BMO Financial Management 3 — Questions and Answers
Question 1: The weighted average cost of capital (WACC) is used in financial management primarily to:
- Calculate dividend payments
- Evaluate the profitability of past projects
- Serve as the discount rate for evaluating new investments (Correct answer)
- Determine employee compensation
Correct answer: Serve as the discount rate for evaluating new investments
WACC represents the minimum return a company must earn on its investments to satisfy all capital providers, and is used as the hurdle rate in NPV analysis.
Question 2: Which financial statement reports retained earnings?
- Income statement
- Cash flow statement
- Balance sheet (Correct answer)
- Statement of changes in equity only
Correct answer: Balance sheet
Retained earnings appear in the stockholders' equity section of the balance sheet, representing cumulative net income not distributed as dividends.
Question 3: A project has an NPV of -$50,000. A business manager should:
- Accept the project because it generates cash
- Reject the project because it destroys value (Correct answer)
- Accept the project if payback is under 3 years
- Defer the decision until IRR is calculated
Correct answer: Reject the project because it destroys value
A negative NPV means the project returns less than the required rate of return, destroying shareholder value, so it should be rejected.
Question 4: Operating leverage refers to the degree to which a firm uses:
- Debt financing in its capital structure
- Fixed costs in its cost structure (Correct answer)
- Variable costs to scale production
- Short-term borrowing for operations
Correct answer: Fixed costs in its cost structure
Operating leverage measures the sensitivity of operating income to sales changes, driven by the proportion of fixed versus variable costs.
Question 5: Which of the following is a source of long-term financing for a corporation?
- Accounts payable
- Commercial paper
- Corporate bonds (Correct answer)
- Overdraft facilities
Correct answer: Corporate bonds
Corporate bonds are long-term debt instruments typically maturing in 10–30 years, making them a primary source of long-term capital.
Question 6: What does the term 'amortization' refer to in financial management?
- The gradual write-down of tangible fixed assets
- The gradual repayment of a loan over time (Correct answer)
- The increase in asset value over time
- The liquidation of inventory
Correct answer: The gradual repayment of a loan over time
Amortization is the process of spreading loan repayments (principal and interest) over scheduled periods, or writing off intangible asset costs over their useful life.
Question 7: A firm's quick ratio is 1.5. Which assets are excluded from the quick ratio calculation?
- Cash and cash equivalents
- Accounts receivable
- Inventory (Correct answer)
- Marketable securities
Correct answer: Inventory
The quick ratio excludes inventory (and sometimes prepaid expenses) from current assets because inventory may not be quickly converted to cash.
BMO Financial Management 3
The weighted average cost of capital (WACC) is used in financial management primarily to: