesis (EMH) has been tested with many empirical studies and found valid and so, it is impossible for an investor to consistently beat the market. b. Although preferred stock has a fixed payment like bonds, a failure to make this payment will not lead to bankruptcy. c. The cost of capital is a key factor in decisions relating to the use of debt versus equity capital. d. Managers should view companies as ongoing concerns, and calculate their costs of capital as weighted averages of the various types of funds they use, regardless of the specific source of financing employed in a particular year. e. If two projects are of equal size and have the same life, then NPV (Net Present Value) and MIRR (Modified Internal Rate of Return) will always lead to the same decision. Correct Answer: a 9. Which of the following statements is normally not correct? a. Competitive advantage period is the one during which companies can grow at rates higher than the long-term sustainable growth rate. b. The constant ratio method of forecasting assumes that the forecasted percentage of sales for each item is the same as the percentage for the year preceding the forecast period, CSE 8363 / NTU EF 720 - N Final Exam. 3

4 c. Because of the relationship between profit margins and the additional capital requirements, some very rapidly growing firms do not need much external capital. d. A restricted, lean-and-mean current asset investment policy generally provides the highest expected return on the investment, but it entails the greatest risk e. A movement toward the goal of zero working capital generates cash, speeds up production and helps business make more timely deliveries and operate more efficiently. In this context, the definition of working capital is = Inventory + Receivables Current Liabilities. Correct Answer: e 10. Which of the following statements is normally not correct? a. Accounts payable, or trade credit, is the largest single category of short term debt, representing about 40% of the current liabilities of the average non-financial corporation. b. Although banks do make longer-term loans, the bulk of their lending is on a short-term basis. c. The effects of asymmetric information suggest that, to the extent possible, managers should avoid both new common stocks sales and dividend cuts, because both actions tend to lower stock prices. d. In the case of a small company going public for the first time, the investment banker is under some obligation to maintain a market in the shares after the issue has been completed and such stocks are typically traded in the over-the-counter market. e. Under a defined contribution pension plan, the risks fall primarily on the corporation, and under the defined benefit plan the risks are shared between the corporation and the employees. Correct Answer: c CSE 8363 / NTU EF 720 - N Final Exam. 4

5 11. Determine the increase or decrease in cash flow for Rinky Supply Company for last year, given the following information. ( Assume no other changes occurred during the past year) a. -$50K b. +$40K c. $30K d. +$20K e. +$30K Decrease in marketable securities = $25K Increase in accounts receivables = $50K Increase in notes payable = $30K Decrease in accounts payable = $20K Increase in accured wages and taxes = $15K Increase in inventories = $35K Retained earnings = $ 5K Correct Answer: c 12. A company has the following balance sheet. What is its net operating working capital? Cash $ 10 Accounts payable $ 20 Short-term investments 20 Accruals 30 Accounts receivable 30 Notes payable 20 Inventory 40 Current liabilities 70 Current assets 100 Long-term debt 30 Net fixed assets 80 Common equity 10 Retained earnings 70 Total assets $180 Total liab. & equity $180 a. $10 b. $20 c. $30 d. $40 e. $50 Correct Answer: c CSE 8363 / NTU EF 720 - N Final Exam. 5

6 13. In 1958 the average tuition for one year at an Ivy League school was $1,800. Thirty years later, in 1988, the average cost was $13,700. What was the growth rate in tuition over the 30- year period? a. 12% b. 9% c. 6% d. 7% e. 8% Correct Answer: d 14. Dean Brothers Inc. recently reported net income of $1,500,000. The company has 300,000 shares of common stock. The stock currently trades at $60 a share. The company continues to expand and anticipates that one year from now its net income will be $2,500,000. Over the next year the company also anticipates issuing an additional 100,000 shares of stock, so that one year from now the company will have 400,000 shares of common stock. Assuming the company's price/earnings ratio remains at its current level, what will be the company's stock price one year from now? a. $55 b. $60 c. $65 d. $70 e. $75 Correct Answer: e CSE 8363 / NTU EF 720 - N Final Exam. 6

7 15. Assume that the average firm in your company s industry is expected to grow at a constant rate of 6% and its dividend yield is 7%. Your company is about as risky as the average firm in the industry, but it has just successfully completed some R&D work which leads you to expect that its earnings and dividends will grow at a rate of 50% {D 1 =D 0 (1+g)=D 0 (1.5)}this year and 25% the following year, after which growth rate should match the 6% industry average rate. The last dividend paid D 0 was $1. What is the value per share of your company s stock? Correct Answer: 25.032 16. Your company is considering two investment projects each of which requires an up-front expenditure of $15 million. You estimate that the investment will produce the following net cash flows: Project A Project B Year Cash Flow Cash Flow 0 -$15,000,000 -$15,000,000 1 5,000,000 20,000,000 2 10,000,000 10,000,000 3 20,000,000 6,000,000 What are the two projects net present value, assuming the cost of capital is a).10%? b). 5% Correct Answer: a = $12.84M & $15.95M b = $16.11M & $18.30M CSE 8363 / NTU EF 720 - N Final Exam. 7

8 17. Petersen Company has a capital budget of $1.2 million. The company wants to maintain a target capital structure which is 60% debt and 40% equity. The company forecasts that its net income this year will be $600,000. If the company follows a residual dividend policy, what will be its payout ratio? Correct Answer: 20% 18. Phoenix Industries has net income of $2,000,000 and it has 1,000,000 shares of common stock outstanding. The company s stock currently trades at $32 a share. Phoenix is considering a plan where it will use available cash to repurchase 20% of its shares in the open market. The repurchase is expected to have no effect on either net income or the company s P/E ratio. What will be its stock price following the stock repurchase? Correct Answer: $40.00 CSE 8363 / NTU EF 720 - N Final Exam. 8

9 19. The Certainty Company (CC) operates in a world of certainty. It has just hired Mr. Jones, age 20, who will retire at age 65, draw retirement benefits for 15 years, and die at age 80. Mr. Jones s salary is $20,000 per year, but wages are expected to increase at the 5% annual rate. CC has a defined benefit plan in which workers receive 1% of the final year s wage for each year of employed. The retirement benefit, once started, does not have a cost-of-living adjustment. CC earns 10% annually on its pension fund assets. Assume that pension contribution and benefit cash flows occur at year-end. How much will Mr. Jones receive in annual retirement benefits? What is CC s required annual contribution to fully fund Mr. Jones s retirement benefits? Correct Answer: $1,209.84 20. Swann Systems is forecasting the following income statement for the upcoming year: Sales $5,000,000 Operating costs $3,000,000 (excluding depreciation) Gross margin $2,000,000 Depreciation $ 500,000 EBIT $1,500,000 Interest $ 500,000 EBT $1,000,000 Taxes (40%) $ 400,000 Net income (after taxes) $ 600,000 The company's president is disappointed with the forecast and would like to see Swann generate higher sales and a forecasted net income of $1,800,000. Assume that operating costs (excluding depreciation) are always 60 percent of sales. Also, assume that depreciation, interest expense, and the company's tax rate, which is 40 percent, will remain the same even if sales change. What level of sales would Swann have to obtain to generate $1,800,000 in net income? a. $ 5,800,000 b. $ 6,000,000 c. $ 7,200,000 d. $ 8,300,000 e. $10,000,000 Correct Answer: e CSE 8363 / NTU EF 720 - N Final Exam. 9