Chapter 17 Managing Business Finance Part 3

65) Why should an investor consider diversification and asset allocation? A) To offset capital gains B) To achieve desired risk-return balance C) To increase total returns D) To achieve higher dividend yields E) To improve price-appreciation values Answer: B Explanation: B) After determining the desired risk-return balance, investors then achieve it in two ways: through (1) diversification and (2) asset allocation. Diversification and asset allocation, together, are essential to protect against the uncertainties (risks) inherent in any single investment. Difficulty: Moderate AACSB: Analytical thinking Objective: 17.4: Describe the risk-return relationship and discuss the use of diversification and asset allocation for investments. 66) What is the proportion of investments in each investment alternative referred to as? A) Portfolio B) Dividend yield C) Asset allocation D) Risk-reward relationship E) Diversification Answer: C Explanation: C) Asset allocation is the proportion (the relative amounts) of funds invested in (or allocated to) each of the investment alternatives. Difficulty: Easy AACSB: Application of knowledge Objective: 17.4: Describe the risk-return relationship and discuss the use of diversification and asset allocation for investments. 67) What type of investment offers low returns, but is insured by the U.S. government? A) Common stock B) Mutual funds C) Exchange-traded funds D) Treasury bills E) Securities Answer: D Explanation: D) Conservative investors, who have a low tolerance for risk, will opt for no-risk U.S. Treasury Bills (fully insured by the U.S. government) or even intermediate-term high-grade corporate bonds that rate low in terms of risk on future returns, but also low on the size of expected returns. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.4: Describe the risk-return relationship and discuss the use of diversification and asset allocation for investments. 68) Aggressive growth funds are designed for investors who can accept the risk of loss inherent in common stock investing with severe price fluctuations, but also the potential for superior returns over time. Answer: TRUE Explanation: Aggressive growth funds have the most potential for superior returns over time, but also carry the most risk. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.4: Describe the risk-return relationship and discuss the use of diversification and asset allocation for investments. 69) An investment's current dividend yield plus its capital gain rate is known as its total return. Answer: TRUE Explanation: The sum of an investment's current dividend (interest) yield and capital gain is referred to as its total return. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.4: Describe the risk-return relationship and discuss the use of diversification and asset allocation for investments. 70) A portfolio represents the proportion of funds invested in each of the investment alternatives. Answer: FALSE Explanation: A portfolio is the combined holdings of all the financial investments, stocks, bonds, mutual funds, real estate of any company or individual. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.4: Describe the risk-return relationship and discuss the use of diversification and asset allocation for investments. 71) Explain how dividend yield and interest dividend yield are computed. Answer: For annual dividend payments of $1.24 and a share price of $33.82, the current yield would be $1.24/$33.82 × 100 = 3.66 percent. Current dividend yield and interest dividend yield are both figured by dividing the yearly dollar amount of dividend income by the investment's current market value. This dividend can then be compared against current yields from other investments. Larger dividend yields, of course, are preferred to smaller returns. Difficulty: Difficult AACSB: Application of knowledge Objective: 17.4: Describe the risk-return relationship and discuss the use of diversification and asset allocation for investments. 72) What is the formula for measuring a firm's working capital? A) Current assets = working capital /current liabilities B) Working capital = current assets - current liabilities C) Current liabilities = current assets + working capital D) Working capital = current assets × current liabilities E) Current liabilities = current assets / working capital Answer: B Explanation: B) Subtracting liabilities from assets lets you know how much money a firm has to work with. Difficulty: Easy AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 73) Which of the following is a formal pledge (an IOU) obligating the issuer to pay interest periodically and repay the principal at maturity (a preset future date) to the lender? A) Commercial bank loan B) Corporate bond C) Mutual fund D) Bond indenture E) Prospectus Answer: B Explanation: B) Bondholders have no claim to ownership in the firm and do not receive dividends. Difficulty: Easy AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 74) What type of loan is guaranteed by collateral? A) Unsecured loan B) Venture capital loan C) Angel investor loan D) Secured loan E) Corporate bond Answer: D Explanation: D) In a secured loan (asset-backed loan), the borrower guarantees repayment of the loan by pledging the asset as collateral to the lender. Difficulty: Easy AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 75) What is the advantage to a small business when planning for shortfalls in cash flow? A) Financial resources can be saved in a savings account until needed. B) Banks are more likely to offer loans if they know when the money will be needed. C) Loans can be obtained in advanced and put in interest earning investments. D) Lower interest loans can be sought for the needed time frame. E) Small businesses will appear more professional, resulting in favorable banking relationships. Answer: C Explanation: C) Such information can be invaluable for the small-business manager. By anticipating shortfalls, managers can seek funds in advance and minimize their costs. By anticipating excess cash, a manager can plan to put the funds to work in short-term, interestearning investments. Difficulty: Moderate AACSB: Analytical thinking Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 76) What can an angel investor offer to small businesses when the small business doesn't have enough history to get a loan from a commercial bank? A) A credit history B) Start-up funds C) Stock options D) Financial oversight E) Bonds Answer: B Explanation: B) Outside individuals who provide capital are called angel investors. Angel investors help many firms grow rapidly by providing what is known as venture capital, private funds from wealthy individuals or companies that seek investment opportunities in new growth companies. Difficulty: Moderate AACSB: Analytical thinking Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 77) How are federal and state projects, such as roads and schools, typically financed? A) Municipal bonds B) Common stock C) Angel investors D) Corporate bonds E) TARP loans Answer: A Explanation: A) The federal government also issues bonds to finance projects and meet obligations, as do state and local governments (called municipal bonds) for financing the building of schools, roads, and sewage disposal systems. Difficulty: Moderate AACSB: Analytical thinking Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 78) What is the legal document that identifies a borrower's obligation when issuing corporate bonds? A) Bondholder's claim B) Risk claim analysis C) Initial public offering D) Mortgage-backed security E) Bond indenture Answer: E Explanation: E) Each new bond issue has specific terms and conditions spelled out in a bond indenture, a legal document identifying the borrower's obligations and the financial returns to lenders. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 79) What is the result of a borrower who fails to make payments to the lender when due? A) Bankruptcy B) Default C) Risk ratings D) Bondholder's claim E) Bond indenture Answer: B Explanation: B) A bond is said to be in default if the borrower fails to make payment when due to lenders. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 80) According to rating services such as Moody's, what type of rating would a bond have if it was one of the safest investments possible, but produced lower returns? A) AAA B) BBB C) Caa D) CCC E) D Answer: A Explanation: A) The highest (safest) grades are AAA and Aaa, and the lowest are C and D, representing speculative and highly risky bonds. Low-grade bonds are usually called junk bonds. Negative ratings do not necessarily keep issues from being successful. Rather, they raise the interest rates that issuers must offer to attract lenders. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 81) What type of loan allows a borrower to maintain a compensating balance at the bank instead of putting up collateral? A) Unsecured loan B) Venture capital loan C) Angel investor loan D) Secured loan E) Corporate bond Answer: A Explanation: A) With an unsecured loan, the borrower does not have to put up collateral. In many cases, however, the bank requires the borrower to maintain a compensating balance, the borrower must keep a portion of the loan amount on deposit with the bank in a non-interest bearing account. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 82) How can an investor request the courts to enforce a bond's terms of payment? A) File for bankruptcy B) Ask for an improved risk rating on the bond C) File a bondholders' claim D) Have the bond converted to stock E) Have the bond converted to a mortgage-backed security Answer: C Explanation: C) A bond is said to be in default if the borrower fails to make payment when due to lenders. Bondholders may then file a bondholders' claim, a request for court enforcement of the bond's terms of payment. Difficulty: Moderate AACSB: Analytical thinking Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 83) When can a bondholder file a bondholders' claim? A) When purchasing an initial issue of the bond B) When buying a bond from a brokerage service C) When the borrower is filing for bankruptcy D) When selling a bond before maturity E) When the borrower fails to make a payment that is due Answer: E Explanation: E) A bond is said to be in default if the borrower fails to make payment when due to lenders. Bondholders may then file a bondholders' claim, a request for court enforcement of the bond's terms of payment. Difficulty: Moderate AACSB: Analytical thinking Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 84) When a new bond is issued, when does the bond's par value have to be repaid? A) When the company files for bankruptcy B) Before the company goes into default C) On the maturity date D) On the issue date E) When the company makes enough profit to cover the value of the bond Answer: C Explanation: C) One of the most important details is the maturity date (or due date), when the firm must repay the bond's face value (also called par value, or the amount purchased) to the lender. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 85) How is the risk involved in purchasing bonds affected by the bond's maturity date? A) The sooner the maturity date, the greater the rate of return is on the bond. B) The further the maturity date, the less likely a bondholders' claim will be filed. C) The sooner the maturity date, the lower the initial offering price of the bond. D) The further the maturity date, the greater the chance for unforeseen circumstances that effect the bond. E) The sooner the maturity date, the greater the chance for significant market changes that effect the bond. Answer: D Explanation: D) Bonds with 5- to 10-year lives are considered intermediate term, and anything longer than 10 years is considered long term. Longer-term corporate bonds are somewhat riskier than shorter-term bonds because they are exposed to greater unforeseen economic conditions that may lead to default. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 86) How does an issuer of mortgage-backed security pay off debt obligations? A) Through the sale of mortgages to consumers B) Through an increase in interest rates on mortgages C) Through the assets of the lending institutions D) Through the closing of a mortgage loan E) Through the influx of cash from mortgage payments Answer: E Explanation: E) Each mortgage-backed security is a group of mortgages bundled together to form a debt obligation (a bond) that entitles the holder (the investor) to the cash that flows in from the mortgages. Difficulty: Moderate AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 87) What is a mortgage-backed security? A) A bundled group of home mortgages B) A bundled group of investments with AAA credit-ratings C) A bundled group of bonds D) A bundled group of stocks E) A bundled group of loans made to risk assessment firms Answer: A Explanation: A) Financial institutions bundle home mortgages into packages and resell them as securities to eager investors who trusted in the securities' risk ratings given by Moody's, Standard & Poor's, and Fitch. Each MBS is a group of mortgages bundled together to form a debt obligation (a bond) that entitles the holder (the investor) to the cash that flows in from the mortgages. Difficulty: Moderate AACSB: Analytical thinking Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 88) Municipal bonds may be issued by federal, state, or local governments. Answer: TRUE Explanation: Municipal bonds are those that are issued by the government. Difficulty: Easy AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 89) A bond is said to be in default if the borrower fails to make payment when due to lenders. Answer: TRUE Explanation: Bondholders may then file a request for court enforcement of the bond's payment terms. Difficulty: Easy AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 90) Bankruptcy is the court-granted permission not to pay some or all debts. Answer: TRUE Explanation: Bankruptcy is filed by an individual or institution that cannot pay their debts. Difficulty: Easy AACSB: Application of knowledge Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 91) When are corporate bonds attractive to a firm? Answer: Bonds are attractive when firms need large amounts for long periods of time. A corporate bond is a formal pledge (an IOU) obligating the issuer to pay interest periodically and repay the principal at maturity (a preset future date) to the lender. Interest payments and repayment of principal are financial obligations; payments to bondholders have priority over dividend payments to stockholders in cases of financial distress. Difficulty: Moderate AACSB: Analytical thinking Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method. 92) Explain the difference between angel investors and venture capital. Answer: Angel investors help many firms grow rapidly by providing what is known as venture capital-private funds from wealthy individuals or companies that seek investment opportunities in new growth companies. In most cases, growth companies turn to angel investors and venture capital because they have not yet built enough credit history to get a loan from commercial banks or other lending institutions. Difficulty: Moderate AACSB: Analytical thinking Objective: 17.5: Describe the various ways that firms raise capital and identify the pros and cons of each method.