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Rob's e2700 Notes

✏️ Warm-up Multiple Choice Questions

While I hope these questions are a helpful review, they aren’t representative of exam questions, which I expect to be more challenging, with more critical thinking and many more calculations. Nonetheless, they should be good practice.

Question 1

✏️ Which of the following best describes a conglomerate merger?

  1. Merger between companies that produce the same products.
  2. Merger between companies that operate in completely unrelated business areas.
  3. Merger designed to expand a company’s reach in its current market.
  4. Merger between a company and one of its suppliers or customers.
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B - Merger between companies that operate in completely unrelated business areas.

A conglomerate merger involves companies from completely different industries or markets coming together. This type of merger is often pursued to diversify business operations and reduce exposure to the risks of a single market.

Question 2

✏️ What does the payback period measure in capital budgeting?

  1. The profitability of a project over its entire life.
  2. The time it takes for the project to generate enough cash flow to cover its initial cost.
  3. The discounted cash flows of a project.
  4. The risk associated with the project’s future cash flows.
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B - The time it takes for the project to generate enough cash flow to cover its initial cost.

The payback period is the duration required to recover the cost of an investment. It is a simple measure that helps managers evaluate the risk of an investment, with shorter paybacks often perceived as less risky.

Question 3

✏️ In the context of business structures, what distinguishes a limited partnership from a general partnership?

  1. Limited partners in a limited partnership have no personal liability.
  2. General partnerships require no formal agreement.
  3. Limited partnerships cannot involve money transfer between partners.
  4. All partners in a general partnership have limited liability.
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A - Limited partners in a limited partnership have no personal liability.

In a limited partnership, limited partners enjoy protection from personal liability beyond their investment in the partnership, unlike general partners who have unlimited liability. This structure allows limited partners to invest without the risk of losing more than their stake in the business.

Question 4

✏️ What impact does the corporate tax rate have on the cost of debt?

  1. It increases the cost of debt.
  2. It decreases the cost of debt through a tax shield.
  3. It has no impact on the cost of debt.
  4. It only affects the cost of debt indirectly through inflation adjustments.
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B - It decreases the cost of debt through a tax shield.

The interest expense on debt is tax-deductible, which reduces the actual cost to the company because it saves on taxes, effectively lowering the net expense of the interest payments.

Question 5

✏️ Which statement best describes the use of NPV in project selection?

  1. A project with zero NPV should always be accepted since it breaks even.
  2. Projects with positive NPV should be accepted because they add value to the firm.
  3. Projects with negative NPV are preferred as they represent lower risk.
  4. NPV can be applied only if cash flows are not discounted.
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B - Projects with positive NPV should be accepted because they add value to the firm.

NPV provides a measure of how much value a project adds to the firm. Projects with a positive NPV increase the firm’s value and are therefore desirable, as they are expected to yield returns greater than the cost of capital.

Question 6

✏️ In the context of project evaluation, what does a breakeven analysis determine?

  1. The time it takes for a project to generate a positive cash flow.
  2. The level of a variable at which the NPV of a project is zero.
  3. The discount rate at which the NPV of a project becomes zero.
  4. The variability of investment returns over different time periods.
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B - The level of output at which a project generates neither profit nor loss.

Breakeven analysis identifies the point at which revenue generated from the project equals the costs, resulting in neither a profit nor a loss. This is crucial for understanding the minimum performance required to ensure the project does not lose money.

Question 7

✏️ What is a primary reason for an acquirer to pay a premium over the market price of a target company’s shares during a takeover?

  1. To ensure regulatory compliance.
  2. To quickly divest non-core business units.
  3. To reflect the intrinsic value added by potential synergies and match the competitive bids from other potential acquirers.
  4. Because of MM proposition 1.
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C - To reflect the intrinsic value added by potential synergies and match the competitive bids from other potential acquirers.

Acquirers often pay a premium over the market price of the target’s shares to reflect the additional value they anticipate from synergies such as cost savings, increased market share, or enhanced revenue potential resulting from the merger.

Question 8

✏️ What does the weighted average cost of capital (WACC) represent?

  1. The average rate of return required by all shareholders.
  2. The total dividends paid to shareholders annually.
  3. The average return expected by all capital providers, adjusted for the risk of each capital source.
  4. The interest rate adjusted for the firm’s default risk.
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C - The average return expected by all capital providers, adjusted for the risk of each capital source.

WACC is the average rate of return a company is expected to pay to all its security holders to finance its assets. It is weighted based on the proportion of equity and debt the company is using to finance its assets.

Question 9

✏️ Which scenario is an appropriate use of WACC?

  1. To determine the distribution of dividends to shareholders.
  2. As a discount rate for evaluating the prospective return on investment projects.
  3. To calculate the daily operational cash flows of a company.
  4. To set the annual salary increases for employees.
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B - As a discount rate for evaluating the prospective return on investment projects.

WACC is used as the discount rate in the Net Present Value (NPV) calculation for prospective projects to determine whether these projects can generate returns above the company’s cost of capital.

Question 10

✏️ In the Statement of Cash Flows, what effect does an increase in inventory have on cash flow from operating activities?

  1. It increases cash flow as it represents additional assets.
  2. It decreases cash flow because it is a use of cash.
  3. It has no effect on cash flow as inventory is a non-cash transaction.
  4. It increases cash flow due to higher sales volumes.
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B - It decreases cash flow because it is a use of cash.

An increase in inventory represents cash that has been spent but not yet returned via sales, thereby reducing the cash available from operating activities. This is considered a use of cash.

Question 11

✏️ According to the trade-off theory of capital structure, what does the optimal capital structure balance?

  1. The benefits of tax shields against the cost of issuing new shares.
  2. The costs of equity against the benefits of increased dividends.
  3. The tax benefits from debt against the costs of financial distress.
  4. The interests of debt holders against those of equity holders.
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C - The tax benefits from debt against the costs of financial distress.

The trade-off theory suggests that firms balance the tax advantages of additional debt against the increased costs of potential financial distress. This theory explains why firms might choose an optimal level of debt that does not fully exploit the tax shield benefits of borrowing.

Question 12

✏️ Which type of merger involves companies at different stages of production cycles within the same industry?

  1. Conglomerate merger.
  2. Horizontal merger.
  3. Vertical merger.
  4. Market extension merger.
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C - Vertical merger.

Vertical mergers occur between companies at different stages of production within the same industry. For example, a manufacturer may merge with a supplier or distributor to streamline production and distribution processes, improving efficiency and reducing costs.

Question 13

✏️ What is a primary characteristic of venture capital firms when investing in young companies?

  1. They offer loans that need to be repaid with interest.
  2. They demand significant control of the company in exchange for capital.
  3. They provide funding without expecting any return on investment.
  4. They only invest in public companies to mitigate risks.
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B - They demand significant control of the company in exchange for capital.

Venture capital firms typically require a significant amount of control in the companies they invest in, which can include seats on the board of directors and substantial influence over business decisions, as a way to manage their investment risk and guide the company towards growth.

Question 14

✏️ What is the Accounting Rate of Return (ARR) primarily focused on?

  1. Project’s impact on accounting profits.
  2. Time value of money.
  3. Risk assessment of future cash flows.
  4. Discount rate of cash inflows and outflows.
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A - Project’s impact on accounting profits.

ARR focuses on the project’s effect on the company’s accounting profits, measuring the average annual profit a project generates compared to the investment made. It does not consider the time value of money, which is a limitation compared to other capital budgeting methods like NPV.

Question 15

✏️ What are the typical benefits sought from economies of scale in a merger?

  1. Decreased production costs per unit due to increased production volume.
  2. Increased bargaining power with suppliers and distributors.
  3. Both A and B.
  4. None of the above.
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C - Both A and B.

Economies of scale in a merger typically result in decreased production costs per unit as a result of increased production volume, and can also lead to increased bargaining power with suppliers and distributors, thereby reducing costs and increasing profitability.

Question 16

✏️ What is the primary purpose of using Net Present Value (NPV) in project valuation?

  1. To determine the actual cost of the project in today’s dollars.
  2. To measure the profitability of a project by considering the time value of money.
  3. To calculate the total revenue generated by a project over its lifetime.
  4. To establish a project’s break-even point based on current market trends.
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B - To measure the profitability of a project by considering the time value of money.

NPV is used to assess the profitability of an investment or project by discounting all expected future cash inflows and outflows to the present, taking into account the time value of money. A positive NPV indicates that the projected earnings generated by a project or investment—in present dollars—exceeds the anticipated costs, also in present dollars.

Question 17

✏️ What is the primary function of restrictive covenants in bond indentures?

  1. To grant the issuer the right to delay interest payments.
  2. To protect bondholders by limiting certain activities of the issuer.
  3. To increase the marketability of bonds by reducing their face value.
  4. To allow bondholders to convert bonds into equity at will.
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B - To protect bondholders by limiting certain activities of the issuer.

Restrictive covenants are included in bond agreements to limit the issuer’s actions, such as taking on additional debt or making significant asset sales, which could jeopardize the issuer’s ability to meet existing obligations to bondholders.

Question 18

✏️ A bond issued with a higher interest rate than the market rate will generally:

  1. Sell at a premium because it offers higher returns than similar bonds.
  2. Sell at a discount due to increased risk.
  3. Be callable at par immediately after issuance.
  4. Have no impact on its selling price relative to market rates.
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A - Sell at a premium because it offers higher returns than similar bonds.

Bonds offering higher interest rates than prevailing market rates are attractive to investors seeking better returns, hence they typically sell at a premium.

Question 19

✏️ According to MM, the cost of capital for levered equity (r_E) is calculated by adding what to the cost of unlevered equity?

  1. The product of the debt-to-equity ratio (D/E) and the difference between the return on unlevered equity (rU) and the return on debt (rD).
  2. The dividend yield minus the bond yield.
  3. The corporate tax rate multiplied by the cost of debt.
  4. The inflation rate multiplied by the risk-free rate.
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A - The product of the debt-to-equity ratio (D/E) and the difference between the return on assets (ra) and the return on debt (rd).

This formula from MM Proposition II illustrates how financial leverage affects the required return on equity, incorporating the additional risk imposed on equity holders due to the presence of debt.

Question 20

✏️ What is the primary criticism of EBITDA as highlighted by the case of WorldCom?

  1. It does not include cash flow from financing activities.
  2. It can be manipulated by classifying operational costs incorrectly.
  3. It always overstates the company’s earnings due to tax effects.
  4. It underestimates the company’s liabilities by excluding long-term debt.
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B - It can be manipulated by classifying operational costs incorrectly.

The case of WorldCom demonstrated that companies could manipulate EBITDA by improperly classifying regular operating expenses as capital expenditures, thus inflating earnings and misleading investors about the true financial health of the company.

Question 21

✏️ What is the typical market reaction for the acquiring company’s stock price immediately following the announcement of a takeover?

  1. Significant increase due to potential synergies.
  2. Moderate decrease due to the costs associated with the premium paid.
  3. No change as the market has already priced in the takeover.
  4. Significant decrease due to uncertainty about the merger’s success.
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B - Moderate decrease due to the costs associated with the premium paid.

Typically, the acquiring company’s stock price may experience a moderate decrease immediately following the announcement of a takeover. This reaction can be attributed to the market’s concerns about the costs of the acquisition, including the premium paid, and the integration risks associated with the merger.

Question 22

✏️ What does Modigliani and Miller’s Proposition I state about a firm’s value in perfect capital markets?

  1. It is increased by leveraging.
  2. It is reduced by financial distress costs.
  3. It is unaffected by the capital structure.
  4. It depends on the level of debt only.
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C - It is unaffected by the capital structure.

Modigliani and Miller’s Proposition I posits that in perfect capital markets (where there are no taxes, bankruptcy costs, or agency costs), the value of the firm is determined by its real assets and is independent of the capital structure used to finance the firm.

Question 23

✏️ How does increasing leverage affect a firm’s risk profile?

  1. Increases risk due to higher obligations and potential financial distress.
  2. Decreases risk by diversifying the sources of capital.
  3. Has no effect on risk if managed properly.
  4. Reduces risk by decreasing the cost of capital.
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A - Increases risk due to higher obligations and potential financial distress.

Higher leverage means higher fixed obligations (interest payments) which increase the firm’s risk of financial distress, especially if the firm’s revenues are unstable.

Question 24

✏️ What is the main purpose of conducting a sensitivity analysis in capital budgeting?

  1. To determine the project’s profitability at different levels of sales.
  2. To understand how changes in a single variable affect the project’s NPV.
  3. To calculate the total revenue generated by the project.
  4. To assess the overall risk of the project without considering specific variables.
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B - To understand how changes in a single variable affect the project’s NPV.

Sensitivity analysis is used to determine how the project’s net present value (NPV) is affected by changes in one variable at a time. This helps in understanding the sensitivity of the project’s outcome to changes in critical variables, thereby assessing risk associated with variable fluctuations.

Question 25

✏️ The yield to call on a callable bond is calculated under the assumption that:

  1. The bond will be held to maturity.
  2. The bond will be called as soon as it becomes callable.
  3. Interest rates will remain stable throughout the life of the bond.
  4. The bond will default before the call date.
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B - The bond will be called as soon as it becomes callable.

Yield to call estimates the return on a callable bond assuming it is redeemed by the issuer at the earliest call date, reflecting the reduced time frame for receiving interest payments.

Question 26

✏️ What is a significant drawback of using IRR compared to NPV for evaluating projects?

  1. IRR cannot effectively handle multiple cash flow sign changes.
  2. IRR always provides a clear decision without ambiguity.
  3. IRR is less comprehensive because it does not use cash flows.
  4. IRR calculations are less complex and thus less precise.
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A - IRR cannot effectively handle multiple cash flow sign changes.

One of the main criticisms of IRR is that it can yield multiple values when the project’s cash flows change signs multiple times throughout its life. This can lead to ambiguity in decision-making, unlike NPV, which provides a single, clear value.

Question 27

✏️ What is the primary goal of the financial manager in a corporation?

  1. To minimize operational costs.
  2. To maximize shareholder wealth.
  3. To increase employee satisfaction.
  4. To diversify the company’s investments.
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B - To maximize shareholder wealth.

The main goal of a financial manager is to maximize the wealth of the firm’s owners. In the context of a public company, this means maximizing the stockholders’ wealth, which is typically reflected through the company’s stock price.

Question 28

✏️ How does increasing leverage typically affect a firm’s risk of bankruptcy?

  1. It decreases due to diversified financing sources.
  2. It does not affect the bankruptcy risk.
  3. It increases due to higher obligatory interest payments.
  4. It decreases as equity holders take on more risk.
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C - It increases due to higher obligatory interest payments.

Increasing leverage typically raises the firm’s risk of bankruptcy because higher levels of debt lead to greater fixed obligations (interest payments), which the firm must meet regardless of its operating performance, increasing the potential for financial distress.

Question 29

✏️ What does scenario analysis in project management help determine?

  1. The fixed cost required to start a project.
  2. The effects of combining various sensitivity analysis outcomes.
  3. The most profitable project without considering risks.
  4. The impact of different assumption combinations on a project’s outcome.
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D - The impact of different assumption combinations on a project’s outcome.

Scenario analysis involves evaluating a project’s potential outcomes under different sets of assumptions to understand the impact of various scenarios on project performance. It extends sensitivity analysis by considering multiple variables changing at once.

Question 30

✏️ What is the primary benefit of an auction IPO compared to traditional IPO methods?

  1. It guarantees the highest initial stock price possible.
  2. It allows the underwriters to have more control over the pricing process.
  3. It uses market mechanisms to determine the fair price of the stock.
  4. It involves less risk for the investors buying the IPO shares.
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C - It uses market mechanisms to determine the fair price of the stock.

An auction IPO benefits from market dynamics where bids from potential investors determine the stock’s fair market price, potentially leading to a more accurate valuation based on real-time demand.

Question 31

✏️ Which of the following best describes the agency costs of debt?

  1. Costs that arise from the separation of management and ownership.
  2. Costs related to negotiating and implementing debt contracts.
  3. Fees paid to agencies that rate the creditworthiness of the firm.
  4. Costs incurred from defending against hostile takeovers.
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A - Costs that arise from the separation of management and ownership.

Agency costs of debt refer to conflicts of interest that arise when the goals of corporate managers diverge from those of debt holders, particularly as the firm approaches financial distress and the risk of asset substitution increases.

Question 32

✏️ What is meant by the term “financial distress costs” in corporate finance?

  1. Costs incurred from restructuring debts under Chapter 11.
  2. Costs associated with a firm’s bankruptcy and potential pre-bankruptcy conditions.
  3. Expenses related to the issuance of new equity or debt.
  4. Overhead costs related to maintaining an excessively leveraged position.
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B - Costs associated with a firm’s bankruptcy and potential pre-bankruptcy conditions.

Financial distress costs include both direct costs such as lawyer fees, administrative expenses during bankruptcy, and indirect costs like lost revenues, customer and supplier attrition, and reduced operational efficiency that occur as a firm approaches bankruptcy.

Question 33

✏️ What is the primary benefit of debt financing due to market imperfections like taxes?

  1. Debt increases the overall cost of capital.
  2. Interest payments on debt reduce taxable income, creating a tax shield.
  3. Debt increases the company’s stock price directly.
  4. Interest payments are counted as business expenses, increasing profits.
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B - Interest payments on debt reduce taxable income, creating a tax shield.

The tax shield generated by deducting interest payments from taxable income reduces the overall tax burden of the firm, thereby increasing the value available to all investors.

Question 34

✏️ Why might a company engage in a cash merger or acquisition?

  1. To utilize excess cash reserves effectively.
  2. To avoid the dilution of current shareholders’ equity.
  3. To simplify the transaction process.
  4. All of the above.
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D - All of the above.

Companies may engage in cash mergers or acquisitions to utilize excess cash reserves effectively, avoid dilution of existing shareholders’ equity, and simplify the transaction process, making it quicker and potentially less complicated than stock transactions.

Question 35

✏️ What is a primary drawback of forming a sole proprietorship?

  1. The business does not pay corporate taxes.
  2. The owner has unlimited personal liability.
  3. The business is limited to two owners.
  4. The profits of the business are taxed at the highest corporate rate.
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B - The owner has unlimited personal liability.

The main drawback of a sole proprietorship is that the owner has unlimited personal liability for the business’s debts, which means personal assets are at risk if the business incurs debt or legal issues.

Question 36

✏️ Why is EBITDA often used by analysts and investors to assess a company’s financial health?

  1. It shows the company’s profitability after taxes.
  2. It includes the effects of taxes and interest on earnings.
  3. It excludes non-cash expenses like depreciation and amortization.
  4. It provides a measure of gross revenue only.
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C - It excludes non-cash expenses like depreciation and amortization.

EBITDA is favored because it provides a clear view of the earnings from ongoing operations by excluding non-cash expenses such as depreciation and amortization, which can give a clearer picture of the company’s operational effectiveness and cash-generating ability.

Question 37

✏️ In the context of the Capital Asset Pricing Model (CAPM), what does beta represent?

  1. The dividend growth rate.
  2. The volatility of a stock in relation to the overall market.
  3. The interest rate on corporate bonds.
  4. The expected return on the market.
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B - The volatility of a stock in relation to the overall market.

Beta measures the responsiveness of a stock’s price to changes in the overall market. A higher beta indicates greater volatility compared to the market.

Question 38

✏️ How is the cost of preferred stock typically calculated?

  1. Dividend divided by stock price plus growth rate.
  2. Dividend divided by stock price.
  3. Growth rate multiplied by stock price.
  4. Stock price minus dividend.
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B - Dividend divided by stock price.

The cost of preferred stock is calculated as the dividend expected to be paid on the stock divided by the current price per share. This represents the return investors demand to invest in the preferred stock.

Question 39

✏️ What is the primary reason for a private company to issue preferred stock when selling equity for the first time?

  1. To simplify the valuation process.
  2. To limit voting rights while offering potential conversion to common stock.
  3. Because it is the only option available for private companies.
  4. To maximize the dividend payout to new investors.
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B - To limit voting rights while offering potential conversion to common stock.

Issuing preferred stock allows the company to attract investors by offering dividends and potential conversion to common stock, while limiting the voting rights that would typically come with common stock, thereby maintaining more control with the original owners.

Question 40

✏️ What does a credit risk in bond investment primarily refer to?

  1. The risk that bond prices will decrease due to a rise in interest rates.
  2. The possibility that the bond issuer will fail to make scheduled interest or principal payments.
  3. The risk of the bond’s price increasing, leading to lower yields.
  4. The potential for bond prices to fluctuate based on changes in currency exchange rates.
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B - The possibility that the bond issuer will fail to make scheduled interest or principal payments.

Credit risk in bond investment concerns the issuer’s ability to meet the obligations of interest and principal payments as scheduled, which is critical for bondholders relying on this income.

Question 41

✏️ What is a key feature of a limited liability company (LLC)?

  1. Only one owner can control the company, similar to a sole proprietorship.
  2. All owners have limited liability and can participate in the management of the business.
  3. There must be at least one general partner with unlimited liability.
  4. Owners are personally liable for the company’s debts.
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B - All owners have limited liability and can participate in the management of the business.

Unlike limited partnerships that require at least one general partner with unlimited liability, an LLC allows all owners to enjoy limited liability while still participating in the management of the business, making it a popular choice for its flexibility and protection.

Question 42

✏️ Which of the following is not a task of a financial manager?

  1. Making investment decisions.
  2. Determining employee benefits.
  3. Managing short-term cash needs.
  4. Making financing decisions.
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B - Determining employee benefits.

Determining employee benefits is generally not within the scope of a financial manager’s responsibilities. Their main tasks include making investment and financing decisions, and managing the firm’s cash flow from operating activities.

Question 43

✏️ Which of the following is a characteristic of a callable bond?

  1. It can be converted into equity at the discretion of the bondholder.
  2. It can be redeemed by the issuer before its maturity at predetermined terms.
  3. It grants the bondholder voting rights in the issuing corporation.
  4. It cannot be traded on public markets.
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B - It can be redeemed by the issuer before its maturity at predetermined terms.

Callable bonds include terms that allow the issuer to redeem the bond before its maturity date. This feature provides issuers with flexibility to refinance debt if interest rates decline but typically requires them to pay a premium to bondholders.

Question 44

✏️ What does the Weighted Average Cost of Capital (WACC) represent in corporate finance?

  1. The minimum return that a company must earn on existing assets to satisfy its shareholders.
  2. The rate used exclusively for internal audit purposes.
  3. The discount rate used solely in the valuation of preferred stocks.
  4. The total amount of dividends a company expects to pay out in one fiscal year.
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A - The minimum return that a company must earn on existing assets to satisfy its shareholders.

WACC represents the average cost of capital a company pays for its debt and equity financing, factoring in the weight of each component. It serves as a hurdle rate for evaluating investment projects.

Question 45

✏️ Why might a company want to maintain a low WACC?

  1. To maximize dividend payments to shareholders.
  2. To enhance its borrowing capacity from banks.
  3. To increase its return on investment and enhance shareholder value.
  4. To comply with international financial reporting standards.
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C - To increase its return on investment and enhance shareholder value.

A lower WACC indicates a lower hurdle rate for investments, making it easier for projects to meet the required return threshold, thereby potentially increasing profitability and shareholder value.

Question 46

✏️ In the context of MM Proposition I with taxes, the value of a levered firm is equal to:

  1. The value of an unlevered firm plus the present value of the interest tax shields.
  2. The value of an unlevered firm minus the costs of issuing new debt.
  3. Only the present value of the expected future earnings.
  4. The value of the unlevered firm plus any retained earnings.
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A - The value of an unlevered firm plus the present value of the interest tax shields.

This equation reflects the benefit of the tax shield obtained through interest payments, which adds to the total value of a firm when leverage is included.

Question 47

✏️ Which financial ratio is important in determining the safety of a bond?

  1. Price-to-earnings ratio.
  2. Dividend yield.
  3. Coverage ratio.
  4. Payout ratio.
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C - Coverage ratio.

Coverage ratios, which compare company profits to fixed costs, are essential in assessing bond safety. They indicate how easily a company can handle its fixed expenses, including interest payments on debt.

Question 48

✏️ What is a key characteristic of vertical integration through mergers and acquisitions?

  1. It eliminates competition by absorbing direct competitors.
  2. It involves acquiring companies to access new geographical markets.
  3. It coordinates production and distribution processes to enhance efficiency.
  4. It diversifies the company’s portfolio across different industries.
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C - It coordinates production and distribution processes to enhance efficiency.

Vertical integration through mergers and acquisitions involves acquiring companies that operate at different stages of the production cycle within the same industry. This strategy is aimed at coordinating production and distribution processes to streamline operations and enhance overall efficiency.

Question 49

✏️ What is the role of the board of directors in a corporation?

  1. To manage day-to-day operations.
  2. To elect the CEO.
  3. To make decisions on specific investments.
  4. To directly manage financial operations.
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B - To elect the CEO.

The board of directors is elected by shareholders and holds the ultimate decision-making authority in the corporation. One of their key roles is to elect the Chief Executive Officer (CEO), who is responsible for running the corporation.

Question 50

✏️ According to Modigliani and Miller’s Proposition I, in perfect capital markets, the total value of a firm:

  1. Is maximized when financed entirely by debt.
  2. Is unaffected by its choice of capital structure.
  3. Is dependent on the market’s interest rates.
  4. Decreases as the firm increases its leverage.
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B - Is unaffected by its choice of capital structure.

According to MM Proposition I, in perfect capital markets where there are no taxes, bankruptcy costs, or agency costs, the total value of a firm is determined by its operating assets and is independent of how the firm is financed.

Question 51

✏️ What impact does leveraging have on a firm’s cost of equity, according to Modigliani and Miller’s Proposition II?

  1. It decreases as debt increases due to tax shields.
  2. It remains unchanged regardless of debt levels.
  3. It increases as the debt-to-equity ratio increases.
  4. It has no predictable pattern and is dependent on external market conditions.
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C - It increases as the debt-to-equity ratio increases.

MM Proposition II states that the cost of equity increases linearly with the increase in debt-to-equity ratio. This reflects the increased risk taken on by equity holders as more debt is introduced into the capital structure.

Question 52

✏️ What is a significant disadvantage of the payback period method?

  1. It calculates the exact return on investment.
  2. It considers the profitability of a project after its initial cost is recovered.
  3. It does not account for the time value of money.
  4. It is difficult to understand and apply.
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C - It does not account for the time value of money.

The payback period method does not consider the time value of money, which is a critical flaw. It simply measures how quickly the initial investment can be recovered, ignoring any benefits that occur after the payback period and not discounting the cash flows that contribute to the payback.

Question 53

✏️ What does the term “Yield to Worst” indicate in bond investments?

  1. It is the highest potential yield that can be achieved by holding a bond until maturity.
  2. It represents the lowest possible yield that can be obtained between the yield to call and the yield to maturity.
  3. It measures the bond’s yield assuming no default occurs.
  4. It is a mandatory yield calculation required by international bond markets.
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B - It represents the lowest possible yield that can be obtained between the yield to call and the yield to maturity.

Yield to Worst is a conservative measure used in bond investments to indicate the lowest possible yield an investor might receive on a bond, considering all potential call options versus holding the bond to its maturity.

Question 54

✏️ What is the effect of an additional depreciation expense on a company’s tax bill and cash position?

  1. It decreases both the tax bill and cash position.
  2. It decreases the tax bill and increases the cash position.
  3. It increases both the tax bill and cash position.
  4. It has no effect on the tax bill but increases the cash position.
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B - It decreases the tax bill and increases the cash position.

Additional depreciation expense lowers the taxable income, which decreases the tax bill. Since depreciation is a non-cash expense, the actual cash outflow does not increase, resulting in a net increase in the cash position due to lower taxes paid.

Question 55

✏️ How does depreciation affect a company’s cash flow statement?

  1. It increases cash flow by reducing taxable income.
  2. It decreases cash flow by increasing operational costs.
  3. It has no effect on cash flow as it is a non-cash transaction.
  4. It reduces cash flow by decreasing net income.
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A - It increases cash flow by reducing taxable income.

Depreciation does not directly affect cash flow since it is a non-cash expense; however, it reduces taxable income, which in turn lowers tax payments and effectively increases cash flow.

Question 56

✏️ What kind of decision is a financial manager making when choosing between issuing new equity or borrowing money?

  1. Investment decision.
  2. Financing decision.
  3. Dividend decision.
  4. Working capital decision.
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B - Financing decision.

Choosing between issuing new equity or borrowing money is a financing decision. It involves deciding the best way to raise capital while considering the cost and impact on shareholder value.

Question 57

✏️ What role does Chapter 11 of the Bankruptcy Code play in a firm’s financial strategy?

  1. It mandates the liquidation of the firm’s assets.
  2. It allows the firm to reorganize under a court-approved plan.
  3. It restricts new debt issuances until old debts are settled.
  4. It provides tax relief for up to five years following restructuring.
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B - It allows the firm to reorganize under a court-approved plan.

Chapter 11 of the Bankruptcy Code provides a mechanism for reorganization, where the existing management has the opportunity to restructure the company’s debts and operations to regain profitability, avoiding the firm’s liquidation.

Question 58

✏️ In capital budgeting, why is it important to estimate incremental cash flows rather than total cash flows?

  1. Incremental cash flows only include positive cash flows, enhancing project appeal.
  2. Total cash flows include sunk costs, which do not affect the future decisions.
  3. Incremental cash flows focus on the additional benefits and costs due directly to the project.
  4. Total cash flows overestimate the benefits by including existing operations.
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C - Incremental cash flows focus on the additional benefits and costs due directly to the project.

Incremental cash flows are critical in project evaluation because they consider only the additional cash flows that arise directly from undertaking the project. This method excludes cash flows that the company would generate anyway, ensuring that the project’s actual impact is assessed.

Question 59

✏️ Which component is not included in the calculation of WACC?

  1. Cost of debt.
  2. Tax rate.
  3. Cost of equity.
  4. Cost of retained earnings.
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D - Cost of retained earnings.

WACC calculation typically includes the cost of debt and the cost of equity. The cost of retained earnings is conceptually part of the cost of equity, not a separate component in the WACC formula.

Question 60

✏️ What does the term “post-money valuation” refer to in venture capital financing?

  1. The valuation of a company after deducting all liabilities.
  2. The valuation of a company immediately before a new financing round.
  3. The valuation of a company including the new capital from the latest financing round.
  4. The valuation of a company based solely on its assets.
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C - The valuation of a company including the new capital from the latest financing round.

Post-money valuation includes the amount of new capital injected in the latest financing round, reflecting the company’s value after this investment has been made.

Question 61

✏️ Why is NPV considered a superior method in capital budgeting?

  1. It is simpler to calculate than other methods.
  2. It only focuses on the earnings before interest and taxes.
  3. It considers the time value of money and provides a direct measure of added value.
  4. It uses the accounting rate of return for its calculations.
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C - It considers the time value of money and provides a direct measure of added value.

NPV is considered the best method theoretically because it accounts for the time value of money and measures the value a project adds to the firm. It provides a dollar amount that indicates how much value the project is expected to generate, considering both the inflows and outflows adjusted for the time value of money.

Question 62

✏️ What is the main advantage of using debt financing for a corporation?

  1. It provides voting rights to the lenders.
  2. It does not dilute ownership.
  3. It is free from interest payments.
  4. There is no obligation to repay the debt.
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B - It does not dilute ownership.

Debt financing is advantageous because it does not dilute the ownership stakes of existing shareholders, unlike equity financing which involves issuing new shares.

Question 63

✏️ What describes an IPO underpricing phenomenon?

  1. IPO shares are typically sold at a price above the market value to maximize initial returns.
  2. IPO shares are sold at a discount in aftermarket trading, resulting in initial losses.
  3. IPO shares are priced below their market value at launch, often leading to a first-day price jump.
  4. IPO shares consistently perform well above expectations in the long-term.
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C - IPO shares are priced below their market value at launch, often leading to a first-day price jump.

Underpricing of IPOs is a common phenomenon where shares are intentionally priced below their market value at launch. This often results in a significant price jump on the first day of trading, benefiting initial investors but potentially leaving money on the table for the issuing company.

Question 64

✏️ How does the Internal Rate of Return (IRR) influence project selection?

  1. A project is considered desirable if its IRR is less than the cost of capital.
  2. A project is considered undesirable if its IRR equals the net present value.
  3. A project is considered desirable if its IRR exceeds the project’s discount rate.
  4. A project is rejected if its IRR exceeds the project’s initial cost.
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C - A project is considered desirable if its IRR exceeds the project’s discount rate.

The IRR is the discount rate that makes the NPV of all cash flows from a particular project equal to zero. Projects are typically accepted if their IRR exceeds the prevailing cost of capital because it implies that the project has a return sufficient to compensate for the risk plus the cost of capital.

Question 65

✏️ What is the primary consequence of financial distress according to corporate finance theory?

  1. Increased stock price due to perceived value.
  2. Reduced costs associated with fewer investments.
  3. Increased direct and indirect costs impacting firm value.
  4. Lower interest rates on newly issued bonds.
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C - Increased direct and indirect costs impacting firm value.

Financial distress not only involves direct costs such as legal and administrative expenses but also indirect costs like lost sales, reduced customer trust, and operational inefficiencies, all of which can substantially decrease the overall value of the firm.

Question 66

✏️ Which scenario illustrates an agency problem in a corporation?

  1. A CEO maximizes shareholder wealth by cutting unnecessary costs.
  2. A financial manager invests in a project that is expected to lose money.
  3. A CEO uses company funds for personal benefits.
  4. Shareholders vote on a new board of directors.
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C - A CEO uses company funds for personal benefits.

An agency problem occurs when managers put their own self-interest ahead of the interests of shareholders, such as a CEO using company funds for personal benefits, which detracts from shareholder wealth.

Question 67

✏️ What is the primary advantage of a corporation over a partnership?

  1. Corporations do not allow stock trading.
  2. Owners have limited liability in a corporation.
  3. Corporations are easier and cheaper to form.
  4. All corporate profits are tax-free.
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B - Owners have limited liability in a corporation.

The primary advantage of a corporation is that it provides its owners, who are shareholders, with limited liability, meaning they are legally protected from being personally liable for the corporation’s debts and obligations.

Question 68

✏️ What typically triggers merger waves according to historical trends in corporate control?

  1. Economic recessions and bear markets.
  2. Government interventions in business operations.
  3. Economic expansions and bull markets.
  4. Changes in international trade policies.
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C - Economic expansions and bull markets.

Historical trends show that merger waves, which are peaks of intense merger and acquisition activity, often occur during economic expansions and are correlated with bull markets. These conditions generally boost corporate profits and stock prices, providing firms with better resources and incentives to pursue mergers and acquisitions.

Question 69

✏️ What is the ‘Pecking Order’ hypothesis in capital structure theory?

  1. Firms prefer to issue debt over equity when stocks are undervalued.
  2. Firms prioritize internal financing, followed by debt, and issue equity as a last resort.
  3. Managers choose capital structures based on the pecking order of creditor seniority.
  4. Equity is preferred over debt to avoid the costs associated with financial distress.
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B - Firms prioritize internal financing, followed by debt, and issue equity as a last resort.

The Pecking Order hypothesis suggests that companies prefer to finance new projects using internal funds first (retained earnings), then with debt, and turn to issuing new equity as the last option, primarily to avoid the negative signaling effects associated with new equity issuance.

Question 70

✏️ Which of the following best describes Monte Carlo simulation in capital budgeting?

  1. It uses historical data to predict future outcomes.
  2. It simulates different outcomes based on varying assumptions about key variables.
  3. It provides a precise, single-point estimate of project outcome.
  4. It ignores the variability in key project parameters to simplify analysis.
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B - It simulates different outcomes based on varying assumptions about key variables.

Monte Carlo simulation is a statistical method used in capital budgeting to model and analyze the effects of risk and uncertainty in project forecasting. It runs a large number of simulations to generate possible outcomes for a project based on random variations in input variables.

Question 71

✏️ Which of the following is a true statement about the use of real options in project valuation?

  1. They are irrelevant in the presence of uncertainty and volatility.
  2. They evaluate a project based solely on its initial costs and profits.
  3. They provide flexibility to adapt or revise decisions as a project progresses.
  4. They eliminate the need for traditional project evaluation methods like NPV.
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C - They provide flexibility to adapt or revise decisions as a project progresses.

Real options in project valuation consider the flexibility to make future decisions that can alter the course of the project based on the unfolding of certain events. This approach values the choices available to project managers to adapt, expand, contract, or abandon projects as conditions change.

Question 72

✏️ In a rights offering, what would be a potential outcome if the subscription price is set below the current market price of the stock?

  1. It can lead to undervaluation of the company.
  2. It will likely lead to a dilution of the stock but encourage participation.
  3. It may result in excessive capital raising beyond what is needed.
  4. The company’s stock will likely be delisted from exchanges.
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B - It will likely lead to a dilution of the stock but encourage participation.

Setting the subscription price below the market price in a rights offering can lead to stock dilution as more shares are purchased at a lower price, but it encourages existing shareholders to participate and exercise their rights, securing capital for the company.

Question 73

✏️ What does homemade leverage refer to in the context of perfect capital markets?

  1. The practice of issuing debt to repurchase equity.
  2. Investors using personal borrowing to replicate the effects of corporate leverage.
  3. Companies borrowing on behalf of their shareholders.
  4. Restructuring corporate debt to reduce interest rates.
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B - Investors using personal borrowing to replicate the effects of corporate leverage.

Homemade leverage occurs when investors adjust their personal leverage to offset or replicate the leverage decisions made by the firms in which they hold equity, thereby maintaining their preferred risk exposure.

Question 74

✏️ What role does the discount rate play in the calculation of NPV?

  1. It adjusts future cash flows for risk and the time value of money.
  2. It is used to increase the projected cash flows for inflation.
  3. It represents the expected return on investments of similar risk.
  4. It decreases the initial cost of the project for budgeting purposes.
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A - It adjusts future cash flows for risk and the time value of money.

The discount rate in NPV calculations is crucial as it adjusts the future cash flows to present value, accounting for both the time value of money and the risk associated with the project. A higher discount rate is used for riskier projects, which reduces the present value of future cash inflows.