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Flashcards in Financial Management - Part 3 Deck (34):
1

Each of the following periods is included when computing a firm's target cash conversion cycle, except the
A. Inventory conversion period.
B. Payables deferral period.
C. Average collection period.
D. Cash discount period.

D. Cash discount period.


The cash discount period is not included when computing a firm's target cash conversion cycle. The cash discount period is the period of time during which a debtor is offered a discount for early payments of an account and does not establish when cash is actually received. The actual collection of cash could be any time during or after the discount period and it is that actual date of collection that enters into the measurement of the cash conversion cycle.

2

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.

3

A company has the following information in its financial records:

Beginning Ending
Balance Balance
Cash $ 3,900 $ 3,000
Marketable Securities 3,800 4,400
Accounts Receivable 14,600 12,900
Total current assets $ 22,300 $20,300


Net sales $103,200
Expenses 20,430
Net Income $ 82,770

What is the company's receivable turnover ratio?
A. 6.0.
B. 7.1.
C. 7.5.
D. 8.0.

C. 7.5.

A company's accounts receivable turnover ratio measures the number of times that its accounts receivable are incurred and collected (turnover) within a period. It is computed as net sales (or net credit sales) divided by the average of net accounts receivable outstanding for the period. The average accounts receivable for the period normally is determined by summing the beginning and ending accounts receivable balance and dividing by 2. In this question the beginning and ending accounts receivable balances are $14,600 and $12,900, respectively. Thus, the correct calculation would have been net sales $103,200/($14,600 + $12,900/2) = $103,200/$13,750 = 7.5.

4

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.

5

Which one of the following constitutes (measures) the operating cycle of an entity?
A. Accounts payable conversion cycle + accounts receivable conversion cycle.
B. Inventory conversion cycle + accounts payable conversion cycle.
C. Inventory conversion cycle + cash conversion cycle.
D. Inventory conversion cycle + accounts receivable conversion cycle.

D. Inventory conversion cycle + accounts receivable conversion cycle.


The operating cycle measures 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.

6

The controller of Peabody, Inc. has been asked to present an analysis of accounts receivable collections at the upcoming staff meeting. The following information is used:
12/31, year 2 12/31, year 1
Accounts receivable $100,000 $130,000
Allowance, doubtful accounts (20,000) (40,000)
Sales 400,000 200,000
Cost of goods sold 350,000 70,000

What is the receivables turnover ratio as of December 31, year 2?
A. 5.0
B. 4.7
C. 3.5
D. 0.6

B. 4.7

Accounts receivable turnover is calculated as: (Net Credit) Sales/Average Net Accounts Receivable.

In this question, it is first necessary to compute average net accounts receivable.

Average Net Accounts Receivable = [Beginning Net Accounts Receivable ($130,000 - $40,000 = $90,000) + Ending Net Accounts Receivable ($100,000 - $20,000 = $80,000)]/2 = ($90,000 + $80,000 = $170,000)/2 = $85,000

Accounts Receivable Turnover = $400,000/$85,000 = 4.705

7

A corporation manages inventory performance by monitoring its inventory turnover. Selected financial records for the corporation are as follows:
Year 1 Year 2 Year 3
Annual sales $1,262,500 $1,062,500 $1,459,000
Gross annual profit percentage 45% 30% 40%

The beginning finished goods inventory for year 2 was 20% of year 2 sales. The ending finished goods inventory for year 2 was 18% of year 3 sales. What was the corporation's inventory turnover for year 2?
A. 1.34
B. 2.83
C. 3.03
D. 3.13

D. 3.13

Inventory turnover measures the number of times that inventory is acquired and sold or used during a period. It is calculated as: Cost of Goods Sold/Average Inventory (i.e., beginning inventory + ending inventory/2). In this question, the cost of goods sold is determined using the inverse of the gross annual profit percentage (which is the gross annual cost percentage), or $1,062,500 x (1.0 - .30) = $1,062,500 x .70 = $743,750, the cost of goods sold. The average inventory is determined using the percentage of sales that constitutes inventory as give in the facts. Specifically, year 2 beginning inventory is $1,062,500 x .20 = $212,500 and year 2 ending inventory is $1,459,000 x .18 = $262,620. The average is the sum of beginning plus ending divided by 2, or $212,500 + 262,620 = $475,120/2 = $237,560, the average inventory. Therefore, the inventory turnover is: $743,740/$237,560 = 3.13 - the inventory turned over 3.13 times during year 2.

8

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

B. $330,000


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.

9

Stent Co. had total assets of $760,000, capital stock of $150,000, and retained earnings of $215,000. What was Stent's debt-to-equity ratio?
A. 2.63
B. 1.08
C. 0.52
D. 0.48

B. 1.08


The debt-to-equity ratio is computed as: Total Liabilities/Total Equity. In this question, it is first necessary to compute both total liabilities and total equity.

Total Equity = Capital Stock ($150,000) + Retained Earnings ($215,000) = $365,000

Total Liabilities = Assets ($760,000) - Total Equity ($365,000) = $395,000

Debt-to Equity Ratio = Total Liabilities ($395,000)/Total Equity ($365,000) = 1.0821.

10

Echo Company has a long-term, variable-rate note payable outstanding, for which it does not elect the fair value option. Early in its fiscal year, the interest rate on its note increased as a result of changes in the market.

What effect will the increase in interest rate on its note payable have on its net income for the fiscal year and on its debt to equity ratio at the end of its fiscal year (compared to no change in the interest rate)?
Net Income Debt to Equity Ratio
Increase Increase
Increase Decrease
Decrease Increase
Decrease Decrease

Decrease Increase

The increase in the interest rate will increase Echo's interest expense for the year and decrease it net income for the year. While the change in interest rate will not change the carrying value of the note payable, the decrease in net income for the year will result in lower retained earnings (than if the interest rate had not changed).
Since retained earnings is an element of equity, the debt to equity ratio will increase - there will be less equity relative to the same debt.

11

Debt-paying ability of a company might be assessed using the "debt ratio" or the "debt to equity ratio" (among others). For each of these ratios, is the company's debt-paying ability (debt position) better if the ratio is higher or lower?
Debt Ratio Debt to Equity Ratio
Higher Higher
Higher Lower
Lower Higher
Lower Lower

Lower Lower


The debt ratio measures the percentages of a company's assets that are financed by total debt, both short-term and long-term. The calculation would be:

Debt ratio = Total Debt
Total Assets

The resulting percentage (which must be less than 1.00) shows the extent to which the company's assets are financed by debt. The reciprocal percent (i.e., 1.00 - debt ratio) would be the percent of assets financed by owners' equity. (Remember: Assets = Debt + Equity). The lower the existing debt ratio (level of debt relative to assets), the better the firm's debt-paying ability (or position). The debt to equity ratio measures the relative amounts of financing provided by creditors and owners.
The calculation would be:

Debt to equity ratio = Total Debt
Total Owners' Equity

The resulting percentage (which could be more or less than 1.00) shows the amount of resource financing provided by creditors relative to owners. The lower the existing debt to equity ratio (level of debt relative to owners' equity), the better the firm's debt-paying ability (or position). Therefore, the lower each of these ratios, the better the debt position of a company.

12

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.

13

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.

14

A firm with cash in excess of its immediate needs is considering a temporary investment in newly issued 10-year treasury obligations, which pay a fixed rate of interest.
If the investment will be for one year, which of the following risks, if any, would be of concern?
Default Risk Interest Risk
Yes Yes
Yes No
No Yes
No No

No Yes


Debt obligations of the U.S. government are considered to be free of the risk of default, therefore risk of default on the debt would not be of concern. Interest rate risk would be of concern. Interest rate risk derives from the effects on market value resulting from changes in the rate of interest in the market. If the interest rate increases relative to the rate at the time the fixed-rate Treasury obligations are acquired, the market value of the Treasury obligations will decrease (and vice versa).

Furthermore, the longer the maturity of the fixed-rate obligations, the greater the influence of a given interest rate change on current market value. Since the Treasury obligation is to be sold in one year, not held to maturity, the value of the obligations at the date of sale will depend on the market interest rate at that time relative to the rate when the obligations are acquired.

15

If a CPA's client expected a high inflation rate in the future, the CPA would suggest to the client which of the following types of investments?
A. Precious metals.
B. Treasury bonds.
C. Corporate bonds.
D. Common stock.

A. Precious metals.


Of the alternative answer choices listed, during a period of high inflation, the best investment is precious metals. Because of their scarcity, precious metals tend to increase in market value during periods of inflation. Treasury bonds and corporate bonds, both of which typically pay fixed rates of return, face market interest rate risk and will lose market value as inflation drives up the general rate of interest. While common stock may provide some protection during a period of high inflation, that inflation causes the costs of productive inputs to increase, therefore, increasing pressure on company profits and returns to common stock shareholders.

16

The following data pertain to Cowl Inc. for the year ended December 31, Year 1:

Net sales
$ 600,000
Net income
150,000
Total assets, January 1, Year 1
2,000,000
Total assets, December 31, Year 1
3,000,000

Which one of the following was Cowl's rate of return on assets for Year 1?
A. 5%
B. 6%
C. 20%
D. 24%

B. 6%


The rate of return on assets (ROA) is computed as: ROA = Net Income + Interest Expense/Average Total Assets Since this question does not provide the amount of interest expense, the unadjusted net income must be used as the numerator. Beginning and ending total assets must be used to get an average total assets for the year. That calculation would be: Beginning assets $2,000,000 + Ending assets $3,000,000 = $5,000,000/2 = $2,500,000 average total assets. The ROA calculation would be: ROA = NI/Average Asset = $150,000/$2,500,000 = .06, or 6% ROA.

17

The following selected data pertain to the Darwin Division of Beagle Co. for Year 1:

Sales $400,000
Operating income 40,000
Capital turnover 4
Imputed interest rate 10%
What was Darwin's Year 1 residual income?
A. $0
B. $4,000
C. $10,000
D. $30,000

D. $30,000

Residual income is the excess of the division's income over the income that would be required based on the 10% imputed interest rate and the amount invested in divisional assets. This question requires a determination of divisional assets. The division's assets turned over four times, meaning, with sales of $400,000, the division has $100,000 of assets. The expected income for this division is then 10% of that amount, or $10,000. Thus, residual income is: Operating income ($40,000) - expected income ($10,000) = $30,000. This amount represents the excess of actual operating income of the division over the minimum amount that is required for a division with $100,000 worth of assets invested.

18

Ral Co.'s target gross margin is 60% of the selling price of a product that costs $5.00 per unit. The product's selling price per unit should be
A. $17.50
B. $12.50
C. $8.33
D. $7.50

B. $12.50

Gross margin is Selling Price - Cost of Sales. Therefore, the formula for solution is:

Selling Price - Cost = .60 Selling Price.
Rearranged: Selling Price - .60 Selling Price = Cost ($5.00).

Therefore, .40 Selling Price = $5.00, or Selling Price = $5.00/.40 = $12.50.

19

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) represents the residual income that remains after the cost of all capital, including equity capital, has been deducted. It is calculated as an entity's net after-tax operating profit less the cost of capital provided by debt holders and shareholders. It is a performance metric intended to measure economic profit, not accounting profit.

20

The amount of net sales minus the amount of cost of goods sold measures:
A. Gross profit
B. Net profit
C. Financial leverage
D. Operating leverage

A. Gross profit

Net sales minus cost of goods sold is gross profit, the amount available to cover operating and other expenses, and provide a net profit.
The gross profit is used to compute the gross profit margin (or ratio) = gross profit/ net sales, which denotes the percent of each dollar of sale remaining after cost of goods sold are deducted.

21

Kim Co.'s profit center Zee had Year 1 operating income of $200,000 before a $50,000 imputed interest charge for using Kim's assets. Kim's aggregate net income from all of its profit centers was $2,000,000. During Year 1, Kim declared and paid dividends of $30,000 and $70,000 on its preferred and common stock, respectively.

Zee's Year 1 residual income was
A. $140,000
B. $143,000
C. $147,000
D. $150,000

D. $150,000


The dividend information is not relevant to the question. Dividends are a distribution, rather than a determinant, of income. Residual income is computed as:

Residual income = operating income - imputed charge
= $200,000 - $50,000
= $150,000
The imputed charge is the product of a minimum rate of return and the invested capital in the division. The imputed charge is the minimum income that should be achieved by the division with that much invested capital.

22

Which one of the following characteristics is not an advantage of the Black-Scholes option pricing model?
A. Incorporates the probability that the price of the stock will pay off within the time to expiration.
B. Incorporates the probability that the option will be exercised.
C. Discounts the exercise price.
D. Accommodates options when the price of the underlying stock changes significantly and rapidly.

D. Accommodates options when the price of the underlying stock changes significantly and rapidly.


The Black-Scholes option pricing model does not accommodate options when the price of the underlying stock changes significantly and rapidly. The Black-Scholes model assumes that the stock for which the option is being valued increases in small increments.

23

Which one of the following is not a limitation of the basic Black-Scholes option pricing model?
A. It fails to consider the probability that the option will be exercised.
B. It assumes the stock does not pay dividends.
C. It assumes the risk-free rate of return used for discounting remains constant during the option period.
D. It assumes the option can be exercised only at the expiration date.

A. It fails to consider the probability that the option will be exercised.


Failing to consider the probability that the option will be exercised is not a limitation of the basic Black-Sholes option pricing model. The basic Black-Scholes option pricing model does consider the probability (likelihood) that the option will be exercised.

24

The P/E ratio for a share of common stock is computed as:
A. Par value/EPS.
B. Par value x EPS.
C. EPS x Market price.
D. Market price/EPS.

D. Market price/EPS.


The price/earnings (P/E) ratio is computed as the market price of the stock divided by the earnings per share (EPS). Note that both values are on a per share basis and the resulting calculation shows the relationship between the price of a share of stock in the market and the earnings for each share of stock.

25

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 method (IRR - also called the time adjusted rate of return) evaluates 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 cash outflows. The rate so determined is the rate of return earned by the project. The IRR uses both present value and cash flows.

26

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

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.

27

The discount rate is determined in advance for which of the following capital budgeting techniques?
A. Payback.
B. Accounting rate of return.
C. Net present value.
D. Internal rate of return.

C. Net present value.

The discount rate is determined in advance when using the net present value capital budgeting technique. The net present value technique compares the present value of expected cash inflows with the present value of cash outflows to determine whether or not a capital project is economically feasible. Determining present values requires the use of a predetermined discount rate. Often the firm's cost of capital is used as the discount rate.

28

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 metric equates the present value of a project's expected cash inflows to the present value of the project's expected costs. It does so by determining the discount (interest) rate that equates the present value of the project's future cash inflows with the present value of the project's cash outflows. The rate so determined is the rate of return earned on the project.

29

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.

An internal rate of return is a time-adjusted rate of return from an investment. In capital budgeting an internal rate of return approach (also called a time adjusted rate of return) evaluates 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 cash outflows. The rate so determined is the expected rate of return to be earned by the project.

30

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.

31

Which of the following formulas should be used to calculate the historic economic rate of return on common stock?
A. (Dividends + change in price) divided by beginning price.
B. (Net income - preferred dividend) divided by common shares outstanding.
C. Market price per share divided by earnings per share.
D. Dividends per share divided by market price per share.

A. (Dividends + change in price) divided by beginning price.


For common stock, expected returns are from dividends and stock price appreciation. Thus, the rate of return on the common stock would be (dividends paid during the period + change in the stock price)/price of the stock at beginning of the period.

32

The overall objective of accounts receivable management is to:
A. Maximize sales.
B. Minimize credit losses.
C. Maximize profits.
D. Minimize uncollectible accounts.

C. Maximize profits.


The overall objective of accounts receivable management is to maximize profits. A policy that is too loose will grant credit to those who are not creditworthy and result in unnecessary uncollectible accounts and lower profit. A policy that is too strict will result in not making credit sales that would be paid and, thereby, increase profit.

33



The time between paying cash for raw materials and collecting cash from the sale of products made with those raw materials is called which one of the following?
A. Inventory cycle.
B. Accounts receivable cycle.
C. Cash conversion cycle.
D. Business cycle.

C. Cash conversion cycle.


The cash conversion cycle is concerned with the period beginning with paying cash for inventory and ending with the collection of cash from the sale of products made with that inventory.

34

A company's return on investment is the
A. Profit margin percentage divided by the capital turnover.
B. Profit margin percentage multiplied by the capital turnover.
C. Capital turnover divided by invested capital.
D. Capital turnover multiplied by invested capital.

B. Profit margin percentage multiplied by the capital turnover.


Return on investment = Income/Investment

Profit margin percentage = Income/Sales
Capital turnover = Sales/Investment

Therefore: Return on investment = (Income/Sales) x (Sales/Investment) = Profit margin percentage x capital turnover.
This answer correctly states: Profit margin percentage MULTIPLIED by the capital turnover.