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Indian Institute of Management Calcutta Financial Management, Practice Questions

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1. Which of the following best describes the constant-growth dividend discount model? A) It is the formula for the present value of an ordinary annuity. B) It is the formula for the present value of a growing annuity. C) It is the formula for the present value of a ordinary perpetuity. D) It is the formula for the present value of a growing perpetuity. 2. A preferred stock pays annual dividends of $1.80 per share. What is this stock worth to you today if you desire a 14.5 percent return on this investment? A) B) C) D)

$11.87 $12.41 $25.98 $26.10

3. A project will produce cash flows of $2,400, $2,800, and $4,100 a year for the next three years, respectively. What is the net value of these cash flows today if the applicable discount rate is 12 percent? A) B) C) D)

$7,778.80 $8,056.16 $7,293.30 $8,303.57

4. Which one of the following represents a potential agency problem? A) B) C) D)

Managers works for the well being of the share holders Hiring a manager and compensating her with shares of company stock Paying a management bonus based on the number of employees managed Paying all company earnings out to shareholders in the form of dividends

5. The plowback ratio is best defined as: A) B) C) D)

the profit margin minus the dividend payout ratio. annual dividends paid divided by net income. the change in retained earnings from one year to the next. one minus the dividend payout ratio.

6. Concrete Rail Ties recently announced that it will pay its first annual dividend next year in the amount of $0.45 a share. The dividend will be increased by 4 percent annually Page 1 of 5

thereafter. How much are you willing to pay today for one share of this stock if you require a 10 percent rate of return? A) B) C) D)

$6.50 $6.80 $7.50 $8.65

7. What's the value to you of a $1,000 face-value bond with an 8% coupon rate when your required rate of return is 15 percent? A) More than its face value B) Less than its face value C) Equal to its face value D) Can’t say 8. The net present value of a particular investment project represents: A) the increase or decrease in wealth that the project will generate for the investing business. B) the discounted value of the inflows from the project. C) the present investment required to undertake the project. D) the rate of return that the project will earn for the investing business. 9. You have just assessed a project, involving an immediate cash outflow followed by a series of cash inflows over the next seven years, by deducing the NPV and the IRR. You have now discovered that you have underestimated the discount rate. Correcting for the underestimation will have the following effects, relative your original deductions: (assume conventional cash flows) A) NPV: Reduce , IRR: No change B) NPV: No change, IRR: No change C) NPV: Increase, IRR: Reduce D) NPV: Increase, IRR: Increase 10. Which of the following is not a disadvantage of using the IRR method rather than the NPV method of project appraisal? A) If the cash flows are non-conventional there may be more than one IRR B) IRR does not take into account the time value of money C) IRR has an implicit reinvestment assumption which is not reasonable D) IRR ranks in terms of percentage returns whereas NPV ranks in terms of absolute amounts of money

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11. Which statement is not true regarding the market portfolio? A) It includes all publicly traded financial assets. B) It lies on the efficient frontier. C) All securities in the market portfolio are held in proportion to their market values. D) It is the tangency point between the capital market line and the indifference curve

12. Which one of the following projects -- A, B, C, or D -- should be accepted? The expected return on the market is 16% and the risk-free rate is 6%. A) Project A, which has a beta of 0.50 and has an expected return of 11.2%. B) Project B, which has a beta of 2.50 and has an expected return of 25.4%. C) Project C, which has a beta of 1.25 and has an expected return of 18.2%. D) Project D, which has a beta of 1.00 and has an expected return of 15.8%. 13. ABC Company has a debt-to-equity ratio of 25% and a marginal tax rate of 25%. The average unlevered β of comparable companies is 1.1. The levered β of the company should be: A) 0.89 B) 1.16 C) 1.27 D) 1.37 14. Two firms that are virtually identical except for their capital structure are selling in the market at different values. According to M&M A) one will be at greater risk of bankruptcy. B) the firm with greater financial leverage will have the higher value. C) this proves that markets cannot be efficient. D) this will not continue because arbitrage will eventually cause the firms to sell at the same value. 15. A firm has a debt-to-equity ratio of 1.75. If it had no debt, its cost of equity would be 9%. Its cost of debt is 7%. What is its cost of equity if the corporate tax rate is 50%? A) 7.73% B) 10.00% C) 10.75% D) None of the above 16. Which of the following is not a recognized approach for determining the cost of equity? A) Dividend discount model approach. B) Before-tax cost of preferred stock plus risk premium approach. Page 3 of 5

C) D)

Before-tax cost of preferred stock plus risk premium approach. Before-tax cost of debt plus risk premium approach.

17. The capital structure for the ABC Corporation is the following: bonds $5500 and common stock $11000. If ABC has an after-tax cost of debt of 6% and a 16% cost of common stock, what is its weighted average cost of capital (WACC)? A) 9.33% B) 12.67% C) 13.33% D) 14.67% 18. Using market values rather than book values for cost of capital computations ensures that the firm: A) Does not ignore the value of retained earnings. B) Gets the full value of the debt tax shield. C) Uses expected rates of return. D) Will not invest in negative NPV Projects. 19. Firm Pickemon, Inc. has had earnings of $3.20, $3.00, and $5.50 per share for the past three years. The firm anticipates maintaining the same dividend policy this year as the past three years. That dividend policy has resulted in dividends per share of $1.28, $1.20, and $2.20 for the past three years. It is anticipated that the next year will result in a large increase in earnings to $9.80 per share. What dividend do you expect the firm to pay in the next year? A) $3.92 B) $1.56 C) $3.12 D) $4.68 20. A(n) __________ occurs when there is an increase in the number of shares outstanding by reducing the par value of stock. A) Stock split B) Stock dividend C) Extra dividend D) Regular dividend

21. Modigliani and Miller argue that the dividend decision __________. A) is irrelevant as the value of the firm is based on the earning power of its assets B) is relevant as the value of the firm is not based just on the earning power of its assets Page 4 of 5

C) is irrelevant as dividends represent cash leaving the firm to shareholders, who own the firm anyway D) is relevant as cash outflow always influences other firm decisions 22. Which of the following would be consistent with a conservative approach to financing working capital? A) Financing short-term needs with short-term funds. B) Financing short-term needs with long-term debt. C) Financing seasonal needs with short-term funds. D) Financing some long-term needs with short-term funds. 23. Which of the following will improve a company's working capital management position? A) An increased debtor collection period B) An increase in the length of the production process C) An increase in the credit period allowed by suppliers D) An increase in the stock turnover period 24. Drop plc has annual credit sales of £5 million and debtors pay within 60 days. The company proposes to offer a 2 percent discount for payment within 30 days and expects 60 percent of customers to use the discount. Remaining customers will continue to take 60 days and the level of sales will remain unchanged. Administration costs would fall by £50 000. If the company's cost of short-term finance is 12 percent, calculate the expected benefit of the proposed policy (to the nearest £500). A) 17,500 B) 14,500 C) 20,000 D) 16,000 25. Given the following information, what is the cash conversion cycle in days of ABC plc? Total Sales 276,000 Stocks 37,000 Cost of Goods Sold 200,000 Debtors 43,000 Purchases 120,000 Creditors 15,000 A) 35 days B) 125 days C) 60 days D) 79 days

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