Flashcards in STUDY UNIT TEN CAPITAL BUDGETING II AND CORPORATE PERFORMANCE Deck (18):

1

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An entity has operating income of $10,000,000, beginning total assets of $100,000,000, and ending total assets of $140,000,000. If upper management has set a 5% target rate of return, the company’s residual income is $4,000,000.

True

False

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True

Your answer is correct.

Residual income is the excess of the return on an investment over a targeted amount, which is equal to an imputed interest charge on average invested capital. In this case, it is calculated as follows: $10,000,000 – ($120,000,000 × 5%) = $4,000,000.

2

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Return on investment (ROI) is a very popular tool because it allows quick and easy comparisons with other monetary-based measures, such as the firm’s cost of capital and the ROIs of competitors.

True

False

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False

Your answer is correct.

Return on investment (ROI) is a very popular tool because it allows quick and easy comparisons with other percentage-based measures, such as the firm’s cost of capital and the ROIs of competitors.

3

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The return on common equity measures the amount of income a company earns per dollar invested by all shareholders.

True

False

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False

Your answer is correct.

The return on common equity measures the amount of income a company earns per dollar invested by common shareholders.

4

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Economic value added (EVA) represents a business unit’s true accounting profit primarily because a charge for the cost of equity capital is implicit in the cost of capital.

True

False

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False

Your answer is correct.

Economic value added (EVA) represents a business unit’s true economic profit primarily because a charge for the cost of equity capital is implicit in the cost of capital. The cost of equity is an opportunity cost, that is, the return that could have been obtained on the best alternative investment of similar risk. Hence, EVA measures the marginal benefit obtained by using resources in a particular way.

5

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A firm with a long-term-debt-to-equity ratio of 1.2 is more solvent than a firm whose ratio is 1.5.

True

False

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Your answer is correct.

A firm whose long-term debt is 1.2 times its equity capital will have an easier time retiring its long-term obligations than one whose debt load is 1.5 times its equity.

6

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The debt-to-total-assets ratio is identical to the total-debt-to-total-capital ratio.

True

False

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True

Your answer is correct.

The debt-to-total-assets ratio (also called the debt ratio) reports the total debt burden carried by a company per dollar of assets. Numerically, this ratio is identical to the total-debt-to-total-capital ratio since total capital equals total assets.

7

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

A Internal rate of return method.

B Payback period method.

C Net present value method.

D Time-adjusted rate of return method.

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C Net present value method.

This answer is correct.

The net present value method discounts the after-tax cash flows over a project’s life. Because these cash flows are discounted, the discount rate must be determined in advance.

8

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A company uses its fixed assets of $1,000,000 at 95% capacity to generate sales of $2,000,000. The company wishes to generate sales of $3,000,000. What amount of additional fixed assets must be acquired, assuming that all fixed assets will operate at maximum capacity?

A $578,000

B $500,000

C $475,000

D $425,000

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D $425,000

This answer is correct.

The company generates $2.1053 ($2,000,000 sales ÷ $950,000 fixed assets currently in use) of sales per $1 of fixed assets that are currently in use. Therefore, to generate $3,000,000 of sales, the company needs to use at full capacity fixed assets of $1,425,000 [($3,000,000 required sales ÷ ($2,000,000 ÷ ($950,000)]. Since the company currently has $1,000,000 fixed assets, it needs to acquire additional $425,000 of fixed assets ($1,425,000 – $1,000,000).

9

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The technique that measures the estimated performance of a capital investment by dividing the project’s annual after-tax net income by the average investment cost is called the

A Bail-out payback method.

B Internal rate of return method.

C Accounting rate of return method.

D Profitability index method.

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C Accounting rate of return method.

This answer is correct.

The accounting rate of return (also called the unadjusted rate of return or book value rate of return) measures investment performance by dividing the accounting net income by the average investment in the project. This method ignores the time value of money.

View Subunit 10.2 Outline

10

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A firm earning a profit can increase its return on investment by

A Increasing sales revenue and operating expenses by the same dollar amount.

B Increasing sales revenues and operating expenses by the same percentage.

C Increasing investment and operating expenses by the same dollar amount.

D Decreasing sales revenues and operating expenses by the same percentage.

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B Increasing sales revenues and operating expenses by the same percentage.

This answer is correct.

ROI equals income divided by invested capital. If a company is already profitable, increasing sales and expenses by the same percentage will increase ROI. For example, if a company has sales of $100 and expenses of $80, its net income is $20. Given invested capital of $100, ROI is 20% ($20 ÷ $100). If sales and expenses both increase 10% to $110 and $88, respectively, net income increases to $22. ROI will then be 22% ($22 ÷ $100).

View Subunit 10.3 Outline

11

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Sharif Co. has total debt of $420,000 and equity of $700,000. Sharif is seeking capital to fund an expansion. Sharif is planning to issue an additional $300,000 in common stock and is negotiating with a bank to borrow additional funds. The bank requires a debt-to-equity ratio of .75. What is the maximum additional amount Sharif will be able to borrow?

A $750,000

B $330,000

C $225,000

D $525,000

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B $330,000

This answer is correct.

Sharif will have $1 million ($700,000 + $300,000) in total equity. The debt-to-equity restriction allows up to $750,000 ($1,000,000 × .75) in debt. Sharif already has $420,000 in debt, so the additional borrowing cannot exceed $330,000 ($750,000 – $420,000).

View Subunit 10.5 Outline

12

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A company currently has 1,000 shares of common stock outstanding with zero debt. It has the choice of raising an additional $100,000 by issuing 9% long-term debt or issuing 500 shares of common stock. The company has a 40% tax rate. What level of earnings before interest and taxes (EBIT) would result in the same earnings per share (EPS) for the two financing options?

A. An EBIT of $27,000 would result in EPS of $7.20 for both.

B. An EBIT of $(18,000) would result in EPS of $(7.20) for both.

C. An EBIT of $27,000 would result in EPS of $10.80 for both.

D. An EBIT of $(10,800) would result in EPS of $(7.92) for both.

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Answer (C) is correct.

If new debt is issued, interest expense will be $9,000 per year ($100,000 face amount × 9% coupon rate); if new common stock is issued, interest expense will continue to be zero. Thus, earnings before taxes and income available to common shareholders (the EPS numerator) will be different depending on the financing option. The EPS denominator will also be different, since there are only 1,000 common shares outstanding under the debt alternative but 1,500 outstanding under the common stock alternative. EBIT ($27,000) can be calculated from the following EPS equation:

The differing numerators and denominators result in identical results for EPS as shown in the full calculations below:

Common

Debt

Stock

Earnings before interest and taxes

$27,000

$27,000

Less: interest expense

(9,000)

0

Earnings before taxes

$18,000

$27,000

Less: income tax expense (40%)

(7,200)

(10,800)

Income available to common stockholders

$10,800

$16,200

Divided by: common shares outstanding

÷ 1,000

÷ 1,500

Earnings per share

$ 10.80

$ 10.80

(10.5.89)

13

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Which of the following formulas should be used to calculate the economic rate of return on common stock?

A. (Net income – preferred dividend) divided by common shares outstanding.

B. Dividends per share divided by market price per share.

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

D. Market price per share divided by earnings per share.

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

Answer (C) is correct.

The economic rate of return on common stock is calculated by (1) adding the dividends received over the period of ownership to the change in the stock price during the period of ownership and (2) dividing this amount by the original price paid for the stock.

(10.4.74)

14

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Mesa Company is considering an investment to open a new banana processing division. The project in question would entail an initial investment of $45,000, and cash inflows of $20,000 can be expected in each of the next 3 years. The hurdle rate is 10%. What is the profitability index for the project? The present value of an ordinary annuity of 1 discounted at 10% for 3 periods is 2.487. The present value of 1 due in 3 periods discounted at 10% is .751.

A. 1.1771

B. 1.1379

C. 1.1053

D. 1.0784

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C. 1.1053

Answer (C) is correct.

At a 10% hurdle rate, the present value of the future cash inflows is $49,740 (20,000 × 2.487), yielding a net present value for the project of $4,740 ($49,740 – $45,000). The profitability index is thus 1.1053 ($49,740 ÷ $45,000).

(10.1.10)

15

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Which of the following statements is correct regarding the payback method as a capital budgeting technique?

A. The payback method provides the years needed to recoup the investment in a project.

B. An advantage of the payback method is that it indicates if an investment will be profitable.

C. Payback is calculated by dividing the annual cash inflows by the net investment.

D. The payback method considers the time value of money.

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A. The payback method provides the years needed to recoup the investment in a project.

Answer (A) is correct.

The payback period is the number of years required for the net cash inflows to equal the original investment. The strength of the payback method is its simplicity. It is calculated by dividing the initial investment by the annual cash inflows.

(9.6.114)

16

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The technique that incorporates the time value of money by determining the compound interest rate of an investment such that the present value of the after-tax cash inflows over the life of the investment is equal to the initial investment is called the

A. Profitability index method.

B. Internal rate of return method.

C. Accounting rate of return method.

D. Capital asset pricing model.

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B. Internal rate of return method.

Answer (B) is correct.

A project’s internal rate of return is the discount rate at which the present value of the cash inflows equals the present values of the cash outflows (including the original investment). It is the rate at which the project’s net present value is zero.

(10.2.26)

17

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Which one of the following statements pertaining to the return on investment (ROI) as a performance measurement is false?

A. The use of ROI can make it undesirable for a skillful manager to take on troubleshooting assignments such as those involving turning around unprofitable divisions.

B. The use of ROI may lead managers to reject capital investment projects that can be justified by using discounted cash flow models.

C. ROI relies on financial measures that are capable of being independently verified, while other forms of performance measures are subject to manipulation.

D. When the average age of assets differs substantially across segments of a business, the use of ROI may not be appropriate.

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C. ROI relies on financial measures that are capable of being independently verified, while other forms of performance measures are subject to manipulation.

Answer (C) is correct.

Return on investment is the key performance measure in an investment center. ROI is a rate computed by dividing a segment’s income by the invested capital. ROI is therefore subject to the numerous possible manipulations of the income and investment amounts. For example, a manager may choose not to invest in a project that will yield less than the desired rate of return, or (s)he may defer necessary expenses.

(10.3.50)

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