Financial Management Flashcards
Which one of the following statements concerning cash flow determination for capital budgeting purposes is incorrect?
A. Tax depreciation must be considered since it affects cash payments for taxes.
B. Book depreciation is relevant since it affects net income.
C. Sunk costs are not incremental flows and should not be included.
D. Net working capital changes should be included in cash flow forecasts.
B. Book depreciation is relevant since it affects net income.
Depreciation itself is not a cash outflow. Depreciation is relevant for capital budgeting purposes only because it affects the income upon which taxes must be assessed. Taxes are a cash outflow. Therefore, only tax depreciation is relevant. Book depreciation is not relevant despite its effect on net income.
To determine the inventory reorder point, calculations normally include the:
A. ordering cost.
B. carrying cost.
C. average daily usage.
D. economic order quantity.
C. average daily usage.
The reorder point (RP) is the inventory level at which an order is placed. The reorder point is average demand during the lead-time period plus any safety stock. Average daily usage is required to compute the demand during the lead-time, and so is needed to compute the reorder point.
The ordering cost and carrying cost are used to compute the best quantity to order, but not the reorder point. The economic order quantity (EOQ) is the quantity of inventory that should be ordered at one time in order to minimize the associated costs of carrying and ordering inventory, such as purchase-order processing, transportation, and insurance.
Sylvan Corporation has the following capital structure.
Debenture bonds $10,000,000
Preferred equity 1,000,000
Common equity 39,000,000
The financial leverage of Sylvan Corporation would increase as a result of:
A. issuing common stock and using the proceeds to retire preferred stock.
B. issuing common stock and using the proceeds to retire debenture bonds.
C. financing its future investments with a higher percentage of bonds.
D. financing its future investments with a higher percentage of equity funds.
C. financing its future investments with a higher percentage of bonds.
Leverage refers to the amount of debt in the firm’s capital structure. Of the financial instruments mentioned, only debenture bonds are considered to be debt. Both common and preferred stock are considered equity, even though preferred stock may pay a fixed dividend.
A small vacuum cleaner repair shop is located in a once-quiet, out-of-the way neighborhood. Recently, however, a large entertainment complex that will be used for concerts, basketball games, and other major events was just opened a block from this small business. When determining the fair value of this property, the fair value should be based upon:
A. the use of the property as a small vacuum cleaner repair shop.
B. the use of the property as a small restaurant serving a variety of light meals, exotic desserts, and alcohol.
C. the use of the property as a small restaurant serving a variety of light meals, exotic desserts, and alcohol only if the current owner plans to sell the property.
D. the average of the property value based upon its current use and the highest and best use.
B. the use of the property as a small restaurant serving a variety of light meals, exotic desserts, and alcohol.
FASB ASC 820 provides guidance when determining the fair value of an asset or business ownership. The fair value measurement assumes that the business (or item) being valued will be put to the highest and best use that is physically possible, legally permissible, and financially feasible. The result will be the maximization of value. It is important to realize that the highest and best use may not be the current use; therefore, the highest and best use is determined from the viewpoint of the purchaser and not the seller.
In this scenario, the use of the facility as a vacuum cleaner repair shop is clearly not the highest and best use of the property. Due to the need to have small restaurants and bars in the vicinity of a large entertainment complex, the highest and best use of the property would likely be an establishment such as a small restaurant serving light fare for the before-the-event crowd and desserts for the after-the-event group.
Which of the following is an advantage of net present value modeling?
A. It is measured in time, not dollars.
B. It uses the accrual basis, not the cash basis of accounting for a project.
C. It uses the accounting rate of return.
D. It accounts for compounding of returns.
D. It accounts for compounding of returns.
Advantages of using the net present value method for decision making include the following:
The time value of money is considered (compounding of returns).
Given a perfect market, correct decision advice will be obtained.
A correct ranking will be obtained for mutually exclusive projects given similar lives and investments.
An absolute value is obtained.
Disadvantages of using the net present value method for decision making include the following:
The discount rate is difficult to determine.
Assumptions related to cash flows have to be made that may or may not be correct.
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) has developed a widely accepted and used framework for internal control that was designed to provide reasonable assurance for a company’s objectives related to all items except:
A. effectiveness and efficiency of operations.
B. reliability of financial reporting.
C. expansion of markets.
D. compliance with laws and regulations
C. expansion of markets.
COSO has developed a widely accepted and used framework for internal control that was designed to provide reasonable assurance for a firm’s objects related to: effectiveness and efficiency of operations, reliability of financial reporting, and compliance with laws and regulations.
Although the expansion of markets may be in the strategic plan for a company and may come about due to the effectiveness and efficiency of operations, it is not a focus of the COSO Framework designed for internal control.
The gross margin ratio can be subjected to detailed analysis by a firm’s:
A. creditors.
B. customers.
C. investors.
D. management.
D. management.
Sales = Unit Price x Number of Units
COGS = Unit Cost x Number of Units
Gross Margin = (Unit Price - Unit Cost) x Number of Units
The above detailed information is available only to the firm’s management.
Thus, a detailed analysis could not be performed by the other parties mentioned.
The payback reciprocal can be used to approximate a project’s:
A. net present value.
B. accounting rate of return if the cash flow pattern is relatively stable.
C. payback period.
D. internal rate of return if the cash flow pattern is relatively stable.
D. internal rate of return if the cash flow pattern is relatively stable.
Payback reciprocal = 1/Payback period
Where: Payback = Net cash invested/Annual cash inflow
If the cash flow pattern is relatively stable, the payback reciprocal number serves as a good approximation of a present value of an annuity table factor. Using the payback number and a PV of an Annuity table, it becomes a relatively simple matter to look up an interest rate corresponding to the appropriate number of years’ life of a project. This interest rate will be a close approximation of the internal rate of return.
A company’s internal controls are established to provide protection for the company’s assets as well as to detect fraud. An internal control allows for the firm’s resources to be all of the following except:
A. monitored.
B. designed.
C. properly used.
D. measured.
B. designed.
A financial transaction control is a procedure that is developed to discover and/or prevent errors, misappropriations, or policy noncompliance in a financial transaction process. Such a control will aid an organization in achieving specific goals and objectives. It is an internal control that allows for a firm’s resources to be properly: used, monitored, and measured.
It is hoped that such controls will detect fraud and provide adequate protection for the company’s assets.
The working capital financing policy that subjects the firm to the greatest risk of being unable to meet the firm’s maturing obligations is the policy that finances:
A. fluctuating current assets with long-term debt.
B. permanent current assets with long-term debt.
C. permanent current assets with short-term debt.
D. fluctuating current assets with short-term debt.
C. permanent current assets with short-term debt.
Of the possible solutions offered, financing permanent current assets with short-term debt places a firm at the greatest risk because of its possible inability to meet its maturing obligations as economic conditions change, forcing the firm to respond to unfavorable refinancing situations to replace the short-term debt.
What is an internal rate of return?
A. A net present value
B. An accounting rate of return
C. A payback period expected from an investment
D. A time-adjusted rate of return from an investment
D. A time-adjusted rate of return from an investment
The internal rate of return (IRR) can be referred to as the yield (return) expected over the life of a project. It is computed by equating the initial investment with the present value of the cash flows over the life of the project. IRR is the discount rate that results in the net present value of all cash flows equal to zero. Due to the fact that present values of all cash flows are used in the determination of IRR, it is a time-adjusted rate of return related to the project being considered.
All of the following about the economic order quantity (EOQ) model are true, except:
A. the EOQ model is designed to determine an optimal order size that will minimize inventory costs.
B. the use of a just-in-time inventory system makes the EOQ model irrelevant.
C. the values in the EOQ model cannot remain constant for any material length of time during a period of inflation.
D. the reorder quantity determined using the EOQ model is best for companies requiring flexibility.
D. the reorder quantity determined using the EOQ model is best for companies requiring flexibility.
The EOQ model determines a particular reorder quantity. However, some companies require a great deal of flexibility in taking advantage of an opportunity to stockpile inventory before a price increase or as a protection against shortages. Although the EOQ model provides valuable information in regard to the optimal reorder quantity, it does not give management flexibility.
Since the just-in-time inventory system does not require inventory, this inventory system makes the EOQ model irrelevant.
Net present value as used in investment decision-making is stated in terms of which of the following options?
A. Net income
B. Earnings before interest, taxes, and depreciation
C. Earnings before interest and taxes
D. Cash flow
D. Cash flow
The net present value determines whether the present value of the estimated net future cash inflows at a desired rate of return will be greater or less than the cost of the proposed investment. Using this method, the present value of the net cash inflows is calculated and compared to the initial investment. An investment proposal is desirable if the net present value is positive.
The other answer choices are incorrect because the net present value method uses cash flows, not net income or earnings before interest, taxes, or depreciation.
The market approach is one of the three basic methodologies available to the valuator. When determining whether this approach can be employed in a particular engagement (whether guideline companies are available), the valuator must keep all of the following in mind except:
A. the normalized statements of the subject of the valuation need to use similar GAAP choices, such as LIFO and FIFO, as the guideline companies.
B. one company does not make a comparable.
C. the guideline companies will need to be identical to the subject of the valuation.
D. a guideline company needs to produce (supply) similar products, serve similar markets, and be within a similar size range as the subject company.
C. the guideline companies will need to be identical to the subject of the valuation.
Finding guideline companies when performing a business valuation is often difficult. When developing a list of potential guideline companies, the business valuator assesses items such as whether the potential guideline company:
uses similar GAAP choices as the subject company.
has a similar product diversification as the subject company.
serves similar markets as the subject company.
has a similar geographic diversification as the subject company.
is of a similar size as the subject company.
has similar financial and operating leverage as the subject company.
has similar liquidity, solvency, growth, and profitability as the subject company.
It is important to note that a business valuation cannot be based upon one guideline organization, nor is a comparable expected to be identical to the subject of the valuation in any manner.
The market approach to determining the fair value of a small company is based upon the theory that:
A. an organization with newer assets will be worth more than one with older and possibly obsolete assets.
B. an investor will require that an investment will not only cover the cost of the initial investment but also provide a return necessary to compensate for the riskiness of that investment.
C. companies within the industry that have similar performance records and structure will have similar value.
D. the economic substitution principle provides a basis to develop a value that takes into consideration the functional obsolescence and physical deterioration of the assets employed in the company.
C. companies within the industry that have similar performance records and structure will have similar value.
There are three basic valuation approaches:
The cost approach, the market approach and the income approach
The market approach to determining fair value uses market comparisons of identical or comparable items. A comparable item is one that has reasonable and justifiable similarity to the item being valued, be that a single asset or an entire business.
The cost approach to determining fair value is an example of the economic substitution principle. In other words, what would it cost to replace the item in question with an asset of like function and capacity?
The income approach to determining fair value focuses on the company’s ability to create earnings or some other benefit stream, such as cash inflows, and the risk related to that investment. An investor will approach any investment from the perspective of the expected future benefit streams, and the requirement that those future benefit streams need to cover not only the cost of the initial investment but also a return commensurate with its risk.
In Belk Co.’s “just in time” production system, costs per setup were reduced from $28 to $2. In the process of reducing inventory levels, Belk found that there were fixed facility and administrative costs that previously had not been included in the carrying cost calculation. The result was an increase from $8 to $32 per unit per year. What were the effects of these changes on Belk’s economic lot size and relevant costs?
A. Lot size, decrease; Relevant Costs, increase
B. Lot size, increase; Relevant Costs, decrease
C. Lot size, increase; Relevant Costs, increase
D. Lot size, decrease; Relevant Costs, decrease
D. Lot size, decrease; Relevant Costs, decrease
Inventory decision models work with opposing costs. Carrying costs increase as the size of the order increases. Setup or ordering costs, however, decrease as the size of the production run or order increases.
Lower setup costs result in decreased lot sizes because it becomes less expensive to produce a smaller lot.
Increased carrying costs also result in decreased lot sizes because the greater the cost of carrying inventory, the fewer the units you will want to produce in a lot.
When performing a fair value valuation, John CPA has found a quoted market price for a similar asset to the one held by the reporting organization. There are some questions, however, related to the condition of the asset being valued in comparison to the similar asset. John should:
A. consider this a Level 1 fair value measurement since a current market price was available for an asset similar to the one being valued.
B. consider this a Level 2 fair value measurement since a current market price was available for an asset similar to the one being valued.
C. consider this a Level 3 fair value measurement if the potential adjustments necessary due to the condition of the assets being valued merit the classification of an unobservable input.
D. make all possible efforts to find another input that will be a closer comparison to the subject asset.
C. consider this a Level 3 fair value measurement if the potential adjustments necessary due to the condition of the assets being valued merit the classification of an unobservable input.
Per FASB ASC 820, there are three groups of inputs used when developing fair value:
Level 1: directly observable inputs of identical items, such as quoted active market prices
Level 2: directly or indirectly observable inputs of similar items
Level 3: unobservable inputs
In John’s valuation situation, the quoted market price is for the allegedly similar asset; therefore, this can be no more than a Level 2 fair value measurement. However, since there is a question as to the similarity of the conditions between the subject asset and the comparable, John will need to consider whether these questions related to the condition of the subject asset are significant enough to lower the fair value measurement to a Level 3.
Although FASB ASC 820 expects that the CPA will attempt to use more observable than unobservable inputs when doing a fair value valuation, it only requires the use of information that is available without undue cost or effort
The use of an accelerated method instead of the straight-line method of depreciation in computing the net present value of a project has the effect of:
A. raising the hurdle rate necessary to justify the project.
B. lowering the net present value of the project.
C. increasing the present value of the depreciation tax shield.
D. increasing the cash outflows at the initial point of the project.
C. increasing the present value of the depreciation tax shield.
Cash flows in the form of revenue are taxable so revenues must be computed net of tax. Cash outflows in the form of expenses are deductible in computing taxes payable. Therefore, these cash outflows must be computed net of tax also. Depreciation is not a cash flow but it is a deductible expense and therefore affects the amount of taxes payable. An accelerated method of depreciation will cause larger amounts of depreciation to be deducted sooner than straight-line. Although the same amount of tax will be shielded in nominal dollars, the present value of the tax savings (or shield) is greater under accelerated depreciation because less tax is paid out earlier in the project’s life.
A firm that often factors its accounts receivable has an agreement with its finance company that requires the firm to maintain a 6% reserve and charges 1% commission on the amount of receivables. The net proceeds would be further reduced by an annual interest charge of 10%. Assuming a 360-day year, what amount of cash (rounded to the nearest dollar) will the firm receive from the finance company at the time a $100,000 account that is due in 90 days is turned over to the finance company?
A. $93,000
B. $90,000
C. $83,000
D. $90,675
D. $90,675=(100,000-(6%+1%100,000)-((10%93000)*(90/360))
Factoring involves the sale of accounts receivable as a way for the seller to obtain financing. However, the seller receives an amount less than the face amount of the accounts sold to compensate the factor for assuming the risk and the costs of collection. In this case, the amount of cash the seller will receive from the finance company is $90,675, computed as follows:
Face amount of accounts receivable factored = $100,000
LESS: 6% reserve = .06 x $100,000 = $6,000
1% commission = .01 x $100,000 = $1,000 7,000
Net amount available $ 93,000
LESS: 10% interest = .10 x $93,000 x (90 / 360) = 2,325
Cash proceeds $ 90,675
Joe CPA has been retained to determine the fair value of the capital assets of the warehousing division of the Trinket Company. In doing so, Joe will assume that:
A. the potential market participants were obligated to complete the hypothetical sale of the capital assets.
B. all market activities related to the hypothetical sale of the capital assets took place on a specific measurement date.
C. the hypothetical sale occurred in an orderly fashion.
D. there was no principal market for the hypothetical sale of the capital assets.
C. the hypothetical sale occurred in an orderly fashion.
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
In determining the price under this fair value assumption, it is assumed that the hypothetical sale occurs in an orderly fashion and not under distress or due to liquidation. In other words, the seller would have the ability to take advantage of what would be considered to be normal market activities resulting from taking advantage of all normal market exposure activities prior to the measurement date.
Another important aspect of the fair value assumptions as presented in FASB ASC 820 assumes that the hypothetical transaction is considered to have occurred in the principal market for such a transaction. In the absence of a principal market, the transaction is considered to have occurred in the most advantageous market. These markets are defined from the current holder’s perspective.
The hypothetical seller and buyer would:
not be related parties.
both be knowledgeable about the item(s) involved in the hypothetical transaction.
both have the ability to complete the hypothetical transaction.
both be willing to complete the hypothetical transaction, but not be forced to do so.
The Frame Supply Company has just acquired a large account and needs to increase its working capital by $100,000. The controller of the company has identified four alternative sources of funds, which are given as follows.
Pay a factor to buy the company’s receivables, which average $125,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at 10% and charge a fee of 2% on all receivables purchased. The controller estimates that the firm would save $24,000 in collection expense over the year. Assume that the fee and interest are not deductible in advance.
Borrow $110,000 from a bank at 12% interest. A 9% compensating balance would be required.
Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every six months.)
Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.
Assume a 360-day year on all of your calculations.
The cost of Alternative 1 is:
A. 10.0%.
B. 12.0%.
C. 14.8%.
D. 16.0%.
Annual Cost:
Interest on average balance
($100,000 x .10 rate) $10,000
Fee payable to factor
(2% of purchased receivables) 30,000
(.02 x $125,000 x 12 mo.)
= $40,000
Less savings on collection expense (24,000)
Net Cost $16,000
Cost as a % = $16,000 / $100,000 = 16%
The difference between the amount advanced and the receivable is not a cost of financing as that amount will be collected and returned to the company. If any amount is not collected, then it would be written off as bad debt.·
A company can finance an equipment purchase through a loan. Alternatively, it often can obtain the same equipment through a lease arrangement. A factor that would not be considered when comparing the lease financing with the loan financing is:
A. whether the lessor has a higher cost of capital than the lessee.
B. whether the lessor and lessee have different tax reduction opportunities.
C. the residual value of the property.
D. the capacity of the equipment.
D. the capacity of the equipment.
The financing of the equipment by either lease or loan will not affect the physical output, or capacity, that the equipment has the ability to generate. The equipment will utilize the same capacity regardless of the means by which it is financed.
Neu Co. is considering the purchase of an investment that has a positive net present value based on Neu’s 12% hurdle rate. The internal rate of return would be:
A. 0.
B. 12%.
C. greater than 12%.
D. less than 12%.
C. greater than 12%.
Consider the relationship:
Present value of cash inflows $XXX
Less present value of cash outflows XX
Net present value $ XX
If the internal rate of return is equal to the hurdle rate, no “excess return” will occur so net present value will be zero.
A positive net present value indicates that the internal rate of return exceeds the hurdle rate. Thus, for the proposed Neu Co. project the internal rate of return (IRR) is greater than 12%.
The hurdle rate is simply the cost of capital or cost of borrowing for Neu Co.
A ratio that examines the percentage change in earnings available to common stockholders that is associated with a given percentage change in earnings before interest and taxes is a measure of:
A. the degree of operating leverage.
B. the degree of financial leverage.
C. return on investment.
D. return on equity.
B. the degree of financial leverage.
This ratio basically compares the change in earnings after interest and taxes to the change in earnings before interest and taxes. The higher this ratio, the greater the return available to companies who finance their asset purchases with debt.
The capital budgeting model that is generally considered the best model for long-range decision making is the:
A. payback model.
B. accounting rate of return model.
C. unadjusted rate of return model.
D. discounted cash flow model.
D. discounted cash flow model.
The capital budgeting model that is generally considered the best model for long-range decision making is the discounted cash flow model because the time value of money (present and future values) is considered.
The payback model and accounting rate of return model are unadjusted rate of return models which do not consider the time value of money.
Brad CPA has been approached by a small-business client and asked to provide a list of potential internal controls for his small office. Brad included such things as segregation of duties, authorization for return and adjustments, the use of hash totals as an information processing control, additional employee training, the preparation of a formal company manual, and reconciliations. After reviewing the list, the small-business owner had raised concerns related to the implementation of some of the suggestions. All of these concerns were potentially valid except:
A. the staff size did not lend itself to segregation of duties.
B. the small business could not handle the cost of some of the recommended internal control activities.
C. all members of the small staff of the company were longtime, trusted employees.
D. the efficiency and effectiveness of employee performance was felt to be adequate.
Control activities are only designed to provide reasonable assurance related to the achievement of the company’s stated objectives; however, risk will never be completely eliminated since there are limitations related to the control process. Limitations would include the following:
Small staff size, resulting in the inability to effectively segregate duties
The cost of the implementing a control being higher than the benefit of having that control
The need for rapid responses by employees, thus affecting their judgment and performance
Breakdowns in communication, training, and technology
The collusion of two or more employees
The override of various controls by management for illegitimate purposes
All of the following are the rates used in net present value analysis except for the:
A. cost of capital.
B. hurdle rate.
C. accounting rate of return.
D. required rate of return.
C. accounting rate of return.
The accounting rate of return is a capital budgeting method or technique which disregards the time value of money. It is not a rate used in a net present value analysis. Each of the other terms—cost of capital, hurdle rate, and required rate of return—describes a rate used in net present value analysis.
The Dixon Corporation has an outstanding 1-year bank loan of $300,000 at a stated interest rate of 8%. In addition, Dixon is required to maintain a 20% compensating balance in its checking account. Assuming the company would normally maintain a zero balance in its checking account, the effective interest rate on the loan is:
A. 8.0%.
B. 9.6%.
C. 10.0%.
D. 28.0%.
C. 10.0%.
The $300,000 loan is going to cost Dixon Corporation $24,000 (8% times $300,000). However, if the bank is going to require a 20% compensating balance, then Dixon Corporation will only have an effective use of $240,000 ($300,000 - ($20% × $300,000)). The $24,000 interest charge then becomes interest on $240,000, (the amount that Dixon is allowed to use of the $300,000 loan). $24,000 ÷ $240,000 represents an effective interest rate of 10%.
Which of the following covenants obliges the borrower to repay the bonds if a large quantity of common stock is held by a single investor and the bond rating is downgraded?
A. Poison put clause
B. Cross-default clause
C. Affirmative covenant
D. Negative pledge clause
A. Poison put clause
A poison put clause is a covenant that obliges the borrower to repay the bonds if a large quantity of common stock is held by a single investor and the bond rating is downgraded. This type of bond covenant is used as a defensive strategy to prevent hostile takeovers.
Residual income of an investment center is the center’s:
A. income plus the imputed interest on its invested capital.
B. income less the imputed interest on its invested capital.
C. contribution margin plus the imputed interest on its invested capital.
D. contribution margin less the imputed interest on its invested capital.
B. income less the imputed interest on its invested capital.
Residual income is the amount of net income in excess of the imputed interest on its invested capital, so “income less the imputed interest on its invested capital” is correct. The imputed interest on investment is a rate determined by corporate headquarters to encourage the investment center managers to invest in projects that would return more than that rate since residual income will be increased.
“Income plus the imputed interest on its invested capital” is incorrect because the imputed interest is subtracted from income rather than added.
“Contribution margin plus [or less] the imputed interest on its invested capital” is incorrect because the contribution margin is not used in the computation of residual income.
Given a 10% discount rate with cash inflows of $3,000 at the end of each year for five years and an initial investment of $11,000, what is the net present value?
A. $(9,500)
B. $370
C. $4,000
D. $11,370
B. $370
The net present value is the excess of the discounted present value of future cash returns less the investment cost.
The formula to calculate present value for any single future payment is PV = Payment ÷ (1 + r)n, where r is the interest rate and n is the number of periods.
The present value of the payment in the first year is $3,000 ÷ 1.1, or $2,727.
The present value of the payment in the second year is $3,000 ÷ (1.1 × 1.1), or $2,479.
The present value of the payment in the third year is $3,000 ÷ (1.1 × 1.1 × 1.1), or $2,254.
The present value of the payment in the fourth year is $3,000 ÷ (1.1 × 1.1 × 1.1 × 1.1), or $2,049.
The present value of the payment in the fifth year is $3,000 ÷ (1.1 × 1.1 × 1.1 × 1.1 × 1.1), or $1,863.
The sum of the present value of the five future payments is $11,372. The cost of the investment is $11,000, so the net present value is $11,372 - $11,000, or $372, rounded to $370.
The cost approach to valuation is appropriate to use when:
A. relevant guideline data is available.
B. the value of the firm is basically related to the assets held.
C. the projected future benefit stream is expected to differ significantly from the past.
D. a substantial amount of goodwill appears to exist.
B. the value of the firm is basically related to the assets held.
The use of a cost (asset-based) approach for valuation is appropriate when:
the company is in liquidation.
the company is worth more in liquidation than as a going concern.
the company’s value is basically related to the assets held.
the company has had no income in recent years.
future benefit streams cannot be adequately predicted.
Handyman, Inc., operates a chain of hardware stores across New England. The controller wants to determine the optimum safety stock levels for an air purifier unit. The inventory manager has compiled the following data:
The annual carrying cost of inventory approximates 20% of the investment in inventory.
The inventory investment per unit averages $50.
The stockout cost is estimated to be $5 per unit.
The company orders inventory on the average of 10 times per year.
Total cost = Carrying cost + Expected stockout cost
The probabilities of a stockout per order cycle with varying levels of safety stock are as follows:
Safety Stock Stockout
(in units) (in units) Probability
200 0 0%
100 100 15%
0 200 20%
The total cost of safety stock on an annual basis with a safety stock level of 100 units is:
A. $1,750.
B. $1,950.
C. $2,000.
D. $650.
A. $1,750.
Safety stock is a minimum level of inventory used as a buffer against possible stockouts. As with all inventory, there is a cost of holding this asset. This cost is called carrying cost. Along with carrying cost is the expected cost of running out of stock, called the stockout cost.
Total cost is defined in the problem as carrying cost plus expected stockout costs. Carrying cost is stated to be 20% of the investment in inventory. The value of the inventory is $50 per unit. At a safety stock of 100 units, the carrying cost would be 20% of 100 units at $50 a unit or $1000 (0.20 × 100 units × $50). Stockout cost is stated to be $5 per unit and at a safety stock level of 100 units, the stockout in units will be 100 with a 15% probability of occurrence. Therefore, stockout cost per cycle equals 100 units at $5 per unit times a 15% probability of $75 per cycle (100 units × $5 × 0.15).
Since the company orders inventory 10 times per year, annual stockout cost will equal $75 times 10 cycles or $750 (10 cycles × $75). The annual carrying cost of $1,000 plus the annual stockout cost of $750 will equal a total annual safety stock cost of $1,750 ($1,000 + $750).
An investment advisor is working with a client to be sure that he understands the client’s needs and preferences as he develops recommendations for the client’s portfolio. As he speaks with the client, he ascertains that the client is willing to accept a reasonable level of risk in her portfolio. He further determines that the client expects to be fairly compensated for the level of risk that is assumed by a commensurate increase in value to her portfolio. The investment advisor believes that his client is:
A. a risk taker.
B. desirous of having her portfolio on the security market line.
C. risk adverse.
D. looking for a passively managed portfolio.
C. risk adverse.
The definition of a risk-adverse investor is one who is willing to take risk but believes that they will be reasonably compensated for the level of risk being taken. The security market line is a theoretical construct that provides a graphic representation of the expected return of a particular security as a function of beta, i.e., nondiversifiable risk.
Spotech Co.’s budgeted sales and budgeted cost of sales for the coming year are $212,000,000 and $132,500,000, respectively. Short-term interest rates are expected to average 5%. If Spotech could increase inventory turnover from its current eight times per year to 10 times per year, its expected cost savings in the current year would be:
A. $331,250.
B. $250,000.
C. $165,625.
D. $81,812.
C. $165,625.=（(132,500,000/8)-(132,500,000/10))*5%
The key to this problem is to determine how much inventory is reduced by the increased inventory turnover and the resulting savings in interest costs due to reduced working capital requirements. A company must either borrow funds to acquire working capital or give up the next best investment opportunity to fund working capital requirements (opportunity cost). Either way, it costs a company to hold inventory. Any reduction in inventory levels reduces that cost.
The formula for inventory turns is annual cost of sales divided by inventory. Solve for inventory by dividing annual cost of sales by inventory turns. Initially, Spotech has an inventory level of $16,562,500 ($132,500,000 divided by 8 turns). Spotech hopes to decrease the level to $13,250,000 by increasing inventory turns to 10 ($132,500,000 divided by 10 turns). Working capital is reduced by this change in inventory ($16,562,500 - $13,250,000 = $3,312,500).
The interest avoided on the $3,312,500 represents a savings of $165,625 ($3,312,500 × 5%).
A potential problem indicated by a higher than industry average inventory turnover is risk of:
A. high storage costs.
B. obsolescence.
C. stockouts.
D. building up excessive funds in inventory.
C. stockouts. 无存货
Inventory turnover is costs of goods sold divided by average inventory. A very high inventory turnover could be the result of very low inventory levels. If this is the case, a serious risk of stockouts could exist. Management should certainly check this situation out.
Each of the other answers would result from excessive inventory holdings (i.e., a lower than average inventory turnover situation).
Your firm currently has on hand some idle cash that will be needed in three months to pay dividends to shareholders. Which of the following would be the most appropriate investment for that cash?
A. 30-year U.S. Treasury bonds with a current annual yield of 7.8%
B. Ford Motors’ long-term AAA-rated bonds with a current annual yield of 9.25%
C. Shares of Ford Motors’ common stock, which have been appreciating in price approximately 6% annually and paying a quarterly dividend that is the equivalent of a 5% annual yield
D. 90-day Ford Motors commercial paper with a current annual yield of 6%
D. 90-day Ford Motors commercial paper with a current annual yield of 6%
The most appropriate investment would appear to be the 90-day commercial paper. Commercial paper is short-term unsecured debt that may be issued directly to a purchaser on a discount basis and set to mature on a specific date. By purchasing directly, broker fees and other changes are avoided.
The treasury analyst for Garth Manufacturing has estimated the cash flows for the first half of next year (ignoring any short-term borrowings) as follows:
Cash (Millions)
Inflows Outflows January $2 $1 February 2 4 March 2 5 April 2 3 May 4 2 June 5 3 Garth has a line of credit of up to $4 million, on which it pays interest monthly at a rate of 1% of the amount utilized. Garth is expected to have a cash balance of $2 million on January 1 and no amount utilized on its line of credit. Assuming all cash flows occur at the end of the month, approximately how much will Garth pay in interest during the first half of the year?
A. $0
B. $61,000
C. $80,000
D. $132,000
B. $61,000
To calculate how much Garth will pay in interest during the first half of the year, the table provided must be used to develop an ongoing cash/credit balance:
The total interest payments as shown above equal $60,702. This is approximately $61,000.
The trick with this problem is to remember that interest is an additional cash outflow in the month paid.
BEG INFLOW OUTFLOW INT-OUTFLOW CR END CASH
2 2 -1 0 0 3
3 2 -4 0 0 1
1 2 -5 0 2 0
0 2 -3 -.002 1.020* 0
0 4 -2 -0.302 -1.9698** 0
0 5 -3 -0.10502 -1.0502 939,298
Opening Balance Change in Ending Balance
0 0 0 0
0 0 0 0
0 2,000,000 2,000,000 0
2,000,000 1,020,000* 3,020,000 20,000
3,020,000 -1,969,800** 1,050,200 30,200
1,050,200 -1,050,200 0 10,502
TOTAL 60,702
Financial statements were being prepared for the ABC Company, and among its long-term investments were 1,000 shares of XYZ common stock, a publicly held company traded on a major market. At the close of the day related to the date of the financial statements, the XYZ stock had a quoted market price of $65 per share; however, at approximately 4:30 p.m., after the close of the market, it was announced that a major fire had destroyed the only production plant held by XYZ Company. As a result of this new information, the quoted market price for the XYZ common stock fell to $25 per share on the following day. When considering all of this information, ABC Company should value the investment of the XYZ common stock at:
A. $65 per share since there is valid Level 1 input available for the date of the valuation.
B. $25 per share due to the new information; however, the input level would be dropped to Level 2.
C. $65 per share since there is valid Level 1 input available for the date of the valuation; however, the slide to $25 per share should be disclosed in the notes to the financial statements.
D. $45 (an average of $65 and $25) and drop the input level to Level 2.
B. $25 per share due to the new information; however, the input level would be dropped to Level 2.
As a general rule, if observable inputs such as quoted market prices for identical assets are available, the subject asset should be used in determining value, since this would represent a Level 1 input in the fair value hierarchy. However, if a company announces negative information that has a negative impact on the market price shortly after the close of the market, the fair value valuation should employ the use of the new information and list the value of the subject asset at the lower price. This would also drop the input level to Level 2.
Williams, Inc., is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described as follows, the company can sell unlimited amounts of all instruments.
Williams can raise cash by selling $1,000, 8%, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay flotation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8%.
Williams can sell 8% preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.
Williams’ common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and flotation costs are expected to amount to $5 per share.
Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
Williams’ preferred capital structure is long-term debt, 30%; preferred stock, 20%; and common stock, 50%.
The firm’s weighted average cost of capital would be:
A 4.8%.
B. 6.6%.
C. 6.8%
D. 7.3%.
B. 6.6%. The weighted cost of capital is 6.6%.
Step 1: Calculate the after-tax cost of each source of capital.
The cost of long-term debt, after tax, is given at 4.8%.
The cost of new preferred stock can be calculated as:
kpm = D / (PO - u - f), or kpm = 8.40 / (105 - 0 - 5) = 8.4%
Where:
D = Annual dividend, or 0.08 × $105 (the par value), or $8.4
PO = Selling price to the public of the new issue
u = Underpricing
f = Flotation cost per share
New equity consists of retained earnings and/or new issues of common stock. In this case, 50% of the 200,000 of total new funds must come from equity. Since the firm has $100,000 in retained earnings, the relevant cost of new equity is the cost of retained earnings, 7 ÷ 100 + 0%, or 7.0%.
Step 2: Calculate the Weighted Average Cost of Capital:
Source After-Tax Cost x Weight =
a. L-T Debt .048 x .30 = .0144
b. Pref. Stock .084 x .20 = .0168
c. Ret. Earnings .070 x .50 = .0350
Weighted Average Cost of Capital = .066 or 6.6%
A company manufactures several lines of automobiles including basic family passenger cars, recreational vehicles, sports cars, small trucks, and luxury cars. As part of its annual planning process, managers of each product line are required to submit estimates for the next five years for sales; changes in staffing levels; radio, television, and newspaper advertising requirements; equipment and building replacements; and new equipment and building needs.
Which of the following are you most likely to use to help you estimate the price at which goods might be sold in future years?
A. CPM (critical path method)
B. PERT (program evaluation review method)
C. Current CPI
D. Current PPI
C. Current CPI
Although the consumer price index (CPI) does not have any forecasting capability itself, a forecast of price levels is a necessary component of any business plan. Extrapolating the CPI is often used as an estimate of future prices since it is more stable than the PPI (producer price index).
Letters of credit are often used to facilitate international trade. The basic purpose of the letter of credit is to reduce risk to the:
A. bank.
B. exporter.
C. final customer.
D. importer.
B. exporter.
The basic transaction involves a sale of goods by a foreign exporter to a domestic importer. The letter of credit issued by a bank essentially substitutes the bank’s credit, for that of the importer. Thus, the risk of uncollectibility to the exporter is virtually eliminated.
The quick (or acid-test) ratio for Uptown Video Rentals is the same as its current ratio of 2.2 to 1. This suggests that:
A. all rentals by customers are charged.
B. current liabilities exceed current receivables.
C. current receivables are equal to current liabilities.
D. uptown has no merchandise inventory.
D. uptown has no merchandise inventory.
The difference between the current ratio and the quick ratio lies in the numerator. The numerator of the current ratio includes all current assets, usually cash, marketable securities, receivables, and merchandise inventory. Inventory is not included in the numerator used to calculate the quick ratio.
Therefore, the only way the two ratios could be exactly the same would be if Uptown has no merchandise inventory.
Everything else being equal, a noncallable bond will be priced in comparison to a callable bond so that the noncallable bond will provide:
A. a higher yield.
B. a lower yield.
C. the same yield.
D. a yield 1% less.
B. a lower yield.
Callable bonds reduce issuer risk by allowing the bonds to be called in if interest rates decline. The holder of callable bonds, however, is exposed to greater risk (i.e., loss of relatively high interest in a declining interest rate period).
In contrast, a noncallable bond is less risky for a bondholder, so it should sell at a lower yield.
In order to increase production capacity, Gunning Industries is considering replacing an existing production machine with a new technologically improved machine effective January 1, 20X1. The following information is being considered by Gunning Industries:
The new machine would be purchased for $160,000 in cash. Shipping, installation, and testing would cost an additional $30,000.
The new machine is expected to increase annual sales by 20,000 units at a sales price of $40 per unit. Incremental operating costs are comprised of $30 per unit in variable costs and total fixed costs of $40,000 per year.
The investment in the new machine will require an immediate increase in working capital of $35,000.
Gunning uses straight-line depreciation for financial reporting and tax reporting purposes. The new machine has an estimated useful life of five years and zero salvage value.
Gunning is subject to a 40% corporate income tax rate.
Gunning uses the net present value method to analyze investments and will employ the following factors and rates.
Present Value of an
Present Value of Ordinary Annuity of
Period $1 at 10% $1 at 10%
1 0.9091 0.9091
2 0.8264 1.7355
3 0.7513 2.4869
4 0.6830 3.1699
5 0.6209 3.7908
The acquisition of the new production machine by Gunning Industries will contribute a discounted net-of-tax contribution margin of:
A. $242,624.
B. $303,280.
C. $363,936.
D. $454,896.
D. $454,896.
Contribution margin calculated as sales revenue less variable costs. The additional contribution margin provided by the new machine is:
Sales revenue: 20,000 units x $40 = $800,000
Variable Cost: 20,000 units x $30 = $600,000
Before Tax Contribution Margin $200,000
less taxes ($200,000 x .40) 80,000
After Tax Contribution Margin $120,000
To discount the additional annual contribution margin over five years, apply the Present Value of an Ordinary Annuity of $1 at 10% for five periods provided by the problem.
– After Tax annual Contribution Margin $120,000
– Present Value of an Ordinary Annuity of
$1 at 10% for 5 periods x 3.7908
Discounted net-of-tax contribution margin
for the project $454,896
The Look Company is considering an investment that would require an initial investment of $120,000. The investment would provide cash inflows of $20,000 per year for 10 years, starting one year from today. Look is trying to compute the internal rate of return for this investment.
On the line for 10 periods on the present value of an annuity factor table, the factor is 6.145 for 10%. If the hurdle rate for acceptable projects is 10%, will the project be accepted?
A. Yes
B. No
C. The internal rate of return is equal to the hurdle rate.
D. Cannot be determined from information given
A. Yes
As interest rates get higher, the factors for the same number of periods become smaller. This is because, as the interest rates become higher, the time value of the money becomes higher. This makes the present value of the money lower. In this case, the factor of internal rate of return is 6:
$120,000 ÷ $20,000 = 6
If the hurdle rate of return is 10%, with a factor of 6.145, then the actual rate of return will be greater than 10%, and the project will be accepted.
Which of the following observations regarding the valuation of bonds is correct?
A. The market value of a discount bond is greater than its face value during a period of rising interest rates.
B. When the market rate of return is less than the stated coupon rate, the market value of the bond will be more than its face value, and the bond will be selling at a premium.
C. When interest rates rise so that the required rate of return increases, the market value of the bond will increase.
D. For a given change in the required return, the shorter its maturity, the greater the change in the market value of the bond.
B. When the market rate of return is less than the stated coupon rate, the market value of the bond will be more than its face value, and the bond will be selling at a premium.
The market value of bonds is based upon the present value of discounted future cash flows, comprised of an annuity plus a lump sum. The bond’s market value fluctuates with changes in the market interest rates.
When the face interest rate is the same as the market interest rate, the market value of the bond will be the same as the face (i.e., par) value. If the face interest rate is less than the market interest rate, the bond will sell at a discount; if it is greater, the bond will sell at a premium.
When estimating cash flow for use in capital budgeting, depreciation is:
A. included as a cash or other cost.
B. excluded for all purposes in the computation.
C. utilized to estimate the salvage value of an investment.
D. utilized in determining the tax costs or benefit.
D. utilized in determining the tax costs or benefit.
The only effect depreciation expense has on cash flows is the determination of income tax. Depreciation expense is subtracted from income to find taxable income. Therefore, while depreciation is not a cash flow directly, it does affect income tax cash flows.
“Included as a cash or other cost” is incorrect because depreciation is not a cash flow. “Excluded for all purposes in the computation” is incorrect because depreciation is considered in determining cash flows for income taxes. “Utilized to estimate the salvage value of an investment” is incorrect because the salvage value is the cash value of the asset at the end of its useful life, which is not related to the book value remaining after deducting annual depreciation expense.
In relation to the internal control process, control sufficiency is:
A. the group of controls with a variety of degrees of precision necessary to achieve a control objective.
B. the alignment between a risk and the control activity designed to mitigate that risk.
C. the measurement of the effectiveness of a specific control in alleviating the defined risk.
D. the testing of the effectiveness of a control procedure.
A. the group of controls with a variety of degrees of precision necessary to achieve a control objective.
Two important definitions related to the internal control process are control precision and control sufficiency:
Control precision is the alignment between a risk and the control activity designed to mitigate that risk. In other words, a control activity that has a direct influence on the achievement of a stated objective is considered to be more precise than one that only has an indirect influence.
Control sufficiency is a group of controls with a variety of degrees of precision necessary to achieve a control objective. For example, there would potentially be a number of control activities such as segregation of duties, reconciliation of bank statements, and daily deposits of receipts in order to protect all incoming receivable payments from theft or fraud.
Oak Company bought a machine that they will depreciate on the straight-line basis over an estimated useful life of seven years. The machine has no salvage value. They expect the machine to generate after-tax net cash inflows from operations of $110,000 in each of the seven years. Oak’s minimum rate of return is 12%. Information on present value factors is as follows:
Present value of $1 at 12% at the end of seven periods 0.4523
Present value of an ordinary annuity of $1 at 12% for seven periods 4.5638
Assuming a positive net present value of $12,000, what was the cost of the machine?
A. $480,000
B. $490,018
C. $502,040
D. $514,040
B. $490,018=(4.5638*110,000)-12,000
Because the machine is expected to generate an after-tax net cash flow from operations each year for seven years, an ordinary annuity situation exists. The cost of the machine is determined as follows:
Let NPV = Net present value
NPV = Present value of inflows - Present value of outflows
$12,000 = (4.5638 x $110,000) - (Cost of machine)
$12,000 = $502,018 - Cost of machine
Cost of machine = $502,018 - $12,000
= $490,018
The present value of $1 serves to bring a single cash flow to the present, not a series of cash flows ($110,000 per year for seven years) as stated in the question.
Which of the following factors is inherent in a firm’s operations if it utilizes only equity financing?
A. Financial risk
B. Business risk
C. Interest rate risk
D. Marginal risk
B. Business risk
Both financial risk and interest rate risk deal with the concept of financial leverage and the cost of debt, and since the firm only utilizes equity financing, these risk types do not apply.
Marginal risk is the risk that is assumed by the issuer of a foreign exchange contract or debt (forward contract) in the event that the investor goes bankrupt. It is related to the risk of the last dollar of a transaction defaulting.
Business risk is the uncertainty associated with the ability to forecast EBIT (earnings before interest and taxes) due to such things as sales variability and operating leverage. This risk is inherent in equity financing.
Which of the following phrases defines the internal rate of return on a project?
A. The number of years it takes to recover the investment
B. The discount rate at which the net present value of the project equals zero
C. The discount rate at which the net present value of the project equals one
D. The weighted-average cost of capital used to finance the project
B. The discount rate at which the net present value of the project equals zero
The internal rate of return is the interest rate that will make the present value of the future net cash flows equal to the initial cash outlay. In other words, it is the interest rate that gives a net present value of zero.
The answer choice “the number of years it takes to recover the investment” is incorrect because it is the definition of the payback period, a number of years, not a rate of return.
“The discount rate at which the net present value of the project equals one” is incorrect because the internal rate of return is the rate of return where the net present value is zero, not one.
“The weighted-average cost of capital used to finance the project” is incorrect because weighted-average cost of capital is the interest rate that the company is paying on its other sources of financing. It is used to determine that project rate of return that would be acceptable to the company, but it is not used to calculate the internal rate of return.
A firm’s target or optimal capital structure is consistent with which one of the following?
A. Maximum earnings per share
B. Minimum cost of debt
C. Minimum risk
D. Minimum weighted average cost of capital
D. Minimum weighted average cost of capital
Since capital consists of debt and equity components, answers that regard only one or the other are inadequate. The cost of capital is a weighted average of the various debt and equity portions of capital. Therefore, a firm’s optimal capital structure would be the minimum weighted average cost of capital.
Marsh, Inc., is experiencing a sharp increase in credit sales activity and has, therefore, had a steady increase in production. Management has also adopted an aggressive working capital policy by decreasing the inventory conversion period and holding the receivables collection period and the payables deferral period constant. Original inventory levels were higher than accounts receivable. Therefore, the company’s current level of net working capital:
A. would most likely be lower than under other business conditions in order that the company can maximize profits while minimizing working capital investment.
B. would most likely be higher than under other business conditions so that there will be sufficient funds to replenish assets.
C. can be financed most economically through the sale of common stock.
D. would most likely be higher than under other business conditions as the company’s profits are increasing.
A. would most likely be lower than under other business conditions in order that the company can maximize profits while minimizing working capital investment.
Net working capital is current assets minus current liabilities. As sales increase, accounts receivable, a component of current assets, will increase providing the receivable collection period (average accounts receivable/average sales per day) remains constant. If credit sales increase by 10%, receivables would be expected to increase by 10%, thus increasing working capital.
If the inventory conversion period (average inventory/average sales per day) is decreased, this means that inventory would be held for a shorter amount of time; therefore, in this situation, production has increased in order to accommodate increase sales; however, since the inventory conversion period has decreased, this means that inventory would have decreased or increased slower than sales.
As sales and production increase, accounts payable and accrued production costs will increase providing the payables deferral period (average payables/average purchases per day) remains constant. If purchases and production increase by 10%, accounts payable and payables related to variable production costs would be expected to increase by 10% thus decreasing working capital. (This is assuming that unit variable costs of production remain unchanged).
If the original balances of accounts receivable were less than the original inventory balances, it would be expected that working capital would decrease since the increase in accounts receivable would be less than the increases in payables related to the increased sales production.
The net present value (NPV) of a project has been calculated to be $215,000. Which one of the following changes in assumptions would decrease the NPV?
A. Decrease the estimated effective income tax rate.
B. Decrease the initial investment amount.
C. Increase the estimated salvage value.
D. Increase the discount rate.
D. Increase the discount rate.
The net present value method adjusts for the time value of money. It seeks to determine whether the present value of estimated future cash inflows at a desired rate of return will be greater or lesser than the cost of the proposed investment. The present value of the cash inflows is calculated and compared to the initial investment. The formula for the present value (or discounted value) of $1 is:
Present value = F (1)/ (1 + i)’n
Where:
F is a specified amount in a given number of years.
n is a given number of years.
i is the interest rate (discount rate).
For this formula, if the discount rate is increased, the present value of the future cash inflows will decrease, thus decreasing net present value.
When calculating a company’s cost of common stock, an analyst evaluates the following four components: risk-free rate, stock’s beta coefficient, rate of return on the market portfolio, and required rate of return on the company’s stock. Which of the following measurement models is being used?
A. Constant growth
B. Weighted marginal cost of capital
C. Capital asset pricing
D. Overall cost of capital
C. Capital asset pricing
The capital asset pricing model uses the beta coefficient, the market risk premium, and the risk-free rate.
The other answer choices are incorrect: Constant growth is an assumption that dividends increase at a constant rate in perpetuity. The weighted marginal cost of capital combines the rates on all sources of capital; this question asks about only one security, common stock. The overall cost of capital combines the rates on all sources of capital; this question asks about only one security, common stock.
A corporation is considering purchasing a machine that costs $100,000 and has a $20,000 salvage value. The machine will provide net annual cash inflows of $25,000 per year and has a 6-year life. The corporation uses a discount rate of 10%. The discount factor for the present value of a single sum 6 years in the future is 0.564. The discount factor for the present value of an annuity for 6 years is 4.355. What is the net present value of the machine?
A. $(2,405)
B. $8,875
C. $20,155
D. $28,875
C. $20,155=(25,0004.355+20,0000.564)-100,000
The net present value is the excess of the discounted present value of future cash returns above the investment cost.
The present value of the future cash returns is the annual cash flow of $25,000 multiplied by the present value of an annuity of $1 a year for six years at 10%, which is 4.355. Thus, the present value of the future cash flows is $108,875 ($25,000 × 4.355).
The salvage value of $20,000 will be received in cash in six years, so its present value is $20,000 multiplied by the present value of a single payment of $1 in six years at 10%, or 0.564, giving a present value of the salvage value of $11,280.
Summing the present value of the annual payments ($108,875) and the present value of the salvage value ($11,280) gives a total present value of future cash flows of $120,155.
The cost of the machine is $100,000, so the net present value is $120,155 less $100,000, or $20,155.
A company uses the following formula in determining its optimal level of cash:
C* = Square root of 2bT/i
Where:
b = Fixed cost per transaction
i = Interest rate on marketable securities
T = Total demand for cash over a period of time
This formula is a modification of the economic order quantity (EOQ) formula used for inventory management. Assume that the fixed cost of selling marketable securities is $10 per transaction, and the interest rate on marketable securities is 6% per year. The company estimates that it will make cash payments of $12,000 over a 1-month period. What is the average cash balance (rounded to the nearest dollar)?
A. $2,000
B. $3,464
C. $6,928
D. $12,000
B. $3,464=Square root of( (21012000)/(0.06/12))/2
There are two issues to be careful with in this question: the word “average” and making certain the periods of time are consistent for all factors. Simply calculating the optimal level of cash causes you to arrive at $6,928. This is the square root of 2 times the fixed cost ($10) times the total demand in one month ($12,000) divided by the interest rate for one month (.06 divided by 12). Of course you need to use the interest rate for one month, not one year, because the applicable period of time is one month.
The average cash balance will be one-half of the optimal level of cash because the balance will be used down to zero and will be replenished to the optimal level. The average of zero and $6,928 is the sum (0 + $6928) divided by 2, or $3,464.
DQZ Telecom is considering a project for the coming year which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment:
Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8%, and flotation costs of 2% of par.
Use $35 million of funds generated from earnings.
The equity market is expected to earn 12%. U.S. Treasury bonds are currently yielding 5%. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40%.
Assume that the after-tax cost of debt is 7% and the cost of equity is 12%. Determine the weighted average cost of capital.
A. 10.50%
B. 8.50%
C. 9.50%
D. 15.83%
A. 10.50%
To solve this problem, a weighted average of the two different interest rates for the two different forms of capital needs to be calculated. $15 million of the $50 million will be debt with an after-tax cost of 7%. $35 million of the $50 million will be equity with a cost of 12%.
$15 million / $50 million x .07 = .021
+ $35 million / $50 million x .12 = .084
Weighted average .105 or 10.5%.
A company uses its fixed assets of $1,000,000 at 95% capacity to generate sales of $2,000,000. The company wishes to generate sales of $3,000,000. What amount of additional fixed assets must be acquired, assuming that all fixed assets will operate at maximum capacity?
A. $425,000
B. $475,000
C. $500,000
D. $578,000
A. $425,000
The ratio of the new total fixed assets to sales of $3,000,000 must be the same as the ratio of 95% of $1,000,000 of fixed assets is to sales of $2,000,000.
(Total fixed assets) ÷ $3,000,000 = (0.95 × $1,000,000) ÷ $2,000,000
Total fixed assets = ($3,000,000 × $950,000) ÷ $2,000,000 = $1,425,000
Since the company has fixed assets now of $1,000,000, the increase in fixed assets is $425,000.
Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment’s estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322.
What is the accrual accounting rate of return based on initial investment?
A. 30%
B. 20%
C. 12%
D. 10%
D. 10%
Annual accrual accounting “income” = Annual saving - Depreciation
= $20,000 - ($100,000 / 10 years)
= $20,000 - $10,000
= $10,000
Accrual accounting rate of return = Accounting “income” / Investment
= $10,000 / $100,000
= 10%
An in-exchange premise as used when making a fair value calculation assumes that the maximum value of the item(s) being valued would come from:
A. the current use of that item.
B. using the item in its highest and best use.
C. using that item in conjunction with other assets as a group.
D. using the item alone.
D. using the item alone.
Per FASB ASC 820, a fair value determination can use either an in-exchange or an in-use premise. An in-exchange premise assumes that the maximum value of the subject item would come from the purchaser’s perspective when the item is used alone. An in-use premise assumes that the maximum value of the subject item would come from the purchaser’s perspective when the item is used in conjunction with other assets as a group.
Troy Toys is a retailer operating in several cities. The individual store managers deposit daily collections at a local bank in a non-interest bearing checking account. Twice per week, the local bank issues a depository transfer check (DTC) to the central bank at headquarters. The controller of the company is considering using a wire transfer instead. The additional cost of each transfer would be $25; collections would be accelerated by two days; and the annual interest rate paid by the central bank is 7.2% (0.02% per day). At what amount of dollars transferred would it be economically feasible to use a wire transfer instead of DTC? Assume a 360-day year.
A. $125,000 or above
B. Any amount greater than $173
C. Any amount greater than $62,500
D. Any amount; it would always be economically feasible
C. Any amount greater than $62,500
Transfer Amount = $25 ÷ .0004 or $62,500
Therefore, a transfer amount of at least $62,500 would be necessary to justify a $25 expenditure to achieve the faster transfer.
Each day that Troy Toys does not have their money in their possession costs them 0.02% in lost interest. A process that accelerates transfer of cash by two days earns 0.04% (2 days × 0.02%/day) in interest on that cash. If that process costs $25, what amount of cash would have to be transferred to earn at least $25 in interest to offset the cost? To answer this, we restate the simple formula for interest earned. Interest earned equals the principal times the interest rate. In this case, the principal is the transfer amount. This can be restated to be the transfer amount (principal) equals the interest earned divided by the interest rate. Transfer Amount (Principal) = Interest Earned ÷ Interest Rate
DQZ Telecom is considering a project for the coming year which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment:
Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8%, and flotation costs of 2% of par.
Use $35 million of funds generated from earnings.
The equity market is expected to earn 12%. U.S. Treasury bonds are currently yielding 5%. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40%.
The before-tax cost of DQZ’s planned debt financing, net of flotation costs, in the first year is:
A. 11.80%.
B. 8.08%.
C. 7.92%.
D. 8.00%.
B. 8.08%.
DQZ Telecom must pay interest at the coupon rate of 8% on $15 million. This amounts to $1,200,000. The money DQZ has received in this transaction comes from $15 million in bonds sold at a premium price of 101, which means DQZ received $15,150,000 ($15,000,000 × 1.01). Out of this amount, DQZ had to pay 2% of $15 million ($300,000) in flotation costs. That means DQZ had effective use of $14,850,000 ($15,150,000 - $300,000). $1,200,000 interest paid on $14,850,000 reflects an 8.08% effective interest rate ($1,200,000 ÷ $14,850,000).
A company currently has 1,000 shares of common stock outstanding with zero debt. It has the choice of raising an additional $100,000 by issuing 9% long-term debt or issuing 500 shares of common stock. The company has a 40% tax rate. What level of earnings before interest and taxes (EBIT) would result in the same earnings per share (EPS) for the two financing options?
A. An EBIT of $27,000 would result in EPS of $10.80 for both.
B. An EBIT of $27,000 would result in EPS of $7.20 for both.
C. An EBIT of - $18,000 would result in EPS of $(7.20) for both.
D. An EBIT of - $10,800 would result in EPS of $(7.92) for both.
A. An EBIT of $27,000 would result in EPS of $10.80 for both.
The raising of funds through taking on additional debt will result in a lower EAT (earnings after taxes) due to the $9,000 of interest expense ($100,000 × 0.09); however, the number of shares will remain at 1,000.
EPS calculation for use of debt financing:
EPS = (EBIT - Interest - ((EBIT - Interest) × 0.40)) ÷ Number of shares
EPS = (EBIT - $9,000 - ((EBIT - $9,000) × 0.40)) ÷ 1,000 shares
EPS calculation for sales of additional common shares:
EPS = (EBIT - (EBIT × 0.40)) ÷ Number of shares
EPS = (EBIT - (EBIT × 0.40)) ÷ 1,500 shares
The solution for when EPS is equal under each of these financing options can be determined by setting the two above equations equal to each other and solving for EBIT:
(EBIT - $9,000 - ((EBIT - $9,000) × 0.40)) ÷ 1,000 shares = (EBIT - (EBIT × 0.40)) ÷ 1,500 shares
1,500 EBIT - $13,500,000 - (600 EBIT + $5,400,000) = 1,000 EBIT - 400 EBIT
300 EBIT = $8,100,000
EBIT = $27,000
Additional Debt Additional Stock EBIT $27,000 $27,000 Interest 9,000 0 EBT $18,000 $27,000 Tax 7,200 10,800
$10,800 $16,200
Additional debt:
EPS = Net income ÷ Number of shares outstanding
EPS = $10,800 ÷ 1,000 shares = $10.80 per share
Additional stock:
EPS = Net income ÷ Number of shares outstanding EPS = $16,200 ÷ 1,500 shares = $10.80 per share
Super Mart reported the following information in its most recent financial statements:
Sales $2,100,000
Gross profit 600,000
Cash (beginning) 100,000
Cash (ending) 120,000
Accounts receivable (beginning) 300,000
Accounts receivable (ending) 275,000
Inventories (beginning) 240,000
Inventories (ending) 300,000
Super Marts’ number of days sales in inventory (use 360 days) was ________ days.
A. 45
B. 55
C. 65
D. 75
C. 65
Cost of Goods Sold = Sales - Gross Profit
= $2,100,000 - $600,000
= $1,500,000
Inventory Turnovers = Cost of Goods Sold / Average Inventory
= $1,500,000 / (0.5 x ($240,000 + $300,000))
= $1,500,000 / (0.5 x $540,000)
= $1,500,000 / $270,000
= 5.56 times
Number of Days Sales in Inventory = 360 / Inventory Turnover
= 360 / 5.56
= 64.74 or 65 days
Space Tech Company (STC) specializes in designing and fabricating components used in lunar and planetary landing and exploration systems. At the end of last year, STC reported the following data in its financial statements:
Total Assets $16,000,000 Total Debt 10,000,000 Sales 22,000,000 Net income 2,000,000 The debt to equity ratio of STC was \_\_\_\_\_\_\_\_ to 1.
A. .60
B. .80
C. 1.25
D. 1.67
D. 1.67
Debt to equity is total debt divided by total stockholders’ equity. STC’s total stockholders’ equity consists of total assets of $16,000,000 less total debt of $10,000,000 for a net of $6,000,000.
Thus, STC’s ratio of debt to equity is:
Debt to Equity = $10,000,000 / $6,000,000
= 1.67
Newman Products has received proposals from several banks to establish a lockbox system to speed up receipts. Newman receives an average of 700 checks per day averaging $1,800 each, and its cost of short-term funds is 7% per year. Assuming that all proposals will produce equivalent processing results and using a 360-day year, which one of the following proposals is optimal for Newman?
A. A $0.50 fee per check
B. A flat fee of $125,000 per year
C. A fee of 0.03% of the amount collected
D. A compensating balance of $1,750,000
D. A compensating balance of $1,750,000
Considering that each proposal will produce equivalent processing results, the optimal proposal for Newman will be the lowest cost proposal. Consequently, to solve this problem, the costs of each of the proposals must be calculated.
A. 700 checks × $0.50 × 360 days = $126,000 per year
B. $125,000 per year
C. $1,800 per check × 700 checks × 360 days × 0.03% = $136,080
D. $1,750,000 × 7% = $122,500
Which of the following inventory management techniques focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials?
A. Materials requirements planning
B. Cycle counting
C. Safety stock reorder point
D. Economic order quantity
A. Materials requirements planning
Materials requirements planning (MRP) is ordering raw materials and other components used in manufacturing based on needs for completed products. The system uses a bill of material and master production schedule to plan the acquisition of components. It is demand-dependent since materials are not ordered until the system plans when those materials will be used in manufacturing.
Cycle counting refers to counting physical inventory in batches, where all inventory is counted over time, but only a subcomponent of it is counted in each separate cycle. It has nothing to do with determining proper levels of inventory.
A safety stock reorder point system automatically reorders components when a minimum inventory level is reached. It is not demand-dependent.
The economic order quantity is the number of units to order at one time to minimize the total of inventory holding and stockout costs. It is not demand-dependent because it does not determine when to order the components, only the quantity to order.
Each of the following will affect a company’s return on investment, except:
A. raising prices as demand remains unchanged.
B. maintaining the company’s cost of capital at current levels.
C. decreasing expenses.
D. decreasing investment in assets.
B. maintaining the company’s cost of capital at current levels.
Return on investment (ROI) focuses on optimal use of invested capital. Net income from the income statement is divided by invested capital from the balance sheet; therefore, raising prices, decreasing expenses, and decreasing investment in assets would all affect ROI.
A rational approach to capital budgeting requires that the return on investment of a project equal or exceed the firm’s:
A. average revenue.
B. cost of capital.
C. explicit costs.
D. opportunity cost.
B. cost of capital.
For an investment to be undertaken, it should at a minimum produce a return that equals or exceeds the firm’s cost of capital.
You walk into a little boutique in the nearby mall. As you walk up to the cash register with an item that you wish to purchase, you notice that there appears to be only one employee in this small store. With a limited number of personnel in the store at any given time, what would be the best internal control procedure to provide a reasonable guarantee that all cash sales are being rung up properly and cash put in the cash drawer?
A. Carefully screen all new employees
B. Require that all sales be rung up on the cash register using barcodes
C. Increase the minimum number of employees at the store at any given time to three
D. Post a sign in a visible spot near the checkout counter that states, “If you do not get a receipt, your purchase is free.”
D. Post a sign in a visible spot near the checkout counter that states, “If you do not get a receipt, your purchase is free.”
Internal controls are designed to provide reasonable assurance that objectives are achieved and compliance to laws and regulations is obtained. All of the items listed would be reasonable control procedures; however, the store receipts may not be able to support a minimum of three employees at the store at any given time. The cost of an internal control procedure is not expected to exceed its benefit. Although it would be important to carefully screen all new employees, it is often difficult to judge an individual’s character during one or two short interviews, and in today’s litigious society, it is often difficult to get valuable information from prior employees or other references.
Following are some of the internal control goals related to this transaction:
Validity: The owner would want only valid, authorized, and legal transactions to be processed. By requiring all transactions to be rung up on the cash register, the owner has the ability to review all transactions. The owner could examine items sold, discounts given, and any other adjustments recorded in sales. However, when only one employee is in the store, it would be difficult to enforce the use of the cash register for cash sales.
Accuracy of recording and evidence of supportability: The owner would want transactions to be recorded free of omissions. By using the customer as a part of the internal control process, the customer can be a “monitor” of the transaction when the owner is not in the store and/or when only one employee is on the selling floor. The transaction would need to be entered into the cash register (recorded) in order to print a register receipt. Given that it may be necessary to have only one employee in the store at slower times during the day, the owner has a final “backup” to have reasonable assurance that the employees are using the other required internal control procedures—thus making this procedure key in the internal control process.
The Steelworkers Union argued that the standard-of-living for union members had declined through the life of the recently expired contract. The management negotiating team replied that this was not true since workers had received a 3% wage increase in each year of the 3-year contract. Could the union assertion be true?
A. Yes, because the workers’ real income might fall if price increases had been proportionally smaller that the wage increases received by the workers
B. No, because the workers’ real income might rise if price increases are proportionally greater than the wage increases received by the workers
C. No, because the workers’ real income might rise if price increases are proportionally greater than the decline in worker income
D. Yes, because the workers’ real income might fall if price increases are proportionally greater than the wage increases received by the workers
D. Yes, because the workers’ real income might fall if price increases are proportionally greater than the wage increases received by the workers
Even though the workers received a 3% annual increase in their nominal wages, their real income (standard-of-living) could have declined if inflation had averaged more than 3% annually during the contract period.
Maylar Corporation has sold $50 million of $1,000 par value, 12% coupon bonds. The bonds were sold at a discount and the corporation received $985 per bond. If the corporate tax rate is 40%, the after-tax cost of these bonds for the first year (rounded to the nearest hundredth percent) is:
A. 7.31%.
B. 12.18%.
C. 12.00%.
D. 7.09%.
A. 7.31%.
Interest payment per year ($1,000 x 12%) = $120 Before-tax cost = 120 / 985 = .1218 After-tax cost = .1218 x (1-40%) = 7.31% Note the use of the $985 proceeds, not the par value, in this calculation.
Alternative Calculation:
Interest payment per year ($1,000 x 12%) = $120
Tax Savings per year ($120 x 40%) = $ 48
Effective Interest paid per year = $ 72
After-tax cost ($72 / $985) = 7.31%
The following table contains Emerald Corp.’s quarterly revenues, in thousands, for the past three years. During that time, there were no major changes to Emerald’s selling strategies and total capital investment.
Year 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr.
Year 1 500 500 550 750
Year 2 525 550 600 800
Year 3 550 525 625 850
Which of the following statements best describes the likely cause of the fluctuations in Emerald’s revenues and is the best response to those fluctuations?
A. The fluctuations are from changes in the economy, and Emerald should examine its cost structure for potential changes.
B. The fluctuations are from changes in the economy, and Emerald should manage its inventories and cash flow to match the cycle.
C. The fluctuations are from the seasonal demand for Emerald’s products, and Emerald should examine its cost structure for potential changes.
D. The fluctuations are from the seasonal demand for Emerald’s products, and Emerald should manage its inventories and cash flow to match the cycle.
D. The fluctuations are from the seasonal demand for Emerald’s products, and Emerald should manage its inventories and cash flow to match the cycle.
The pattern of demand shown in the table shows a consistent pattern of growth on a year-to-year basis with a similar pattern of fluctuations within each year where demand peaks during the fourth quarter. This is what is defined as a seasonal pattern of demand. It is also reasonable for a firm to attempt to manage inventories and cash flow to match their demand cycle
Jackson Distributors sells to retail stores on credit terms of 2/10, net 30. Daily sales average 150 units at a price of $300 each. Assuming that all sales are on credit and 60% of customers take the discount and pay on Day 10 while the rest of the customers pay on Day 30, the amount of Jackson’s accounts receivable is:
A. $1,350,000.
B. $990,000.
C. $900,000.
D. $810,000.
D. $810,000. (10150300.6)+(30150300.4)
10-Day Accounts Receivable:
Collection Ratio = 10 = Accounts receivable / Average daily sales
10 = Accounts receivable / ($45,000 x 60%)
solve for A/R: Accounts receivable = $270,000
30-Day Accounts Receivable:
Collection ratio = 30 = Accounts receivable / Average daily sales
30 = Accounts receivable / ($45,000 x 40%)
solve for A/R: Accounts receivable $540,000
Total Accounts Receivable: $810,000
Which of the following is a reliable early predictor of future inflation?
A. Consumer price index
B. Cost-push multiplier
C. Demand-pull multiplier
D. Wholesale price index
D. Wholesale price index
The wholesale price index (WPI) reflects the change in prices of goods at the wholesale level. Since price increases are generally passed on to consumers, the WPI serves as an early predictor for changes in consumer price levels.
To measure inventory management performance, a company monitors its inventory turnover ratio. Listed below are selected data from the company’s accounting records:
Current Year Prior Year
Annual sales $2,525,000 $2,125,000
Gross profit percent 40% 35%
Beginning finished goods inventory for the current year was 15% of the prior year’s annual sales, and ending finished goods inventory was 22% of the current year’s annual sales. What was the company’s inventory turnover at the end of the current period?
A. 1.82
B. 2.31
C. 2.73
D. 3.47
D. 3.47
The inventory turnover ratio can be calculated as follows:
Cost of goods sold (COGS) ÷ Average inventory
The cost of goods sold (COGS) for the current period can be determined with the help of the gross profit percentage:
Revenue - COGS = Gross profit
If gross profit represents 40% of sales, then COGS represents 60% of sales; therefore:
Sales × 0.60 = COGS
$2,525,000 × 0.60 = $1,515,000
The beginning and ending inventory value can be calculated using the percentage of sales given in the problem:
Beginning FG (finished goods) inventory = 0.15 × $2,125,000 = $318,750
Ending FG inventory = 0.22 × $2,525,000 = $555,500
The company’s current inventory turnover can now be calculated:
COGS ÷ Average inventory = $1,515,000 ÷ (($318,750 + $555,500) ÷ 2) = 3.47 times
Green, Inc., a financial investment-consulting firm, was engaged by Maple Corp. to provide technical support for making investment decisions. Maple, a manufacturer of ceramic tiles, was in the process of buying Bay, Inc., its prime competitor. Green’s financial analyst made an independent detailed analysis of Bay’s average collection period to determine which of the following?
A. Financing
B. Return on equity
C. Liquidity
D. Operating profitability
C. Liquidity
Liquid assets are those most easily converted to cash. The average collection period is a measure of how long it takes to collect accounts receivable after a sale is made; thus, how long it takes to collect the cash, a measure of liquidity.
Financing refers to raising money using debt or equity securities, not a measure of immediate liquidity. Return on equity is a measure of profitability, not liquidity.
Profitability does not measure liquidity; many potentially profitable businesses have failed due to an inability to pay debts currently due.
During a meeting with the CEO of the Marble Company, Connie CPA learned that the son of the CEO had worked at the company during one summer doing odd jobs. The year in question was included in the past financial records being used as a basis for the business valuation for which Connie had been engaged. The payroll records revealed that the son had received $40,000 (including taxes and other benefits) for this summer work. Connie should make a normalization adjust for:
A. a nonoperating item for the full $40,000 received by the son.
B. a nonrecurring item for the full $40,000 received by the son since he only worked at the Mable Company for one summer.
C. a comparability item for $20,000 since it is not likely that guideline companies would have paid $40,000 for the work performed.
D. a discretionary item for $35,000 since the going market rate for the work performed by the son would have been $5,000.
D. a discretionary item for $35,000 since the going market rate for the work performed by the son would have been $5,000.
Business valuators often have to make adjustments during the normalization process. There are four basic categories of normalization adjustments:
Nonoperating adjustments: the removal of nonoperating items included in the historical financial statements that are not part of normal operations. The performance of “odd jobs” around a business facility would be normal operating items.
Nonrecurring adjustments: the removal of unusual, unexpected, or items not likely to occur again from the financial statements. Although the son is not likely to perform these duties in the future, someone would need to do general maintenance on an ongoing basis.
Comparability adjustments: adjustments of the historical financial statements to match GAAP choices of potential guideline companies. The payment of wages is not a “GAAP” question, even though they may be excessive.
Discretionary adjustments: adjustments to the historical financial statement to include or to remove items not considered part of normal operations. Excessive wages paid to family members are considered to be discretionary items. The normalization adjustment would need to be made to bring the amount paid within going market rates.
The profitability index is a variation on which of the following capital budgeting models?
A. Internal rate of return
B. Economic value added
C. Net present value
D. Discounted payback
C. Net present value
The profitability index is also known as the excess present value index. It is calculated by dividing the project’s initial (or average) cost into the present value of the cash flows. If the profitability index is greater than one, then a project’s net present value (NPV) is positive. This index allows comparisons between two projects.
The profitability index is a variation on the net present value method of capital budgeting. The net present value method adjusts for the time value of money by comparing the present value of the estimated net future cash inflows to the cost of the investment. The profitability index uses these same two variables in its calculation.
The internal rate of return budgeting model calculates the rate of discount (interest) that equates the present value of the net cash flows (including the initial cash outlay) to zero. If the resulting rate of return is lower than the desired rate of return, the project should not be undertaken.
The calculation of the economic value added amount (EVA) is not considered a capital budgeting method.
The discounted payback method is the length of time required to recover the initial cash investment using a sum of the discounted future cash flows.
CyberAge Outlet, a relatively new store, is a cafe that offers customers the opportunity to browse the Internet or play computer games at their tables while they drink coffee. The customer pays a fee based on the amount of time spent signed on to the computer. The store also sells books, T-shirts, and computer accessories. CyberAge has been paying all of its bills on the last day of the payment period, thus forfeiting all supplier discounts. Data on CyberAge’s two major vendors, including average monthly purchases and credit terms, are shown here.
Average
Monthly
Vendor Purchases Credit Terms
Web Master $25,000 2/10,net 30
SoftIdee’s 50,000 5/10,net 90
Assuming a 360-day year and that CyberAge continues paying on the last day of the credit period, the company’s rounded, weighted annual interest rate for trade credit (ignoring the effects of compounding) for these two vendors is:
A. 7.0%.
B. 27.0%.
C. 28.0%.
D. 29.3%.
C. 28.0%.
Because CyberAge ignores the payment discount offered in the suppliers’ payment terms, CyberAge is essentially borrowing money at an interest rate which equals the cost (forfeited discount) of holding on to the money for the extra period of time beyond the discount terms. The trick to solving this problem correctly is realizing that CyberAge is not paying 2% or 5% on the entire balance, but is paying the entire balance and forfeiting a 2% or 5% savings. This really represents an interest rate of 2% divided by 98% of the balance (100% - 2% = 98%) or 2.041% for Web Master, and 5% divided by 95% of the balance (100% - 5% = 95%) or 5.263% for SoftIdee’s. With this in mind, the correct weighted annual interest rate for trade credit may be calculated as follows:
Web Master: It costs 2.041% to hold money for the extra 20 days (30 - 10 = 20). There are 18 20-day periods in a 360-day year (360/20) and Web Master represents one-third of the purchases ($25,000 ÷ $25,000 + $50,000). Therefore, Web Master’s contribution to the weighted annual interest rate is .02041 × 18 × .3333 = .12245 or 12.245%.
SoftIdee’s: It costs 5.263% to hold money for extra 80 days (90 - 10 = 80). There are 4.5 80-day periods in a 360-day year (360 ÷ 80) and SoftIdee’s represents two-thirds of the purchases ($50,000 ÷ ($25,000 + $50,000)). Therefore, SoftIdee’s contribution to the weighted annual interest rate is .05263 × 4.5 × .6667 = .15789 or 15.789%.
Add these two contributions to arrive at the annual weighted interest rate: .12245 + .15789 = .28034, or 28.034%, rounded to 28%. Note that if you ignored the consideration that this is 2% on 98% and 5% on 95%, you would have incorrectly calculated the annual weighted interest rate at 27%, one of the alternative responses.
MFC Corporation has 100,000 shares of stock outstanding. Following is part of MFC’s Statement of Financial Position for the last fiscal year.
MFC Corporation
Statement of Financial Position - Selected Items
December 31, 2006
Cash $455,000 Accounts receivable 900,000 Inventory 650,000 Prepaid assets 45,000 Accrued liabilities 285,000 Accounts payable 550,000 Current portion, long-term notes payable 65,000
What is the maximum amount MFC can pay in cash dividends per share and maintain a minimum current ratio of 2 to 1? (Assume that all accounts other than cash remain unchanged.)
A. $2.05
B. $2.50
C. $3.35
D. $3.80
B. $2.50
To determine the maximum amount that MFC can pay in cash dividends per share and maintain a minimum current ratio of at least 2 to 1, you must set up an algebraic problem based on the current ratio formula:
Total Current Assets ÷ Total Current Liabilities = Current Ratio
We know Total Current Liabilities equals $900,000 and our desired minimum current ratio is 2.0. We also know cash dividends reduce cash, which reduces Current Assets, and have no affect on Current Liabilities. Replace these terms with these values and solve for Total Current Assets.
If Total Current Assets ÷ $900,000 = 2.0, then Total Current Assets = $1,800,000
If Total Current Assets are now $2,050,000, a maximum of $250,000 may be paid out in cash dividends to keep Total Current Assets from dropping below $1,800,000 ($2,050,000 - $1,800,000 = $250,000). $250,000 of cash dividends divided by 100,000 of stock outstanding equals $2.50 per share ($250,000 ÷ 100,000 = $2.50).
