Ch. 3 SIMS

Question 1

SIM#1 cost of capital-

Define cost of capital

Answer 1

Is the cost of debt and various equity components of the firms capital structure

Question 2

SIM#1 cost of capital- Explain why it’s important to determine it’s value

Answer 2

It is important because the rate of return on various possible investments is compared to the cost of capital

Question 3

SIM#1 cost of capital- List the variables below that enter into the calculation.

1. Cost of debt?
2. Cost of preferred stock?

Answer 3

Cost of debt = Interest cost & marginal tax rate

Cost of preferred stock = preferred dividend amount & the price of stock

Question 4

SIM#1 - Before evaluating investment decisions, what do you do?

Answer 4

We must first determine the cost of capital for the corporation

Question 5

SIM#1 cost of capital- What is taken into consideration for cost of common equity?

Answer 5

1. Amount of the dividend paid to common shareholders
2. The new common stock price
3. The rate of growth of the dividend

Question 6

SIM #2 LIFO/FIFO~ In a period of rising prices, LIFO will give ____ ending inventory value?
Higher or lower

Answer 6

Lower ending inventory because LIFO includes oldest purchases and those goods cost less than current purchases

Question 7

SIM #2 LIFO/FIFO- In a period of rising prices, LIFO May result in what?

Answer 7

In recognition of a holding gain that actually occurred in a prior year. Ending inventory under LIFO will include older, lower costs.

When the undervalued inventory is sold in a later year, a larger profit will be recognized and taxed in that later year.

Question 8

SIM #2 LIFO/FIFO- Which method matches the most current costs with revenue?

Answer 8

LIFO

Question 9

SIM #2 LIFO/FIFO- In a period of rising prices, what’s the advantages of using FIFO?

Answer 9

It better appropriates the actual physical flow of units through inventory by reducing spoilage and obsolescence costs when using oldest first

Question 10

SIM 3- Before evaluating investment decisions, what should we first do?

Answer 10

Determine the cost of capital

Question 11

SIM 3- what is cost of capital?

Answer 11

Cost of debt + various equity

Question 12

SIM 3- What do projects with higher rate of return than the firms cost of capital do for the company?

Answer 12

Increase the value of the firm

Question 13

SIM 3- How is cost of capital computed?

Answer 13

Cost of debt (interest rate on new debt + marginal tax rate)
+ Cost of preferred stock (preferred dividend + net issuance price of stock)
+ Cost of common equity (dividend amount + new stock price + dividend growth rate + selling price)
= cost of capital

Question 14

SIM 3- After cost of capital has been determined, what does company do?

Answer 14

Use various calculation methods to compare investment options

Question 15

SIM2- Which will have higher property taxes during rising prices LIFO or FIFO?

Answer 15

FIFO will have higher costs from later purchases in ending inventory. A higher inventory valuation will result in higher property taxes, not lower.

Question 16

SIM 2- Which will have higher income tax LIFO or FIFO?

Answer 16

In period of rising prices, FIFO will have higher costs from later purchases in ending inventory and the lower cost of earlier purchases in cost of sales.
A lower cost of sales will increase taxable income. Thus, income taxes will be higher with FIFO than with LIFO.
FIFO matches older costs with revenue.

Question 17

SIM 4- What is the net income after tax formula?

Annual Pre-Tax Revenues $60, Initial Investment $150
Salvage value $15, 20% tax rate

Answer 17

Revenue - Depreciation Exp = Income before tax
Income before tax x ( 1 - tax rate) = Net Income after tax

$60 rev - (($150 cost - $15 salvage) / 15 years) = $51
$60 rev - $9 depreciation = $51
$51 income before tax x (1 - 20%) = $40.8

Question 18

SIM 4-
What is the income before tax?
What is the net income after tax?
What is the cash inflow after tax?

Annual Pre-Tax Revenues $60, Initial Investment $150
Salvage value $15, 20% tax rate,
net income after tax $40.8, depreciation $9

Answer 18

Revenue - Depreciation Exp = Income before tax
$60 revenue - $9 depr exp = $51

Income before tax x ( 1 - tax rate) = Net Income after tax
$51 x (1 - 20%) = $40.8 net income

Net Income after tax + Depreciation = Cash Inflow
$40.8 net income + $9 depreciation = $49.8 cash inflow

Question 19

SIM 4- What is the payback in years?

Cash inflow $49.8
Initial Investment $150

Answer 19

Initial investment / cash inflow after tax = payback

$150 / $49.8 = 3 years