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Flashcards in Financial Management Deck (209)
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1

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.

2

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.

3

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.

4

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.

5

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.

6

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.

7

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.

8

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.

9

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.

10

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.

11

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.

12

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.

13

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.

14

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.

15

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.

16

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.

17

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

18

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.

19

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

20

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.

21

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.·

22

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.

23

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.

24

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.

25

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.

26

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

27

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.



28

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%.

29

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.

30

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.

31

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.

32

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.

33

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).

34

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.

35

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%).

36

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).

37

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.

38

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

39

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.

40

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%

41

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).

42

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.

43

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.

44

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.

45

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

46

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.

47

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.

48

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.

49

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.

50

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.

51

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.

52

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.

53

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.

54

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.

55

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.

56

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.

57

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=(25,000*4.355+20,000*0.564)-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.

58

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( (2*10*12000)/(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.

59

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%.

60

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.

61

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%

62

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.

63

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

64

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).

65

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

66

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

67

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

68

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

69

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.

70

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.

71

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.

72

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.

73

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.

74

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%

75

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

76

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. (10*150*300*.6)+(30*150*300*.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

77

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.

78

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

79

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.

80

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.

81

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.

82

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.

83

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).

84

Which of the following characteristics represent(s) an advantage of the internal rate of return technique over the accounting rate of return technique in evaluating a project?

Recognition of the project's salvage value
Emphasis on cash flows
Recognition of the time value of money

A. I only

B. I and II

C. II and III

D. I, II, and III

C. II and III

Accounting rate of return (ARR) is simply “accounting income” from a project divided by the investment cost of the project.

Internal rate of return (IRR) considers the amount and timing of cash inflows and outflows in calculating a “true” (internal) rate of return on a project.

Concerning the characteristics:
Both ARR and IRR consider salvage value—ARR in computation of depreciation expense and IRR as a future cash flow.
The primary emphasis in IRR is cash flows. Cash flows are not addressed in ARR.
Time value of money lies at the heart of IRR analysis but is not considered in ARR.
Thus, (2) and (3) are advantages of the IRR analysis.

85

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.

In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns closest to:

A. 0.65.

B. 1.30.

C. 5.00.

D. 5.65.

C. 5.00.

The payback period serves as a fair approximation of the annuity factor value from the table of present values of an annuity.

Using the data given:
Payback = Investment / Annual saving
= $100,000 / $20,000
= 5.00

Thus, internal rate of return can be obtained as a percentage rate from an annuity table for 10 periods nearest the annuity factor of 5.00.

86

Dartmoor Company's budgeted sales for the coming year are $40,500,000, of which 80% are expected to be credit sales at terms of n/30. Dartmoor estimates that a proposed relaxation of credit standards would increase credit sales by 20% and increase the average collection period from 30 days to 40 days. Based on a 360-day year, the proposed relaxation of credit standards would result in an expected increase in the average accounts receivable balance of:

A. $540,000.

B. $2,700,000.

C. $1,620,000.

D. $945,000.

C. $1,620,000.

The firm wants to relax credit standards and increase the average collection period. Previous sales are $40,500,000 and 80% of these, or $32,400,000, are credit sales. The new policies will increase these credit sales by 20%, to $38,880,000 ($32,400,000 × 1.20).

Under the old system, the average day's credit sales were $32,400,000 ÷ 360 or $90,000. Each day's credit sales remained in accounts payable for 30 days, so the total amount in accounts payable under the old system was $90,000 × 30 days = $2,700,000.

Under the new system, average day's credit sales will be $38,880,000 ÷ 360, or $108,000. These daily sales will remain in accounts payable for 40 days, so the new accounts receivable balance will be $108,000 × 40 = $4,320,000. The expected increase in accounts receivable will be ($4,320,000 - $2,700,000) = $1,620,000.

87

Superstrut is considering replacing an old press that cost $80,000 six years ago with a new one that would cost $225,000. Shipping and installation would cost an additional $20,000. The old press has a net book value of $15,000 and could be sold for $5,000. The increased production of the new press would increase inventories by $4,000, accounts receivable by $16,000, and accounts payable by $14,000. Superstrut's net investment for analyzing the acquisition of the new press, assuming a 40% marginal tax rate, would be:

A. $242,000.

B. $250,000.

C. $245,000.

D. $236,000.

A. $242,000.

Net investment:
Cash outflows - Cash inflows = $251,000 - $9,000 = $242,000

Cash outflows:
The new press costs $225,000 and will require $20,000 to install ($225,000 + $20,000 = $245,000).

In addition, the investment in the new press will require an increase in working capital of $6,000.

Increase in inventory: $ 4,000
Increase in accounts receivable: 16,000
Increase in accounts payable: (14,000)
Increase in working capital: $ 6,000

From a cash flow perspective, an increase in inventory and accounts receivable is a reduction of cash. An increase in accounts payable is an increase in cash.

Therefore, the total cash outflow is $251,000 ($245,000 + $6,000).

Cash inflows:
The old press has a book value of $15,000. The loss on the sale is $10,000 ($15,000 book value - $5,000 cash received) and the tax savings from the loss is $4,000 (40% × $10,000). Thus, total cash inflows are $9,000 ($5,000 + $4,000).

88

Theamatics, Inc., leased 400 acres of vacant land from Farmco, Inc., on January 1. Theamatics hopes to construct a hotel-shopping center complex on the land. The lease agreement states that title to the land will pass to Theamatics at the end of the lease term. The cost of the land to Farmco was $500,000. The fair value of the land and the present value of the lease payments is $625,000. The collectibility of the lease payments is reasonably predictable, and no important uncertainties surround the amount of unreimbursable costs yet to be incurred by Farmco on the lease. What type of lease is this for Farmco?

A. Operating lease

B. Capital lease

C. Direct financing lease

D. Sales-type lease

D. Sales-type lease

If at the inception of a lease involving land only, Criterion A1 (transfer of ownership) is met and the lease gives rise to dealer's profit (loss), the lease is classified as a sales-type lease.

FASB ASC 840

89

The discount rate used when preparing a business valuation when employing an income approach is critical. Which of the following statements about discount rates is true?

A. The higher the risk, the higher the discount rate, and the lower the present value of the subject company.

B. The discount rate or cost of capital is a predetermined amount as dictated in Revenue Ruling 68-609.

C. The capital asset pricing model (CAPM) is the best and most frequently used method to develop a discount rate for a business valuation.

D. Discount rates and capitalization rates often employed when using an income approach for a business valuation are interchangeable.

A. The higher the perceived risk involved in a particular investment, the greater the return that an investor would demand on that investment; therefore, the higher the discount rate used, the lower the present value.

IRS Revenue Ruling 68-609 states, “The 8 percent rate of return and the 15 percent rate of capitalization are applied to tangibles and intangibles, respectively, of businesses with a small risk factor and stable and regular earnings; the 10 percent rate of return and 20 percent rate of capitalization are applied to businesses in which the hazards of business are relatively high.”

However, even the IRS has denounced the use of the treasury method discussed in Revenue Ruling 68-609 as well as a blanket approach to determine discount and capitalization rates.

There are a number of ways to determine the discount rate: CAPM (capital asset pricing model), build-up methods, and the weighted average cost of capital. Although CAPM is a frequently used tool in finance, it is generally not used in business valuations.

Discount and capitalization rates are not the same. A company's capitalization rate is often derived by subtracting a company's expected long-term annual growth rate from its discount rate; therefore, a growing company's capitalization rate is usually lower than its discount rate.

90

Janet Taylor Casual Wear has $75,000 in a bank account as of December 31, 2007. If the company plans on depositing $4,000 in the account at the end of each of the next three years (2008, 2009, and 2010) and all amounts in the account earn 8% per year, what will the account balance be at December 31, 2010? Ignore the effect of income taxes.

8% Interest Rate Factors
Period Future Value of $1 Future Value of an Annuity of $1
1 1.0800 1.0000
2 1.1664 2.0800
3 1.2597 3.2464
4 1.3605 4.5061

A. $87,000

B. $88,001

C. $96,070

D. $107,464

D. $107,464

The problem is set up to enable you to use both the “Future value of $1” factors and the “Future value of an annuity of $1” factors. The initial investment will earn interest for three years (December 31, 2007, until December 31, 2010) and will be factored with a “future value” factor of 1.2597. The three deposits of $4,000 are an annuity of $4,000 for three years. This annuity will use a “future value of an annuity” factor of 3.2464.


Initial Deposit: $75,000 x 1.2597 = $ 94,478
Annuity of $4,000 for 3 years at 8%: $ 4,000 x 3.2464 = $ 12,986
Total account balance at 12/31/10 $107,464

91

An investment in a new product will require an initial outlay of $20,000. The cash inflow from the project will be $4,000 a year for the next six years. The payment will be received at the end of each year. What is the net present value of the investment at 8% using the correct factor from below?
Present value of $1 to be received after 6 periods 0.63017
Present value of an ordinary annuity of $1 per
period for 6 periods 4.62288
Present value of an ordinary annuity due of $1 per
period for 6 periods 4.99271
Future value of $1 at the end of 6 periods 1.58687

A. $(4,875.92)

B. $(1,508.48)

C. $(29.16)

D. $18,084.88

B. $(1,508.48)=20,000-(4000*4.62288)

The net present value is the excess of the discounted present value of future cash returns above the investment cost. An ordinary annuity assumes payments at the end of each year, while an annuity due assumes payments at the beginning of each year. The present value of an ordinary annuity factor of 4.62288 is used because the payments will be received at the end of each period.

The present value of the future cash returns is the annual cash flow of $4,000 multiplied by the present value of an annuity of $1 a year for six years at 8%, or 4.62288. Thus, the present value of the future cash flows is $18,491.52.

The cost of the machine is $20,000, so the net present value is $18,492 less $20,000, or a negative net present value of $1,508.48.

92

The purpose of the TDRA (top-down risk assessment) is for the company to analyze the internal controls currently in place and to assess the effectiveness of those controls so as to avoid material misstatement in the company's financial reporting. As part of that assessment process, which of the following items would be done?

A. The TDRA will focus on the identification and analysis of pertinent risks related to the achievement of the company's objectives. The starting point for this assessment will be the lowest-level control, such as a process-level control (separation of duties and steps involved in a single task, such as issuing a credit for returned merchandise).

B. As a starting point of the TDRA, management must conclude whether the danger of an internal control failure is high, medium, or low. After that decision is made, the focus then shifts to the areas suspected of being vulnerable.

C. The focus of the TDRA assessment of internal controls is to ferret out all possible areas of error within the financial reporting process.

D. As part of the TDRA, management will develop a list related to a particular account that would have a reasonable likelihood of material misstatement, focusing on problems that have been encountered in the past and the solutions that were developed to avoid such errors in the future.

D. As part of the TDRA, management will develop a list related to a particular account that would have a reasonable likelihood of material misstatement, focusing on problems that have been encountered in the past and the solutions that were developed to avoid such errors in the future.

The purpose of the TDRA is for the company to analyze the internal controls currently in place and to assess the effectiveness of those controls to avoid material misstatement in the firm's financial reporting.

The focus of the assessment of internal controls will deal with significant (material) accounts.
The TDRA will focus on the identification and analysis of pertinent risks related to the achievement of the company's objectives. The higher levels are examined first in the assessment process.
Based upon the identification and analysis of risks and the associated internal control to mitigate those risks, management needs to conclude whether the danger of an internal control failure is low, medium, or high. This step is taken after the internal controls in place have been assessed.

93

A preferred stock is sold for $101 per share, has a face value of $100 per share, underwriting fees of $5 per share, and annual dividends of $10 per share. If the tax rate is 40%, the cost of funds (capital) for the preferred stock is:

A. 6.2%.

B. 10.0%.

C. 10.4%.

D. 5.2%.

C. 10.4%. The cost of the preferred stock to the firm will be 10.4%.

The cost to the firm of selling preferred stock is equal to the annual dividend the firm must pay, divided by the net funds received when the stock was sold. Since preferred dividends are not tax deductible, there is no tax adjustment for the cost of preferred stock as there is for debt. The formula for calculating the cost of preferred stock to the firm is as follows:
ks = D1 / (PO - u - f)
Where:
D1 = Annual preferred dividends
PO = Current market price of the stock
u = Underpricing per share, if any
f = Flotation costs paid the investment banker
Here, ks = 10 / (101 - 0 - 5) = 10 / 96 = 0.104, or 10.4%.

94

Which of the following is correct regarding the consumer price index (CPI) for measuring the estimated decrease in a company's buying power?

A. The CPI is measured only once every 10 years.

B. The products a company buys differ from those a consumer buys and therefore the CPI is not the appropriate index for estimating the decrease in a company's purchasing power.

C. The CPI measures what consumers will pay for items.

D. The CPI is skewed by foreign currency translations.

B. The products a company buys differ from those a consumer buys and therefore the CPI is not the appropriate index for estimating the decrease in a company's purchasing power.

The CPI is determined on a monthly basis by the prices of a particular market basket of goods purchased by consumers and does not include prices of goods purchased specifically by companies. The producer price index measures the average change over time in the selling prices received by domestic producers for their output and that purchasers pay for their inputs and thus is the appropriate index for measuring the decrease in a company's purchasing power.

95

In year 1, a large domestic manufacturer produces all of its motors domestically and sells them internationally. The company's management team is in the process of developing its year 2 budget, and copper costs represent a significant line item in the budget. In year 1, the company spent $1,000,000 in purchasing 250,000 pounds of copper. Economic data indicate that in year 1 copper costs had a price index of 120.0, and expectations are that the index will increase to 126.0 in year 2. Management anticipates a 5% increase in copper usage for year 2. What amount represents the year 2 budget for copper purchases?

A. $1,000,000

B. $1,050,000

C. $1,102,500

D. $1,300,000

C. $1,102,500

Copper purchases in year 2 will increase due to two factors: inflation in the cost of copper, and an increase in the actual usage of copper (i.e., quantity needed).

To adjust for changes in price, the following formula is used: Cost in year 1 × Change in price index:

$1,000,000 × (126 ÷ 120) = $1,050,000
The second step is to adjust for increased demand:

$1,050,000 × 1.05 = $1,102,500

96

By using the dividend growth model, estimate the cost of equity capital for a firm with a stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10%.

A. 21.1%

B. 12.2%

C. 10.0%

D. 20.0%

D. 20.0%

The Dividend Growth Model is a way to value stocks by valuing the dividend cash flow. The value per share is calculated by dividing the annual dividends per share by the difference between the required rate of return and the dividend growth rate.

The formula is:
Value per Share = Annual Dividends per Share/ (Required Rate of Return - Dividend Growth Rate)
If we are calculating the cost of equity capital then we solve for the rate of return required by the investor.

Therefore:
Required Rate of Return =
(Annual Dividends per Share/Dividend Growth Rate) +Value per Share
or the cost of equity capital = (3.00 ÷ 30.00) + .10 = 20%.

97

A company invests $100,000 in property. The company has a contract to sell it for $120,000 in one year. The bank has a guaranteed interest rate of 10%. Information on present and future value factors is as follows:

Present value of $1 at 10% at the end of one period: 0.90909
Future value of $1 at 10% at the end of one period: 1.10000
What is the net present value of the company's investment in the property?

A. $9,091

B. $10,000

C. $109,091

D. $110,000

A. $9,091

The net present value (NPV) method adjusts for the time value of money. It determines whether the present value of the estimated net future cash inflows at a desired (or required) rate of return will be greater or less than the cost of the proposed investment. The present value (PV) of the net cash inflows is calculated and compared to the initial investment. An investment proposal is desirable if its NPV is positive. The PV factor for a single sum for one period at 10% is .90909.

PV = $120,000 × .90909 (rounded) = $109,091
Cash outflow (cost) = (100,000)
Net present value = $ 9,091

98

Morton Company needs to pay a supplier's invoice of $50,000 and wants to take a cash discount of 2/10, net 40. The firm can borrow the money for 30 days at 12% per annum plus a 10% compensating balance.

Assuming Morton Company borrows the money on the last day of the discount period and repays it 30 days later, the effective interest rate on the loan is:

A. 13.61%.

B. 13.33%.

C. 13.20%.

D. 13.48%.

B. 13.33%.

Morton Co. must borrow $54,444 ($49,000 plus compensating balance of 10% of loan).

To calculate: $49,000(0.98*50,000) represents 90% of the loan. $49,000 ÷ .9 = $54,444. Algebraically, if X = amount of loan, then .9x = $49,000, and X = $54,444.

Breakdown of loan proceeds:
Cash needed for payment to vendor $49,000 90%
Compensating balance 5,444 10%
Total loan $54,444 100%

Interest at 12% per annum on this amount for 30 days, totals:
0.12 × (30 ÷ 360) × $54,444 = $544.44
The effective yield is then (annualized):

$544.44 ÷ $49,000 × 12 months = 0.1333, or 13.33%
The invoice total less the cash discount ($50,000 - 2%) is $49,000. This amount is used in this calculation because that is the amount required to pay the supplier's invoice and usable by the company.

99

Morton Company needs to pay a supplier's invoice of $50,000 and wants to take a cash discount of 2/10, net 40. The firm can borrow the money for 30 days at 12% per annum plus a 10% compensating balance.

The amount Morton Company must borrow to pay the supplier within the discount period and cover the compensating balance is:

A. $55,000.

B. $55,056.

C. $55,556.

D. $54,444.

D. $54,444.

The total amount of the loan must be the amount due the supplier less the 2% discount plus the compensating balance of 10% of the total loan, or:

$50,000(1.00 - 0.02) + 0.10(Loan) = Loan
$49,000 + 0.10X = X
$49,000 = X - 0.10X
$49,000 = 0.90X
$54,444 = X

100

What type of covenant requires a corporation to maintain, at all times, some minimum level of working capital?

A. Poison put clause

B. Cross-default clause

C. Affirmative covenant

D. Negative pledge clause

C. Affirmative covenant肯定条款

An affirmative covenant is a covenant that requires a corporation to maintain, at all times, some minimum level of working capital.

101

The following selected data pertain to a 4-year project being considered by Metro Industries:

A depreciable asset that costs $1,200,000 will be acquired on January 1, 20X1. The asset, which is expected to have a $200,000 salvage value at the end of four years, qualifies as 3-year property under the modified accelerated cost recovery system (MACRS).
The new asset will replace an existing asset that has a tax basis of $150,000 and can be sold January 1, 20X1, for $180,000.
The project is expected to provide added annual sales of 30,000 units at $20 each. Additional cash operating costs are variable, $12 per unit; fixed, $90,000 per year.
A $50,000 working capital investment that is fully recoverable at the end of the fourth year is required.
Metro is subject to a 40% income tax rate and rounds all computations to the nearest dollar. Assume that any gain or loss affects the taxes paid at the end of the year in which it occurred. The company uses the net present value method to analyze investments and will employ the following factors and rates.

Present Value Present Value of MACRS
Period of $1 at 12% $1 Annuity at 12% rate
1 0.8929 0.8929 .33
2 0.7972 1.6901 .45
3 0.7118 2.4018 .15
4 0.6355 3.0373 .07

The discounted cash flow for 20X4 MACRS depreciation on the new asset is:

A. $17,920.

B. $21,353.

C. $26,880.

D. $32,256.

B. $21,353.

Discounted cash flow for 2014 MACRS Depreciation=
Cost of new assets *MACRS rate for period 4* INT TAX RATE* PV Factor for Period 4 at 12%
= $1,200,000 x .07 x .40 x .6355
= $21,353

102

The amount of inventory that a company would tend to hold in stock would increase as the:

A. sales level falls to a permanently lower level.

B. cost of carrying inventory decreases.

C. cost of running out of stock decreases.

D. length of time that goods are in transit decreases.

B. cost of carrying inventory decreases.

The EOQ model formula attempts to minimize costs when faced with the trade-off between the cost to procure and the cost to hold inventory. The formula is the square root of the quotient of two times the annual demand multiplied by the order cost (or setup cost), divided by the annual unit carrying cost.

EOQ = Square root of 2DS/Ci
Where:

D = Demand per year in units
S = Setup or ordering cost per order
C = Cost per unit
i = Carrying cost, expressed as a percentage of inventory cost
(C × i is the carrying cost per unit.)
For this formula, if carrying costs are decreased, then the EOQ will increase. As the EOQ increases, the amount of inventory that a company would tend to hold also increases.

103

Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?

A. Accounting rate of return

B. Payback period

C. Internal rate of return

D. Cost-benefit ratio

C. Internal rate of return

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 to be zero.

Neither the accounting rate of return nor the payback methods consider the time value of money, and the cost-benefit ratio is not a capital budgeting tool.

104

Ralph was thinking about how to approach developing his investment philosophy. He thought about something he had learned in an investments class he had taken at the local university. He recalled a discussion about something called the efficient market hypothesis and remembered that at the time he really was taken by the idea that “you can't beat the market” in the long run. He wanted to incorporate that concept in his philosophy when he talked to his investment manager. This idea suggests that Ralph believes in the ________ form of the efficient market hypothesis.

A. semi-strong

B. weak

C. behavioral

D. strong

D. strong

The efficient market hypothesis relates to the degree to which past or current information is incorporated in and/or influences the current market prices of securities. The strong form of the hypothesis states that all available information is incorporated in the current market prices of securities, and thus the investor cannot find undervalued securities and would be unable to make choices that would allow him or her to outperform the market index in the long run.

The semi-strong form of the hypothesis assumes that all readily available information is incorporated into current market prices of securities and that fundamental analysis would be unlikely to identify inaccurately valued securities. The weak form of the hypothesis assumes that current market prices reflect all past prices and information, and therefore this information cannot be used for predictive purposes.

105

The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate of 14%. The corporate tax rate is 30%. What is the firm's net cost of debt?

A.
8.4%

B.
9.8%

C.
12.0%

D.
14.0%

B.
9.8%

The cost of debt is the expected interest cost on new debt minus the marginal tax rate due to the fact that interest payments are tax deductible.

The interest cost of the bonds is 14%. Use the effective rate rather than the standard rate; it is adjusted for compounding the interest more than annually.

The tax savings equals 30% of 14%, or 4.2% (.30 × .14).

Subtracting the tax savings from the interest cost yields the true cost of the debt:

14% - 4.2% = 9.8%

106

A firm's dividend policy may treat dividends either as the residual part of a financing decision or as an active policy strategy.

Treating dividends as the residual part of a financing decision assumes that:

A.
earnings should be retained and reinvested as long as profitable projects are available.

B.
dividends are important to shareholders, and any earnings left over after paying dividends should be invested in high-return assets.

C.
dividends are relevant to a financing decision.

D.
dividends are costly, and the firm should retain earnings and issue stock dividends.

A.
earnings should be retained and reinvested as long as profitable projects are available.

Treating dividends as the residual part of a financing decision assumes that earnings should be retained and reinvested as long as profitable projects are available.

Dividends do not need to be a focus of company strategy, since in a world with taxes, dividends can be problematic for both the company (dividends are not tax deductible) and the stockholder (dividends are taxable).

In addition, the transaction and other costs of financing by selling additional stock (as discussed by Rozeff) lead a company to prefer using internal funds (i.e., retained earnings) for expansion.

Masulis and Trueman suggest that firms will use internal funds to finance all investments that have high returns—younger firms will invest more and older firms will pay more dividends since profitable investment opportunities for older firms will be smaller relative to funds available.

107

A company with a combined federal and state tax rate of 30% has the following capital structure:
Weight Instrument Cost of Capital
40% Bonds 10%
50% Common stock 10%
10% Preferred stock 20%
What is the weighted-average after-tax cost of capital for this company?

A.
3.3%

B.
7.7%

C.
8.2%

D.
9.8%

D. 9.8%

The weighted average cost of capital is the weighted average of the debt and equity used to finance the assets of the company. This weighted average can be based upon either the current capital structure of the organization or on a particular target structure desired by management, both using market values of the various components.

The cost of debt is the before-tax rate. Since interest expense is a tax-deductible item, thus providing a depreciation shield, an after-tax cost must first be determined:

After-tax cost of debt = kd × (1 - T)
After-tax cost of debt = .10 × (1 - 0.30) = 0.07 (7%)
(kd = Pretax cost of debt; T = Tax rate)

Now the weighted average of the cost of capital can be calculated:
Capital Item Weight Cost Weighting Factor
Debt 40% 7% 2.8%
Preferred Stock 10% 20% 2.0%
Common Stock 50% 10% 5.0%
100% WACC 9.8%

108

The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?

A.
The decline in the value of the investment should be reflected in the determination of net present value.

B.
Depreciation adjusts the book value of the investment.

C.
Depreciation represents cash outflow that must be added back to net income.

D.
Depreciation increases cash flow by reducing income taxes.

D.
Depreciation increases cash flow by reducing income ta

Depreciation is the systematic expensing of a prior cash outflow. It is not a cash flow in a current period; however, it does reduce the amount of taxes that are paid in a particular period since it is a deductible expense. Since taxes are a cash outflow, any deductible expense reduces the amount of taxes that must be paid, thus increasing cash flow for that period.

109

An organization has four investment proposals with the following costs and expected cash inflows:
Expected Cash Inflows
Project Cost End of Year 1 End of Year 2 End Year 3
A unknown $10,000 $10,000 $10,000
B $20,000 $ 5,000 $10,000 $15,000
C $25,000 $15,000 $10,000 $ 5,000
D $30,000 $20,000 unknown $20,000

Additional Information:
Present Value of
Number Present Value of an Annuity of $1
of $1 due at the end per period for n
Discount Rate Periods of n periods (PVIF) periods (PVIFA)
5% 1 0.9524 0.9524
5% 2 0.9070 1.8594
5% 3 0.8638 2.7232

10% 1 0.9091 0.9091
10% 2 0.8264 1.7355
10% 3 0.7513 2.4869

15% 1 0.8696 0.8696
15% 2 0.7561 1.6257
15% 3 0.6575 2.2832

If the discount rate is 5% and the discounted payback period of project D is exactly two years, then the year two cash inflow for project D is:

A. $5,890.

B. $10,000.

C. $12,075.

D. $14,301.

C.
$12,075.

The discounted payback period is the length of time required for discounted cash flows to recover the cost of the investment. The year two cash inflow for project D which is consistent with a discounted payback period of two years can be calculated as follows:

Investment cost = Present value of Year 1 and 2 cash inflows
$30,000 = ($20,000 × PVIF(5%, 1)) + (Year 2 cash inflow × PVIF(5%, 2))
$30,000 = ($20,000 × .9524) + (Year 2 cash inflow × .9070)

Year 2 cash inflow = ($30,000 - ($20,000 × .9524)) ÷ .9070 = $12,074.97

110

Which of the following is correct?

A.
Short-term credit can be obtained more quickly than long-term credit, but long-term credit is more flexible.

B.
Short-term credit is generally less costly than long-term credit due to the prepayment penalties associated with long-term credit.

C.
The shape of the yield curve implies that interest costs will generally be higher using long-term credit than short-term credit.

D.
Short-term credit can generally be obtained quicker than long-term credit; however, short-term credit holds more risk due to the need to renew more often.

D.
Short-term credit can generally be obtained quicker than long-term credit; however, short-term credit holds more risk due to the need to renew more often.

Short-term credit can generally be obtained quicker than long-term credit.
Generally short-term credit is more flexible than long-term credit.
Short-term credit is generally less costly than long-term credit as shown by the yield curve.
Prepayment penalties are generally associated with long-term credit, but these penalties are not the basic reasons for a higher cost for long-term credit.
Short-term credit holds more risk than long-term credit due to the need to renew more often.

111

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 cost of funds from retained earnings for Williams, Inc., is:

A. 7.0%.

B. 7.6%.

C. 7.4%.

D. 7.8%.

A. 7.0%. The cost of retained earnings is 7.0%.

The cost of retained earnings, using the Gordon Model, ignores flotation costs and underpricing, since the firm does not need to issue new stock. However, it must earn a return for the owners of the retained earnings, that is, the existing shareholders, as follows:

krm = (D1 / PO) + g, or krm = 7 / 100 + 0% = 7.0%

Where:
krm = Cost, in percentage, of using existing equity in the form of retained earnings
D1 = Estimated dividend that will be paid next year
PO = Current market price of the stock
g = Estimated annual growth rate in dividends, in percentage

112

A company issues 10-year bonds with a face value of $1 million, dated January 1, 20X1, and bearing interest at an annual rate of 12% payable semi-annually on January 1 and July 1. The market rate of interest on bonds of similar risk and maturity, with the same schedule of interest payments, is also 12%. If the bonds are issued on February 1, 20X1, the amount the issuing company receives from the buyers of the bonds on that date is:

A.
$990,000.

B.
$1,000,000.

C.
$1,010,000.

D.
$1,020,000.

C. $1,010,000.

The amount the issuing company receives on February 1, 20X1, is the face value of the issue plus one month of accrued interest:

$1,000,000 + ($1,000,000 × 0.12 × 1/12) = $1,010,000

The buyers of the bond must pay the seller the interest accrued from the last interest payment date to the date of issue in advance. In effect, they are paying for the portion of the first full 6-month interest payment that they are not entitled to because they did not hold the bonds for the full 6-month period.

113

A company enters into an agreement with a firm which will factor the company's accounts receivable. The factor agrees to buy the company's receivables, which average $100,000 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 an annual rate of 10% and charge a fee of 2% on all receivables purchased. The controller of the company estimates that the company would save $18,000 in collection expenses over the year. Fees and interest are not deducted in advance. Assuming a 360-day year, what is the annual cost of financing?

A.
10.0%

B.
12.0%

C.
16.0%

D.
17.5%

D. 17.5%

A factor buys a company's accounts receivables, assumes the risk of collection and the company gets its money immediately. In this problem, the standard factoring solution is complicated by the fact the fees and interest are not deducted in advance, changing the amount of interest.

Amount of receivables to be factored $100,000
Less: 20% factoring reserve (1.00 - .80) (20,000)
Amount loaned to company $ 80,000

2% factoring fee (assessed on entire $100,000) $2000
10% interest for 30 days (assessed on the entire $80,000) 667
Total fees assessed on $80,000 loan $2,667

These fees are offset by the savings in collection expenses. This amount is $1,500 for one month ($18,000 divided by 12). The net cost per month is $1,167 ($2,667 - 1,500). The monthly interest rate is 1.46% ($1,167 divided by $80,000). This represents an annual rate of 17.5% (1.46% × 12).

114

All of the following are inventory carrying costs except:

A.
storage.

B.
insurance.

C.
opportunity cost of inventory investment.

D.
inspections.

D. inspections.

Inventory carrying costs are those costs incurred as a result of holding inventory for a period of time. All of the following are considered carrying costs:

Storage
Insurance
Opportunity cost of inventory investment (i.e., the lost return that could have been earned by investing the cash used to purchase the inventory in some other way)
The cost of inspections is not a function of the holding of inventory.

115

Which of the following events would decrease the internal rate of return of a proposed asset purchase?

A. Decrease tax credits on the asset

B. Decrease related working capital requirements

C. Shorten the payback period

D. Use accelerated instead of straight-line depreciation

A. Decrease tax credits on the asset

Two general rules can be developed related to the internal rate of return (IRR) of a proposed asset purchase:

Increases in cash inflows (decreases in cash outflows) will result in a higher internal rate of return.
The earlier the cash inflows (the later the cash outflows) the higher the internal rate of return, all else being equal.
Taxes in general will lower the IRR of a proposed asset purchase, as will decreases in the tax credits available when an asset is purchased

116

Joe CPA has just accepted a business valuation engagement for The Charter Company, a small business. Some of the facts related to this company are as follows:

The company has been in existence for 25 years.
For the last 3 years, the company has shown little, if any, profit.
The owner has recently had some difficulty making expected loan principal repayments.
The owner met with a credit counselor last month and is in the process of making some recommended changes.
As a beginning step in the valuation process, Joe has determined the premise of value to be:

A. liquidation.

B. bankruptcy.

C. reorganization.

D. a going concern.

D. a going concern.

As defined in the International Glossary of Business Valuation Terms, the premise of value is defined as “an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation.”

The premise of value will be one of two situations: a going concern or liquidation. Although The Charter Company has displayed poor performance in the past few years, the business does not appear to be in liquidation at this time. Companies can falter, regroup, and continue. It appears that The Charter Company is currently in the process of regrouping, as demonstrated by the owner's attempts to obtain and implement expert advice; therefore, this business valuation should use a “going concern” as the premise of value.

117

The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.
Martin Corporation can now issue debt at 150 basis points over U.S. Treasury bonds.
The current risk-free rate (U.S. Treasury bonds) is 7%.
Martin's common stock is currently selling at $32 per share.
The expected market return is currently 15%.
The beta value for Martin is 1.25.
Martin's effective corporate income tax rate is 40%.
Martin Corporation's current net cost of debt for issuing new debt is:

A.
5.5%.

B.
7.0%.

C.
5.1%.

D.
8.5%.

C. 5.1%.

The problem provides the information that Martin Corporation can now issue debt at 150 basis points over U.S. Treasury bonds and that U.S. Treasury bonds have a current rate of 7%. This means Martin Corporation can now issue debt at 8.5%= 7.0% plus 1.50% (150 basis points). Because interest is tax deductible, the cost of debt is less than the interest rate and equals the interest rate times 1 minus the tax rate. Cost of debt = 8.5% × (1 - .40) = 5.1%.

118

When evaluating capital budgeting analysis techniques, the payback period emphasizes:

A. liquidity.

B. profitability.

C. cost of capital.

D. net income.

A. liquidity.

Payback period is the length of time in years required to recover the cash invested in a project. Payback is computed as net investment divided by average expected annual cash inflow.

Payback focuses on rapid recovery of cash investment (i.e., liquidity).

119

Why would a firm generally choose to finance temporary assets with short-term debt?

A.
Matching the maturities of assets and liabilities reduces risk.

B.
Short-term interest rates have traditionally been more stable than long-term interest rates.

C.
A firm that borrows heavily long term is more apt to be unable to repay the debt than a firm that borrows heavily short term.

D.
Financing requirements remain constant.

A. Matching the maturities of assets and liabilities reduces risk.

Temporary assets are often represented by temporary working capital—that is, the working capital that supports the company's operations above a minimal level and does not need to be maintained throughout the annual business cycle. The maturity matching concept states that the maturity date of the financing for an asset or project should match the maturity of the related asset. This means that the loan will be repaid at approximately the same time that cash becomes available at the end of a project or sale (or collection) of the asset. This situation is considered to be self-liquidating since the funds that become available at the end of the temporary period will be used to repay the short-term loan. The risk is considered to be lower for such a loan since the funds that will be used to repay the short-term loan are definite (reduction in working capital) as opposed to being dependent upon the general profitability of the organization.

120

The CFO of a company is concerned about the company's accounts receivable turnover ratio. The company currently offers customers terms of 3/10, net 30. Which of the following strategies would most likely improve the company's accounts receivable turnover ratio?

A.
Pledging the accounts receivable to a finance company

B.
Changing customer terms to 1/10, net 30

C.
Entering into a factoring agreement with a finance company

D.
Changing customer terms to 3/20, net 30

C. Entering into a factoring agreement with a finance company

The accounts receivable turnover ratio measures how quickly these receivables are collected. The quicker that they are collected, the less financing that is needed to support receivables. One method of speeding up the collection process is to offer discounts for quick payment, such as 3/10. (The customer can take a 3% discount if the invoice is paid within 10 days.) By reducing the discount to 1/10 or 3/20, the customers are less likely to pay quickly, resulting in a deterioration of the accounts receivable turnover ratio.

Pledging is using the accounts receivable balance to secure a loan. This would have no effect on the accounts receivable turnover ratio.

Factoring is a situation where a company sells its accounts receivable at a discount, thus resulting in an immediate receipt of cash related to the receivables sold. This situation would likely improve the company's accounts receivable turnover.

121

A firm with a higher degree of operating leverage when compared to the industry average implies that the:

A.
firm has higher variable costs.

B.
firm's profits are more sensitive to changes in sales volume.

C.
firm is more profitable.

D.
firm uses a significant amount of debt financing.

B. firm's profits are more sensitive to changes in sales volume.

Operating leverage is the impact on operating income resulting from a change in sales. The change in operating income is affected by the relative amounts of fixed and variable costs within total costs. The higher the fixed costs in relation to variable costs (due to such things as large investments in automation, etc.), the greater the impact on operating income from a change in sales. The degree of operating leverage is calculated from the ratio of the operating income change divided by the change in sales. A high degree of operating leverage indicates a firm's profits will be more sensitive to changes in sales.

122

The Alda Company plans to issue bonds with a maturity value of $1,000,000 and a stated rate of interest of 10%. What could be said about the issuance if the effective rate of interest (also known as the yield to maturity) is 9%?

A. The bond is issued at a discount.

B. The bond is issued at par.

C. The bond is issued at a premium.

D. The stated rate is changed to 9%.

C. The bond is issued at a premium.

If the Alda Company issues bonds with a maturity value of $1,000,000, a stated rate of interest of 10%, and an effective rate of interest (also known as the yield to maturity) of 9%, then the bonds are not issued at a discount. Bonds are issued at par when both rates are equal and at a premium when the stated rate of interest is more than the effective rate.

123

A company invested in a new machine that will generate revenues of $35,000 annually for 7 years. The company will have annual operating expenses of $7,000 on the new machine. Depreciation expense, included in the operating expenses, is $4,000 per year. The expected payback period for the new machine is 5.2 years. What amount did the company pay for the new machine?

A.
$145,600

B.
$161,200

C.
$166,400

D.
$182,000

C. $166,400=(5.2*(35000-(7000-4000)))

The payback period is the length of time required to recover the initial cash investment with net cash flows. In this case, the operating expenses of $7,000 include depreciation of $4,000, so the cash operating expenses are $3,000 per year. Subtracting $3,000 of annual cash operating expenses from the $35,000 annual revenue gives a net cash inflow of $32,000 per year.

Since the investment will be recovered in 5.2 years, we multiply the 5.2 years by the annual net cash inflow of $32,000 to find the cost of the investment must be $166,400.

124

XYZ Lawn Care Services provides a variety of lawn care supplies such as seed and fertilizer. In addition, the firm provides lawn care services on a customer requested basis. Sales and services vary greatly by season and are affected by changes in weather conditions.

The financing method that would likely result in meeting XYZ's cash needs at the lowest cost is:

A. factoring accounts receivable.

B. line of credit.

C. long-term borrowing.

D. using credit card debt.

B.
line of credit.

XYZ should use the line of credit form of financing because of its flexibility and having interest charged only for funds actually being used. None of the other methods of financing listed provides this degree of flexibility.

125

Which of the following factors would likely cause a firm to increase its use of debt financing as measured by the debt-to-total-capitalization ratio?

A.
An increase in the degree of operating leverage

B.
An increase in the price/earnings ratio

C.
An increase in the corporate income tax rate

D.
A decrease in times interest earned

C. An increase in the corporate income tax rate

Firms respond to an increase in corporate income tax rates by increasing their explicit costs (i.e., those which are tax deductible). Therefore, debt financing which requires specific (tax deductible) interest payments would be preferred to equity (dividends are not tax deductible) financing when tax rates rise.

Increased operating leverage and a decreased times interest earned ratio would increase the risk to the firm's investors; thus, the cost to the firm of borrowed funds would also increase, discouraging further debt financing.

126

Maxgo Company is considering replacing its current computer system. The new system would cost Maxgo $60,000 to have it installed and operational. It would have an expected useful life of four years and an estimated salvage value of $12,000. The system would be depreciated on a straight-line basis for financial statement reporting purposes and use the modified accelerated cost recovery system (MACRS) depreciation method for income tax reporting purposes. Assume that the percentages of depreciation for MACRS are 25%, 40%, 20%, and 15% for the 4-year life of the new computer.

Maxgo's current computer system has been fully depreciated for both financial statement and income tax reporting purposes. It could be used for four more years, but not as effectively as the new computer system. The old system currently has an estimated salvage value of $8,000 and will have an estimated salvage value of $1,000 in four years. It is estimated that the new system will save $15,000 per year in operating costs. Also, because of features of the new software, working capital could immediately be reduced by $3,000 if the new system is purchased. Maxgo expects to have an effective income tax rate of 30% for the next four years.

Assume that Maxgo Company purchases the new system. How would the capital budgeting decision differ if the company chooses to use straight-line depreciation for both financial statement and income tax reporting purposes?

A. The net present value of the new system would be lower, and the investment would be judged less desirable.

B. This should have no effect on the decision because depreciation is a noncash expense.

C. The net present value of the new system would be higher, and the investment would be judged more desirable.

D. The effect could be either positive or negative, but there is not enough information given to make an informed decision.

A. The net present value of the new system would be lower, and the investment would be judged less desirable.

The use of MACRS depreciation would result in a greater deduction in Year 2 (40% MACRS versus 25% straight line). This will result in tax dollars saved in the early life of the project. The use of straight line (SL) would, of course, not provide this saving until the third and fourth years. The result would be:

a slightly lower net cash flow from the use of SL in year 2.
lower net present value using SL.
less desirable investment.

127

Short-term interest rates are:

A. generally lower than long-term rates.

B. generally higher than long-term rates.

C. lower than long-term rates during periods of high inflation only.

D. not significantly related to long-term rates.

A. generally lower than long-term rates.

Short-term interest rates are usually lower than long-term rates, because there is less risk involved in a shorter time period, and lenders require less compensation since their money is tied up for a shorter time. Short-term rates are definitely related to long-term rates, but tend to be more volatile, in part due to the exercise of monetary policy actions by the Federal Reserve.

128

The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What percentage represents the firm's cost of common equity?

A. 12.0%

B. 8.4%

C. 7.0%

D. 5.0%

A. 12.0%

The dividend growth model estimates the cost of common equity. The formula used is:

Cost of common equity = (Dividend ÷ Price) + Growth percentage
Cost of common equity = ($4.25 ÷ $85) + 7% = 5% + 7% = 12%

Since dividends paid on common stock are not deductible by the corporation for tax purposes, the cost does not include any tax effect.

129

When the economic order quantity (EOQ) model is used for a firm which manufactures its inventory, ordering costs consist primarily of:

A. insurance and taxes.

B. obsolescence and deterioration.

C. storage and handling.

D. production setup.

D. production setup.

The EOQ model formula attempts to minimize costs when faced with the trade-off between the cost to procure and the cost to hold inventory. The formula is the square root of the quotient of two times the annual demand multiplied by the order cost (or setup cost), divided by the annual unit carrying cost.

EOQ = Square root of (2DS/Ci)
Where:
D = Demand per year in units
S = Production setup or ordering cost per order
C = Cost per unit
i = Carrying cost, expressed as a percentage of inventory cost
(C × i is the carrying cost per unit.)
Costs to procure inventory are ordering cost for a reseller and production setup costs for a manufacturer.

130

Yarrow Co. is considering the purchase of a new machine that costs $450,000. The new machine will generate net cash flow of $150,000 per year and net income of $100,000 per year for 5 years. Yarrow's desired rate of return is 6%. The present value factor for a 5-year annuity of $1, discounted at 6%, is 4.212. The present value factor of $1, at compound interest of 6% due in 5 years, is 0.7473. What is the new machine's net present value?

A.
$450,000

B.
$373,650

C.
$181,800

D.
$110,475

C. $181,800

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 $150,000 multiplied by the present value of an annuity of $1 a year for five years at 6%, which is 4.212.

Thus, the present value of the future cash flows is $631,800 ($150,000 × 4.212). The cost of the machine is $450,000, so the net present value is:

$631,800 - $450,000 = $181,800.

131

The following information pertains to Bala Co. for the year ended December 31, Year 1:

Sales $600,000
Net income 100,000
Capital investment 400,000

Which of the following equations should be used to compute Bala’s return on investment?

A. (4 / 6) × (6 / 1) = ROI

B. (6 / 4) × (1 / 6) = ROI

C. (4 / 6) × (1 / 6) = ROI

D. (6 / 4) × (6 / 1) = ROI

B. (6 / 4) × (1 / 6) = ROI =1/4=25%

Return on investment (ROI) is net income ($100,000) divided by investment ($400,000), or 25%.

(6 / 4) × (1 / 6) = ROI is correct because it simplifies to 1/4, which equals 25%.
(4 / 6) × (6 / 1) = ROI is incorrect because it simplifies to 4/1, which is 400% rather than 25%.
(4 / 6) × (1 / 6) = ROI is incorrect because it simplifies to 4/36, which is 11.1% rather than 25%.
(6 / 4) × (6 / 1) = ROI is incorrect because it simplifies to 36/4, which is 900% rather than 25%.

132

A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?

A. Less than the company's weighted average cost of capital

B. Less than the project's internal rate of return

C. Greater than the company's weighted average cost of capital

D. Greater than the project's internal rate of return

B. Less than the project's internal rate of return

The net present value of an investment is calculated by subtracting the initial investment from the present value of the future cash flows. A positive net present value means that the investment should be made, because the cash to be received (taking into account the time value of money) is greater than the initial investment.

By definition, an acceptable investment would also have an internal rate of return that is greater than the required rate of return—or, as the question states it, the required rate of return would be less than the project's internal rate of return. Weighted average cost of capital has no bearing on this problem.

133

A project has an initial investment of $100,000 and a project profitability index of 1.15. The firm's cost of capital is 12%. The net present value of the project is:

A.
$15,000.

B.
$115,000.

C.
$112,000.

D.
$12,000.

A.
$15,000

Project profitability index = Present value of future inflows / Initial investment
1.15 = Present value of future inflows / $100,000
$100,000 x 1.15 = Present value of future inflows
$115,000 = Present value of future inflows

Net present value:
= Present value of future inflows - Initial investment
= $115,000 - $100,000
= $15,000

134

Whatney Co. is considering the acquisition of a new, more efficient press. The cost of the press is $360,000, and the press has an estimated 6-year life with zero salvage value. Whatney uses straight-line depreciation for both financial reporting and income tax reporting purposes and has a 40% corporate income tax rate. In evaluating equipment acquisitions of this type, Whatney uses a goal of a 4-year payback period. To meet Whatney's desired payback period, the press must produce a minimum annual before-tax, operating cash savings of:

A. $90,000.

B. $110,000.

C. $114,000.

D. $150,000.

B. $110,000.

Payback period is the number years required to repay the initial investment in a capital project. A $360,000 capital investment would need an after-tax cash flow of $90,000 to meet the goal of a 4-year payback. The key to solving this problem involves remembering to consider the cash savings resulting from decreased taxes due to the depreciation expense. Note that the problem asks for the operating cash savings.

In this problem, operating cash savings would be total cash savings less nonoperating cash savings (e.g., cash savings from lower taxes). Annual depreciation on a $360,000 asset with an estimated 6-year life with zero salvage value using straight-line depreciation is $60,000. The tax savings generated by this depreciation is $60,000 times 40%, or $24,000. Now calculate after-tax operating cash savings: $90,000 - $24,000 = $66,000. However, the problem asks for before-tax operating cash savings, calculated as follows:
$66,000 ÷ (1 - Tax rate of 0.40) = $66,000 ÷ 0.60 = $110,000

135

Which of the following statements is correct when a corporation is earning excess profits?

A. Participating preferred stock acts more like equity than cumulative preferred stock.

B. Cumulative preferred stock acts more like equity than participating preferred stock.

C. Cumulative preferred stock does not act more or less like equity than participating preferred stock.

D. No statement can be made comparing cumulative preferred and participating preferred stocks to equity.

A. Participating preferred stock acts more like equity than cumulative preferred stock.

Participating preferred stock acts more like equity than cumulative preferred stock when a corporation is earning excess profits because the stock does not receive a fixed percentage like debt. When excess profits are earned, the participating preferred stock receives additional dividends.

136

The primary purpose for the use of depository transfer checks, or official bank checks, is to ________ within the banking system.

A. increase customer perception of companies

B. move funds from one account to another

C. reduce ATM usage

D. spread a company's funds out

B. move funds from one account to another

Depositor transfer checks are non-negotiable. They are used to move funds from one account to another (i.e., from a local bank to a concentration bank). This allows companies to have flexibility and control over their cash accounts but it can be somewhat time consuming.

137

Gartshore, Inc., is a mail-order book company. The company recently changed its credit policy in an attempt to increase sales. Gartshore's variable cost ratio for obtaining credit is 70% and its required rate of return is 12%. The company projects that annual sales will increase from the current level of $360,000 to $432,000, but the average collection period on receivables will go from 30 to 40 days. Ignoring any tax implications, what is the cost of carrying additional investment in accounts receivable, using a 360-day year?

A.
$168

B.
$1,512

C.
$2,000

D.
$2,160

Correct B.
$1,512

Cost of holding accounts receivable before credit policy change: $360,000 sales ÷ 360 days = $1,000 average daily sales:

30 days average collection period = $30,000 average A/R balance
12% required rate of return = $3,600 annual interest
Cost of holding accounts receivable after credit policy change: $432,000 sales ÷ 360 days = $1,200 average daily sales:

40 days average collection period = $48,000 average A/R balance
12% required rate of return = $5,760 annual interest
$5,760 - $3,600 = $2,160 additional annual interest on holding A/R balance.

However, by stating the variable cost ratio, the problem implies it expects a distinction made between actual investment in A/R and margin earned. The actual investment by Gartshore is its variable cost, which for a mail-order book company represents cost of goods purchased for sale. That is, there is no change in fixed costs. Consequently, the $2,160 needs to be reduced to represent only the interest on the variable cost portion: $2,160 × 70% variable cost = $1,512.

138

Mein Co.'s sales totaled $300,000 for the current year. Mein's cost of goods sold was $150,000. Mein's accounts receivable balance was $20,000 on January 1 and $30,000 on December 31. What was Mein's accounts receivable turnover rate for the current year?

A. 6 times

B. 10 times

C. 12 times

D. 15 times

C. 12 times

Accounts receivable turnover is net credit sales of $300,000 divided by the average accounts receivable (($20,000 + $30,000) ÷ 2, or $25,000). This equals a turnover of 12.

139

Edwards Manufacturing Corporation uses the standard economic order quantity (EOQ) model. If the EOQ for Product A is 200 units and Edwards maintains a 50-unit safety stock for the item, what is the average inventory of Product A?

A.
250 units

B.
150 units

C.
100 units

D.
50 units

B. 150 units

The average inventory level when the standard economic order quantity model is used is one-half of the EOQ. The EOQ for Product A is 200 units. One-half of 200 is 100. Add the 50-unit safety stock to arrive at 150 units as the average inventory of Product A.

140

If the average age of inventory is 90 days, the average age of accounts payable is 60 days, and the average age of accounts receivable is 65 days, the number of days in the cash flow cycle is:

A.
215 days.

B.
150 days.

C.
95 days.

D.
85 days.

C. 95 days.

The cash flow cycle is the full cycle of cash inflows adjusted for outflows, calculated as 90 + 65 - 60 = 95 days. By this formula, one can see that reducing either the inventory holding period or the collection period for receivables will reduce the number of days in the cash flow cycle by accelerating sales turnover and cash collections, respectively. Increasing the payables period also reduces the cash flow cycle, since cash outflows can be delayed while new inventory and receivables periods can begin.

141

Which of the following methods should be used if capital rationing needs to be considered when comparing capital projects?

A.
Net present value

B.
Internal rate of return

C.
Return on investment

D.
Profitability index

D. Profitability index

The profitability index is the present values of the cash flows after the initial investment divided by the amount of that investment.

This allows the comparison of projects with differing investment amounts. It represents the percentage that a project's net present value exceeds the cost of the project. Since it is expressed as a percentage rather than a dollar amount of net present value, the profitability index allows comparisons of mutually exclusive projects. The project with the highest profitability index is selected.

The other answer choices (net present value, internal rate of return, and return on investment) are incorrect because they calculate rates of return for a specific project, but do not facilitate a comparison of the capital investments required among separate projects, which is necessary if investment capital is limited.

142

In order to increase production capacity, Gunning Industries is considering replacing an existing production machine with a new technologically improved machine effective January 1, 2007. 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 that will not be needed at the end of the useful life of the new machine.
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 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 overall discounted cash flow impact of Gunning Industries' working capital investment for the new production machine would be:

A. $(7,959).

B. $(10,680).

C. $(13,268).

D. $(35,000).

C.
$(13,268)

The overall discounted cash flow impact of Gunning Industries' Working Capital investment for the new production machine is calculated as follows:
-- Initial working capital investment at
beginning of Year 1: $(35,000)
-- Discounted return of initial WC investment
at end of Year 5:

$35,000 x Present value of $1 at 10% for
5 periods (.6209) 21,732

Overall discounted cash flow of Working Capital
Investment: $(13,268)

143

The optimal capitalization for an organization usually can be determined by the:

A. maximum degree of financial leverage (DFL).

B. maximum degree of total leverage (DTL).

C. lowest total weighted-average cost of capital (WACC).

D. intersection of the marginal cost of capital and the marginal efficiency of investment.

C. lowest total weighted-average cost of capital (WACC).

The cost of capital is the weighted-average cost (percentage) that a firm will incur in raising new funds to finance future investment.

Given a need to finance specific assets, the optimal capital structure is determined by computing the lowest weighted-average cost of capital to raise that amount.

The maximum degree of financial leverage (DFL). and maximum degree of total leverage (DTL) are incorrect because leverage is a measure of the portions of capital from debt and from equity; it does not determine the optimal allocation between the two. "Intersection of the marginal cost of capital and the marginal efficiency of investment" is incorrect because the marginal efficiency of investment indicates the sensitivity of the cost of capital to changes in interest rates.

144

Which of the following terms represents the residual income that remains after the cost of all capital, includ­ing equity capital, has been deducted?

A.
Free cash flow

B.
Market value-added

C.
Economic value-added

D.
Net operating capital

C. Economic value-added

Economic value added (EVA) is after-tax operating income less the weighted average cost of capital.

Free cash flow is a measure of financial performance calculated as operating cash flow minus capital expenditures, not a measure of income.

Market value added is the difference between the current market value of a firm measured by the price of stock on the stock exchange and the capital contributed by investors, not the income remaining after cost of capital is deducted.

Net operating capital is a term used to describe working capital (current assets less current liabilities), not the cost of capital.

145

When evaluating projects, the discounted breakeven period is best described as:

A. Annual fixed costs ÷ Monthly contribution margin.

B. Project investment ÷ Annual net cash inflows.

C. the point where cumulative cash inflows on a project equal total cash outflows.

D. the point where discounted cumulative cash inflows on a project equal discounted total cash outflows.

D. the point where discounted cumulative cash inflows on a project equal discounted total cash outflows.

Stated very simply, the discounted breakeven period is the time required to recover the cash invested in a project. However, since almost all investment projects span several years, it is necessary to discount both cash inflows and outflows. When this is done, breakeven time becomes “the point where discounted cumulative cash inflows on a project equal discounted total cash outflows.”

146

In general, it is more expensive for a company to finance with equity capital than with debt capital because:

A. investors are exposed to greater risk with equity capital.

B. the interest on debt is a legal obligation.

C. equity capital is in greater demand than debt capital.

D. dividends fluctuate to a greater extent than interest rates.

A. investors are exposed to greater risk with equity capital.

Stockholders are the last to be paid, making their risk in the company greater. The greater degree of risk requires a greater reward. Bondholders, on the other hand, can expect a fixed return, known in advance, and therefore have a lower degree of risk.

147

Which of the following statements about investment decision models is true?

A. The discounted payback rate takes into account cash flows for all periods.

B. The payback rule ignores all cash flows after the end of the payback period.

C. The net present value model says to accept investment opportunities when their rates of return are less than the company's incremental borrowing rate.

D. The internal rate of return rule is to accept the investment if the opportunity cost of capital is greater than the internal rate of return.

B. The payback rule ignores all cash flows after the end of the payback period.

The payback period method can be used as an easy screening tool for capital budgeting projects since it determines the length of time required to recover the initial cash investment through net cash flows. As a general rule, the sooner the investment is recovered, the better.

Weaknesses of the payback method include the following:

All cash flows occurring after the payback period are ignored.
The time value of money is not considered.

148

Salem Co. is considering a project that yields annual net cash inflows of $420,000 for years 1 through 5, and a net cash inflow of $100,000 in year 6. The project will require an initial investment of $1,800,000. Salem’s cost of capital is 10%. Present value information is presented below:

Present value of $1 for 5 years at 10% is 0.62.
Present value of $1 for 6 years at 10% is 0.56.
Present value of an annuity of $1 for 5 years at 10% is 3.79.
What was Salem’s expected net present value for this project?

A. $83,000

B. $(108,000)

C. $(152,200)

D. $(442,000)

C. $(152,200)

Net present value is a measure of the projected return on investment that accounts for the time value of money. It is the difference between the present value of future cash inflows from an investment and the costs related to the investment, including the investment's initial cost.

Using a 10% interest rate, the present value of an annuity of $420,000 a year for five years is $420,000 × 3.79, or $1,591,800. The present value of a single payment of $100,000 in six years is $100,000 × 0.56, or $56,000. These sum to a present value of future cash inflows of $1,647,800.

The net present value is this sum ($1,647,800) less the original investment of $1,800,000. The difference is a negative net present value of $152,200.

149

Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first two years and by $20,000 in Year 3. Present values of an annuity of $1 at 14% are:

Period 1 0.8772
2 1.6467
3 2.3216
Using a 14% cost of capital, what is the present value of these future savings?

A. $59,600

B. $60,800

C. $62,900

D. $69,500

C. $62,900=(30,000*1.6467)+)20,000*(2.3216-1.6467)

Present value of Year 1 and 2 savings of $30,000 = Savings x Annuity factor for 2 years
= $30,000 x 1.6467= $49,401

Present value of Year 3 savings of $20,000
= Savings x Difference between second- and third-year annuity factor
= $20,000 x (2.3216 -1.6467)
= $20,000 x 0.6749
= $13,498

Present value of Years 1-3 savings = Present value of Year 1 and 2 savings + Present value of Year 3 savings
= $49,401 + $13,498
= $62,899, or $62,900 rounded

150

ProjecT Initial Outlay Net Present Value at 15% IRR
1 $500,000 $125,000 23%
2 250,000 75,000 17%
3 150,000 25,000 35%
4 100,000 50,000 25%
5 150,000 50,000 25%

The company should choose which of the following projects?

A. Project 1 only

B. Projects 2, 3, and 4 only

C. Projects 2, 4, and 5 only

D. Projects 3, 4, and 5 only

C. Projects 2, 4, and 5 only

Several alternative projects can be ranked by comparing their profitability indexes (PV (present value) of future cash flows divided by the initial investment). For these projects, the index is found as follows:

$625/$500 = 1.25
$325/$250 = 1.33
$175/$150 = 1.17
$150/$100 = 1.50
$200/$150 = 1.33

The projects with the highest profitability index should be selected first. This includes #4, #2, and #5. At that point the entire $500,000 that is available has been invested in the most profitable alternatives.

151

Newmass, Inc., paid a cash dividend to its common shareholders over the past 12 months of $2.20 per share. The current market value of the common stock is $40 per share and investors are anticipating the common dividend to grow at a rate of 6% annually. The costs to issue new common stock will be 5% of the market value. The cost of a new common stock issue will be:

A. 11.50%.

B. 11.79%.

C. 11.83%.

D. 12.13%.

D. 12.13%.

Use the Gordon Growth Model on this one, and remember that it is the next dividend that is used. In this case, this year's dividend will be 6% greater than last year's $2.20, or $2.33. In the formula, capital cost equals dividend/net proceeds of stock sale plus growth rate.

Ks = Dividend/Price (1-flotation) + G
Here Ks = 2.33/[40(1-.05)] + .06
= 2.33/38 + .06 = 12.13

The cost of equity using the Gordon Growth Models equals the quotient of the next dividend divided by the stock price, plus the growth rate in earnings per share. To account for flotation costs, the stock price is multiplied by one minus the flotation cost. Given that the next dividend is $2.332 (1.06 × $2.20), the cost of the new common stock is 12.13% ([2.332 ÷ ($40 × (1 -.05))] + .06).

152

The Sarbanes-Oxley Act of 2002 (SOX) requires that all publicly traded firms establish internal controls related to financial reporting that are documented, tested, and maintained for the purpose of preventing fraud. Per SOX, a company needs to do all of the following except:

A. develop documentation of existing internal controls and procedures associated with financial reporting.

B. test the effectiveness of the existing internal controls and procedures.

C. provide information on deficiencies in the controls and/or documentation of those controls.

D. include all areas of potential risk to the misstatement of the financial statements in this documentation, testing, and reporting process.

D. include all areas of potential risk to the misstatement of the financial statements in this documentation, testing, and reporting process.

Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) requires that all publicly traded firms establish internal controls related to financial reporting that are documented, tested, and maintained. The purpose of these controls is to reduce the probabilities of corporate fraud. In order to be in compliance with SOX 404, a company needs to:
develop documentation of existing internal controls and procedures associated with financial reporting, test the effectiveness of those controls and procedures, and
provide details on any deficiencies in the controls and/or documentation.

Although the initial response to SOX was to document, test, and report on both high- and low-risk areas related to financial reporting, the Public Company Accounting Oversight Board (PCAOB) developed Auditing Standard 5 (An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements), approved by the SEC, that limits such activities. This standard takes a risk-based approach related to internal control documentation and testing, thus limiting the compliance measures necessary under SOX. SOX was never meant to create unnecessary compliance burdens on a company, but rather to protect shareholders' investment from fraud.

153

Shaw Corporation is considering a plant expansion that will increase its sales and net income. The following data represents management's estimate of the impact the proposal will have on the company.
Current Proposal
Cash $ 100,000 $ 120,000
Accounts payable 350,000 430,000
Accounts receivable 400,000 500,000
Inventory 380,000 460,000
Marketable securities 200,000 200,000
Mortgage payable (current) 175,000 325,000
Fixed assets 2,500,000 3,500,000
Net income 500,000 650,000

The effect of the plant expansion on Shaw's net working capital would be:

A. a decrease of $150,000.

B. a decrease of $30,000.

C. an increase of $30,000.

D. an increase of $150,000.

B. a decrease of $30,000.

Net working capital is defined as current assets minus current liabilities. To calculate the change in net working capital, calculate the current level of net working capital and compare it to the proposed level:
Current Proposal
Cash $100,000 $120,000
Mkt. Sec. 200,000 200,000
Acc. Rec. 400,000 500,000
Inven. 380,000 460,000
TOTAL CUR. ASSETS: $1,080,000 $1,280,000
Less Acc. Pay (350,000) (430,000)
Less Mort. Pay (175,000) (325,000)
WORKING CAPITAL: $555,000 $525,000

The change in net working capital is a decrease of $30,000 ($555,000 - $525,000).

154

If a firm identifies (or creates) an investment opportunity with a present value ________ its cost, then the value of the firm and the price of its common stock will ________.

A. greater than; increase

B. greater than; decrease

C. equal to; increase

D. equal to; decrease

A. greater than; increase

Investments with present values in excess of their costs (that is, positive net present values) that can be identified or created by the capital budgeting activities of the firm will have a positive impact on firm value and on the price of the common stock of the firm.

Positive net present value investments will increase, not decrease, firm value and share prices for a firm.

Investments with present values equal to their costs have a zero net present value and neither increase nor decrease firm value and share price.

155

Market risk or systemic risk includes all the following except:

A. company risk.

B. congressional tax reform.

C. inflation or recession.

D. world energy situation(s).

A. company risk.

Market or systemic risk is risk that cannot be eliminated through diversification. It includes noncontrollable factors such as inflation or recession, fluctuations in world energy markets, and congressional tax reform.

Company risk is not a component of market risk. It is related to a particular company and is much more specific than market risk. Company risk can be alleviated or avoided through diversification.

156

Which of the following represents a firm's average gross receivable balance?

Days sales in receivables × Accounts receivable turnover
Average daily sales × Average collection period
Net sales ÷ Average gross receivables

A. I only

B. I and II only

C. I, II, and III

D. II only

D. II only

Average daily sales times average collection period represents a firm's average gross receivable balance. Because the average collection period is the time it takes to collect on a sale (indicated in days, this is the average age of a receivable in accounts receivable), multiplying this by average daily sales would give you the average gross receivable balance. Alternately, average gross receivable divided by average daily sales gives you the average collection period.

157

The Jones Company is considering using a lockbox system. The company has gathered the following information:

The per-check processing cost will be $0.20.
The days saved in the collection process will be 1.2 days.
The average size of the check will be $1,000.
If funds are freed, they could be invested at a 5% annual rate.
On average, 150 checks will be processed per day.
Should the Jones Company adopt the lockbox system, and why or why not?

A. Yes, since the company can earn 5% on the funds that are freed up

B. Yes, since the company will save $5 a day over their current collection process

C. No, since the benefit to the company is $0.17 per check processed

D. Yes, since the benefit to the company is $0.17 per check processed

C. No, since the benefit to the company is $0.17 per check processed

The cost to the company in terms of the cost per check being cleared can be stated as:
Cost per check cleared = (D)(S)(i)
D = days saved in the collection process
S = average check size
i = daily interest rate or opportunity cost (5% ÷ 360 = .0139%)

Substituting the given information into the equation:
Cost per check cleared = 1.2 days × $1,000 × .0139% = $0.17 per check cleared

Since the cost of the service would be $.20 per check cleared, the Jones Company should not adopt this alternative.

158

What happens to bond prices, in general, when interest rates decline?

A. Increase

B. No change

C. Decrease

D. Some increase and some decrease

A. Increase

In general, bond prices increase when interest rates decline because the stated rate of interest on the bond is more attractive relative to the market interest rate.

159

Which of the following changes would result in the highest present value?

A. A $100 decrease in taxes each year for four years

B. A $100 decrease in the cash outflow each year for three years

C. A $100 increase in disposal value at the end of four years

D. A $100 increase in cash inflow each year for three years

A. A $100 decrease in taxes each year for four years

Two general rules can be developed related to present value calculations:

Increases in cash inflows (decreases in cash outflows) will result in higher present values, all else being equal.
The earlier the cash inflows (the later the cash outflows) the higher the present value, all else being equal.
Increases in cash flows can be the result of increased revenues, increases in other cash inflows, or decreases in cash outflows. Of the answer choices available, only one (a $100 decrease in taxes each year for four years) results in increased net cash inflows for each of four years, thus resulting in the highest present value.

160

Management at MDK Corp. is deciding whether to replace a delivery van. A new delivery van costing $40,000 can be purchased to replace the existing delivery van, which cost the company $30,000 and has accumulated depreciation of $20,000. An employee of MDK has offered $12,000 for the old delivery van. Ignoring income taxes, which of the following correctly states relevant costs when making the decision whether to replace the delivery vehicle?

A. Purchase price of new van, disposal price of old van, gain on sale of old van

B. Purchase price of new van, purchase price of old van, gain on sale of old van

C. Purchase price of new van, disposal price of old van

D. Purchase price of new van, purchase price of old van, accumulated depreciation of old van, gain on sale of old van, disposal price of old van

C. Purchase price of new van, disposal price of old van

Relevant costs include all expected future costs that will differ among alternatives for a particular decision. Other costs will not change and are not relevant to the decision.

Purchase price of the new van is relevant because that cost will not be incurred if the van is not replaced. Disposal price of the old van is relevant because that cash will not be received unless the van is replaced.

The other answer choices are incorrect because they include the gain on the sale of the old van, the difference between its sales price and book value. That book value (cost less accumulated depreciation) is a sunk cost and cannot be changed by the decision to replace the van.

161

A company uses its company-wide cost of capital to evaluate new capital investments. What is the implication of this policy when the company has multiple operating divisions, each having unique risk attributes and capital costs?

A. High-risk divisions will over-invest in new projects and low-risk divisions will under-invest in new projects.

B. High-risk divisions will under-invest in high-risk projects.

C. Low-risk divisions will over-invest in low-risk projects.

D. Low-risk divisions will over-invest in new projects and high-risk divisions will under-invest in new projects.

A. High-risk divisions will over-invest in new projects and low-risk divisions will under-invest in new projects.

Using a single company-wide cost of capital means each division will invest in projects with a rate of return above the company-wide cost of capital.

Low-risk divisions will find low-return investments and invest very little. Since those divisions will have a lower divisional cost of capital, they will reject some investments based on the corporate cost of capital even though that investment would have been profitable for the division with a low cost of capital.

High-risk divisions will find high-return investments and invest in those projects with a return higher than the company-wide cost of capital even though it is lower than that division's cost of capital. Since those divisions have a higher divisional cost of capital, they will accept some investments that are not profitable for that division.

Such a firm should use division cost of capital to evaluate investments in that division, resulting in each division maximizing its return to the company as a whole.

162

Division A is considering a project that will earn a rate of return that is greater than the imputed interest charge for invested capital, but less than the division’s historical return on invested capital. Division B is considering a project that will earn a rate of return that is greater than the division’s historical return on invested capital, but less than the imputed interest charge for invested capital. If the objective is to maximize residual income, should these divisions accept or reject their projects?

A. Project A, accept; Project B, accept

B. Project A, reject; Project B, accept

C. Project A, reject; Project B, reject

D. Project A, accept; Project B, reject

D. Project A, accept; Project B, reject

Residual income is the amount of net income in excess of the imputed interest charge, so the division’s historical return is irrelevant if the goal is to maximize residual income.

A project should be accepted if it has a rate of return above the implicit rate of return and rejected otherwise. Therefore, Project A should be accepted (rate of return above the implicit rate) and Project B should be rejected (rate of return below the implicit rate).

163

In capital budgeting, the excess present value index (profitability index) is best used to:

A. evaluate mutually exclusive investments of different sizes.

B. adjust for inflation in the net present value computation.

C. select projects when capital budgeting funds are limited.

D. adjust for risk in capital budgeting decisions.

C. select projects when capital budgeting funds are limited.

The excess present value index, or profitability index, is computed as the present value of future net cash inflows divided by the discounted initial investment. The result is an index number rather than a dollar amount.

Because of this, the excess present value is particularly useful in evaluating different-sized projects when capital budgeting funds are limited.

164

Tam Company 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 0.322.

What is the net present value?

A. $5,760

B. $6,440

C. $12,200

D. $13,000

D. $13,000

Net present value is the difference between the present value of future cash inflows from an investment and the investment’s initial cost. The present value of $20,000 per year for 10 years at 12% is 5.65 × $20,000, or $113,000. The investment cost is $100,000, so the difference, the net present value, is $13,000.

165

Which of the following terms refers to a performance measurement that is calculated as an investment center's after-tax operating income minus the product of its total assets multiplied by the company's weighted-average cost of capital (WACC)?

A. Economic value added

B. Return on investment

C. Net realizable value

D. Profitability index

A. Economic value added

Economic value added (EVA) is the economic profit of a project, and focuses on the earnings above the required cost of capital for shareholders. EVA is the after-tax profit of operating income less the product of total assets times WACC.

Return on investment (ROI) focuses on the optimal use of invested capital, and is net income divided by invested capital. Net realizable value (NRV) is not a performance measurement. The profitability index considers both the size of the investment and the value of the discounted cash flow. The present value of cash flows not including the initial investment is divided by the initial investment.

166

Kore Industries is analyzing a capital investment proposal for new equipment to produce a product over the next eight years. The analyst is attempting to determine the appropriate “end-of-life” cash flows for the analysis. At the end of eight years, the equipment must be removed from the plant and will have a net book value of zero, a tax basis of $75,000, a cost to remove of $40,000, and scrap salvage value of $10,000. Kore's effective tax rate is 40%. What is the appropriate “end-of-life” cash flow related to these items that should be used in the analysis?

A. $27,000

B. $12,000

C. $(18,000)

D. $(30,000)

B. $12,000

The key to solving this problem is separating the cash flow items from the noncash items. The $40,000 cost to remove the asset is a cash outflow. The scrap salvage value of $10,000 is a cash inflow. Both of these items are also part of the net income upon which tax must be computed. The $75,000 loss that will result from the disposal is also part of the net income upon which tax must be computed. However, the loss is not a cash outflow. What is a cash flow is the tax or tax savings in the net income or loss.

The “end-of-life” cash flow may be calculated as follows:
Outflow: Cost to remove ($ 40,000)
Inflow: Salvage value $ 10,000
Inflow: Tax savings from net loss $ 42,000 *
Net cash inflow $ 12,000
*105,000*0.4=75000+40000-10000
* The tax savings is calculated on a net loss of $105,000. The loss is a result of the $65,000 tax loss on the asset disposal ($75,000 tax basis offset by $10,000 scrap value) and the $40,000 cost to remove the asset.

167

Which of the following items represents a business risk in capital structure decisions?

A. Contractual obligations

B. Management preferences

C. Cash flow

D. Timing of information

C. Cash flow

Capital structure is defined as the percentage of debt, preferred stock, and common stock used for financing a firm's assets. The company must decide whether to issue stock (and what kind) or to borrow money in order to conduct business. Debt and equity both have costs associated with them. These costs may be explicit or implicit.

The cost of equity is higher than the cost of debt, since stockholders are subject to more risk than debt holders. Firms must have the cash to pay dividends in order to keep their stockholders happy. For a company that chooses the debt option, in a period of declining earnings, the risk is higher that the cash flow may not be available to pay the interest and principal payments in a timely manner. Cash flow represents a business risk in capital structure decisions.

The responsibility to maintain a certain debt-to-equity ratio per contractual obligations is something that management must keep in mind when deciding the makeup of its capital structure. However, it is not a business risk.

Although management may have certain preferences regarding the capital structure, these preferences do not represent a business risk.

The timing of information provided to management is essential in making capital structure decisions. However, it is not a business risk.

168

What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?

A. To cause the price of the company's stock to rise

B. To lower the company's bond rating

C. To reduce the risk for existing bondholders

D. To reduce the interest rate on the bonds being sold

D. To reduce the interest rate on the bonds being sold

Agreeing to a debt covenant limiting the percentage of long-term debt would have an effect on a company's capital structure (debt-to-equity ratio). A favorable debt-to-equity ratio (along with other indicators of financial health) means a higher bond rating. A high bond rating means lower interest rates for bonds being sold, which also lowers the cost of capital for future bond issuances.

A debt covenant would not have any effect on risk for current bondholders or on the price of the company's stock.

169

Depository transfer checks, also called official bank checks, are related to or characterized by each of the following except:

A. cashable at any bank.

B. involve a concentration bank.

C. are non-negotiable.

D. payable to a single company account.

A. cashable at any bank.

Depository transfer checks, or official bank checks, are used to move funds from one account to another as part of a firm's cash management process. These checks are not cashable at any bank. They are related to the characteristics described in the other answers.

170

Assume that each day a company writes and receives checks totaling $10,000. If it takes five days for the checks to clear and be deducted from the company's account, and only four days for the deposits to clear, what is the float?

A. $10,000

B. $(10,000)

C. $50,000

D. $25,000

A. $10,000

The delay for the checks and deposits to clear the company's account is called the “float.” During the float, the company has the use of the cash equal to the amount of checks written but does not have the use of deposits until they clear its bank.

Since it takes five days for the checks to clear (i.e., be deducted from the company's account), the company has the use of $10,000 for five days or what is essentially a “loan” of $50,000. However, for the four days required for the deposits to clear, the company is losing the use of $10,000 × 4 or $40,000. Thus, the company enjoys a net 1-day float on the checks it writes of $10,000.

Thus, skillful management of the float requires the company to delay the coverage of checks as long as possible and to deposit checks received as quickly as possible.

171

The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, the machine is expected to produce 2,000 units per year with a selling price of $500 each and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over five years with no estimated salvage value. Moore has a marginal tax rate of 40%.

What is the net cash flow for the third year that Moore Corporation should use in a capital budgeting analysis?

A. $68,400

B. $68,000

C. $64,200

D. $53,700

A. $68,400 The problem specifically states that the federal regulation used does not recognize salvage value.

The net cash flow for the third year that Moore Corporation should use in a capital budgeting analysis should include net cash inflow expected from the sale and production of 2,000 units less tax on income. In calculating tax, one should remember to consider depreciation. Although depreciation is not a cash outflow, it does reduce the amount of income upon which tax is calculated.

Inflow = 2000 units x ($500 - $450) = $100,000
Outflow (tax): = Income from production = $100,000
Less depreciation = (21,000)*
Operating income = $ 79,000
x Tax rate x .40
= Tax $ 31,600
Net cash flow = $100,000 - 31,600 = $68,400

* Depreciation = ($90,000 + $6,000 + $9,000) / 5 = $21,000

172

Moss Converters, Inc., uses 100,000 pounds of raw material annually in its production process. Material cost is $12 per pound. The cost to process a purchase order is $45, which includes variable costs of $35 and allocated fixed costs of $10. Out-of-pocket handling and storage costs amount to 20% of the per pound cost. The company's cost of capital is 15%.

The formula to determine the economic order quantity is:

EOQ = Square root of 2AD/K
Where:
A = Annual unit demand
D = Cost per order
K = Cost of carrying one unit per year
Moss' economic order quantity is:

A. 1,291 units.

B. 1,464 units.

C. 1,708 units.

D. 1,936 units.

A. 1,291 units.

Moss Converters wants to find the economic order quantity, utilizing the formula which is given:
EOQ = Square root of 2AD × OC/K
EOQ = Square root of (2 × Annual demand) × (Order cost ÷ Unit carrying cost). To replace the unknowns with numeric values, solve for each.

Annual Demand = A = 100,000 Units (Given)
Cost per Order = D = $35 (Variable Cost Only, Ignore Allocation of Fixed Cost)

Carrying Cost/Unit/Year = K = Handling Costs + Interest
Handling Cost = 20% of Cost (Given) = (.2) ($12) = $2.40
Interest (Capital Cost) = 15% (Given) of Cost (Given) =
(.15) ($12) = $1.80

Carrying Cost = K = $2.40 + $1.80 = $4.20
EOQ = Sq. Root of 2AD/K = Sq. Root of ((2 x 100,000 x $35)/$4.20)
EOQ = Sq. Root of 7,000,000/4.20
EOQ = Sq. Root of 1,666,666
EOQ = 1,291

173

The Huron Corporation purchases 60,000 head bands per year. The average purchase lead time is 20 working days. Maximum lead time is 27 working days. The corporation works 240 days per year.

Huron Corporation should reorder head bands when the quantity in inventory reaches:

A. 5,000 units.

B. 6,750 units.

C. 1,750 units.

D. 5,250 units.

B. 6,750 units.

The reorder point is that quantity of materials on hand that equals the lead time quantity plus safety stock (i.e., the total needed to continue production until the next delivery is received):
Daily usage = 60,000/240 Days= 250 units

Safety Maximum Average Daily
stock = (lead time - lead time) x usage = (27 - 20) x 250 = 1,750 units

Reorder Purchase point = lead time units + safety stock
= (20 days x 250 units) + 1,750
= 5,000 + 1,750
= 6,750 units

174

A company purchases an item for $43,000. The salvage value of the item is $3,000. The cost of capital is 8%. Pertinent information related to this purchase is as follows:
Net Cash Flow Present Value Factor at 8%
Year 1 $10,000 0.926
Year 2 15,000 0.857
Year 3 20,000 0.794
Year 4 27,000 0.735

What is the discounted payback period in years?

A. 3.10

B. 3.25

C. 2.90

D. 3.14

The discounted payback method uses the present value of the projected cash flows in determining the payback period; thus, the payback period is longer than one calculated using the more traditional payback method.

The first step is to calculate the present value of the projected cash flows:

Net Cash Flow PV Factor at 8% Present Value
Year 1 $10,000 0.926 $ 9,260
Year 2 15,000 0.857 12,855
Year 3 20,000 0.794 15,880
Year 4 27,000 0.735 19,845
The discounted payback can then be calculated:
Year 0 Year 1 Year 2 Year 3 Year 4
Annual cash flow $ 9,260 $12,855 $15,880 $19,845
Cum cash flow -$43,000 -33,470 -20,885 -5,005 14,840

The payback period falls between Year 3 and Year 4, and extrapolating (3 years + ($5,005 ÷ $19,845) = 3.25 years), it can be determined that the projected discounted payback period would be 3.25 years.

175

The controller of Gray, Inc., has decided to use ratio analysis to analyze business cycles for the past two years in an effort to identify seasonal patterns. Which of the following formulas should be used to compute percentage changes for account balances for Year 1 to Year 2?

A. (Prior balance - Current balance) / Current balance

B. (Prior balance - Current balance) / Prior balance

C. (Current balance - Prior balance) / Current balance

D. (Current balance - Prior balance) / Prior balance

D. (Current balance - Prior balance) / Prior balance

The question concerns the change for Year 2 compared to Year 1. The amount of change is the increase or decrease from the prior year to the current year, equal to the current balance less the prior balance. The percentage change is calculated by dividing the amount of change by the beginning balance.

176

Which of the following inventory management approaches orders at the point where carrying costs equate nearest to restocking costs in order to minimize total inventory cost?

A. Economic order quantity

B. Just-in-time

C. Materials requirements planning

D. ABC

A. Economic order quantity

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. 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.

Just-in-time (JIT) is a manufacturing philosophy where the company receives raw materials just in time to go into production, manufactures parts just in time to be assembled into products, and completes products just in time to be shipped to customers. JIT reduces the cost of carrying inventory but does not equate inventory carry costs with restocking costs.

Materials requirements planning (MRP) meets forecasted sales demand by balancing existing production capacity and raw materials needs. MRP does not attempt to equalize restocking and carrying costs.

The ABC inventory management system establishes priorities based on valuation of the inventory items (A = high value; B = medium value; C = small value) so that management can pay more attention to categories A and B. It has nothing to do with ordering points.

177

Carlisle Company presently sells 400,000 bottles of perfume each year. Each bottle costs $.84 to produce and sells for $1.00. Fixed costs are $28,000 per year. The firm has annual interest expense of $6,000, preferred stock dividends of $2,000 per year, and a 40% tax rate. Carlisle uses the following formulas to determine the company's leverage:
Operating leverage = Q (S-VC)/ Q (S-VC) - FC

Financial leverage = EBIT/ EBIT - I - (P/(1 -t))

Total leverage = Q (S-VC)/
Q (S-VC) - FC - I - (P/(1 - t))
Where:
Q = Quantity FC = Fixed cost VC = Variable cost
S = Selling price I = Interest expense P = Preferred dividends
t = Tax rate EBIT = Earnings before interest and taxes
If Carlisle Company did not have preferred stock, the degree of total leverage would:

A. decrease in proportion to a decrease in financial leverage.

B. increase in proportion to an increase in financial leverage.

C. decrease but not be proportional to the decrease in financial leverage.

D. decrease but not have an effect on financial leverage.

A. decrease in proportion to a decrease in financial leverage.

The degree of total leverage decreases proportionately to a decrease in financial leverage.

Leverage, whether financial or operating, is based on the relationship between fixed and variable costs. Operating leverage increases when the proportion of fixed operating costs to variable operating costs increases.

Financial leverage increases when the proportion of fixed payment obligations from interest and preferred dividends increases relative to the “variable” payments to common stockholders. Common stock dividends are variable, in the sense that there is no fixed, definite amount of dividends that must be paid each year. Interest, on the other hand, must be paid regardless of the firm's profits or cash flow, or the firm may face bankruptcy and preferred must be paid for the company to remain credible. A decrease in preferred stock dividends thus decreases financial leverage. The formula for total leverage shows that as preferred dividends decrease (increasing the value of the denominator), total leverage decreases.

178

A measure of project risk is provided by the capital budgeting technique of:

A. net present value.

B. internal rate of return.

C. accounting rate of return.

D. payback.

D. payback.

The payback capital budgeting technique indicates how soon a project will recover its cost. The sooner the cost is recovered, the less risky the project—returns are less knowable the further in the future they are.

179

For 20X1, Nelson Industries increased earnings before interest and taxes by 17%. During the same period, net income after tax increased by 42%. The degree of financial leverage that existed during 20X1 is:

A.
1.70.

B.
4.20.

C.
2.47.

D.
1.68.

C.
2.47.

The degree of financial leverage:
% change in net income/ % change in operating income
= 42 / 17 = 2.47

180

The economic order quantity formula assumes that:

A. periodic demand for the good is known.

B. carrying costs per unit vary with quantity ordered.

C. costs of placing an order vary with quantity ordered.

D. purchase costs per unit differ due to quantity discounts.

A. periodic demand for the good is known.

Assumptions of economic order quantity analysis include the following:
Periodic demand for the good is known.
Total carrying costs vary with quantity ordered.
Costs of placing an order are unaffected by quantity ordered.
Purchase costs per unit are not affected by quantity discounts.

181

Regal Industries is replacing a grinder purchased five years ago for $15,000 with a new one costing $25,000 cash. The original grinder is being depreciated on a straight-line basis over 15 years to a zero salvage value; Regal will sell this old equipment to a third party for $6,000 cash. The new equipment will be depreciated on a straight-line basis over 10 years to a zero salvage value. Assuming a 40% marginal tax rate, Regal's net cash outlay at the time of purchase if the old grinder is sold and the new one purchased is:

A. $19,000.

B. $15,000.

C. $17,400.

D. $21,000.

C. $17,400.

Cash outlay for new grinder:
Cash paid for new grinder $25,000
Less: Proceeds from sale of old grinder $6,000
Net of cash tax "saving" resulting from loss on sale
(1)(40% x $4,000) 1,600 = 7,600
Net cash outlay $17,400
(1)
Cost of old grinder $15,000
Less accumulated depreciation (5/15 x $15,000) 5,000
Book value of old grinder = 10,000
Less proceeds from sale 6,000
Loss on sale $ 4,000

182

Which of the following statements is true regarding opportunity cost?

A. Opportunity cost is recorded in the accounts of an organization that has a full costing system.

B. The potential benefit is not sacrificed when selecting an alternative.

C. Idle space that has no alternative use has an opportunity cost of zero.

D. Opportunity cost is representative of actual dollar outlay.

C. Idle space that has no alternative use has an opportunity cost of zero.

An opportunity cost is the lost inflow of the next best alternative that is forgone as the result of a decision. Although opportunity costs are important in the decision-making process, they are not included as actual costs in financial statements.

For example, a company has idle space that could be used for the production of a new product or could be rented to a third party. If the production of a new product is considered, then the lost rental income would be an opportunity cost that would have to be considered during the decision-making process. If idle space has no alternative use, it has an opportunity cost of zero.

183

Variable rate loans can be used to reduce the risk associated with changes in interest rates during the term of the loan. The greatest level of risk relates to ________ loans.

A. short-term

B. intermediate-term

C. long-term

D. non-interest-bearing

C. long-term

Long-term fixed interest rate loans create the greatest interest-rate risk for both borrowers and lenders.

Borrowers benefit from fixed rates when interest rates go up but lose when they decline. Lenders' risk is in the opposite direction.

The chance for interest rates to change is much greater over a long time period than over a short time period.

184

The level of safety stock in inventory management depends on all of the following except the:

A. level of uncertainty of the sales forecast.

B. level of customer dissatisfaction for back orders.

C. cost of running out of inventory.

D. cost to reorder stock.

D. cost to reorder stock.

The level of safety stock does not depend on the cost to reorder stock.

Safety stock is held in order to avoid the likelihood of a stock out, or running out of inventory. A higher level of safety stock is needed when sales forecasts are uncertain. Customers dislike waiting for orders to be filled, and lead time from suppliers is uncertain.

The cost of reordering inventory is a consideration in the optimal quantity of inventory to order each time an order is placed, but not in the additional safety stock that should be held. When the inventory falls to the level of minimum safety stock, then a new order should be placed.

185

When the risks of the individual components of a project's cash flows are different, an acceptable procedure to evaluate these cash flows is to:

A. compute the net present value of each cash flow using the firm's cost of capital.

B. compare the internal rate of return from each cash flow to its risk.

C. utilize the accounting rate of return.

D. discount each cash flow using a discount rate that reflects the degree of risk.

D. discount each cash flow using a discount rate that reflects the degree of risk.

Risk analysis tries to evaluate the probability of the achievement of future returns from the proposed investment. Discount rates are often risk-adjusted to address the risk in an investment (adjusting the discount rate upward would require the expected net cash flow to be larger and thus compensating for a riskier project). This same technique may be applied to individual components of a project's cash flows to produce acceptable results in a capital budgeting analysis.

186

If Brewer Corporation's bonds are currently yielding 8% in the marketplace, why would the firm's cost of debt be lower?

A. Market interest rates have increased.

B. Additional debt can be issued more cheaply than the original debt.

C. Interest is deductible for tax purposes.

D. There is a mixture of old and new debt.

C. Interest is deductible for tax purposes.

Brewer Corporation's cost of debt is lower than the current yield of their bonds because interest expenses are tax deductible.

The cost of capital is almost always calculated on an after-tax basis, since the payments to the suppliers of the capital are made from after-tax cash flows. Consider a firm with interest expense of $80 annually:

Case A: Firm With Interest Case B: Firm Without Interest
EBIT $100 EBIT $100
less Int (80) less Int 0
EBT 20 EBT 100
less Tax (40%) ( 8) less Tax (40%) (40)
EAT $ 12 EAT $ 60

The firm with interest expense has cash flows that are $48 less than a no-interest case, not the $80 less that would be expected without the tax benefit. The cost of debt to the firm is: Interest × (1 - Tax rate). The cost of the interest is thus Interest × (1 - .40), or $80 × .6 = $48.

8% bonds paying $80 in interest per year would have a face value of $1,000 ($1,000 × 8% = $80).

The actual after tax cost of debt for case A would be 4.8% ($48 ÷ $1,000), which would be lower than the marketplace 8%.

187

Which of the following responses is not an advantage to a corporation that uses the commercial paper market for short-term financing?

A. This market provides more funds at lower rates than other methods provide.

B. The borrower avoids the expense of maintaining a compensating balance with a commercial bank.

C. There are no restrictions as to the type of corporation that can enter into this market.

D. This market provides a broad distribution for borrowing.

C. There are no restrictions as to the type of corporation that can enter into this market.

Commercial paper is a short-term note payable which is unsecured and usually discounted. It is issued in large denominations with maturities ranging from 2 to 270 days. There are several advantages to a corporation using commercial paper for short-term financing. The commercial paper market provides more funds at lower rates than other methods available. There is no required compensating balance at a lending bank. There is a broad and efficient distribution and the borrower's name becomes more widely known through this market. What is not an advantage to a corporation that uses the commercial paper market is the statement “there are no restrictions as to the type of corporation that can enter into this market.” This is false. Commercial paper is issued in denominations of $100,000 or more and is almost always backed by bank lines of credit. This limits the access to this market to large corporations only. Plus, commercial paper is rated by Standard & Poor's and Moody's and, consequently, only top-rated corporations with high credit ratings can enter this market.

188

A company has the following target capital structure and costs:
Proportion of Interest or
Capital Structure Dividend Rates
Debt 30% 10%
Common stock 60% 12%
Preferred stock 10% 10%

The company's marginal tax rate is 30%. What is the company's weighted-average cost of capital?

A. 7.84%

B. 9.30%

C. 10.30%

D. 11.20%

C. 10.30%

The weighted-average cost of capital is the weighted average of the cost of debt and the various equity components of the firm's capital structure. The marginal tax rate is considered in determining the cost of capital for each component that has a tax effect (such as the debt interest). Since the interest is deductible, the cost of debt is 10% less 30% tax savings, or 7%.

Multiply the cost of each source of capital by the proportion of capital from that source, and add the results:

Debt = 0.30 × 0.07 = 0.021
Common stock = 0.60 × 0.12 = 0.072
Preferred stock = 0.10 × 0.10 = 0.01
These total 10.3%.

189

What is the relationship between the allowance for doubtful accounts and working capital?

A. When bad debts expense is recorded for the period, working capital decreases.

B. When bad debts expense is recorded for the period, cash increases.

C. When an account is written off against the allowance, working capital decreases.

D. When an account is written off against the allowance, cash decreases.

A. When bad debts expense is recorded for the period, working capital decreases.

Working capital (WC) is short-term assets such as cash, receivables, and inventory. Net working capital is current assets less current liabilities.
An increase in bad debt expense results in a corresponding increase in the Allowance for Doubtful Accounts. Since the Allowance account is a contra-current asset, any increase results in a decrease to current assets, which leads to a decrease in WC.

Bad debt expense and account write-offs do not affect cash. Writing an account receivable off against the allowance is a wash entry: the decrease in accounts receivable decreases WC while the decrease in the Allowance account increases WC.

190

If you were to see the formula (Portfolio return - Risk-free rate) ÷ Standard deviation, you would be dealing with:

A. the Jensen measure.

B. the Sharpe measure.

C. the Treynor index.

D. a swap transaction.

B. the Sharpe measure.

The formula for the Sharpe measure for portfolio performance is (Portfolio return - Risk-free rate) ÷ Standard deviation.

The formula for the Treynor index for portfolio performance is (Portfolio return - Risk-free rate) ÷ Beta.

The formula for the Jensen measure of portfolio performance measure of return on portfolio is Risk-free rate + ((Return on market index - Risk-free rate) × Beta).

191

It was time for an investment advisor to meet with one of her major clients for the annual review of his portfolio. She knew that the investor would be very interested in the performance of his portfolio in the turbulent and volatile market that had existed for the past 12 months. She reviewed the client's file and saw that he had indicated that he expected his portfolio would provide him with a risk-adjusted return that provided a high portfolio return per unit of risk. She picked up the phone and called one of the firm's analysts and asked him to complete an analysis of the ________ for the portfolio.

A. Treynor index

B. Jensen measure

C. fair market value

D. Sharpe measure

A. Treynor index

The Treynor index is based on the premise that there are two components of risk:

Risk produced by fluctuations in the market
Risk produced by fluctuations of the individual stock

The index measures the portfolio return per unit of risk using the following equation:
(Portfolio return - Risk-free rate) ÷ Beta
The Sharpe measure of portfolio risk provides information similar to that of the Treynor index, except that the risk measure is the standard deviation of the portfolio rather than beta. The Jensen measure of portfolio risk measures the absolute value of performance of a portfolio on a risk-adjusted basis.

192

A company is considering two projects, which have the following details:
Project A Project B
Expected sales $1,000 $1,500
Cash operating expense 400 700
Depreciation 150 250
Tax rate 30% 30%

Which project would provide the largest after-tax cash inflow?

A. Project A because after-tax cash inflow equals $465

B. Project A because after-tax cash inflow equals $315

C. Project B because after-tax cash inflow equals $635

D. Project B because after-tax cash inflow equals $385

C. Project B because after-tax cash inflow equals $635


Project A produces taxable income of $450 ($1,000 less $400 less $150). Multiplying taxable income of $450 by a 30% tax rate gives income tax of $135. After-tax cash inflow for Project A is $1,000 sales less cash expenses of $400 and income tax of $135, or $465.

Project B produces taxable income of $550 ($1,500 less $700 less $250). Multiplying taxable income of $550 by a 30% tax rate gives income tax of $165. After-tax cash inflow for Project B is $1,500 sales less cash expenses of $700 and income tax of $165, or $635.

193

For the next two years, a lease is estimated to have an operating net cash inflow of $7,500 per annum, before adjusting for $5,000 per annum tax basis lease amortization and a 40% tax rate. The present value of an ordinary annuity of $1 per year at 10% for two years is 1.7355. What is the lease's after-tax present value using a 10% discount factor?

A. $2,611

B. $4,350

C. $9,569

D. $11,281

D. $11,281

Net annual cash inflows = Cash inflow - income taxes
= $7,500 - (.40 x ($7,500 - $5,000))
= $7,500 - (.40 x ($2,500))
= $7,500 - $1,000 = $6,500

Present value of cash inflow = Net annual cash inflow x PV factor
= $6,500 x 1.7355
= $11,280.75, or 11,281 rounded

194

Datacomp Industries, which has no current debt and has a beta of .95 for its common stock. Management is considering a change in the capital structure to 30% debt and 70% equity. This change would increase the beta on the stock to 1.05, and the after-tax cost of debt will be 7.5%. The expected return on equity is 16%, and the risk-free rate is 6%. Should Datacomp's management proceed with the capital structure change?

A. No, because the cost of equity capital will increase

B. Yes, because the cost of equity capital will decrease

C. Yes, because the weighted average cost of capital will decrease

D. No, because the weighted average cost of capital will increase

C. Yes, because the weighted average cost of capital will decrease

Required rate of return for equity = Risk-free rate + beta(LT average risk premium for the market - Risk-free rate)

Expected return for equity = 16%
Risk-free rate = 6%
beta = .95

Substituting the known items in the CAPM equation, the LT average risk premium for the market can be determined:
Required rate of return for equity = Risk-free rate + beta(LT average risk premium for the market - Risk-free rate)
16% = 6% + .95(LT average risk premium for the market - 6%)

LT average risk premium for the market = 16.5%

Step 2: The proposed change to 30% debt and 70% equity provides the following known information:

LT average risk premium for the market = 16.5%
Risk-free rate = 6%
beta = 1.05

The new required rate of return for equity can now be calculated as:
Required rate of return for equity = Risk-free rate + beta(LT average risk premium for the market - Risk-free rate)
Required rate of return for equity = 6% +1.05(16.5% - 6%)
Required rate of return for equity = 17.0%

Step 3: The WACC of capital under the proposed capital structure can then be calculated as:
Proposed WACC = Weighted cost of debt + Weighted cost of equity
= (30% x 7.5%) + (70% x 17.0%)
= 2.3% + 11.9%
= 14.2%
Comparison of the current structure and the proposed structure:
Current Proposed
Structure Structure
Cost of debt 7.5%
Cost of equity 16.0% 17.0%
WACC 16.0% 14.2%

195

A company recently issued 9% preferred stock. The preferred stock sold for $40 a share with a par of $20. The cost of issuing the stock was $5 a share. What is the company's cost of preferred stock?

A. 4.5%

B. 5.1%

C. 9.0%

D. 10.3%

B. 5.1%=((20*0.09)/(40-5))

The cost of preferred stock is the annual dividend payment divided by the net issuance price for the preferred stock. Since dividends paid on preferred stock are not deductible by the corporation for tax purposes, the cost does not include any tax effect.

The annual dividend per share is 9% multiplied by the par value of $20, or $1.80. The stock sold for $40. Subtracting the $5 issue costs gives net proceeds of $35 a share.

The cost of preferred stock is the $1.80 dividend divided by proceeds of $35 a share, which is 5.1%.

196

Lin Co. is buying machinery it expects will increase average annual operating income by $40,000. The initial increase in the required investment is $60,000, and the average increase in required investment is $30,000. To compute the accrual accounting rate of return, what amount should be used as the numerator in the ratio?

A. $20,000

B. $30,000

C. $40,000

D. $60,000

C. $40,000

Accounting rate of return = Increase in income ÷ Required investment

Increase in income (numerator) = $40,000

197

The following selected data pertain to a 4-year project being considered by Metro Industries:

A depreciable asset that costs $1,200,000 will be acquired on January 1, 2008. The asset, which is expected to have a $200,000 salvage value at the end of four years, qualifies as 3-year property under the modified accelerated cost recovery system (MACRS).
The new asset will replace an existing asset that has a tax basis of $150,000 and can be sold January 1, 2008, for $180,000.
The project is expected to provide added annual sales of 30,000 units at $20 each. Additional cash operating costs are variable, $12 per unit; fixed, $90,000 per year.
A $50,000 working capital investment that is fully recoverable at the end of the fourth year is required.
Metro is subject to a 40% income tax rate and rounds all computations to the nearest dollar. Assume that any gain or loss affects the taxes paid at the end of the year in which it occurred. The company uses the net present value method to analyze investments and will employ the following factors and rates.

Present Value Present Value of MACRS
Period of $1 at 12% $1 Annuity at 12%
1 0.8929 0.8929 .33
2 0.7972 1.6901 .45
3 0.7118 2.4018 .15
4 0.6355 3.0373 .07
The discounted, net-of-tax amount that relates to disposal of the existing asset is:

A. $168,000.

B. $169,285.

C. $180,000.

D. $190,680.

B. $169,285.

Proceeds from sale of asset on January 1, 2008 $180,000 (1)
Less present value of income taxes
on gain ($30,000 gain x 40% x .8929) $(10,715) (2)
Discounted net-of-tax amount related to disposal of existing asset $169,285
1 Proceeds from the sale on January 1, 2008, is the present value at that date.

2 Taxes on gain are assumed payable at the end of 2008.

198

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 cost of funds from the sale of common stock for Williams, Inc., is:

A. 7.0%.

B. 7.6%.

C. 7.4%.

D. 7.8%.

B. 7.6%.

The cost of funds from the sale of common stock is 7.6%. According to the Gordon Dividend Capitalization Model, the market value of a share of stock is equal to the present value of future dividend streams. This formula states:

kcm = (D / (P - u - f)) + g
= (7 / (100 - 3 - 5)) + 0
= 7 / 92
= 7.6%

Where:

kcm = Cost, in percentage, of issuing new common stock
D = Dividend the firm is expected to pay next year
P = Current price of a share
u = Dollar amount of underpricing per share from the market price needed to sell the new issue
f = Flotation cost per share paid to the investment banking firm for selling the new issue
g = Expected annual growth rate in dividends, in percentage

199

Under which one of the following conditions is the internal rate of return method less reliable than the net present value technique?

A. When the net present value of the project is equal to zero

B. When income taxes are considered in the analysis

C. When both benefits and costs are included, but each is separately discounted to the present

D. When there are net cash inflows of sizable amounts early in the project

D. When there are net cash inflows of sizable amounts early in the project

The real issue here is the reinvestment assumption applied to “recovered funds.” Net present value (NPV) assumes reinvestment at the cost of capital whereas internal rate of return (IRR) assumes reinvestment at the IRR.

NPV makes the more realistic assumption about the rate of return that can be earned on cash flows from the project.

200

Which of the following cash management techniques focuses on cash disbursements?

A. Lockbox system

B. Zero-balance account

C. Preauthorized checks

D. Depository transfer checks

B. Zero-balance account

A zero-balance account (imprest fund) is a checking account that normally carries a zero balance. When a large number of checks will be written at once (such as for payroll), the net amount of the checks is deposited in the account. As the checks clear, the balance in the account equals the outstanding checks, and when all have cleared, the balance in the account is again zero. It is a common control on cash disbursements 垫付款.

A lockbox system is used with cash deposits, not cash disbursements. Preauthorized checks are not a cash management technique; they speed the issuance of checks for small payments. Depository transfer checks are official bank checks used to move funds from one account to another within the banking system; they are not used as a cash disbursement management technique.

201

If income tax considerations are ignored, how is depreciation handled by the following capital budgeting techniques?

A. Accounting rate of return is included; internal rate of return and payback are excluded.

B. Internal rate of return and payback are included; accounting rate of return is excluded.

C. Payback is included; internal rate of return and accounting rate of return are excluded.

D. Internal rate of return, accounting rate of return, and payback are included.

A. Accounting rate of return is included; internal rate of return and payback are excluded.

Internal rate of return is a capital budgeting method which attempts to determine the internal return from a proposed project (NPV inflows = NPV outflows). The internal rate of return is that rate which produces a zero net present value. With this in mind, depreciation is only relevant if it affects cash flows. So, if tax considerations are ignored, depreciation must be excluded in performing internal rate of return analysis.

Accounting rate of return is calculated as follows:

Accounting ROR= Increase in accounting income/Cash invested in project

Since depreciation is used in computing accounting income, it must be included.

Payback, like internal rate of return, focuses on cash flows. Because of this, if tax considerations are ignored, there is no cash flow effect from depreciation so it is excluded from the calculation.

202

Which one of the following provide a spontaneous source of financing for a firm?

A. Accounts payable

B. Mortgage bonds

C. Accounts receivable

D. Debentures

A. Accounts payable

Because trade credit arises automatically from purchase transactions, it provides a spontaneous 无意识的 source of financing for the firm. Trade credit is represented on the balance sheet of the borrowing firm as Accounts Payable.

203

A company has an outstanding 1-year bank loan of $500,000 at a stated interest rate of 8%. The company is required to maintain a 20% compensating balance in its checking account. The company would maintain a zero balance in this account if the requirement did not exist. What is the effective interest rate of the loan?

A.
8%

B.
10%

C.
20%

D.
28%

B. 10%

Compensating balances increase the cost of the loan due to the fact that fewer funds are available for use. The effective interest rate for a loan requiring a compensating balance for which the company would not otherwise hold such funds would be the actual interest paid divided by the funds available for use. In this case:
Full amount of loan $500,000
Stated interest rate 8%
Compensating balance ($500,000 x 0.20) $100,000
Annual interest expense ($500,000 x 0.08) $ 40,000

The effective interest rate for the loan requiring a compensating balance would be:

Annual interest expense ÷ (Full loan amount - Compensating balance) = $40,000 ÷ ($500,000 - $100,000) = 0.10 (10%)

204

A client wants to know how many years it will take before the accumulated cash flows from an investment exceed the initial investment, without taking the time value of money into account. Which of the following financial models should be used?

A. Payback period

B. Discounted payback period

C. Internal rate of return

D. Net present value

A. Payback period

The payback period method can be used as an easy screening tool for capital budgeting projects since it determines the length of time required to recover the initial cash investment through net cash flows. As a general rule, the sooner the investment is recovered, the better.

Weaknesses of the payback method are the following:
All cash flows occurring after the payback period are ignored.
The time value of money is not considered.

205

A company has income after tax of $5.4 million, interest expense of $1 million for the year, depreciation expense of $1 million, and a 40% tax rate. What is the company's times-interest-earned ratio?

A. 5.4

B. 6.4

C. 7.4

D. 10.0

D. 10.0

The times-interest-earned ratio is (Net income before tax + Interest expense) ÷ Interest expense.

To find net income before tax:
Before-tax income - (0.40 × Before-tax income) = After-tax income
0.60 × Before-tax income = After-tax income = $5.4 million
Before-tax income = $5.4 million ÷ 0.60 = $9 million

To find the times-interest-earned ratio:
Times interest earned = (Net income before tax + Interest expense / Interest expense
= ($9 million + $1 million) / $1 million
= 10.0

206

Which of the following metrics equates the present value of a project's expected cash inflows to the present value of the project's expected costs?

A. Net present value

B. Return on assets

C. Internal rate of return

D. Economic value-added

C. Internal rate of return

The internal rate of return is the interest rate that will make the present value of 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 net present value metric is calculated using an assumed minimum desired interest rate that normally would not result in a present value equal to cost. Return on assets is the current net income divided by the total assets; it does not consider future cash flows. Economic value-added (EVA) is the earnings above the required cost of capital for shareholders, a dollar figure that does not consider future cash flows.

207

Garo Company, a retail store, is considering foregoing sales discounts in order to delay using its cash. Supplier credit terms are 2/10, net 30. Assuming a 360-day year, what is the annual cost of credit if the cash discount is not taken and Garo pays net 30?

A.
20.0%

B.
24.0%

C.
24.5%

D.
36.7%

D. 36.7%=18*2.041%=2%/(100-2)*(360/20)

The annual cost of credit if the cash discount is not taken and Garo pays net 30 is calculated as follows. The lost discount of holding onto money for an additional 20 days (2/10 means 2% discount if paid in 10 days) is 2% for those 20 days; however, the trick is to realize that the principal upon which the 2% is compared is really gross less 2%; e.g., if a $100 invoice is paid in 10 days with terms of 2/10, the amount paid is $98. The 2% discount ($2) is really potential interest that could be charged on the principal amount of $98. This results in an interest rate that is really 2/98 or 2.041% for 20 days. The 30 in “2/10 net 30” means the total amount of the invoice must be paid in 30 days. If the discount is not taken, the cash is held onto for an additional 20 days (30 - 10 = 20). In a 360-day year, 20 days represents 18 periods. 18 × 2.041% = 36.738%, or 36.7%.

208

Acme Corporation is selling $25 million of cumulative, nonparticipating preferred stock. The issue will have a par value of $65 per share with a dividend rate of 6%. The issue will be sold to investors for $68 per share and issuance costs will be $4 per share. The cost of preferred stock to Acme is:

A.
5.42%.

B.
5.74%.

C.
6.00%.

D.
6.09%.

D. 6.09%.=Ks = 3.90 / 64 = (6%*$65)/(68-4)

Use the Gordon Growth Model to calculate the cost of capital:

Capital cost Ks = (Next Dividend/ Mkt Price (1- Flotation cost) + Dividend growth rate
Ks = ( D/ P(1-F))+ G

Here, the dividend = 6% of par value of $65 so D = $3.90. We have the net proceeds of the stock sale rather than the flotation cost as a percentage. The net proceeds to Acme are $64 per share, and no dividend growth is mentioned.

209

Consumers in Microlandia buy only three general types of products, X, Y, and Z. Each product type is weighted in the consumers market-basket based on the quantity of the item that is purchased. Changes in the prices of these items on a year-to-year basis are given below:
Average Price per Unit
Product Quantity Year 1 Year 2
x 20 $15 $18
y 18 25 28
z 6 40 38
Using Year 1 as the base year, the country's CPI for Year 2 is:

A. 1.05.

B. 110.3.

C. 90.7.

D. 107.8.

B. 110.3.

In the first year it cost the consumers $990 to purchase the market-basket of goods ((20 × $15) + (18 × $25) + (6 × $40)). In year 2 it took $1,092 to purchase the same market-basket of goods ((20 × $18) + (18 × $28) + (6 × $38)). Thus, if the base year is 100 = ($990 ÷ $990) × 100, the CPI for the second year would be ($1,092 ÷ $990) × 100 = 110.3.