IAR Economic & Financial Concepts 5 — Questions and Answers
Question 1: A company's 'free cash flow' is best described as:
- Net income plus depreciation and amortization charges
- Cash flow from operations minus capital expenditures (Correct answer)
- Total revenue minus all operating and non-operating expenses
- Earnings before interest, taxes, depreciation, and amortization (EBITDA)
Correct answer: Cash flow from operations minus capital expenditures
Free cash flow equals operating cash flow minus capital expenditures, representing cash available to pay investors after maintaining and expanding the asset base.
Question 2: The yield spread between corporate bonds and comparable U.S. Treasury bonds is primarily driven by:
- Differences in coupon payment frequency
- Compensation for credit risk and liquidity risk in corporate bonds (Correct answer)
- Tax treatment differences between corporate and government bonds
- Foreign exchange risk associated with multinational corporations
Correct answer: Compensation for credit risk and liquidity risk in corporate bonds
Corporate bond yield spreads over Treasuries compensate investors for the additional credit default risk and typically lower liquidity of corporate versus government debt.
Question 3: Which scenario best illustrates the concept of 'adverse selection' in financial markets?
- Investors selling securities in a declining market, accelerating the decline
- Borrowers with the highest default risk being most eager to take on loans (Correct answer)
- Portfolio managers choosing lower-risk investments during market volatility
- Regulators selecting which financial firms to audit based on risk scores
Correct answer: Borrowers with the highest default risk being most eager to take on loans
Adverse selection occurs when information asymmetry causes higher-risk borrowers to disproportionately seek credit, as lenders cannot perfectly distinguish risk levels.
Question 4: According to the Capital Asset Pricing Model (CAPM), a stock's expected return is determined by:
- The stock's dividend yield plus anticipated capital appreciation
- The risk-free rate plus the stock's beta multiplied by the market risk premium (Correct answer)
- The industry average return adjusted for company-specific growth prospects
- The stock's historical average return over the past 10 years
Correct answer: The risk-free rate plus the stock's beta multiplied by the market risk premium
CAPM calculates expected return as the risk-free rate plus beta (systematic risk) times the market risk premium, linking return to non-diversifiable market risk.
Question 5: When GDP is calculated using the expenditure approach, which components are included?
- Wages + profits + rents + interest payments
- Consumption + Investment + Government spending + Net exports (Correct answer)
- Total revenue of all businesses minus intermediate goods costs
- Personal income + transfer payments + corporate retained earnings
Correct answer: Consumption + Investment + Government spending + Net exports
The expenditure approach sums C (consumption) + I (investment) + G (government spending) + NX (net exports = exports minus imports) to arrive at GDP.
Question 6: Which of the following would most accurately describe a 'liquidity trap'?
- A situation where banks hoard cash rather than lending to consumers
- A condition where interest rates are so low that monetary policy becomes ineffective at stimulating the economy (Correct answer)
- A scenario where highly liquid assets are suddenly frozen during a market panic
- A regulatory restriction preventing banks from converting assets to cash quickly
Correct answer: A condition where interest rates are so low that monetary policy becomes ineffective at stimulating the economy
A liquidity trap occurs when interest rates are near zero, making conventional monetary policy (rate cuts) ineffective because people hoard cash instead of spending or investing.
Question 7: In analyzing a company's financial health, a DECREASING current ratio over time most likely indicates:
- Improving ability to meet short-term obligations with current assets
- Declining short-term liquidity, suggesting potential cash flow challenges (Correct answer)
- Higher long-term debt relative to equity financing
- Greater profitability due to more efficient asset utilization
Correct answer: Declining short-term liquidity, suggesting potential cash flow challenges
The current ratio (current assets ÷ current liabilities) measures short-term liquidity; a declining ratio suggests the company has fewer current assets relative to its short-term obligations.
IAR Economic & Financial Concepts 5
A company's 'free cash flow' is best described as: