FINANCE I (FIN 257)

SAMPLE MIDTERM EXAM

Chapter 1

Multiple Choice

1) Joe is a general partner in a limited partnership firm, while Jane is a limited partner in that same firm. Which of the
following statements regarding their respective relationships to the firm is correct?
A) Joe has no management authority within the partnership.
B) Jane is legally involved in the managerial decision making of the firm.
C) Jane's liability for the firm's debts consists solely of her investment in the firm.
D) Withdrawal of Jane from the partnership will dissolve that partnership.
E) Jane's liability consists of all the firm's outstanding debts.

2) What is the process of double taxation for the stockholders in a corporation?

A) Their shares are taxed when they are both bought and sold.
B) The corporation is taxed on the profits it makes, and the owners are taxed when this profit is distributed to them.
C) The owners of a corporation are taxed when they receive dividend payments and when they make a profit from the
sale of shares.
D) The corporation must pay taxes on any profits it makes, and the capital raised by the sale of shares is also subject to
taxation.
E) The corporation is taxed on any profits it makes, and owners are taxed when they sell their shares.

3) Why in general do financial managers make financial decisions in a corporation, rather than the owners making these
decisions themselves?
A) It is best for the control of the finances of a corporation to be in the hands of a disinterested third party.
B) The interests of the various owners may conflict with each other.
C) The owners may not be Canadian citizens or residents.
D) There are often many owners, and they can often change as they buy and sell stock.
E) The owners will make decisions for their own self-interest rather than the corporation's interests.

4) How do the shareholders of most corporations exercise their control of that corporation?
A) by voting on issues that concern them
B) by electing members of a board of directors
C) by vetting the decisions of the board of directors
D) by providing oversight of the day-to-day running of the corporation
E) by hiring other shareholders to run the corporation

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5) A factory owner wants his workers to produce as many widgets as they can, so he pays his workers based on how
many widgets they produce. However, in order to make sure that the workers do not rush and produce a large number of
poorly made widgets, he checks the widgets at random at various stages of their manufacture. If a defect is found in a
widget, the pay of the entire section of the factory responsible for that defect is docked. How is this factory owner
seeking to solve the principal-agent problem in this case?
A) by supplying incentives so the agents act in the way principal desires
B) by ensuring that all workers co-operate to maximize the gains of their section
C) by making the agents into principals themselves
D) by maximizing the information that the principal obtains about the behaviour of the agents
E) by using quality control techniques

Problems/Short Answers

6) Why is the secondary market important?

7) Saskatoon Smelting is a corporation that earned $4 per share before it paid any taxes. The firm retained $2 of after-tax
earnings for reinvestment, and distributed what remained in dividend payments. If the corporate tax rate was 25% and
dividend earnings were taxed at 15%, what was the value of the dividend earnings received after tax by a holder of
10,000 shares of Saskatoon Smelting?

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Chapter 2

Multiple Choice

1) Which of the following people would be likely to calculate financial ratios for a company?

a) Bondholders
b) Equity holders
c) Suppliers
d) All of these would calculate ratios on a company

2) What is the main problem in using a statement of financial position to provide an accurate assessment of the value of
a company's equity?
A) Valuable assets such as the company's reputation, the quality of its work force, and the strength of its management
are not captured on the statement of financial position.
B) The statement of financial position does not accurately represent the book value of assets held by the company.
C) The equity shown on the statement of financial position does not reflect the market capitalization of the company.
D) Knowing at a single point in time what assets a firm possesses and the liabilities a firm owes does not give any
indication of what those assets can produce in the future.
E) The statement of financial position does not provide enough detail about the company's equity.

3) Which of the following is a way that the Operating Activity section of the statement of cash flows adjusts Net Income
from the balance sheet?
A) It subtracts all expenses and costs related to the firm's operating activities.
B) It adds all non-cash entries related to the firm's operating activities.
C) It adds the cash that flows from investors to the firm.
D) It removes the cash used for investment purposes.
E) It adds cash received from investments.

4) A software company acquires a smaller company in order to acquire the patents that it holds. Where will the cost of
this acquisition be recorded on the statement of cash flows?
A) as an outflow under Operating Activities
B) as an outflow under Investment Activities
C) as an outflow under Financial Activities
D) The acquisition would not be recorded on the statement of cash flows.
E) as an inflow under Financial Activities

5) A firm whose primary business is in a line of regional grocery stores would be most likely to have to include which of
the following facts, if true, in the firm's management discussion and analysis (MD&A)?
A) that a large number of funds were allocated to advertising to increase awareness of the firm's brand in new areas it
had expanded into this year
B) that some senior members of the management team have retired in this financial year
C) that the company has lost a class action suit brought against the firm by its employees and is expected to have to pay
a large amount of damages
D) that the firm has plans to expand into the organic food business in the next financial year by purchasing several small
organic food retailers
E) that food prices have increased, increasing the firm's costs

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Problems/Short Answers

6) Why is an increase in net working capital a decrease in free cash flow?

Use the table for the question(s) below.

Luther Corporation
Consolidated Income Statement
Year ended December 31 (in $ millions)
2015 2014
Total sales 610.1 578.3
Cost of sales (500.2) (481.9)
Gross profit 109.9 96.4
Selling, general, and
administrative expenses (40.5) (39.0)
Research and development (24.6) (22.8)
Depreciation and amortization (3.6) (3.3)
Operating income 41.2 31.3
Other income --- ---
Earnings before interest and taxes (EBIT) 41.2 31.3
Interest income (expense) (25.1) (15.8)
Pretax income 16.1 15.5
Taxes (5.5) (5.3)
Net income 10.6 10.2

Price per share $16 $15

Shares outstanding (millions) 10.2 8.0
Stock options outstanding (millions) 0.3 0.2

Shareholders' Equity 126.6 63.6

Total Liabilities and Shareholders' Equity 533.1 386.7

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7a) Refer to the income statement above. Luther's operating margin for the year ending December 31, 2014 is closest to:

7b) Refer to the income statement above. Luther's net profit margin for the year ending December 31, 2014 is closest to:

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7c) Refer to the income statement above. Luther's return on equity (ROE) for the year ending December 31, 2015 is
closest to:

7d) Refer to the income statement above. Luther's return on assets (ROA) for the year ending December 31, 2015 is
closest to:

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Chapter 3

Multiple Choice

1) Which of the following is the overarching principle that a financial manager should follow when making decisions?
A) Decisions should generate the greatest benefits for the firm.
B) Decisions should provide benefit to the firm without incurring costs greater than those benefits to others.
C) Decisions should be on behalf of the firm's owners that give the greatest benefit to those owners, the firm's
employees, and the firm's other stakeholders.
D) Decisions should increase the value of the firm to its investors.
E) Decisions should be in the strategic competitive interests of the firm.

2) Which of the following is the best statement of the Valuation Principle?

A) It is not possible to compare costs and benefits that occur at different points in time, in different currencies, or with
different risks.
B) The value of a commodity or an asset to the firm or its investors is determined by its competitive market price. When
the value of the benefits exceeds the value of the costs in terms of market prices, the decision will increase the market
value of the firm.
C) The rate at which we can exchange money today for money in the future by borrowing or investing is the current
market interest rate and is same across all banks.
D) If equivalent goods or securities trade simultaneously in different markets across the world, they will trade for the
same price.
E) The value of a commodity or an asset is determined by assessing its use to the firm.

3) To compute the future value of a cash flow, you must

A) discount it.
B) compound it.
C) double it.
D) arbitrage it.
E) first find the present value.

4) Why are arbitrage opportunities short-lived?

A) Federal regulations will kick in to restrict trade and effectively shut the opportunity down.
B) Prices will fluctuate up and down as traders take advantage of the opportunity, resulting in the net present value
(NPV) fluctuating between positive and negative values.
C) Once investors take advantage of the opportunity, prices will respond so that the buying and selling price become
equal.
D) Arbitrage opportunities need a lot of information processing, which is very slow to arrive.
E) Investors will stop taking advantage of them for fear of being caught by regulators.

5) How can we convert the value of money from one point in time to another?
A) using the current exchange rate
B) using a cost benefit analysis
C) using the Valuation Principle
D) using the current interest rate
E) using competitive market prices

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Problems/Short Answers

6) Explain the difference between simple interest and compound interest.

7a) An investment will pay you $100 in one year and $200 in two years. If the interest rate is 5%, what is the present
value of these cash flows?

7b) Suppose the price of gold in New York is $1750 per ounce, while the price of gold in London is $1760. If there are
transaction costs of 0.5% when buying or selling in either market, what is the net effect of buying one ounce of gold in
New York and selling it in London?

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Chapter 4

Multiple Choice

4) Why is a dollar today always worth at least a dollar in the future?

a) Because of the risk involved with investing
b) Because of the opportunity cost of money
c) Because of inflation
d) All of the above

3) You are given two choices of investments, Investment A and Investment B. Both investments have the same future
cash flows. Investment A has a discount rate of 4%, and Investment B has a discount rate of 5%. Which of the following
is true?
A) The present value of cash flows in Investment A is higher than the present value of cash flows in Investment B.
B) The present value of cash flows in Investment A is lower than the present value of cash flows in Investment B.
C) The present value of cash flows in Investment A is equal to the present value of cash flows in Investment B.
D) The present value of cash flows in Investment A is half the present value of cash flows in Investment B.
E) No comparison can be made - we need to know the cash flows to calculate the present value.

18) Elie is considering an investment that will require her to deposit $500 per month for 6 years with the first payment
occurring today. This is an example of:
a) an ordinary annuity.
b) an annuity due.
c) a reverse ordinary annuity.
d) a reverse annuity due.

12) Which of the following is true about perpetuities?

A) Since a perpetuity generates cash flows every period infinitely, the cash flow generated equals the PV times the
interest rate.
B) Since a perpetuity generates cash flows every period infinitely, each cash flow must be discounted to calculate the
present value.
C) Since a perpetuity generates cash flows every period infinitely, there is no way to solve for the cash flow given the
present value and the interest rate.
D) A perpetuity does not generate cash flows every period infinitely.
E) Since a perpetuity generate cash flows every period infinitely, the cash flow generated equals the PV divided by the
interest rate.

33) To compare interest rates, we should compare the:

a) Quoted rates
b) Nominal rates
c) Effective rates
d) Periodic rates

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Problems/Short Answers

16) An annuity will pay you $1,000 per year for 30 years. What is the FV of this annuity at the end of 30 years, if your
cost of capital is 3%?

9) Anya finally decides that she will give her cousin, Zen, the loan he requested. He is expected to pay Anya $12,500
each year for the next 5 years, starting at the end of this year. The loan interest rate at the bank is 5% but because he is
family, she will only charge him half of this interest rate. What is the current value of this loan, today?

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12) The present value of an annuity that pays $1 million per year for n years, is $9 million. If the interest rate is 5% per
annum, n is approximately equal to how many years?

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 SOLUTION

Chapter 1

Multiple Choice

1) Answer: C 2) Answer: B 3) Answer: D 4) Answer: B 5) Answer: A

Problems/Short Answers

6) Answer:
The secondary market is where investors trade already issued securities. It is important because it provides liquidity to
investors. If an efficient secondary market did not exist, investors would be very reluctant to hold securities with
longer maturities. It is necessary for the function of the primary market.

7) Answer:
Corporate tax paid on $4 earnings = $4 0.25 = $1; earnings after tax =4 - 1 = $3; earnings distributed as dividends = $3
- $2 = $1; taxes paid on dividends by a shareholder = 1 0.15 = 0.15; after-tax dividends per share = 1 - 0.15 = $0.85;
hence a holder of 10,000 shares receives 0.85 100,000 = $8,500

Chapter 2

Multiple Choice

1) Answer: d 2) Answer: A 3) Answer: B 4) Answer: B 5) Answer: C

Problems/Short Answers

6) Answer:
Net working capital = Current assets Current liabilities. For example: (Accounts receivable + Inventory)
Accounts Payable.

If NWC increases, we can have (amongst other possibilities):

1. Accounts receivable increase: decreases free cash flows as customers are paying their bills later; we are receiving
the cash later hence less FCF
2. Inventory increase: have to invest more cash to buy inventory hence lower FCF
3. Accounts payable decrease: have to use cash to repay bills hence less FCF

As NWC increases, we are tying up more cash in AR, AP and Inventory so consequently we have lower free cash
flows.

7a) Answer:
Operating margin = Operating income / Sales
OM = 31.3 / 578.3 = 0.054 or 5.4%

7b) Answer:
Explanation: A) Net profit margin = Net income / Total sales = 10.2 / 578.3 = 0.018 or 1.8%

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7c) Answer:
ROE = Net income / Shareholders' equity = 10.6 / 126.6 = 0.084 or 8.4%

7d) Answer:
ROA = Net income / Total assets.
A = L + SE. Total Liabilities and Shareholders' Equity is given and this is the same as Total Assets.
So, ROA = 10.6 / 533.1 = 0.020 or 2.0%.

Chapter 3

Multiple Choice

1) Answer: D 2) Answer: B 3) Answer: B 4) Answer: C 5) Answer: D

Problems/Short Answers

6) Answer:
Simple interest is interest that is paid only on the amount originally invested but not on any interest that accrues
subsequently. In contrast, when interest compounds it is reinvested you earn interest on your interest as well as your
principal invested.

7a) Answer:
100/(1.05) + 200/(1.052) = 95.24 + 181.41 = 276.65

7b) Answer:
-$1750 1.005 = $1758.75; $1760 .995 = $1751.20;
Net effect = -1758.75 + 1751.20 = -$7.55

Chapter 4

Multiple Choice

4) Answer: d 3) Answer: A 18) Answer: b

12) Answer: A 33) Answer: c

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Problems/Short Answers

16) PMT = 1,000; I = 3; N = 30; Compute FV = $47,575

9) PV= (12,500/0.025)(1 - [1/(1.025)5]) = $58,072.86

12) PV = C/r[1 - 1/(1 + r)n]

n = log{1/(1 - [rPV/C])} / log{1 +r }
n = log{1/(1 - [0.05(9)/1])} / log{1.05} = log1.81818/log 1.05 = 12.25 years

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