College of Accounting Education

3F, Business & Engineering Building

Matina, Davao City
Phone No.: (082)300-5456 Local 137

EXERCISES
MAS 7: FINANCIAL MANAGEMENT – RISK, RETURNS AND VALUATION

1. Which of the following statements is most correct?

a. Money markets are markets for long-term debt and common stocks.
b. Primary markets are markets where existing securities are traded among investors.
c. A derivative is a security whose value is derived from the price of some other “underlying”
asset.
d. Statements a and b are correct.
e. Statements b and c are correct.

2. Which of the following statements is most correct?

a. While the distinctions are blurring, investment banks generally specialize in lending money,
whereas commercial banks generally help companies raise capital from other parties.
b. Money market mutual funds usually invest their money in a well-diversified portfolio of liquid
common stocks.
c. The NYSE operates as an auction market, whereas NASDAQ is an example of a dealer market.
d. Statements b and c are correct.
e. All of the statements above are correct.

3. Which of the following is an example of a capital market instrument?

a. Commercial paper.
b. Preferred stock.
c. U.S. Treasury bills.
d. Banker’s acceptances.
e. Money market mutual funds.

4. Money markets are markets for

a. Foreign currency exchange.
b. Consumer automobile loans.
c. Corporate stocks.
d. Long-term bonds.
e. Short-term debt securities.

5. Which of the following statements is correct?

a. The New York Stock Exchange is a physical location auction market.
b. Money markets include markets for consumer automobile loans.
c. If an investor sells shares of stock through a broker, then it would be a primary market
transaction.
d. Capital market transactions involve only the purchase and sale of equity securities.
e. None of the statements above is correct.

6. You recently sold 100 shares of Microsoft stock to your brother at a family reunion. At the reunion
your brother gave you a check for the stock and you gave your brother the stock certificates.
Which of the following best describes this transaction?
a. This is an example of a direct transfer of capital.
 b. This is an example of a primary market transaction.
c. This is an example of an exchange of physical assets.
d. This is an example of a money-market transaction.
e. Statements a, b, and d are correct. Statement c is incorrect.

7. Which of the following statements is most correct?

a. If you purchase 100 shares of Disney stock from your brother-in-law, this is an example of a
primary market transaction.
b. If Disney issues additional shares of common stock, this is an example of a secondary market
transaction.
c. The NYSE is an example of an over-the-counter market.
d. Statements a and b are correct.
e. None of the statements above is correct.

8. You recently sold 200 shares of Disney stock to your brother. This is an example of:
a. A money market transaction.
b. A primary market transaction.
c. A secondary market transaction.
d. A futures market transaction.
e. Statements a and b are correct.

9. Which of the following are examples of a primary market transaction?

a. A company issues new common stock.
b. A company issues new bonds.
c. An investor asks his broker to purchase 1,000 shares of Microsoft common stock.
d. All of the statements above are correct.
e. Statements a and b are correct.

10. Assume that inflation is expected to steadily decline in the years ahead, but that the real risk-free
rate, k*, is expected to remain constant. Which of the following statements is most correct?
a. If the expectations theory holds, the Treasury yield curve must be downward sloping.
b. If the expectations theory holds, the yield curve for corporate securities must be downward
sloping.
c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
d. Statements b and c are correct.
e. All of the statements above are correct.

11. Which of the following statements is most correct?

a. Downward sloping yield curves are inconsistent with the expectations theory.
b. The shape of the yield curve depends only on expectations about future inflation.
c. If the expectations theory is correct, a downward sloping yield curve indicates that interest
rates are expected to decline in the future.
d. Statements a and c are correct.
e. None of the statements above is correct.

12. Which of the following statements is most correct?

a. If the maturity risk premium (MRP) is greater than zero, the yield curve must be upward
sloping.
b. If the maturity risk premium (MRP) equals zero, the yield curve must be flat.
c. If interest rates are expected to increase in the future and the maturity risk premium (MRP) is
greater than zero, the yield curve will be upward sloping.
d. If the expectations theory holds, the yield curve will never be downward sloping.
e. All of the statements above are correct.
13. Which of the following statements is most correct?
a. If companies have fewer productive opportunities, interest rates are likely to increase.
b. If individuals increase their savings rate, interest rates are likely to increase.
c. If expected inflation increases, interest rates are likely to increase.
d. All of the statements above are correct.
e. Statements a and c are correct.

14. Which of the following is likely to increase the level of interest rates in the economy?
a. Households start saving a larger percentage of their income.
b. Corporations step up their plans for expansion and increase their demand for capital.
c. The level of inflation is expected to decline.
d. All of the statements above are correct.
e. None of the statements above is correct.

15. Which of the following factors are likely to lead to an increase in nominal interest rates?
a. Households increase their savings rate.
b. Companies see an increase in their production opportunities that leads to an increase in the
demand for funds.
c. There is an increase in expected inflation.
d. Statements b and c are correct.
e. All of the statements above are correct.

16. Which of the following is likely to lead to an increase in the cost of funds?
a. Companies’ production opportunities decline, leading to a decline in the demand for funds.
b. Households save a larger portion of their income.
c. Households increase the amount of money they borrow from their local banks.
d. Statements a and b are correct.
e. Statements a and c are correct.

17. Assume that the expectations theory describes the term structure of interest rates. Which of the
following statements is most correct?
a. In equilibrium long-term rates equal short term rates.
b. An upward-sloping yield curve implies that interest rates are expected to decline in the years
ahead.
c. The maturity risk premium is zero.
d. Statements a and b are correct.
e. None of the statements above is correct.

18. Which of the following are reasons why companies move into international operations?
a. To take advantage of lower production costs in regions of inexpensive labor.
b. To develop new markets for their finished products.
c. To better serve their primary customers.
d. Because important raw materials are located abroad.
e. All of the statements above are correct.

19. Multinational financial management requires that

a. The effects of changing currency values be included in financial analyses.

b. Legal and economic differences be considered in financial decisions.
c. Political risk be excluded from multinational corporate financial analyses.
d. Statements a and b are correct.
e. All of the statements above are correct.
20. If the inflation rate in the United States is greater than the inflation rate in Sweden, other things held
constant, the Swedish currency will
a. Appreciate against the U.S. dollar.
b. Depreciate against the U.S. dollar.
c. Remain unchanged against the U.S. dollar.
d. Appreciate against other major currencies.
e. Appreciate against the dollar and other major currencies.

21. Which of the following statements is incorrect?

a. Any bond sold outside the country of the borrower is called an international bond.
b. Foreign bonds and Eurobonds are two important types of international bonds.
c. Foreign bonds are bonds sold by a foreign borrower but denominated in the currency of the
country in which the issue is sold.
d. The term Eurobond specifically applies to any foreign bonds denominated in U.S. currency.
e. None of the statements above is correct.

22. A decrease in the debt ratio will generally have no effect on

a. Financial risk.
b. Total risk.
c. Business risk.
d. Market risk.
e. None of the above is correct. (It will affect each type of risk above.)

23. Business risk is concerned with the operations of the firm. Which of the following is not
associated with (or not a part of) business risk?
a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. Changes in required returns due to financing decisions.
e. The ability to change prices as costs change.

24. Which of the following factors would affect a company’s business risk?
a. The level of uncertainty regarding the demand for its product.
b. The degree of operating leverage.
c. The amount of debt in its capital structure.
d. Statements a and b are correct.
e. All of the statements above are correct.

25. Which of the following statements is most correct?

a. A firm’s business risk is solely determined by the financial characteristics of its industry.
b. The factors that affect a firm’s business risk are determined partly by industry characteristics
and partly by economic conditions. Unfortunately, these and other factors that affect a
firm’s business risk are not subject to any degree of managerial control.
c. One of the benefits to a firm of being at or near its target capital structure is that financial
flexibility becomes much less important.
d. The firm’s financial risk may have both market risk and diversifiable risk components.
e. None of the statements above is correct.
26. Which of the following statements is most correct?
a. As a rule, the optimal capital structure is found by determining the debt-equity mix that
maximizes expected EPS.
b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for
maximizing the stock price.
d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity,
and the WACC.
e. None of the statements above is correct.

27. Which of the following statements best describes the optimal capital structure?
a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes
the company’s earnings per share (EPS).
b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes
the company’s stock price.
c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes
the company’s weighted average cost of capital (WACC).
d. Statements a and b are correct.
e. Statements b and c are correct.

28. The firm’s target capital structure is consistent with which of the following?
a. Maximum earnings per share (EPS).
b. Minimum cost of debt (kd).
c. Minimum risk.
d. Minimum cost of equity (ks).
e. Minimum weighted average cost of capital (WACC).

29. Which of the following is likely to encourage a company to use more debt in its capital
structure?
a. An increase in the corporate tax rate.
b. An increase in the personal tax rate.
c. A decrease in the company’s degree of operating leverage.
d. Statements a and c are correct.
e. All of the statements above are correct.

30. Which of the following statements is most correct?

a. A reduction in the corporate tax rate is likely to increase the debt ratio of the average
corporation.
b. An increase in the personal tax rate is likely to increase the debt ratio of the average
corporation.
c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this
would likely reduce the debt ratio of the average corporation.
d. All of the statements above are correct.
e. None of the statements above is correct.

31. Which of the following statements is likely to encourage a firm to increase its debt ratio in its
capital structure?
a. Its sales become less stable over time.
 b. Its corporate tax rate declines.
c. Management believes that the firm’s stock is overvalued.
d. Statements a and b are correct.
e. None of the statements above is correct.

32. Which of the following factors is likely to encourage a corporation to increase the proportion of
debt in its capital structure?
a. An increase in the corporate tax rate.
b. An increase in the personal tax rate.
c. An increase in the company’s degree of operating leverage.
d. The company’s assets become less liquid.
e. An increase in expected bankruptcy costs.

33. Which of the following would increase the likelihood that a company would increase its debt
ratio in its capital structure?
a. An increase in costs incurred when filing for bankruptcy.
b. An increase in the corporate tax rate.
c. An increase in the personal tax rate.
d. A decrease in the firm’s business risk.
e. Statements b and d are correct.

34. Which of the following factors is likely to encourage a company to increase its debt ratio?
a. An increase in the corporate tax rate.
b. An increase in the personal tax rate.
c. Its assets become less liquid.
d. Both statements a and c are correct.
e. All of the statements above are correct.

35. Which of the following statements is most correct?

a. When a company increases its debt ratio, the costs of both equity and debt capital increase.
Therefore, the weighted average cost of capital (WACC) must also increase.
b. The capital structure that maximizes stock price is generally the capital structure that also
maximizes earnings per share.
c. Since debt financing is cheaper than equity financing, increasing a company’s debt ratio will
always reduce the company’s WACC.
d. The capital structure that maximizes stock price is generally the capital structure that also
maximizes the company’s WACC.
e. None of the statements above is correct.

36. Which of the following statements is most correct?

a. When a company increases its debt ratio, the costs of equity and debt capital both increase.
Therefore, the weighted average cost of capital (WACC) must also increase.
b. The capital structure that maximizes stock price is generally the capital structure that also
maximizes earnings per share.
c. All else equal, an increase in the corporate tax rate would tend to encourage a company to
increase its debt ratio.
d. Statements a and b are correct.
e. Statements a and c are correct.
37. Which of the following statements is most correct?
a. Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will
always increase the company’s WACC.
b. Since debt financing is cheaper than equity financing, increasing a company’s debt ratio will
always reduce the company’s WACC.
c. Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and
equity financing; however, it still may raise the company’s WACC.
d. Statements a and c are correct.
e. None of the statements above is correct.

38. Which of the following statements is most correct?

a. The capital structure that maximizes stock price is also the capital structure that minimizes
the weighted average cost of capital (WACC).
b. The capital structure that maximizes stock price is also the capital structure that maximizes
earnings per share.
c. The capital structure that maximizes stock price is also the capital structure that maximizes
the firm’s times interest earned (TIE) ratio.
d. Statements a and b are correct.
e. Statements b and c are correct.

39. Which of the following statements about capital structure theory is most correct?
a. Signaling theory suggests firms should in normal times maintain reserve borrowing capacity
that can be used if an especially good investment opportunity comes along.
b. In general, an increase in the corporate tax rate would cause firms to use less debt in their
capital structures.
c. According to the “trade-off theory,” an increase in the costs of bankruptcy would lead firms
to reduce the amount of debt in their capital structures.
d. Statements a and c are correct.
e. All of the statements above are correct.

40. Which of the following statements is most correct?

a. The rate of depreciation will often affect operating cash flows, even though depreciation is
not a cash expense.
b. Corporations should fully account for sunk costs when making investment decisions.
c. Corporations should fully account for opportunity costs when making investment decisions.
d. Statements a and c are correct.
e. All of the statements above are correct.

41. Given the following returns on Stock Q and “the market” during the last three years, what is the
difference in the calculated beta coefficient of Stock Q when Year 1-Year 2 data are used as
compared to Year 2-Year 3 data?

Year Stock Q Market

1 6.30% 6.10%
2 -3.70 12.90
3 21.71 16.20
 42. Consider the following information for three stocks, Stock A, Stock B, and Stock C. The returns on
each of the three stocks are positively correlated, but they are not perfectly correlated. (That is,
all of the correlation coefficients are between 0 and 1.)

Expected Standard
Stock Return Deviation Beta
Stock A 10% 20% 1.0
Stock B 10 20 1.0
Stock C 12 20 1.4

Portfolio P has half of its funds invested in Stock A and half invested in Stock B. Portfolio Q has
one third of its funds invested in each of the three stocks. The risk-free rate is 5 percent, and
the market is in equilibrium. (That is, required returns equal expected returns.) What is the
market risk premium (kM - kRF)?

43. Company X has a beta of 1.6, while Company Y’s beta is 0.7. The risk-free rate is 7 percent, and
the required rate of return on an average stock is 12 percent. Now the expected rate of
inflation built into kRF rises by 1 percentage point, the real risk-free rate remains constant, the
required return on the market rises to 14 percent, and betas remain constant. After all of these
changes have been reflected in the data, by how much will the required return on Stock X
exceed that on Stock Y?

44. An investor is forming a portfolio by investing P50,000 in stock A that has a beta of 1.50, and
P25,000 in stock B that has a beta of 0.90. The return on the market is equal to 6 percent and
Treasury bonds have a yield of 4 percent. What is the required rate of return on the investor’s
portfolio?

45. An analyst has put together the following spreadsheet to estimate the intrinsic value of the stock of
Rangan Company (in millions of pesos):

t=1 t=2 t=3

Sales P3,000 P3,600 P4,500
NOPAT 500 600 750
Net investment in operating capital* 300 400 500

*Net investment in operating capital = Capital expenditures + Changes in net operating capital –

Depreciation.

After Year 3 (t = 3), assume that the company’s free cash flow will grow at a constant rate of 7 percent a year
and the company’s WACC equals 11 percent. The market value of the company’s debt and preferred stock is
P700 million. The company has 100 million outstanding shares of common stock.

a. What is the company’s free cash flow the first year (t = 1)?
b. Using the free cash flow model, what is the intrinsic value of the company’s stock today?