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Flashcards in Financial Management - Other Deck (27):
1

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%

2

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 12%
Factor fee on total receivables factored 2%

If Nexco factors $200,000 of its accounts receivable due in 30 days with Factorco and, during that 30 days, $10,000 of those accounts receivable are reversed because the related goods were return or allowances were granted, which one of the following is the amount that Nexco will receive from Factorco at the end of the 30 day period?
A. $ -0- (no amount)
B. $ 9,800
C. $10,000
D. $19,600

C. $10,000


The amount held in reserve was .10 x $200,000, or $20,000. During the 30-day period of the factor agreement, $10,000 of the accounts receivable factored had to be reversed because of sales returns and allowances. Therefore, at the end of the 30-day period, Factorco would pay Nexco the remaining $10,000 ($20,000 reserve - $10,000 reversed = $10,000).

3

Which one of the following is a form of inventory secured loan in which the inventory is placed under the control of an independent third party?
A. Floating lien agreement.
B. Chattel mortgage agreement.
C. Field warehouse agreement.
D. Recourse loan agreement.

C. Field warehouse agreement.


In a field warehouse agreement, the inventory that serves as security for a borrowing remains with the borrower, but is place under the control of an independent third party. (Also, in a terminal warehouse agreement, the inventory is moved to a public warehouse and placed under the control of an independent third party.)

4

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.

5

Which of the following statements concerning long-term financing is/are correct?

I. Long-term financing consists of sources that constitute capital structure.

II. Long-term financing consists of sources on which the weighted-average cost of capital is based.

III. Long-term financing consists only of equity sources of capital.
A. I only.
B. I and II, only.
C. I and III, only.
D. I, II, and III.

B. I and II, only.

Statements I and II are correct; Statement III is not correct. Long-term financing consists of sources that constitute capital structure (as opposed to financial structure). These are the sources of financing that are used to calculate the weighted-average cost of capital (Statements I and II, respectively). Statement III is not correct because long-term financing includes long-term debt, as well as equity.

6

Which one of the following would not be considered a means of long-term financing?
A. Financial lease.
B. Common stock.
C. Trade accounts payable.
D. Bonds payable.

C. Trade accounts payable

The use of trade accounts payable (a current liability) is a means of short-term financing, not long-term financing.

7

What impact will the issuing of new preferred stock have on the following for the issuing entity?
Long-Term Debt Debt-to-Equity Ratio
Increase Increase
Increase Decrease
No Change Increase
No Change Decrease

No Change Decrease

Since preferred stock is not debt, there will be no effect on long-term debt; however, since preferred stock is equity, the debt-to-equity ratio will decrease.

8

Bander Co. is determining how to finance some long-term projects. Bander has decided it prefers the benefits of no fixed charges, no fixed maturity date, and an increase in the credit-worthiness of the company. Which of the following would best meet Bander's financing requirements?
A. Bonds.
B. Common stock.
C. Long-term debt.
D. Short-term debt.

B. Common stock.

Issuing common stock to finance its projects would best meet Bander's financing strategy. Specifically, issuing common stock would (1) not result in fixed charges, since dividends are at the discretion of the Board of Directors, (2) not result in a fixed maturity date, since common stock does not mature, and (3) would likely increase the credit-worthiness of the company because the issuance of additional common stock would reduce its debt to equity ratio by increasing equity.

9

The market price of a bond issued at a premium is equal to the present value of its principal amount
A. Only, at the stated interest rate.
B. And the present value of all future interest payments, at the stated interest rate.
C. Only, at the market (effective) interest rate.
D. And the present value of all future interest payments, at the market (effective) interest rate.

D. And the present value of all future interest payments, at the market (effective) interest rate.


The market price of a bond, whether issued at par, at a premium, or at a discount, will be the present value of the principal amount plus the present value of future interest payments, all at the market (effective) rate of interest.

10

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%


The current cost of capital for newly issued preferred stock is computed as the net proceeds per share divided into the annual cost (dividends) of the newly issued shares. In this question, the net proceeds per share is given as $40 sales price less $5 per share issue cost, or $35 per share net proceeds. The annual cost of the newly issued shares is the par value, $20, multiplied by the preferred dividend rate, 9%, or $20 x .09 = $1.80 annual dividend per share. Therefore, the cost of capital for the newly issued preferred stock is $1.80/$35.00 = 5.1%.

11

Allen issues $100 par value preferred stock that is selling for $101 per share, on which the firm has to pay an underwriting fee of $5 per share sold. The stock is paying an annual dividend of $10 per share. Allen's tax rate is 40%. Which one of the following is the cost of preferred stock financing to Allen?
A. 4.2%
B. 6.2%
C. 9.9%
D. 10.4%

D. 10.4%


The correct calculation is the annual dividend divided by the net proceeds of the stock issuance. Therefore, the calculation would be $10 annual dividend/$101 selling price - $5 underwriter's fee = $96 proceeds, or $10/$96 = 10.4%

12

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 firm's cost of common equity is the rate of return currently expected by potential investors in the firm's common stock. When it is assumed that the dividends are expected to grow at a constant rate, that rate of return is calculated as:

Common Stock Expected Return (CSER) = (Dividend in 1st Year/Market Price) + Growth Rate

Using the values given: CSER = ($4.25/$85.00) + .07
CSER = .05 + .07 = .12 (or 12%)

The CSER of 12% is the cost of capital through common stock financing.

13

Which of the following considerations typically would be important in selecting investments for the temporary use of "excess" cash?
Safety of Principal Ready Marketability
Yes Yes
Yes No
No Yes
No No

Safety of Principal Ready Marketability
Yes Yes


In selecting short-term investments for "excess" cash, a firm would be concerned with (1) safety of principal, (2) price stability of the investment instrument, and (3) ability to readily convert the investment to cash without undue cost.

14

Moe's Boat Service currently does not offer a discount to encourage its customers to pay early for services provided to them. Moe has discussed with his accountant the possibility of offering a 2% discount to improve its cash conversion cycle. Moe's accountant determined the following:

Credit sales expected to remain unchanged at $1,000,000
The 2% discount is expected to be taken on 40% of accounts receivable balance amounts.
The average accounts receivable would likely decrease by $ 30,000
Moe has an opportunity cost of 15% associated with its use of cash.

Which one of the following is the dollar amount of net benefit or cost that Moe would obtain if the proposed 2% discount plan is implemented?
A. $ 3,500
B. $ 4,500
C. $ 8,000
D. $20,000

A. $ 3,500

The benefits obtained would be the reduction in working capital required for carrying average accounts receivable of $30,000 multiplied by the opportunity cost of .15 = $4,500. The cost of the plan would be the reduced cash collected on accounts receivable of .02 times the 40% expected to take advantage of the discount (.02 x .40 = .008) times the credit sales, or .008 x $1,000,000 = $8,000. So, the net results would be an increase in cost of $4,500 - $8,000 = - $3,500. Although not clearly stated in the problem "facts," the decrease is intended to be average accounts receivable. As this is an actual AICPA exam question, the wording has been left unchanged.

15

Which of the following inventory management approaches seeks to minimize total inventory costs by considering both the restocking (reordering) cost and the carrying costs?
A. Economic order quantity.
B. Just-in-time.
C. Materials requirements planning.
D. ABC.

A. Economic order quantity.


The economic order quantity model seeks to determine the order size that will minimize total inventory cost, both order cost and carrying costs.

While the question can be answered quite easily, because the economic order quantity answer choice is the only one that is concerned with minimizing total inventory cost by considering carrying cost and restocking cost (reordering costs), the wording of the question is ambiguous at best. It would have been better worded as "Which of the following inventory management approaches seeks to minimize total inventory costs by considering both the restocking (reordering) cost and the carrying costs?" Because it is an actual AICPA exam question, the wording has been left unchanged.

16

Which one of the following is not a characteristic of a just-in-time inventory system?
A. Reducing distance and time between related production operations.
B. Establishing close, long-term relationships with suppliers.
C. Decreasing the number of deliveries from suppliers.
D. Reducing raw material safety stock.

C. Decreasing the number of deliveries from suppliers.

Under a just-in-time inventory system, a firm reduces its inventory on-hand and relies on suppliers to make more frequent deliveries – deliveries that provide inventory just in time to be input into the production process. Thus, decreasing the number of deliveries from suppliers is not a characteristic of a just-in-time inventory system; rather, such a system increases the number of deliveries.

17

The cost of debt most frequently is measured as
A. Actual interest rate.
B. Actual interest rate adjusted for inflation.
C. Actual interest rate plus a risk premium.
D. Actual interest rate minus tax savings.

D. Actual interest rate minus tax savings.

The cost of debt most frequently is measured as the actual interest rate minus the tax savings. The tax savings result because the interest expense is deductible for tax purposes and the resulting tax savings reduce the effective cost (and rate) of debt financing. For example, if the stated (actual) interest rate is 10% and the tax rate is 40%, the effective interest rate (actual interest rate minus tax savings) will be 10% x (1.00 - .40), or 10% x .60 = 6% effective cost of debt.

18

Selected data pertaining to Lore Co. for the calendar year 2003 is as follows:

Net cash sales $ 3,000
Cost of goods sold 18,000
Inventory at beginning of year 6,000
Purchases 24,000

Which one of the following was Lore's average days' sales in inventory?
A. 3 days
B. 6 days
C. 25 days
D. 180 days

D. 180 days


The average days' sales in inventory is calculated as: 360 days/Inventory Turnover.
Inventory Turnover = COGS/Average Inventory
In this problem, average inventory is BI = $6,000 + EI = $12,000 = $18,000/2 = $9,000.
The EI is BI = $6,000 + Purchases = $24,000 = $30,000 - COGS = $18,000 = $12,000.
Therefore, inventory turnover is COGS = $18,000/Avg Inven = $9,000 = 2.
Then, 360/2=180.

19

Cyco, Inc. determined the following concerning its operating activities:

Accounts receivable conversion cycle 18 days
Accounts payable conversion cycle 21 days
Inventory conversion cycle 24 days

Which one of the following is the length of Cyco's operating cycle?
A. 42 days.
B. 39 days.
C. 21 days.
D. 15 days.

A. 42 days.


The operating cycle is the average length of time between the acquisition of inventory and the collection of cash from the sale of that inventory. It is measured by the inventory conversion cycle + the accounts receivable conversion cycle. Cyco's inventory conversion cycle is 24 days and its accounts receivable conversion cycle is 18 days. Thus its operation cycle is 24 + 18 = 42 days.

20

Which of the following statements concerning ratio analysis is/are correct?

I. Ratio analysis uses only monetary measures for analysis purposes.

II. Ratio analysis uses only measures from financial statements for analysis purposes.
A. I. only.
B. II only.
C. Both I and II.
D. Neither I nor II.

D. Neither I nor II.

Ratio analysis uses monetary measures as well as other quantitative measures. For example, in the earnings per share calculation, the number of shares of common stock, a non-monetary measure, is used. Ratio analysis also uses financial statement measures in addition to measures that are not a part of financial statements. For example, the price-earnings ratio uses the market price of the stock, a measure not found in the financial statements.

21

Information that relates to a firm's solvency is used primarily to assess a firm's ability to
A. Convert assets to cash.
B. Pay its debts.
C. Generate profits.
D. Collect its receivables in a timely manner.

B. Pay its debts.

Measures related to the solvency of a firm are primarily concerned with the ability of a firm to pay its debts as they become due.

22

Cyco, Inc. determined the following concerning its operating activities:

Accounts receivable conversion cycle 18 days
Accounts payable conversion cycle 21 days
Inventory conversion cycle 24 days

Which one of the following is the length of Cyco's cash cycle?
A. 42 days.
B. 39 days.
C. 21 days.
D. 15 days.

C. 21 days.

The cash cycle can be determined as the operating cycle (i.e., inventory conversion cycle [24 days] + accounts receivable conversion cycle [18 days]) less the accounts payable conversion cycle [21 days]. Thus, Cyco's cash cycle would be computed as 24 + 18 = 42 - 21 = 21 days, the correct answer.

23

Barr Co. has total debt of $420,000 and stockholders' equity of $700,000. Barr is seeking capital to fund an expansion.
Barr is planning to issue an additional $300,000 in common stock and is negotiating with a bank to borrow additional funds. The bank is requiring a debt-to-equity ratio of .75.

What is the maximum additional amount Barr will be able to borrow if the stock is issued?
A. $225,000
B. $330,000
C. $525,000
D. $750,000

Barr's implied balance sheet and related calculations are:

Total Assets $1,120,000
Total Debt 420,000
Owners' Equity 700,000 + New Issue $300,000 = $1,000,000
Debt + Equity $1,120,000 Debt to Equity Ratio .75
Total Possible Debt $ 750,000
Less: Current Debt 420,000
Maximum Additional Debt $ 330,000

In summary, if Barr issues $300,000 in new common stock, it would have $1,000,000 in common stock outstanding.
With a maximum debt to equity ratio of .75, the maximum debt is .75 x $1,000,000 = $750,000. Since it now has total debt of $420,000, a maximum additional $330,000 in debt could be incurred.

24

Will the capitalization of a lease by the lessee increase or decrease the debt to equity and asset turnover ratios?
Debt to Equity Ratio Asset Turnover Ratio
Increase Increase
Increase Decrease
Decrease Increase
Decrease Decrease

Debt to Equity Ratio Asset Turnover Ratio
Increase Decrease

Capitalization of a lease by a lessee results in the lessee recording an asset and a liability. The increase in a liability (debt), without a change in equity, will increase the debt to equity ratio. The results can be seen in the following example:

Debt = $200 = 2:1 + Lease $50 = $250 = 2.5:1
Equity $100 $100

A change from 2:1 to 2.5:1 is an increase in the debt to equity ratio. Since capitalization of a lease increases the assets of an entity, the asset turnover ratio will decrease. The results can be seen in the following example:

Net Sales = $600 = 3 times+ Lease $50 = $600 = 2.4 times
Assets $200 $250

A change from 3 times to 2.4 times is a decrease in the turnover ratio

25

A company has several long-term floating-rate bonds outstanding. The company's cash flows have stabilized, and the company is considering hedging interest rate risk. Which of the following derivative instruments is recommended for this purpose?
A. Structured short-term note.
B. Forward contract on a commodity.
C. Futures contract on a stock.
D. Swap agreement.

D. Swap agreement.


A swap agreement would be recommended to hedge interest rate risk on long-term floating-rate bonds. In an interest rate swap agreement one stream of future interest payments (e.g., floating-rate payments) is exchanged for another stream of future interest payments (e.g., fixed-rate payments) for a specified principal amount. In this case, an interest rate swap would hedge (mitigate) exposure to fluctuations in interest rates of the floating-rate bonds by exchanging those payments for a fixed-rate payment.

26

Which one of the following named risks cannot be mitigated through diversification of investments?
A. Unsystematic risk.
B. Systematic risk.
C. Firm-specific risk.
D. Company unique risk.

B. Systematic risk.

Systematic risk, also called non-diversifiable risk or market-related risk, cannot be mitigated or eliminated through diversification of investments. This type of risk is most closely associated with elements of the macroeconomic environment in which a firm operates and would include, for example, interest rate risk and inflation risk.

27

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 (PI) method of capital project evaluation should be the method used in comparing capital projects when capital rationing needs to be considered. The profitability index method (also called the cost/benefit ratio) is primarily intended for use in ranking projects. It does so by taking into account both the present value and the cost of each project.