Finance 341

22. What are the three key determinants of the value of most any asset? Explain. We discussed these three key dimensions of performance or value:

1. Level (or size) of cash flow: More value is preferred to less 2. Timing of cash flow: The sooner cash is received the more value it has 3. Risk of cash flow: Less risky cash flows are more valuable than riskier cash flows (or assets)

4. You are scheduled to receive $10,000 in one year. What will be the effect of an increase in the interest rate on the present value of this cash flow? A) It will cause the present value to fall. B) It will cause the present value to rise. C) It will have no effect on the present value. D) The effect cannot be determined with this information.

A

14. You are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too high, but you will be the CEO of the combined, much larger company. You know that when the company gets bigger, your pay and prestige will increase. What is the nature of the agency conflict here and how is it related to ethical considerations? (Select all the choices that apply.) A. There is an ethical dilemma when the CEO of a firm has incentives that are opposite to those of the shareholders. B. There is a legal issue when the CEO of a firm has incentives that are opposite to those of the shareholders. C. In this case, you (as the CEO) have an incentive to potentially overpay for another company (which would be damaging to your shareholders) because your pay and prestige will improve. D. In this case, you (as the CEO) have an incentive to potentially overpay for another company (which would be damaging to your shareholders) because the value of the combined company will improve.

A and C are correct

13. Recall the last time you ate at an expensive restaurant where you paid the bill. Now think about the last time you ate at a similar restaurant, but your parents paid the bill. Did you order more food (or more expensive food) when your parents paid? Explain how this relates to the agency problem in corporations. (Select all the choices that apply.) A. In both situations there may be a lack of interest in controlling costs if those costs are not borne directly by the person making the decision. B. Your situation could never lead to an agency problem since your parents would only want the best for you. C. While you may be faced with an agency problem (spending more when your parents are buying than you would if you were paying), corporate managers are seldom faced with such decisions. D. The agency problem leads an individual (in your case) and corporate managers (in the corporate setting) to put their own self-interest ahead of the interests of the shareholders (your parents in your case).

A and D are correct

15. Why do all shareholders agree on the same goal for the financial manager? (Select all the choices that apply.) A. All of the decisions by the financial manager are made within the context of the overriding goal of financial management—to maximize the wealth of the owners, the stockholders. B. All of the decisions by the financial manager are made within the context of the overriding goal of financial management—to maximize the wealth of the corporation. C. The stockholders have invested in the corporation, putting their money at risk to become the managers of the corporation. D. The stockholders have invested in the corporation, putting their money at risk to become the owners of the corporation.

A and D are correct

10. If $17,000 is invested at 10% per year, in approximately how many years will the investment double? A) 7.3 years B) 8.4 years C) 11.0 years D) 14.6 years

A. Calculate the N with

13. Sara wants to have $600,000 in her savings account when she retires. How much must she put in the account now, if the account pays a fixed interest rate of 8%, to ensure that she has $600,000 in 20 years? A) $128,729 B) $180,221 C) $231,712 D) $139,541

A. Calculate the PV

5. If the rate of interest (r) is 9%, then you should be indifferent about receiving $750 in one year or __. A) $688.07 today B) $750 today C) $825.68 today D) None of the above

A. PV = FV / (1+r)n = 750 / (1+ .09)1 = $688.07 today.

24. What are the advantages and disadvantages of corporations and limited companies?

Advantages: o Unlimited life o Easy transfer of ownership o Limited liability o Ease of raising capital Disadvantages: o Double taxation (Corporation tax and dividends) o Cost of set-up and report filing o Often higher agency costs than other corporate forms

27. Why should interest rates be generally positive?

An investor should be compensated for foregoing current consumption and, everything else remaining the same, a positive interest rate serves to compensate the investor.

3. An annuity is set up that will pay $1500 per year for ten years. What is the present value (PV) of this annuity given that the discount rate is 9%? A) $5776 B) $9626 C) $11,551 D) $13,476

Answer: B. Calculate PV annuity using TVM keys: input number of and interest

7. If the current rate of interest is 7%, then the future value (FV) of an investment that pays $1200 per year and lasts 18 years is closest to ________. A) $24,479 B) $40,799 C) $48,959 D) $57,119

Answer: B. N = 18; I = 7; PMT = $1200; PV = 0; Compute FV = $40,799

6. You are interested in purchasing a new automobile that costs $33,000. The dealership offers you a special financing rate of 9% APR (0.75% per month) for 60 months. Assuming that you do not make a down payment on the auto and you take the dealer's financing deal, then your monthly car payments would be closest to ________. A) $548 B) $685 C) $959 D) $1096

Answer: B. PV = 33,000 ; I = 0.75 ; N = 60 ; FV = 0 ; Compute payment = $685.03.

2. Which of the following investments has a higher present value, assuming the same (strictly positive) interest rate applies to both investments? Year, Investment X, Investment Y 1 $5,000 $11,000 2 $7,000 $9,000 3 $9,000 $7,000 4 $11,000 $5,000 A) Investment X has a higher present value. B) Investment Y has a higher present value. C) Investment X and Investment Y have the same present value, since the total of the cash flows is the same for both. D) No comparison can be made—we need to know the interest rate to calculate the present value.

Answer: B. While the CFs for these investments sum up the same, because Y's CFs are larger earlier, while X's are larger later, the PV of Y's will be greater. Y's CFs are weighted more towards the present, which is more valuable.

9. Clarissa wants to fund a growing perpetuity that will pay $10,000 per year to a local museum, starting next year. She wants the annual amount paid to the museum to grow by 5% per year. Given that the interest rate is 9%, how much does she need to fund this perpetuity? A) $125,000.00 B) $200,000.00 C) $300,000.00 D) $250,000.00

Answer: D PV growth perpetuity = $10,000/(0.09-0.05) = $250,000.00

3. How much would you have to invest today at 9% compounded annually to have $35,000 available for the purchase of a car five years from now? a. $20,267.26 b. $22,747.60 c. $24,147.25 d. $26,370.10 e. $28,149.57

B. PV = FV / (1+r)n = 35000 / (1+ .09)5 = $22,747.60 today (or use your financial calculator)

15. An investment will pay you $120 in one year and $200 in two years. If the interest rate is 4%, what is the present value of these cash flows? A) $304.91 B) $307.69 C) $300.29 D) $320.00

C

2. If the rate of interest (r) is 8%, then you should be indifferent about receiving $500.00 today or ___. A) $462.96 in one year B) $500.00 in one year C) $540.00 in one year D) None of the above

C. FV = PV * (1+r)n = $500.00 × (1.08)1 = $540.00

6. What is the present value (PV) of $90,000 received six years from now, assuming the interest rate is 5% per year? A) $58,500.00 B) $57,085.48 C) $67,159.39 D) $117,528.93

C. Calculate the PV

7. What is the present value (PV) of $50,000 received twenty years from now, assuming the interest rate is 6% per year? A) $32,500.00 B) $13,251.70 C) $15,590.24 D) $27,282.92

C. Calculate the PV

12. Jeff has the opportunity to receive lump-sum payments either now or in the future. Which of the following opportunities is the best, given that the interest rate is 4% per year? A) one that pays $900 now B) one that pays $1080 in two years C) one that pays $1350 in five years D) one that pays $1620 in ten years

C. Calculate with FV = 1350, I = 4%, N = 5, which gives a PV=$1109.60, and this is the highest value compared to the PV of the alternatives.

4. You are saving money to buy a car. If you save $310 per month starting one month from now at an interest rate of 6% APR, compounded monthly, how much will you be able to spend on the car after saving for 4 years? A) $10,062.20 B) $20,124.40 C) $16,770.33 D) $23,478.46

C. Use #periods & periodic rate. N=4*12= 48; I=APR/#periods=6%/12=.5% ; PMT=$310; PV=0; FV = $16,770.33

20. Why do we care so much about cash flows and market values in finance and not about earnings and book values?

Cash flows determine the value of the firm. A share of stock is only worth money because it is a claim to future cash flows, which can be consumed. Market values are forward-looking and estimate the value today of an asset based on its ability to generate cash flows now and into the future. Earnings are not cash flows—they start as cash flows and then make non-cash flow adjustments. Since they are only a poor representation of the underlying cash flows, in finance we instead focus on the cash flows themselves. Book values are historical and backward looking, often having nothing to do with the actual value of an asset or its ability to generate cash flows.

26. If an analyst incorrectly adds cash flows occurring at different points in time, what is the implied assumption in the process?

Cash flows occurring at different points in time cannot be added because a dollar today is worth more than a dollar tomorrow. In other words, these cash flows are not in the same units. The compounding and discounting effect causes these cash flows to be different across time. However, this is only valid for nonzero interest rates. Hence, the implied assumption in adding cash flows across time is that interest rate is zero.

19. Is there a need to distinguish between cash inflows and outflows on a timeline?

Cash inflows and outflows should have opposite signs to give meaningful results that can be used in decision making. One convention that is easier to follow is to assign a positive sign to all cash coming in, i.e., cash inflows, and a negative sign to all cash going out, i.e., cash outflows.

11. An investment will pay $289,940 at the end of next year for an investment of $190,000 at the start of the year. If the market interest rate is 9% over the same period, should this investment be made? A) No, because the investment will yield $82,840 less than putting the money in a bank. B) Yes, because the investment will yield $66,272 more than putting the money in a bank. C) Yes, because the investment will yield $74,556 more than putting the money in a bank. D) Yes, because the investment will yield $82,840 more than putting the money in a bank.

D

14. Which of the following statements is FALSE about valuing cash at different points in time? A) The process of moving forward along the timeline to determine a cash flow's value in the future is known as compounding. B) The effect of earning interest on interest is known as compound interest. C) It is only possible to compare or combine values at the same point in time. D) A dollar in the future is worth more than a dollar today.

D. A dollar in the future is worth less than a dollar today.

8. What is the future value (FV) of $50,000 in thirty years, assuming the interest rate is 6% per year? A) $32,500.00 B) $244,098.38 C) $258,457.10 D) $287,174.56

D. Calculate the FV

5. The monthly mortgage payment on your house is $821.69. It is a 30-year mortgage at a 6.5% APR compounded monthly. How much did you borrow? a. $ 85,000 b. $100,000 c. $115,000 d. $130,000 e. $140,000

D. Use a monthly rate of 6.5%/12, N=30*12=360 mos., & the given PMT; solve for PV. (Ensure FV=0)

1. Which of the following comparison statements is (are) true? I. An annuity has equal payments, a perpetuity does not. II. Both an annuity and a perpetuity are streams of cash flows. III. An annuity covers a longer period of time than a perpetuity. IV. Whereas annuity payments are comprised of interest only, perpetuity payments cover some principal and some interest. V. An annuity may be viewed as the difference between two perpetuities. a. II only b. III only c. I & II only d. II & III only e. II & IV only f. II & V only g. III & IV only h. II, IV, & V z. none of these are correct.

F

21. TRUE/FALSE & EXPLAIN: The goal of a financial manager is to maximize earnings.

FALSE. The goal of the financial manager is to increase the value of the company (increase shareholder wealth). Maximizing earnings is not the same thing. First of all, earnings are not cash flows, but are accounting constructs instead. You can't buy anything with earnings, but you can buy things with cash flows. Second, which earnings should I maximize? I could maximize this year's earnings by not spending anything on future production, thus killing next year's earnings. How should I weight earnings in various years? Luckily, the computation of Net Present Value accounts for the size, timing, and risk of all future cash flows!

23. I have a friend who offered his girlfriend a choice of an engagement ring or $10,000 worth of Google stock. She took the ring and they're still happily married 6 years later. Assuming Google stock earned 12% per year on average over those 6 years, what would the value of the stock have been today?

FV= 10,000(1.12)6 = 19738.23, which can be quickly checked because the rule of 72 says that the value should approximately double (72/12 = 6) in that time

19. What are the main types of decisions that financial managers make? Explain which one you think is more critical to firm value.

From LN 1, we learned that the primary types of decisions that managers make is what projects to pick (capital budgeting decision - what to invest in), how to finance those investments (capital structure decision), and day-to-day cash management (working capital, or liquidity decision). We discussed in class that the investment (capital budgeting) decision is the most important one because it fundamentally determines what the firm does and what its cash flows will be. Financing simply determines how those cash flows will be split between bondholders and shareholders. Whereas investing decisions maximize the value today of the difference between the benefits and the costs, financing decisions tend to create less value, typically by minimizing costs.

8. Which of the following comparison statements is (are) true? I. A perpetuity covers a longer period of time than an annuity. II. Both an annuity and a perpetuity are streams of cash flows. III. A perpetuity can have equal payments, but annuities generally do not have equal payments. IV. Whereas annuity payments are comprised of interest only, perpetuity payments cover some principal and some interest. V. An annuity may be viewed as the difference between two perpetuities. a. II & III only b. I, II, & III only c. I, II & IV only d. II & IV only e. III & IV only f. II & V only g. III & V only h. I, II, & V only z. none of these are correct.

H

11. Joe just inherited the family business, and having no desire to run the family business, he has decided to sell it to an entrepreneur. In exchange for the family business, Joe has been offered an immediate payment of $100,000. Joe will also receive payments of $50,000 in one year, $50,000 in two years, and $75,000 in three years. The current market rate of interest for Joe is 6%. In terms of present value (PV), how much will Joe receive for selling the family business?

In dollar value today, Joe receives: PV = $100,000 + $50,000 / (1.06)1 + $50,000 / (1.06)2 + $75,000 / (1.06)3 = $254,641

25. The objective of a financial manager is to maximize the wealth of the shareholders (also known as maximizing the market value of the assets). Why is this a better objective than maximizing earnings? Why is it better than maximizing market share?

Maximizing earnings is an imprecise and misdirected goal. Earnings are the yearly accounting numbers created for tax purposes. They differ from cash flows due to things like depreciation expense. Shareholders care about cash flows, not earnings, so earnings are not the right numbers to maximize. Further, which earnings do we maximize? This year's or next year's? The value of the assets will appropriately reflect all of the future cash flows generated by those assets, not simply near-term earnings. Maximizing market share is only rarely the same as maximizing shareholders' wealth. I can maximize market share by giving the product away, but that won't make my shareholders any better off.

21. You expect to receive $1000 in one year. A bank is offering loans at 6% interest per year. How much can you borrow today?

Plan: You need to compute the PV of $1000 (a Future Value) based on a 6% discount rate, meaning every $1.06 in one year is worth only $1 today. Execute: PV = FV / (1+r)n = 1000 / (1+ .06)1 = $943.40 today. Or with financial calculator: [1000][FV][1][N][6][I/Y][CPT][PV=][-943.40] Evaluate: If you expect to have $1000 in one year, you could borrow $943.40 today and in one year you would have exactly enough to pay off the loan with 6% interest.

20. You have $100 and a bank is offering 5% interest on the deposits. If you deposit the money in the bank how much will you have in one year?

Plan: You need to compute the future value (FV) based on a 5% interest rate and a present value (PV) of $100. A 5% interest rate means for every $1 today, you get $1.05 in a year. Execute: using the formula, FV = PV * (1+r)n = 100 (1 + .05)1 = $105 in one year. Or with a financial calculator: [-100][PV] [1][N] [5][I/Y] [CPT][FV=][105] Evaluate: $100 today and $105 in one year have equivalent values to you because with $100 today, you could deposit it and have $105 in one year.

23. Identify and justify the goal of the financial manager.

The financial manager's goal is to maximize shareholder wealth. Why maximize the shareholders' wealth? Because it is the shareholders that own the company and it is their wealth most at risk. The financial manager is the caretaker of the shareholders' money (i.e., agent for the stockholders) and his/her job is to make decisions in the best interest of the owners. In general, an increase in stockholders' wealth means that value has been added to a firm's assets (and wealth of society has generally increased.) The way to do this is to make decisions (particularly investment decisions) that maximize the value of the firm, and therefore the value of ownership of that firm. To get full credit you needed to say something about the fact that the money the managers are working with belongs to the shareholders. This idea motivates why it is that managers should maximize shareholder wealth. The two italicized sentences above are sufficient for full credit.

16. Identify the goal of a financial manager and justify that goal (why is it the correct goal?).

The goal of a financial manager is to maximize the wealth of the shareholders (they implement this by maximizing the value of the company's assets). It is the correct goal because shareholders are the owners of the firm. Their money is at risk.

22. What does a "present value" represent? That is, when we say that $1000 to be received 10 years from today has a present value of $558.39, what does that mean?

The present value is what it would cost you today to replicate the future cash flow yourself given your discount rate (or opportunity cost of capital). That is what the future cash flow is worth to us today--what it would cost us to replicate it ourselves and not a penny more. A full credit answer recognizes the notion of opportunity cost, and/or the idea that it would take $558.39 today to replicate that future $1000, given available returns to the investor.

12. A friend who owns a perpetuity that promises to pay $1,000 at the end of each year, forever, comes to you and offers to sell you all of the payments to be received after the 25th year for a price of $1,000. At an interest rate of 10%, should you pay the $1,000 today to receive payment numbers 26 and onwards? What does this suggest to you about the value of perpetual payments?

The present value of the perpetuity is $10,000, and the present value of the first 25 payments is $9,077.04 (use annuity formula), thus you should be willing to pay only $922.96 for payments 26 and onwards. This suggests that the value of a perpetuity is derived primarily from the payments received early in its life, and the payments to be received later have little worth today. Note that you could also find the PV using the two steps for valuing a deferred (or displaced) annuity (see above & below).

18. Explain the determinants of a required rate of return (interest rate).

The required rate of return is comprised of: Real (risk-free) rate of interest, aka the basic time value of money: the price you charge, or compensation you require, even if you are certain to get your money back. Optional addition: Captures an economy's aggregated "time preference for consumption", which also depends on production opportunities. Expected inflation: You must include a component to cover the expected increase in prices (loss in value of your currency) over time. Risk: The riskier is the loan/investment, the higher the return you will require.

14. You will probably want to give something back to the WWU at some point in your lifetime. Assuming that this is money and not a less-than-flattering hand gesture, you could endow a scholarship when you retire. Assume that, 40 years from now, in-state tuition for the WWU will be $90,000. How much would it cost today to endow a scholarship that paid $90,000 per year forever starting 40 years from now? Assume a discount rate of 8% per year, compounded annually.

This is a deferred perpetuity question: 0 1... 0 39 0 40 90,000 41 ... 90,000.... In year 39, when the perpetuity is one year away from starting, it will be worth: 90000/.08=$1,125,000. However it is not year 39; it is today, so the present value today of that $1,125,000 in 39 years is $1,125,000/(1.08)^39=55,927.60. What a bargain!

15. Suppose Elon Musk has decided to give WWU $200 million to fund scholarships. If WWU believes it can reliably earn 4.5% on its invested endowment funds, and assuming it wants the scholarships to keep up with 3% expected inflation (i.e., grow at 3% per year) for the foreseeable future, what amount could it disburse in scholarships next year?

This is a perpetuity with growth (look ahead: we will apply this to dividend-paying stocks). Musk is giving $200 million now to fund scholarships forever. The $200 million is then the present value of a growing perpetuity where the cash flows are paid annually and the first cash flow occurs in one year. The growth rate (g) is 3% (to keep up with inflation) and the discount rate (r) is 4.5%: Check LN3 for equation Thus, WWU could disburse $3 million next year, and then increase that amount with inflation. This assumes that WWU can perpetually continue to earn 4.5% on its investments, of course, and that inflation turns out to be 3%.

17. Why must we convert accounting data (earnings and book values) when performing financial analysis? Explain.

We convert earnings to cash flows because investors care about cash flows. Earnings can be manipulated (both legally and illegally). Investments are made with cash, and therefore investors want cash in return. Book values are historical costs, which are backward-looking. Market values are forward looking and represent the true value of the asset to the firm.

18. How can we make a financial decision with cash flows occurring at different points in time?

We need to transform the cash flows to a single point in time either through using present value (PV) tools (i.e., using exponential computations) or through future value (FV) computations, therefore bringing all of them to the same point in time; then, we can combine them by performing the simple algebraic computation of adding or subtracting.

24. Your friend notices that $1000 invested in small stocks in 1926 would have grown to over $1 million by 1990. He says, "Hey, wait a minute--the annual return on small stocks has averaged only 18% per year over that period. 18% of $1000 is $180, so over those 64 years, the $1000 could have only grown to $12,520 [=1000+(64*180)]. Is this one of those investment scams?!" While you're floored by your friend's knowledge of historical returns, you feel obligated to explain where he's gone wrong in his analysis. Do so in the space below.

Your friend is only looking at the return on the original $1000 investment. He's ignoring the fact that after a year of 18% return, your investment will have grown to $1180. The next year, if you remain fully invested and continue to earn 18%, you will earn 18% on the full $1180, leaving you with $1392.40 and so on. In other words, you friend has focused on simple interest, and forgotten about the effect of compounding or earning interest on interest (or return on return).

12. The primary goal of a publicly-owned firm interested in serving its stockholders should be to a. Maximize the stock price per share over the long run, which is the stock's intrinsic value. b. Maximize the firm's expected EPS. c. Minimize the chances of losses. d. Maximize the firm's expected total income. e. Maximize the stock price on a specific target date.

a. Maximize the stock price per share over the long run, which is the stock's intrinsic value.

13. Assume that you want to endow a scholarship that will pay $10,000 per year forever. The university can invest your money at 9% per year. a. Suppose you want the university to begin paying the annual award in one year. What is the cost of endowing this scholarship today? b. If you want the first scholarship to be awarded today (immediately), how much will it cost to endow the scholarship? c. Suppose instead you instruct the university to delay paying the $10K annual scholarship for 8 years. When you write your check, what amount should you use?

a. This is an ordinary perpetuity, so we can simply use the formula PV=CF/r, or $10,000/0.09 = $111,111.11. [ If this amount earns 9% per year forever, then the university can pay annual interest of .09*(111,111.11) = $10,000 per year indefinitely. Immortality comes cheap! ] b. The cost of a regular perpetuity is PV=CF/r, or $10,000/0.09 = $111,111.11 - this amount captures time periods 1 to infinity. However, this perpetuity starts immediately, so you need to add on the initial payment of $10,000 (already in PV terms) for a total of $121,111.11. c. This is a deferred perpetuity; two steps: step (1) find the cost of the ordinary perpetuity at time 7, one period before the first payment: PVn= CFn+1 / r , so PV7= CF8 / r = $10,000/0.09 = $111,111.11 (emphasis: this is value in time 7 dollars). Then, step (2) discount this amount (a lump sum) seven years: PV = $111,111.11 /(1.09)7 = $60,781.58.

10. a. You want to endow the prestigious YourNameHere scholarship at Western; it will pay $5,000 per year forever, starting one year from now. If the university can earn 5% on its endowment, what amount must you donate to endow the scholarship? b. How much must you donate now, assuming the first scholarship is awarded to a student 20 years from today?

a. Using the PV(perpetuity) = CF/r formula, PV = 5,000/0.05 = 100,000 b. Value this deferred perpetuity in two steps: 1. Calculate the value of the perpetuity in year 19, when it will start in only one year (we already did this in part a.). The value in year 19 is 5,000/0.05 = 100,000. 2. Discount that value back to the present. PV= 100,000/(1.0519) = 39,573.396 = $39,573.40. The price of immortality just became less expensive! Fin. Calculator: You must use formula for step 1. Step 2: FV = 100K, I = 5, N =19, solve for PV.

8. Limited liability is a big advantage of the corporate form of business... a. but the corporation's income is double taxed b. but it is hard to transfer ownership without disrupting the business c. but shareholders can be personally sued if something goes wrong. d. all of the above

a. but the corporation's income is double taxed

3. Which of the following is NOT considered one of the basic questions of corporate finance? a. What long-term investments should the firm choose. b. At what rate of interest should a firm borrow. c. Where will the firm get the long-term financing to pay for its investments. d. What mixture of debt and equity should the firm use to fund its operations. e. How should the firm manage its working capital, i.e., its everyday financial activities.

b. At what rate of interest should a firm borrow.

9. Name two primary differences between a partnership and a corporation. a. General partners have limited liability and are only taxed at the personal level b. Corporate shareholders have limited liability and are double taxed c. A partnership is double taxed and has joint and several liability d. A corporation has joint and several liability and is double taxed

b. Corporate shareholders have limited liability and are double taxed

The fundamental goal of financial management should be: a. Maximize sales. b. Maximize the market value of the existing stock. c. Avoid financial distress. d. Maintain steady earnings growth. e. Maximize profits. f. none of these.

b. Maximize the market value of the existing stock.

10. Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership? a. Corporations generally find it relatively difficult to raise large amounts of capital. b. Less of a corporation's income is generally subjected to taxes than would be true if the firm were a partnership. c. Corporate shareholders escape liability for the firm's debts, although this factor may be somewhat offset by the tax disadvantages of the corporate form of organization. d. Corporate investors are exposed to unlimited liability. e. Corporations generally face relatively few regulations.

c. Corporate shareholders escape liability for the firm's debts, although this factor may be somewhat offset by the tax disadvantages of the corporate form of organization.

1. The future value of a single lump sum invested today will increase more rapidly when: I. The interest rate increases. II. The interest rate decreases. III. The frequency of compounding increases. IV. The frequency of compounding decreases. a. I only. b. III only. c. I & IV only. d. I & III only. e. II & III only. f. None of these.

d

4. You want to pool your resources with your best friend and start your own telecommunications firm. However, you are concerned about the risk this business poses to your accumulated personal wealth. To limit your exposure, you and your friend should organize the business: a. As a general partnership b. As a limited partnership c. As a sole proprietorship d. As a corporation or PLC e. As a real estate investment trust f. none of these.

d. As a corporation or PLC

5. For most financial managers, the correct and fundamental goal of financial management is to: a. Maximize sales. b. Maintain steady earnings growth. c. Avoid financial distress. d. Maximize the market value of the existing stock. e. Maximize profits. f. Maximize market share.

d. Maximize the market value of the existing stock.

11. Which of the following statements is CORRECT? a. The financial manager's proper goal should be to attempt to maximize the firm's market share, since that will add the most to the individual shareholders' wealth. b. The financial manager should seek that combination of assets that will generate the largest expected projected after-tax income over the relevant time horizon, generally the coming year. c. One example of financial managers maximizing value is when they delay a large investment in a project so that the firm may maximize its near-term earnings per share (EPS). d. Potential agency problems can arise between managers and stockholders, because managers hired as agents to act on behalf of the owners may instead make decisions favorable to themselves rather than the stockholders.

d. Potential agency problems can arise between managers and stockholders, because managers hired as agents to act on behalf of the owners may instead make decisions favorable to themselves rather than the stockholders. Note: selection a. is incorrect, because one way to maximize market share is to cut prices, which likely will reduce profitability and therefore the firm's future cash flows.

7. You are planning to borrow money to buy a Porsche. Which of the following is a core determinant of the interest rate the bank might charge you? I. Whether the bank has a branch in your home town. II. Expected inflation. III. The real, risk-free rate of interest. IV. The lender's assessment of your risk as a borrower. V. Your cousin recently missed a payment to the bank. a. I & III only b. II & III only c. I, II, & III only d. II & IV only e. II, III, & IV only f. IV & V only g. I, II & IV only h. I, IV, & V only k. I, II, & V only

e. II, III, & IV only

The mixture of debt and equity used by the firm to finance its operations is called: a. working capital management. b. financial depreciation. c. agency cost analysis. d. capital budgeting. e. capital structure. f. none of these.

e. capital structure.

9. Six years ago, Mason invested $3,500 in an account paying annually compounded interest. No other investments or withdrawals have been made. Today the account is worth $7,000. What annual rate of return has Mason earned thus far? a. 2% b. 10% c. 36% d. 64.01% e. 100% f. None of these.

f. Note that the investment has doubled in 6 years, so use the Rule of 72 for the quickest solution. Rate to double = 72/ # years = 72/6 = 12%, approximately. Or, use r = (FV/PV) 1/t - 1 , r = (7000/3500) 1/6 - 1 = 12.3%

6. Which of the following is considered one of the basic questions of corporate finance? I. Which projects or assets the firm should choose. II. At what rate of interest should a firm borrow. III. How the firm should structure the payment to its employees. IV. What mixture of debt and equity should the firm use to fund its operations. V. How should the firm manage its day-to-day cash levels. a. I & III only b. II & III only c. I, II, & III only d. II & IV only e. II, III, & IV only f. IV & V only g. I, II & IV only h. I, IV, & V only k. I, II, & V only

h. I, IV, & V only

25. A friend wants to borrow $100 from you. She promises to pay you back $115 in two years. What annual interest rate is she offering you?

use your financial calculator with inputs 2=N, -100=PV, 0=PMT, 115=FV, compute I, get 7.238%