Chapter 16 Managing Finances 1. An exchange-traded fund (ETF) is a bundle of stocks (or bonds) that are in an index that tracks the overall movement of a market. Answer: True Explanation: ETFs will earn a return that is indexed to the overall market movement. 2. The largest stock exchange in the world is the Tokyo exchange. Answer: False Explanation: The New York Stock Exchange is the largest stock exchange in the world, though it has faced stiff competition recently from both the electronic markets in the United States and large foreign exchanges. 3. Unlike the Dow and the S&P 500, all NASDAQ-listed companies, not just a selected few, are included in the index for a total of some 3,800 firms across six continents. Answer: True Explanation: NASDAQ is one of the largest stock indexes in the world. 4. Stocks are known as securities because they represent a secured interest in a company. Answer: True Explanation: A stock's value is secure because it is rooted in company assets. 5. The market in which mutual funds are sold are called securities markets. Answer: False Explanation: Mutual funds are sold in mutual funds markets. 6. In a secondary securities market, new stocks and bonds are bought and sold by firms and governments. Answer: False Explanation: Existing stocks and bonds are sold in a secondary securities market. 7. An investment bank is a financial institution that specializes in issuing and reselling new securities. Answer: True Explanation: Investment banks make money by selling new securities. 8. A stock exchange is an organization of individuals coordinated to provide an institutional auction setting in which stocks can be bought and sold. Answer: True Explanation: Stock exchanges are institutions that provide a market for stocks. 9. The New York Stock Exchange is one of the smaller exchanges. Answer: False Explanation: The NYSE is the largest stock exchange in the world. 10. The NASDAQ is the largest exchange. Answer: False Explanation: The NASDAQ is an index of stock performance, not an exchange. 11. The New York Stock Exchange, the world's oldest electronic stock market, has orders gathered and executed on a computer network. Answer: False Explanation: The NYSE is a hybrid exchange that utilizes both floor and electronic trading. 12. Stock brokers earn commissions from the individuals and organizations for whom they place orders. Answer: True Explanation: Stock brokers make money from commissions. 13. The Dow Jones Industrial Average (DJIA) has remained unchanged in recent years. Answer: False Explanation: The DJIA is an index of stock prices that fluctuates on a long-term basis. 14. Municipal bonds may be issued by federal, state, or local governments. Answer: True Explanation: Municipal bonds are those that are issued by the government. 15. 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. 16. Bankruptcy is the court-granted permission not to pay some or all debts. Answer: True Explanation: Bankruptcy is filed by an individual or institution who cannot pay their debts. 17. Initial public offerings (IPOs) are the first sale of a company's stock to the general public and are a major source of funds that fuel continued growth for many firms. Answer: True Explanation: IPOs generate a lot of funding for companies that engage in public trading of stock. 18. Because of the uncertainties involved in stock prices, investment professionals believe day-to-day prices to be a generally poor indicator of any stock's real value. Answer: True Explanation: A stock's investment value is generally rated in terms of its long-term performance. 19. The investment industry categorizes firms according to size of capitalization. Answer: True Explanation: The largest firms are most likely to appear in overall market indices. 20. In case of financial distress, the firm would pay its stockholders before paying its bondholders. Answer: False Explanation: A firm owes its bondholders first. 21. Dividend payments are optional and variable—the corporation's CEO decides whether and when a dividend will be paid, as well as the amount that is best for the future of the company and its employees. Answer: False Explanation: Dividend payments are required and are indexed to a company's overall performance. 22. 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. 23. An investment bank operates in the secondary securities market. Answer: False Explanation: Investment banks provide services needed to bring a new security to the market. 24. When an investment bank engages in underwriting, that investment bank is taking on risk in the process of launching new securities. Answer: True Explanation: When investment banks underwrite, they buy new securities, thus bearing some of the risks of issuing them. 25. Although advising and underwriting may be tasks of an investment bank, distribution of new securities is NOT one of their services. Answer: False Explanation: Investment banks create distribution networks for moving new securities through groups of other banks and brokers into the hands of individual investors. 26. What value of a stock is calculated by dividing total shareholders' equity by the total number of shares of stock issued? A) par value B) market value C) book value D) chime value E) total value Answer: C Explanation: C) Book value is usually less than market value. 27. Which of the following statements is NOT true about dividend payments? A) Many companies distribute between 30 and 70 percent of their profits to shareholders. B) Some firms, especially fast-growing companies, do not pay dividends. C) Many fast-growing companies use cash earnings for expanding the company so that future earnings can grow even faster. D) During unprofitable years, companies are still required by law to pay dividends to their stockholders. E) Dividend payments are made to stockholders on a regular basis. Answer: D Explanation: D) Companies are not compelled by law to pay dividends; stockholders receive dividends only if the company makes money. 28. Which of the following is an advantage of ETFs over mutual funds? A) ETFs can be traded throughout the day like a stock. B) ETFs have high operating expenses. C) ETFs do not require high initial investments. D) ETFs are not regulated by the government. E) ETFs are difficult to sell in a timely manner. Answer: A Explanation: A) ETFs are traded on the stock exchange, just like stocks. 29. Which of the following are stocks, bonds, and mutual funds representing secured, or financially viable, claims on the part of investors? A) private placements B) securities C) exchanges D) commodities E) dividends Answer: B Explanation: B) The name "securities" comes from the fact that these represent secured, or financially viable, claims on the part of investors. 30. New stocks and bonds are sold in what market? A) private placement market B) secondary market C) primary market D) tertiary market E) open market Answer: C Explanation: C) Sales may be public or private in the primary market. 31. Which of the following is the federal government agency that regulates U.S. securities markets? A) New York Stock Exchange B) Federal Reserve C) Commerce Department D) Securities and Exchange Commission E) Treasury Department Answer: D Explanation: D) The SEC must approve a new security before it is brought to market. 32. Which of the following is an organization of individuals coordinated to provide an institutional setting in which stock can be bought and sold? A) stock exchange B) brokerage C) server D) over-the-counter market E) commission Answer: A Explanation: A) Each exchange regulates where and when trading may occur. 33. Which of the following is a requirement for a firm to be listed on the New York Stock Exchange? A) capital value of at least $35 million B) total value of outstanding stock C) number of shareholders must exceed 100 D) number of shares of stock must exceed 1 million E) company must be headquartered in North America Answer: B Explanation: B) The number of shares of stock offered by firms listed on the NYSE varies widely, and there is no requirement for the number. 34. Which of the following receives and executes buy-and-sell orders for other people in return for commissions? A) stock exchanges B) stock brokers C) investment banks D) stock agents E) savings banks Answer: B Explanation: B) Stock brokers usually work on commission. 35. Lito is working with a discount broker. Which service would Lito NOT be likely to receive? A) stock research B) industry analysis C) face-to-face consultations D) screening for specific types of stocks E) quality suggestions for investments Answer: C Explanation: C) Although such consultations are not offered, discount brokers can be much less expensive than traditional brokers. 36. Which of the following is a summary of price trends in a specific industry and/or the stock market as a whole? A) investment index B) average index C) market indicator D) market index E) prospectus Answer: D Explanation: D) Market indexes do not indicate the status of individual securities. 37. Hugh is an investor who opts for no-risk U.S. Treasury Bills and intermediate-term high-grade corporate bonds. What kind of investor is Hugh? A) professional B) aggressive C) amateur D) conservative E) sporadic Answer: D Explanation: D) Generally speaking, the higher the risk, the higher the return. 38. If you purchased a share of GE stock for $33.82, then sold it one year later for $36.50, what would the price appreciation be? A) $1.68 B) $2.68 C) $33.82 D) $36.50 E) $67.24 Answer: B Explanation: B) Price appreciation is an increase in the dollar value of an investment, thus you would subtract $33.82 from $36.50. 39. Kim has investments in stocks, and wants to calculate her total return. What should she do? A) Divide the yearly dollar amount of dividend income by the investment's current market value. B) Compare the dividend against current yields from other investments. C) Subtract the cost of the stock from what she sold it for. D) Divide the current dividend payment plus capital gain by the original investment. E) Subtract current liabilities from current assets. Answer: D Explanation: D) Total return is expressed as a percentage. 40. 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 x 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. 41. 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. 42. What is a stock's market value? A) the current price of a share of stock in the stock market B) the average price of one share of stock over the past year C) the face value of a share of stock, set by the issuing company's board of directors D) the price of the stock plus the previous year's dividend E) the monthly average of a stock's price over a year Answer: A Explanation: A) Market value represents what buyers are willing to invest in a firm. 43. What is a stock's book value? A) the current price of a share of stock in the stock market B) the average price of one share of stock over the past year C) the face value of a share of stock, set by the issuing company's board of directors D) the value of a common stock expressed as total stockholders' equity divided by the total number of shares of stock issued E) the value of a preferred stock as expressed by the number of stock shares issued by the board of directors Answer: D Explanation: D) Book value is used as a comparison indicator because the market value for successful companies is usually greater than its book value. 44. Don Dillon is a 24-year-old graphic designer. He eventually wants to get married, raise a family, and buy a house. He knows that he has to start putting money away so that his goals can someday become a reality. He has heard that investing is risky because you can lose money as well as make money. So Don decides to play it safe and deposit money in a bank on a regular basis. Why might this not be his best strategy? A) Stock investments will always result in high returns. B) It pays to take chances with your money. C) You can actually lose money with bank savings due to inflation and taxes. D) People usually benefit from risky investments. E) Most savings accounts are insured by the FDIC. Answer: C Explanation: C) The interest on your savings is taxed, which is partly how you can lose money. Inflation can make the dollars in your savings account worth less over time. 45. Which of the following is a function performed by an investment bank? A) handling a client's portfolio in the secondary market B) establishing relationships for a client with a commercial bank C) underwriting purchases of stocks and bonds D) arranging travel abroad for purchasers of foreign currencies E) providing insurance services for clients Answer: C Explanation: C) Investment banks advise companies on timing and financial terms of new issues, underwrite new securities, and create distribution networks for moving new securities through groups of other banks and brokers into the hands of individual investors. 46. Peter Kim wanted to buy a new car. To help finance the purchase, he decided to sell his Organic Markets bond in the secondary market. Peter's bond had a par value of $10,000 and a coupon of 6 percent. Current interest rates were 3 percent. What would Peter's bond sell for? A) for par value B) for $10,600 C) at a discount to par value D) for $9,700 E) at a premium to par value Answer: E Explanation: E) Bonds trade in the secondary market at prices at a premium or discount to par value. A bond whose coupon is higher than prevailing interest rates will sell at a premium to its par value. 47. Hector Rivera was interested in buying shares of ABC Computer Corp, which was currently trading at $50 per share. Analysts expected the share price to rise sharply in the next few months. Hector decided to buy a call option for $400, giving him the right to purchase 100 shares of ABC Computer for $60 per share at any time between his purchase and the option's expiration date. Three months later at the expiration date, ABC stock was trading at $73. Hector used his option and purchased 100 shares of ABC Computer. How much money could Hector have saved had he bought the shares three months earlier instead of the call option? A) $1,400 B) $400 C) $1,000 D) $2,300 E) $200 Answer: A Explanation: A) By buying the call option for $400 and then the stock shares for $6,000, Hector spent $6,400. Had he bought the shares in the first place, he would have spent only $5,000 and therefore would have saved $1,400. 48. Which of the following is considered by many to be the best single indicator of the U.S. equities market? A) NASDAQ Composite B) Russell 2000 C) Dow Jones Industrial Average D) Standard & Poor's 500 E) New York Stock Exchange Answer: D Explanation: D) The S&P 500 considers more companies than the Dow Jones, and so is regarded as a better indicator. 49. Which of the following is an electronic securities exchange? A) Pacific Stock Exchange B) NASDAQ C) Osaka Securities Exchange D) Securities and Exchange Commission E) Europa Answer: B Explanation: B) The NASDAQ telecommunications system operates the NASDAQ Stock Market by broadcasting trading information on an intranet to more than 350,000 terminals worldwide. 50. Which stock exchange has the highest volume of shares traded? A) American Stock Exchange B) New York Stock Exchange C) NASDAQ D) Philadelphia Stock Exchange E) SEC Answer: C Explanation: C) Although the volume of shares traded surpasses that of the New York Stock Exchange, the total market value of NASDAQ's U.S. stocks is less than that of the NYSE. 51. Twenty-six-year-old Lisa Lamont became an investor one day after a friend explained that there was a much better way to make her money work for her than by letting it sit in a savings account earning a very low rate of interest. Lisa decided to withdraw $10,000 from her savings account and invest it in stocks. She wanted to invest it in such a way as to minimize her risk. Which one of the following strategies makes the most sense for a new investor like Lisa? A) Invest all $10,000 in a small fast-growing computer company. B) Invest $5,000 in a gold mining company and $5,000 in a silver mine. C) Invest the $10,000 in four different home builders. D) Invest $10,000 in ten different oil companies. E) Invest $10,000 in a large-cap mutual fund. Answer: E Explanation: E) As a person investing in stocks for the first time, the possibility of losing money can be scary. For peace of mind, the safest way to go is to choose maximum diversification. A large-cap mutual fund offers this diversification, and large-cap companies offer potential capital gains with less risk than small-cap companies. 52. Which of the following allows after-hours trading and protects traders' anonymity? A) National Association of Securities Dealers Automated Quotation (NASDAQ) B) New York Stock Exchange (NYSE) C) Electronic Communication Networks (ECNs) D) Standard & Poor's 500 E) mutual funds Answer: C Explanation: C) ECNs must register with the SEC as broker-dealers. 53. What is the term for buying several different kinds of investments rather than just one? A) spreading B) shorting C) margin buying D) diversification E) management Answer: D Explanation: D) The risk of loss is reduced by spreading the investment across stocks. 54. Javier wants to invest, but wants to reduce his risk of loss by spreading the total investment across more stocks. Javier would be most interested in which of the following? A) spreading B) shorting C) margin buying D) diversification E) asset allocation Answer: D Explanation: D) Diversification means buying several different kinds of investments rather than just one. 55. What is the term for the proportion of funds invested in each of several investment alternatives? A) spreading B) shorting C) margin buying D) asset allocation E) diversification Answer: D Explanation: D) For example, you may decide to allocate $10,000 to common stocks, $5,000 to a money market mutual fund, and $2,500 to a U.S. Treasury bond fund. 56. Which of the following is figured by dividing the yearly dollar amount of dividend income by the investment's current market value? A) bond yield B) current dividend yield C) debenture D) trading volume E) EBIDA Answer: B Explanation: B) In 2008 each share of GE stock was receiving annual dividend payments of $1.24. If on a particular day the share price was $33.82, the current yield would be 3.66 percent ($1.24/$33.82 × 100). 57. Marty and his sister Robin both invested in shares of the Heavy Metal Steel Company. Marty bought common shares and Robin bought the company's preferred shares. The two had been holding their stock for several years and had been pleased with their stock's performance. But sadly, Heavy Metal's business took a turn for the worse. After several quarters of disappointing numbers, the company suddenly announced it was going out of business. Marty and Robin, had they seen this coming, could have sold their shares at any time. But now it was too late. Which one of the following is the most likely outcome? A) Marty loses his entire investment, but Robin might receive a partial repayment after Heavy Metal's bondholders are repaid. B) Marty and Robin lose their entire investment. C) Robin is repaid immediately, while Marty is eventually repaid after the sale of all of the company's assets. D) Marty and Robin are repaid all of their initial investment due to a successful shareholder lawsuit. E) Marty and Robin's investments regain value once Heavy Metal restarts operations. Answer: A Explanation: A) As a common shareholder in Heavy Metal, Marty is likely to lose his entire investment. As a preferred shareholder, Robin is in a better position, being next in line for repayment after the company's bondholders. 58. Diamond Electronics has ascertained that it is has positive working capital. Which of the following must be true of Diamond Electronics? A) The firm's current liabilities are large enough to pay off current assets. B) The firm may need to borrow money from a commercial bank. C) The firm's current assets are large enough to pay off current liabilities. D) The firm does not need to issue stock. E) The firm would be a bad risk for any investor to consider. Answer: C Explanation: C) Working capital is calculated by subtracting current liabilities from current assets. 59. What is the term for a division of stock that gives stockholders a greater number of shares but does not change each individual's proportionate share of ownership? A) stock dividend B) stock split C) stock yield D) stock warrant E) stock exchange Answer: B Explanation: B) For example, a 2-for-1 split would indicate that 50 shares of a $10 stock become 100 shares of a $5 stock. 60. The stock of Simonsen, Inc. is being bought up by an individual who intends to take over Simonsen and sell off its assets for a profit. What is the individual in this scenario called? A) angel investor B) corporate raider C) inside trader D) stock broker E) bondholder Answer: B Explanation: B) If a corporate raider succeeds, the company will disappear. 61. "I am a chemist with the nation's largest chemical company. We have secretly developed a cure for three of the world's most serious epidemics. Before this news breaks out, I'm going to buy as many shares of stock in my company as I can get my hands on. Then I'll sit back and watch the stock price head for the sky." What is the person making this statement about to engage in? A) selling shares of stock B) insider trading C) blue-sky trading D) open-market operations E) investment banking Answer: B Explanation: B) Insider trading occurs when individuals use special knowledge about a firm for profit or gain. 62. Before Allied Corporation sells securities, it is required by law to offer future investors the opportunity to read through a document which contains complete information on both the new issue and the corporations. What is that required document called? A) book report B) affidavit C) prospectus D) portfolio E) balance sheet Answer: C Explanation: C) Further, false statements are subject to criminal penalty. 63. Trina is a loan borrower, and the terms of her loan say she must keep a portion of the loan amount on deposit with the bank in a non-interest-bearing account. What is Trina required to have? A) a compensating balance B) an unsecured loan C) an angel investor D) venture capital E) collateral Answer: A Explanation: A) Such an account protects the bank's investment. 64. Jessica Jenkins, a 30-year-old history teacher, planned to invest $10,000 in an equity mutual fund. She wanted a fund with maximum geographical diversification. Jessica was seeking high capital gains from her investment and was comfortable with a fair amount of risk. Which one of the following types of mutual fund would Jessica most likely choose? A) large-cap technology fund B) global large-cap value fund C) global small-cap growth fund D) Asian large-cap growth fund E) foreign medium-cap growth fund Answer: C Explanation: C) A global fund gives maximum geographical diversification because it includes U.S. stocks as well as foreign stocks. And small-cap growth stocks have the potential of delivering higher capital gains than large-cap value stocks. 65. Which of the following is the name for a portion of the ownership of a corporation? A) Schedule C B) stock C) partnership D) LLC E) dividend Answer: B Explanation: B) A corporation will sell stocks, portions of ownership, in order to raise capital. 66. Which of the following statements is true about common stocks as investments? A) Stocks are among the riskiest of all investments. B) Stocks are most suitable for investors who seek security. C) Stocks will never become worth less than their purchase price. D) Stock prices reflect only government action. E) Stock prices are easily manipulated. Answer: A Explanation: A) Stocks are a volatile and risky investment, and crashes can lead to sizable losses. 67. Shawna has gotten into investing and is interested in aggressive growth funds. Which of the following must be true about Shawna? A) She is interested in the best possible returns over time. B) She is interested in making money as quickly as possible. C) She has comparatively little money to invest. D) She wants to make as secure an investment as possible. E) She is investing for a financial thrill ride. Answer: A Explanation: A) The chance to make more money on an investment appeals to investors who are not risk averse. 68. The profit realized when the market value of an investment increases is known as which of the following? A) capital gains B) asset allocation C) diversification D) price appreciation E) profiteering Answer: A Explanation: A) The capital gain can be calculated by subtracting the purchase price from the end value of the investment. 69. The time it takes to double an investment can be estimated by using which of the following? A) book value B) the Rule of 72 C) blue-chips D) dividends E) market value Answer: B Explanation: B) By dividing the interest rate by 72, you can estimate how many years it will take to double your investment. 70. Tim wants to invest in stocks and bonds that will double his money in seven years. Which of the following interest rates should he be targeting? A) 7% B) 7.2% C) 8% D) 10% E) 10.3% Answer: E Explanation: E) Using the Rule of 72, dividing 72 by 7 years gives an interest rate of 10.3% to double the money in 7 years. 71. Marco is a bullish investor, but the stock market is currently bearish. What is Marco most likely to do? A) sell every stock and go to a 100 percent cash position B) sell certain winning stocks to realize a profit and put the cash to work when the market decline appears to have ended C) maintain all stock positions until the market completely recovers and then buy more stocks D) sell losing stocks to avoid further losses, and hold onto winners E) buy defensive stocks in the expectation that they will not fall much Answer: B Explanation: B) Many investors in a bear market become bearish on stocks and gloomy about the market's prospects. A bullish investor, however, will continue to believe in the market's eventual recovery. Such an investor will look for opportunities to sell certain stocks if any profits can be realized, and take the opportunity to buy stocks at low prices in anticipation of higher prices ahead once the market recovers. 72. While it's invested, money grows by earning interest or yielding some other form of return. What is this known as? A) compound growth B) dividend C) capital gains D) security E) diversity Answer: A Explanation: A) The compound growth comes from interest paid over time. 73. Dynamo Motors has begun to sell corporate securities. Dynamo is required by law to offer future investors the opportunity to read a document that contains complete information on both the new issue and the corporation itself. What is that required document called? A) book report B) affidavit C) prospectus D) order blank E) corporate profile Answer: C Explanation: C) Further, false statements are subject to criminal penalty. 74. Which is the most widely cited U.S. stock market index? A) Standard & Poor's Composite Index of 500 Stocks B) the NYSE index C) Dow Jones Industrial Average D) Moody's Stock List E) the NASDAQ Answer: C Explanation: C) Further, the Dow measures the performance of U.S. financial markets by focusing on 30 blue-chip companies as reflectors of economic health. 75. Tonio has some stocks and is carefully watching the stock market. Which of the following should he pay attention to in order to find out the performance of the largest companies? A) Standard & Poor's 500 B) the NYSE index C) Dow Jones Industrial Average D) Moody's Stock List E) the NASDAQ Answer: C Explanation: C) The Dow includes only 30 of the thousands of companies on the market, but these companies are the largest and most important. 76. Marcia has purchased some corporate bonds, which come with bond indentures that stipulate the terms. What is the most important detail of the bond indenture that Marcia should pay attention to? A) maturity date B) face value C) par value D) dividend payments E) amount invested Answer: A Explanation: A) This is the date by which the firm must repay the bondholder. 77. What are low grade bonds usually called? A) bankruptcy B) default bonds C) junk bonds D) corporate bonds E) grade B bonds Answer: C Explanation: C) These bonds have very low credit ratings. 78. Explain the principle of compound growth. Answer: Time value stems from the principle of compound growth—the compounding of interest paid to the investor over given time periods. Explanation: With each additional time period, interest payments accumulate and earn more interest, thus multiplying the earning capacity of the investment. 79. Explain the Rule of 72. Answer: The Rule of 72 is used to figure out how long it takes to double an investment. You can find the number of years needed to double your money by dividing the annual interest rate (in percent) into 72. The Rule of 72 can also calculate how much interest you must get if you want to double your money in a given number of years. Explanation: The Rule of 72 lesson for the investor is clear: seek higher interest rates because money will double more frequently. 80. Differentiate between market value and book value. Answer: Market value is the current price of a share in the stock market and reflects the amount that buyers are willing to pay for a share of the company's stock. Book value for a share of common stock is determined as the firm's owners' equity (from the balance sheet) divided by the number of common shares owned by all shareholders. Book value is used as a comparison indicator because the market value for successful companies is usually greater than its book value. Explanation: When market price falls to near book value, some profit-seeking investors buy the stock on the principle that it is underpriced and will increase in the future. 81. Describe the services provided by investment banks. Answer: Investment banks provide three important services: (1. They advise companies on the timing and financial terms of new issues; (2. by underwriting new securities, they bear some of the risk of issuing them; and (3. they create the distribution networks for moving new securities through groups of other banks and brokers into the hands of individual investors. Explanation: The large U.S. investment banks Morgan Stanley and Goldman Sachs underwent changes in structure following the financial collapse of 2008, when they were allowed to become bank holding companies (much like a commercial bank). Despite these changes, they still provide the three important investment banking services. 82. Explain what exchange-traded funds are and how they are tracked. Answer: As with an index mutual fund, an exchange-traded fund (ETF) is a bundle of stocks (or bonds) that are in an index that tracks the overall movement of a market; unlike a mutual fund, however, an ETF can be traded like a stock. Each share of an ETF rises and falls as market prices change continuously for the market being tracked. Explanation: Because they are traded on stock exchanges (hence, "exchange traded"), ETFs can be bought and sold—priced continuously—any time throughout the day. 83. In 2008, each share of GE stock was receiving annual dividends payments of $1.24. If on a particular day, the share price was $33.82, what would the current yield be? Answer: 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. In 2008, each share of GE stock was receiving annual dividends payments of $1.24. If, on a particular day, the share price was $33.82, the current yield would be 3.66 percent ($1.24/$33.82 × 100). Explanation: This dividend can then be compared against current yields from other investments. Larger dividend yields, of course, are preferred to smaller returns. 84. If you purchased a share of GE stock for $33.82, then sold it one year later for $36.50, what would the price appreciation be? Answer: The price appreciation is $2.68 ($36.50 - 33.82). Explanation: Price appreciation is an increase in the dollar value of an investment. This profit, realized from the increased market value of an investment, is known as a capital gain. 85. Mathematically explain how a stock split works if a company has 100,000 common shares outstanding that are trading at $100 per share. Answer: If a company has 100,000 common shares outstanding that are trading at $100 per share, but the company wants it priced in the $20 or $80 range, it can declare a 2-for-1 stock split, meaning the company gives shareholders one additional share for each share they own. Now the company has 200,000 shares outstanding but its financial performance has not changed, so the stock price immediately falls to $50 per share. Every shareholder's investment value, however, is unchanged; they previously owned one share at $100, and now they own two shares at $50 each. Explanation: Corporations may use stock splits to lower the stock's price, believing it will attract a larger pool of investors. If the price gets too high, many investors can't afford to buy shares. 86. More Americans are investing in the stock market through online trading. Explain the value of online trading. Answer: The popularity of online trading stems from convenient access to the Internet, fast no-nonsense transactions, and the opportunity for investors to manage their own investments while paying low fees for trading. Explanation: Online investors buy into and sell out of the stocks of thousands of companies daily. Consequently, keeping track of who owns what at any given time has become a monumental burden. Relief has come from book-entry ownership. Historically, shares of stock have been issued as physical paper certificates; now they are simply recorded in the companies' books, thereby eliminating the costs of storing, exchanging, and replacing certificates. 87. When are corporate bonds attractive to a firm? Answer: Bonds are attractive when firms need large amounts for long periods of time. Explanation: 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. 88. Explain the difference between debt financing and equity financing? Answer: Firms can meet their capital needs through debt financing (from outside the firm) and equity financing (putting the owners' capital to work). Both outside sources and inside sources can be used; however, there are pros and cons to each. Explanation: Although debt financing often has strong appeal, equity financing—looking inside the company for long-term funding—is sometimes preferable. Equity financing includes either issuing common stock or retaining the firm's earnings. 89. 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. Explanation: 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. 90. When giving an unsecured loan, what might a bank require? Answer: 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. Explanation: Firms with bad credit scores typically cannot get unsecured loans. Because access to such loans requires a good credit history, many firms establish a relationship with a commercial bank and, over time, build a good credit record by repaying loan principal and interest on time. 91. What is an angel investor? Answer: Outside individuals who provide additional capital for growth to successfully launched businesses are called angel investors. Explanation: In return for their investment, angel investors typically expect a sizable piece of ownership in the company as well as a formal say in how the company is run. 92. What do angel investors receive in return for their investment? Answer: Angel investors typically expect a sizable piece of ownership in the company (up to 50 percent of its equity). They may also want a formal say in how the company is run. Explanation: If the firm is bought by a larger company or if it sells its stock in a public offering, the angel investor may receive additional payments. 93. Omar Ansari, a relatively conservative investor, received a prospectus from his stockbroker providing details about XYXY Biotech Company and its planned IPO. XYXY was developing a new and promising type of anti-cancer drug. After studying the prospectus, Omar decided not to invest in the IPO. Which one of the following items of information in the prospectus was most likely NOT a factor in Omar's decision? A) XYXY was competing with many other biotech companies. B) XYXY's CEO, although not a famous scientist, had a solid background in cancer research. C) XYXY's drug might not be approved by the FDA. D) XYXY would not be profitable for many years, even if its new drug was approved by the FDA. E) XYXY would soon have to return to the capital market for additional financing. Answer: B Explanation: B) The identity of the CEO was not a factor in Omar's decision. If anything, this piece of information might have had the opposite effect. Choices A, C, D, and E are all reasons that might have influenced Omar not to invest. Ryerson: Money is hard to come by, so when one has money one should make sure that, above all, one doesn't lose it. One hears a lot of success stories about people making a lot of money by investing, but of course you don't hear about the people who lose money investing. As risky as it is, based on so many unknown factors, investing your money really is like gambling. The only prudent plan is to keep money in a savings account where it can earn a predictable amount of interest. One can't lose money that way, at least, so with money in a savings account one can always count on it being there for future needs. Groh: Investing is inherently risky, but the risk need not be insurmountable. It is true that the more potential there is for a higher return, the higher the chance is also for more money to be lost. But there are more and less risky ways to invest, and even the less risky investments can give a significantly higher return than a simple savings account. When one diversifies one's stock holdings, one increases the chances of getting a good return among one's holdings, and decreases the damage from a loss in value. Also, even if stocks lose value temporarily, the value of stocks overall has always gone up over long periods of time. So a savings account, while it may seem prudent and safe, is probably not the best way to ensure that money is being saved in the most optimal way possible. 94. Which of the following assumptions does Ryerson have to make to support his statements? A) Some people make money by investing. B) Interest is the only thing that changes the value of a savings account. C) Most people want to save money instead of spending it. D) Companies issue stock only if there is no other way to make money. E) There are few companies whose stock always grows in value. Answer: B Explanation: B) Ryerson assumes that money in a savings account can grow only through interest, and that no other factors affect its value. Ryerson concedes that some people may make money through investing (Choice A), but if that were false it would not affect his argument. He does not need to assume that most people want to save (Choice C), as his argument is trying to establish that such is a good thing. Ryerson is not assuming that companies issue stocks only because they have no other choice (Choice D), and he does not assume that no companies have stocks that grow in value (Choice E)—only that it is too risky to try to choose which companies will have such stocks. 95. Which of the following, if true, would undermine Ryerson's argument? A) Some companies have stock that grows in value. B) The stock market sometimes falls in overall value. C) Savings interest rates are not as high as those of some stocks. D) Savings interest rates can be lower than the rate of inflation. E) Savings accounts can be opened only with a minimum balance. Answer: D Explanation: D) Ryerson claims that one cannot lose money in a savings account, but one's savings would lose overall value if the rate of inflation over time outpaced the interest one earned in the savings account. Ryerson does not claim that no stock ever gains value over time (Choice A), or that the stock market doesn't sometimes fall (Choice B), but only that the uncertainty of guessing whether certain stocks or the overall market will gain value makes it too risky. He does not claim that savings interest rates are higher than stock gains (Choice C), but only that they are much more reliable. Opening balance requirements on savings accounts are not relevant (Choice E). 96. Which of the following issues do Ryerson and Groh disagree about? A) whether the risk of investing is worthwhile B) whether savings accounts bear interest C) whether companies issue stocks in order to raise funds D) whether anyone makes money by investing in stocks E) whether investing always carries risk with it Answer: A Explanation: A) Both Ryerson and Groh acknowledge that investing carries risk with it (Choice E), but only Groh thinks the risk can be worthwhile. Groh does not deny that savings accounts bear interest (Choice B), nor does Ryerson deny that some people may make money by investments in stock (Choice D). Neither denies that companies issue stocks in order to raise funds (Choice C). 97. Which of the following assumptions does Groh make? A) Inflation can outpace any interest rate. B) Given enough time, any stock will eventually go up in value. C) The riskier the investment, the more value it will have over a long period of time. D) The more stocks you invest in, the higher their value will be. E) The stock market overall will experience net growth over time. Answer: E Explanation: E) Groh argues that holding many stocks over a long time will ensure growth in value, which assumes that the stock market as a whole grows in value over time: if it did not, then holding several stocks over a long period of time may not be sufficient to ensure growth in value. Groh does not assume that interest rates will always be lower than inflation (Choice A); that any stock will increase in value given enough time (Choice B); that risk in investment correlates with growth in value over time (Choice C); or that investing in more stocks ensures that they will all increase in value (Choice D). 98. Which of the following, if true, would undermine Groh's point about diversification? A) Not every investor can afford every stock. B) The value of some stocks drop and never recover. C) When one stock value drops, others tend to also drop. D) Some investors prefer as little risk as possible when investing. E) The value of some stock is greater than others. Answer: C Explanation: C) If it were the case that stock values rise or fall together, then diversification in different stocks would not increase the chances of overall growth. Groh does not insist that every investor should be able to buy every stock (Choice A). He also doesn't insist that stocks always recover from a drop (Choice B), since the value of the other stocks would soften the blow, or that investors differ in their appetite for risk (Choice D). Groh's point about diversification is not undermined by the fact that the value of some stock is greater than others (Choice E); in fact, it depends on it. A firm wants to use its benefit package to appeal to applicants. One part of the benefits package is the opportunity to contribute to a retirement savings program. The recent instability of the stock market has made this less attractive. 99. Which of the following, if true, might make the option more appealing to a prospect? A) In recent months, the stock market has become more bullish, making mutual funds a better bet. B) The firm pays the maintenance fees for the investments. C) Employees may choose the amount set aside each month, up to 10 percent of gross income, which is untaxed until the money is removed from the fund. D) Over a ten-year period, the mutual funds included in the firm's option have accrued at a rate equal to the consumer price index. E) The firm allows employees to select from and move funds around to a wide range of mutual fund options, some more conservative than others. Answer: E Explanation: E) A new employee will place more of a premium on his or her ability to participate in the investment process in the here and now, rather than assurances that the funds will accrue later. So Choice E is correct: employees will appreciate being able to protect the investment at difficult times and have the chance to move it to a fund that can bring a higher return during times of growth. Investments merely keeping up with inflation (Choice D) are not attractive, and we can't be sure that the recent economic downturn that reduced the value of portfolios was temporary (Choice A). But reassuring workers that better times will come is not a way to make the option intrinsically more attractive. Paying overhead fees (Choice B) and letting workers choose the level of their involvement (Choice C) do nothing to make the savings option more beneficial if the value of the investment is unstable and liable to loss of principal. Aardvark is a small pest-control business that has 30 employees. The company started business within the past year, and needs to make a decision on how best to make sure its finances are managed well as the company continues to grow its customer base and its business. 100. Aardvark needs some short-term financing to meet a cash-flow gap while it makes immediate capital expenditures. Which of the following, if true, would strengthen the case for the company's using a credit card for this purpose? A) Family members of the company owners have a lot of liquid assets. B) The company is not sure when it will be able to repay the money. C) The company expects to be able to repay the money next month. D) The company needs to obtain a line of credit without interest. E) The company can provide collateral for a secured loan. Answer: C Explanation: C) Business credit cards can be a viable source of very short-term financing if the company can expect to pay off the balance within a month, thus avoiding potentially high interest charges. If the money can't be repaid within a month (Choice B), then family members (Choice A) who might be the source of short-term loans would be preferable to a credit card advance. The line of credit from a credit card is without interest for only a very limited time–usually a month, or less, depending on the card (Choice D). Choice E: Having collateral would strengthen the case that the company could obtain a bank loan, in which case it would not need to use a credit card. 101. Aardvark needs some quickly obtainable funds to pay some overdue bills. It is considering using factoring—obtaining cash in exchange for outstanding accounts receivable funds. Which of the following, if true, would strengthen the case for using factoring? A) Factoring can be a costly way to obtain ready cash. B) Aardvark would not have to liquidate any of its core assets to stay in business. C) Customers may be annoyed if they think their account has been turned over to a collection agency. D) Additional accounting practices are necessary to keep track of factored customer accounts. E) Factoring companies usually won't take on receivables more than 90 days old. Answer: B Explanation: B) Factoring can help a company obtain cash for pressing needs without having to take more drastic steps, such as liquidating core assets. Factoring has several disadvantages, however, for the company selling its receivables, including the costs, either in fixed fees or as a percentage of the receivables (Choice A); the possibility that customers may not realize the difference between a factoring agency and a collection agency (Choice C); the additional bookkeeping necessary to keep track of accounts (Choice D); and the fact that factoring companies are not going to help collect on older receivables (Choice E). 102. Aardvark is considering issuing corporate bonds in order to raise money. Which of the following, if true, would strengthen the case for doing this? A) The company's customer base has been declining. B) The company has debts that need to be paid immediately. C) The company's main interest is in long-term solvency. D) The company is interested in cutting costs. E) The company's assets are rapidly depreciating. Answer: B Explanation: B) Selling bonds would result in an immediate inflow of cash that could be used to pay short-term debts. Choices A, D, and E: these do not relate to the choice of issuing corporate bonds. Choice C suggests that the company should pursue some financial option that will pay dividends over the long term. 103. Aardvark needs to calculate its current working capital in order to assess its current financial state. Which of the following questions would best help answer the question of what the company's working capital is? A) What are the company's current liabilities? B) What is the interest rate on outstanding loans to the company? C) How much of the company's assets are used as collateral? D) What is the company's credit history like? E) What is the risk rating of the company's bonds? Answer: A Explanation: A) Subtracting the company's current liabilities from its current assets will give the company's current working capital. The other choices do not directly relate to the calculation of working capital. 104. Aardvark is considering undertaking an IPO in order to raise money. Which of the following, if true, would strengthen the case for doing so? A) The company's expected stock price will be low. B) The company wants to maintain internal control over all its decision-making. C) The company's customer base has been in decline. D) The company has a healthy amount of assets. E) The company is in a significant amount of debt. Answer: D Explanation: D) Offering an IPO means offering part of the company for sale, so a healthy amount of assets should ensure a decent stock price and expected performance. Choice A opens up the possibility that a corporate raider may take over the company. The other choices all weaken the case that now is a good time for an IPO. Test Bank for Business Essentials US Edition Ronald J. Ebert, Ricky W. Griffin 9780133034028, 9780273766599, 9780136070764
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