Finance Conceptual Questions and Answers

Finance Concept Questions

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Preparing for a Corporate Finance Interview? This list contains the top corporate finance interview questions that are most frequently asked by employers.

  1. What are the Financial Statements of a company and what do they tell about a company?

Answer: Financial Statements of a company are statements, in which the company keeps a formal record about the company’s position and performance over time. The objective of Financial Statements is to provide financial information about the reporting entity that is useful to exist and potential investors, creditors, and lenders in making decisions about whether to invest, give credit or not. There are mainly three types of financial statements which a company prepares.

  1. Income Statement – Income Statement tells us about the performance of the company over a specific account period. Financial performance is given in terms of revenue and expense generated through operating and non-operating activities.
  2. Balance Sheet – Balance Sheet tells us about the position of the company at a specific point in time. Balance Sheet consists of Assets, Liabilities and Owner’s Equity. The basic equation of Balance Sheet: Assets = Liabilities + Owner’s Equity.
  3. Cash Flow Statement – Cash Flow Statement tells us the amount of cash inflow and outflow. Cash Flow Statement tells us how the cash present in the balance sheet changed from last year to the current year.

2) What is a clean and dirty price of a bond?

Ans. Clean price is a price of a coupon bond not including the interest accrued. In other words, clean price is the present value of the discounted future cash flows of a bond excluding the interest payments. Dirty price of a bond includes accrued interest in the calculation of bond. Dirty price of the bond is the present value of the discounted future cash flows of a bond which include the interest payments made by the issuing entity.

3) What are Stock Options?

Ans. Stock Options are the options to convert into common shares at a predetermined price. These options are given to the employees of the company in order to attract them and make them stay longer. The options are generally provided by the company to its upper management to align management’s interests with that of its shareholders.

Stock Options generally have a venting period i.e. a waiting period before the employee can actually exercise his or her option to convert into common shares. A Qualified option is a tax-free option which means that they are not subject to taxability after the conversion. An Unqualified option is a taxable option which is taxed immediately after conversion and then again when the employee sells the stock.

Terms and answers to learn

We can imagine the financial manager doing several things on behalf of the firm’s stockholders. For example, the manager might do the following:
a. Make shareholders as wealthy as possible by investing in real assets.
b. Modify the firm’s investment plan to help shareholders achieve a particular time pattern of consumption.
c. Choose high- or low-risk assets to match shareholders’ risk preferences.
d. Help balance shareholders’ checkbooks.
However, in well-functioning capital markets, shareholders will vote for only one of these goals. Which one will they choose?
a. Make shareholders as wealthy as possible by investing in real assets
Which of the following are investment decisions, and which are financing decisions?
Should we stock up with inventory ahead of the holiday season?
Investment decision
Which of the following are investment decisions, and which are financing decisions?
Do we need a bank loan to help buy the inventory?
Financing decision
Which of the following are investment decisions, and which are financing decisions?
Should we develop a new software package to manage our inventory?
Investment decision
Which of the following are investment decisions, and which are financing decisions?
With a new automated inventory management system, it may be possible to sell off our Birdlip warehouse.
Investment decision
Which of the following are investment decisions, and which are financing decisions?
With the savings we make from our new inventory system, it may be possible to increase our dividend.
Financing decision
Which of the following are investment decisions, and which are financing decisions?
Alternatively, we can use the savings to repay some of our long-term debt.
Financing decision
Which of the following forms of compensation is most likely to align the interests of managers and shareholders?
A fixed salary
A salary linked to company profits
A salary that is paid partly in the form of the company’s shares
A salary that is paid partly in the form of the company’s shares
Expenditure on research and development
(Financial decision or Investment decision)
Investment decision
A bank loan
(Real asset or Financial asset)
Financial asset
Listed on a stock exchange
(Closely held corporation or Public corporation)
Public corporation
Has limited liability
(Partnership or Corporation)
Corporation
Responsible for bank relationships
(The treasurer or The controller)
The treasurer
Agency cost
(The cost resulting from conflicts of interest between managers and shareholders or The amount charged by a company’s agents such as the auditors and lawyers)
The cost resulting from conflicts of interest between managers and shareholders
Which of the following statements always apply to corporations?
Unlimited liability
Limited life
Ownership can be transferred without affecting operations
Managers can be fired with no effect on ownership
Ownership can be transferred without affecting operations
Managers can be fired with no effect on ownership
Is the following an advantage in separating ownership and management in large corporations?
Managers no longer have the incentive to act in their own interests.
No
Is the following an advantage in separating ownership and management in large corporations?
The corporation survives even if managers are dismissed.
Yes
Is the following an advantage in separating ownership and management in large corporations?
Shareholders can sell their holdings without disrupting the business.
Yes
Is the following an advantage in separating ownership and management in large corporations?
Corporations, unlike sole proprietorships, do not pay tax; instead, shareholders are taxed on any dividends they receive.
No
Is the following a real asset or a financial asset?
A share of stock
Financial asset
Is the following a real asset or a financial asset?
A personal IOU
Financial asset
Is the following a real asset or a financial asset?
A trademark
Real asset
Is the following a real asset or a financial asset?
A truck
Real asset
Is the following a real asset or a financial asset?
Undeveloped land
Real asset
Is the following a real asset or a financial asset?
The balance in the firm’s checking account
Financial asset
Is the following a real asset or a financial asset?
An experienced and hardworking sales force
Real asset
Is the following a real asset or a financial asset?
A bank loan agreement
Financial asset
Company A pays its managers a fixed salary. Company B ties compensation to the performance of the stock.
Which company’s compensation would most help to mitigate conflicts of interest between managers and shareholders?
Company B
Company A pays its managers a fixed salary. Company B ties compensation to the performance of the stock.
Other things equal, which company would experience the greatest variation in earnings?
Company A
Periodic receipts of interest by the bondholder are known as:
the coupon rate.
a zero-coupon.
the default premium.
coupon payments.
coupon payments.
True or False
A bond’s rate of return is equal to its coupon payment divided by the price paid for the bond.
False
If a bond offers a current yield of 5% and a yield to maturity of 5.45%, then the:
bond has a high default premium.
bond is selling at a discount.
promised yield is not likely to materialize.
bond must be a Treasury Inflation-Protected Security.
bond is selling at a discount.
True or False
A Treasury bond’s bid price will be lower than the ask price.
True
When an investor purchases a $1,000 par value bond that was quoted at 97.162, the investor:
receives $971.62 upon the maturity date of the bond.
pays 97.162% of face value for the bond.
pays $10,971.62 for a $10,000 face value bond.
receives 97.162% of the stated coupon payments.
pays 97.162% of face value for the bond.
What happens to the coupon rate of a $1,000 face value bond that pays $80 annually in interest if market interest rates change from 9% to 10%?
The coupon rate remains at 8%.
The coupon rate increases to 10%.
The coupon rate remains at 9%.
The coupon rate decreases to 8%.
The coupon rate remains at 8%.
Investors who purchase bonds having lower credit ratings should expect:
lower coupon payments.
higher purchase prices.
lower yields to maturity.
higher default possibilities.
higher default possibilities.
True or False
Asked yields can be guaranteed only to investors who buy a bond and hold it until maturity.
True
False
True
Bonds that have a Standard & Poor’s rating of BBB or better are considered to be investment-grade bonds.
True
False
True
The coupon rate of a bond equals:
its yield to maturity.
the yield to maturity when the bond sells at a discount.
a defined percentage of its face value.
the annual interest divided by the current market price.
a defined percentage of its face value.
Which one of the following is fixed for the life of a given bond?
Current price
Yield to maturity
Current yield
Coupon rate
Coupon rate
A bond’s yield to maturity takes into consideration:
price changes but not the current yield.
neither the current yield nor any price changes.
current yield but not any price changes.
both the current yield and any price changes.
both the current yield and any price changes.
The current yield of a bond can be calculated by:
dividing the price by the par value.
multiplying the price by the coupon rate.
dividing the annual coupon payments by the price.
dividing the price by the annual coupon payments.
dividing the annual coupon payments by the price.
How does a bond dealer generate profits when trading bonds?
By lowering the bond’s coupon rate upon resale
By maintaining bid prices higher than ask prices
By maintaining bid prices lower than ask prices
By retaining the bond’s next coupon payment
By maintaining bid prices lower than ask prices
Which one of the following must be correct for a bond currently selling at a premium?
Its current yield is lower than its coupon rate.
Its yield to maturity is higher than its coupon rate.
Its coupon rate is lower than the current market rate on similar bonds.
Its coupon rate is variable.
Its current yield is lower than its coupon rate.
A bond’s par value can also be called its:
market value.
face value.
present value.
coupon payment.
face value.
True or False
The current yield measures the bond’s total rate of return.
True
False
False
True or False
A bond’s payment at maturity is referred to as its face value.
True
False
True
If a bond is priced at par value, then:
it must be a zero-coupon bond.
its coupon rate equals its yield to maturity.
it has a very low level of default risk.
the bond is quite close to maturity.
its coupon rate equals its yield to maturity.
Use of a profitability index to evaluate mutually exclusive projects in the absence of capital rationing:
will provide the same rankings as an NPV criterion.
will maximize NPV, but not IRR.
is technically impossible.
can result in misguided selections.
can result in misguided selections.
A project’s opportunity cost of capital is:
equal to the average return on all company projects.
the return earned by investing in the project.
the foregone return from investing in the project.
designed to be less than the project’s IRR.
the foregone return from investing in the project.
If the opportunity cost of capital for a lending project exceeds the project’s IRR, then the project has a(n):
positive profitability index.
positive NPV.
acceptable payback period.
negative NPV.
negative NPV.
When mutually exclusive projects have different lives, the project that should be selected will have the:
highest NPV, discounted at the opportunity cost of capital.
lowest equivalent annual cost.
highest IRR.
longest life.
lowest equivalent annual cost.
When a project’s internal rate of return equals its opportunity cost of capital, then the:
project should be rejected.
net present value will be positive.
net present value will be zero.
project has no cash inflows.
net present value will be zero.
When managers cannot determine whether to invest now or wait until costs decrease later, the rule should be to:
invest now to maximize the NPV.
postpone until costs reach their lowest level.
invest at the date that provides the highest NPV today.
postpone until the opportunity cost reaches its lowest level.
invest at the date that provides the highest NPV today.
The decision rule for net present value is to:
reject all projects lasting longer than 10 years.
reject all projects with rates of return exceeding the opportunity cost of capital.
accept all projects with positive net present values.
accept all projects with cash inflows exceeding the initial cost.
accept all projects with positive net present values.
Firms that make investment decisions based on the payback rule may be biased toward rejecting projects:
with late cash inflows.
with short lives.
that have negative NPVs.
with long lives.
with long lives.
A project can have as many different internal rates of return as it has:
changes in the sign of the cash flows.
cash outflows.
periods of cash flow.
cash inflows.
changes in the sign of the cash flows.
When projects are mutually exclusive, selection should be made according to the project with the:
highest IRR.
highest NPV.
longer life.
larger initial size.
highest NPV.
Which one of the following best illustrates the problem imposed by capital rationing?
Accepting projects with the highest IRRs first
Bypassing projects that have positive NPVs
Accepting projects with the highest NPVs first
Bypassing projects that have zero IRRs
Bypassing projects that have positive NPVs
The internal rate of return is most reliable when evaluating:
a single project with cash outflows at time 0 and the final year and inflows in all other time periods.
a single project with alternating cash inflows and outflows over several years.
mutually exclusive projects of differing sizes.
a single project with only cash inflows following the initial cash outflow.
a single project with only cash inflows following the initial cash outflow.
When a manager does not accept a positive-NPV project, shareholders face an opportunity cost in the amount of the:
soft capital rationing budget.
project’s initial cost.
project’s discounted cash inflows.
project’s NPV.
project’s NPV.
Which of the following investment decision rules tends to improperly reject long-lived projects?
Payback period
Profitability index
Net present value
Internal rate of return
Payback period
Soft capital rationing is imposed upon a firm from _____ sources, while hard capital rationing is imposed from _____ sources.
internal; internal
external; external
internal; external
external; internal
internal; external
The profitability index selects projects based on the:
highest net discounted value at time zero.
highest internal rate of return.
largest return per dollar invested.
largest dollar investment per rate of return.
largest return per dollar invested.
Which one of the following changes will increase the NPV of a project?
A decrease in the discount rate
An increase in the initial cost of the project
A decrease in the size of the cash inflows
A decrease in the number of cash inflows
A decrease in the discount rate
Which of the following investment criteria takes the time value of money into consideration?
Profitability index, internal rate of return, and net present value
Internal rate of return and net present value only
Profitability index and net present value only
Net present value only
Profitability index, internal rate of return, and net present value
Which one of the following is a situation where a new project will require a cash investment in net working capital?
Inventory levels will be reduced when the project is introduced.
The project will require additional inventory which will be financed by a supplier.
All sales related to the project will be cash sales to a subsidiary.
The project will increase inventory more than accounts payable.
The project will increase inventory more than accounts payable.
The rationale for not including sunk costs in capital budgeting decisions is that they:
have no incremental effect.
reduce the project’s net present value.
revert at the end of the investment.
are usually small in magnitude.
have no incremental effect.
Which one of the following changes in working capital is least likely, given an increase in the overall level of sales?
A decrease in accounts receivable
An increase in inventories
An increase in accounts payable
An increase in notes payable
A decrease in accounts receivable
The opportunity cost of an asset:
is typically ignored in capital budgeting.
can differ depending on market conditions.
should be depreciated annually.
is important only for parcels of land.
can differ depending on market conditions.
Which one of the following methods will provide a correct analysis for capital budgeting purposes?
Discounting nominal cash flows with real rates.
Discounting nominal cash flows with either real or nominal rates.
Discounting real cash flows with real rates.
Discounting real cash flows with nominal rates.
Discounting real cash flows with real rates.
Which one of these represents a cash outflow for a project?
Accrued expenses
A sunk cost
Depreciation
Increase in accounts receivable
Increase in accounts receivable
When a depreciable asset is ultimately sold, the sales price is:
nontaxable only if accelerated depreciation was used.
taxable to the extent that the sales price exceeds book value.
nontaxable.
fully taxable.
taxable to the extent that the sales price exceeds book value.
Allocations of overhead should not affect a project’s incremental cash flows unless the:
overhead will not be recovered at the end of the project.
project actually changes the total amount of overhead expenses.
accountant is required to allocate costs to this project.
overhead is not currently fully allocated to existing projects.
project actually changes the total amount of overhead expenses.
You are evaluating a new project that will introduce a revolutionary new product that will be produced by a new, highly efficient machine. Which one of these will lower the net present value of that project?
The increase in annual depreciation resulting from the asset purchase
A reduction in the firm’s total variable costs due to the purchase of the new machine
A loss of current sales due to the introduction of the new product
The sale of the machine after it is fully depreciated
A loss of current sales due to the introduction of the new product
Which one of the following capital budgeting proposals is most apt to be associated with a conflict of interests?
The proposal to solve pollution problems cited by the EPA
The proposal with the longest payback period
The proposal with the highest IRR and quickest payback
The proposal with the highest NPV
The proposal with the highest IRR and quickest payback
If sensitivity analysis concludes that the largest impact on profits would come from changes in the sales level, then:
variable costs should be traded for fixed costs.
fixed costs should be traded for variable costs.
additional marketing analysis may be beneficial before proceeding.
the project should not be undertaken.
additional marketing analysis may be beneficial before proceeding.
Which one of the following changes, if of a sufficient magnitude, could turn a negative NPV project into a positive NPV project?
An increase in the discount rate
A decrease in the fixed costs
A decrease in the estimated annual sales
An increase in the initial investment
A decrease in the fixed costs
The difference between an NPV break-even level of sales and an accounting break-even level of sales is the:
consideration of opportunity cost.
inclusion of income taxes.
consideration of interest expense.
allowance of the sales level to vary in response to changes in demand.
consideration of opportunity cost.
The purpose of sensitivity analysis is to show:
how price changes affect break-even volume.
seasonal variation in product demand.
the optimal level of capital expenditures.
how variables in a project affect profitability.
how variables in a project affect profitability.
Which one of the following techniques may be more appropriate to analyze projects with interrelated variables?
Scenario analysis
DOL analysis
Sensitivity analysis
Break-even analysis
Scenario analysis
What effect will a reduction in the cost of capital have on the accounting break-even level of revenues?
This cannot be determined without knowing the length of the investment horizon.
It reduces the break-even level.
It has no effect on the break-even level.
It raises the break-even level.
It has no effect on the break-even level.
Firms that lack competitive advantages will:
be forced to operate with a high degree of operating leverage.
be forced to capture larger market shares to be profitable.
have difficulty finding positive NPV projects for investment.
avoid the need to conduct sensitivity analyses.
have difficulty finding positive NPV projects for investment.
The accounting break-even level of sales represents the point where:
variable costs are covered.
fixed costs, variable costs, and depreciation are covered.
fixed costs and variable costs are covered.
fixed costs are covered.
fixed costs, variable costs, and depreciation are covered.
The likely effect of discounting nominal cash flows with real interest rates will be to:
make an investment’s NPV appear more attractive.
correctly calculate an investment’s NPV, regardless of expected inflation.
correctly calculate an investment’s NPV if inflation is expected.
make an investment’s NPV appear less attractive.
make an investment’s NPV appear more attractive.
Analysis results indicate that a project’s level of success is primarily dependent upon the firm controlling the variable costs. What type of analysis was conducted?
Scenario analysis
Sensitivity analysis
Real option analysis
Break-even analysis
Sensitivity analysis
The appropriate opportunity cost of capital is the return that investors give up on alternative investments that:
earn the risk-free rate of return.
are included in the S&P 500 index.
earn the average market rate of return.
possess the same level of risk.
possess the same level of risk.
Which one of these is considered to be the safest investment?
U.S. Treasury bonds
Common stock
U.S. Treasury bill
Preferred stock
U.S. Treasury bill
The wider the dispersion of returns on a stock, the:
lower the variance.
lower the expected rate of return.
lower the real rate of return.
higher the standard deviation.
higher the standard deviation.
An estimation of the opportunity cost of capital for projects that have an “average” level of risk is the rate of return on:
Treasury bills.
the market portfolio minus the rate of return on Treasury bills.
Treasury bonds plus a maturity premium.
the market portfolio.
the market portfolio.
The variance of a stock’s returns can be calculated as the:
average value of squared deviations from the mean.
average value of deviations from the mean.
sum of the deviations from the mean.
square root of the average value of deviations from the mean.
average value of squared deviations from the mean.
Which one of the following security classes has the highest standard deviation of returns?
Treasury bills
Corporate bonds
Long-term Treasury bonds
Common stocks
Common stocks
If you were willing to bet that the overall stock market was heading up on a sustained basis, it would be logical to invest in:
low beta stocks.
high beta stocks.
stocks that plot below the security market line.
stocks with large amounts of unique risk.
high beta stocks.
If a security plots below the security market line, it is:
offering too little return to justify its risk.
underpriced, a situation that should be temporary.
ignoring all of the security’s unique risk.
a defensive security, which expects to offer lower returns.
offering too little return to justify its risk.
Macro events only are reflected in the performance of the market portfolio because:
the unique risks have been diversified away.
the market portfolio contains only risk-free securities.
the firm-specific events would be too numerous to quantify.
only macro events are tracked by economists.
the unique risks have been diversified away.
When the overall market experiences a decline of 8%, investors with portfolios of aggressive stocks will probably experience portfolio:
losses of less than 8%.
gains of less than 8%.
gains greater than 8%.
losses greater than 8%.
losses greater than 8%.
The return on a security includes premiums for:
time value of money and market risk.
unique risk and firm-specific risk.
market risk and unique risk.
diversification and portfolio risk.
time value of money and market risk.
Treasury bonds have provided a higher historical return than Treasury bills, which can be attributed to their:
greater exposure to interest rate risk.
higher level of unique risk.
greater default risk.
illiquidity.
greater exposure to interest rate risk.
Which one of the following risks is most important to a well-diversified investor in common stocks?
Unsystematic risk
Diversifiable risk
Market risk
Unique risk
Market risk
The CAPM provides a model of determining expected security returns that is:
excellent for high beta stocks.
precise in its calculations of risk premiums.
imprecise, but generally an acceptable guideline.
excellent for all well-diversified portfolios.
imprecise, but generally an acceptable guideline.
he slope of the regression line that exhibits the past relationship between a stock’s returns and the market’s returns is the:
market’s beta.
stock’s standard deviation.
stock’s beta.
market risk premium.
stock’s beta.
Which one of the following companies is most apt to be exposed to the least amount of macro risk?
A regional airline
A large producer of flour
A major commercial bank
A machine tool manufacturer
A large producer of flour
The basic tenet of the CAPM is that a stock’s expected risk premium should be:
greater than the expected market return.
proportionate to the market return.
greater than the risk-free rate of return.
proportionate to the stock’s beta.
proportionate to the stock’s beta.
Which one of these is a specific risk?
Inflation increase of 2.3%
Revision to the corporate tax laws
Reduction in the overall economic output
Retirement of a company executive
Retirement of a company executive
Investment risk can best be described as the:
elimination of macro risk through diversification.
level of systematic risk for an undiversified investor.
dispersion of possible returns.
possibility of changes in the cost of capital.
dispersion of possible returns.
What type of risk is properly reflected in a project’s discount rate?
Diversifiable risk
Unique risk
Total risk
Market risk
Market risk
WACC can be used to determine the value of a firm by discounting the firm’s:
free cash flows.
cash inflows.
after-tax net profits.
pretax profits.
free cash flows.
The company cost of capital is the return that is expected on a portfolio of the company’s:
existing securities.
debt securities.
proposed securities.
equity securities.
existing securities.
To calculate the present value of a business, the firm’s free cash flows should be discounted at the firm’s:
aftertax cost of debt.
weighted-average cost of capital.
cost of equity.
pre-tax cost of debt.
weighted-average cost of capital.
Which one of the following changes offers the greatest chance of changing a project’s NPV from negative to positive?
Decreasing the marginal tax rate
Substituting preferred stock for debt
Selling the debt at less than par value
Reducing the risk level of the project
Reducing the risk level of the project
A firm’s WACC:
is the proper discount rate for every project the firm undertakes.
is used to value all of the firm’s existing projects.
is a benchmark discount rate that is adjusted for the riskiness of each project.
is an informational value only and should never be used as a discount rate.
is a benchmark discount rate that is adjusted for the riskiness of each project.
Which one of the following statements is incorrect concerning the equity component of the WACC?
The value of retained earnings is excluded.
There is a tax shield on the dividends paid.
Preferred equity is a separate component of WACC.
Market values should be used in the calculations.
There is a tax shield on the dividends paid.
A firm is considering expanding its current operations and has determined the internal rate of return on that expansion is 12.2%. The firm’s WACC is 11.8%. Given this, you know the:
appropriate discount rate for the project is between 11.8% and 12.2%.
expansion should be undertaken as it has a positive net present value.
project will have a lower debt-equity ratio than the firm’s current operations.
project has slightly more risk than the firm’s current operations.
expansion should be undertaken as it has a positive net present value.

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