Chapter 15

Business Essentials, Canadian Edition, 9e (Ebert)
Chapter 15 Financial Decisions and Risk Management
15.1 Multiple Choice Questions
1) The business activity that is concerned with determining a firm's long-term investments,
obtaining the funds to pay for those investments, and conducting the firm's everyday financial
activities is
A) bookkeeping.
B) corporate finance.
C) investment brokers.
D) chartered banks.
E) money markets.
Answer: B
Diff: 2 Type: MC Page Ref: 329
Skill: Knowledge
Objective: 15.1
2) Which of the following represents the overall objective of financial managers?

A) To ensure that the company has enough funds on hand to purchase materials needed to
produce goods and services
B) To ensure that the company has enough money to pay for its debts
C) To increase the supply of money for the economy
D) To increase the value of the firm and thus to increase shareholder wealth
E) To manage the firm's cash flow
Answer: D
Skill: Knowledge
Objective: 15.1
3) When a firm ensures that it always has enough funds on hand to purchase the materials and
human resources that it needs to produce goods and services, it is exercising
A) cash flow management.
B) government tax reporting.
C) accounting.
D) financial planning.
E) financial control.
Answer: A
Skill: Knowledge
Objective: 15.1
1
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4) All of the following are responsibilities of the financial manager except
A) determining a firm's long-term investments.
B) obtaining funds to pay for those investments.
C) developing the firm's financial statements.
D) conducting the firm's everyday financial activities.
E) managing the risks that the firm takes.
Answer: C
Diff: 1 Type: MC Page Ref: 329-330
Skill: Comprehension
Objective: 15.1
5) Which of the following is correct with respect to chief financial officers (CFOs)?
A) About 50 percent of CEOs were formerly CFOs.
B) CFOs do much more than simply focus on financial documents.
C) In recent years, fewer CFOs have been appointed as chief executive officers (CEOs).
D) The skill set of CFOs is narrowing because they must sharpen their focus on financial issues.
E) All of these are correct.
Answer: B
Objective: 15.1
6) Tony is responsible for planning and controlling the acquisition and dispersal of the
company's financial assets. What is Tony's job title?
A) Management information systems manager
B) Financial manager
C) Purchasing manager
D) Accounting manager
E) Chief risk manager
Answer: B
Objective: 15.1
7) A ________ is essentially a description of how a business will reach some financial position it
seeks for the future; includes projections for sources and uses of funds.
A) cash flow management plan
B) financial plan
C) leveraging plan
D) budget plan
E) financial control
Answer: B
Objective: 15.1
2
8) The three basic areas of responsibility for financial managers are
A) cash flow management, financial control, and financial planning.
B) risk management, portfolio diversification, and cash flow management.
C) credit policy, cash flow management, and policy decisions on equity vs. debt financing.
D) short-term, medium-term, and long-term financing.
E) none of these.
Answer: A
Objective: 15.1
9) A ________ is an important financial control measure; it is the "measuring stick" against

which performance is evaluated.
A) budget
B) cash flow statement
C) financial plan
D) balance sheet
E) debt statement
Answer: A
Skill: Knowledge
Objective: 15.1
10) Naveen has received notice from a supplier that all invoices must be paid within 30 days
rather than 60 days as previously granted. Which of the following will be impacted by this
change?
A) Inventories
B) Raw materials inventory
C) Accounts receivable
D) Capital expenditures
E) Cash flow
Answer: E
Objective: 15.2
11) When managers at Kraft Foods anticipate how much cheddar cheese Safeway supermarkets
will buy each month and when Safeway will pay for those purchases, Kraft is managing its
A) accounts payable.
B) accounts receivable.
C) credit policies.
D) capital expenditures.
E) inventories.
Answer: B
Objective: 15.2
3
12) Milan is looking at a bill for supplies his company bought. It is dated May 1st and the terms
are 2/10; net 30. In order to pay the least amount, when should he pay the bill?
A) Any day in May
B) May 10
C) May 21
D) May 31
E) May 15
Answer: B
Skill: Application
Objective: 15.2
13) Which of the following terms would a firm use to speed up cash flow?
A) 1/10; net 60
B) 1/10; net 30
C) 3/10; net 30
D) 2/10; net 60
E) 2/10; net 30
Answer: C
Objective: 15.2
14) A credit policy of "2/10, net 30" means

A) that if a customer pays its bill within 10 days, it will receive a 30 percent discount.
B) that if a customer pays its bill within 30 days, it will receive a 10 percent discount.
C) that if a customer pays its bill within 2 days, it will receive a 10 percent discount.
D) that if a customer pays its bill within 10 days, it will receive a 2 percent discount.
E) None of these are correct.
Answer: D
Objective: 15.2
15) Marie is looking at an invoice dated July 1st for $1000 that has terms of 2/10; net 30. If she
pays the bill on July 3rd how much should she write the cheque for?
A) $900
B) $980
C) $998
D) $1000
E) $700
Answer: B
Skill: Application
Objective: 15.2
4
16) Why is it necessary for a business firm to establish a credit policy?
A) A credit policy is necessary to determine how much money the business can borrow to
purchase supplies.
B) A credit policy is necessary to determine how dividends will be distributed to the
shareholders.
C) A credit policy is necessary to determine which suppliers the firm needs to pay.
D) A credit policy is a means of accounting for the dollar value of inventory-in-process.
E) A credit policy provides financial managers with expected dates of payment from buyers of
the firm's products and services.
Answer: E
Objective: 15.2
17) Sellers adjust credit terms in order to influence

A) when dividends are paid.
B) when customers pay their bills.
C) their net profit.
D) their goods-in-process inventory.
E) their accounts payable.
Answer: B
Skill: Knowledge
Objective: 15.2
18) Scott is managing a company and he has been advised by his financial manager that his
largest source of short-term debt is too high. What source of funding is Scott's financial manager
probably talking about?
A) Inventory loans
B) Bank notes
C) Credit cards
D) Commercial paper
E) Accounts payable
Answer: E
Objective: 15.2
5
19) Scott has been informed by his financial manager that his accounts receivable are being paid
much too late. To fix this problem, Scott should
A) develop a credit policy.
B) call the companies and request the funds.
C) charge higher interest rates.
D) demand that the money be paid.
E) sell the late accounts to collection agents.
Answer: A
Skill: Application
Objective: 15.2
20) Long-term expenditures are usually more carefully planned than short-term outlays because
A) they represent a binding commitment of company funds that continues long into the future.
B) they are usually sold at high-profit margins.
C) they can be used to pay off accounts payable.
D) the expenditures must finance items that are easily liquidated.
E) all of these.
Answer: A
Objective: 15.2
21) For Levi Strauss' jean-making operation, rolls of denim are considered ________, while cut-
but-not-yet-sewn jeans are considered ________.
A) work-in-process inventory; raw materials inventory
B) short-term capital; long-term capital
C) capital stock; supplies
D) raw materials inventory; work-in-process inventory
E) short-term credit; long-term credit
Answer: D
Objective: 15.2
22) Cut out but not-yet-sewn jeans are part of the ________ inventory at a clothing
manufacturer.
A) raw materials
B) work-in-process
C) finished goods
D) just-in-time
E) last in, first out
Answer: B
Skill: Knowledge
Objective: 15.2
6
23) Capital expenditures differ from operating expenditures in that
A) they are much smaller.
B) they are shorter commitments.
C) they are part of working capital.
D) they are not budgeted.
E) they are not normally sold or converted into cash.
Answer: E
Skill: Knowledge
Objective: 15.2
24) Which term is used to identify the granting of credit by one firm to another?
A) A line of credit
B) A commitment fee
C) Trade credit
D) A secured loan
E) An interfirm understanding of commercial intent
Answer: C
Skill: Knowledge
Objective: 15.3
25) The most common form of trade credit is

A) the trade acceptance.
B) the trade draft.
C) the promissory note.
D) open-book credit.
E) none of these.
Answer: D
Skill: Knowledge
Objective: 15.3
26) Mega has just shipped one of its products to Compucell on faith that they will pay the
invoice. This is a(n)
A) trade acceptance.
B) revolving credit agreement.
C) line of credit.
D) open-book credit.
E) promissory note.
Answer: D
Objective: 15.3
7
27) What is a promissory note?
A) A "gentleman's agreement" to pay for products which were shipped on faith that the payment
would be forthcoming
B) A short-term loan which uses accounts receivable as collateral for a loan
C) An agreement signed by the buyer stating when and how much money will be paid to the
seller in return for immediate credit
D) The requirement for a firm to maintain a certain amount of funds on deposit with the lending
bank
E) The right given to a bank to seize certain assets if payment is not made when due
Answer: C
Objective: 15.3
28) Jack is setting up a global operation. The form of trade credit that is particularly useful for
Jack's international transactions would be
A) revolving credit agreement.
B) promissory notes.
C) trade acceptance.
D) line of credit.
E) open-book credit.
Answer: C
Objective: 15.3
29) Sallyanne is selling merchandise to a retailer using the terms of a trade draft. As a new
employee of Sallyanne's, you find out that a trade draft is
A) a means of pledging accounts receivable.
B) an agreement to meet certain terms, which is attached to the shipment and which must be
signed before the goods are delivered to the buyer.
C) a legal agreement promising to pay for the goods, which is signed by the buyer before the
seller will ship the goods.
D) a type of secured loan with trade products serving as collateral.
E) the seller ships products on faith that payment will be forthcoming.
Answer: B
Objective: 15.3
8
30) Sallyanne is selling merchandise to Jack's Machine Shop. Sallyanne felt secure in receiving
payment because she had Jack sign a promissory note. Sallyanne felt secure because a
promissory note is
A) an agreement signed by the buyer stating when and how much money will be paid to the
seller in return for immediate credit.
B) the requirement for a firm to maintain a certain amount of funds on deposit with the lending
bank.
C) a "gentleman's agreement" to pay for products which were shipped on faith that the payment
would be forthcoming.
D) the right given to a bank to seize certain assets if payment is not made when due.
E) basically the same thing as a trade acceptance.
Answer: A
Objective: 15.3
31) Which term is used to identify a bank's requirement for the borrower to give the bank the
right to seize certain assets if payments are not made as promised?
A) Pledging accounts payable
B) Open-book credit
C) Pledging accounts receivable
D) Collateral
E) Trade acceptance
Answer: D
Skill: Knowledge
Objective: 15.3
32) The main source of collateral for companies like accounting firms and law firms is
A) cash flow.
B) equipment and buildings.
C) accounts receivable.
D) accounts payable.
E) goodwill.
Answer: C
Skill: Knowledge
Objective: 15.3
9
33) Secured, short-term loans are usually secured by
A) deposits with the bank.
B) fixed assets.
C) inventories.
D) commercial paper.
E) trade credit.
Answer: C
Skill: Knowledge
Objective: 15.3
34) For a specific firm, which of the following is most likely to carry the lowest interest rate?
A) Loan secured by fixed assets
B) Commercial paper
C) Loan secured by finished goods
D) Unsecured loan
E) Loan secured by raw materials
Answer: C
Objective: 15.3
35) How may a firm obtain an unsecured short-term bank loan?

A) Obtain open-book credit
B) Provide a fixed asset as a guarantee of payment
C) Pledge accounts receivable
D) Obtain a line of credit agreement
E) Obtain an inventory loan
Answer: D
Objective: 15.3
36) Which of the following requires a commitment fee?

A) Line of credit
B) Factoring
C) Revolving credit agreement
D) Trade acceptance
E) Commercial paper
Answer: C
Skill: Knowledge
Objective: 15.3
10
37) Which of the following guarantees that funds will be available?
A) Trade credit
B) Pledging assets
C) Trade draft
D) Line of credit
E) Revolving credit agreement
Answer: E
Skill: Knowledge
Objective: 15.3
38) What is the difference between factoring accounts receivable and using accounts receivable
as collateral for a short-term loan?
A) Factoring is the collateral used when issuing commercial paper.
B) There is no difference.
C) Factoring involves selling the accounts receivable instead of using them to obtain a loan.
D) Factoring accounts receivable is accomplished through a finance company whereas using
them as collateral is arranged with a bank.
E) Factoring involves agreeing to repurchase accounts receivable at a future date instead of using
them as collateral to obtain a loan.
Answer: C
Objective: 15.3
39) Why is it necessary for a business firm to put up collateral when it takes out a loan?
A) So that the bank can keep a portion as advance payment on the loan
B) To show the bank that the business is big enough to require the loan
C) To assure the bank that loan payments will be made as promised
D) So the financial managers know dates of payment
E) So that the accounting people can generate accurate financial statements
Answer: C
Objective: 15.3
40) Which of the following is a financing method for short-term funds?

A) Retained earnings
B) Trade credit
C) Equity financing
D) Common stock
E) Bonds
Answer: B
Skill: Knowledge
Objective: 15.3
11
41) A factor buys $50 000 worth of receivables. How much will the factor eventually sell the
receivables for?
A) $40 000
B) $45 000
C) $80 000
D) $85 000
E) It is impossible to know, given the information that is provided.
Answer: E
Skill: Application
Objective: 15.3
42) Carlos bought $40 000 worth of receivables for 60 percent of that sum ($24 000). He will
profit if the money he eventually collects exceeds the amount he paid for the receivables. Carlos
is involved in
A) pledging accounts receivable.
B) leveraging goods-in-process inventory.
C) collateralizing inventory.
D) factoring accounts receivable.
E) hedging.
Answer: D
Objective: 15.3
43) Carlos is a factor who has just bought $40 000 worth of finished goods for $24 000. The
profit that he will make on this transaction depends on
A) the quality of the receivables, the cost of collecting them, and interest rates.
B) the cash he has available, and the trade credit he is able to get.
C) the availability of government loans, the quality of the receivables, and the interest rate.
D) the interest rate, the cost of collecting the receivables, and the maturity date of bonds of his
company.
E) the general state of the economy, the number of firms who might be interested in the
receivables, and the amount of money those firms have available.
Answer: A
Objective: 15.3
12
44) What is the difference between a line of credit and a revolving credit agreement?
A) A line of credit is normally used by charitable and public-sector organizations, while a
revolving credit agreement is usually used by private-sector business firms.
B) More money can be borrowed with a line of credit than with a revolving credit agreement.
C) There is no guarantee that the money will be available when it is requested in a line of credit,
but there is an agreement that it will be available when requested in a revolving credit agreement.
D) A line of credit is only obtainable from a credit union, while a revolving credit agreement is
only obtainable from a bank.
Answer: C
Objective: 15.3
45) Monolith Corp.'s credit rating is so high that it is able to issue ________, which is backed
solely by the firm's promise to pay.
A) accounts receivable
B) commercial paper
C) promissory notes
D) trade credit
E) debentures
Answer: B
Objective: 15.3
46) The two primary sources of long-term debt funds are

A) lines of credit and revolving credit agreements.
B) common stock and preferred stock.
C) trade credit and commercial paper.
D) commercial paper and bank loans.
E) long-term loans and the sale of bonds.
Answer: E
Skill: Knowledge
Objective: 15.4
47) Which of the following is a source of long-term borrowing from outside the corporation?
A) Corporate bonds
B) Sale of equity shares
C) Commercial paper
D) Line of credit
E) Inventory loans
Answer: A
Skill: Knowledge
Objective: 15.4
13
48) Which of the following is correct with respect to long-term loans?
A) Businesses try to avoid them whenever possible because banks charge high interest rates.
B) Large borrowers may have trouble finding lenders to supply enough funds.
C) Once a loan's terms are set; they cannot be changed until all the money is paid back.
D) Loans are difficult to arrange quickly.
E) The time frame of the loan may be difficult to match with the borrower's needs.
Answer: B
Objective: 15.4
49) What is the major source of long-term debt financing for most large corporations?
A) Corporate bonds
B) Long-term loans
C) Trade credit
D) Equity financing
E) Retained earnings
Answer: A
Skill: Knowledge
Objective: 15.4
50) Manitoba Hydro has steady, predictable profits and cash flow patterns. Its best choice for
long-term funding is most likely
A) factoring accounts receivable.
B) common stock.
C) either common or preferred stock but not bonds.
D) preferred stock.
E) bonds.
Answer: E
Objective: 15.4
51) Issuers of bonds are most likely to call them in when

A) the prevailing rate of interest exceeds that stipulated on the bonds.
B) investor confidence goes down.
C) the prevailing rate of interest is less than that stipulated on the bonds.
D) investor confidence goes up.
E) the government revises its capital gains tax law.
Answer: A
Objective: 15.4
14
52) A ________ bond permits the issuing firm to retire portions of the bond issue at different
predetermined dates.
A) municipal
B) serial
C) secured
D) callable
E) convertible
Answer: B
Skill: Knowledge
Objective: 15.4
53) What is an advantage of issuing a bond with a sinking fund provision?

A) This provision offers greater security to an investor because funds to retire the bond issue are
set aside each year into the sinking fund.
B) The bonds may be converted to a specified number of shares of common stock at the firm's
convenience.
C) The firm has the right to call in the outstanding bonds at any time and thus sink the bond
issue.
D) The firm can decide to redeem the fund at any time.
E) The firm may retire portions of the bond issue at different predetermined dates.
Answer: A
Objective: 15.4
54) What is the difference between registered bonds and bearer bonds?
A) Registered bonds must be registered with the government of Canada, but bearer bonds do not.
B) Registered bonds generally pay lower rates of interest than bearer bonds.
C) Registered bondholders automatically receive interest cheques, but holders of bearer bonds
must clip coupons and send them to the company.
D) Registered bonds have lower financial risk than bearer bonds.
E) There is no practical difference between registered and bearer bonds.
Answer: C
Objective: 15.4
15
55) In most cases, equity financing takes two forms:
A) revolving credit agreements and lines of credit.
B) bank loans and commercial paper.
C) issuing common stock and retaining the firm's earnings.
D) issuing common stock and lines of credit.
E) commercial paper and retaining the firm's earnings.
Answer: C
Skill: Knowledge
Objective: 15.5
56) What is the meaning of "par value" when discussing common stock?
A) The current price of a share of stock
B) The selling price of the previous day's last transactions involving that stock
C) The average price paid on the previous day's trades
D) The face value of a share of common stock
E) One dollar
Answer: D
Objective: 15.5
57) Suppose you were interested in purchasing a printing company. This might be an attractive
target if the _________value of the stock was less than the ________value.
A) book; market
B) par; market
C) book; par
D) market; book
E) market; par
Answer: D
Objective: 15.5
58) Which of the following represents a stock's real value?

A) Profitability ratio
B) Market value
C) Price earnings ratio
D) Par value
E) Book value
Answer: B
Skill: Knowledge
Objective: 15.5
16
59) Mega Computer issued stock with a face value of one cent and then sold the shares to the
public for $20.00 each. Ted bought 10 shares at that price. Today, Ted sold his shares to Deirdre
for $25.00 each. What is the par value of the stock?
A) $20.00
B) $25.00
C) $5.00
D) $19.99
E) $0.01
Answer: E
Skill: Application
Objective: 15.5
for $25.00 each. What is the market value of the stock?
A) $50.00
B) $25.00
C) $20.00
D) $19.99
E) $0.01
Answer: B
Skill: Application
Objective: 15.5
for $25.00 each. What are Ted's capital gains?
A) $19.99
B) $20.00
C) $25.00
D) $50.00
E) $0.01
Answer: D
Skill: Application
Objective: 15.5
17
62) Regarding the issue of investor relations, it is correct to say that
A) investor relations activities do not have much impact on the price of a firm's stock.
B) investor relations may include inviting financial analysts to one of the operating sites of a
firm.
C) investor relations is a relatively new idea that began to be practised in the late 1980s.
D) investor relations are not that important to a firm's success.
E) investor relations target individual buyers of corporate stock rather than brokers and financial
analysts.
Answer: B
Objective: 15.5
63) Which of the following is correct?

A) The par value of stock is generally the best indicator of the real value of a share of stock.
B) The market value of a share of stock is determined almost solely by objective, financial
considerations.
C) The book value of a share of stock is calculated by dividing stockholders' equity by the
current market price of the stock.
D) A company's market capitalization is determined by multiplying the number of a company's
outstanding shares times the market value of each share.
E) By law, subjective factors like rumours and stockbroker recommendations are not allowed to
influence the market price of a share of stock.
Answer: D
Objective: 15.5
64) Corporation B had sales revenue last year of $20 million, operating expenses of $16 million,
and net profit of $4 million. There are 2 million shares of stock outstanding. What is the par
value of the company's stock?
A) $5
B) $4.83
C) $4
D) $10
E) The par value cannot be determined with the information given.
Answer: E
Skill: Application
Objective: 15.5
18
65) Mega Computer's financial statements show 1000 shares of common stock with a par value
of $10 000, retained earnings of $20 000, additional paid in capital of $10 000, and long-term
debt of $30 000. What is the book value of a share of stock?
A) $70.00
B) $10.00
C) $40.00
D) $30.00
E) $50.00
Answer: C
Skill: Application
Objective: 15.5
66) Which of the following is correct with regard to market capitalization?

A) There is considerable stability in the market capitalization of companies from year to year.
B) Market capitalization is computed by dividing owners' equity by the number of outstanding
shares.
C) In Canada, most of the companies with the highest market capitalization are financial
institutions or resource companies.
D) There is general agreement that market capitalization really doesn't tell us very much about
the real value of a company.
Answer: C
Objective: 15.5
67) Dennis can compute the market capitalization of the company he works for by
A) adding up all the fixed assets the company owns and subtracting the money still owed on
those fixed assets.
B) multiplying the market price of one share of the company's stock by the total number of
shares outstanding.
C) adding up all the funds the company has received through selling its stock.
D) adding up the book value, par value, and market value of the company's stock.
E) adding up the company's assets and subtracting its liabilities.
Answer: B
Objective: 15.5
19
68) Mega Computer's financial statements show 1000 shares of common stock with a par value
of $10 000, retained earnings of $20 000, additional paid in capital of $10 000, and long-term
debt of $30 000. What is the market value of a share of Mega's stock?
A) $70.00
B) $20.00
C) $40.00
D) $30.00
E) It is not possible to tell from the information given.
Answer: E
Skill: Application
Objective: 15.5
69) Preferred stock with a $100 par value and a 6 percent dividend is currently trading on the
market at $110 per share. What is the amount of the dividend the holder is entitled to receive
each year?
A) $66
B) 6 percent of $110
C) $6 percent of the total book value of preferred shares
D) $6
E) $0
Answer: D
Skill: Application
Objective: 15.5
70) Preferred stock with a $100 par value and a 5 percent dividend is currently trading on the
market at $90 per share. What is the amount of the dividend the holder is entitled to receive each
year on each share?
A) $90 (i.e., 90 percent of $100)
B) 5 percent of $90
C) 5 percent of total corporate profits divided by the number of shares outstanding
D) $5
E) None of these
Answer: D
Skill: Application
Objective: 15.5
20
71) All of the following are features of debt financing except
A) it must be repaid by a deadline.
B) it makes regular and fixed claims on income.
C) it may lead to challenge for control of company.
D) its interest is tax deductible.
E) it constrains management flexibility.
Answer: E
Objective: 15.4
72) Rosella is financial manager who is comparing the effects of debt and equity financing. She
finds that
A) debt financing affects management control, whereas equity financing does not.
B) debt financing makes a regular claim on income, whereas equity financing does not.
C) debt financing involves no fixed deadlines, whereas equity financing does.
D) debt financing does not affect management's flexibility, whereas equity financing does.
E) neither debt financing nor equity financing is tax deductible.
Answer: B
Objective: 15.5
73) From a company's perspective, which of the following is the most conservative mix of long-
term funding?
A) 25% debt, 75% equity
B) 75% debt, 25% equity
C) 100% equity
D) 100% debt
E) 50% debt, 50% equity
Answer: C
Skill: Knowledge
Objective: 15.5
74) From a company's perspective, which of the following is the riskiest mix of long-term
funding?
A) 25% debt, 75% equity
B) 100% equity
C) 50% debt, 50% equity
D) 75% debt, 25% equity
E) 100% debt
Answer: E
Skill: Knowledge
Objective: 15.5
21
75) Laura is analyzing several investment possibilities. She thinks that some options have better
chances of a good payback but those paybacks are smaller. She is exploring the
A) cash flow trade-off.
B) cash flow decision.
C) risk–return relationship.
D) safety factor.
E) risky principle.
Answer: C
Objective: 15.5
76) What is the difference between debt and equity financing?

A) Debt financing is more expensive than equity financing.
B) Equity financing is cheaper than debt financing because no money has to be paid back to the
people who bought the company's stock.
C) Debt financing is riskier than equity financing because with debt financing debts are incurred
which must be paid back.
D) Debt financing is more short-term oriented than equity financing.
E) Equity financing can be done successfully only when stock markets are rising, whereas debt
financing can be done any time.
Answer: C
Objective: 15.5
77) Which of the following is a function performed by an investment bank?

A) Handling a client's portfolio in the secondary market
B) Establishing relationships for a client with a commercial bank
C) Underwriting purchases of stocks and bonds
D) Arranging travel abroad for purchasers of foreign currencies
E) Providing insurance services for clients
Answer: C
Objective: 15.5
22
78) Javier wants to invest but wants to reduce his risk of loss by spreading the total investment
across more stocks. Javier would be most interested in which of the following?
A) Spreading
B) Shorting
C) Margin buying
D) Diversification
E) Asset allocation
Answer: D
Objective: 15.5
79) Len is working with a discount broker. Which service would he be least likely to receive?
A) Stock research
B) Industry analysis
C) Face-to-face consultations
D) Screening for specific types of stocks
E) Quality suggestions for investments
Answer: C
Objective: 15.5
80) Which of the following is correct with respect to retained earnings?

A) Retained earnings represent debt financing.
B) Retained earnings equal the profits that have been paid out as dividends.
C) Using retained earnings means that the firm will have to borrow money and pay interest on
loans or bonds.
D) The smaller dividends that may be paid to shareholders as a result of retaining earnings may
decrease the demand for, and thus the price of, the company's stock.
E) None of these are correct.
Answer: D
Objective: 15.5
23
81) If Sunshine Tanning's founders invested $10 000 by buying the original 500 shares at $20.00
per share in 2014 and then raised $50 000 by selling 500 more shares at $100 per share, the
additional paid-in capital would bring shareholder's equity to
A) $40 000.
B) $50.00 per shareholder.
C) $60 000.
D) $51 000.
E) $100.00 per shareholder.
Answer: C
Skill: Application
Objective: 15.5
82) Equity financing via common stock can be more expensive than issuing bonds because
A) common stocks must be insured.
B) there is more administration involved.
C) common stocks are backed by retained earnings.
D) common stock must be sold through a broker.
E) interest paid to bondholders is a tax-deductible business expense, but stock dividends are not
tax-deductible.
Answer: E
Objective: 15.5
83) Kim has investments in stocks and wants to calculate her total return. What should she do?
A) Divide the yearly dollar amount of dividend income by the investment's current market value
B) Compare the dividend against current yields from other investments
C) Subtract the cost of the stock from what she sold it for
D) Divide the current dividend payment plus capital gain by the original investment
E) Subtract current liabilities from current assets
Answer: D
Objective: 15.5
84) What is a stock's market value?

A) The current price of a share of stock in the stock market
B) The average price of one share of stock over the past year
C) The face value of a share of stock, set by the issuing company's board of directors
D) The price of the stock plus the previous year's dividend
E) The monthly average of a stock's price over a year
Answer: A
Objective: 15.5
24
85) What is a stock's book value?
A) The current price of a share of stock in the stock market
B) The average price of one share of stock over the past year
C) The face value of a share of stock, set by the issuing company's board of directors
D) The value expressed as total stockholders' equity divided by the total number of shares of
stock issued
E) The value expressed by the number of stock shares issued by the board of directors
Answer: D
Objective: 15.5
86) Sanjay Gupta is a 24-year-old graphic designer. He eventually wants to get married, raise a
family, and buy a house. He knows that he has to start putting money away so that his goals can
someday become a reality. He has heard that investing is risky because you can lose money as
well as make money. Therefore, Sanjay decides to play it safe and deposit money in a bank on a
regular basis. Why might this not be his best strategy?
A) Stock investments will always result in high returns.
B) It pays to take chances with your money.
C) You can actually lose money with bank savings due to inflation and taxes.
D) People usually benefit from risky investments.
E) Most savings accounts are insured by the CDIC.
Answer: C
Objective: 15.5
87) From an investor's perspective, which of the following statements is true about common
stocks as investments?
A) Stocks are among the riskiest of all investments.
B) Stocks are most suitable for investors who seek security.
C) Stocks will never become worth less than their purchase price.
D) Stock prices reflect only government action.
E) Stock prices are easily manipulated.
Answer: A
Objective: 15.5
25
88) Hannah wants to invest in stocks and bonds that will double her money in seven years.
Which of the following interest rates should she be targeting?
A) 7 percent
B) 7.2 percent
C) 8 percent
D) 10 percent
E) 10.3 percent
Answer: E
Objective: 15.5
89) Which of the following is true with regard to preferred stock?

A) Dividends must be paid each year on preferred stock.
B) The growth potential of preferred stock is limited due to its fixed dividend.
C) Preferred stock is more risky than common stock.
D) The usual par value of a preferred share is $1.
E) It cannot be callable.
Answer: B
Objective: 15.5
90) What are the two variables that are used to determine where a specific financial instrument
will be placed on the risk–return continuum?
A) The prime interest rate and the quality of the company in question
B) The amount of debt and the amount of equity the company has
C) The size of the financial returns that must be offered to induce investment and the uncertainty
about financial returns on investments
D) The size of the financial returns that must be offered to induce investment and the economic
growth prospects over the next year
E) The mix of short- and long-term sources of funds the firm is using
Answer: C
Skill: Knowledge
Objective: 15.5
26
91) The most conservative investments are government savings bonds and bank GICs. In
decreasing order of conservativeness, the next two investments are
A) medium-quality preferred stock and high-grade corporate bonds.
B) commercial paper and lower-quality common stocks.
C) high-grade corporate bonds and commercial paper.
D) commercial paper and medium-quality preferred stocks.
E) junk bonds and high-grade corporate bonds.
Answer: C
Objective: 15.5
92) The least conservative investments are low-quality common stocks. In decreasing order of
aggressiveness, the next two investments are
A) medium-quality preferred stock and high-grade corporate bonds.
B) commercial paper and lower-quality common stocks.
C) junk bonds and medium-quality preferred stocks.
D) commercial paper and medium-quality preferred stocks.
E) junk bonds and high-quality cyclical common stocks.
Answer: E
Objective: 15.5
93) Molly has been very aggressive in her investment strategy and currently invests in lower-
quality common stocks. What type of investment would you recommend to Molly if she says she
wants to move down one notch in risk?
A) Medium-quality preferred stock and high-grade corporate bonds
B) Commercial paper and lower-quality common stocks
C) Junk bonds and medium-quality preferred stocks
D) Commercial paper and medium-quality preferred stocks
E) Junk bonds and high-quality cyclical common stocks
Answer: E
Skill: Application
Objective: 15.5
27
94) Maury currently invests in medium-quality preferred stock. What type of investment would
you recommend to Maury if he says he wants to move up one notch in risk?
A) High-quality, stable common stocks
B) Junk bonds
C) High-quality, cyclical common stocks
D) Lower quality common stocks
E) High-grade corporate bonds
Answer: C
Skill: Application
Objective: 15.5
95) Which market handles the buying and selling of new stocks and bonds by business firms or
governments?
A) The primary securities market
B) The tertiary security market
C) The over-the-counter market
D) The commodities market
E) The secondary securities market
Answer: A
Skill: Knowledge
Objective: 15.6
96) Previously owned stocks and bonds are bought and sold in the
A) primary securities market.
B) securities and exchange commission.
C) private placement market.
D) investment bank.
E) secondary securities market.
Answer: E
Skill: Knowledge
Objective: 15.6
97) When an investment bank underwrites a new security, they are

A) assessing the risk of that new security.
B) privately supporting the issuing organization.
C) buying the new security.
D) co-signing the bonds.
E) attesting to the good investment potential of a new security.
Answer: C
Objective: 15.6
28
98) A ________ is an organization of individuals formed to provide an institutional setting where
stocks can be bought and sold.
A) credit union
B) commodity exchange
C) stock exchange
D) bank
E) market
Answer: C
Skill: Knowledge
Objective: 15.6
99) A(n) ________ is an individual or organization who receives and executes buy and sell
orders on behalf of other people in return for commissions.
A) commodities market
B) broker
C) stock exchange
D) agent
E) investment bank
Answer: B
Skill: Knowledge
Objective: 15.6
100) If you bought a corporation bond that was selling for 155 1/4, how much would it cost you?
A) $155.25
B) $1555.25
C) $1552.50
D) $1000.00
E) It depends on how much demand there is for the bond.
Answer: C
Skill: Application
Objective: 15.6
101) In order for a security to be listed on the Toronto Stock Exchange (TSX), the issuing
corporation must
A) have at least 200 employees.
B) have paid a fee.
C) never have traded its stock anywhere else.
D) be making a profit.
E) all of these.
Answer: B
Skill: Knowledge
Objective: 15.6
29
102) Bonds that receive poor ratings are likely to
A) be registered.
B) not be issued.
C) pay higher interest rates.
D) require more underwriting.
E) reduce the total amount issued.
Answer: C
Objective: 15.6
103) Which of the following is correct with respect to bonds?

A) The market value (selling price) of a bond at any given time is determined solely by its stated
interest rate.
B) A bond with a higher stated interest rate than the "going rate" on similar quality bonds will
probably sell at a price below its face value.
C) A bond with a sinking fund provision is riskier than a bond without such a provision.
D) The amount of the premium or discount on a bond depends largely on how far in the future
the maturity date is.
E) None of these are correct; bond prices are influenced by too many factors to make simple
statements.
Answer: D
Objective: 15.6
104) The ________ is the percentage of the total sales price that a buyer must put up to place an
order for a stock or a futures contract.
A) installment
B) up-front money
C) purchase money
D) down payment
E) margin
Answer: E
Skill: Knowledge
Objective: 15.6
30
105) Assume you bought a $1000 par value bond in 2011 for 85 1/4 with an interest rate of 4.7
percent. If you held the bond until maturity in 2021, what would be the total amount that you
would earn on this bond?
A) $1000.00
B) $852.50
C) $617.50
D) $$470.00
E) The amount cannot be calculated given the information provided.
Answer: C
Skill: Application
Objective: 15.6
106) A stock quote of 30.5 means

A) the stock is down 30 cents from 80 cents to 50 cents.
B) the stock is selling at $30.50.
C) the stock is selling at 30 cents.
D) the stock is up 30 cents from 50 cents to 80 cents.
E) the stock will be selling between 50 cents and 80 cents for the next 30 days.
Answer: B
Objective: 15.6
107) Suppose you purchased a $1000 par-value bond in 2009 for $650. Its stated interest rate is 6
percent and it matured in 2019. What was your yield?
A) 6.1 percent
B) 7.2 percent
C) 10.4 percent
D) 9.2 percent
E) 8.4 percent
Answer: D
Skill: Application
Objective: 15.6
108) During a bear market,

A) stock prices as a whole are rising.
B) corporations are being funded through secondary market transactions.
C) stock prices as a whole are falling.
D) both stock prices as a whole are falling and speculators are avoiding short selling.
E) speculators are avoiding short selling.
Answer: C
Skill: Knowledge
Objective: 15.6
31
109) Marco is a bullish investor, but the stock market is currently bearish. What is Marco most
likely to do?
A) Sell every stock and go to a 100 percent cash position
B) Sell certain winning stocks to realize a profit and put the cash to work buying stock when
prices are low
C) Maintain all stock positions until the market completely recovers and then buy more stocks
D) Sell losing stocks to avoid further losses, and hold onto winners
E) Buy defensive stocks in the expectation that they will not fall much
Answer: B
Skill: Knowledge
Objective: 15.6
110) A(n) ________ is an order to a stock broker to buy or sell a security at the prevailing price
at the time the order is placed.
A) stop order
B) limit order
C) odd lot order
D) market order
E) round lot order
Answer: D
Skill: Knowledge
Objective: 15.6
111) A ________ is the right to buy a particular stock at a certain price until a particular date,
while a ________ gives the owner the right to sell a particular stock at a specified price until a
particular date.
A) put option; call option
B) limit order; sales order
C) call option; put option
D) sales order; limit order
E) market purchase order; market sales order
Answer: C
Skill: Knowledge
Objective: 15.6
32
112) When an investor gets involved in a short sale, what is that investor hoping for in the
movement of the price of the stock?
A) A sharp drop
B) Maintenance of the current price
C) An unchanged and very stable S&P/TSX index
D) Appreciation
E) A boost upward
Answer: A
Objective: 15.6
113) A(n) ________ is an order to a stock broker to buy a security only if its price is equal to or
less than a specified amount.
A) stop order
B) round lot order
C) limit order
D) market order
E) odd lot order
Answer: C
Skill: Knowledge
Objective: 15.6
114) A(n) ________ is an order to a stock broker to sell a security if its price falls to or below a
specified amount.
A) limit order
B) stop order
C) round lot order
D) market order
E) odd lot order
Answer: B
Skill: Knowledge
Objective: 15.6
33
115) If a stock option is "underwater" what does that mean?
A) The company has experienced flood damage to its facilities and cannot pay off on any stock
options.
B) The federal government has blocked the company from paying off stock options.
C) The market price of the stock that the option applies to is lower than the option price.
D) The market price of the stock that the option applies to is higher than the option price.
E) The person holding the stock option will not exercise it because it would constitute poor
public relations (the option is therefore "underwater" and out of sight).
Answer: D
Objective: 15.6
116) Klaus just called his broker to place an order to buy 100 shares of IBM at a price of $70 or
less. Which of the terms below describe his order?
A) Both a round lot and a limit order
B) Limit order
C) Both a round lot and a stop order
D) Odd lot
E) Stop order
Answer: A
Objective: 15.6
117) Klaus just called his broker to place an order to sell his 50 shares of IBM if the price falls to
100. Which of the terms below describe his order?
A) Stop order, round lot
B) Round lot, limit order
C) Market order, round lot
D) Limit order, odd lot
E) Odd lot, stop order
Answer: E
Objective: 15.6
34
118) Suppose that in June 2018 you bought a call option that allows you to buy 100 shares of a
certain stock for $20 before October 2018. If the market price of the stock at some point before
October 2018 is $23, and you exercise your option, what will happen?
A) You will make a $30.00 profit.
B) You will make a $300.00 profit.
C) You will make a $3000.00 profit.
D) You will incur a loss of $30.00.
E) You will incur a loss of $300.00.
Answer: B
Objective: 15.6
119) What is a mutual fund?

A) A mutual fund is a pool of funds established by corporate financial managers to provide for
short-term business loans.
B) A mutual fund is a loan to the federal government made by a business firm.
C) Investors pool resources from individuals and business firms to purchase a portfolio of stocks,
bonds, and short-term securities.
D) A mutual fund consists of money raised by selling a share of ownership in a business firm.
E) A mutual fund is a product of a mutual life company.
Answer: C
Objective: 15.7
120) Mutual funds that invest in new companies or even troubled companies and other high-risk
securities are emphasizing
A) aggressive growth.
B) stability.
C) high current income.
D) growth.
E) safety.
Answer: A
Skill: Knowledge
Objective: 15.7
35
121) Mutual funds that include money market funds and government bonds are emphasizing
A) high current income.
B) aggressive growth.
C) stability.
D) growth.
E) safety.
Answer: E
Skill: Knowledge
Objective: 15.7
122) Which of the following is correct with regard to hedge funds?

A) Historically, they have been bought only by conservative investors who don't have a lot of
money to invest.
B) Hedge funds avoid risky practices like short-selling and leveraging.
C) Hedge funds are not as closely regulated as mutual funds.
D) Management fees in hedge funds are much lower than for mutual funds.
Answer: C
Objective: 15.7
123) Twenty-six-year-old Lisa Lamont became an investor one day after a friend explained that
there was a much better way to make her money work for her than by letting it sit in a savings
account earning a very low rate of interest. Lisa decided to withdraw $10,000 from her savings
account and invest it in stocks. She wanted to invest it in such a way as to minimize her risk.
Which one of the following strategies makes the most sense for a new investor like Lisa?
A) Invest all $10 000 in a small fast-growing social media company.
B) Invest $5000 in a gold mining company and $5000 in a silver mine.
C) Invest the $10 000 in four different home builders.
D) Invest $10 000 in ten different oil companies.
E) Invest $10 000 in a mutual fund.
Answer: E
Skill: Knowledge
Objective: 15.7
36
124) Before a corporation sells securities, that corporation is required by law to offer future
investors the opportunity to read through a document which contains complete information on
both the new issue and the corporation. What is that document called?
A) Prospectus
B) Book report
C) Affidavit
D) Income statement
E) Order blank
Answer: A
Skill: Knowledge
Objective: 15.7
125) Blue-sky laws apply mainly to the

A) operation of local brokerage firms.
B) sale of new securities.
C) purchase of shares by insiders.
D) sale of securities on the secondary market.
E) issuance of unsecured bonds.
Answer: B
Skill: Knowledge
Objective: 15.7
126) Madhu is planning to start a new business. The bank has requested she complete ________
so that her cash flow projections can be more understandable.
A) a statement of cash flows
B) a business plan
C) a consumer analysis
D) a sales forecast
E) a risk-return analysis
Answer: B
Objective: 15.7
37
127) Madhu should prepare a cash flow requirements projection because
A) she can see how much anticipated taxes she will have to pay.
B) by anticipating shortfalls, she can seek funds in advance and minimize their cost, and by
anticipating excess cash she can plan to put funds to work in short-term, interest-bearing
investments.
C) she will be able to plan her vacation.
D) she will know when to hire extra staff for peak periods.
E) she will need this information when she is planning for an initial public offering of her
company's stock.
Answer: B
Objective: 15.7
128) The risk associated with the chance of a warehouse fire is a(n) ________ risk.
A) "act of God"
B) pure
C) speculative
D) financial
E) market
Answer: B
Skill: Knowledge
Objective: 15.8
129) Conserving the firm's earning power and assets by reducing the threat of losses due to
uncontrollable events is ________ management.
A) disaster
B) financial
C) risk
D) insurance
E) contingency
Answer: C
Skill: Knowledge
Objective: 15.8
130) The second step in a risk management program is to

A) measure frequency and severity of potential losses.
B) monitor results of the program.
C) evaluate alternatives.
D) implement the program.
E) identify risks and potential losses.
Answer: A
Skill: Knowledge
Objective: 15.8
38
131) The final step in a risk management program is to
A) measure frequency and severity of potential losses.
B) identify risks and potential losses.
C) monitor results of the program.
D) implement the program.
E) evaluate alternatives.
Answer: C
Skill: Knowledge
Objective: 15.8
132) Which of the following methods of risk management is a business firm practising when it
chooses to terminate its delivery system to avoid the risk of physical damage or injury?
A) Risk shift
B) Risk control
C) Risk transfer
D) Risk avoidance
E) Risk retention
Answer: D
Skill: Knowledge
Objective: 15.8
133) When a pharmaceutical maker withdraws a new drug for fear of liability suits, it is
practising
A) risk avoidance.
B) risk shift.
C) risk control.
D) risk transfer.
E) risk retention.
Answer: A
Objective: 15.8
134) A firm that buys an insurance policy to protect itself against automobile wrecks is
practising
A) risk avoidance.
B) risk transfer.
C) risk acceptance.
D) risk control.
E) risk retention.
Answer: B
Objective: 15.8
39
135) Installing a new sprinkler system is an example of
A) risk retention.
B) risk avoidance.
C) risk transfer.
D) risk shift.
E) risk control.
Answer: E
Objective: 15.8
136) Which one of the following risk management techniques does a firm practise when it
chooses self-insurance instead of submitting claims to an insurance company?
A) Risk transfer
B) Risk avoidance
C) Risk retention
D) Risk control
E) Risk shift
Answer: C
Objective: 15.8
137) Blake Corp. wants to transfer its risk to another organization. Which of the following
methods would it most likely use?
A) Surety bonds
B) Fidelity bonds
C) Premiums
D) Contracts
E) Insurance
Answer: E
Objective: 15.8
138) Jarvis Corp. is expanding its product line; this is an example of ________ risk.
A) speculative
B) avoidance
C) pure
D) transferable
E) financial
Answer: A
Objective: 15.8
40
139) Magnum Corp. has embarked on a risk-management process. They have just completed
identifying risks and potential losses. What should they do next?
A) Choose techniques that best handle the loss
B) Implement the risk management program
C) Measure the frequency and severity of losses
D) Transfer the risk
E) Evaluate alternatives for handling risk
Answer: C
Skill: Application
Objective: 15.8
140) Parker Corp. has decided to pay employee medical costs out of company funds rather than
buying insurance. This is an example of
A) risk control.
B) risk avoidance.
C) risk transfer.
D) risk shift.
E) risk retention.
Answer: E
Objective: 15.8
141) Quick-X Corp. has recently sent its delivery drivers to a defensive driving course in order to
reduce accidents with company vehicles. This is an example of
A) risk shift.
B) risk control.
C) risk transfer.
D) risk retention.
E) risk avoidance.
Answer: B
Objective: 15.8
41
142) Which of the following best describes the business function that involves making decisions
about a firm's long-term investments and obtaining the funds to pay for those investments?
A) Accounting
B) Banking
C) Acquisitions
D) Commerce
E) Finance
Answer: E
Skill: Knowledge
Objective: 15.1
ESL: Alternate/ESL
143) Which of the following is one of the four responsibilities involved in the business activity
known as corporate finance?
A) Managing the risks that the firm takes
B) Determining a firm's short-term investments
C) Managing the firm's stock portfolio
D) Conducting the firm's everyday accounting activities
E) Buying stocks and bonds for the firm
Answer: A
Skill: Knowledge
Objective: 15.1
ESL: Alternate/ESL
144) Financial planning, cash-flow management and financial control are the responsibility of
which type of manager?
A) Accounting manager
B) Financial manager
C) Investment manager
D) Portfolio manager
E) Accounts manager
Answer: B
Skill: Knowledge
Objective: 15.1
ESL: Alternate/ESL
42
145) CFO stands for which of the following?
A) Chief financial officer
B) Certified fiduciary officer
C) Certified financial officer
D) Chartered financial officer
E) Chartered fiduciary officer
Answer: A
Skill: Knowledge
Objective: 15.1
ESL: Alternate/ESL
146) A financial manager's overall objective is to do which of the following?

A) Manage the company's payroll and expenditures
B) Ensure the company pays the least amount of tax
C) Coordinate the flow of money coming in versus the flow of money going out of the firm
D) Increase a firm's value and stockholders' wealth
E) Make sure there is enough money to pay all the bills
Answer: A
Skill: Knowledge
Objective: 15.1
ESL: Alternate/ESL
147) Managing the pattern in which cash flows into the firm in the form of revenues and out of
the firm in the form of debt payments is referred to as which of the following?
A) Income and expense management
B) Financial control
C) Cash-flow management
D) Financial planning
E) Asset allocation
Answer: C
Skill: Knowledge
Objective: 15.1
ESL: Alternate/ESL
43
148) Checking actual performance against plans to ensure that the desired financial status is
achieved is called
A) financial control.
B) financial planning.
C) cash-flow management.
D) performance monitoring.
E) budget oversight.
Answer: A
Skill: Knowledge
Objective: 15.1
ESL: Alternate/ESL
149) Which of the following is a description of how a firm will reach some financial position in
the future?
A) Financial projection
B) Financial goals
C) Financial budgeting
D) Financial plan
E) Financial forecast
Answer: D
Skill: Knowledge
Objective: 15.1
ESL: Alternate/ESL
150) The time frame for short-term expenditures is typically which of the following?
A) Less than 1 year
B) Less than 6 months
C) Less than 1 quarter (3 months)
D) Less than 1 month
E) Less than 2 years
Answer: A
Skill: Knowledge
Objective: 15.2
ESL: Alternate/ESL
44
151) Which of the following is the largest single category of short-term debt?
A) Accounts receivable
B) Accounts payable
C) Wages payable
D) Taxes
E) Inventory
Answer: B
Skill: Knowledge
Objective: 15.2
ESL: Alternate/ESL
152) Funds tied up in materials and goods that will sell within the year are referred to as which
of the following?
A) Inventory
B) Accounts payable
C) Materials management
D) Accounts receivable
E) Cost of goods sold
Answer: A
Skill: Knowledge
Objective: 15.2
ESL: Alternate/ESL
153) The granting of credit by one firm to another is

A) a company loan.
B) credit extension.
C) financing.
D) goodwill.
E) trade credit.
Answer: E
Skill: Knowledge
Objective: 15.3
ESL: Alternate/ESL
45
154) Which type of loan gives the bank the right to seize certain assets if payments are not
made?
A) Secured loan
B) Unsecured loan
C) Collateral loan
D) Asset loan
E) Unprotected loan
Answer: A
Skill: Knowledge
Objective: 15.3
ESL: Alternate/ESL
155) Which of the following is a standing agreement with a bank to lend a firm a maximum
amount of funds on request?
A) Revolving loan
B) Line of credit
C) Flexible loan
D) Open loan
E) Preapproved loan
Answer: B
Skill: Knowledge
Objective: 15.3
ESL: Alternate/ESL
156) Which of the following is a contract where the company will pay the investor a certain
amount of money on a specified date plus interest in return for the use of the investor's money?
A) Bond
B) Loan
C) Pledge
D) Commercial paper
E) Preferred stock
Answer: A
Skill: Knowledge
Objective: 15.4
ESL: Alternate/ESL
46
157) Which of the following are the 2 types of equity financing?
A) Issuing stock and retained earnings
B) Corporate bonds and issuing stock
C) Corporate bonds and retained earnings
D) Loans and issuing stock
E) Retained earnings and loans
Answer: A
Skill: Knowledge
Objective: 15.5
ESL: Alternate/ESL
158) What is the face value of a stock called?

A) Book value
B) Market value
C) Current value
D) Set value
E) Par value
Answer: E
Skill: Knowledge
Objective: 15.5
ESL: Alternate/ESL
159) Multiplying the number of a company's outstanding shares times the market value of each
share is referred to as which of the following?
A) Market capitalization
B) Book value
C) Market value
D) Public valuation
E) Corporate worth
Answer: A
Skill: Knowledge
Objective: 15.5
ESL: Alternate/ESL
47
160) The relative mix of a firm's debt and equity financing is
A) financial balance.
B) capital structure.
C) corporate financial planning.
D) asset and liability balance.
E) long-term financing control.
Answer: B
Skill: Knowledge
Objective: 15.5
ESL: Alternate/ESL
161) Stock prices moving upwards is called a

A) bear market.
B) bumper market.
C) rising market.
D) bull market.
E) lifting market.
Answer: D
Skill: Knowledge
Objective: 15.6
ESL: Alternate/ESL
162) What is the percentage of the total sales price that a buyer must put up to place an order for
stock or a futures contract called?
A) Put
B) Margin
C) Call
D) Bear
E) Short sell
Answer: B
Skill: Knowledge
Objective: 15.6
ESL: Alternate/ESL
48
163) A pool of investments used to purchase a portfolio of stocks, bonds and short-term
securities is called which of the following?
A) Hedge fund
B) Pension fund
C) Mutual fund
D) Equity fund
E) No load fund
Answer: C
Skill: Knowledge
Objective: 15.7
ESL: Alternate/ESL
164) Which of the following are private pools of money that try to give investors a positive
return regardless of stock-market performance?
A) Hedge funds
B) Mutual funds
C) Pension funds
D) Exchange-traded funds
E) Sinking funds
Answer: A
Skill: Knowledge
Objective: 15.7
ESL: Alternate/ESL
165) An event that offers the chance for either a gain or loss is referred to as which of the
following?
A) Calculated risk
B) Pure risk
C) Positive risk
D) Unknown risk
E) Speculative risk
Answer: E
Skill: Knowledge
Objective: 15.8
ESL: Alternate/ESL
49
166) Techniques to prevent, minimize or reduce losses or the consequences of losses is
A) risk control.
B) risk management.
C) risk optimization.
D) risk reduction.
E) risk utilization.
Answer: A
Skill: Knowledge
Objective: 15.8
ESL: Alternate/ESL
15.2 Critical Thinking Questions
1) Omar Ansari, a relatively conservative investor, received a prospectus from his stockbroker
providing details about Utopia Biotech Company and its planned IPO. Utopia was developing a
new and promising type of anti-cancer drug. After studying the prospectus, Omar decided not to
invest in the IPO. Which one of the following items of information in the prospectus was most
likely not a factor in Omar's decision?
A) Utopia was competing with many other biotech companies.
B) Utopia's CEO, although not a famous scientist, had a solid background in cancer research.
C) Utopia's drug might not be approved by Health Canada.
D) Utopia would not be profitable for many years, even if its new drug was approved by Health
Canada.
E) Utopia would soon have to return to the capital market for additional financing.
Answer: B
Diff: 3 Type: MC
Skill: Analysis
50
2) Ryerson says: "Money is hard to come by, so when one has money one should make sure that,
above all, one doesn't lose it. One hears a lot of success stories about people making a lot of
money by investing, but of course you don't hear about the people who lose money investing. As
risky as it is, based on so many unknown factors, investing your money really is like gambling.
The only safe plan is to keep money in a savings account where it can earn a predictable amount
of interest. One can't lose money that way; with money in a savings account one can always
count on it being there for future needs."
Groh responds by saying: "Investing is inherently risky, but the risk need not be insurmountable.
It is true that the more potential there is for a higher return, the higher the chance is also for more
money to be lost. But there are more and less risky ways to invest, and even the less risky
investments can give a significantly higher return than a simple savings account. When one
diversifies one's stock holdings, one increases the chances of getting a good return among one's
holdings and decreases the damage from a loss in value. Also, even if stocks lose value
temporarily, the value of stocks overall has always gone up over long periods of time. So, a
savings account, while it may seem prudent and safe, is probably not the best way to ensure that
money is being saved in the most optimal way possible."
Which of the following assumptions does Ryerson have to make to support his statements?
A) Some people make money by investing.
B) Interest is the only thing that changes the value of a savings account.
C) Most people want to save money instead of spending it.
D) Companies issue stock only if there is no other way to make money.
E) There are few companies whose stock always grows in value.
Answer: B
Diff: 3 Type: MC
Skill: Analysis
51
Which of the following, if true, would hurt Ryerson's argument?
A) Some companies have stock that grows in value.
B) The stock market sometimes falls in overall value.
C) Savings interest rates are not as high as those of some stocks.
D) Savings interest rates can be lower than the rate of inflation.
E) Savings accounts can be opened only with a minimum balance.
Answer: D
Diff: 3 Type: MC
Skill: Analysis
52
Which of the following issues do Ryerson and Groh disagree about?
A) Whether the risk of investing is worthwhile
B) Whether savings accounts bear interest
C) Whether companies issue stocks in order to raise funds
D) Whether anyone makes money by investing in stocks
E) Whether investing always carries risk with it
Answer: A
Diff: 3 Type: MC
Skill: Analysis
53
Which of the following assumptions does Groh make?
A) Inflation can outpace any interest rate.
B) Given enough time, any stock will eventually go up in value.
C) The riskier the investment, the more value it will have over a long period of time.
D) The more stocks you invest in, the higher their value will be.
E) The stock market overall will experience net growth over time.
Answer: E
Diff: 3 Type: MC
Skill: Analysis
54
Which of the following, if true, would undermine Groh's point about diversification?
A) Not every investor can afford every stock.
B) The value of some stocks drop and never recover.
C) When one stock value drops, others tend to also drop.
D) Some investors prefer as little risk as possible when investing.
E) The value of some stock is greater than others.
Answer: C
Diff: 3 Type: MC
Skill: Analysis
7) A firm wants to use its benefit package to appeal to applicants. One part of the benefits
package is the opportunity to contribute to a retirement savings program. The recent instability of
the stock market has made this less attractive.
Which of the following, if true, might make the option more appealing to a prospect?
A) In recent months, the stock market has become more bullish, making mutual funds a better
bet.
B) The firm pays the maintenance fees for the investments.
C) Employees may choose the amount set aside each month, up to 10 percent of gross income,
which is untaxed until the money is removed from the fund.
D) Over a 10-year period, the mutual funds included in the firm's option have accrued at a rate
equal to the consumer price index.
E) The firm allows employees to select from and move funds around to a wide range of mutual
fund options, some more conservative than others.
Answer: E
Diff: 3 Type: MC
Skill: Analysis
55
8) Aardvark is a small pest-control business that has 30 employees. The company started
business within the past year and needs to decide on how best to make sure its finances are
managed well as the company continues to grow its customer base and its business.
Aardvark needs some short-term financing to meet a cash flow gap while it makes immediate
capital expenditures. Which of the following, if true, would strengthen the case for the company
using a credit card for this purpose?
A) Family members of the company owners have a lot of liquid assets.
B) The company is not sure when it will be able to repay the money.
C) The company expects to be able to repay the money next month.
D) The company needs to obtain a line of credit without interest.
E) The company can provide collateral for a secured loan.
Answer: C
Diff: 3 Type: MC
Skill: Analysis
Aardvark needs some quickly obtainable funds to pay some overdue bills. It is considering using
factoring–obtaining cash in exchange for outstanding accounts receivable funds. Which of the
following, if true, would strengthen the case for using factoring?
A) Factoring can be a costly way to obtain ready cash.
B) Aardvark would not have to liquidate any of its core assets to stay in business.
C) Customers may be annoyed if they think their account has been turned over to a collection
agency.
D) Additional accounting practices are necessary to keep track of factored customer accounts.
E) Factoring companies usually won't take on receivables more than 90 days old.
Answer: B
Diff: 3 Type: MC
Skill: Analysis
business within the past year and needs to make a decision on how best to make sure its finances
are managed well as the company continues to grow its customer base and its business.
Aardvark is considering issuing corporate bonds in order to raise money. Which of the following,
if true, would strengthen the case for doing this?
A) The company's customer base has been declining.
B) The company has debts that need to be paid immediately.
C) The company's main interest is in long-term solvency.
D) The company is interested in cutting costs.
E) The company's assets are rapidly depreciating.
Answer: B
Diff: 3 Type: MC
Skill: Analysis
56
business within the past year and needs to make a decision on how best to make sure its finances
are managed well as the company continues to grow its customer base and its business.
Aardvark needs to calculate its current working capital in order to assess its current financial
state. Which of the following questions would best help answer the question of what the
company's working capital is?
A) What are the company's current liabilities?
B) What is the interest rate on outstanding loans to the company?
C) How much of the company's assets are used as collateral?
D) What is the company's credit history like?
E) What is the risk rating of the company's bonds?
Answer: A
Diff: 3 Type: MC
Skill: Analysis
Aardvark is considering undertaking an IPO in order to raise money. Which of the following, if
true, would strengthen the case for doing so?
A) The company's expected stock price will be low.
B) The company wants to maintain internal control over all its decision making.
C) The company's customer base has been in decline.
D) The company has a healthy amount of assets.
E) The company is in a significant amount of debt.
Answer: D
Diff: 3 Type: MC
Skill: Analysis
13) Munschausen is a German-based appliance company that is preparing to begin international

operations. It plans to open several production facilities and sales centres abroad. The company
needs a substantial amount of capital to start its international operations and needs to decide
whether it should pursue debt financing by acquiring loans, or whether it can get equity financing
from investors.
Which of the following, if true, would strengthen the case for Munschausen's seeking to acquire
capital by debt financing?
A) Munschausen will have very slim profit margins in its international sales.
B) Munschausen will hire many new salespeople to work internationally.
C) Munschausen will have a steady stream of revenue from its international sales.
D) Munschausen will be launching several new product lines soon.
E) Munschausen will have to specially train its employees to work internationally.
Answer: C
Diff: 3 Type: MC
Skill: Analysis
57
from investors.
Which of the following, if true, would weaken the case for Munschausen's seeking to acquire
capital by debt financing?
A) Munschausen has several marketing managers with international experience.
B) Munschausen projects rapid growth into international markets that it targets.
C) Munschausen plans to sell its products only in the most advanced economies.
D) Munschausen will grow its business only slowly for its first several years.
E) Munschausen gets its engineering talent from all over the world.
Answer: D
Diff: 3 Type: MC
Skill: Analysis

from investors.
Which of the following, if true, would strengthen the case for Munschausen's seeking to acquire
capital by equity financing?
A) Most investors are not currently expressing interest in German companies.
B) Munschausen is not sure whether its international sales will be profitable.
C) Munschausen employs some of the best engineers in Germany.
D) Munschausen will get savings through economies of scale by producing in greater quantity.
E) Several venture capitalists are interested in investing in Munschausen.
Answer: E
Diff: 3 Type: MC
Skill: Analysis

from investors.
Which of the following, if true, would weaken the case for Munschausen's seeking to acquire
capital by equity financing?
A) The equity capital market in Europe is currently very strong.
B) Equity financiers expect a consistent return on their investments.
C) Many of the companies in Germany get financing from equity capital.
D) Only the largest companies are listed on Germany's public stock exchange.
E) Most of the companies in Germany are listed on its stock exchange.
Answer: D
Diff: 3 Type: MC
Skill: Analysis
58
15.3 True/False Questions
1) A financial manager's overall objective is to increase the value of the firm and thus to increase
shareholders' wealth.
Answer: TRUE
Diff: 1 Type: TF Page Ref: 329
Skill: Knowledge
Objective: 15.1
2) Budgets are key in financial control.

Answer: TRUE
Skill: Knowledge
Objective: 15.1
3) The responsibilities of financial managers fall into three general categories: cash flow
management, financial control, and financial planning.
Answer: TRUE
Skill: Knowledge
Objective: 15.1
4) Canadian Pacific Railway Ltd. announced that it would invest $1.2 billion in order to improve
its operating ratio. This is an example of a financial plan.
Answer: TRUE
Objective: 15.1
5) Accounts payable is the largest single category of short-term debt for most companies.
Answer: TRUE
Skill: Knowledge
Objective: 15.2
6) It is in the firm's best interest to pay its accounts payables as rapidly as possible.
Answer: FALSE
Skill: Knowledge
Objective: 15.2
7) Accounts payable and accounts receivable are both part of the important category called
"short-term expenditures."
Answer: TRUE
Skill: Knowledge
Objective: 15.2
59
8) A credit policy of "2/10, net 30" means that the selling company offers a 2 percent discount if
the customer pays within 10 days.
Answer: TRUE
Skill: Knowledge
Objective: 15.2
9) Work-in-process inventory consists of goods partway through the production process that are
damaged and must be written off.
Answer: FALSE
Objective: 15.2
10) Open-book credit is a secured short-term loan that requires that the borrower put up
collateral.
Answer: FALSE
Skill: Knowledge
Objective: 15.3
11) A promissory note states when payment will be made and how much money will be paid to
the seller in return for immediate credit.
Answer: TRUE
Skill: Knowledge
Objective: 15.3
12) Once a trade draft is signed it becomes a trade acceptance.

Answer: TRUE
Skill: Knowledge
Objective: 15.3
13) Most bank loans do not require a promissory note.

Answer: FALSE
Skill: Knowledge
Objective: 15.3
14) Collateral gives the lender the right to seize certain assets if payment is not made as
promised.
Answer: TRUE
Skill: Knowledge
Objective: 15.3
60
15) Inventory can only rarely be used as collateral.
Answer: FALSE
Objective: 15.3
16) The terms "pledging accounts receivable" and "factoring accounts receivable" are essentially
synonymous.
Answer: FALSE
Objective: 15.3
17) When accounts receivables are used as collateral, the process is called factoring accounts
receivable.
Answer: FALSE
Skill: Knowledge
Objective: 15.3
18) Factors typically earn about 8 percent on their investment.

Answer: FALSE
Skill: Knowledge
Objective: 15.3
19) With a line of credit, a business knows the maximum amount of money it will be able to
borrow, but only if the bank has the money available to lend.
Answer: TRUE
Objective: 15.3
20) The main difference between a line of credit and a revolving credit agreement is that more
money is involved with a revolving credit agreement.
Answer: FALSE
Objective: 15.3
21) Commercial paper is generally issued by companies that have trouble getting regular bank
loans.
Answer: FALSE
Skill: Knowledge
Objective: 15.3
61
22) A company that pledges accounts receivable is probably in financial difficulty.
Answer: FALSE
Objective: 15.3
23) Debt financing refers to the long-term borrowing of funds from outside the company.
Answer: TRUE
Skill: Knowledge
Objective: 15.4
24) The three basic types of long-term financing are debt, equity, and hybrid financing.
Answer: TRUE
Skill: Knowledge
Objective: 15.4
25) Bonds differ in terms of riskiness, but they are identical in terms of maturity dates.
Answer: FALSE
Objective: 15.4
26) The most important element in the bond indenture is the company's cash flow situation.
Answer: FALSE
Objective: 15.4
27) Bearer bonds require the owner to clip coupons and send them to the issuer in order to
receive their interest payments.
Answer: TRUE
Skill: Knowledge
Objective: 15.4
28) Convertible bonds can be converted to common stock, but only with approval of the issuing
company.
Answer: TRUE
Objective: 15.4
62
29) Equity financing involves obtaining long-term funding from within the business firm.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
30) The market value of a share of stock is influenced by both objective factors like corporate
profits and subjective factors like rumours.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
31) The par value of a stock is an arbitrary accounting value that is generally of little interest to
stock purchasers.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
32) The book value of a common stock is a firm's shareholders' equity divided by the number of
outstanding shares of common stock.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
33) Stocks are known as securities because they represent a secured interest in a company.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
34) In a secondary securities market, new stocks and bonds are bought and sold by firms and
governments.
Answer: FALSE
Skill: Knowledge
Objective: 15.5
35) From an investor's perspective, common stocks are among the riskiest of securities.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
63
36) If Microsoft's shares are trading at $30.00 and there are 3 million shares outstanding, then
Microsoft's market capitalization would be $9 million.
Answer: FALSE
Skill: Application
Objective: 15.5
37) A business firm may elect to provide for long-term funding needs by retaining earnings
instead of paying dividends to the shareholders.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
38) Preferred shares never mature, however, payments to the holder are fixed in amount and can
be withheld if the company wishes.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
39) The mix between debt and equity financing is termed a company's capital structure.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
40) In case of financial distress, the firm would pay its stockholders before paying its
bondholders.
Answer: FALSE
Skill: Knowledge
Objective: 15.5
41) When an investment bank engages in underwriting, that investment bank is taking on risk in
the process of launching new securities.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
42) High-grade corporate bonds rate low in terms of risk and high in terms of expected returns.
Answer: FALSE
Skill: Knowledge
Objective: 15.5
64
43) Debt financing does not affect management control, but it does affect management
flexibility.
Answer: TRUE
Objective: 15.5
44) Debt financing is a wiser investment from a financial perspective than equity financing.
Answer: FALSE
Objective: 15.5
45) Primary securities markets are those that handle the most important stock and bond issues,
while secondary markets are those which handle the less important issues.
Answer: FALSE
Skill: Knowledge
Objective: 15.6
46) A corporate bond selling at 155 1/4 would cost a buyer $1552.50 plus commission.
Answer: TRUE
Skill: Application
Objective: 15.6
47) A stop order prevents the broker from selling a client's stock.
Answer: FALSE
Skill: Knowledge
Objective: 15.6
48) A market order requests the broker to buy or sell a certain security at the prevailing market
price at the time.
Answer: TRUE
Skill: Knowledge
Objective: 15.6
49) In a short sale of stocks, you sell stocks that you don't own.
Answer: TRUE
Skill: Knowledge
Objective: 15.6
65
50) A call option requires brokers to call their clients before buying or selling stocks.
Answer: FALSE
Skill: Knowledge
Objective: 15.6
51) A put option gives its owner the right to sell a stock at a specified price.
Answer: TRUE
Skill: Knowledge
Objective: 15.6
52) A mutual fund, pools investments from individuals and firms to purchase a portfolio of
stocks, bonds, and short-term securities.
Answer: TRUE
Skill: Knowledge
Objective: 15.7
53) One difference between mutual funds and exchange traded funds is that the latter are priced
continuously, not just at the end of the trading day.
Answer: TRUE
Skill: Knowledge
Objective: 15.7
54) Mutual funds vary according to the investment goals emphasized by the fund managers.
Answer: TRUE
Skill: Knowledge
Objective: 15.7
55) A futures contract is an agreement to purchase a specified amount of a mutual fund at a given
price on a set date in the future.
Answer: FALSE
Skill: Knowledge
Objective: 15.7
56) Selling prices in the commodities market reflect traders' beliefs about the future prices of
commodities, such as coffee beans, livestock, and gold.
Answer: TRUE
Skill: Knowledge
Objective: 15.7
66
57) Most commodities investors have no intention of ever taking possession of the commodities
in which they trade.
Answer: TRUE
Skill: Knowledge
Objective: 15.7
58) Hedge funds try to give their investors a positive return no matter how the stock market is
performing.
Answer: TRUE
Skill: Knowledge
Objective: 15.7
59) An exchange-traded fund (ETF) is a bundle of stocks (or bonds) that are in an index that
tracks the overall movement of a market.
Answer: TRUE
Skill: Knowledge
Objective: 15.7
60) Hedge funds are not allowed to engage in risky practices such as short selling and
leveraging.
Answer: FALSE
Skill: Knowledge
Objective: 15.7
61) A prospectus is a statement filed by the issuing company before the issuance of a new
security that contains detailed information about the company and the proposed new issue.
Answer: TRUE
Skill: Knowledge
Objective: 15.7
62) Start-up firms without proven financial success usually aren't required to present a business
plan, as long as the owner has considerable financial assets.
Answer: FALSE
Objective: 15.7
67
63) In a highly seasonal business, cash flow planning is less critical than in a year-round
business.
Answer: FALSE
Skill: Knowledge
Objective: 15.7
64) Small businesses are notorious for not planning cash flow needs properly.
Answer: TRUE
Skill: Knowledge
Objective: 15.8
65) The two basic types of business risk are speculative risks and pure risks.
Answer: TRUE
Skill: Knowledge
Objective: 15.8
66) Financial managers deal only with speculative risks.

Answer: FALSE
Skill: Knowledge
Objective: 15.8
67) Designing and distributing a new product is a pure risk because there is the possibility of
either a gain or a loss.
Answer: FALSE
Objective: 15.8
68) When a delivery service trains its drivers in defensive-driving techniques and maintains their
trucks in good working order, they are practising risk avoidance.
Answer: FALSE
Objective: 15.8
69) When a company decides to insure its buildings and equipment against loss by fire, it is
practising risk transfer.
Answer: TRUE
Objective: 15.8
68
70) The first step in the risk management process is to measure the frequency and severity of
losses and their impact.
Answer: FALSE
Skill: Knowledge
Objective: 15.8
71) The chance of a flood is pure risk.

Answer: TRUE
Objective: 15.8
72) The business function involving decisions about a firm's long-term investments and
obtaining the funds to pay for those investments is known as accounting.
Answer: FALSE
Skill: Knowledge
Objective: 15.1
ESL: Alternate/ESL
73) Inventory is the materials and goods currently held by a company that will be sold within the
year.
Answer: TRUE
Skill: Knowledge
Objective: 15.2
ESL: Alternate/ESL
74) An unsecured loan is a short-term loan in which the borrower is not required to put up
collateral.
Answer: TRUE
Skill: Knowledge
Objective: 15.3
ESL: Alternate/ESL
75) Equity financing is the raising of money to meet long-term expenditures by borrowing from
outside the company.
Answer: FALSE
Skill: Knowledge
Objective: 15.4
ESL: Alternate/ESL
69
76) The value of a common stock expressed as total stockholders' equity divided by the number
of shares of stock is known as par value.
Answer: FALSE
Skill: Knowledge
Objective: 15.5
ESL: Alternate/ESL
77) Diversification means buying several kinds of investments rather than just one kind.
Answer: TRUE
Skill: Knowledge
Objective: 15.5
ESL: Alternate/ESL
78) A period of falling stock prices is called a bear market.

Answer: TRUE
Skill: Knowledge
Objective: 15.6
ESL: Alternate/ESL
79) Laws regulating how corporations must back up securities are known as blue-sky laws.
Answer: TRUE
Skill: Knowledge
Objective: 15.7
ESL: Alternate/ESL
80) A bundle of stocks (or bonds) that is in an index that tracks the overall movement of the
market is known as an exchange-traded fund (ETF).
Answer: TRUE
Skill: Knowledge
Objective: 15.7
ESL: Alternate/ESL
81) An event that offers no possibility of gain, only the chance of a loss or no loss is known as
speculative risk.
Answer: FALSE
Skill: Knowledge
Objective: 15.8
ESL: Alternate/ESL
70
15.4 Short Answer Questions
1) What is a financial manager?

Answer: A financial manager is responsible for planning and controlling the acquisition and
dispersal of a firm's financial resources.
Diff: 2 Type: SA Page Ref: 329
Objective: 15.1
2) What is the financial manager's overall objective?

Answer: To increase a firm's value (and thus stockholders' wealth)
Objective: 15.1
3) What are the four responsibilities of finance (corporate finance)?

Answer:
- Determining a firm's long-term investments
- Obtaining funds to pay for those investments
- Conducting the firm's everyday financial activities
- Helping to manage the risks that the firm takes
Skill: Knowledge
Objective: 15.1
4) What is involved in cash flow management?

Answer: Stated most generally, financial managers must make sure that the company always has
enough funds on hand to purchase the materials and human resources it needs to produce the
goods and services that are sold to consumers. Financial managers must also make specific
decisions about investing funds that are not needed immediately.
Objective: 15.1
5) What is financial control?

Answer: Financial control is the process of checking actual performance against plans to ensure
that desired financial outcomes occur. Control involves monitoring revenues and making
appropriate financial adjustments.
Objective: 15.1
71
6) What is a credit policy?
Answer: A credit policy states the guidelines that a company uses when extending credit to
customers. A credit policy sets a standard to help managers decide which buyers are eligible for
what type of credit. Credit policy also sets specific payment terms.
Objective: 15.2
7) What do credit terms of 2/10; net 30 refer to?

Answer: The selling company is offering a two percent discount if the bill is paid within 10
days. The customer has 30 days to pay the regular price.
Objective: 15.2
8) List the three forms of inventory that companies typically carry.

Answer: Raw materials inventory, work-in-process inventory, and finished goods inventory
Skill: Knowledge
Objective: 15.2
9) List three sources of short-term funds.

Answer: Trade credit, secured loans, and unsecured loans
Skill: Knowledge
Objective: 15.3
10) What is open-book credit?

Answer: A gentlemen's agreement whereby buyers receive merchandise along with invoices
stating credit terms. Sellers ship products on faith that payment will be forthcoming.
Objective: 15.3
11) Differentiate between a trade draft and a trade acceptance.

Answer: A trade draft is a form of trade credit in which buyers must sign statements of payment
terms attached to merchandise by sellers. A trade acceptance is a trade draft that has been signed
by the buyer.
Objective: 15.3
72
12) What is a line of credit?
Answer: A line of credit is a standing arrangement in which a lender agrees to make available a
specified amount of funds upon the borrower's request.
Objective: 15.3
13) What is commercial paper?

Answer: Commercial paper is a short-term security, or note, containing a borrower's promise to
pay.
Objective: 15.3
14) What are the two primary sources of debt financing?

Answer: Long-term loans and bonds
Skill: Knowledge
Objective: 15.4
15) What is a bond?

Answer: A bond is an IOU, that is, a written promise that the borrower will pay the lender, at
some stated future date, a sum of money and a stated rate of interest.
Objective: 15.4
16) What is a debenture?

Answer: Debentures are bonds which are unsecured. In other words, no specific property has
been pledged as security to back up the borrowing.
Objective: 15.4
17) What is the difference between registered bonds and bearer bonds?
Answer: The issuing company mails interest cheques to owners of registered bonds, but a bearer
bond owner must clip coupons and send them to the issuer in order to receive interest payments.
Objective: 15.4
18) Why is paying dividends more expensive than paying bond interest?
Answer: Because bond interest is tax deductible, but stock dividends are not
Objective: 15.5
73
19) Of par value, market value, and book value, which is the most important to investors and
why?
Answer: Market value is of most importance to investors, as it represents the current price of a
share of stock in the market.
Objective: 15.5
20) What is par value?

Answer: Par value is the arbitrary value of a stock set by the company's board of directors, and
stated on stock certificates, and used by accountants but is of little significance to investors.
Objective: 15.5
21) What is the risk-return relationship?

Answer: The higher the risk, the more return the investors will expect to receive; the lower the
risk, the smaller the expected return.
Objective: 15.5
22) Explain the principle of compound growth.

Answer: Compound growth is the compounding of interest paid to the investor over given time
periods. With each additional time period, interest payments accumulate, are capitalized, and
then earn more interest, thus multiplying the earning capacity of the investment. The principle of
compound growth is the basis for the time value of money.
Objective: 15.5
23) Explain the Rule of 72.

Answer: The Rule of 72 is used to figure out how long it takes to double an investment. You can
find the number of years needed to double your money by dividing the annual interest rate (in
percent) into 72. The Rule of 72 can also calculate how much interest you must get if you want
to double your money in a given number of years. The Rule of 72 lesson for the investor is clear:
seek higher interest rates because money will double more frequently.
Objective: 15.5
24) What is a security?

Answer: A security is a stock or bond representing a secured or asset-based claim by investors
against issuers.
Objective: 15.5
74
25) Describe the differences between primary and secondary securities markets.
Answer: In primary securities markets, businesses and governments buy new stocks and bonds,
a process often handled by an investment bank. The primary securities markets also offer private
placements, or new securities sold to a single buyer or small group of buyers. Secondary
securities markets are where investors buy and sell existing stocks and bonds. The trading in the
secondary securities market is handled by stock exchanges and by online trading with electronic
communication networks.
Objective: 15.5
26) Differentiate between bull and bear markets.

Answer: A bull market is a period of rising stock prices, while a bear market is a period of
falling stock prices.
Objective: 15.6
27) Differentiate between odd and round lots.

Answer: A round lot is a purchase or sale of stock in units of 100 shares, while an odd lot is the
purchase or sale of stock in fractions of round lots.
Objective: 15.6
28) What is a short sale?

Answer: A short sale is a stock sale in which an investor borrows securities from a broker to be
sold and then replaced at a specified future date.
Objective: 15.6
29) What is a call option?

Answer: A call option is the right to buy or sell a stock at a specific price during a specified
period of time.
Objective: 15.7
30) What is a mutual fund?

Answer: A mutual fund is a company that pools investments from individuals and organizations
to purchase a portfolio of stocks, bonds, and other securities.
Objective: 15.7
75
31) Explain what exchange-traded funds are and how they are tracked.
Answer: As with an index mutual fund, an exchange-traded fund (ETF) is a bundle of stocks (or
bonds) that are in an index that tracks the overall movement of a market; unlike a mutual fund,
however, an ETF can be traded like a stock. Each share of an ETF rises and falls as market prices
change continuously for the market being tracked. Because they are traded on stock exchanges
(hence, "exchange traded"), ETFs can be bought and sold—priced continuously—any time
throughout the day.
Objective: 15.7
32) What is a hedge fund?

Answer: Hedge funds are private pools of money that try to give investors a positive return
regardless of stock market performance. Hedge funds often engage in risky practices like short
selling and leveraging.
Objective: 15.7
33) Differentiate between pure and speculative risk.

Answer: Speculative risk is risk involving the possibility of gain or loss, while pure risk
involves only the possibility of loss or no loss.
Objective: 15.8
34) List the four choices that a company has to handle risk.
Answer: Risk avoidance, risk control, risk retention, and risk transfer
Skill: Knowledge
Objective: 15.8
15.5 Essay Questions
1) Briefly explain the three responsibilities of a financial manager.

Answer:
- Cash flow management: managing the pattern in which cash flows into the firm in the form of
revenues and out of the firm in the form of debt payments
- Financial control: the process of checking actual performance against plans to ensure that the
desired financial status is achieved
- Financial planning: a description of how a business will reach some financial position it seeks
for the future; includes projections for sources and uses of funds
Diff: 1 Type: ES Page Ref: 329
Objective: 15.1
76
2) What questions must the financial manager ask in order to develop a sound financial plan?
Answer: There are three basic questions: (1) What funds are needed to meet immediate plans?
(2) When will the company need more funds? (3) Where can the company get the funds it needs
so that it can meet its short- and long-term needs?
Objective: 15.1
3) What are the three financial or operational areas that must be carefully managed by the
financial manager to provide for short-term expenditures?
Answer:
- Accounts payable: to pay them on time, but not too early, to allow for cash for short-term
investments
- Accounts receivable: to be sure to receive them in a timely fashion with discounts and penalties
to shorten the wait period before payment occurs
- Inventories: inventories must be monitored so as to purchase when needed without having too
much cash tied up in inventories
Objective: 15.2
4) In what way is accounts receivable a short-term (operating) expenditure?

Answer: Accounts receivable refers to funds due from customers who have bought on credit.
Because accounts receivable represents an investment in products for which a firm has not yet
received payment, they temporarily tie up its funds.
Objective: 15.2
5) How do long-term expenditures differ from short-term expenditures?

Answer: Compared to short-term expenditures, long-term expenditures are used to buy fixed
assets which are not normally sold or converted to cash. Their acquisition requires a relatively
large investment, and they represent a binding commitment of company funds that continues
long into the future.
Diff: 2 Type: ES Page Ref: 330-331
Objective: 15.2
77
6) Explain the difference between the three basic types of inventory that companies typically
carry.
Answer: The supplies a firm buys to use in its production process are its raw materials inventory
(for example, rolls of denim to make jeans). Work-in-process inventory consists of goods
partway through the production process (for example, cut-out but not-yet-sewn jeans). Finished
goods inventory refers to items that are ready for sale (for example, completed blue jeans ready
for shipment to dealers).
Objective: 15.2
7) Describe the primary short-term sources of funds.

Answer: There are four sources:
(1) Trade credit—the granting of credit by a selling firm to a buying firm (open-book credit,
promissory notes, trade drafts);
(2) Secured short-term loans—the borrower is required to put up collateral (inventory loans,
accounts receivable) and the lender has these items as security that the loan will be repaid or they
take possession of inventories and/or accounts receivable;
(3) Unsecured short-term loans—the borrower is not required to put up collateral (lines of credit,
revolving credit agreements, commercial paper); and
(4) Factoring accounts receivable—selling a firm's accounts receivable to another company for
some percentage of their face value in order to realize immediate cash
Objective: 15.3
8) How can a lender gain some sort of assurance that the borrower of funds will repay the debt?
Answer: The most basic way is to make a secured loan, which requires the borrower to put up
collateral (for example, inventories, accounts receivable, and other assets).
Objective: 15.3
9) Briefly describe the three key sources of unsecured, short-term funds.

Answer: Three types of unsecured short-term funds:
- Lines of credit: a standing agreement that specifies the maximum amount that will be made
available to a borrower, which the borrow can get when the funds are available
- Revolving credit agreement: a guaranteed line of credit for which the funds are available on
demand
- Commercial paper: notes that are sold for less than face value which are bought back by the
borrower later for face value
Objective: 15.3
78
10) How is a line of credit different than a revolving credit agreement?
Answer: With a line of credit, the company borrowing the money knows the maximum amount
it will be allowed to borrow (if the bank has sufficient funds). With a revolving credit agreement,
the company knows not only the maximum amount, but it is also guaranteed that the bank will
make the money available (the company pays a commitment fee to get this guarantee).
Objective: 15.3
11) Define and describe the process of factoring accounts receivable.

Answer: A firm can raise funds rapidly by factoring, i.e., by selling the firm's accounts
receivables. In this process, the purchaser of the receivables, usually a financial institution, is
known as the factor. The factor pays some percentage of the full amount of receivables due to the
selling firm. The seller gets this money immediately. The factor profits to the extent that the
money it eventually collects exceeds the amount it is paid.
Objective: 15.3
12) Give an example of how commercial paper works.

Answer: Suppose Corporation X needs $20 million dollars to buy new equipment. It might issue
commercial paper with a total face value of $20.4 million to various other organizations that
would like to earn interest on their idle funds (say, for example, an insurance company). These
other companies would loan Corporation X a total of $20 million, and after say, 90 days, they
would receive a total of $20.4 million from Corporation X. The extra $400 000 represents the
interest that the other companies earn for providing cash to Corporation X.
Objective: 15.3
13) What are the main methods of debt financing? What is the major source of debt financing for
most corporations?
Answer: The two main methods are long-term loans (which extend three to ten years, usually
from chartered banks but may also be from insurance companies, credit companies, and pension
funds) and corporate bonds (which represent a promise by the issuing company to pay the holder
a certain amount of money on a specified date, with stated interest payments in the interim).
Corporate bonds are the major source of debt financing for most corporations because of the
large amounts of money that are available for loan.
Objective: 15.4
79
14) Discuss the methods by which bonds may be retired. Which method offers the greatest
security for investors? Which method does the issuing firm prefer?
Answer:
- Callable bonds may be paid off by the issuer before the maturity date.
- A sinking-fund provision is a clause in the bond indenture that requires the issuing company to
put enough money into a special account each year to cover the retirement of the bond issue on
schedule; this is the safest for investors.
- A serial bond is a bond issue in which redemption dates are staggered so that a firm pays off
portions of the issue at different predetermined dates.
- A convertible bond is any bond that offers bondholders the option of accepting common stock
instead of cash in repayment; this is the method preferred by the issuing firm.
Objective: 15.4
15) Why are convertible bonds attractive to investors?

Answer: They are attractive because they give the owner the option to convert the bond to
common shares at a certain price (known as the strike price). If the price of the company's stock
is above the strike price, the bondholder makes a profit (in addition to the interest the bondholder
collected along the way).
Objective: 15.4
16) How do convertible bonds work?

Answer: Convertible bonds can be converted into the common stock of the issuing company.
For example, suppose that Arctic Enterprises sold a $100-million issue of 4.5 percent convertible
bonds in 2015. The bonds were issued in $1000 denominations, and they mature in 2025. At any
time before maturity, each bond of $1000 is convertible into 19.125 shares of the company's
common stock. Suppose that between October 2015 and March 2015, the stock price ranged
from a low of $28 to a high of $67. In that time, then, 19.125 common shares had a market value
ranging from $535 to $1281. The bondholder could have exchanged the $1000 bond in return for
stock to be kept or sold at a possible profit (or loss).
Objective: 15.4
17) Since equity funding is expensive, why don't businesses rely totally on debt capital?
Answer: Because that would be too risky. Long-term loans and bonds carry fixed interest rates
and represent a fixed promise to pay regardless of the profitability of the company. If the
company can't make its fixed payments, it may have to declare bankruptcy, but it doesn't have to
pay dividends to stockholders if it is short of funds.
Objective: 15.4
80
18) Why is retained earnings viewed as a form of equity financing?
Answer: Because the earnings that are retained in the business (and not paid out to stockholders
as dividends) allow the company to avoid borrowing money and therefore having to pay interest
on loans or bonds. This saves the company more money.
Objective: 15.5
19) Identify, briefly describe, and give one example for each of the two types of long-term
financing.
Answer: Long-term financing can be done though debt or equity financing.
- Debt financing can be done through long-term loans or issuing corporate bonds.
- Equity financing can be done through issuing common stock or using retained earnings.
Objective: 15.5
20) What are the two methods of equity financing for long-term funding requirements? What
issues must be considered before the choice is made between the two methods? Explain your
reason.
Answer:
- Common stock: selling shares in ownership to raise money
- Retained earnings: using the built-up stock of cash as a form of financing
The use of retained earnings means that a company will not have to borrow money or pay
interest on that money. However, it will result in lower dividends, which may lead to lower stock
prices.
Objective: 15.5
21) What is the difference between par value, market value, and book value?
Answer: They are different ways of evaluating a stock's worth.
- Par: is the face amount of the stock and it never changes
- Market: is the price investors are currently willing to pay for the stock
- Book: is the calculated value taken from the firm's financial statements
Objective: 15.5
81
22) Discuss the advantages and disadvantages of financing using preferred stock.
Answer: Preferred stock is a form of hybrid financing, falling somewhere between debt and
equity financing. It is a hybrid because it has some of the features of corporate bonds, and some
of the features of common stock. Like bonds, payments on preferred stock are for fixed amounts.
However, unlike bonds, preferred stock never matures. It can be held indefinitely. Dividends
need not be paid if the company makes no profit. If dividends are paid, preferred shareholders
receive them first in preference to dividends on common stock. A major advantage of preferred
shares financing is the flexibility: no loss of control, no repayment of principal amount, no
maturity, and no requirement to pay dividends in leaner times.
Objective: 15.5
23) Why is preferred stock referred to as hybrid financing?

Answer: It has features of both debt and equity financing:
- Like bonds, there are fixed payments and no loss of control as there are no voting rights.
- Like equity, it never matures and there is no requirement to pay dividends if the company is
unprofitable.
Objective: 15.5
24) Discuss the value of common stock and preferred stock to shareholders and describe the
secondary market for each type of security.
Answer: Common stock affords investors the prospect of capital gains, dividend income, or
both. Preferred stock is less risky than common stock and it offers the prospect of steadier
income than common stock. Shareholders of preferred stock must be paid dividends before
shareholders of common stock. Both common and preferred stock are traded on stock exchanges
and in over-the-counter markets.
Objective: 15.5
25) What is meant by investor relations?

Answer: Investor relations involves publicizing the positive aspects of a company's financial
position to financial analysts and financial institutions. It is done to create more demand for a
stock, which will cause its price to increase.
Objective: 15.5
82
26) Discuss the investment traits of preferred stock.
Answer:
- Stocks are issued with a stated par value.
- Dividends are a percentage of the par value.
- Some preferred stock may be callable.
- Dividends are not as certain as interest payments from bonds issued by the same company.
Objective: 15.5
27) What factors influence the market value of a stock?

Answer: The market value of a share of stock can be influenced by both objective factors (for
example, company profits) and subjective factors (e.g., rumours, investor relations activities, and
recommendations by stockbrokers).
Objective: 15.5
28) Explain how the Rule of 72 works using an example.

Answer: The Rule of 72 is used to determine the number of years that are needed to double your
money. Simply divide the annual interest rate (in percent) into 72. For example, if you invest at 8
percent, you'll double your money in about 9 years (72/8 = 9 years). By the same reasoning, if
you invest at 4 percent, your money will double in about 18 years. The Rule of 72 can also
calculate how much interest you must get if you want to double your money in a given number
of years. Simply divide 72 by the desired number years. For example, if you want to double your
money in 10 years, you need to get 7.2 percent annual interest (72/10 = 7.2 percent interest rate).
Objective: 15.5
29) What are the key areas that must be considered when comparing debt and equity financing?
Answer: The key issues are (1) when repayment must be made (there is a fixed deadline for
bonds, but not for stocks); (2) the claims made on income (bond claims are regular and fixed, but
stock claims are residual only); (3) the claims made on assets (bondholders have preference over
stockholders); (4) the impact on management control (none for bonds, more for stocks); (5)
effect on taxes (bond interest is tax deductible, but dividends on stock are not); and (6) impact on
management flexibility (many constraints for bonds, few constraints for stocks).
Objective: 15.5
83
30) What is the difference between debt financing and equity financing?
Answer: Equity financing means selling ownership in the company (common stock) as a means
of getting the long-term funds it needs to buy things like land, buildings, and equipment. This
money does not have to be paid back (although investors may expect dividends to be paid on a
regular basis). By contrast, debt financing (long-term loans and the sale of bonds) means
borrowing money to use in the company. This borrowed money must be paid back at some point.
Objective: 15.5
31) How is the current dividend yield calculated?

Answer: Current dividend yield is calculated by dividing the yearly dollar amount of dividend
income by the investment's current market value. For example, if each share of stock in a
company receives an annual dividend of $1.80, and on a given day the share price is $35.67, the
current yield would be 5.05 percent ($1.80/$35.67 × 100).
Objective: 15.5
32) Explain how various financial instruments (government bonds, common stock, etc.) relate to
each other in terms of risk and return.
Answer: The basic risk–return principle says that for low risk instruments, investors are willing
to accept lower the return, but for high risk instruments, investors demand higher returns. So,
government bonds, which are very low risk, provide very modest returns but virtually no chance
for a big gain or a big loss. By contrast, low quality common stocks, which are very high risk,
may provide very high returns or very large losses.
Objective: 15.5
33) Explain the differences between primary and secondary securities markets.
Answer:
- Primary securities markets: involve the buying and selling of new securities, either in public
offerings or through private placements
- Secondary securities markets: involve the trading of existing stocks and bonds through such
familiar bodies as the New York Stock Exchange and Toronto Stock Exchange
Objective: 15.5
84
34) What is the difference between diversification and asset allocation?
Answer: Diversification means buying several different kinds of investments rather than just
one. For example, as applied to common stocks, diversification means that you invest in the
stocks of several different companies in different industries and in different countries. This
reduces the risk of loss because although any one stock may tumble, the chances are slim that all
of them will decline at the same time. Diversification is furthered when a variety of investments
are used (stocks, bonds, mutual funds, real estate, and so on). Asset allocation is the proportion
of funds invested in each of the investment alternatives. Young investors may decide to allocate,
say, 50 percent of their funds to common stocks, 25 percent to bonds, and 25 percent to
guaranteed investment certificates (GICs). But older investors would typically have a larger
proportion in more conservative investments like bonds and GICs) and a smaller proportion in
stocks.
Objective: 15.5
35) Describe the services provided by investment banks.

Answer: Investment banks provide three important services: (1) They advise companies on the
timing and financial terms of new issues; (2) by underwriting new securities, they bear some of
the risk of issuing them; and (3) they create the distribution networks for moving new securities
through groups of other banks and brokers into the hands of individual investors.
Objective: 15.5
36) What is the difference between full-service and discount brokers?

Answer: Full-service brokers offer services to clients who are either not very well informed
about investment possibilities, or who are simply not interested in the details of investing. These
brokers offer services such as consulting advice for personal financial planning, estate planning,
and tax strategies, along with a wider range of investment products. In addition to delivering and
interpreting information, full-service brokers can identify investments that clients might not
otherwise notice in the large amount of online financial data that is available. By contrast,
discount brokers offer well-informed individual investors a fast, low-cost way to participate in
the market. Discount brokerage services cost less because sales personnel receive fees or
salaries, not commissions. Discount brokers do not offer investment advice or person-to-person
sales consultations. However, they do offer automated online services: stock research, industry
analysis, and screening for specific types of stocks.
Objective: 15.5
85
37) Why has online trading become so popular?
Answer: The popularity of online trading stems from convenient access to the Internet, fast no-
nonsense transactions, and the opportunity for investors to manage their own investments while
paying low fees for trading. Online investors can buy into and sell the stocks of thousands of
companies daily.
Objective: 15.5
38) What should an investor consider when selecting an investment broker?

Answer: Determine what assistance one needs in buying and selling securities. If considerable
assistance is needed, then one may want a full-service brokerage. If the investor is going to find
all the information and only needs someone to execute trades, then a discount brokerage house
may be best. Discount broker fees are much lower because they don't offer services such as
investment advice and person-to-person sales conversations.
Objective: 15.5
39) What is a market index? Identify and describe the major market indices in Canada and the
United States.
Answer: A market index is a measure of the market value of stocks; provides a summary or
price trends in a specific industry or of the stock market as a whole
Major market indices:

-The S&P/TSX index is an average computed from 246 large Canadian stocks from various
industry groups. The index has also been very volatile during the past few years.
- The Dow Jones Industrial Average—the Dow is the sum of market prices for 30 of the largest
industrial firms listed on the NYSE
- The S&P 500—consists of 500 stocks, including 400 industrial firms, 40 utilities, 40 financial
institutions, and 20 transportation companies; the index average is weighted according to market
capitalization of each stock
- The NASDAQ Composite Index—all NASDAQ-listed companies are included in the index and
it includes U.S. and non-U.S. based common stocks listed on the NASDAQ market
Objective: 15.6
86
40) List and briefly describe the different types of orders that investors can place when deciding
to buy or sell a security.
Answer:
- Market order: an order to a broker to buy or sell a certain security at the current market price
- Limit order: an order to a broker to buy a certain security only if its price is less than or equal to
a given limit
- Stop order: an order to a broker to sell a certain security if its price falls to a certain level or
below
- Round lot: the purchase or sale of stock in units of 100 shares
- Odd lots: the purchase or sale of stock in units other than 100 shares
Objective: 15.6
41) Explain the process by which securities are bought and sold.
Answer: Investors generally use financial information from online sources and newspaper
services to examine stock, bond, and OTC quotations to learn about possible investments.
Market Indexes such as the S&P/TSX index, the Dow Jones Industrial Average, Standard &
Poor's Composition Index, and the NASDAQ Composite Index provide summaries of trends,
both in specific industries and in the market as a whole. Investors can then place different types
of orders. Market orders are orders to buy or sell at current market prices. Because investors do
not know exactly what prices will be when market orders are executed, they may issue limit or
stop orders that are to be executed only if prices rise to or fall below specified levels. Rounds lots
are purchased in multiples of 100 shares. Odd lots are purchases in fractions of round lots.
Securities can be bought on margin or as part of short sales (sales in which investors sell
securities that are borrowed from brokers and returned at a later date).
Objective: 15.6
87
42) What is margin trading? Give an example.
Answer: Margin trading means putting down only a portion of the stock's price when it is
purchased. You borrow the rest from your broker, who, in turn, borrows from the banks at a
special rate and secures the loans with stock. An example: suppose you purchase worth
of stock. Let's also say that you paid of your own money and borrowed the other
from your broker at 10 percent interest. Valued at its market price, your stock serves as your
collateral. If shares have risen in value to $115 000 after one year, you can sell them and pay
your broker ( principal plus $5000 interest). You will have left over. Your
original investment of $50 000 will have earned a 20 percent profit ($10 000). If you had paid
the entire price out of your own pocket, you would have earned only a 15 percent return. So, if
the price of the stock goes up, margin trading means that profits are amplified. But, if the stock
price drops, losses are also amplified. If the value of your initial investment of had
instead fallen to $85 000 after one year, you would have lost 15 percent if you had put up all the
money yourself. However, if you had used margin trading, you would have lost ($5000
interest payment share decrease) on a investment, which amounts to a 40 percent
loss.
Objective: 15.6
43) What are stock options? Describe the two types of options available to investors.
Answer:
- Stock option—the purchased right to buy or sell a stock
- Call option—the purchased right to buy a stock at a certain price until a specified date
- Put option—the purchased right to sell a stock at a certain price until a specified date
Objective: 15.6
44) What is short selling and how does it work? Why do people do it? Give an example.
Answer: In a short sale, the investor borrows shares of stock from a broker and sells them (one
of the few times it is legal to sell what you do not own). At a given time in the future, the
investor must restore an equal number of shares of that stock to the broker, along with a fee. For
example, suppose that in June you believe the price of Bombardier stock will soon fall. You
order your broker to "sell short" 1000 shares at the market price of $5 per share. Your broker
makes the sale and credits $5000 to your account. If Bombardier's price falls to $3.50 per share
in July, you can buy 1000 shares for $3500 and give them to your broker, leaving you with a
$1500 profit (before the broker's commissions). The risk is that Bombardier's price will not fall,
but will hold steady or rise, leaving you with a loss. Investors "sell short" if they have reason to
believe that the price of a given company's stock is going to fall in the near future.
Objective: 15.6
88
45) Explain the operation of a mutual fund. What are the advantages to a small investor?
Answer: A mutual fund is any company that pools the resources of many investors and uses
those funds to purchase various types of financial securities, depending on the fund's financial
goals. Mutual funds are advantageous for small investors because they get access to professional
financial management.
Objective: 15.7
46) What is an exchange-traded fund (ETF)? How is it different than a mutual fund?
Answer: An ETF is a bundle of stocks (or bonds) that is in an index that tracks the overall
movement of a market. Unlike mutual funds—which are priced only at the end of each day—you
can buy or sell ETFs at any time during the day when the market reaches your target price. Also,
unlike mutual funds—which incur the costs of active management—ETFs have lower operating
expenses because they are bound by rules that specify what stocks will be purchased and when.
Once the rule is established, little human action is needed, and this reduces management
expenses.
Objective: 15.7
47) How do commodity markets work? What are the risks involved when investing in the
commodities market? What are the rewards or potential rewards?
Answer:
- Commodities markets sell futures contracts on specific commodities
- Most of the time futures are bought on margin
- Can be riskier because:
* Price volatility is high
* Exposure is greater through margins
- Rewards can be higher because the use of margins allow relatively small fluctuations to
translate into high returns on investment
Objective: 15.7
89
48) What are futures contracts? Explain how they work by giving an example.
Answer: Futures contracts are agreements to purchase a specified amount of a commodity at a
given price on a set date in the future. They are available for commodities ranging from coffee
beans and live hogs to propane and platinum, as well as for stocks. Since selling prices reflect
traders' beliefs about the future, prices of such contracts are very volatile, and futures trading is
very risky. An example: Suppose that on January 3, 2018 the price of gold was $1625 per ounce.
If futures gold contracts for July 2019 were selling for $1575 per ounce, this price would reflect
investors' judgments that gold prices would be slightly lower in July. Now suppose that you
purchased a 100-ounce gold futures contract in January for $157 500 ($1575 × 100). If in March
2019, the July gold futures sold for $1700, you could sell your contract for $170 000. Your profit
after the two months would be $12 500. Of course, if the futures contract had been selling for
less than $1575, you would have lost money.
Objective: 15.7
49) What is the purpose of the various provincial securities commissions? What are some of the
difficulties these agencies encounter as they try to protect investors?
Answer: Three areas:
- Blue-sky laws: laws that regulate how corporations back up securities
- Prospectus: requirement for a detailed registration statement about a new stock
- Insider trading: prohibition of the use of special knowledge about a firm to make a profit on the
stock market
Objective: 15.7
50) What is risk? What is the difference between speculative risk and pure risk? What is risk
management?
Answer:
- Risk: uncertainty about future events
- Speculative risk: involve the possibility of gain or loss
- Pure risk: involve the possibility of loss or no loss only
- Risk management: conserving a firm's financial power or assets by minimizing the financial
effect of accidental losses
Objective: 15.8
90
51) What are the five steps in the risk management process?
Answer:
- Step 1: Identify risks and potential losses
- Step 2: Measure the frequency and severity of losses and their impact
- Step 3: Evaluate alternatives and choose the techniques that will best handle the losses
- Step 4: Implement the risk-management program
- Step 5: Monitor results
Skill: Knowledge
Objective: 15.8
52) Explain the strategies that are used by business firms to cope with risk. Give an example of
each strategy.
Answer: There are four basic strategies. Risk avoidance means stopping participation in or
refusing to participate in ventures that carry any risk. For example, a firm with a fleet of delivery
trucks could avoid any risk of physical damage or bodily injury by closing down its delivery
service and contracting it out to a company specializing in deliveries. Risk control involves
techniques to prevent, minimize, or reduce losses or the consequences of losses. For example, a
delivery service can prevent losses by training its drivers in defensive-driving techniques,
mapping out safe routes, and conscientiously maintaining its trucks. Risk retention means
covering a firm's unavoidable losses with its own funds. For example, if a firm with a fleet of
trucks may find that each vehicle suffers vandalism totalling 300 each year, it may find that it's
cheaper to pay for repairs out of pocket than it is to submit claims to an insurance company. Risk
transfer means transferring the risk to another individual or firm. For example, the company with
the delivery trucks can buy insurance to protect itself against physical damage to trucks and
bodily injury to drivers.
Objective: 15.8
91

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Business Essentials, Canadian Edition, 9e (Ebert)

Chapter 15 Financial Decisions and Risk Management

15.1 Multiple Choice Questions

2) Which of the following represents the overall objective of financial managers?

9) A ________ is an important financial control measure; it is the "measuring stick" against

14) A credit policy of "2/10, net 30" means

17) Sellers adjust credit terms in order to influence

25) The most common form of trade credit is

35) How may a firm obtain an unsecured short-term bank loan?

36) Which of the following requires a commitment fee?

40) Which of the following is a financing method for short-term funds?

46) The two primary sources of long-term debt funds are

51) Issuers of bonds are most likely to call them in when

53) What is an advantage of issuing a bond with a sinking fund provision?

58) Which of the following represents a stock's real value?

63) Which of the following is correct?

66) Which of the following is correct with regard to market capitalization?

76) What is the difference between debt and equity financing?

77) Which of the following is a function performed by an investment bank?

80) Which of the following is correct with respect to retained earnings?

84) What is a stock's market value?

89) Which of the following is true with regard to preferred stock?

97) When an investment bank underwrites a new security, they are

103) Which of the following is correct with respect to bonds?

106) A stock quote of 30.5 means

108) During a bear market,

119) What is a mutual fund?

122) Which of the following is correct with regard to hedge funds?

125) Blue-sky laws apply mainly to the

130) The second step in a risk management program is to

146) A financial manager's overall objective is to do which of the following?

153) The granting of credit by one firm to another is

158) What is the face value of a stock called?

161) Stock prices moving upwards is called a

15.2 Critical Thinking Questions

13) Munschausen is a German-based appliance company that is preparing to begin international

15) Munschausen is a German-based appliance company that is preparing to begin international

16) Munschausen is a German-based appliance company that is preparing to begin international

2) Budgets are key in financial control.

12) Once a trade draft is signed it becomes a trade acceptance.

13) Most bank loans do not require a promissory note.

18) Factors typically earn about 8 percent on their investment.

66) Financial managers deal only with speculative risks.

71) The chance of a flood is pure risk.

78) A period of falling stock prices is called a bear market.

1) What is a financial manager?

2) What is the financial manager's overall objective?

3) What are the four responsibilities of finance (corporate finance)?

4) What is involved in cash flow management?

5) What is financial control?

7) What do credit terms of 2/10; net 30 refer to?

8) List the three forms of inventory that companies typically carry.

9) List three sources of short-term funds.

10) What is open-book credit?

11) Differentiate between a trade draft and a trade acceptance.

13) What is commercial paper?

14) What are the two primary sources of debt financing?

15) What is a bond?

16) What is a debenture?

20) What is par value?

21) What is the risk-return relationship?

22) Explain the principle of compound growth.

23) Explain the Rule of 72.

24) What is a security?