Financial Theory & Practice Test #1
ACTUAL QUESTIONS AND CORRECT
ANSWERS
Corporate finance provides the skills managers need to - CORRECT ANSWERS✅✅Identify
and select the corporate strategies and individual projects that add value to their firm.
Forecast the funding requirements of their company, and devise strategies for acquiring those
funds.
Proprietorship - CORRECT ANSWERS✅✅Advantages:Ease of formation,Subject to few
regulations, and No corporate income taxes
Disadvantages:Limited life,Unlimited liability,Difficult to raise capital to support growth
A partnership - CORRECT ANSWERS✅✅has roughly the same advantages and
disadvantages as a sole proprietorship.
A corporation - CORRECT ANSWERS✅✅is a legal entity separate from its owners and
managers. File papers of incorporation with state. Bylaws and Charter
Advantages:Unlimited life,Easy transfer of ownership,Limited liability, and Ease of raising
capital
Disadvantages:Double taxation and Cost of set-up and report filing
Initial Public Offering (IPO) of Stock - CORRECT ANSWERS✅✅Raises cash, Allows
founders and pre-IPO investors to "harvest" some of their wealth
Agency problem - CORRECT ANSWERS✅✅managers may act in their own interests and
not on behalf of owners (stockholders)
,Corporate governance - CORRECT ANSWERS✅✅is the set of rules that control a
company's behavior towards its directors, managers, employees, shareholders, creditors,
customers. Corporate governance can help control agency problems.
What should be management's primary objective? - CORRECT ANSWERS✅✅The primary
objective should be shareholder wealth maximization, which translates to maximizing the
fundamental stock price.
Should firms behave ethically?
Do firms have any responsibilities to society at large? - CORRECT ANSWERS✅✅YES!
YES! Shareholders are also members of society.
Is maximizing stock price good for society, employees, and customers?(1) - CORRECT
ANSWERS✅✅Employment growth is higher in firms that try to maximize stock price. On
average, employment goes up in:
firms that make managers into owners (such as LBO firms) and firms that were owned by the
government but that have been sold to private investors
Is maximizing stock price good?(2) - CORRECT ANSWERS✅✅Consumer welfare is
higher in capitalist free market economies than in communist or socialist economies.
Fortune lists the most admired firms. In addition to high stock returns, these firms have:
high quality from customers' view
employees who like working there
What three aspects of cash flows affect an investment's value? - CORRECT
ANSWERS✅✅(1)Amount of expected cash flows (bigger is better)
(2)Timing of the cash flow stream (sooner is better)
(3)Risk of the cash flows (less risk is better)
Free Cash Flows (FCF) - CORRECT ANSWERS✅✅Free cash flows are the cash flows that
are available (or free) for distribution to all investors (stockholders and creditors).
FCF = sales revenues - operating costs - operating taxes - required investments in operating
capital.
, What is the weighted average cost of capital (WACC)? - CORRECT ANSWERS✅✅WACC
is the average rate of return required by all of the company's investors.
WACC is affected by: - CORRECT ANSWERS✅✅Capital structure (the firm's relative use
of debt and equity as sources of financing)
Interest rates
Risk of the firm
Investors' overall attitude toward risk
What determines a firm's fundamental, or intrinsic, value? - CORRECT
ANSWERS✅✅Intrinsic value is the sum of all the future expected free cash flows when
converted into today's dollars
Intrinsic Value - CORRECT ANSWERS✅✅The intrinsic value is the actual value of a
company or an asset based on an underlying perception of its true value including all aspects
of the business, in terms of both tangible and intangible factors.
What do we call the price, or cost, of debt capital? - CORRECT ANSWERS✅✅The interest
rate
What do we call the price, or cost, of equity capital? - CORRECT ANSWERS✅✅Cost of
equity = Required return = dividend yield + capital gain
What four factors affect the cost of money? - CORRECT ANSWERS✅✅Production
opportunities
Time preferences for consumption
Risk
Expected inflation
What economic conditions affect the cost of money? - CORRECT ANSWERS✅✅Federal
Reserve policies
Budget deficits/surpluses
ACTUAL QUESTIONS AND CORRECT
ANSWERS
Corporate finance provides the skills managers need to - CORRECT ANSWERS✅✅Identify
and select the corporate strategies and individual projects that add value to their firm.
Forecast the funding requirements of their company, and devise strategies for acquiring those
funds.
Proprietorship - CORRECT ANSWERS✅✅Advantages:Ease of formation,Subject to few
regulations, and No corporate income taxes
Disadvantages:Limited life,Unlimited liability,Difficult to raise capital to support growth
A partnership - CORRECT ANSWERS✅✅has roughly the same advantages and
disadvantages as a sole proprietorship.
A corporation - CORRECT ANSWERS✅✅is a legal entity separate from its owners and
managers. File papers of incorporation with state. Bylaws and Charter
Advantages:Unlimited life,Easy transfer of ownership,Limited liability, and Ease of raising
capital
Disadvantages:Double taxation and Cost of set-up and report filing
Initial Public Offering (IPO) of Stock - CORRECT ANSWERS✅✅Raises cash, Allows
founders and pre-IPO investors to "harvest" some of their wealth
Agency problem - CORRECT ANSWERS✅✅managers may act in their own interests and
not on behalf of owners (stockholders)
,Corporate governance - CORRECT ANSWERS✅✅is the set of rules that control a
company's behavior towards its directors, managers, employees, shareholders, creditors,
customers. Corporate governance can help control agency problems.
What should be management's primary objective? - CORRECT ANSWERS✅✅The primary
objective should be shareholder wealth maximization, which translates to maximizing the
fundamental stock price.
Should firms behave ethically?
Do firms have any responsibilities to society at large? - CORRECT ANSWERS✅✅YES!
YES! Shareholders are also members of society.
Is maximizing stock price good for society, employees, and customers?(1) - CORRECT
ANSWERS✅✅Employment growth is higher in firms that try to maximize stock price. On
average, employment goes up in:
firms that make managers into owners (such as LBO firms) and firms that were owned by the
government but that have been sold to private investors
Is maximizing stock price good?(2) - CORRECT ANSWERS✅✅Consumer welfare is
higher in capitalist free market economies than in communist or socialist economies.
Fortune lists the most admired firms. In addition to high stock returns, these firms have:
high quality from customers' view
employees who like working there
What three aspects of cash flows affect an investment's value? - CORRECT
ANSWERS✅✅(1)Amount of expected cash flows (bigger is better)
(2)Timing of the cash flow stream (sooner is better)
(3)Risk of the cash flows (less risk is better)
Free Cash Flows (FCF) - CORRECT ANSWERS✅✅Free cash flows are the cash flows that
are available (or free) for distribution to all investors (stockholders and creditors).
FCF = sales revenues - operating costs - operating taxes - required investments in operating
capital.
, What is the weighted average cost of capital (WACC)? - CORRECT ANSWERS✅✅WACC
is the average rate of return required by all of the company's investors.
WACC is affected by: - CORRECT ANSWERS✅✅Capital structure (the firm's relative use
of debt and equity as sources of financing)
Interest rates
Risk of the firm
Investors' overall attitude toward risk
What determines a firm's fundamental, or intrinsic, value? - CORRECT
ANSWERS✅✅Intrinsic value is the sum of all the future expected free cash flows when
converted into today's dollars
Intrinsic Value - CORRECT ANSWERS✅✅The intrinsic value is the actual value of a
company or an asset based on an underlying perception of its true value including all aspects
of the business, in terms of both tangible and intangible factors.
What do we call the price, or cost, of debt capital? - CORRECT ANSWERS✅✅The interest
rate
What do we call the price, or cost, of equity capital? - CORRECT ANSWERS✅✅Cost of
equity = Required return = dividend yield + capital gain
What four factors affect the cost of money? - CORRECT ANSWERS✅✅Production
opportunities
Time preferences for consumption
Risk
Expected inflation
What economic conditions affect the cost of money? - CORRECT ANSWERS✅✅Federal
Reserve policies
Budget deficits/surpluses
