FIN 340 EXAM – UPDATED PRACTICE QUESTIONS AND
DETAILED ANSWERS COVERING THE FUNDAMENTALS OF
FINANCIAL MANAGEMENT
Which of the following are reasons why external financing occurs in an
economy? 1. People like to consume the same amount they earn each year, even
if their earnings vary over their lifetimes. 2. Some entrepreneurs do not have
enough money to fund their investment projects, while some individuals have
more than enough money to fund their current consumption. 3. Some
entrepreneurs who have enough money to fund their own projects would prefer
not to "put all their eggs in one basket."
1, 2, and 3
An entrepreneur needs $1,000 to finance a one-year risky project. He can raise
the money from an outside investor either by issuing equity or by issuing debt.
The relationship of the payoff to the outside investor to the final project
outcome is shown below for each of the two cases. If the project is financed
with equity, the payoff to the investor will be given by line ____ and her
ownership share will be ___.
Line X; 80%
In the previous question, the outside investor will bear ____ risk, and the
entrepreneur will bear ____ risk, if the project is financed with debt than if the
project is financed with equity.
less; more
Which of the following are other differences between debt and equity as forms
of external financing? 1. Equity usually comes with more control over
, management. 2.Debt usually comes with more control over management. 3.
Dividends are tax-deductible, while interest expense is not. 4. Interest expense
is tax-deductible, while dividends are not.
1 and 4
Alice has formed an LLC (limited liability corporation) in order to finance a
one-period investment project. The project requires an investment of 1,000 and
has a probability of 0.8 of yielding 2,200 and a probability of 0.2 of yielding
700. If Bob decides to lend the money to Alice at an interest rate of 25%, his
expected rate of return will be ____ %.
14
Bob is trying to finance a one-period investment project that requires an
investment of 1,000 and has a ½ probability of yielding 2,200 and a ½
probability of yielding 800. Alice is considering funding the project with an
equity investment. If she is given 70% ownership, her expected rate of return
will be ____%.
5
Moral hazard arises in external financing only when the user of the funds____.
cannot be easily monitored by the supplier of the funds
When moral hazard arises in equity financing, the supplier of funds is mainly
worried that the user will ____. When moral hazard arises in debt financing, the
supplier of funds is mainly worried that the user will ____.
loaf or waste money on perks; choose risky projects
For adverse selection to arise in debt financing, which of the following
conditions must be met? 1. Lenders have a hard time telling risky borrowers
from safe borrowers. 2. Lenders can easily distinguish risky borrowers from
safe borrowers. 3. An increase in the interest rate causes more risky borrowers
to drop out of the market than safe borrowers. 4. An increase in the interest rate
causes more safe borrowers to drop out of the market than risky borrowers.
1 and 4
The difference between direct and indirect finance is that ____ in direct finance,
while ____ in indirect finance.
DETAILED ANSWERS COVERING THE FUNDAMENTALS OF
FINANCIAL MANAGEMENT
Which of the following are reasons why external financing occurs in an
economy? 1. People like to consume the same amount they earn each year, even
if their earnings vary over their lifetimes. 2. Some entrepreneurs do not have
enough money to fund their investment projects, while some individuals have
more than enough money to fund their current consumption. 3. Some
entrepreneurs who have enough money to fund their own projects would prefer
not to "put all their eggs in one basket."
1, 2, and 3
An entrepreneur needs $1,000 to finance a one-year risky project. He can raise
the money from an outside investor either by issuing equity or by issuing debt.
The relationship of the payoff to the outside investor to the final project
outcome is shown below for each of the two cases. If the project is financed
with equity, the payoff to the investor will be given by line ____ and her
ownership share will be ___.
Line X; 80%
In the previous question, the outside investor will bear ____ risk, and the
entrepreneur will bear ____ risk, if the project is financed with debt than if the
project is financed with equity.
less; more
Which of the following are other differences between debt and equity as forms
of external financing? 1. Equity usually comes with more control over
, management. 2.Debt usually comes with more control over management. 3.
Dividends are tax-deductible, while interest expense is not. 4. Interest expense
is tax-deductible, while dividends are not.
1 and 4
Alice has formed an LLC (limited liability corporation) in order to finance a
one-period investment project. The project requires an investment of 1,000 and
has a probability of 0.8 of yielding 2,200 and a probability of 0.2 of yielding
700. If Bob decides to lend the money to Alice at an interest rate of 25%, his
expected rate of return will be ____ %.
14
Bob is trying to finance a one-period investment project that requires an
investment of 1,000 and has a ½ probability of yielding 2,200 and a ½
probability of yielding 800. Alice is considering funding the project with an
equity investment. If she is given 70% ownership, her expected rate of return
will be ____%.
5
Moral hazard arises in external financing only when the user of the funds____.
cannot be easily monitored by the supplier of the funds
When moral hazard arises in equity financing, the supplier of funds is mainly
worried that the user will ____. When moral hazard arises in debt financing, the
supplier of funds is mainly worried that the user will ____.
loaf or waste money on perks; choose risky projects
For adverse selection to arise in debt financing, which of the following
conditions must be met? 1. Lenders have a hard time telling risky borrowers
from safe borrowers. 2. Lenders can easily distinguish risky borrowers from
safe borrowers. 3. An increase in the interest rate causes more risky borrowers
to drop out of the market than safe borrowers. 4. An increase in the interest rate
causes more safe borrowers to drop out of the market than risky borrowers.
1 and 4
The difference between direct and indirect finance is that ____ in direct finance,
while ____ in indirect finance.
