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2015-16 Business Finance MCQs Answers

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UNIVERSITY OF SURREY©
Faculty of Arts and Social Sciences
Surrey Business School
MAN2089
BUSINESS FINANCE
Level FHEQ5
(Year 2)
Mid-term test, 16th November 2015
ANSWERS TO MCQ QUESTIONS (appearing with bold)
Distributed by F. Pasiouras, 19/11/2015
1
1. Which one of the following statements is correct?
A. both partnerships and corporations incur double taxation.
B. both sole proprietorships and partnerships are taxed in a similar fashion.
C. partnerships are the most complicated type of business to form.
D. the partnership is a legal “person” separate and distinct from its owners
E. all types of business formations have limited lives.
Note:
Slides 19 and 21 - Lecture 1. Slide 19 - the third bullet point for Sole proprietorship mentions
“Profits taxed as personal income”. The exact same sentence appears in the fifth bullet point for
Partnership”.
Book page 18 -Chapter 2: in the section that refers to Sole Proprietorship it is being mentioned
that “…, so all business income is taxed as personal income”, and the section that refers to
Partnership mentions “All income is taxed as personal income…”
2. Which one of the following statements is related to capital budgeting?
A. a firm should monitor the ratio of debt to equity financing which it uses.
B. a firm should monitor the amount of its current assets as compared to its current liabilities.
C. a firm should consider the size, risk, and timing of an asset's cash flows before deciding
to purchase that asset.
D. a firm should consider various types of loans offered by various lenders before taking out a
loan.
E. a firm should determine the ideal level of inventory that should be kept on hand.
Note:
Slide 3 – Lecture 1: Investment Decision (Capital Budgeting): What long term investments will
you make? (e.g. lines of business, kind of buildings, machinery, equipment, etc.)
Slide 10 – Lecture 1: “Financial managers must be concerned not only with how much cash
they expect to receive, but also with when they expect to receive it and how likely they are to
receive it”. So, it refers to size (i.e. how much), time (i.e. when), and risk (i.e. how likely).
Book Page 4 – Chapter 1 “Evaluating the size, timing and risk of future cash flows is the
essence of capital budgeting”.
2
3. Top Hotels Plc has currently 500,000 shares traded in the London Stock Exchange. The
management decides to raise more capital by issuing 100,000 new shares. This new issue of
equity is known as:
A. retained earnings
B. cash flow from investing activities
C. initial public offering
D. seasoned equity offering
E. secondary market transaction
Note:
Slide 15 – Lecture 1: “Money that is raised goes to issuing firm” and “Second Share Issue is called
a seasoned offering”
4. The legal papers which designate a firm's name, nature of business, and intended life are
called the:
A. memorandum of association.
B. articles of incorporation.
C. partnership agreement.
D. joint stock company forms.
E. proprietary declaration.
Note:
Slide 20 – Lecture 1. The first three bullet points indicate that the the articles of incorporation
include: name of corporation, business purpose, intended life of the corporation (maybe forever).
Book page 19 – Chapter 2: “The articles of incorporation must contain a number of things,
including the corporation’s name, its intended life (which can be forever), its business purpose…”
5. You cannot attend the shareholder's meeting for ABC Plc so you authorize another
shareholder to vote on your behalf. What is the granting of this authority called?
A. altering
B. cumulative voting
C. straight voting
D. indenture agreement
E. voting by proxy
Note:
Slide 28 – Lecture 1 Proxy voting: “A grant of authority by a shareholder allowing another
individual to vote his or her shares”.
Book page 26 – Chapter 2 - first sentence: Proxy Voting – “A proxy is the grant of authority by
a shareholder to someone else to vote his or her shares” and also in a box on the top left hand
side: proxy: “A grant of authority by a shareholder allowing another individual to vote his or her
shares”.
3
6. A short-term creditor would be most interested in
A. profitability ratios
B. asset utilization ratios
C. liquidity ratios
D. debt utilization ratios
E. market value ratios
Note:
Slide 25 – Lecture 2: The heading of the slide is: Liquidity or Short-Term Solvency Ratios. I
also mentioned during both lectures that these ratios are of interest to short-term creditors.
Book page 52 – Chapter 3: “For obvious reasons, liquidity ratios are particularly interesting to
short-term creditors”
7. For a given level of profitability as measured by profit margin, the firm's return on equity will
A. increase as its debt-to-assets ratio decreases.
B. decrease as its current ratio increases.
C. increase as its debt-to assets ratio increases.
D. decrease as its times-interest-earned ratio decreases.
E. none of the above
Note:
Based on Du Pont Identity and the fact that Total assets = Equity + Liabilities
The Du Pont identify is covered in slides 36-37 of Lecture 3. It was also made available in the
Formula Sheet. See also book pages 58-59 – Chapter 3.
The fact that Total assets = Equity + Liabilities is fundamental and was shown in several slides
(e.g. slides 6, 10 and 13, Lecture 2), tutorial exercises (see the balance sheet), and various
examples of the book (e.g. example 3.1 – page 41; Table 3.1 – page 42)
The Du Pont shows that Return on equity (ROE) = Profit margin * Asset Turnover *
Equity/Assets.
So, B and D above are irrelevant.
From the above formula it is clear, that to increase ROE, if the profit margin is constant, then the
firm has to increase Equity/Assets. Given the aforementioned relationship between equity,
liabilities, and assets, this happens when we have an increase in the debt/assets ratio. So, it is C.
This is also stated very clearly in book page 59 – Chapter 3: “Considering the Du Pont, it
appears that the ROE could be leveraged up by increasing the amount of debt in the firm”.
4
8. Holding other things constant, a firm’s sustainable growth will increase by:
A. a decrease in profit margin
B. a decrease in the debt-to-equity ratio
C. a decrease in total asset turnover
D. a decrease in the dividend payout ratio
E. none of the above
Note:
Slide 29 – Lecture 3: It shows that the sustainable growth rate depends on profit margin, total
asset turnover, financial policy, dividend policy.
Book pages A13 and A14- Appendix 3A (appendix in new edition; second part of Chapter 3 in
old edition, material covered in Lecture 3):
“An increase in profit margin…and thereby increase its sustainable growth”. So, it is not A.
“An increase in the debt-equity ratio…it increases the sustainable growth rate”. So, it is not B.
“An increase in the firm’s total asset turnover…and thereby increases the sustainable growth
rate. So, it is not C.
“A decrease in…paid out as dividends…and thus increase sustainable growth”. So, it is D.
9. You invested £10,000 six years ago and expected to have £15,000 today. You have not added
or withdrawn any money from this account since your initial investment. All interest was
reinvested in the account. As it turns out, you only have £14,200 in you account today. Which
one of the following must be true?
A. You earned simple interest rather than compound interest
B. You earned a lower interest rate than you expected
C. You did not earn any interest on interest as you expected
D. The future value interest factor turned out to be higher than you expected
E. None of the above
Note:
Based on understanding of basic principles discussed in Lecture 4 (and accompanying
tutorial/additional exercises), book chapter 4, and formula PV = FV / (1+r)t
It is given that interest was reinvested. So, it is not A or C.
The future value is lower than expected. So, it is not D.
You earned a lower interest than expected. This is true and the correct answer is B. [Actually, the
interest earned is around 6%, whereas to have £15,000 you would need an interest around 7%
(calculations of interest are not needed – they are given here as a proof only)]
5
10. You want to have £500,000 in your savings account when you retire. You plan on investing
a single lump sum today to fund this goal. You are planning on investing in an account which
will pay 5% annual interest. Which of the following will reduce the amount that you must
deposit today if you are to have your desired £500,000 on the day you retire?
I. Invest in a different account paying a higher rate of interest.
II. Invest in a different account paying a lower rate of interest.
III. Retire later.
IV. Retire sooner.
A. I only
B. II only
C. I and III only
D. I and IV only
E. II and III only
Note:
Based on understanding of basic principles discussed in Lecture 4 (and accompanying
tutorial/additional exercises), book chapter 4, and formula PV = FV / (1+r)t
Answer I. will reduce the amount that you must deposit, so it is correct.
Answer II. will have the opposite effect from I. So it is not correct.
Answer III. means that you will earn interest for more years, so it is correct.
Answer IV. will have the opposite effect from III. So, it is not correct
11. A firm has long term assets equal to £80,000, total assets equal to £180,000, inventory equal
to £25,000 and current liabilities equal to £50,000. This means that:
A. current ratio = 2.0; quick ratio = 1
B. current ratio = 3.0; quick ratio = 1.5
C. current ratio = 1.5; quick ratio = 2.0
D. current ratio = 2.0; quick ratio = 1.5
E. none of the above
Solution:
Current assets = Total assets – long term assets = 180,000 -80,000 = 100,000
Current ratio = current assets / current liabilities = 100,000 / 50,000 = 2
Quick ratio = (Current assets – inventory) / current liabilities = (100,000 – 25,000) /50,000 = 1.5
Note:
The fact that Total assets = current assets + long term assets has been shown in slides 7, 8, 10Lecture 2.
Current ratio and quick ratio are available in slide 26 – Lecture 2, and were given in the
Formula Sheet. See also book page 52 – Chapter 3. For illustrations of these calculations see
ratios (1) and (2) in the tutorial exercise.
6
12. A company has a profit margin of 0.20, a total asset turnover of 0.40, a current ratio of 2.5,
total assets of £25,000, and equity of £5,000. The return on equity is:
A. 0.40 or 40%
B. 0.20 or 20%
C. 0.02 or 2%
D. 0.15 or 15%
E. None of the above
Solution:
ROE = Profit margin x total asset turnover x (Assets / Equity) = 0.20 x 0.40 x (25,000 / 5,000) =
0.40 or 40%
Note:
Simple application of the Du Pont Identity covered in slides 36-37 of Lecture 3. It was also
made available in the Formula Sheet. See also book pages 58-59 – Chapter 3.
13. Which of the following will allow your firm to achieve its targeted 16% ROA with an asset
turnover of 2.5?
A. a leverage ratio of 0.0667
B. a P/E ratio of 14
C. a return on equity of 25%
D. a profit margin of 4%
E. none of the above
Solution:
ROA = Asset turnover x profit margin.
So to have ROA = 16, we should have profit margin = ROA / Asset turnover = 16% / 2.5 =
6.4%. However profit margin in D = 4% which is not enough.
A, B, and C are not relevant.
So answer is none of the above
Note:
A similar question using the formula ROA = Asset turnover x profit margin was presented in
slide 31 – Lecture 3. In that case, students were given the profit margin, and data to calculate
ROA. Then, they were asked to solve for Asset turnover.
The difference in the present one is that they are asked to calculate the necessary profit margin to
achieve the targeted ROA, given an asset turnover. Then compare the calculated profit margin to
D.
7
14. Johnson & Brown Plc has shareholders' equity of £150,000. The firm owes a total of £110,000
of which 55% is payable within the next year. The firm has non-current assets of £140,000. What
is the amount of the net working capital?
A. £ 10,000
B. £ 40,000
C. £ 60,500
D. £ 59,500
E. £ 77,000
Solution:
Current liabilities = 0.55 x 110,000 = 60,500
Current assets = Total assets – Non current assets = (Equity + Total debt) – Non Current assets =
(150,000 + 110,000) – 140,000 = 120,000
Working capital = current assets – current liabilities = 120,000 – 60,500 = 59,500
Note:
Based on the fact that:
Total liabilities = current liabilities + non current liabilities (see slides 7, 8, 10, 13, Lecture 2,
etc.),
Total assets = current assets + non current assets (see slides 7, 8, 10-Lecture 2),
Total assets = Equity + liabilities (slides 6, 10 and 13, Lecture 2), tutorial exercises (see the
balance sheet), and various examples of the book (e.g. example 3.1 – page 41; Table 3.1 – page
42)
Working capital = current assets – current liabilities (see slides 9, 10, 11, 12, Lecture 2), Problem
3 in additional exercises (available at SurreyLearn), practice MCQ 5.
Practice MCQ 6 is very close to this one.
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15. Your firm has net income of £40,000, shareholders’ equity of £90,000, current liabilities of
£45,000, and long-term liabilities of 65,000. The company distributes 60% of its net income to
the shareholders in the form of dividends. The internal growth rate is:
A. 8.70%
B. 15.75%
C. 17.50%
D. 19.06%
E. 21.62%
Solution:
Retention (b) = 1 – dividend payout ratio = 1 - 0.6 = 0.4
Debt = Current liabilities + long term liabilities = 45,000 + 65,000 = 110,000
Total assets = equity + debt = 90,000 + 110,000 = 200,000
ROA = Net income / total assets = 40,000 / 200,000 = 0.20
Internal Growth = (ROA*b) / [1-(ROA*b)] = 8.70%
Note:
For internal growth see slides 25 to 31 in Lecture 3, and book page A12. Formula was
available in the Formula sheet.
For a similar question see Practice MCQ 7.
16. ABC Plc is forecasting next year’s sales at £70,000. The firm has a 40% dividend payout
ratio, and a profit margin of 15%. The projected increase in retained earnings is:
A. £4,200
B. £6,300
C. £10,500
D. £28,000
E. £42,000
Answer
Net income = 70,000 * 0.15 = 10,500 and Retained earnings = 10,500 * (1-0.40) = 6,300
Note:
Based on simple application of the formula profit margin = net income / sales (see ratio 11 in
tutorial of Week 2; slide 33 – Lecture 2; and formula sheet), while solving for net income.
Retained earnings is calculated as shown in slides 9, 12, 18 of Lecture 3.
9
17. Black & White Plc wants to maintain a growth rate of 10% without incurring any additional
equity financing. The firm maintains an equity multiplier of 1.6, a total asset turnover ratio of 1.4,
and a profit margin of 10%. What must the dividend payout ratio be?
A. 26.26%
B. 35.06%
C. 40.58%
D. 59.42%
E. 64.94%
Answer
ROE = Profit margin * total asset turnover * equity multiplier = 0.10 * 1.40 * 1.6 = 0.224
Sustainable growth rate = (ROE x b) / [1-(ROE*b)]
0.10 = 0.224b / (1 - 0.224b)
b=0.4058
Dividend payout = 1- 0.4058 = 59.42%
Note:
Application of the standard formula of sustainable growth rate. See slides 25 to 31 in Lecture 3,
and book page A13.
See Practice MCQ 8 for a similar exercise, the main difference being that here students were
asked here to solve for b and payout, using the standard formula, available in the Formula Sheet.
18. William deposited £20,000 today at 3% interest for 8 years. You would like to have just as
much money at the end of the next 8 years as William will have. However, you can only earn 2%
interest. How much more money must you deposit today than William did if you are to have the
same amount at the end of the 8 years?
Answer
William will have: FV = 20,000 (1.03)8 = 25,335.4
So, you must deposit: PV = 25,335.4 / (1+0.02)8 =21,623.52
Difference = 21,623.52 – 20,000 = 1,623.52
Note:
Simple application of the two formulas discussed in Lecture 4 (i.e. FV and PV), Tutorial 4 and
accompanying additional exercises.
Not to be marked.
10
19. You need £55,000 as a down payment for a house 5 years from now. Your financial advisor
recommended an investment with an interest rate of 7%. You can either invest one lump sum today
for this purpose or you can wait a year and invest a lump sum. How much additional money must
you invest if you wait for one year rather than making the investment today?
A. £845.98
B. £975.14
C. £1,138.95
D. £2,745.00
E. £3,550.00
Answer
PV = FV / (1+i)n
PVnow = 55,000 / (1+0.07)5 = 39,214.24
PV1year later option = 55,000 / (1+0.07)4 =41,959.24
Difference = 2,745.00
Note:
Simple application of the Present Value formula discussed in Lecture 4, Week 4 Tutorial
Problem 2, Week 4 Additional exercises problems 2 and 3.
Similar to Practice MCQ15
20. Suppose you find a three-year investment that pays 10% per year. If you invest £7,500, the
simple interest that you will earn over the three years period is:
A. 232.50
B. 465.00
C. £2,250.00
D. £2,482.50
E. £9,982.50
Answer
7,500 * 0.10 *3 = £2,250
Note:
For simple interest see Problem 1 in Tutorial of Week 4, Slide 11 and 19 –Lecture 4.
For a similar question see Practice MCQ 10.
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