Financial Management Exam 1 Practice Test

Which of the following works to reduce agency conflicts between stockholders and bondholders? a. Including restrictive covenants in the company's bond contract. b. Providing managers with a large number of stock options. c. The passage of laws that make it easier for companies to resist hostile takeovers. d. Statements b and c are correct. e. All of the statements above are correct.

Agency *Answer: a * Statement a is correct; the other statements are false. Restrictive covenants resolve differences between bondholders and stockholders.

Which of the following actions are likely to reduce the agency problem between stockholders and managers? a. Congress passes a law that severely restricts hostile takeovers. b. A manager receives a lower salary but receives additional shares of the company's stock. c. The board of directors has become more vigilant in its oversight of the company's management. d. Statements b and c are correct. e. All of the statements above are correct.

Agency *Answer: d* Statement a will serve to increase the agency problems by preventing takeovers. Both statements b and c will reduce agency problems.

The Howe family recently bought a house. The house has a 30-year, $165,000 mortgage with monthly payments and a nominal interest rate of 8 percent. What is the total dollar amount of interest the family will pay during the first three years of their mortgage? (Assume that all payments are made at the end of the month.) a. $ 3,297.78 b. $38,589.11 c. $39,097.86 d. $43,758.03 e. $44,589.11

Amortization *Answer: c* Step 1: Determine the monthly payment of the mortgage: Enter the following inputs in the calculator: N = 360; I = 8/12 = 0.6667; PV = -165,000; FV = 0; and then solve for PMT = $1,210.7115. Step 2: Determine the amount of interest during the first 3 years of the mortgage by using the calculator's amortization feature: 2nd PV (AMORT) P1 = 1, P2 = 36 = displays Int: $39,097.8616.

Frank Lewis has a 30-year, $100,000 mortgage with a nominal interest rate of 10 percent and monthly compounding. Which of the following statements regarding his mortgage is most correct? a. The monthly payments will decline over time. b. The proportion of the monthly payment that represents interest will be lower for the last payment than for the first payment on the loan. c. The total dollar amount of principal being paid off each month gets larger as the loan approaches maturity. d. Statements a and c are correct. e. Statements b and c are correct.

Amortization *Answer: e * Statements b and c are correct; therefore, statement e is the correct choice. Monthly payments will remain the same over the life of the loan.

Suppose someone offered you the choice of two equally risky annuities, each paying $10,000 per year for five years. One is an ordinary (or deferred) annuity, the other is an annuity due. Which of the following statements is most correct? a. The present value of the ordinary annuity must exceed the present value of the annuity due, but the future value of an ordinary annuity may be less than the future value of the annuity due. b. The present value of the annuity due exceeds the present value of the ordinary annuity, while the future value of the annuity due is less than the future value of the ordinary annuity. c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity. d. If interest rates increase, the difference between the present value of the ordinary annuity and the present value of the annuity due remains the same. e. Statements a and d are correct.

Annuities *Answer: c* By definition, an annuity due is received at the beginning of the year while an ordinary annuity is received at the end of the year. Because the payments are received earlier, both the present and future values of the annuity due are greater than those of the ordinary annuity.

At an inflation rate of 9 percent, the purchasing power of $1 would be cut in half in 8.04 years. How long to the nearest year would it take the purchasing power of $1 to be cut in half if the inflation rate were only 4 percent? a. 12 years b. 15 years c. 18 years d. 20 years e. 23 years

Effect of inflation *Answer: c* Financial calculator solution: Inputs: I = 4; PV = -1; PMT = 0; FV = 0.50. Output: N = -17.67 18 years.

Elizabeth has $35,000 in an investment account. Her goal is to have the account grow to $100,000 in 10 years without having to make any additional contributions to the account. What effective annual rate of interest would she need to earn on the account in order to meet her goal? a. 9.03% b. 11.07% c. 10.23% d. 8.65% e. 12.32%

Effective annual rate *Answer: b* Enter the following inputs into the calculator: N = 10; PV = -35000; PMT = 0; FV = 100000; and then solve for I = 11.069% » 11.07%.

You recently received a letter from Cut-to-the-Chase National Bank that offers you a new credit card that has no annual fee. It states that the annual percentage rate (APR) is 18 percent on outstanding balances. What is the effective annual interest rate? (Hint: *Remember these companies bill you monthly.*) a. 18.81% b. 19.56% c. 19.25% d. 20.00% e. 18.00%

Effective annual rate *Answer: b* Use the formula for calculating effective rates from nominal rates as follows: EAR = (1 + 0.18/12)12 - l = 0.1956 or 19.56%. 2nd 2 (ICONV); NOM = 18, C/Y = 12, Compute EFF

You are interested in investing your money in a bank account. Which of the following banks provides you with the highest effective rate of interest? a. Bank 1; 8 percent with monthly compounding. b. Bank 2; 8 percent with annual compounding. c. Bank 3; 8 percent with quarterly compounding. d. Bank 4; 8 percent with daily (365-day) compounding. e. Bank 5; 7.8 percent with annual compounding.

Effective annual rate *Answer: d* Statement d is correct; the other statements are false. Looking at responses a through d, you should realize the choice with the greatest frequency of compounding will give you the highest EAR. This is statement d. Now, compare choices d and e. We know EARd > 7.8%; therefore, statement d is the correct choice. The EAR of each of the statements is shown below. EARa = 8.30%; EARb = 8%; EARc = 8.24%; EARd = 8.328%; EARe = 7.8%.

You deposited $1,000 in a savings account that pays 8 percent interest, compounded quarterly, planning to use it to finish your last year in college. Eighteen months later, you decide to go to the Rocky Mountains to become a ski instructor rather than continue in school, so you close out your account. How much money will you receive? a. $1,171 b. $1,126 c. $1,082 d. $1,163 e. $1,008

FV of a sum *Answer: b* Financial calculator solution: Inputs: N = 6; I = 2; PV = -1000; PMT = 0. Output: FV = $1,126.16 $1,126.

Terry Austin is 30 years old and is saving for her retirement. She is planning on making 36 contributions to her retirement account at the beginning of each of the next 36 years. The first contribution will be made today (t = 0) and the final contribution will be made 35 years from today (t = 35). The retirement account will earn a return of 10 percent a year. If each contribution she makes is $3,000, how much will be in the retirement account 35 years from now (t = 35)? a. $894,380 b. $813,073 c. $897,380 d. $987,118 e. $978,688

FV of an annuity *Answer: c* To calculate the solution to this problem, change your calculator to Begin mode. Then enter N = 36-1 = 35 otherwise it would be 36 years from now; I = 10; PV = 0; PMT = 3,000; and then solve for FV = $894,380.4160. Add the last payment of $3,000, and the value at t = 35 is $897,380.4160 » $897,380.

Today is your 23rd birthday. Your aunt just gave you $1,000. You have used the money to open up a brokerage account. Your plan is to contribute an additional $2,000 to the account each year on your birthday, up through and including your 65th birthday, starting next year. The account has an annual expected return of 12 percent. How much do you expect to have in the account right after you make the final $2,000 contribution on your 65th birthday? a. $2,045,442 b. $1,811,996 c. $2,292,895 d. $1,824,502 e. $2,031,435

FV of an annuity *Answer: a* The payments start next year, so the calculator should be in END mode. Enter the following data in your calculator: N = 42; I/Yr = 12; PV = -1000; PMT = -2000. Then solve for FV = $2,045,442.

What is the future value of a 5-year ordinary annuity with annual payments of $200, evaluated at a 15 percent interest rate? a. $ 670.44 b. $ 842.91 c. $1,169.56 d. $1,522.64 e. $1,348.48

FV of an annuity *Answer: e* Financial calculator solution: Inputs: N = 5; I = 15; PV = 0; PMT = -200. Output: FV = $1,348.48.

You just put $1,000 in a bank account that pays 6 percent nominal annual interest, compounded monthly. How much will you have in your account after 3 years? a. $1,006.00 b. $1,056.45 c. $1,180.32 d. $1,191.00 e. $1,196.68

FV under monthly compounding *Answer: e* Financial calculator solution: N = 3 12 = 36; I = 6/12 = 0.5; PV = -1,000; PMT = 0; and then solve for FV = $1,196.68.

Until this year, Cheers Inc. was organized as a partnership. This year, the partners have decided to organize the business as a corporation. As a result of this change in organizational form, which of the following statements is most correct? a. Cheers' shareholders (the ex-partners) will now have limited liability. b. Cheers will now be subject to fewer regulations. c. Cheers will now pay less in taxes. d. Cheers' investors will now find it more difficult to transfer ownership . e. Cheers will now find it more difficult to raise additional capital.

Firm organization *Answer: a* Except for statement a, all the other statements are exactly opposite for corporations.

Which of the following statements is most correct? a. One advantage of forming a corporation is that you have limited liability. b. Corporations face fewer regulations than sole proprietorships. c. One disadvantage of being a sole proprietor is that you have to pay corporate taxes, even though you don't realize the benefits of being a corporation. d. Statements b and c are correct. e. None of the statements above is correct.

Firm organization *Answer: a * Statement a is correct; the others are false. Corporations have limited liability; however, they face more regulations than the other forms of organization. Sole proprietorships do not pay corporate taxes.

Which of the following statements is most correct? a. Corporations are taxed more favorably than sole proprietorships. b. Corporations have unlimited liability. c. Because of their size, large corporations face fewer regulations than smaller corporations and sole proprietorships. d. Reducing the threat of corporate takeover increases the likelihood that managers will act in shareholders' interest. e. Bond covenants are designed to reduce potential conflicts between stockholders and bondholders.

Firm organization *Answer: e* The other statements are incorrect, only e is correct

The primary goal of a publicly-owned firm interested in serving its stockholders should be to a. Maximize expected total corporate profit. b. Maximize expected EPS. c. Minimize the chances of losses. d. Maximize the stock price per share. e. Maximize expected net income.

Goal of firm *Answer: d* The primary financial goal of management is shareholder wealth maximization, which translates to maximizing stock price.

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%

Growth rate *Answer: d* Financial calculator solution: Inputs: N = 30; PV = -1800; PMT = 0; FV = 13700. Output:I = 7.0%.

South Penn Trucking is financing a new truck with a loan of $10,000 to be repaid in 5 annual end-of-year installments of $2,504.56. What annual interest rate is the company paying? a. 7% b. 8% c. 9% d. 10% e. 11%

Interest rate *Answer: b* Financial calculator solution: Inputs: N = 5; PV = - 10000; PMT = 2504.56; FV = 0. Output: I = 8%. When paying back loans, PV is negative while PMT is positive. Effectively reducing the loan every period.

Which of the following is likely to encourage a firm's managers to make decisions that are in the best interest of shareholders? a. Executive compensation comes primarily in the form of stock options. b. The state legislature recently passed a law that makes it more difficult to successfully complete a hostile takeover. c. Institutional investors such as mutual funds and pension funds hold large amounts of the firm's stock. d. Statements a and b are correct. e. Statements a and c are correct.

Managerial incentives *Answer: e* The correct answer is statement e. If compensation comes primarily from stock options, then the managers will be shareholders and will share the same concerns as other shareholders. Therefore, they will make decisions that are in the best interests of shareholders, so statement a is correct. If it is more difficult for hostile takeovers to take place, managers will have less fear of being thrown out of their jobs. Therefore, they will be less concerned with the interests of shareholders. Statement b is incorrect. If institutional investors hold a large amount of the firm's stock, they will like to have more say in the management of the company. (Some may even make sure that they get board seats.) Since they are shareholders and have more influence, they will ensure that managers act in the best interests of shareholders, so statement c is true.

You are considering buying a new car. The sticker price is $15,000 and you have $2,000 to put toward a down payment. If you can negotiate a nominal annual interest rate of 10 percent and you wish to pay for the car over a 5-year period, what are your monthly car payments? a. $216.67 b. $252.34 c. $276.21 d. $285.78 e. $318.71

Monthly loan payments *Answer: c* First, find the monthly interest rate = 0.10/12 = 0.8333%/month. Now, enter in your calculator N = 60; I/YR = 0.8333; PV = -13,000; FV = 0; and then solve for PMT = $276.21.

On its savings accounts, the First National Bank offers a 5 percent nominal interest rate that is compounded monthly. Savings accounts at the Second National Bank have the same effective annual return, but interest is compounded quarterly. What nominal rate does the Second National Bank offer on its savings accounts? a. 5.12% b. 5.00% c. 5.02% d. 1.28% e. 5.22%

Monthly vs. quarterly compounding *Answer: c* There are several ways to do this, but the easiest is with the calculator: Step 1: Find the effective rate on the account with monthly compounding: 2nd 2 (ICONV) NOM% = 5; C/YR = 12; and then solve for EFF% = 5.1162%. Step 2: Translate the effective rate to a nominal rate based on quarterly compounding: EFF% = 5.1162; C/YR = 4; and then solve for NOM% = 5.0209% » 5.02%.

You have the opportunity to buy a perpetuity that pays $1,000 annually. Your required rate of return on this investment is 15 percent. You should be essentially indifferent to buying or not buying the investment if it were offered at a price of a. $5,000.00 b. $6,000.00 c. $6,666.67 d. $7,500.00 e. $8,728.50

PV of a perpetuity = PMT / Interest *Answer: c* PVper = PMT/i = $1,000/0.15 = $6,666.67.

What is the present value of a 5-year ordinary annuity with annual payments of $200, evaluated at a 15 percent interest rate? a. $ 670.43 b. $ 842.91 c. $1,169.56 d. $1,348.48 e. $1,522.64

PV of an annuity *Answer: a* Financial calculator solution: Inputs: N = 5; I = 15; PMT = -200; FV = 0. Output: PV = $670.43.

A real estate investment has the following expected cash flows: Year Cash Flows 1 $10,000 2 25,000 3 50,000 4 35,000 The discount rate is 8 percent. What is the investment's present value? a. $103,799 b. $ 96,110 c. $ 95,353 d. $120,000 e. $ 77,592

PV of an uneven CF stream *Answer: b* NPV = $10,000/1.08 + $25,000/(1.08)2 + $50,000/(1.08)3 + $35,000/(1.08)4 = $9,259.26 + $21,433.47 + $39,691.61 + $25,726.04 = $96,110.38 » $96,110. Financial calculator solution: Using cash flows Inputs: C0 = 0; C01 = 10,000; F01 = 1; C02 = 25,000; F02 = 1; C03 = 50,000; F03 = 1; C04 = 35,000; F04 - 1; NPV; I = 8; Compute NPV Output: NPV = $96,110.39 » $96,110.

Assume that you will receive $2,000 a year in Years 1 through 5, $3,000 a year in Years 6 through 8, and $4,000 in Year 9, with all cash flows to be received at the end of the year. If you require a 14 percent rate of return, what is the present value of these cash flows? a. $ 9,851 b. $13,250 c. $11,714 d. $15,129 e. $17,353

PV of an uneven CF stream *Answer: c* Financial calculator solution: Using cash flows Inputs: C0 = 0; C01 = 2000; F01 = 5; C02 = 3000; F02 = 3; C03 = 4000; F03 = 1, NPV; I = 14; Compute NPV = $11,714

If $100 is placed in an account that earns a nominal 4 percent, compounded quarterly, what will it be worth in 5 years? a. $122.02 b. $105.10 c. $135.41 d. $120.90 e. $117.48

Quarterly compounding *Answer: a* Financial calculator solution: Inputs: N = 20; I = 1; PV = -100; PMT = 0. Output: FV = $122.02.

A bank recently loaned you $15,000 to buy a car. The loan is for five years (60 months) and is fully amortized. The nominal rate on the loan is 12 percent, and payments are made at the end of each month. What will be the remaining balance on the loan after you make the 30th payment? a. $ 8,611.17 b. $ 8,363.62 c. $14,515.50 d. $ 8,637.38 e. $ 7,599.03

Remaining loan balance *Answer: a* Step 1: Solve for the monthly payment: Enter the following input data in the calculator: N = 60; I = 12/12 = 1; PV = -15,000; FV = 0; and then solve for PMT = $333.6667. Step 2: Determine the loan balance remaining after the 30th payment: 1 INPUT 30 n AMORT = displays Int: $3,621.1746 = displays Prin: $6,388.8264 = displays Bal: $8,611.1736. Therefore, the balance will be $8,611.17.

A baseball player is offered a 5-year contract that pays him the following amounts: Year 1: $1.2 million Year 2: 1.6 million Year 3: 2.0 million Year 4: 2.4 million Year 5: 2.8 million Under the terms of the agreement all payments are made at the end of each year. Instead of accepting the contract, the baseball player asks his agent to negotiate a contract that has a present value of $1 million more than that which has been offered. Moreover, the player wants to receive his payments in the form of a 5-year annuity due. All cash flows are discounted at 10 percent. If the team were to agree to the player's terms, what would be the player's annual salary (in millions of dollars)? a. $1.500 b. $1.659 c. $1.989 d. $2.343 e. $2.500

Required annuity payments *Answer: c* Enter CFs: C0 = 0, C01 = 1.2; F01 = 1; C02 = 1.6; F02 = 1; C03 = 2.0; F03 = 1; C04 = 2.4; F04 = 1; C05 = 2.8; F05 = 1; I = 10; NPV = $7.2937 million. $1 + $7.2937 = $8.2937 million. Now, calculate the annual payments: BEGIN mode, N = 5; I/YR = 10; PV = -8.2937; FV = 0; and then solve for PMT = $1.989 million.

If a 5-year ordinary annuity has a present value of $1,000, and if the interest rate is 10 percent, what is the amount of each annuity payment? a. $240.42 b. $263.80 c. $300.20 d. $315.38 e. $346.87

Required annuity payments *Answer: b* Financial calculator solution: Inputs: N = 5; I = 10; PV = -1000; FV = 0 Output: Compute PMT = $263.80.

You are currently investing your money in a bank account that has a nominal annual rate of 7 percent, compounded monthly. How many years will it take for you to double your money? a. 8.67 b. 9.15 c. 9.50 d. 9.93 e. 10.25

Time for a sum to double *Answer: d* I = 7/12; PV = -1; PMT = 0; FV = 2; and then solve for N = 119.17 months = 9.93 years.

Jill currently has $300,000 in a brokerage account. The account pays a 10 percent annual interest rate. Assuming that Jill makes no additional contributions to the account, how many years will it take for her to have $1,000,000 in the account? a. 23.33 years b. 3.03 years c. 16.66 years d. 33.33 years e. 12.63 years

Time for lump sum to grow *Answer: e* Enter the data given in your financial calculator: I = 10; PV = -300,000; PMT = 0; FV = 1,000,000. Then solve for N = 12.63 years.

The future value of a lump sum at the end of five years is $1,000. The nominal interest rate is 10 percent and interest is compounded semiannually. Which of the following statements is most correct? a. The present value of the $1,000 is greater if interest is compounded monthly rather than semiannually. b. The effective annual rate is greater than 10 percent. c. The periodic interest rate is 5 percent. d. Statements b and c are correct. e. All of the statements above are correct.

Time value concepts *Answer: d* Statements b and c are correct; therefore, statement d is the correct choice. The present value is smaller if interest is compounded monthly rather than semiannually.

House cost is $300,000 Down Payment paid is 20% of the House Cost Finance the remaining amount at 4% Annual 30 Years Mortgage Fixed a. Find the Payment b. Find the Balance in 1 Year c. Find the Balance From 36 Months to 56 Months

a. N = 12 x 30 = 360; I/Y = 4/12; PV = -(300,000 - 20%) = 240,000; FV = 0; Compute PMT = 1,145.80 b. 2nd PV (AMORT); P1 = 1; P2 = 12; Balance = 235,773.51 c. 2nd PV (AMORT); P1 = 36; P2 = 56; Balance = 218,748.91