FOUNDATIONS OF FINANCE 10TH EDITION ORIGINAL
PRACTICE EXAM [QUESTIONS 1-200] AND ANSWERS —
2026/2027 | DETAILED RATIONALES
INTRODUCTION
Foundations of Finance, 10th Edition by Arthur J. Keown, John D. Martin, and J. William Petty
is an undergraduate corporate-finance text centered on valuation and the financial decision-
making process. The 10th edition develops finance through five foundational principles and
applies those principles to decisions involving financial markets, risk and return, valuation,
capital budgeting, financing, and financial management. Pearson describes the text as
emphasizing real-world financial decisions and a multi-step approach to solving financial
problems. (Pearson)
This original practice bank is designed for students preparing for demanding undergraduate
finance examinations based on the major concepts covered by the text. The questions emphasize
application rather than memorization: students must interpret financial information, select
appropriate valuation methods, calculate returns and present values, evaluate projects, analyze
financing choices, and recognize conflicts between managers and owners. The questions
deliberately combine conceptual reasoning with quantitative analysis so that students practice
deciding which financial tool to use, why it applies, and what the result means. Use the bank
alongside the textbook, lecture materials, and instructor-provided objectives for the strongest
preparation.
CORE DOMAINS TESTED
1. Foundations of Financial Management — financial decision-making, value creation,
shareholder wealth, and the role of financial managers.
2. Financial Markets and Institutions — capital markets, intermediaries, securities,
market efficiency, and information.
3. Financial Statements and Analysis — accounting information, ratios, cash flows,
profitability, liquidity, and financial performance.
4. Time Value of Money — present value, future value, annuities, perpetuities, and
compounding.
5. Risk and Return — expected return, variance, standard deviation, diversification,
systematic risk, and required return.
6. Bond Valuation — bond pricing, yields, interest-rate risk, duration concepts, and term
structure.
7. Stock Valuation — dividend-discount models, growth, required return, and market
valuation.
8. Capital Budgeting — NPV, IRR, payback, incremental cash flows, project risk, and
replacement decisions.
9. Cost of Capital — component costs, WACC, capital structure, and project discount
rates.
, 10. Capital Structure and Financing — debt/equity choices, leverage, financial risk, and
financing decisions.
11. Dividend Policy — distributions, retention, investment needs, and shareholder value.
12. Working Capital Management — liquidity, receivables, inventory, payables, and short-
term financing.
13. Financial Planning and Forecasting — projected statements, financing requirements,
growth, and cash planning.
14. Corporate Governance and Agency Issues — managerial incentives, agency costs,
governance mechanisms, and ethical decision-making.
QUESTIONS 1-200
FOUNDATIONS OF FINANCIAL MANAGEMENT
Q1: A firm's CFO is evaluating two mutually exclusive projects. Project A produces larger
accounting profits during the first two years, while Project B produces lower early profits but
substantially higher cash flows and economic value over its life. If the firm's objective is
shareholder wealth maximization, which criterion should dominate the decision?
A) Accounting income in the first year
B) The project's incremental market value created for shareholders
C) Average earnings per share during the first two years
D) The project's total undiscounted accounting profit
Rationale: The correct answer is B because shareholder wealth maximization focuses on the
value created by future incremental cash flows after considering timing and risk. A and D
emphasize accounting measures rather than economic value, while C can be affected by
financing and accounting choices and therefore is not the fundamental objective.
Q2: A manager rejects a project with a positive NPV because the project would increase the
firm's reported depreciation expense. What is the fundamental error?
A) Depreciation should never be considered in capital budgeting
B) Accounting expense has been confused with the project's relevant economic cash flows
C) Positive-NPV projects always increase accounting earnings
D) Depreciation is a financing rather than operating item
Rationale: The correct answer is B because capital budgeting focuses on incremental after-tax
cash flows. Depreciation is noncash, although its tax shield can affect cash flow. A is incorrect
because depreciation matters through taxes; C is not necessarily true; D incorrectly classifies
depreciation.
Q3: A publicly traded company announces a project expected to generate large cash flows, but
investors immediately sell the stock because the project exposes the firm to substantially greater
risk than previously anticipated. Which principle best explains the reaction?
,A) Money has no time value
B) Risk and expected cash flows jointly determine value
C) Accounting earnings determine market value
D) Financing decisions are irrelevant to investors
Rationale: The correct answer is B because investors value risky future cash flows using
required returns appropriate to their risk. A is false because timing matters, C confuses
accounting with valuation, and D is too broad because financing can affect risk and value.
Q4: A CEO receives a bonus based exclusively on annual revenue growth. The CEO then
approves acquisitions that increase revenue but destroy shareholder value. This is most directly
an example of:
A) Market efficiency
B) An agency problem created by poorly designed managerial incentives
C) Diversification benefit
D) Interest-rate risk
Rationale: The correct answer is B because managers may pursue actions that improve their
own compensation rather than shareholder wealth when incentives are misaligned. A, C, and D
do not explain the conflict between managerial objectives and shareholder value.
Q5: An investor can receive €10,000 today or €10,000 five years from now. Assuming a positive
required return, which statement is correct?
A) The two payments have equal economic value
B) The €10,000 received today is more valuable
C) The future payment is more valuable because it avoids inflation
D) Timing is irrelevant if the nominal amount is identical
Rationale: The correct answer is B because money received today can be invested and earn a
return. C is incorrect because inflation generally reduces purchasing power; A and D ignore the
time value of money.
Q6: A firm considers outsourcing a component currently produced internally. Which information
is most important for determining the financial impact?
A) Historical cost of the existing factory
B) Future incremental costs and benefits that differ between the alternatives
C) The original purchase price of the factory
D) Total company-wide fixed costs regardless of the decision
Rationale: The correct answer is B because only relevant future incremental cash flows should
affect the decision. A and C are generally sunk costs, while D includes costs that may not change
because of the decision.
, Q7: A company's share price rises after management announces a restructuring program even
though next year's accounting earnings are expected to fall. What is the most plausible
explanation?
A) Stock markets ignore cash flows
B) Investors expect the restructuring to increase the firm's future economic value
C) Lower earnings always increase stock prices
D) Accounting earnings have no relationship to valuation under any circumstances
Rationale: B is correct because market value reflects expectations about future risk-adjusted
cash flows. A and D are overly absolute, while C incorrectly claims that lower earnings
inherently increase value.
Q8: A financial manager must choose between a project yielding a guaranteed 5% and a risky
project expected to yield 8%. Which additional information is most necessary before making the
decision?
A) The projects' historical accounting depreciation
B) The risk associated with the 8% expected return and the investor's required return
C) The firm's current revenue growth
D) The number of employees assigned to each project
Rationale: B is correct because an expected return cannot be evaluated without considering risk
and the appropriate required return. The other information does not directly establish whether
the additional expected return compensates for additional risk.
Q9: A firm deliberately chooses an investment with a negative NPV because it allows executives
to expand the size of the company and increase their compensation. This decision is inconsistent
with:
A) The liquidity principle
B) The shareholder wealth-maximization objective
C) The matching principle
D) The accounting conservatism principle
Rationale: B is correct because a negative-NPV project destroys economic value under the
assumptions of the analysis. The other principles are not the central objective being violated.
Q10: Which situation most clearly demonstrates the importance of incremental analysis?
A) Evaluating the historical profitability of a completed project
B) Comparing cash flows with and without a proposed investment
C) Recording depreciation on an existing asset
D) Calculating last year's tax expense
PRACTICE EXAM [QUESTIONS 1-200] AND ANSWERS —
2026/2027 | DETAILED RATIONALES
INTRODUCTION
Foundations of Finance, 10th Edition by Arthur J. Keown, John D. Martin, and J. William Petty
is an undergraduate corporate-finance text centered on valuation and the financial decision-
making process. The 10th edition develops finance through five foundational principles and
applies those principles to decisions involving financial markets, risk and return, valuation,
capital budgeting, financing, and financial management. Pearson describes the text as
emphasizing real-world financial decisions and a multi-step approach to solving financial
problems. (Pearson)
This original practice bank is designed for students preparing for demanding undergraduate
finance examinations based on the major concepts covered by the text. The questions emphasize
application rather than memorization: students must interpret financial information, select
appropriate valuation methods, calculate returns and present values, evaluate projects, analyze
financing choices, and recognize conflicts between managers and owners. The questions
deliberately combine conceptual reasoning with quantitative analysis so that students practice
deciding which financial tool to use, why it applies, and what the result means. Use the bank
alongside the textbook, lecture materials, and instructor-provided objectives for the strongest
preparation.
CORE DOMAINS TESTED
1. Foundations of Financial Management — financial decision-making, value creation,
shareholder wealth, and the role of financial managers.
2. Financial Markets and Institutions — capital markets, intermediaries, securities,
market efficiency, and information.
3. Financial Statements and Analysis — accounting information, ratios, cash flows,
profitability, liquidity, and financial performance.
4. Time Value of Money — present value, future value, annuities, perpetuities, and
compounding.
5. Risk and Return — expected return, variance, standard deviation, diversification,
systematic risk, and required return.
6. Bond Valuation — bond pricing, yields, interest-rate risk, duration concepts, and term
structure.
7. Stock Valuation — dividend-discount models, growth, required return, and market
valuation.
8. Capital Budgeting — NPV, IRR, payback, incremental cash flows, project risk, and
replacement decisions.
9. Cost of Capital — component costs, WACC, capital structure, and project discount
rates.
, 10. Capital Structure and Financing — debt/equity choices, leverage, financial risk, and
financing decisions.
11. Dividend Policy — distributions, retention, investment needs, and shareholder value.
12. Working Capital Management — liquidity, receivables, inventory, payables, and short-
term financing.
13. Financial Planning and Forecasting — projected statements, financing requirements,
growth, and cash planning.
14. Corporate Governance and Agency Issues — managerial incentives, agency costs,
governance mechanisms, and ethical decision-making.
QUESTIONS 1-200
FOUNDATIONS OF FINANCIAL MANAGEMENT
Q1: A firm's CFO is evaluating two mutually exclusive projects. Project A produces larger
accounting profits during the first two years, while Project B produces lower early profits but
substantially higher cash flows and economic value over its life. If the firm's objective is
shareholder wealth maximization, which criterion should dominate the decision?
A) Accounting income in the first year
B) The project's incremental market value created for shareholders
C) Average earnings per share during the first two years
D) The project's total undiscounted accounting profit
Rationale: The correct answer is B because shareholder wealth maximization focuses on the
value created by future incremental cash flows after considering timing and risk. A and D
emphasize accounting measures rather than economic value, while C can be affected by
financing and accounting choices and therefore is not the fundamental objective.
Q2: A manager rejects a project with a positive NPV because the project would increase the
firm's reported depreciation expense. What is the fundamental error?
A) Depreciation should never be considered in capital budgeting
B) Accounting expense has been confused with the project's relevant economic cash flows
C) Positive-NPV projects always increase accounting earnings
D) Depreciation is a financing rather than operating item
Rationale: The correct answer is B because capital budgeting focuses on incremental after-tax
cash flows. Depreciation is noncash, although its tax shield can affect cash flow. A is incorrect
because depreciation matters through taxes; C is not necessarily true; D incorrectly classifies
depreciation.
Q3: A publicly traded company announces a project expected to generate large cash flows, but
investors immediately sell the stock because the project exposes the firm to substantially greater
risk than previously anticipated. Which principle best explains the reaction?
,A) Money has no time value
B) Risk and expected cash flows jointly determine value
C) Accounting earnings determine market value
D) Financing decisions are irrelevant to investors
Rationale: The correct answer is B because investors value risky future cash flows using
required returns appropriate to their risk. A is false because timing matters, C confuses
accounting with valuation, and D is too broad because financing can affect risk and value.
Q4: A CEO receives a bonus based exclusively on annual revenue growth. The CEO then
approves acquisitions that increase revenue but destroy shareholder value. This is most directly
an example of:
A) Market efficiency
B) An agency problem created by poorly designed managerial incentives
C) Diversification benefit
D) Interest-rate risk
Rationale: The correct answer is B because managers may pursue actions that improve their
own compensation rather than shareholder wealth when incentives are misaligned. A, C, and D
do not explain the conflict between managerial objectives and shareholder value.
Q5: An investor can receive €10,000 today or €10,000 five years from now. Assuming a positive
required return, which statement is correct?
A) The two payments have equal economic value
B) The €10,000 received today is more valuable
C) The future payment is more valuable because it avoids inflation
D) Timing is irrelevant if the nominal amount is identical
Rationale: The correct answer is B because money received today can be invested and earn a
return. C is incorrect because inflation generally reduces purchasing power; A and D ignore the
time value of money.
Q6: A firm considers outsourcing a component currently produced internally. Which information
is most important for determining the financial impact?
A) Historical cost of the existing factory
B) Future incremental costs and benefits that differ between the alternatives
C) The original purchase price of the factory
D) Total company-wide fixed costs regardless of the decision
Rationale: The correct answer is B because only relevant future incremental cash flows should
affect the decision. A and C are generally sunk costs, while D includes costs that may not change
because of the decision.
, Q7: A company's share price rises after management announces a restructuring program even
though next year's accounting earnings are expected to fall. What is the most plausible
explanation?
A) Stock markets ignore cash flows
B) Investors expect the restructuring to increase the firm's future economic value
C) Lower earnings always increase stock prices
D) Accounting earnings have no relationship to valuation under any circumstances
Rationale: B is correct because market value reflects expectations about future risk-adjusted
cash flows. A and D are overly absolute, while C incorrectly claims that lower earnings
inherently increase value.
Q8: A financial manager must choose between a project yielding a guaranteed 5% and a risky
project expected to yield 8%. Which additional information is most necessary before making the
decision?
A) The projects' historical accounting depreciation
B) The risk associated with the 8% expected return and the investor's required return
C) The firm's current revenue growth
D) The number of employees assigned to each project
Rationale: B is correct because an expected return cannot be evaluated without considering risk
and the appropriate required return. The other information does not directly establish whether
the additional expected return compensates for additional risk.
Q9: A firm deliberately chooses an investment with a negative NPV because it allows executives
to expand the size of the company and increase their compensation. This decision is inconsistent
with:
A) The liquidity principle
B) The shareholder wealth-maximization objective
C) The matching principle
D) The accounting conservatism principle
Rationale: B is correct because a negative-NPV project destroys economic value under the
assumptions of the analysis. The other principles are not the central objective being violated.
Q10: Which situation most clearly demonstrates the importance of incremental analysis?
A) Evaluating the historical profitability of a completed project
B) Comparing cash flows with and without a proposed investment
C) Recording depreciation on an existing asset
D) Calculating last year's tax expense
