Review for Finance

What area of finance deals with sources of funding and the capital structure of corporations?

Business Finance.

What is the primary difference between finance and accounting?

Finance focuses on the future, while accounting is backward-looking.

Which sub-specialty of finance involves deciding which assets create more wealth?

Investments.

What is the primary goal of the financial manager of a firm?

To maximize owner wealth.

What should a firm consider when making investment decisions?

Do the benefits of this investment outweigh the costs?

What is the primary aim of personal finance goals?

To maximize one's utility.

What task does a financial manager perform when obtaining a loan for a new project?

Making financing decisions.

Which financial career focuses on investing in privately held firms?

Private Equity.

What task does a financial manager perform when assessing potential project costs and benefits?

Making investment decisions.

What tool helps you understand your overall personal cash flows?

Budgeting.

What is a reasonable alternative to keeping an emergency stash of cash?

Investing in a savings account.

What process is involved when you obtain a mortgage for house payments?

Financing.

What area of finance focuses on which assets to invest in for future wealth?

Investments.

What task is Hannah performing in raising funds for a project she recommended?

Making a financing decision.

What is the objective of setting financial goals, like saving for a trip?

To maximize individual utility.

Which professional helps individuals achieve their financial goals?

Financial Planner.

What is Omar doing when deciding how to pay for a new car?

Financing a goal.

What are the purposes of financial markets?

To provide liquidity and determine prices.

Which market trades securities after their initial issuance?

Secondary Market.

What kind of market allows short-term borrowing and lending?

Money Market.

What market will a company use for its initial public offering (IPO)?

Primary Market.

What is the primary role of financial institutions?

To conduct financial transactions such as investments, loans, and deposits.

What is a depository institution?

An institution that accepts and pays interest on deposits and extends loans.

Which financial institution ensures that a nation’s economy remains healthy by controlling the amount of money circulating in the economy?

Central Banks

How do insurance companies pay policyholders when a claim is made?

Use returns from stocks and bonds.

Which type of financial institution deals mainly with providing for retirement through employers?

Pension Fund.

A large corporation is looking to merge with another large corporation. Which financial institution can help them do this?

Investment Bank.

Unemployment rate is which type of economic indicator?

Lagging

The Federal Reserve sometimes adjusts the interest rate at which commercial banks can borrow from it. What is the purpose of adjusting the interest rate?

To regulate inflation and unemployment.

What would an inverted yield curve signal?

It may indicate an economic downturn (recession).

In what way are coincident indicators useful?

They are analyzed during economic shifts to provide information about the current state of the economy.

Which responsibility is a focus of the U.S. Securities and Exchange Commission (SEC)?

To protect investors.

Which type of financial institution provides individuals and firms with access to financial markets?

Investment Institutions.

Which financial institution includes entities that receive money from institutional investors and wealthy individuals to buy troubled companies to improve them and earn returns by selling them or going public?

Private Equity.

Yield curve is which type of economic indicator?

Leading.

About a year ago, the short-term Treasury bill had 1.54% interest and the long-term Treasury note had 2.54% interest. This week, the 1-year Treasury bill has an interest rate of 3.13%, while the 10-year Treasury note has an interest rate of 2.28%. What does this information indicate about the future economy?

Since the long-term Treasury interest rate is lower than the short-term rate, it has an inverted yield curve, which may indicate a economic downturn (recession).

Which term reflects a person’s beliefs about right and wrong, good and bad, or just and unjust?

Moral(s).

What characterizes an ethical action?

An ethical action is based on accepted standards of conduct.

Lucas is a financial advisor working for Bullzai, Inc. He is faced with a dilemma. Bullzai has started changing its practices in order to increase profit. As a financial advisor, he is now supposed to suggest to clients to invest in portfolios that will not do as well as the portfolios that Bullzai invested in. This is an accepted practice done by other businesses in the industry, and it complies with all standards set by the government. However, Lucas knows that this practice is not in his clients’ best interest. What type of dilemma is Lucas facing?

Moral.

Which type of error would result in a set repercussion or penalty given by the government?

Legal.

Nora is an investment manager, which means that she is paid to invest other people’s money. To meet her goal for the month, she is seeking to invest money from clients in an investment that is risky but potentially has a higher return. What about this situation represents an ethical dilemma?

Nora is considering investing in a risky asset just to meet her monthly goal.

What are the effects of attempting to maximize shareholder value for a business in an unethical way?

It leads to decreased shareholder value for the business.

Why would bondholders set bond contracts that are very strict to deter the company from taking on risky projects?

Bondholders are primarily interested in making sure they will be paid back.

Which kind of projects are bondholders interested in?

Safe projects with a higher chance of providing sufficient compensation.

Which scenario is an example of an agency problem?

A manager purchases a company car and allocates it as a company expense.

How can agency costs be mitigated?

Aligning managers’ interests with shareholders’ interests.

What is the third step in finding a solution to an ethical dilemma?

Consider all stakeholders involved.

What does the term “legal” describe?

An action that is in accordance with the laws and rules set by an authority.

Jack is a personal financial advisor. He is with a new client, and the client is asking him what he recommends for her portfolio. Jack knows that his firm’s investment product performed well last year, but its performance changes from year to year — some years it is better than the market, and some years it is not. Also, the fee to invest in the product is higher than the fee to invest in a market index fund. If Jack sells his company’s investment product, the customer’s loyalty to the company is doubled. Which actions should Jack take?

Give a personal recommendation of the company’s product while explaining its performance relative to the market over the past several years.

Why might a manager manipulate accounting procedures?

To make the company’s performance look good.

Which situation is an example of an agency problem?

Managers follow their own interests instead of the owners’ interests

A company is trying to finance a project with a mortgage loan from a bank. The company’s assessment of the project indicates that the company may experience several years of loss until the project becomes profitable. This means that the company might lose its ability to pay back the loan and the interest on the mortgage. What action might the bank take to protect its interest?

Set a strict covenant that the company cannot easily achieve.

What are the main services offered by financial institutions?

Accepting a wide variety of deposits, offering investment products, providing loans, and brokering financial transactions.

What is the main objective of personal financial goals?

To maximize individual utility.

Which task does the financial manager of a firm perform that involves the issuance of new stocks and bonds?

Making financing decision.

Why is understanding the definition of finance important in managing personal finances?

It helps individuals compare the costs and benefits of an action to determine whether to take that action.

In which type of market would a company issue bonds or stocks for the first time?

Primary Market.

Which type of financial institution is a mutual fund?

Investment Institution.

Which financial institution specializes in managing and administering retirement funds?

Pension Funds.

Which type of economic indicator is the consumer price index?

Leading Indicator.

What does the term “ethical” refer to?

The accepted standards of conduct that guide a person’s behavior.

A company’s officers and board of directors are selling their stocks in the firm at higher prices due to false accounting reports that made the stock seem more valuable than it truly was. Which ethical issue is occurring in this situation?

Agency problem due to conflicting interests.

What is the term for the percentage of the principal that a lender charges a borrower for the use of assets?

Interest Rate.

How is the interest rate expressed?

As a percentage.

What is the main purpose of charging interest?

It allows borrowers to pay to use the assets of another entity to accomplish their own goals.

What is a component of the required rate of return?

Opportunity Cost.

Why would a long-term investment require a higher rate of return?

There is a greater risk involved and a higher opportunity cost.

You just inherited $25,000 from a long-term relative. You decide to put the money in a savings account for the time being. What would be considered an opportunity cost of putting the money in savings?

Buying a brand-new car worth $25,000.

Five years ago, Ahmed decided he was going to save up to purchase a car with cash. The car he wants is priced at $15,000. He saved $245 a month in an account that gave him enough interest to have $15,000 in five years. Today, he pulled out $15,000 from his account to buy the car, but the price of the car is now $16, 562. Which component of the required rate of return did Ahmed forget to consider?

Inflation.

Why is built-in inflation linked to adaptive expectations?

Workers want a higher wage to keep their standard of living as prices increase, which pushes the prices even higher.

Why does an increased demand for goods and services cause inflation?

An increase in demand often causes an insufficient supply in the market, which causes prices to go up until demand is once again equal to the supply.

What happens to prices in a market in which there is inflation?

Prices rise.

What is the compensation for risk to investors?

Risk Premium.

Which type of interest rate is the rate at which invested money grows for a certain period of time?

Nominal Rate.

Which component of an interest rate is an indicator of inflation and opportunity cost?

Risk-Free Rate.

What is the name for the interest rate expressed on an annual basis?

Annual Percentage Rate (APR).

Why is the required rate of return also known as the “hurdle rate”?

It is the minimum rate that a firm must surpass to accept a project.

What is the inflation rate?

The rate at which the average price level of a basket of goods and services in an economy increases.

What does the risk-free rate indicate?

Inflation and Opportunity Cost.

Suppose Sophia is considering a new stock investment for her retirement account. This stock has significant risk, but is quite popular in the market. Inflation for the next few years is expected to be 2-3% per year, and the current U.S. Treasury rates are about 2%. How should she use this information to decide what type of return she can expect from the stock?

Based on the inflation rate, she should expect this stock to provide a return higher than this for the associated risk.

What is the name for a series of equal payments made at the end of consecutive periods over a fixed length of time?

Ordinary Annuity.

If you invest $10,000 today and then $5,000 each year for the next 5 years into an investment with an interest rate of 4%, you can withdraw $39,248.14 in 5 years. What does $39,248.14 represent?

Future Value.

What is the name for the concept that a dollar today is worth more than a dollar in the future?

Time Value of Money (TVM).

You are considering purchasing a house for $250,000. You have two options to finance it. One is a 20-year mortgage with an interest rate of 3.5%, and the other is a 30-year mortgage with an interest rate of 3.5%. Which mortgage option requires you to pay more in total interest?

A 30-year mortgage.

Why does the time value of money play an important role in financial decision-making?

Because the benefits of investments received at different times are comparable only when you consider the time value of money.

You are calculating the present value of an annuity due of $5,000 a year for 20 years. The discount rate is 3%. What should be the “type” input variable of the PV function?

1

You are calculating the future value of an ordinary annuity. You are planning to save $1,000 a year for the next 10 years in an account that gives a 3% interest rate. You set up an Excel sheet as follows:

What should you have in cell C7 in order to calculate the future value correctly and to make sure that any changes in inputs reflect automatically when you change any of the variables in cells C2:C6?

=FV(C2,C3,C4,C5,C6).

You are calculating the lump sum of money needed now in order to withdraw $10,000 a year over the next 5 years from an account that earns a 3% interest rate. Which Excel function should you use?

PV Function.

Which Excel function should you use when you are finding a present value of uneven cash flows to find the PV in one step?

NPV.

Which Excel function should be input to cell C5 to find the interest rate of the following cash flows? Assume the discount rate is 12%.

=IRR(B3:E3).