Flashcards in Financial Management Deck (57):

1

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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.

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

Opportunity cost is the discounted dollar value of benefits lost from an opportunity (alternative) as a result of choosing another opportunity. An opportunity cost does not involve an actual transaction or cash outlay. If idle space has no alternative use, then its opportunity cost is zero. There is no alternative use of the space and, therefore, no opportunity cost exists.

2

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For the year ended December 31, 2004, Abel Co. incurred direct costs of $500,000 based on a particular course of action during the year. If a different course of action had been taken, direct costs would have been $400,000. In addition, Abel's 2004 fixed costs were $90,000. The incremental cost was

A. $10,000

B. $90,000

C. $100,000

D. $190,000

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C. $100,000

Incremental costs are those that are different between two or more alternatives under consideration. In this case, the incremental cost is the difference between the direct costs of taking one action ($400,000) versus another ($500,000). The $100,000 difference in cost is the only cost that differs between the two courses of action. The fixed costs are present regardless of which action is taken.

3

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Which of the following statements is correct regarding the weighted-average cost of capital (WACC)?

A. One of a company's objectives is to minimize the WACC.

B. A company with a high WACC is attractive to potential shareholders.

C. An increase in the WACC increases the value of the company.

D. WACC is always equal to the company's borrowing rate.

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A. One of a company's objectives is to minimize the WACC.

A company will seek to minimize its weighted-average cost of capital (WACC). The WACC is not only the cost to the firm for its long-term financing, but also the minimum the firm must earn on its investments. The lower the WACC, the lower the required revenue needed to earn a profit and the easier it is to increase shareholder value.

4

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The measurement of the benefit lost by using resources for one purpose and not another is

A. Sunk cost.

B. Opportunity cost.

C. Incremental cost.

D. Differential cost.

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B. Opportunity cost.

Opportunity cost is the discounted dollar value of benefits lost from an opportunity as a result of choosing another opportunity.

5

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Which one of the following costs, if any, is relevant in making financial decisions?

Sunk Costs Opportunity Costs

Yes Yes

Yes No

No Yes

No No

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Sunk Costs Opportunity Costs

No Yes

Sunk costs are costs of resources that have already been incurred. These costs will not be changed as a result of current or future decision-making and, therefore, are not relevant in making financial (or other) decisions.

Opportunity costs are the benefits (e.g., revenues) given up when a selection of one course of action precludes another course of action (and the benefit it would have provided). As the name implies, these are the costs of forgoing one opportunity by choosing another opportunity.

6

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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%

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D. 9.8%

This correct answer properly assumes a 30% tax savings on the bonds and no tax savings on the common or preferred stock. Thus, the correct answer is:

Bonds .40 x .10 = .04 x .70 = 2.8%

C/S .50 x .10 = .05 = 5.0%

P/S .10 x .20 = .02 = 2.0%

Weighted Average 9.8%

7

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Carter Co. paid $1,000,000 for land three years ago. Carter estimates it can sell the land for $1,200,000, net of selling costs. If the land is not sold, Carter plans to develop the land at a cost of $1,500,000. Carter estimates net cash flow from the development in the first year of operations would be $500,000. What is Carter's opportunity cost of the development?

A. $1,500,000

B. $1,200,000

C. $1,000,000

D. $ 500,000

###
B. $1,200,000

Opportunity cost is the (discounted) dollar value of benefits lost from an alternative (opportunity) as a result of choosing another alternative (opportunity). By choosing to develop the land, Carter would give up the opportunity to sell the land for $1,200,000, the opportunity cost.

8

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Josey maintained a $10,000 balance in his savings account throughout year 1, the first year of the account. The savings account paid 2% interest compounded annually. For year 1, the inflation rate was 3%. For year 1, what is Josey's real interest rate on the savings account?

A. - 1%.

B. 1%

C. 3%

D. 5%

###
A. - 1%.

The real interest rate is the stated (or nominal) rate of interest for a period less the rate of inflation for that period. Since Josey earned 2% on the checking account for the year and inflation for the year was 3%, Josey's real interest rate was: 2% - 3% = -1%.

9

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---~

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 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are:

Period 1 0.88

2 1.65

3 2.32

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

Since only present values of an annuity factor are given, the correct answer can be determined only by converting the values given into two annuities. An annuity is a series of equal payments. The given values are:

$30,000 for years 1 and 2, and $20,000 for year 3.

Those values are not equal for every year (therefore not an annuity), so the annuity factors given cannot be used with those values (as given). But, they can be converted into two series of equal payments comprised of:

$20,000 for years 1, 2 and 3, and $10,000 for years 1 and 2.

Those two cash flow streams would look like:

YEAR STREAM 1 STREAM 2 STREAM 3

Year 1 $20,000 $10,000 = $30,000

Year 2 $20,000 $10,000 = $30,000

Year 3 $20,000 = $20,000

Note that now there are two series, each of equal amounts, but which total to the same amounts as the values given. The present value of an annuity for 3 years can now be applied to $20,000 and the present value of an annuity for 2 years can be applied to $10,000. The results would be:

(1) $10,000 annuity for two years: $10,000(1.65) = $16,500

(2) $20,000 annuity for three years $20,000(2.32) 46,400

Total present value $62,900

10

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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 inflows each year for three years.

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

This question is intended to test a candidate's understanding of the conceptual relationships between present values of single amounts and present values of annuities, and the impact of length of time on present value amounts. Getting the correct answer does not require (or expect) the actual calculation of present values for each of the four choices. Here is the logic:

1. Recognize that all of the choices are for the same amount, $100. Therefore, the amount of the principal will not create a difference in present values for the choices.

2. Next, notice that choices A, B, and D are for annuities; choice C is for a single amount to be received in four years, longer than choices B and D, and as long as choice A. Since the present value of a single amount has to be less than the present value of a series of equal amounts due within the same or less time, choice C cannot result in the highest present value.

3. Next, since choices A, B, and D are all for annuities of the same amount, the longer the annuity, the higher the present value. Choices B and D are for three years; choice A is for four years.

4. Therefore, choice A will result in the highest present value.

11

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Which one of the following is interest earned on both an initial principal and the unpaid accrued interest that accumulated on that principal from prior periods?

A. Annual interest.

B. Simple interest.

C. Compound interest.

D. Discount interest.

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C. Compound interest.

Compound interest is the interest earned on both an initial principal and the unpaid accrued interest that accumulated on that principal from prior periods. In effect, with compound interest, interest is paid on interest.

12

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The following information is available on market interest rates:

The risk-free rate of interest 2%

Inflation premium 1%

Default risk premium 3%

Liquidity premium 2%

Maturity risk premium 1%

What is the market rate of interest on a one-year U.S. Treasury bill?

A. 3%.

B. 5%.

C. 6%.

D. 7%.

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A. 3%

The market rate of interest on a one-year U.S. Treasury bill would be 3%. Notice that the risk-free rate of interest and the various premiums are for the general market rate of interest, not for the rate on a one-year U.S. Treasury bill. Treasury bills are considered risk free in an environment where zero inflation is expected. Therefore, the market rate of interest on a one-year U.S. Treasury bill would be the risk-free rate plus the inflation premium (for the expected rate of inflation during the life of the security), or 2% + 1% = 3%. One-year U.S. Treasury bills are considered free of default risk, liquidity risk (because there is a very large and active secondary market for T-bills), and maturity risk (because they are for only one year).

13

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On November 1, Year 1, a company purchased a new machine that it does not have to pay for until November 1, Year 3. The total payment on November 1, Year 3 will include both principal and interest. Assuming interest at a 10% rate, the cost of the machine would be the total payment multiplied by what time value of money concept?

A. Present value of annuity of 1.

B. Present value of 1.

C. Future amount of annuity of 1.

D. Future amount of 1.

###
B. Present value of 1.

A present value of 1 factor is used because only one payment is to be made. Present value (which also is cost) = (present value of 1 factor) x (future payment). The future payment is being discounted to its present value.

14

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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 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are:

Period 1 0.88

2 1.65

3 2.32

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

Since only present values of an annuity factor are given, the correct answer can be determined only by converting the values given into two annuities. An annuity is a series of equal payments. The given values are:

$30,000 for years 1 and 2, and $20,000 for year 3.

Those values are not equal for every year (therefore not an annuity), so the annuity factors given cannot be used with those values (as given). But, they can be converted into two series of equal payments comprised of:

$20,000 for years 1, 2 and 3, and $10,000 for years 1 and 2.

Those two cash flow streams would look like:

YEAR STREAM 1 STREAM 2 STREAM 3

Year 1 $20,000 $10,000 = $30,000

Year 2 $20,000 $10,000 = $30,000

Year 3 $20,000 = $20,000

Note that now there are two series, each of equal amounts, but which total to the same amounts as the values given. The present value of an annuity for 3 years can now be applied to $20,000 and the present value of an annuity for 2 years can be applied to $10,000. The results would be:

(1) $10,000 annuity for two years: $10,000(1.65) = $16,500

(2) $20,000 annuity for three years $20,000(2.32) 46,400

Total present value $62,900

15

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Which one of the following is the annual rate of interest applicable when not taking trade credit terms of "2/10, net 30?"

A. 2.00%

B. 24.00%

C. 36.00%

D. 36.73%

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D. 36.73%

Credit terms of "2/10, net 30" mean that the debtor may take a 2% discount from the amount owed if payment is made within 10 days of the bill, otherwise the full amount is due within 30 days. The 2% discount is the interest rate for the period between the 10th day and the 30th day; it is not the effective annual rate of interest. The computation of the annual rate of interest using $1.00 would be:

Interest 1

APR = _______ x ________________

Principal Time fraction of year

.02 1

APR = ___ x ______ = .0204 x (360/20) =

.98 20/360

APR = .0204 x 18 = 36.73%

Thus, the effective annual interest rate for not taking the 2% (.02) discount is 36.73%. The 20 days in the 360/20 fraction is (30 - 10), the period of time over which the discount was lost as a result of not paying early.

16

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On August 31, Year 1, Ashe Corp. adopted a plan to accumulate $1,000,000 by September 1, Year 5. Ashe plans to make four equal annual deposits to a fund that will earn interest at 10% compounded annually.

Ashe will make the first deposit on September 1, Year 1. Future value and future amount factors are as follows:

Future value of $1.00 at 10% for 4 periods 1.46

Future amount of ordinary annuity of $1.00 at 10% for 4 periods 4.64

Future amount of annuity due of $1.00 at 10% for 4 periods 5.11

Present value of ordinary annuity of $1.00 @ 10% for 4 periods 3.17

Which one of the following would be the amount of annual deposits Ashe should make (rounded)?

A. $250,000

B. $215,500

C. $195,700

D. $146,000

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C. $195,700

***While the payments in an annuity can be made as frequently as every week, in practice, ordinary annuity payments are made monthly, quarterly, semi-annually or annually. The opposite of an ordinary annuity is an annuity due, where payments are made at the beginning of each period.***

The question is concerned with determining a series of equal deposit amounts that would total $1,000,000 at the end of four years, a future amount. Thus, a future value table, not a present value table, should be used.

Because Ashe will make a series of payments, not a single lump-sum payment, the future value of $1.00 table (1.46) is not appropriate. Finally, since Ashe will make the first payment at the beginning of the first year of the four year period (9/1/Year 1 - 9/1/Year 5), the appropriate future value (or amount) table is for an annuity due—payments are made at the beginning of each period.

Thus, the correct factor is 5.11 and the calculation would be:

$X (annual deposit) x 5.11 = $1,000,000

$X = $1,000,000/5.1 = $195,700 (rounded)

So, $195,700 deposited on September 1 of Year 1, Year 2, Year 3 and Year 4 at an interest rate of 10% would accumulate to $1,000,000 by September 1, Year 5.

17

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A corporation obtains a loan of $200,000 at an annual rate of 12%. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but it normally does not have a cash balance account with the bank. What is the effective cost of the loan?

A. 12.0%

B. 13.3%

C. 15.0%

D. 16.0%

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C. 15.0%

The effective cost of the loan (i.e., the effective interest rate on the loan) is determined as the annual dollar cost of the loan divided by the net useable proceeds of the loan. The annual dollar cost is the principal multiplied by the annual rate, or $200,000 x .12 = $24,000. The net useable proceeds of the loan is the principal amount less the amount of the compensating balance that must be maintained with the bank, or $200,000 - ($200,000 x .20) = $200,000 - $40,000 = $160,000. Therefore, the effective cost of the loan is $24,000/$160,000 = .15 (or 15%).

18

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Which one of the following U.S. GAAP approaches to determining fair value converts future amounts to current amounts?

A. Market approach.

B. Sales comparison approach.

C. Income approach.

D. Cost approach.

###
C. Income approach.

Converting future amounts to current amounts is an income approach to determining fair value under the U.S. GAAP framework. Specifically, the use of discounted cash flows to determine the current value of those flows is an example of the income approach to determining fair value.

19

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Assume the following rates exist in the U.S.:

Prime interest rate = 6%

Fed discount rate = 4%

U.S. Treasury Bond rate = 2%

Inflation rate = 1%

Which one of the following is most likely the nominal risk-free rate of return in the U.S.?

A. 1%

B. 2%

C. 4%

D. 6%

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B. 2%

In the U.S., the rate paid on U.S. Treasury Bonds (2%) is considered the risk-free rate of return; that is, the rate of return that is paid for delayed use of funds by investing them, without any risk premium attached to or paid for default risk.

20

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Which one of the following is not an element in the capital asset pricing model formula?

A. Risk-free rate of return.

B. Expected rate of return for the class of item being valued.

C. Prime interest rate.

D. A measure of volatility for the item being valued.

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C. Prime interest rate.

****The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.***

The prime interest rate is not an element in the capital asset pricing model formula. The elements used in the formula include the risk-free rate of return, beta (a measure of volatility for the asset being valued) and the expected rate of return for the entire class of the asset being valued.

21

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Assume the following values for an investment:

Risk-free rate of return = 2%

Expected rate of return = 9%

Beta = 1.4

Which one of the following is the required rate of return for the investment?

A. 9.0%

B. 9.8%

C. 11.8%

D. 12.6%

###
C. 11.8%

The required rate of return for the investment is 11.8% calculated as:

Required rate = Risk-free rate + Beta(Expected rate - Risk-free rate), or

Required rate = .02 + 1.4(.09 - .02), or

Required rate = .02 + 1.4(.07), or

Required rate = .02 + .098, or

Required rate = .118, or 11.8%

22

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A business with a net book value of $150,000 has an appropriate fair value of $120,000. Charles Harvey, one of three owners, has decided to sell his 10% interest in the business. Which one of the following is most likely the amount at which Harvey can sell his interest?

A. $40,000

B. $15,000

C. $12,000

D. < $12,000

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D. < $12,000

Harvey would likely receive less than $12,000 upon sale of his interest. While Harvey has a claim to 10% of the fair value of the business, because his ownership interest is very minor, the value of his interest upon sale would likely be less than $12,000 due to a noncontrolling interest discount.

23

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Which one of the following is not an income approach to the valuation of a business?

A. Discounted cash flow.

B. Comparable sales.

C. Earnings multiple.

D. Free cash flow.

###
B. Comparable sales.

The use of comparable sales is not an income approach to valuation of a business, it is a market approach. Under the comparable sales approach, the value of a business is determined by comparing it to other entities with comparable characteristics for which the value is more readily determinable.

24

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Which one of the following approaches to valuing a business is most likely to be appropriate when the business has been losing money and is going to be sold in a distressed sale?

A. Asset approach.

B. Market approach.

C. Income approach using capitalized earnings.

D. Income approach using free cash flow.

###
A. Asset approach.

The asset approach values a business by adding (summing) the values of the individual assets that comprise the business. When a business is losing money and is going to be sold in a distressed sale, the value of the individual assets is a better basis for valuing the business than would be other methods of valuation (e.g., market approach or income approach).

25

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Assume the following values for an investment:

Risk-free rate of return = 2%

Expected rate of return = 9%

Beta = 1.4

Which one of the following is the required rate of return for the investment?

A. 9.0%

B. 9.8%

C. 11.8%

D. 12.6%

###
C. 11.8%

The required rate of return for the investment is 11.8% calculated as:

Required rate = Risk-free rate + Beta(Expected rate - Risk-free rate), or

Required rate = .02 + 1.4(.09 - .02), or

Required rate = .02 + 1.4(.07), or

Required rate = .02 + .098, or

Required rate = .118, or 11.8%

26

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A graph that plots beta would show the relationship between

A. Asset risk and asset return.

B. Asset risk and benchmark return.

C. Benchmark risk and asset return.

D. Asset return and benchmark return.

###
D. Asset return and benchmark return.

A graph which plots beta would show the relationship between the return of an individual asset and the return of the entire class of that asset, as reflected in a benchmark return for the class.

27

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Which one of the following is not an income approach to the valuation of a business?

A. Discounted cash flow.

B. Comparable sales.

C. Earnings multiple.

D. Free cash flow.

###
B. Comparable sales.

The use of comparable sales is not an income approach to valuation of a business, it is a market approach. Under the comparable sales approach, the value of a business is determined by comparing it to other entities with comparable characteristics for which the value is more readily determinable.

28

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Which one of the following sets shows each type of business forecasting in the correct method classification?

Qualitative Methods Quantitative Methods :

Delphi method Causal models

Executive Opinion Delphi method

Time series models Causal models

Executive Opinion Market research surveys

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Delphi method Causal models

The Delphi method is a qualitative method and causal models are quantitative methods of business forecasting. The Delphi method is a qualitative forecasting method that involves development of a consensus by a group of experts using a multi-stage process to converge on a forecast. Causal models make forecasts based on relationships between variables.

29

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Which one of the following forecasting methods is based on extrapolation of past data?

A. Delphi method.

B. Causal models.

C. Time series models.

D. Market research.

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C. Time series models.

Time series models are based on extrapolation of past data. Specifically, time series models use past values or patterns to predict a future value or values.

30

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Which one of the following sets shows the most likely method appropriate for short-term and long-term forecasting?

Short-term Forecasting Long-term Forecasting

Time series models Market research surveys

Causal models Time series models

Time series models Delphi method

Delphi method Time series models

###
Time series models Delphi method

Times series models are most likely appropriate for short-term forecasting and the Delphi method is most likely appropriate for long-term forecasting. Time series models use past values or patterns to predict a future value or values, but the longer the forecasting period, the less likely will the past values or patterns be relevant to those future values. The Delphi method is a qualitative forecasting method that involves a group of experts developing a consensus using a multi-stage process to converge on a forecast, which is a particularly useful approach for long-term forecasting.

31

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A company invested in a new machine that will generate revenues of $35,000 annually for seven 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

The expected payback period is computed as the length of time needed for net cash flows to recover the initial cash investment in a project. Since the payback period is given, that period multiplied by the annual net cash inflow will result the cost of the new machine. The annual revenue is $35,000 and the annual cash expenses are $3,000, which is determined as the total operating expenses less the amount of depreciation expense included (since it is a non-cash expense). Thus, the annual net cash flow is $35,000 - $3,000 = $32,000 x 5.2 = $166,400, the correct answer.

32

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Which of the following statements concerning the discounted payback period method of evaluating capital projects is/are correct?

I. It is useful in evaluating the liquidity of a project.

II. It measures total project profitability.

III. It results in a longer computed payback period than does the undiscounted payback period method.

A. I only.

B. I and III, only.

C. II and III, only.

D. I, II and III

###
B. I and III, only.

Statements I and III are correct, but statement II is not correct. The discounted payback period method does not measure the total project profitability, it measures only the period required to recover the initial investment. The total profitability or loss of the project is not assessed.

33

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Which of the following statements concerning the discounted payback period approach to project evaluation is/are correct?

I. It takes into account cash flows received over the entire life of the project.

II. Any project economically acceptable under the payback period approach will be acceptable under the discounted payback period approach.

III. Any project economically acceptable under the discounted payback period approach will be acceptable under the payback period approach.

A. I only.

B. II only.

C. III only.

D. I and III, only

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C. III only.

All projects economically acceptable under the discounted payback period approach will be acceptable under the (undiscounted) payback period approach. The discounted payback period approach takes the time value of money into account by discounting future cash flows. That discounting results in lower current values than the undiscounted cash flows. Thus, a project that would be acceptable under the lower values of the discounted payback period approach would be acceptable under the undiscounted payback period approach. Statements I and II are not correct.

34

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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 six-year life. The corporation uses a discount rate of 10%. The discount factor for the present value of a single sum six years in the future is 0.564. The discount factor for the present value of an annuity for six 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

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C. $20,155

The net present value of the new machine is determined as the present value of future cash inflows less the present value of the current costs of the machine. The facts of this question contain two cash inflows: (1) the cash inflow of $25,000 per year for six years; and (2) the cash inflow from the salvage value of $20,000 at the end of the asset's life. The present values of those inflows are $25,000 x 4.355 (the present value of an annuity for six years) = $108,875 and $20,000 x .564 (the present value of $1 discounted for six years) = $11,280, for a total of $108,875 + $11,280 = $120,155. The present value of the cost of the new machine is $100,000. Thus, the net present value of the machine is $120,155 - $100,000 = $20,155.

35

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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.

The project with the largest after-tax [net] cash inflow would be project B, with a net cash inflow of $635. The net cash inflow would be computed as: $1,500 - $700 = $800 x (1 - .30) = $800 x .70 = $560 + ($250 x .30) = $560 + $75 = $635. The ($250 x .30) is the tax savings from the deductibility of the depreciation for tax purposes.

36

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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 five years. Yarrow's desired rate of return is 6%. The present value factor for a five-year annuity of $1, discounted at 6%, is 4.212. The present value factor of $1, at compound interest of 6% due in five 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 of the new machine is determined as the present value of future cash inflows less the present value of the current costs of the machine. Net income is not relevant in computing the net present value. In this question, the cash inflow is $150,000 per year for five years. The present value of that inflow is $150,000 x 4.212 (the present value of an annuity for five years) = $631,800. The present value of the cost of the new machine is $450,000. Thus, the net present value of the machine is $631,800 - $450,000 = $181,800.

37

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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 on a project is defined as the discount rate at which the net present value of the project equals zero. Specifically, the internal rate of return assesses a project by determining the discount rate that equates the present value of the project's future cash inflows with the present value of the project's future cash outflows.

38

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A client wants to know how many years it will take before the accumulated cash flows from an investment exceeds 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 approach to assessing an investment (e.g., a capital project) determines the number of years (or other periods) needed to recover the initial cash investment in the project and compares the resulting time with a pre-established maximum payback period. It uses nominal cash flow and ignores the time value of money.

39

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

I. Recognition of the project's salvage value.

II. Emphasis on cash flows.

III. 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.

Statements II and III are advantages of the IRR over ARR because ARR does not emphasize (use) cash flows, and does not consider the time value of money (discounted cash flow computations). ARR relates a project's annual accrual-based income (as opposed to net cash inflow) to its investment. Furthermore, both approaches consider the project's salvage value, although IRR uses the present value of the salvage amount.

40

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Which one of the following represents the formula used to calculate the profitability index for ranking projects?

A. Project Cash Flow divided by Project Cost

B. Project Cost divided by Project Cash Flow

C. Project Net Present Value divided by Project Cost

D. Project Cost divided by Project Net Present Value

###
C. Project Net Present Value divided by Project Cost

The formula used to calculate the profitability index is project net present value divided by the project cost. The resulting percentage gives a ranking that takes into account both project net present value and initial cost. The higher the percentage, the higher the project rank.

41

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Disco is considering three capital projects that have the following costs and net present values (NPV):

Project Cost NPV

X $40,000 $60,000

Y $60,000 $75,000

Z $50,000 $30,000

Which one of the projects, if any, is not economically feasible?

A. Project X.

B. Project Y.

C. Project Z.

D. All of the projects are economically feasible.

###
D. All of the projects are economically feasible.

Because all of the projects have a positive net present value, they are all economically feasible. NET present value is the difference between present value of cash inflows and cost of the investment.

42

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What is the formula for calculating the profitability index of a project?

A. Subtract actual after-tax net income from the minimum required return in dollars.

B. Divide the present value of the annual after-tax cash flows by the original cash invested in the project.

C. Divide the initial investment for the project by the net annual cash inflows.

D. Multiply net profit margin by asset turnover.

###
B. Divide the present value of the annual after-tax cash flows by the original cash invested in the project.

The profitability index is computed by dividing the present value of annual after-tax cash flows by the original cash invested in the project.

43

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Which of the following statements is correct regarding financial decision making?

A. Opportunity cost is recorded as a normal business expense.

B. The accounting rate of return considers the time value of money.

C. A strength of the payback method is that it is based on profitability.

D. Capital budgeting is based on predictions of an uncertain future.

###
D. Capital budgeting is based on predictions of an uncertain future.

Capital budgeting is the process of measuring, evaluating, and selecting long-term investment opportunities. Inherent in every capital investment opportunity (i.e., capital project) are elements of risk and reward. Risk is the possibility of loss or other unfavorable results that derives from the uncertainty implicit in future outcomes. The time periods, expected costs and savings, and other elements used in capital budgeting are largely estimates or predictions about an uncertain future.

44

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Which of the following statements concerning the accounting rate of return approach to evaluating capital projects is/are correct?

I. It considers the entire life of a project.

II. It considers the time value of money.

III. It assumes that the incremental net income is the same each year.

A. I only.

B. II only.

C. I and II, only.

D. I and III, only.

### D. I and III, only.

45

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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 is acquired. The equipment's estimated useful life is 10 years, with no residual value, and it 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.

Accrual accounting rate of return based on initial investment is

A. 30%

B. 20%

C. 12%

D. 10%

###
D. 10%

The accounting rate of return = (Change in) Annual accounting income/Initial Investment. For the facts given, the annual change in accounting income will be $20,000 - ($100,000/10 years) = $10,000. The accounting rate of return would be: $10,000/$100,000 = 10%.

46

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Phillips Company is considering the acquisition of a new machine that would cost $66,000, has an expected life of 6 years, and an expected salvage value of $16,000. The company expects the machine to provide annual incremental income before taxes of $7,200. Phillips has a tax rate of 30%. If Phillips uses average values in its calculations, which one of the following will be the average accounting rate of return on the machine?

A. 10.08%

B. 10.90%

C. 12.29%

D. 14.40%

###
C. 12.29%

The (average) accounting rate of return is determined by dividing the average annual after-tax net income by the average cost of the investment. The after-tax income would be $7,200 x .70 = $5,040. The average cost of the investment would be beginning book value ($66,000) + ending book value of ($16,000), or $82,000/2 = $41,000. Therefore, the accounting rate of return is: $5,040/$41,000 = 12.29%.

47

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Which one of the following most likely would not be considered when computing the weighted average cost of capital?

A. Short-term debt.

B. Long-term debt.

C. Common stock.

D. Preferred stock.

###
A. Short-term debt.

Short-term debt likely would not be considered when computing the weighted average cost of capital. Short-term debt is not considered part of the capital structure of an entity.

48

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The term "capital structure" refers to which one of the following?

A. All debt.

B. All equity.

C. All debt and equity.

D. All long-term debt and equity.

###
D. All long-term debt and equity.

Capital structure includes all long-term debt and all owners' equity. It does not include short-term debt.

49

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The term "financial structure" refers to which one of the following?

A. All debt.

B. All equity.

C. All debt and equity.

D. All long-term debt and equity.

###
C. All debt and equity.

Financial structure includes all debt and all owners' equity.

50

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Alpha Company borrowed $20,000 from High Bank, giving a one-year note. The terms of the note provided for 6% interest and required a 10% compensating balance. Which one of the following is the effective rate of interest on the loan?

A. 4.0%

B. 6.0%

C. 6.7%

D. 10.0%

###
C. 6.7%

The effective rate of interest on the loan is 6.7% and is computed as the net proceeds from the loan divided into the cost of the loan. The cost of the loan is $1,200 ($20,000 x .06 = $1,200) and the net proceeds is $18,000 ($20,000 - [.10 x $20,000] = $18,000

51

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Which one of the following generally is not an advantage associated with the use of trade accounts payable and accrued accounts payable for short-term financing needs?

A. Flexibility.

B. Ease of use.

C. Available for all short-term needs.

D. Absence of collateral required.

###
C. Available for all short-term needs.

Trade and accrued accounts payable are not available for financing all short-term needs. They can be used only for financing costs/expenses acquired through trade and accrual accounts. For example, they could not be used to finance short-term cash borrowings. A short-term note (or other source) would be used to meet short-term cash needs.

52

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Which one of the following forms of short-term financing is least likely to be restricted as to use of proceeds?

A. Trade accounts payable.

B. Accrued taxes payable.

C. Accrued salaries payable.

D. Short-term notes payable.

###
D. Short-term notes payable.

As a form of short-term financing, short-term notes usually provide cash which often may be used for various asset and expense purposes.

53

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Which one of the following typically is not a characteristic of commercial paper?

A. Matures in the short-term.

B. Loans are secured.

C. Users have high credit ratings.

D. Provide cash for operating use.

###
B. Loans are secured.

Commercial paper is short-term unsecured promissory notes. Typically, use of commercial paper does not involve security from the borrower.

54

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Po Co. plans to use its inventory as collateral for a short-term loan. Which one of the following types of loan agreements with its lender would provide Po Co. the most flexibility in the use of the inventory it pledges as collateral?

A. Field warehouse agreement.

B. Floating lien agreement.

C. Chattel mortgage agreement.

D. Terminal warehouse agreement.

###
B. Floating lien agreement.

Under a floating lien agreement the borrower gives the lender a lien against its inventory, but retains control of the inventory and can continuously sell and replace the inventory.

55

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Which one of the following would an importer of goods from a new foreign supplier most likely use to assure the supplier of payment?

A. Line of credit.

B. Letter of credit.

C. Trade account application.

D. Commercial paper.

###
B. Letter of credit.

A letter of credit would be used to assure a foreign supplier of payment. A letter of credit is a conditional commitment to pay a third party in accordance with specified terms.

56

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Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days:

Value of receivables to be held in reserve for contingencies 10%

Following costs are deducted at time accounts are factored:

Interest rate on amounts provided before deducting interest (annual rate) 12%

Factor fee on total receivables factored 2%

If Nexco plans to factor $200,000 of accounts receivable due in 30 days, which one of the following is the amount it will receive from Factorco at the time the accounts are factored?

A. $154,880

B. $174,240

C. $176,000

D. $196,000

###
B. $174,240

The amount provided would be $200,000 accounts receivable - $20,000 reserve - $4,000 factor fee = $176,000, for which interest would be charged for 30 days, or 1% (i.e., 1/12 of 12%). Therefore, the correct amount received would be $176,000 - ($176,000 x .01) = $176,000 - $1,760 = $174,240.

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