FIN3403 Exam 1 Conceptual Questions

Your company recently issues new common stock and used the proceeds to reduce its short-term notes payable and accounts payable. This action had no effect on the company's total assets or operating income. Determine which of the following effects did occur as a result of this action.

A. The company's current ratio decreased.

B. The company's basic earning power ratio increased.

C. The company's rime interest earned ratio decreased.

D. The company's debt ratio increased.

E. The company's equity multiplier decreased.

E. The company's equity multiplier decreased.

You have collected the following information regarding Companies C and D:

• The two companies have the same total assets.

• The two companies have the same operating income (EBIT).

• The two companies have the same tax rate.

• Company C has a higher debt ratio and interest expense than Company D.

• Company C has a lower profit margin than Company D.

On the basis of this information, select the statement that is most correct.

• A. Company C must have a higher level of sales.

• B. Company C must have a lower ROE.

• C. Company C must have a higher times interest earned (TIE) ratio.

• D. Company C must have a lower ROA.

• E. Company C must have a higher basic earning power (BEP) ratio.

D. Company C must have a lower ROA.

Which of the following statements is incorrect (least correct)?

• A. If the discount (or interest) rate is positive, the future value of an expected series of payments will always exceed the present value of the same series.

• B. To increase present consumption beyond present income normally requires either the payment of interest (because you have borrowed money) or else an opportunity cost of interest forgone (because you have sold off some of your investments).

• C. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to be greater than its future value.

• D. Disregarding risk, if the present value of a sum is equal to its future value, either the interest rate = 0, or the number of time periods =0.

• E. If the discount (or interest) rate is positive, the future value of annuity due will always be less than the future value of an equivalent regular annuity value of an annuity due will always be less than the present value of an equivalent regular annuity.

E. If the discount (or interest) rate is positive, the future value of annuity due will always be less than the future value of an equivalent regular annuity value of an annuity due will always be less than the present value of an equivalent regular annuity.

Which of the following statements is most correct?

• A. The first payment under a 3-year, annual payment, amortized loan for $1,000 will include a smaller percentage (or fraction) of interest if the interest rate is 5 percent than if it is 10 percent.

• B. If you are lending money, then, based on effective interest rates, you should prefer to lend at a 10 percent nominal, or quoted, rate but with semiannual payments, borrower you should prefer the annual payment loan.

• C. The present value of a perpetuity (say for $100 per year) will approach infinity as the interest rate used to evaluate the perpetuity approaches zero.

• D. Statements b and c are correct

• E. All of the statements above are correct.

All of the statements above are correct.

Assume that the economy has been experiencing relatively high rates of interest due to high levels of inflation. If the Federal Reserve wishes to lower the rate of inflation, then which of the following actions might be most successful in accomplishing their goals?

• A. Buy U.S. Treasury securities for the Federal Reserve portfolio from the general public, which would loosen the money supply, lower interest rates, and help to lower the rate of inflation.

• B. Sell U.S. Treasury securities from the Federal Reserve portfolio to the general public, which would tighten the money supply, increase interest rates, and help to lower the rate of inflation.

• C. Decrease the discount rate and the Fed Funds rate, which would lower interest rates charged by financial institutions and thus lower the rate of inflation.

• D. Decrease the reserve requirement, which would decrease the multiplier effect, tighten the supply of money, and lead to higher interest rates and lower rates of inflation.

• E. Increase the reserve requirement, which would increase the multiplier effect, loosen the supply of money, and lead to lower interest rates and lower rates of inflation.

B. Sell U.S. Treasury securities from the Federal Reserve portfolio to the general public, which would tighten the money supply, increase interest rates, and help to lower the rate of inflation.

If the Federal Reserve sells $50 billion of short-term U.S. Treasury securities to the public, other things held constant, what will this tend to do to short-term security prices and interest rates?

• A. Prices and interest rates will both rise.

• B. Prices will rise and interest rates will decline.

• C. Prices and interest rates will both decline.

• D. Prices will decline and interest rates will rise.

• E. There will be no changes in either prices or interest rates.

D. Prices will decline and interest rates will rise.

If the yield curve is upward sloping, the yield on a 2-year corporate bond must be less than the yield on a 5-year Treasury bond.

• A. True

• B. False

B. False

You are an analyst following two companies, Company A and Company B. You have collected the following information:

• The two companies have the same total assets.

• Company A has a higher total asset turnover than Company B.

• Company A has a higher profit margin than Company B.

• Company B has a higher inventory turnover ratio than Company A.

• Company B has a higher current ratio than Company A.

Select the statement that is least correct.

• Company A must have a higher net income.

• Company A must have a higher ROA.

• Company A must have a higher ROE.

Company A must have a higher ROE.

Which of the following variables is not needed to determine a firm’s free cash flow?

Net income

Assume that a firm has just completed Year 2002 (its second year of operations) and depreciated its fixed assets on a 20-year straight-line basis. Also assume that the firm is profitable (positive net income), makes no additional investment in fixed assets during Year 2003, and that all other factors (sales, other expenses, interest, current assets and liabilities, etc.) are constant from Year 2002 through Year 2003, but that there may be changes in the firm’s equity account. Which of the following would you most expect to observe, comparing results for Year 2002 to Year 2003, if the firm changes its depreciable life assumption from 20 years to 10 years for Year 2003?

Total operating capital (TOC) would decrease.

Last year, your firm had positive net cash flow, yet cash on the balance sheet decreased. Which of the following could explain the firm’s financial performance?

• The company issued new common stock.

• The company issued new long-term debt.

• The company eliminated its dividend.

• The company purchased a lot of new fixed assets.

• The company sold off some of its assets.

The company purchased a lot of new fixed assets.

Last year, your firm had positive net cash flow, yet cash on the balance sheet decreased. Which of the following could explain the firm’s financial performance?

• The company purchased a lot of new fixed assets.

• The company issued new common stock.

• The company issued new long-term debt.

• The company sold off some of its assets.

• The company eliminated its dividend.

The company purchased a lot of new fixed assets.

Which of the following is not a disagreement between finance and accounting?

• How to value assets (historical cost or future cash flows).

• How to value equity (book value or market value)

• Where to record inventory (on the income statement or on the balance sheet).

• What constitutes economic returns (net profit or free cash flows).

Where to record inventory (on the income statement or on the balance sheet).

Which of the following will have a positive effect on the firm’s cash flows?

• Decrease in Working Capital

• Decrease in Inventory

• Decrease in Accounts Receivable

• Increase in Accounts Payable

Looking at just profits can be problematic for a few reasons discussed by Desai and/or class lectures. Which of the following metrics are often as proxies for firm performance focused on cash flows?

• Operating Cash Flow

• Free Cash Flow

• EBITDA

Which of the following is true about free cash flow?

It is for all capital providers and is tax adjusted.

Why does finance add back depreciation and amortization in its measure of economic returns?

Depreciation isn’t a cash expense.

The conservatism principle suggests that firms tend to underestimate the value of their assets and overestimate the value of their liabilities.

True

Which of the following statements is incorrect (least correct)?

• If the Liquidity Preference Theory of the Term Structure is correct, then an upward-slopping yield curve does not necessarily indicate that investors expect one-year spot rates to increase in the future.

• Even with a downward sloping yield curve, a 4-year US Treasury Security will always have a lower yield than a 30-year corporate security.

• A 4-year zero-coupon Treasury Security will always have a lower yield than a 4-year, zero-coupon corporate security.

• One of the ways that the Federal Reserve has to try and keep inflation in check is to tighten the money supply and increase interest rates.

• If investors prefer to lend short-term and firms prefer to borrow long-term, then firms might have to offer a maturity risk premium to get investors to hold long-term bonds.

Even with a downward sloping yield curve, a 4-year US Treasury Security will always have a lower yield than a 30-year corporate security.

All of the following are key factors that affect interest rates in the economy except":

• Expected inflation

• Loan payoff rates

• Time preference for consumption

• Risk

• Production opportunities

Loan payoff rates

Which of the following statements is not (or least) correct?

• For single or lump sum cash flows, present value interest factors and future value interest factors are reciprocal functions of each other.

• The present value, as of Period 0, of an annuity with payments in Periods 1 through N can be found as the difference between a perpetuity with payments in Periods 1 through infinity, and another perpetuity with payments in Periods N + 1 through infinity, where both of the perpetuities are evaluated as of Period 0.

• Time value of money calculations allow us to convert values at one point in time to their equivalent values at another point in time.

• If risk and payments were the same for both, you would not be indifferent between a perpetuity starting in Year 6 and a perpetuity starting in Year 11, even though they might appear to have the same value if you used the equation for the value of a perpetuity (V = D/K).

• Except under continuous compounding/discounting, effective annual rates will always be greater than nominal/stated/quoted rates.

Except under continuous compounding/discounting, effective annual rates will always be greater than nominal/stated/quoted rates.

Assuming that the Pure Expectations Theory of the term structure holds, which of the following statements will be most correct?

• Because of uncertainty, long-term U.S. Treasury securities will have a higher level of default risk than short-term corporate bonds.

• Because they are actively traded and thus have more liquidity, most U.S. Treasury securities will have a higher liquidity premium than corporate bonds that may only be thinly traded.

• Long-term interest rate will be equal to an average of the current spot rate and the spot rates investors expect to observe in the future.

• Because of maturity risk premiums, implied forward rates will either be less than or greater than expected spot rates, but they will not be equal.

• The pure or real rate of interest can be found by observing the actual rate demanded by investors on medium-term (10-15 year) U.S. Treasury bonds.

Long-term interest rate will be equal to an average of the current spot rate and the spot rates investors expect to observe in the future.

A $10,000 loan is to be fully amortized over 5 years, with annual end-of-year payments. Given the following facts, which of these statements is most correct?

• The annual payments would be larger if the interest rate were lower.

• The proportion of interest versus principal repayment would be the same for each of the 5 payments.

• The last payment would have a higher proportion of interest than the first payment.

• The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were higher.

• If the loan could be amortized over 10 years rather than 5 years, and if the interest rate were the same in either case, the first payment would include less dollars of interest under the 10-year plan under the 5-year plan.

The proportion of each payment that represents interest as opposed to repayment of principal would be higher if the interest rate were higher.

In general, we expect interest rates to fall during an economic boom and rise during an economic recession.

False

Determine which of the following investments will have the highest future value at the end of 5 years, assuming that the effective annual rate for all investments is the same.

• The investment pays $100 at the end of every year for the next 5 years (a total of 5 payments).

• The investment pays $50 at the beginning of every 6-month period for the next 5 years (a total of 10 payments).

• The investment pays $500 at the end of 5 years (a total of one payment).

• The investment pays $100 at the beginning of every year for the next 5 years (a total of 5 payments).

• The investment pays $50 at the end of every 6-month period for the next 5 years (a total of 10 payments).

The investment pays $100 at the beginning of every year for the next 5 years (a total of 5 payments).

Which of the following statements is incorrect (least correct)?

• The present value of an N-period annuity (cash flows in Periods 1 through N), evaluated as of Period 0, may be found as the difference between a perpetuity with its first cash flow in Period 1 and a perpetuity with its first cash flow in Period N+1, as long as both perpetuities are evaluated as of Period 0.

• The future value of an N-period annuity (cash flows in Periods 1 through N), evaluated as of Period N, may be found as the difference between a perpetuity with its first cash flow in Period 1 and a perpetuity with its first cash flow in Period N+1, as long as both perpetuities are evaluated as of Period N.

• For an installment loan, the amount of interest paid each period will increase, whereas the amount of principal paid will decrease. Thus, the total payment each period, as shown on an amortization schedule, will remain the same.

• If annual compounding is used, then annual nominal rates will be equal to annual effective rates.

• If compounding is more frequent than once per year, then periodic rates will be less than annual nominal rates.

For an installment loan, the amount of interest paid each period will increase, whereas the amount of principal paid will decrease. Thus, the total payment each period, as shown on an amortization schedule, will remain the same.

Which of the following statements is not (or least) correct?

• For single or lump sum cash flows, present value interest factors and future value interest factors are reciprocal functions of each other.

• If risk and payments were the same for both, you would not be indifferent between a perpetuity starting in Year 6 and a perpetuity starting in Year 11, even though they might appear to have the same value if you used the equation for the value of a perpetuity (V = D/K).

• Except under continuous compounding/discounting, effective annual rates will always be greater than nominal/stated/quoted rates.

• Time value of money calculations allow us to convert values at one point in time to their equivalent values at another point in time.

• The present value, as of Period 0, of an annuity with payments in Periods 1 through N can be found as the difference between a perpetuity with payments in Periods 1 through infinity, and another perpetuity with payments in Periods N+1 through infinity, where both of the perpetuities are evaluated as of Period 0.

Except under continuous compounding/discounting, effective annual rates will always be greater than nominal/stated/quoted rates.

Assume that the expectations theory holds.  Select the statement that is most correct.

• The yield curve for Treasury securities cannot be downward sloping.

• The yield curve for both Treasury securities and corporate securities will be flat.

• If 2-year rates yield more than 1-year rates, investors should not purchase 1-year bonds, and should instead purchase 2-year bonds.

• The yield curve for Treasury securities is flat, but the yield curve for corporate securities is likely to be upward sloping.

• The maturity risk premium is zero.

The maturity risk premium is zero.

If the yield curve is downward sloping, the yield on a 10-year Treasury bond must be less than the yield on an 8-year corporate bond.

True

If the pure expectations theory of the term structure is correct, then an upward sloping yield curve implies a positive maturity risk premium (MRP).

False