BEC 4

Question 1

Which of the following could be used to hedge a net receivable denominated in British pounds by a U.S. company?

Purchase a currency put option in British pounds.

Purchase a currency call option in British pounds.

Purchase a forward contract to buy British pounds.

Purchase a forward contract to buy U.S. dollars.

Answer 1

Purchase a currency put option in British pounds.

A currency put option would enable the U.S. company to lock in the price at which it could sell (put) the British pounds when received.

Question 2

A company has recently purchased some stock of a competitor as part of a long-term plan to acquire the competitor. However, it is somewhat concerned that the market price of this stock could decrease over the short run. The company could hedge against the possible decline in the stock’s market price by

Purchasing a call option on that stock.

Purchasing a put option on that stock.

Selling a put option on that stock.

Obtaining a warrant option on that stock.

Answer 2

Purchasing a put option on that stock.

Purchasing a put option on the stock would hedge against the possible decline in the stock’s market price. A put option would give the company the option to sell the stock at a specified price in the future. If the price of the stock declines, the value of the put option will increase by a like amount.

Question 3

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 one 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.

Answer 3

Sell Treasury notes in the futures market.

Selling Treasury notes futures contract would hedge the risk of increases in the short-term interest rates. If the interest rates increase, the value of the Treasury notes contract will decline, which would enable the firm to acquire the notes at the new lower value and sell them at the higher futures contract price, resulting in a gain. The gain would serve to offset the effects of an increase in short-term interest rates on the variable rate financing.

Question 4

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

2. 00%
3. 00%
4. 00%
5. 73%

Answer 4

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 ______
.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.

Question 5

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

Market approach.

Sales comparison approach.

Income approach.

Cost approach.

Answer 5

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.

Question 6

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?

$145,600

$161,200

$166,400

$182,000

Answer 6

$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 $7K - 4K of depreciation = $3K), 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.

Question 7

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

30%

20%

12%

10%

Answer 7

10%

The accounting rate of return = (Change in) Annual accounting income (AFTER TAX!)/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%.

Question 8

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?

10. 08%
11. 90%
12. 29%
13. 40%

Answer 8

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%.

Question 9

The Bread Company is planning to purchase a new machine that it will depreciate on a straight-line basis over a 10-year period. A full year’s depreciation will be taken in the year of acquisition. The machine is expected to produce cash flow from operations, net of income taxes, of $3,000 in each of the 10 years. The accounting rate of return is expected to be 10% on the initial required investment. What is the cost of the new machine?

$12,000

$13,500

$15,000

$30,000

Answer 9

$15,000

The accounting rate of return is calculated as:

ARR = Annual incremental accounting income/Initial (or average) investment

By rearranging the formula: Initial investment = Incremental annual income/ARR

Initial investment = [$3,000 – .10 (Initial investment)]/.10

.10 Initial investment = [$3,000 – .10 (Initial investment)]

.20 Initial investment = $3,000

Initial investment = $3,000/.20

Initial investment = $15,000

Question 10

When calculating cash inflows for NPV with depreciation, depreciation should not be considered as a cash outflow. You consider depreciation for cash saving purposes as it lowers your income taxes. Ex/ Depreciation of $250 and a tax rate of 30% would yield a cash savings of $75 (250*.3)

Answer 10

Same as other side: When calculating cash inflows for NPV with depreciation, depreciation should not be considered as a cash outflow. You consider depreciation for cash saving purposes as it lowers your income taxes. Ex/ Depreciation of $250 and a tax rate of 30% would yield a cash savings of $75 (250*.3)

Question 11

What capital investment structures have an after-tax saving?
Bonds
Common Stock
Preferred Stcok

Answer 11

Bonds

The tax savings applies only to the bonds, on which interest is paid; there is no tax saving associated with common or preferred stock dividend payments.

Question 12

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?

9. 0%
10. 8%
11. 8%
12. 6%

Answer 12

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%

Question 13

Charles Allen was granted options to buy 100 shares of Dean Company stock. The options expire in one year and have an exercise price of $60.00 per share. An analysis determines that the stock has an 80% probability of selling for $72.50 at the end of the one-year option period and a 20% probability of selling for $65.00 at the end of the year. Dean Company’s cost of funds is 10%. Which one of the following is most likely the current value of the 100 stock options?

$1,000

$1,100

$6,875

$7,100

Answer 13

$1,000

The stock has an 80% chance of selling at $72.50 at the end of the option period. That is $12.50 above the option price. The stock has a 20% chance of selling at $65.00 at the end of the option period. That is $5.00 above the option price. Therefore, the value of the option is:

[(.80 x $12.50) + (.20 x $ 5.00)]/1.10, or

[($10.00) + ($1.00)]/1.10, or

$11.00/1.10 = $10.00 x 100 shares = $1,000

Question 14

A company enters into an agreement with a firm who will factor the company’s accounts receivable. The factor agrees to buy the company’s receivables, which average $100,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at an annual rate of 10% and charge a fee of 2% on all receivables purchased. The controller of the company estimates that the company would save $18,000 in collection expenses over the year. Fees and interest are not deducted in advance. Assuming a 360-day year, what is the cost of engaging in this arrangement?

11. 0%
12. 0%
13. 0%
14. 5%

Answer 14

17.5%

The total amount paid to the factor would be ($100,000 × 80%) × 10% + ($100,000 × 12) × 2% = $32,000. The net cost is equal to $14,000 ($32,000 − $18,000 cost savings). Therefore, the annual interest cost is equal to $14,000/$80,000 = 17.5%.

Question 15

How does account receivable factoring work?

Answer 15

Most factoring companies purchase invoices in two installments. The first installment – the factoring advance – covers about 80% of the receivable (this amount varies). The remaining 20%, less the factoring fee, is rebated as soon as your client pays the invoice in full. Here are the steps:

1. You submit the invoices for purchasing
2. The factoring company sends you the advance (e.g., 80% of the invoice)
3. Your client pays 30 to 60 days later
4. The factoring company sends you the rebate (e.g., 20%, less the fee)

Question 16

Lease Expense and NPV - Remember to subtract the tax basis lease amortization and then take the remainder times the tax rate to get your yearly tax expense.
Problem:
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

Answer 16

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
=$2,500 		Taxable lease income
× 40% 		Tax Rate
=$ 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
=$6,500 		Taxable lease income
× 1.74 		PV factor for two years at 10%
=$ 11,310 		NPV

Question 17

Bonds and how a discount or premium is determined

Answer 17

The investors’ required rate of return would be based primarily on the return available from other investment opportunities in the market with comparable perceived risk (i.e., the investors’ opportunity cost). If the investors’ required rate—the market rate—is more than the coupon rate, the bonds will sell at less that par (i.e., at a discount); if the market rate is less than the coupon rate, the bonds will sell at more than par (i.e., at a premium).

Question 18

Apollo Inc.’s common stock is currently selling for $100 per share and will pay a $4.00 per share dividend. If Apollo’s dividend is expected to grow indefinitely at 5%, what is the market’s required rate of return on a prospective investment in Apollo’s stock?

4%

5%

9%

20%

Answer 18

9%

The market’s required rate of return on a prospective investment in Apollo’s stock is 9%. The answer is computed as: (Current dividend/Current market price) + Growth rate, or ($4/$100) + 5% = 4% + 5% = 9%.

Question 19

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?

4. 5%
5. 1%
6. 0%
7. 3%

Answer 19

5.1%

Divended per year / Net Proceeds

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%.

Question 20

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:

1. Credit sales expected to remain unchanged at $1,000,000
2. The 2% discount is expected to be taken on 40% of accounts receivable balance amounts.
3. The average accounts receivable would likely decrease by $30,000
4. 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

Answer 20

$ 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.

Question 21

For Weighted Avg Cost of Capital - if a tax rate is given, you would subtract that from the Cost of Capital.

Answer 21

Example/ Bonds with a Cost of Capital of 10% and a tax rate of 30%. New Cost of Capital rate would become 7% [10%*(100%-30%)]

Question 22

A company has income after tax of $5.4 million, interest expense of $1 million for the year, depreciation expense of $1 million, and a 40% tax rate. What is the company’s times-interest-earned ratio?

5. 4
6. 4
7. 4
8. 0

Answer 22

10.0

The company’s times-interest-earned ratio is 10.0. The times-interest-earned ratio measures the ability of current earnings to cover interest payments for a period. It is measured as:

Times-Interest-Earned Ratio = (Net Income + Interest Expense + Income Tax Expense) / Interest Expense

Therefore:
Times-Interest-Earned Ratio = ($5.4M + $1M + $3.6M*)/$1M
= $10M/$1M = 10.0 times

Income before taxes is computed as: .6X = $5.4M (i.e., 60% of taxable income equals $5.4M). Therefore: X (income before taxes) = $5.4M/.6 = $9.0M. Income before taxes = $9.0M - income after taxes = $5.4M = income taxes = $3.6M.)

The $10M also can be determined as $9.0 income before taxes + $1M interest expense= $10M.

Question 23

The following information was taken from the income statement of Hadley Co.:

Beginning inventory = 17,000
Purchases = 56,000
Ending inventory = 13,000

What is Hadley Co.’s inventory turnover?

3.

4.

5.

6.

Answer 23

4.

Inventory turnover is computed as: Cost of Goods Sold/Average Inventory. Cost of goods sold (COGS) is the sum of beginning inventory (BI) plus purchases (P), which equals cost of goods available for sale (COGAS), less ending inventory (EI); that difference is cost of goods sold. It would be computed as: BI $17,000 + P $56,000 = COGAS $73,000 - (EI) $13,000 = (COGS) $60,000. Average inventory (AI) is computed as (BI) $17,000 + (EI) $13,000/2, or (AI) $30,000/2 = $15,000. Thus, inventory turnover is (COGS) $60,000/(AI) $15,000 = 4.

Question 24

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?

3 days

6 days

25 days

180 days

Answer 24

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.

Question 25

Difference between cash conversion cycle and operating cycle

Answer 25

Cash conversion cycle = Inventory conversion + AR Conversion - AP Conversion
Operating Cycle = Inventory conversion + AR conversion

Question 26

Financial information about a company is as follows:
Receivables = $ 4,000,000
Inventory = 2,600,000
Payables = 3,700,000
Sales = 50,000,000
Cost of goods sold = 45,000,000

Assuming a 365-day year, what is the number of days in the company’s cash conversion cycle?

18. 2 days.
19. 3 days.
20. 2 days.
21. 5 days.

Answer 26

20.3 days.

The cash conversion cycle measures the time between when cash is paid to suppliers and when cash is collected from customers. It is computed using the inventory conversion cycle (DIO) plus the accounts receivable conversion cycle (DSO) less the accounts payable conversion cycle (DPO). For this question, the computation is:

Days inventory outstanding (DIO)=Average inventory/Cost of goods sold per day
=$2,600,000/($45,000,000/365)            
=$2,600,000/$123,288 = 21.08 days

Days sales outstanding (DSO) =Average accounts receivable/Sales per day
=$4,000,000/($50,000,000/365)           
=$4,000,000/$136,986 = 29.20 days

Days payable outstanding (DPO) = Average payables/COGS per day            =$3,700,000/($45,000,000/365)            =$3,700,000/$123,288 = 30.01 days
DIO+DSO-DPO = 21.08 days + 29.20 days - 30.01 days=20.27 days = 20.3 days (rounded).

Question 27

For 2014 Turnco Inc. has annual total sales of $500,000, 50% of which are made on credit. If its receivables turnover for 2014 is 5, what is Turnco’s average days collection period (rounded to the nearest day) using a 360-day year?

14 days.

36 days.

72 days.

139 days.

Answer 27

72 days.

Turnco’s average collection period is 72 days. This answer is calculated as the number of days in a year divided by the receivables turnover, or 360/5 = 72 days. The information about the level of sales and the percentage that was credit sales is unnecessary information and is intended to distract.

Question 28

Key Ratios

Answer 28

Accounts Receivable Turnover = (Net) Credit Sales / Average (Net) Accounts Receivable (e.g., Beginning + Ending/2)

Number of Days’ Sales in Average Receivables = 300 or 360 or 365 (or other measure of business days in a year) / Accounts Receivable Turnover

Inventory Turnover = Cost of Goods Sold / Average Inventory (e.g., Beginning + Ending/2)

Number of Days’ Supply in Inventory = 300 or 360 or 365 (or other measure of business days in a year) / Inventory Turnover

Question 29

In COBIT, the process of identifying automated solutions falls within the ________ control process domain.

Acquire and implement.

Deliver and support.

Monitor and evaluate.

Plan and organize.

Answer 29

Acquire and implement.

The process of identifying automated solutions does fall within the acquire and implement control process domain.

Question 30

What is the role of the systems analyst in an IT environment?

Developing long-range plans and directs application development and computer operations.

Designing systems, prepares specifications for programmers, and serves as intermediary between users and programmers.

Maintaining control over the completeness, accuracy, and distribution of input and output.

Selecting, implementing, and maintaining system software, including operating systems, network software, and the data base management system.

Answer 30

Designing systems, prepares specifications for programmers, and serves as intermediary between users and programmers.

These are, in fact, the primary job functions of systems analysts.