Corporate Finance practice questions

Question: As societies become more complex, their means of control over their members decreases.

Answer Choices:

Answer: B – False

Question: What is the difference between a raid and a feud?

Answer Choices:

Answer: C – A feud includes extending hostilities between two groups.

Question: Which of the following statements is CORRECT? A) An increase in accounts receivable is added to net income in the operating activities section because if accounts receivable increase, then they are collected in cash will come into the firm. B) In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital expenditures and the change in net operating working capital. Free cash flow is the amount of cash that could be withdrawn without harming the firm’s ability to operate and to produce future cash flows. C) The first major section of a typical statement of cash flows is “Operating Activities,” and the first entry in this section is “Net Income.” Then, also in the first section, we show some items that add to or subtract from cash, and the last entry is called “Net Cash Provided by Operating Activities.” This number can be either positive or negative, but if it is negative, the firm is almost certain to soon go bankrupt. D) The next-to-last line on the income statement shows the firm’s earnings, while the last line shows the dividends the company paid. Therefore, the dividends are frequently called “the bottom line.” E) Most rapidly growing companies have positive free cash flows because cash flows from existing operations will exceed fixed assets and working capital needed to support the growth.

Answer Choices:

Answer: B

Question: Which of the following statements is CORRECT? A) Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the company has made the investments in current and fixed assets that are necessary to sustain ongoing operations. B) After-tax operating income is calculated as EBIT(1 – T) + Depreciation. C) Two firms with identical sales and operating costs but with different amounts of debt and tax rates will have different operating incomes by definition. D) If a firm is reporting its income in accordance with generally accepted accounting principles, then its net income as reported on the income statement should be equal to its free cash flow. E) Retained earnings as reported on the balance sheet represent cash and, therefore, are available to distribute to stockholders as dividends or any other required cash payments to creditors and suppliers.

Answer Choices:

Answer: A

Question: Which of the following statements is CORRECT? A) The current cash flow from existing assets is highly relevant to investors. However, since the value of the firm depends primarily upon its growth opportunities, accounting net income projections from those opportunities are the only relevant future flows with which investors are concerned. B) Two metrics that are used to measure a company’s financial performance are net income and free cash flow. Accountants tend to emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people generally put at least as much weight on free cash flows as they do on net income. C) To estimate the net cash provided by operations, depreciation must be subtracted from net income because it is a non-cash charge that has been added to revenue. D) Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to discourage the use of debt financing by corporations. E) If Congress changed depreciation allowances so that companies had to report higher depreciation levels for tax purposes in 2014, this would lower their free cash flows for 2014.

Answer Choices:

Answer: B

Question: Ratio analysis involves analyzing financial statements to help appraise a firm’s financial position and strength. a. True b. False

Answer Choices:

Answer: A – True

Question: Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory. a. True b. False

Answer Choices:

Answer: A – True

Question: According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing. a. True b. False

Answer Choices:

Answer: B – False

Question: According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing. a. True b. False

Answer Choices:

Answer: A – True

Question: According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm’s value. a. True b. False

Answer Choices:

Answer: A – True

Question: 20. Modigliani and Miller’s first article led to the conclusion that capital structure is “irrelevant” because it has no effect on a firm’s value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm’s value would be maximized if it used (almost) 100% debt.

Answer Choices:

Answer: A – True

Question: 21. Modigliani and Miller’s second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm’s value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.

Answer Choices:

Answer: A – True

Question: 22. The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes.

Answer Choices:

Answer: A – True

Question: 23. The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.

Answer Choices:

Answer: B – False

Question: 24. The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the development of the “trade-off” model, where the firm’s value first rises with the use of debt due to the tax shelter of debt, but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits. Under the trade-off theory, an optimal capital structure exists.

Answer Choices:

Answer: A – True

Question: 25. Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were assumed away in their original article. Once they took account of all these assumptions, they concluded that every firm has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm’s optimal debt ratio.

Answer Choices:

Answer: B – False

Question: 26. Some people–including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke)–have argued that one advantage of corporate debt from the stockholders’ standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm’s money on private plane and other “perks.” This is one of the factors that led to the rise of LBOs and private equity firms.

Answer Choices:

Answer: A – True

Question: 27. The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders have the same information about a firm’s future prospects as its managers. That was called “symmetric information,” and it is questionable. The introduction of “asymmetric information” led to the development of the “signaling” theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm’s managers are worried about its future. Other actions give off different signals, and the end result is that capital structure is affected by managers’ perceptions about how their financing decisions will affect investors’ views of the firm and thus its value.

Answer Choices:

Answer: A – True

Question: 28. According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on “reasonable” terms. This occurs because the use of debt financing signals to investors that the firm’s managers think that the future does not look good.

Answer Choices:

Answer: B – False

Question: 29. Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

Answer Choices:

Answer: A – True