FINC 3610 Harrelson
Final Exam Questions and Answers| Latest| Pass Guaranteed
Q1. What is capital budgeting, and why is it considered one of the most important
tasks in corporate finance?
Answer: Rationale: Capital budgeting is the process of identifying, evaluating,
and selecting long-term investment projects (fixed-asset purchases, new
products, expansions) expected to generate cash flows over multiple years. It
is critical because these decisions commit large amounts of capital for long
periods and are a primary driver of the firm's future cash flows, risk, and
ultimately its market value; poor capital budgeting decisions are difficult and
costly to reverse.
Q2. What is the capital structure decision, and what is its primary goal?
Answer: Rationale: The capital structure decision concerns how a firm finances
its assets and operations — the mix of debt versus equity used. The primary
goal is to choose the financing mix that minimizes the firm's weighted average
cost of capital (WACC) and thereby maximizes the firm's overall value (i.e.,
maximizes shareholder wealth).
Q3. What is working capital management, and what two central questions does it
primarily address?
Answer: Rationale: Working capital management involves managing a firm's
short-term (current) assets and current liabilities so day-to-day operations run
smoothly. It primarily addresses: (1) how much cash and inventory the firm
should keep on hand, and (2) how the firm should finance its short-term needs
(short-term vs. long-term financing sources). The goal is to maintain sufficient
liquidity while operating efficiently and profitably.
Q4. A firm has current assets of $500,000 and current liabilities of $350,000.
Calculate its net working capital.
Answer: NWC = $150,000. Rationale: Net working capital = Current assets −
Current liabilities = 500,000 − 350,000 = $150,000. Positive NWC indicates the
firm's current assets exceed its short-term obligations, an indicator of short-
term liquidity.
Q5. Distinguish between capital budgeting decisions and capital structure
decisions in terms of which side of the balance sheet each affects.
, Answer: Rationale: Capital budgeting decisions concern the asset side of the
balance sheet — which long-term investments/projects the firm should
undertake. Capital structure decisions concern the liabilities/equity side of the
balance sheet — how those investments should be financed (the mix of debt
and equity).
Q6. What is the primary goal of financial management (the normative goal of the
firm)?
Answer: Rationale: The primary goal of financial management is to maximize
the current market value per share of the firm's existing stock (i.e., maximize
shareholder wealth) — not merely to maximize profit, sales, or market share,
since those narrower goals can be pursued in ways that harm long-run
shareholder value (e.g., by ignoring risk or the timing of cash flows).
Q7. What is an agency problem, and give an example relevant to a corporation.
Answer: Rationale: An agency problem arises when there is a conflict of
interest between a principal (owner) and an agent (someone hired to act on
the principal's behalf), because the agent may not act purely in the principal's
best interest. A classic example is the conflict between shareholders (principals)
and managers (agents): managers may pursue actions that benefit themselves
— excessive perks, empire-building acquisitions, or avoiding risky-but-value-
creating projects to protect their own job security — rather than actions that
maximize shareholder wealth.
Q8. What are agency costs, and what are the two general categories?
Answer: Rationale: Agency costs are the costs stemming from the conflict of
interest between shareholders and management. They fall into two categories:
(1) direct agency costs — actual expenditures that benefit management at
shareholders' expense (e.g., a corporate jet) or monitoring costs incurred by
shareholders/the board (e.g., audits); and (2) indirect agency costs —
opportunity costs that arise when, for example, shareholders lose out on a
valuable but risky investment because management chooses a safer
alternative to protect its own position.
Q9. What is the single most important advantage of the corporate form of
organization relative to a sole proprietorship or partnership?
Answer: Rationale: The most important advantage is limited liability: a
corporation's shareholders' personal assets are legally separate from the
, corporation's, so their potential loss is limited to their investment in the firm's
stock. Sole proprietors and general partners, in contrast, have unlimited
personal liability for business debts.
Q10. What is the primary disadvantage of the corporate form of organization?
Answer: Rationale: The primary disadvantage is double taxation: corporate
income is taxed at the corporate level, and any income distributed to
shareholders as dividends is taxed again at the individual shareholder level. (A
secondary disadvantage is the potential for agency problems arising from the
separation of ownership and control.)
Q11. What is financial (capital structure) leverage, and what fundamental trade-
off does it create for a firm?
Answer: Rationale: Financial leverage refers to a firm's use of debt financing.
Using more debt magnifies returns to equity holders when operations go well
(and provides a valuable interest tax shield, since interest expense is tax-
deductible), but it also magnifies losses and increases the volatility of earnings
and equity returns when operations go poorly, raising the risk of financial
distress or bankruptcy. The trade-off is between the tax/return benefits of
debt and the increased financial risk it creates.
Q12. Briefly describe the static trade-off theory of capital structure.
Answer: Rationale: The static trade-off theory holds that a firm's optimal
capital structure balances the tax benefits of debt financing (the interest tax
shield, which increases firm value as more debt is added) against the
increasing present value of the costs of financial distress and bankruptcy that
come with higher debt levels. The optimal debt level is where the marginal
benefit of additional debt equals its marginal cost.
Q13. In working capital management, what is the fundamental trade-off between
liquidity and profitability?
Answer: Rationale: Holding more liquid assets (cash and marketable securities)
makes a firm better able to meet short-term obligations and unexpected cash
needs, reducing the risk of financial distress. However, liquid assets typically
earn a lower rate of return than the firm's operating assets, so holding excess
liquidity reduces overall profitability. Effective working capital management
seeks the balance that provides adequate liquidity without sacrificing
excessive return.
Final Exam Questions and Answers| Latest| Pass Guaranteed
Q1. What is capital budgeting, and why is it considered one of the most important
tasks in corporate finance?
Answer: Rationale: Capital budgeting is the process of identifying, evaluating,
and selecting long-term investment projects (fixed-asset purchases, new
products, expansions) expected to generate cash flows over multiple years. It
is critical because these decisions commit large amounts of capital for long
periods and are a primary driver of the firm's future cash flows, risk, and
ultimately its market value; poor capital budgeting decisions are difficult and
costly to reverse.
Q2. What is the capital structure decision, and what is its primary goal?
Answer: Rationale: The capital structure decision concerns how a firm finances
its assets and operations — the mix of debt versus equity used. The primary
goal is to choose the financing mix that minimizes the firm's weighted average
cost of capital (WACC) and thereby maximizes the firm's overall value (i.e.,
maximizes shareholder wealth).
Q3. What is working capital management, and what two central questions does it
primarily address?
Answer: Rationale: Working capital management involves managing a firm's
short-term (current) assets and current liabilities so day-to-day operations run
smoothly. It primarily addresses: (1) how much cash and inventory the firm
should keep on hand, and (2) how the firm should finance its short-term needs
(short-term vs. long-term financing sources). The goal is to maintain sufficient
liquidity while operating efficiently and profitably.
Q4. A firm has current assets of $500,000 and current liabilities of $350,000.
Calculate its net working capital.
Answer: NWC = $150,000. Rationale: Net working capital = Current assets −
Current liabilities = 500,000 − 350,000 = $150,000. Positive NWC indicates the
firm's current assets exceed its short-term obligations, an indicator of short-
term liquidity.
Q5. Distinguish between capital budgeting decisions and capital structure
decisions in terms of which side of the balance sheet each affects.
, Answer: Rationale: Capital budgeting decisions concern the asset side of the
balance sheet — which long-term investments/projects the firm should
undertake. Capital structure decisions concern the liabilities/equity side of the
balance sheet — how those investments should be financed (the mix of debt
and equity).
Q6. What is the primary goal of financial management (the normative goal of the
firm)?
Answer: Rationale: The primary goal of financial management is to maximize
the current market value per share of the firm's existing stock (i.e., maximize
shareholder wealth) — not merely to maximize profit, sales, or market share,
since those narrower goals can be pursued in ways that harm long-run
shareholder value (e.g., by ignoring risk or the timing of cash flows).
Q7. What is an agency problem, and give an example relevant to a corporation.
Answer: Rationale: An agency problem arises when there is a conflict of
interest between a principal (owner) and an agent (someone hired to act on
the principal's behalf), because the agent may not act purely in the principal's
best interest. A classic example is the conflict between shareholders (principals)
and managers (agents): managers may pursue actions that benefit themselves
— excessive perks, empire-building acquisitions, or avoiding risky-but-value-
creating projects to protect their own job security — rather than actions that
maximize shareholder wealth.
Q8. What are agency costs, and what are the two general categories?
Answer: Rationale: Agency costs are the costs stemming from the conflict of
interest between shareholders and management. They fall into two categories:
(1) direct agency costs — actual expenditures that benefit management at
shareholders' expense (e.g., a corporate jet) or monitoring costs incurred by
shareholders/the board (e.g., audits); and (2) indirect agency costs —
opportunity costs that arise when, for example, shareholders lose out on a
valuable but risky investment because management chooses a safer
alternative to protect its own position.
Q9. What is the single most important advantage of the corporate form of
organization relative to a sole proprietorship or partnership?
Answer: Rationale: The most important advantage is limited liability: a
corporation's shareholders' personal assets are legally separate from the
, corporation's, so their potential loss is limited to their investment in the firm's
stock. Sole proprietors and general partners, in contrast, have unlimited
personal liability for business debts.
Q10. What is the primary disadvantage of the corporate form of organization?
Answer: Rationale: The primary disadvantage is double taxation: corporate
income is taxed at the corporate level, and any income distributed to
shareholders as dividends is taxed again at the individual shareholder level. (A
secondary disadvantage is the potential for agency problems arising from the
separation of ownership and control.)
Q11. What is financial (capital structure) leverage, and what fundamental trade-
off does it create for a firm?
Answer: Rationale: Financial leverage refers to a firm's use of debt financing.
Using more debt magnifies returns to equity holders when operations go well
(and provides a valuable interest tax shield, since interest expense is tax-
deductible), but it also magnifies losses and increases the volatility of earnings
and equity returns when operations go poorly, raising the risk of financial
distress or bankruptcy. The trade-off is between the tax/return benefits of
debt and the increased financial risk it creates.
Q12. Briefly describe the static trade-off theory of capital structure.
Answer: Rationale: The static trade-off theory holds that a firm's optimal
capital structure balances the tax benefits of debt financing (the interest tax
shield, which increases firm value as more debt is added) against the
increasing present value of the costs of financial distress and bankruptcy that
come with higher debt levels. The optimal debt level is where the marginal
benefit of additional debt equals its marginal cost.
Q13. In working capital management, what is the fundamental trade-off between
liquidity and profitability?
Answer: Rationale: Holding more liquid assets (cash and marketable securities)
makes a firm better able to meet short-term obligations and unexpected cash
needs, reducing the risk of financial distress. However, liquid assets typically
earn a lower rate of return than the firm's operating assets, so holding excess
liquidity reduces overall profitability. Effective working capital management
seeks the balance that provides adequate liquidity without sacrificing
excessive return.
