1|Page
FOUNDATIONS OF FINANCE 10TH EDITION —
ORIGINAL PRACTICE EXAM QUESTIONS 1-200 |
UPDATED 2026/2027 | DETAILED RATIONALES
INTRODUCTION
Foundations of Finance, 10th Edition by Arthur J. Keown, John D. Martin, and J. William Petty
develops the fundamental principles used to analyze financial decisions in modern organizations.
The text progresses from the role of financial management and financial markets to financial
statement analysis, time value of money, risk and return, security valuation, cost of capital,
capital budgeting, financing decisions, dividend policy, working-capital management, and
international finance. (Pearson)
This practice question bank is designed for students preparing for university-level finance
examinations based on these topics. Rather than testing simple memorization, the questions
emphasize application, quantitative reasoning, interpretation, and decision-making. Each
question contains four alternatives with one best answer, followed by a detailed rationale
explaining both the correct choice and the weaknesses of the alternatives.
The questions are original practice material, not official Pearson examination questions or an
official test bank. They are intended to help students identify conceptual gaps, practice
calculations under exam conditions, and develop the analytical judgment needed for finance
problems.
CORE DOMAINS TESTED
1. Foundations of Financial Management — shareholder wealth maximization, cash flow,
time value, risk, agency relationships, ethics, financial managers, and organizational
forms.
2. Financial Markets and Interest Rates — primary and secondary markets, money and
capital markets, securities issuance, interest-rate determination, inflation, and risk
premiums.
3. Financial Statements and Cash Flows — income statements, balance sheets, cash-flow
relationships, operating/investing/financing activities, and financial decision implications.
4. Financial Performance Analysis — liquidity, asset management, leverage, profitability,
market-value measures, and comparative ratio analysis.
5. Time Value of Money — present value, future value, annuities, perpetuities, effective
rates, and compounding.
6. Risk and Return — expected return, variance, standard deviation, diversification,
systematic risk, beta, and risk premiums.
7. Bond Valuation — coupon payments, yields, prices, duration-related intuition,
premium/discount bonds, and interest-rate effects.
,2|Page
8. Stock Valuation — dividend valuation, growth assumptions, required returns, market
prices, and equity valuation.
9. Cost of Capital — component costs, weighted average cost of capital, capital structure,
and marginal financing costs.
10. Capital Budgeting — NPV, IRR, payback, profitability considerations, mutually
exclusive projects, and investment decisions.
11. Capital-Budgeting Cash Flows — incremental cash flows, depreciation effects, taxes,
working capital, terminal cash flows, and project risk.
12. Financing Mix — debt versus equity, leverage, financial risk, capital structure, and
financing decisions.
13. Dividend Policy and Internal Financing — dividends, retained earnings, payout
decisions, and financing implications.
14. Short-Term Financial Planning — cash budgets, external financing requirements,
forecasting, and liquidity planning.
15. Working-Capital Management — current assets/liabilities, operating cycles, working-
capital policies, and financing strategies.
16. International Business Finance — exchange rates, currency risk, international
investment, and multinational financial decisions.
17. Cash, Receivables, and Inventory Management — cash management, credit policy,
collection decisions, inventory trade-offs, and working-capital efficiency. (Pearson)
QUESTIONS 1-200
Q1
A technology company is considering a project that would increase accounting profit by
$900,000 annually but would require an additional $1.4 million investment in receivables and
inventory. Management argues that the project should be accepted because reported earnings will
increase immediately. Which consideration most directly challenges management's reasoning?
A) Accounting profit is irrelevant to every financial decision
B) Cash flow consequences, including the investment in working capital, must be
considered when evaluating shareholder wealth
C) An increase in working capital always decreases accounting profit
D) Projects should be accepted whenever earnings per share increases
Rationale: The correct answer is B because financial decisions should focus on incremental cash
flows and their effect on shareholder wealth. The additional investment in receivables and
inventory represents a cash outflow that management must incorporate into the project
evaluation. Option A is incorrect because accounting information can provide useful inputs even
though cash flow is central to valuation. Option C is incorrect because investing in working
capital does not automatically reduce accounting profit. Option D is incorrect because an
increase in EPS alone does not establish that shareholder wealth has increased.
,3|Page
Q2
A CFO rejects a project because its expected return is only 8%, even though the project's risk is
substantially below that of the firm's existing operations. Which principle should cause the CFO
to reconsider the decision?
A) Market prices are always equal to intrinsic value
B) Risk requires a reward, but the required reward should depend on the project's risk
C) All corporate projects should earn the same accounting return
D) Higher-risk projects should always be rejected
Rationale: The correct answer is B. A rational required return reflects the risk associated with
the investment, so a relatively low-risk project may appropriately have a lower required return
than a high-risk project. Option A is incorrect because market prices can differ from intrinsic
estimates. Option C is incorrect because projects with different risks do not necessarily have
identical required returns. Option D reverses the principle: riskier projects can be acceptable
when their expected returns adequately compensate investors.
Q3
A corporation's managers have substantial personal wealth invested in the company but are
considering an acquisition that would increase the firm's size while offering little evidence of
increasing shareholder value. Which issue is most directly illustrated?
A) Inflation risk
B) Interest-rate risk
C) An agency conflict between managers and shareholders
D) Foreign-exchange exposure
Rationale: The correct answer is C because managers may pursue objectives such as
organizational growth, prestige, or compensation even when those objectives do not maximize
shareholder wealth. This divergence creates an agency problem. Option A concerns changes in
purchasing power. Option B concerns changes in financing or asset values caused by interest
rates. Option D concerns currency movements and is unrelated to the described conflict.
Q4
An investor buys newly issued shares directly from a corporation. Several months later, the
investor sells those shares to another investor through a stock exchange. Which sequence
correctly identifies the markets involved?
A) Secondary market followed by primary market
B) Money market followed by capital market
C) Primary market followed by secondary market
D) Capital market followed by primary market
, 4|Page
Rationale: The corporation receives funds when it initially issues the shares, making that
transaction a primary-market transaction. The later sale between investors occurs in the
secondary market because the issuing corporation is not receiving the proceeds. Option A
reverses the sequence. Option B describes market maturity rather than the issuance/resale
distinction. Option D likewise does not correctly identify the two transactions.
Q5
A firm's nominal borrowing rate rises from 6% to 9% while the real risk-free rate remains
approximately unchanged. Analysts determine that expected inflation has increased substantially.
Which interpretation is most appropriate?
A) The nominal rate must equal the real rate
B) Higher expected inflation can raise nominal interest rates even when the real risk-free
rate is unchanged
C) Inflation reduces nominal interest rates because lenders receive more purchasing power
D) The change proves that the firm's default risk has disappeared
Rationale: The correct answer is B. Nominal interest rates incorporate compensation for
expected inflation in addition to the real rate and relevant risk premiums. Therefore, higher
expected inflation can produce a higher nominal rate. Option A ignores inflation. Option C is
incorrect because inflation generally reduces the purchasing power of future fixed payments and
therefore requires compensation. Option D has no logical connection to the information
provided.
Q6
A company's current assets are $8 million and current liabilities are $5 million. Management
plans to use $2 million of cash to repay short-term debt immediately. What is the most likely
immediate effect on the current ratio?
A) It necessarily falls below 1.0
B) It remains unchanged because both current assets and liabilities decline
C) It increases because the proportional reduction in current liabilities is greater than the
proportional reduction in current assets
D) It becomes equal to the debt-to-equity ratio
Rationale: Initially, the current ratio is 8/5 = 1.60. After repayment, current assets become $6
million and current liabilities become $3 million, producing a ratio of 2.00. Thus, C is correct.
Option A is false because the resulting ratio is 2.00. Option B overlooks the different starting
magnitudes of the numerator and denominator. Option D incorrectly compares unrelated
financial ratios.
Q7
FOUNDATIONS OF FINANCE 10TH EDITION —
ORIGINAL PRACTICE EXAM QUESTIONS 1-200 |
UPDATED 2026/2027 | DETAILED RATIONALES
INTRODUCTION
Foundations of Finance, 10th Edition by Arthur J. Keown, John D. Martin, and J. William Petty
develops the fundamental principles used to analyze financial decisions in modern organizations.
The text progresses from the role of financial management and financial markets to financial
statement analysis, time value of money, risk and return, security valuation, cost of capital,
capital budgeting, financing decisions, dividend policy, working-capital management, and
international finance. (Pearson)
This practice question bank is designed for students preparing for university-level finance
examinations based on these topics. Rather than testing simple memorization, the questions
emphasize application, quantitative reasoning, interpretation, and decision-making. Each
question contains four alternatives with one best answer, followed by a detailed rationale
explaining both the correct choice and the weaknesses of the alternatives.
The questions are original practice material, not official Pearson examination questions or an
official test bank. They are intended to help students identify conceptual gaps, practice
calculations under exam conditions, and develop the analytical judgment needed for finance
problems.
CORE DOMAINS TESTED
1. Foundations of Financial Management — shareholder wealth maximization, cash flow,
time value, risk, agency relationships, ethics, financial managers, and organizational
forms.
2. Financial Markets and Interest Rates — primary and secondary markets, money and
capital markets, securities issuance, interest-rate determination, inflation, and risk
premiums.
3. Financial Statements and Cash Flows — income statements, balance sheets, cash-flow
relationships, operating/investing/financing activities, and financial decision implications.
4. Financial Performance Analysis — liquidity, asset management, leverage, profitability,
market-value measures, and comparative ratio analysis.
5. Time Value of Money — present value, future value, annuities, perpetuities, effective
rates, and compounding.
6. Risk and Return — expected return, variance, standard deviation, diversification,
systematic risk, beta, and risk premiums.
7. Bond Valuation — coupon payments, yields, prices, duration-related intuition,
premium/discount bonds, and interest-rate effects.
,2|Page
8. Stock Valuation — dividend valuation, growth assumptions, required returns, market
prices, and equity valuation.
9. Cost of Capital — component costs, weighted average cost of capital, capital structure,
and marginal financing costs.
10. Capital Budgeting — NPV, IRR, payback, profitability considerations, mutually
exclusive projects, and investment decisions.
11. Capital-Budgeting Cash Flows — incremental cash flows, depreciation effects, taxes,
working capital, terminal cash flows, and project risk.
12. Financing Mix — debt versus equity, leverage, financial risk, capital structure, and
financing decisions.
13. Dividend Policy and Internal Financing — dividends, retained earnings, payout
decisions, and financing implications.
14. Short-Term Financial Planning — cash budgets, external financing requirements,
forecasting, and liquidity planning.
15. Working-Capital Management — current assets/liabilities, operating cycles, working-
capital policies, and financing strategies.
16. International Business Finance — exchange rates, currency risk, international
investment, and multinational financial decisions.
17. Cash, Receivables, and Inventory Management — cash management, credit policy,
collection decisions, inventory trade-offs, and working-capital efficiency. (Pearson)
QUESTIONS 1-200
Q1
A technology company is considering a project that would increase accounting profit by
$900,000 annually but would require an additional $1.4 million investment in receivables and
inventory. Management argues that the project should be accepted because reported earnings will
increase immediately. Which consideration most directly challenges management's reasoning?
A) Accounting profit is irrelevant to every financial decision
B) Cash flow consequences, including the investment in working capital, must be
considered when evaluating shareholder wealth
C) An increase in working capital always decreases accounting profit
D) Projects should be accepted whenever earnings per share increases
Rationale: The correct answer is B because financial decisions should focus on incremental cash
flows and their effect on shareholder wealth. The additional investment in receivables and
inventory represents a cash outflow that management must incorporate into the project
evaluation. Option A is incorrect because accounting information can provide useful inputs even
though cash flow is central to valuation. Option C is incorrect because investing in working
capital does not automatically reduce accounting profit. Option D is incorrect because an
increase in EPS alone does not establish that shareholder wealth has increased.
,3|Page
Q2
A CFO rejects a project because its expected return is only 8%, even though the project's risk is
substantially below that of the firm's existing operations. Which principle should cause the CFO
to reconsider the decision?
A) Market prices are always equal to intrinsic value
B) Risk requires a reward, but the required reward should depend on the project's risk
C) All corporate projects should earn the same accounting return
D) Higher-risk projects should always be rejected
Rationale: The correct answer is B. A rational required return reflects the risk associated with
the investment, so a relatively low-risk project may appropriately have a lower required return
than a high-risk project. Option A is incorrect because market prices can differ from intrinsic
estimates. Option C is incorrect because projects with different risks do not necessarily have
identical required returns. Option D reverses the principle: riskier projects can be acceptable
when their expected returns adequately compensate investors.
Q3
A corporation's managers have substantial personal wealth invested in the company but are
considering an acquisition that would increase the firm's size while offering little evidence of
increasing shareholder value. Which issue is most directly illustrated?
A) Inflation risk
B) Interest-rate risk
C) An agency conflict between managers and shareholders
D) Foreign-exchange exposure
Rationale: The correct answer is C because managers may pursue objectives such as
organizational growth, prestige, or compensation even when those objectives do not maximize
shareholder wealth. This divergence creates an agency problem. Option A concerns changes in
purchasing power. Option B concerns changes in financing or asset values caused by interest
rates. Option D concerns currency movements and is unrelated to the described conflict.
Q4
An investor buys newly issued shares directly from a corporation. Several months later, the
investor sells those shares to another investor through a stock exchange. Which sequence
correctly identifies the markets involved?
A) Secondary market followed by primary market
B) Money market followed by capital market
C) Primary market followed by secondary market
D) Capital market followed by primary market
, 4|Page
Rationale: The corporation receives funds when it initially issues the shares, making that
transaction a primary-market transaction. The later sale between investors occurs in the
secondary market because the issuing corporation is not receiving the proceeds. Option A
reverses the sequence. Option B describes market maturity rather than the issuance/resale
distinction. Option D likewise does not correctly identify the two transactions.
Q5
A firm's nominal borrowing rate rises from 6% to 9% while the real risk-free rate remains
approximately unchanged. Analysts determine that expected inflation has increased substantially.
Which interpretation is most appropriate?
A) The nominal rate must equal the real rate
B) Higher expected inflation can raise nominal interest rates even when the real risk-free
rate is unchanged
C) Inflation reduces nominal interest rates because lenders receive more purchasing power
D) The change proves that the firm's default risk has disappeared
Rationale: The correct answer is B. Nominal interest rates incorporate compensation for
expected inflation in addition to the real rate and relevant risk premiums. Therefore, higher
expected inflation can produce a higher nominal rate. Option A ignores inflation. Option C is
incorrect because inflation generally reduces the purchasing power of future fixed payments and
therefore requires compensation. Option D has no logical connection to the information
provided.
Q6
A company's current assets are $8 million and current liabilities are $5 million. Management
plans to use $2 million of cash to repay short-term debt immediately. What is the most likely
immediate effect on the current ratio?
A) It necessarily falls below 1.0
B) It remains unchanged because both current assets and liabilities decline
C) It increases because the proportional reduction in current liabilities is greater than the
proportional reduction in current assets
D) It becomes equal to the debt-to-equity ratio
Rationale: Initially, the current ratio is 8/5 = 1.60. After repayment, current assets become $6
million and current liabilities become $3 million, producing a ratio of 2.00. Thus, C is correct.
Option A is false because the resulting ratio is 2.00. Option B overlooks the different starting
magnitudes of the numerator and denominator. Option D incorrectly compares unrelated
financial ratios.
Q7
