Problem Set 1
1. What is the main reason that an agency problem exists in the corporate form of organization?
In this context, what kinds of problems can arise? (1.6)
1) In Corporations, the shareholders select board of directors to work in favor of enterprise and take
decisions in the best interest of the shareholders. The ownership and management are separate.
Hence, the corporations is basically owned by shareholders. The shareholders are investors of the
Company, they are interested in earning higher returns in form of increased share price or profits.
The management takes all important decisions for success of the company. Therefore, the agency
relationship exists. The management acts in favor of shareholders and management. Hence, there
exists an agency relationship between management and shareholders.
Shareholders select persons who can manage and steer the company in right direction. The board
is updated regularly in shareholders general meeting. Public companies also have the policy of selfevaluation of the top management and they report the same to the shareholders. If the shareholders
feel that the board of directors is not working or not taking decisions in favor of company, they
have the right to remove the director. The above points ensure that owners have proper control
over the management.
The problems that may arise due to agency relation is as follows: Board may act in its own best
interest rather than in the interest of the enterprise and the shareholders. The decisions taken may
lead to prejudice to shareholders wealth and effect the company. The board or management is in
full control of the operations, there could be dilution of interest, that is, remuneration of
management, adjusting financial statements, etc.
2) In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders
elect the directors of the corporation, who in turn appoint the firm’s management. This separation of
ownership from control in the corporate form of organization is what causes agency problems to
exist. Management may act in its own or someone else’s best interests, rather than those of the
shareholders. If such events occur, they may contradict the goal of maximizing the share price of the
equity of the firm.
2. Under standard accounting rules, it is possible for a company’s liabilities to exceed its assets.
When this occurs, the owner’s equity is negative. Can this happen with market values? Why or
why not? (2.5)
3. In Comparing accounting net income and operating cash flow, what two items do you find in net
income that are not in operating cash flow? Explain what each is and why it is excluded in operating
cash flow. (2.4)
4. Suppose a company’s cash flow from assets was negative for a particular period. Is this necessarily
a good sign or a bad sign? (2.6) Chung-Ang University School of Business and Economics Financial
Management 2021
5. At the beginning of the year, a firm has current assets of $420 and current liabilities of $380. At
the end of the year, the current assets are $500 and the current liabilities are $410. What is the
change in net working capital? A. -$80 B. -$50 C. $0 D. $50 E. $80
6. Awnings Incorporated has beginning net fixed assets of $560 and ending net fixed assets of $720.
Assets valued at $210 were sold during the year. Depreciation was $50. What is the amount of
capital spending? A. $110 B. $160 C. $210 D. $300 E. $420 Chung-Ang University School of Business
and Economics Financial Management 2021
7. At the beginning of the year, long-term debt of a firm is $310 and total debt is $350. At the end
of the year, long-term debt is $280 and total debt is $370. The interest paid is $50. What is the
amount of the cash flow to creditors? A. -$30 B. $0 C. $20 D. $30 E. $80
8. Peggy Grey's Cookies has net income of $360. The firm pays out 40% of the net income to its
shareholders as dividends. During the year, the company sold $80 worth of common stock. What is
the cash flow to stockholders? A. $64 B. $136 C. $144 D. $224 E. $296
9. Thompson's Jet Skis has operating cash flow of $218. Depreciation is $45 and interest paid is $35.
A net total of $69 was paid on long-term debt. The firm spent $180 on fixed assets and increased
net working capital by $38. What is the amount of the cash flow to stockholders? A. -$104 B. -$28
C. $28 D. $114 E. $142
10. Note that in all of our cash flow computations to determine cash flow of the firm, we never
include the addition to retained earnings. Why not? Is this an oversight? Chung-Ang University
School of Business and Economics Financial Management 2021
11. Note that we added depreciation back to operating cash flow and to additions to fixed assets.
Why add it back twice? Isn't this double-counting?
12. What is operating cash flow and how does it different from the total cash flow to the firm?
13. Frederico's has a profit margin of 6%, a return on assets of 8%, and an equity multiplier of 1.4.
What is the return on equity? A. 6.7% B. 8.4% C. 11.2% D. 14.6% E. 19.6% Chung-Ang University
School of Business and Economics Financial Management 2021
14. Samuelson's has a debt-equity ratio of 40%, sales of $8,000, net income of $600, and total debt
of $2,400. What is the return on equity? A. 6.25% B. 7.50% C. 9.75% D. 10.00% E. 11.25%
15. The inventory turnover ratio is measured as: A. total sales minus inventory. B. inventory times
total sales. C. cost of goods sold divided by inventory. D. inventory times cost of goods sold. E.
inventory plus cost of goods sold.
16. If a firm bases its growth projection on the rate of sustainable growth, and shows positive net
income, then the: A. fixed assets will have to increase at the same rate, regardless of the current
capacity level. B. number of common shares outstanding will increase at the same rate of growth.
C. debt-equity ratio will have to increase. D. debt-equity ratio will remain constant while retained
earnings increase. E. fixed assets, debt-equity ratio, and number of common shares outstanding will
all increase.
17. A firm has sales of $4,000, costs of $3,000, interest paid of $100, and depreciation of $400. The
tax rate is 34%. What is the value of the cash coverage ratio? A. 3 B. 4 C. 6 D. 7 E. 10 Chung-Ang
University School of Business and Economics Financial Management 2021
18. Rosita's Resources paid $250 in interest and $130 in dividends last year. The times interest earned
ratio is 3.8 and the depreciation expense is $80. What is the value of the cash coverage ratio? A.
2.71 B. 3.64 C. 4.12 D. 5.78 E. 6.10
19. Which of the following statements concerning the effective annual rate are correct? I. When
making financial decisions, you should compare effective annual rates rather than annual percentage
rates. II. The more frequently interest is compounded, the higher the effective annual rate. III. A
quoted rate of 6% compounded continuously has a higher effective annual rate than if the rate
were compounded daily. IV. When borrowing and choosing which loan to accept, you should select
the offer with the highest effective annual rate. A. I and II only B. I and IV only C. I, II, and III only
D. II, III, and IV only E. I, II, III, and IV
20. The time value of money concept can be defined as: A. the relationship between the supply and
demand of money. B. the relationship between money spent versus money received. C. the
relationship between a dollar to be received in the future and a dollar today. D. the relationship
between interest rate stated and amount paid. E. None of these. Chung-Ang University School of
Business and Economics Financial Management 2021
21. Discounting cash flows involves: A. discounting only those cash flows that occur at least 10 years
in the future. B. estimating only the cash flows that occur in the first 4 years of a project. C.
multiplying expected future cash flows by the cost of capital. D. discounting all expected future cash
flows to reflect the time value of money. E. taking the cash discount offered on trade merchandise.
22. Find the present value of $5,325 to be received in one period if the rate is 6.5%. A. $5,000.00 B.
$5,023.58 C. $5,644.50 D. $5,671.13 E. None of these.
23. If you have a choice to earn simple interest on $10,000 for three years at 8% or annually
compounded interest at 7.5% for three years which one will pay more and by how much? A. Simple
interest by $50.00 B. Compound interest by $22.97 C. Compound interest by $150.75 D. Compound
interest by $150.00 E. None of these. Chung-Ang University School of Business and Economics
Financial Management 2021
24. The stated interest payment, in dollars, made on a bond each period is called the bond's: A.
coupon. B. face value. C. maturity. D. yield to maturity. E. coupon rate.
25. An asset characterized by cash flows that increase at a constant rate forever is called a: A.
growing perpetuity. B. growing annuity. C. common annuity. D. perpetuity due. E. preferred stock.
26. The bonds issued by Manson & Son bear a 6% coupon, payable semiannually. The bond matures
in 8 years and has a $1,000 face value. Currently, the bond sells at par. What is the yield to maturity?
A. 5.87% B. 5.97% C. 6.00% D. 6.09% E. 6.17% Chung-Ang University School of Business and
Economics Financial Management 2021
27. A Corporate bond has an 8% coupon and pays interest annually. The face value is $1,000 and
the current market price is $1,020.50. The bond matures in 20 years. What is the yield to maturity?
A. 7.79% B. 7.82% C. 8.00% D. 8.04% E. 8.12%
28. Otto Enterprises has a 15-year bond issue outstanding that pays a 9% coupon. The bond is
currently priced at $894.60 and has a par value of $1,000. Interest is paid semiannually. What is the
yield to maturity? A. 8.67% B. 10.13% C. 10.16% D. 10.40% E. 10.45%
29. Chocolate and Rum, Inc. offers a 7% coupon bond with semiannual payments and a yield to
maturity of 7.73%. The bonds mature in 9 years. What is the market price of a $1,000 face value
bond? A. $953.28 B. $963.88 C. $1,108.16 D. $1,401.26 E. $1,401.86
30. Part of the Rock, Inc. has a 6% coupon bond that matures in 11 years. The bond pays interest
semiannually. What is the market price of a $1,000 face value bond if the yield to maturity is 12.9%?
A. $434.59 B. $580.86 C. $600.34 D. $605.92 E. $947.87