Financial Strategy

First Test

1. The difference between the market value of an investment and its

cost is the:
A) Net present value.
B) Internal rate of return.
C) Payback period.
D) Profitability index.
E) Discounted payback period.

2. The process of valuing an investment by determining the present

value of its future cash flows is called (the):
A) Constant dividend growth model.
B) Discounted cash flow valuation.
C) Average accounting valuation.
D) Expected earnings model.
E) Capital Asset Pricing Model.

3. The net present value (NPV) rule can be best stated as:
A) An investment should be accepted if, and only if, the NPV is exactly
equal to zero.
B) An investment should be rejected if the NPV is positive and accepted
if it is negative.
C) An investment should be accepted if the NPV is positive and rejected
if its is negative.
D) An investment with greater cash inflows than cash outflows,
regardless of when the cash flows occur, will always have a positive
NPV and therefore should always be accepted.

4. The length of time required for an investment to generate cash flows

sufficient to recover its initial cost is the:
A) Net present value.
B) Internal rate of return.
C) Payback period.
D) Profitability index.
E) Discounted payback period.

5. An investment's average net income divided by its average book value

is the:
A) Net present value.
B) Internal rate of return.
C) Average accounting return.
D) Profitability index.
E) Payback period.
6. The discount rate that makes the net present value of investment
exactly equal to zero is the:
A) Payback period.
B) Internal rate of return.
C) Average accounting return.
D) Profitability index.
E) Discounted payback period.

7. The internal rate of return (IRR) rule
A) An investment is acceptable if its IRR
present value (NPV).
B) An investment is acceptable if its IRR
C) An investment is acceptable if its IRR
return, else it should be rejected.
D) An investment is acceptable if its IRR
else it should be rejected.
can be best stated as:
is exactly equal to its net
is exactly equal to zero.
is less than the required
exceeds the required return,

8. A situation in which taking one investment prevents the taking of

another is called:
A) Net present value profiling.
B) Operational ambiguity.
C) Mutually exclusive investment decisions.
D) Issues of scale.
E) Multiple rates of return.

9. The present value of an investment's future cash flows divided by

its intial cost is the:
A) Net present value.
B) Internal rate of return.
C) Average accounting return.
D) Profitability index.
E) Payback period.

10. Which of the following calculations takes the time value of money
into account?
I. Payback
II. Average accounting return
III. Profitability index
A) I only
B) II only
C) III only
D) I and III only
E) II and III only
11. The use of which of the following could lead to incorrect decisions
when comparing mutually exclusive investments?
I. Internal rate of return
II. Profitability index
III. Average accounting return
A) I only
B) II only
C) III only
D) I and II only
E) I and III only

12. An NPV of zero implies that an investment's ____________.

A) cost exceeds the present value of its cash inflows
B) cost is equal to the present value of its cash inflows
C) IRR is greater than the firm's required rate of return
D) present value of cash inflows are positive
E) present value of cash inflows exceed the investment's cost

13. Your firm's CFO presents you with two capital budgeting analyses:
one that involves buying a new delivery truck to replace the
existing truck and one that involves the purchase of a 3-ton metal
stamping press to replace the existing press on the plant floor.
This is an example of a decision involving _______________.
A) mutually exclusive projects
B) crossover projects
C) payback projects
D) independent projects
E) working capital projects

14. If financial managers only invest in projects that have a

profitability index greater than one,
I. firm value will be maximized.
II. shareholder wealth will be maximized.
III. share price will be maximized.
A) I only
B) II only
C) III only
D) I and III only
E) I, II, and III

15. Variable costs _________________________.

A) change as a function of the quantity of output produced
B) (for a given time period) are constant no matter the quantity of
output produced
C) change as a function of the next unit of output produced
D) comprise the sum total of all production expenses of the firm for
some time period
E) comprise the sum total of all production expenses of the firm for
some time period, expressed relative to the total output produced
for that same time period
16. Fixed costs __________________________.
A) change as a function of the quantity of output produced
B) (for a given time period) are constant no matter the quantity of
output produced
C) change as a function of the next unit of output produced
D) comprise the sum total of all production expenses of the firm for
some time period
E) comprise the sum total of all production expenses of the firm for
some time period, expressed relative to the total output produced
for that same time period

17. Total costs _____________________.

A) change as a function of the quantity of output produced
B) (for a given time period) are constant no matter the quantity of
output produced
C) change as a function of the next unit of output produced
D) comprise the sum total of all production expenses of the firm for
some time period
E) comprise the sum total of all production expenses of the firm for
some time period, expressed relative to the total output produced
for that same time period

18. The change in firm revenue that occurs for the next unit of output
sold is called:
A) Marginal revenue.
B) Average revenue.
C) Total revenue.
D) Fixed revenue.
E) Variable revenue.

19. The difference between the unit sales price and variable costs per
unit is called:
A) Operating leverage.
B) Contribution margin.
C) Gross profit.
D) Net profit.
E) Marginal revenue.

20. The sales level that results in a project operating cash flow
exactly equal to zero is called:
A) Operational break-even.
B) Leveraged break-even.
C) Accounting break-even.
D) Cash break-even.
E) Financial break-even.
21. The sales level that results in a project net present value exactly
equal to zero is called:
A) Operational break-even.
B) Leveraged break-even.
C) Accounting break-even.
D) Cash break-even.
E) Financial break-even.

22. The degree to which a firm or project relies on fixed production

costs is called its:
A) Operating leverage.
B) Financial break-even.
C) Contribution margin.
D) Cost sensitivity.

23. The percentage change in firm (or project) operating cash flow
relative to the percentage change in quantity sold is called (the):
A) Cash flow marginal profit.
B) Degree of operating leverage.
C) Gross profit.
D) Net profit.
E) Financial break-even.

24. Which of the following statements regarding operating leverage is

correct?
A) All else the same, firms with high operating leverage have higher
total fixed costs.
B) It is generally easier to increase operating leverage than it is to
decrease it.
C) All else the same, operating leverage will rise as output increases.
D) In order to calculate the degree of operating leverage all that is
needed are variable costs and operating cash flows.
E) All else the same, the degree of operating leverage rises as the
price per unit is increased.

25. Your company's scientists have developed an exciting new product

that is unlike anything presently available to consumers. The NPV of
bringing the product to market is positive yet you are uncertain
about the sales projections. The best way for you to test the
validity of the sales projections is to use:
A) Sensitivity and payback analysis.
B) Payback and break-even analysis.
C) Break-even and sensitivity analysis.
D) Operating leverage analysis.
E) IRR analysis.

26. At the accounting break-even point, ______________.

A) net present value is positive
B) net income is positive
C) the project operating cash flow is equal to depreciation expense
D) a project's cash flow is equal to zero
E) the price per unit and variable cost per unit are equal
27. Which of the following describe(s) fixed costs?
I. Are constant for a given period of time
II. Are equal to zero when production is zero
III. Change with the quantity of output produced
A) I only
B) II only
C) I and II only
D) I and III only
E) II and III only

28. Which of the following would most likely be considered a fixed cost
for a given time period?
A) Sales commissions
B) Salary of the Chief Financial Officer
C) Advertising expenditures
D) Shipping expenses
E) Cost of goods sold

29. A portfolio is _________________.

A) a group of assets, such as stocks and bonds, held as a collective
unit by an investor
B) the expected return on a risky asset
C) the expected return on a collection of risky assets
D) the variance of returns for a risky asset
E) the standard deviation of returns for a collection of risky assets

30. The percentage of a portfolio's total value invested in a particular

asset is called that asset's:
A) Portfolio return.
B) Portfolio weight.
C) Portfolio risk.
D) Rate of return.
E) Investment value.

31. The principle of diversification tells us that:

A) Concentrating an investment in two or three large stocks will
eliminate all of your risk.
B) Concentrating an investment in two or three large stocks will reduce
your overall risk.
C) Spreading an investment across many diverse assets cannot (in an
efficient market) eliminate any risk.
D) Spreading an investment across many diverse assets will eliminate
all of the risk.
E) Spreading an investment across many diverse assets will eliminate
some of the risk.
32. Which of the following is a true statement?
A) To calculate the expected risk premium one needs the expected return
on the risky asset and the return on a risk-free asset.
B) The risk premium is the difference between the return on a risky
asset and the return on the market portfolio.
C) The expected return on an asset is equal to the sum of the possible
returns divided by their probabilities.
D) Comparison of two different risky assets cannot be simplified by
calculating the expected return for each.
E) Expected returns depend on the states of the economy but not the
associated probabilities.

33. Which of the following is true about calculating expected portfolio

returns and variances?
A) You need to calculate the weight of each asset relative to the total
portfolio to calculate the portfolio return, but not to calculate
the portfolio variance.
B) Portfolio return can be calculated using the expected return and
portfolio weight for each asset.
C) The portfolio return is not needed to calculate the portfolio
variance.
D) The portfolio return and variance are independent of the possible
states of nature.
E) The portfolio variance is generally a weighted average of the
variances of the individual assets in the portfolio.

34. Unsystematic risk is also known as _____________________-.

A) total risk
B) market risk
C) asset-specific risk
D) non-diversifiable risk
E) specific risk

35. Which of the following would be considered an example of systematic

risk?
I. Lower trade deficit than expected
II. Quarterly profit for GM equals expectations
III. Lower quarterly sales for IBM than expected
A) I only
B) II only
C) III only
D) I and II only
E) I, II, and III

36. Total risk equals _________________.

A) market risk plus firm-specific risk
B) firm-specific risk plus diversifiable risk
C) systematic risk minus unsystematic risk
D) diversifiable risk plus unsystematic risk
E) market risk plus non-diversifiable risk
37. Which of the following would be considered an example of
unsystematic risk?
I. Higher quarterly loss than expected for Procter and Gamble
II. Lower consumer spending than expected
III. Latest unemployment figures increased, as expected
A) I only
B) II only
C) III only
D) II and III only
E) I and III only

38. You sell some of your IBM common stock (which tends to move up and
down with the economy as a whole) and replace it with the common
stock of Fort Knox Gold Mining, Inc. (whose shares tend to rise when
the economy falls, and vice versa). Your portfolio's beta should
_______________.
A) increase
B) decrease
C) remain unchanged
D) either increase or decrease
E) definitely exceed the beta of the market when all is said and done

39. An asset's undiversifiable risk is measured by its ______________.

A) total return
B) expected return
C) variance of returns
D) unexpected component of returns
E) beta coefficient

40. You own 40 shares of stock A, which has a price of $15 per share,
and 200 shares of stock B, which has a price of $2 per share. What
is the portfolio weight for stock A in your portfolio?
A) 18%
B) 25%
C) 40%
D) 60%
E) 75%

41. What is the expected return for the following stock?

State Probability Return
Average .55 .20
Recession .20 .10
Depression .25 –.20
A) 0.055
B) 0.080
C) 0.095
D) 0.105
E) 0.110
42. What is the variance of the following returns?
State Probability Return
Boom .15 .60
Good .50 .20
Recession .25 –.10
Depression .10 –.30
A) 0.0523
B) 0.0673
C) 0.0835
D) 0.1324
E) 0.4156

43. What is the expected portfolio return given the following

information:
Asset Portfolio weight Return
A .25 15%
B .25 20%
C .30 10%
D .20 35%
A) 7.71%
B) 9.23%
C) 18.75%
D) 19.25%
E) 21.15%

44. What is the expected return on asset A if it has a beta of 0.3, the
expected market return is 14%, and the risk-free rate is 5%?
A) 6.0%
B) 9.2%
C) 7.2%
D) 7.7%

45. The proportions of the market value of the firm's assets financed
via debt, common stock, and preferred stock are called the firm's
_____________________.
A) financing costs
B) portfolio weights
C) beta coefficients
D) capital structure weights
E) costs of capital

46. The weighted average of the firm's costs of equity, preferred stock,
and aftertax debt is the:
A) Reward to risk ratio for the firm.
B) Expected capital gains yield for the stock.
C) Expected capital gains yield for the firm.
D) Portfolio beta for the firm.
E) Weighted average cost of capital (WACC).
47. Given the following: the risk-free rate is 8% and the market risk
premium is 8.5%. Which projects should be accepted if the firm's
beta is 1.2?
Project Beta Expected return
I 0.65 12%
II 0.90 17%
III 1.40 19%
A) I only
B) II only
C) III only
D) I and II only
E) None of the projects are acceptable

48. Topstone Industries is expected to pay a dividend of $2.10 per share

in one year. This dividend, along with the firm's earnings, is
expected to grow at a rate of 5% forever. If the current market
price for a share of Topstone is $38.62, what is the cost of equity?
A) 6.00%
B) 10.44%
C) 10.71%
D) 11.00%
E) 11.22%

49. Topstone Industries' preferred stock pays an annual dividend of

$4.00 per share. When issued, the shares sold for their par value of
$100 per share. What is the cost of preferred stock if the current
price is $125 per share?
A) 3.2%
B) 3.7%
C) 4.0%
D) 4.7%
E) 31.3%

50. Treasury bills currently have a return of 3.5% and the market risk
premium is 8%. If a firm has a beta of 1.6, what is its cost of
equity?
A) 8.8%
B) 10.7%
C) 12.8%
D) 16.3%
E) 18.8%
Answer Key

1. A
2. B
3. C
4. C
5. C
6. B
7. D
8. C
9. D
10. C
11. D
12. B
13. D
14. E
15. A
16. B
17. D
18. A
19. B
20. D
21. E
22. A
23. B
24. A
25. C
26. C
27. A
28. B
29. A
30. B
31. E
32. A
33. B
34. C
35. A
36. A
37. A
38. B
39. E
40. D
41. B
42. B
43. C
44. D
45. D
46. E
47. B
48. B
49. A
50. D