978-0134083285 Chapter 1 Part 2

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31) The expected return on a riskless asset is greater than zero due to

A) an expected return for delaying consumption.

B) an expected return for opportunity costs.

C) an expected return for taxes.

D) irrational investors who believe risk is always present.

Keywords: Risk-Return Trade-off

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

32) Joe, a risk-averse investor, is trying to choose between investment A and investment B. If investment

A is riskier than investment B and Joe selects investment A anyway, then

A) the actual return for investment A will be higher than the actual return for investment B.

B) the actual return for investment A will be higher than the expected return for investment B.

C) the expected return for investment A will be higher than the actual return for investment B.

D) the expected return for investment A will be higher than the expected return for investment B.

Keywords: Risk-Return Trade-off

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

33) The principle of risk-return trade-off means that

A) higher risk investments must earn higher returns.

B) an investor who takes more risk will earn a higher return.

C) a rational investor will only take on higher risk if he expects a higher return.

D) an investor who bought stock in a small corporation five years ago has more money than an investor

who bought U.S. Treasury bonds five years ago.

Keywords: Risk-Return Trade-off, Expected Return, Actual Return

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

34) Project A is expected to generate positive cash flow of $1 million in 10 years while Project B is

expected to generate $500,000 in 5 years. Therefore

A) Project A is preferred because shareholder value is based on cash flow.

B) Project B is preferred because its cash flow is expected to be received sooner than the cash flow from

Project A.

C) Both projects have equal value because they average $100,000 per year.

D) Project B may be preferred to Project A if the opportunity cost of money is high enough.

Keywords: Time Value of Money

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

35) Company A reports sales of $100,000 and net income of $15,000. Company B reports sales of $100,000

and net income of $10,000. Therefore

A) Company A‘s cash flow may be higher or lower than Company B’s cash flow even though A’s net

income is higher.

B) Company A’s cash flow is $5,000 more than Company B‘s cash flow.

C) Company B is creating less value for its shareholders than Company A.

D) Company B’s accounts receivable must be higher than Company A’s accounts receivable.

Keywords: Cash Flow, Net Income

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

36) Profits are down so the controller decides to change the corporation’s accounting policy relating to

inventory costing. The change will allow the corporation to report higher income and higher assets,

although the physical inventory has not changed. Which of the following statements is MOST correct?

A) The stock price is likely to increase because income is higher.

B) The stock price is likely to be unaffected because the stock market is efficient.

C) The stock price is likely to decrease because reported inventory is higher.

D) If the stock price increases, the stock market is efficient.

Keywords: Efficient Markets

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

37) All of the following statements about agency problems are true EXCEPT

A) Agency problems interfere with the goal of maximizing shareholder value.

B) Agency costs are paid by the managers who do not act in the shareholders’ best interest.

C) Agency problems result from the separation of management and the ownership of a firm.

D) The root cause of agency problems is conflicts of interest.

Keywords: Agency Problems

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

38) All of the following contributed to recent financial crises EXCEPT

A) Focusing on earnings instead of cash flow.

B) Focusing on the short run.

C) Relying on the efficiency of financial markets.

D) Excessive risk taking due to underestimation of risk.

Keywords: Five Principles of Finance

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

39) A corporate financial manager trying to maximize shareholder value

A) is not concerned with ethics but rather with writing iron-clad contracts.

B) can safely ignore ethics as long as no laws are broken.

C) must behave ethically in order to stay out of jail.

D) is concerned with ethics because unethical behavior destroys trust, and businesses cannot function

without a certain degree of trust.

Keywords: Ethics, Maximizing Shareholder Value

Learning Obj.: L.O. 1.2

AACSB: Ethical understanding and reasoning

40) John invested $1,000 in a risky investment and Bill invested $1,000 in a less risky investment. One year

later, Bill‘s investment is worth $1,030. Which of the following statements is MOST correct?

A) If John‘s investment is worth less than $1,030, then John was irrational to invest in the risky project.

B) John’s investment must be worth more than $1,030 because of the risk-return trade-off, given that

John’s investment was more risky.

C) If John‘s investment is worth more than $1,030, then Bill was irrational to invest in the less risky

investment.

D) The worth of John’s investment cannot be determined with the information given.

Keywords: Risk-Return Trade-off, Expected Return, Actual Return

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

41) In order to reduce agency problems, managers may be provided compensation that includes

A) a fixed salary so managers‘ pay is not at risk, allowing managers to focus on the company‘s business.

B) a bonus based on the level of profit achieved during the year.

C) an option to buy the company‘s stock.

D) incentive pay for achieving higher sales than last year.

Keywords: Agency Problems, Stock Option, Incentive Compensation

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

42) An investor is considering two equally risky investments. Investment A is expected to return $1,000

per year for the next 5 years. Investment B is expected to return $6,000 at the end of 5 years. Which of the

following statements is MOST correct if both investments A and B have the same cost?

A) A risk averse investor will select investment B because it is expected to provide the most cash ($6,000 >

$5,000).

B) A risk averse investor will select investment A because it provides cash earlier than investment B.

C) The investor will select investment A only if the cost is less than $1,000.

D) The investor may select investment A or investment B depending on the opportunity cost of money.

Keywords: Time Value of Money, Cash Flows

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

43) The CEO of High Tech International decides to change an accounting method at the end of the current

year. The change results in reported profits increasing by 5%, but the company‘s cash flows are not

changed. If capital markets are efficient, then

A) the stock price will not be affected by the accounting change.

B) the stock price will increase due to higher profits.

C) the stock price will increase only if the accounting change will also result in higher profits in the next

year.

D) the stock price will decrease because accounting method changes are not permitted under generally

accepted accounting principles.

Keywords: Efficient Markets

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

44) When evaluating an investment project, which of the following best describes the financial

information needed by the decision maker?

A) after-tax accounting profits

B) after-tax incremental cash flows to the company as a whole

C) incremental cash flows before taxes so the decision will not be biased by a tax code that may change in

the future

D) pre-tax accounting profits adjusted for any accounting method changes

Keywords: After-tax Incremental Cash Flows

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

45) The CEO of JLI Corp. decided to expand into a new market in 2010. At the end of 2010, JLI’s stock

price had decreased 5% since the beginning of the year. Which of the following statements is MOST

correct?

A) The CEO made a poor decision to expand because the stock price decreased during the year.

B) The CEO made a poor decision to expand because the company‘s profits for the year obviously

decreased, causing the drop in stock price.

C) The CEO‘s decision may have been optimal, keeping the stock price from falling more than 5% for the

year.

D) CEO decisions are irrelevant because the efficient market determines the value of a company‘s stock.

Keywords: Stock Price Maximization, Efficient Markets

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

46) High Tech Corp. cut its research and development budget in 2010 by $4,000,000 in order to improve

its cash flow for the year. Which of the following statements is MOST correct?

A) The stock price will likely increase because the value of stock is based on reported cash flow.

B) The stock price may decrease because investors may predict that future cash flows will decrease due to

the lack of innovation and new products.

C) The change will have no impact on stock price because the company’s profits will not change in 2010.

D) The stock price will increase only if reported profits in 2010 are higher than profits reported in 2009.

Keywords: Stock Price, Cash Flow

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

47) In which of the following cases will the agency problem between shareholders and managers be the

greatest?

A) 100% of the common stock is owned by the founder of the company who decided to retire and hired a

manager to run his business for him.

B) The Johnson family owns 50% of the common stock of the company. The other 50% is owned by 5

mutual funds.

C) The common stock of the company is owned by many diverse shareholders, with no shareholder

owning more than 1% of the outstanding stock.

D) All top managers in the company own significant amounts of stock and stock options.

Keywords: Agency Problems

Learning Obj.: L.O. 1.2

AACSB: Analytical Thinking

48) Executive compensation in the United States

A) is dominated by performance-based compensation that ensures fair and just pay for corporate

executives.

B) is dominated by performance-based compensation designed to reduce agency problems.

C) cannot be linked to stock prices as this would create a conflict of interest with existing shareholders.

D) is well below levels in Europe and Asia.

Keywords: Agency Problems, Executive Compensation

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

49) The recent financial crises was exacerbated by

A) managers who overestimated risk and hence did not invest sufficient funds.

B) managers who underestimated the real risks of their decisions and borrowed excessively.

C) a lack of financial leverage that made U.S. firms less competitive in world markets.

D) extremely high interest rates in the United States that stifled investment.

Keywords: Risk Requires a Return

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

50) Ethical behavior

A) is the fifth basic principles of finance.

B) cannot be a concern to managers who are expected to maximize shareholder value.

C) in the corporate world means not breaking any laws.

D) is essential in business because unethical behavior destroys trust and business relationships.

Keywords: Ethics

Learning Obj.: L.O. 1.2

AACSB: Ethical understanding and reasoning

51) Investors generally don’t like risk. Therefore, a typical investor

A) will not be induced to take on any risk.

B) will only take on the least risk possible.

C) will only take on additional risk if he expects to be compensated in the form of additional return.

D) will only accept a zero return if the risk is zero.

Keywords: Risk-Return Trade-off

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

52) In finance, we assume that investors are generally

A) neutral to risk.

B) averse to risk.

C) fond of risk.

D) none of the above

Keywords: Risk-Return Trade-off

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

53) Consider the after-tax cash flows for Project S and Project L:

Project S

Project L

Year 1

$3000

Year 2

$3000

A rational person would prefer ________.

A) Project S because the money can be reinvested sooner

B) Project L because they can avoid taxes by receiving cash flows later

C) information about profits instead of cash flows

D) neither investment over the other

Keywords: Time Value of Money

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

54) Assume that an investor is offered a choice of a risk-free government bond or a high-risk corporate

stock. Further assume that the expected return is the same for both. According to one of the axioms of

finance, which investment would be chosen?

A) the corporate stock

B) the government bond

C) neither, the investor would be indifferent

D) none of the above

Keywords: Risk-Return Trade-off

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

55) Assume that an investor is offered a choice of a risk-free government bond that is expected to return

3.5% or a high-risk corporate stock. According to one of the principles of finance, what would induce the

investor to purchase the corporate stock?

A) a return that is substantially lower than 3.5%

B) cash dividends

C) a return that is substantially higher than 3.5%

D) none of the above

Keywords: Risk-Return Trade-off

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

56) Assume that you went to Las Vegas and hit the jackpot for $5 million. Further assume that you were

offered a choice to receive the $5 million today, or receive it in two years. According to one of the

principles of finance, which would you take?

A) the $5 million in two years because you would be afraid of spending it all right away

B) the $5 million in two years because it would be worth more than if you would receive it today

C) You would be indifferent as to when you would receive the $5 million.

D) the $5 million today because it would be worth more than if you would receive it in two years

Keywords: Time Value of Money

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

57) Assume that you won the Lotta Dough Lotto jackpot for $20 million. Further assume that you were

offered a choice to receive the $20 million today, or receive it in equal installments of $1 million per year

for 20 years. According to one of the principles of finance, which would you take?

A) the $20 million in equal installments of $1 million per year for 20 years because you would be afraid of

spending it all right away

B) the $20 million today because it would be worth more than if you would receive it in equal

installments of $1 million per year for 20 years

C) You would be indifferent as to when you would receive the $20 million since the total number of

dollars received is the same either way.

D) the $20 million in equal installments of $1 million per year for 20 years because it would be worth

more than if you would receive it today

Keywords: Time Value of Money

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

58) Which of the following statements best represents the “Agency Problem”?

A) Managers might attempt to benefit themselves in terms of salary and perquisites at the expense of

shareholders.

B) The agency problem results from the separation of management and the ownership of the firm.

C) The agency problem may interfere with the implementation of maximizing shareholder wealth.

D) all of the above

Keywords: Agency Problems

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

59) As of today, the most severe economic crisis to afflict the United States economy is considered to be

A) the Great Depression of the 1930s.

B) the Great Recession of 2007-2009.

C) the Reagan Tax Law Changes of 1985.

D) the Savings and Loan Crisis of 1978-1982.

Keywords: Current Global Financial Crisis

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

60) The “perfect storm” of factors that contributed to the economic crisis of 2007 include

A) increases in the minimum wage rate, unchecked illegal immigration, and state government deficits.

B) financial deregulation, unchecked commodity prices, floating currency exchange rates.

C) poorly chosen mortgage loans, falling housing prices, and a contracting economy.

D) agency costs, inefficient markets, and perfect capital markets.

Keywords: Current Assets, Temporary Sources of Financing

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

61) Which of the following is NOT true regarding mortgaged-backed securities (MBS)?

A) MBS are sold to investors who can hold them as an investment or resell them to other investors.

B) The MBS process allows the mortgage bank or other financial institution that made the original

mortgage loan to get its money back out of the loan and lend it to someone else.

C) Securitization provides liquidity to the mortgage market and makes it possible for banks to loan more

money to home buyers.

D) All of the above statements are true.

Keywords: Current Global Financial Crisis

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

62) Short-term United States Treasury bills are widely used as proxies for risk-free assets, yet the returns

on these T-bills are consistently greater than zero. Is this consistent with the concept of a risk-return

trade-off?

Keywords: Risk-Return Trade-off, Return for Delaying Consumption

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

63) John won the lottery on Monday and can take either $50,000 per year for 20 years, or $500,000 today.

Bill won the same lottery on Tuesday and has the same options for receiving the cash. A well respected

financial advisor is hired by both John and Bill. The advisor recommends that John take the $50,000 per

year for 20 years but advises Bill to take the $500,000 up front payment. How is it possible to give

different advice to two clients regarding the exact same cash flows?

Keywords: Opportunity Cost, Time Value of Money

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

64) The manager of Golden Ray Corporation receives a bonus if company profits exceed $1,000,000 this

year. During the final week of the year, the manager changes an accounting policy that will increase

reported profits from $950,000 to $1,025,000, triggering his bonus. The change in profits of $75,000 will

reverse itself in the next year, and the accounting change has no impact on Golden Ray’s cash flow.

Discuss the above situation as it relates to both an agency problem and efficient markets.

Keywords: Agency Problems, Efficient Markets, Incentive Alignment, Cash Flow Versus Profits

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking

65) Your friend Ricky took a finance class and learned about the risk-return trade-off. Wanting a high

return, Ricky invested in a risky, start-up technology company. A year later the company went bankrupt

and Ricky lost his entire investment. Ricky is furious with his finance professor for misleading him,

claiming he was taught that higher return goes with higher risk. Explain how Ricky misinterpreted the

risk-return trade-off.

Keywords: Risk-Return Trade-off, Actual Return, Expected Return, Risk

Learning Obj.: L.O. 1.2

AACSB: Reflective Thinking