# III. Financial Management Flashcards

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1
Q

The capital budgeting technique known as accounting rate of return uses
- Revenue over life of project
- Depreciation expense
____________________________________________
. No Yes

. No No

. Yes No

. Yes Yes

A

. Yes Yes

The accounting rate of return (ARR) is based on financial statements prepared on the accrual basis. The formula to compute the ARR is

ARR =
Expected increase in annual net income/
Initial (or average) investment

Both the revenue over life of project and depreciation expense are used in the calculation of ARR. Depreciation expense over the project’s life and other expenses directly associated with the project under consideration including income tax effects are subtracted from revenue over life of the project to determine net income over life of project. Net income over the project’s life is then divided by the economic life to determine annual net income, the numerator of the ARR formula. This is a weakness of the ARR method because it does not consider actual cash flows or the time value of money.

2
Q

Which of the following scenarios would encourage a company to use short-term loans to retire its 10-year fixed-rate callable bonds that have five years until maturity?

.The company expects interest rates to increase over the next five years.

.Interest rates have increased over the last five years.

.Interest rates have declined over the last five years.

.The company is experiencing cash flow problems.

A

.Interest rates have declined over the last five years.

If interest rates have declined over the last five years, a company can currently borrow at a lower interest rate than that on the older, fixed-rate debt. Thus, a company would be encouraged to replace the outstanding fixed-rate bonds with short-term borrowings that have a lower interest cost.

3
Q

Southern Corp. has a debt-to-equity ratio of 1.75, and total assets of \$275 million. Southern is considering issuing another \$20 million of debt and another \$20 million of equity. What will be Southern’s debt-to-equity ratio after the issuance?

1. 46
2. 63
3. 75
4. 95
A

1.63

For this question, one needs to first use the current debt-to-equity ratio and total assets to determine the amount of liabilities and shareholders’ equity (remembering A = L + SE). That can be done as follows: SE + 1.75 SE = \$275 million; 2.75 SE = \$275 million; SE = \$275 million/2.75; SE = \$1 million. Therefore: SE = \$1 million and L = 1.75 × \$1 million, or \$1.75 million. Proof: A \$275 = L \$1.75 + SE \$1.00; next, \$20 million needs to be added to each amount, resulting in a debt-to-equity ratio of: L = \$195/SE = \$120; or \$195/\$120 = 1.625, the ratio after adding the new issuances.

4
Q

The discount rate (hurdle rate of return) must be determined in advance for the?

.Internal rate of return method.

.Net present value method.

.Payback period method.

.Time adjusted rate of return method.

A

.Net present value method.

There are two capital budgeting methods which consider time value of money: internal rate of return and net present value. Under the net present value method, all cash inflows and outflows related to a capital project are discounted to a present value and netted to arrive at a net present value for the project. In order to discount the inflows and outflows, a discount rate must be determined in advance of the analysis of the project.

5
Q

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?

.\$ 3,500

.\$ 4,500

.\$ 8,000

.\$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.

6
Q

A company uses portfolio theory to develop its investment portfolio. If the company wishes to obtain optimal risk reduction through the portfolio effect, it should make its next investment in

.An investment that correlates negatively to the current portfolio holdings.

.An investment that is uncorrelated to the current portfolio holdings.

.An investment that is highly correlated to the current portfolio holdings.

.An investment that is perfectly correlated to the current portfolio holdings.

A

.An investment that correlates negatively to the current portfolio holdings.

To reduce the risk of a portfolio, the investor should select investments with negatively correlated returns. In that way, when one investment decreases in value others will increase. Therefore, the company should select an investment that correlates negatively to current portfolio holdings.

7
Q

What is the most important purpose of a balanced scorecard?

.Develop strategy.

.Measure performance.

.Set priorities.

A

.Measure performance.

The balanced scorecard uses financial and non-financial measures to measure performance.

8
Q

Zig Corp. provides the following information:

```Pretax operating profit	\$300,000,000
Tax rate	40%
Capital used to generate profits 50% debt, 50% equity	\$1,200,000,000
Cost of equity	15%
Cost of debt	5%```

Which of the following represent Zig’s year-end economic value-added amount?

\$0

\$60,000,000

\$120,000,000

\$180,000,000

A

\$60,000,000

EVA is equal to net operating profit after taxes minus the after-tax weighted-average cost of capital multiplied by invested capital. In this case, net operating profit after taxes is equal to \$180,000,000 [\$300,000,000 – (40% × \$300,000,000)]. The weighted-average cost of capital is equal to 10% [(15% + 5%) ÷ 2]. EVA is equal to \$180,000,000 – (10% × \$1,200,000,000) = \$60,000,000.

9
Q

The maximum period for which commercial paper may be used for financing purposes is

30 days.

180 days.

270 days.

365 days.

A

270 days.

The maximum period for which commercial paper (short-term, unsecured promissory notes) may be used is 270 days. Notes exceeding 270 days in maturity require SEC registration and would not be considered commercial paper.

10
Q

Which of the following is not a technique for considering the risk of an investment?

Probability analysis.

Simulation techniques.

Internal rate of return.

A

Internal rate of return.

The traditional internal rate of return method does not explicitly include consideration of risk.

11
Q

Which of the following equations correctly represents the economic concept of normal profit?

.Revenue – Explicit Expenses = 0

.Revenue – Explicit Expenses – Implicit Expenses = 0

.Revenue – Explicit Expenses ≥ 0

.Revenue – Explicit Expenses – Implicit Expenses ≥ 0

A

.Revenue – Explicit Expenses – Implicit Expenses = 0

This equation correctly represents the economic concept of normal profit. Normal profit occurs when revenue less both explicit and implicit expenses is equal to zero. Normal profit occurs when revenue just covers operating costs (explicit costs) and compensates owners for any opportunity costs, including such factors as the value of the owner’s time/talent and capital investment.

12
Q

Assume that Company A and Company B are alike in all respects except that Company A utilizes more debt financing and less equity financing than does Company B. Which of the following statements is most likely to be true?

• Company A has more net earnings variability than Company B.
• Company A has more operating earnings variability than Company B.
• Company A has less operating earnings variability than Company B.
• Company A has less financial leverage than Company B.
A

-Company A has more net earnings variability than Company B.

Company A is more highly leveraged. It has greater fixed charges in the form of interest. Therefore, Company A will have more volatile net earnings than Company B.

13
Q

Kipling Company invested in an 8-year project. It is expected that the annual cash flow from the project, net of income taxes, will be \$20,000. Information on present value factors is as follows:

Present value of \$1 at 12% for eight periods 0.404
Present value of an ordinary annuity of \$1 at 12% for eight periods 4.968

Assuming that Kipling based its investment decision on an internal rate of return of 12%, how much did the project cost?

\$160,000
\$ 99,360
\$ 80,800
\$ 64,640

A

\$ 99,360

This means that the present value of future net cash inflows, discounted at 12%, is exactly equal to the cost of the project. The project provides an annual inflow of \$20,000 for 8 years. The relationship can be shown as:

Project cost/annual cash inflow = PV of ordinary annuity factor for 12%

`x/\$20,000    	=	4.968`
```x	=	4.968 × \$20,000
x	=	\$99,360```

Note that in practice, the project cost is ordinarily known and the annuity factor is the unknown. Once the factor is derived, the rate is found in an ordinary annuity table.

14
Q

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

• Free cash flow.
• Net operating capital.
A

economic value-added is equal to net operating profit after taxes minus the cost of capital.

15
Q

A company wants to approximate the 12% annual interest rate based on a 365-day year it pays on its working capital loan. Which of the following terms should the company offer its customers?

1. 00%, 15, net 45.
2. 00%, 15, net 45.
3. 75%, 10, net 30.
4. 50%, 10, net 30.
A

1.00%, 15, net 45.

These terms would provide the desired 12% annual interest rate. The interest rate associated with discount terms is computed as:
[Discount Rate/Principal] × [1/(Length of discount period/365)]; where:
Principal = Amount after discount
Length of discount period = Difference between discount date and net date
Using the facts in this question: [.01/.99] × [1/(30/365)] = .0101 × (365/30) =
.0101 × 12.16 = 12.28 (or 12% rounded) annual interest rate, the correct answer.

(NOTE: An easier and quicker approximation can be made by dividing the discount period into the days in a year, or 45 – 15 = 30 days; 365/30 = 12.1, and multiplying that by the discount amount = 12.1 × .01 = .121 (or 12% rounded), the correct answer.)

16
Q

Strobel Company has a large amount of variable rate financing due in one year. Management is concerned about the possibility of increases in short-term rates. Which of the following would be an effective way of hedging this risk?

• Buy Treasury notes in the futures market.
• Sell Treasury notes in the futures market.
• Buy an option to purchase Treasury bonds.
• Sell an option to purchase Treasury bonds.
A

-Sell Treasury Notes in the futures Market.

Treasury notes for delivery in the future, the company can hedge increases in short-term interest rates. If interest rates increase, the value of the Treasury notes will decline, resulting in a gain to the company. If the hedge is effective, the gain will offset the increase in the company’s interest costs.

17
Q

For the next two years, a lease is estimated to have an operating net cash inflow of \$7,500 per annum, before adjusting for \$5,000 per annum tax basis lease amortization, and a 40% tax rate. The present value of an ordinary annuity of \$1 per year at 10% for two years is 1.74. What is the lease’s after-tax present value using a 10% discount factor?

\$ 2,610

\$ 4,350

\$ 9,570

\$11,310

A

\$11,310

The net present value of a project equals

NPV = (PV future cash flows) − (Investment)

Since this problem involves a lease requiring only annual payments there is no initial investment in this case. Lease amortization must be subtracted from cash inflows to determine income tax expense.

```\$7,500		Annual cash inflow
− 5,000		Tax basis lease amortization
\$2,500		Taxable lease income
× 40%
\$ 1,000		Tax expense per year```

However, lease amortization is not a cash outflow and is thus excluded from the calculation of NPV. The after-tax present value of the lease equals:

```\$7,500		Annual cash inflow
− 1,000		Cash outflow for taxes
\$6,500		Annual net cash flow
× 1.74		PV factor for two years at 10%
\$ 11,310		PV of cash flow = lease value```