Financial Management Flashcards
Which of the following statements is true regarding opportunity cost?
A. Opportunity cost is recorded in the accounts of an organization that has a full costing system.
B. The potential benefit is not sacrificed when selecting an alternative.
C. Idle space that has no alternative use has an opportunity cost of zero.
D. Opportunity cost is representative of actual dollar outlay.
C. Idle space that has no alternative use has an opportunity cost of zero.
Opportunity cost is the discounted dollar value of benefits lost from an opportunity (alternative) as a result of choosing another opportunity. An opportunity cost does not involve an actual transaction or cash outlay. If idle space has no alternative use, then its opportunity cost is zero. There is no alternative use of the space and, therefore, no opportunity cost exists.
For the year ended December 31, 2004, Abel Co. incurred direct costs of $500,000 based on a particular course of action during the year. If a different course of action had been taken, direct costs would have been $400,000. In addition, Abel's 2004 fixed costs were $90,000. The incremental cost was A. $10,000 B. $90,000 C. $100,000 D. $190,000
C. $100,000
Incremental costs are those that are different between two or more alternatives under consideration. In this case, the incremental cost is the difference between the direct costs of taking one action ($400,000) versus another ($500,000). The $100,000 difference in cost is the only cost that differs between the two courses of action. The fixed costs are present regardless of which action is taken.
Which of the following statements is correct regarding the weighted-average cost of capital (WACC)?
A. One of a company’s objectives is to minimize the WACC.
B. A company with a high WACC is attractive to potential shareholders.
C. An increase in the WACC increases the value of the company.
D. WACC is always equal to the company’s borrowing rate.
A. One of a company’s objectives is to minimize the WACC.
A company will seek to minimize its weighted-average cost of capital (WACC). The WACC is not only the cost to the firm for its long-term financing, but also the minimum the firm must earn on its investments. The lower the WACC, the lower the required revenue needed to earn a profit and the easier it is to increase shareholder value.
The measurement of the benefit lost by using resources for one purpose and not another is A. Sunk cost. B. Opportunity cost. C. Incremental cost. D. Differential cost.
B. Opportunity cost.
Opportunity cost is the discounted dollar value of benefits lost from an opportunity as a result of choosing another opportunity.
Which one of the following costs, if any, is relevant in making financial decisions? Sunk Costs Opportunity Costs Yes Yes Yes No No Yes No No
Sunk Costs Opportunity Costs
No Yes
Sunk costs are costs of resources that have already been incurred. These costs will not be changed as a result of current or future decision-making and, therefore, are not relevant in making financial (or other) decisions.
Opportunity costs are the benefits (e.g., revenues) given up when a selection of one course of action precludes another course of action (and the benefit it would have provided). As the name implies, these are the costs of forgoing one opportunity by choosing another opportunity.
A company with a combined federal and state tax rate of 30% has the following capital structure:
Weight Instrument Cost of capital
40% Bonds 10%
50% Common stock 10%
10% Preferred stock 20%
What is the weighted-average after-tax cost of capital for this company? A. 3.3% B. 7.7% C. 8.2% D. 9.8%
D. 9.8%
This correct answer properly assumes a 30% tax savings on the bonds and no tax savings on the common or preferred stock. Thus, the correct answer is:
Bonds .40 x .10 = .04 x .70 = 2.8%
C/S .50 x .10 = .05 = 5.0%
P/S .10 x .20 = .02 = 2.0%
Weighted Average 9.8%
Carter Co. paid $1,000,000 for land three years ago. Carter estimates it can sell the land for $1,200,000, net of selling costs. If the land is not sold, Carter plans to develop the land at a cost of $1,500,000. Carter estimates net cash flow from the development in the first year of operations would be $500,000. What is Carter's opportunity cost of the development? A. $1,500,000 B. $1,200,000 C. $1,000,000 D. $ 500,000
B. $1,200,000
Opportunity cost is the (discounted) dollar value of benefits lost from an alternative (opportunity) as a result of choosing another alternative (opportunity). By choosing to develop the land, Carter would give up the opportunity to sell the land for $1,200,000, the opportunity cost.
Josey maintained a $10,000 balance in his savings account throughout year 1, the first year of the account. The savings account paid 2% interest compounded annually. For year 1, the inflation rate was 3%. For year 1, what is Josey's real interest rate on the savings account? A. - 1%. B. 1% C. 3% D. 5%
A. - 1%.
The real interest rate is the stated (or nominal) rate of interest for a period less the rate of inflation for that period. Since Josey earned 2% on the checking account for the year and inflation for the year was 3%, Josey’s real interest rate was: 2% - 3% = -1%.
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Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are:
Period 1 0.88 2 1.65 3 2.32 Using a 14% cost of capital, what is the present value of these future savings? A. $59,600 B. $60,800 C. $62,900 D. $69,500
C. $62,900
Since only present values of an annuity factor are given, the correct answer can be determined only by converting the values given into two annuities. An annuity is a series of equal payments. The given values are:
$30,000 for years 1 and 2, and $20,000 for year 3.
Those values are not equal for every year (therefore not an annuity), so the annuity factors given cannot be used with those values (as given). But, they can be converted into two series of equal payments comprised of:
$20,000 for years 1, 2 and 3, and $10,000 for years 1 and 2.
Those two cash flow streams would look like:
YEAR STREAM 1 STREAM 2 STREAM 3
Year 1 $20,000 $10,000 = $30,000
Year 2 $20,000 $10,000 = $30,000
Year 3 $20,000 = $20,000
Note that now there are two series, each of equal amounts, but which total to the same amounts as the values given. The present value of an annuity for 3 years can now be applied to $20,000 and the present value of an annuity for 2 years can be applied to $10,000. The results would be:
(1) $10,000 annuity for two years: $10,000(1.65) = $16,500
(2) $20,000 annuity for three years $20,000(2.32) 46,400
Total present value $62,900
Which of the following changes would result in the highest present value?
A. A $100 decrease in taxes each year for four years.
B. A $100 decrease in the cash outflow each year for three years.
C. A $100 increase in disposal value at the end of four years.
D. A $100 increase in cash inflows each year for three years.
A. A $100 decrease in taxes each year for four years.
This question is intended to test a candidate’s understanding of the conceptual relationships between present values of single amounts and present values of annuities, and the impact of length of time on present value amounts. Getting the correct answer does not require (or expect) the actual calculation of present values for each of the four choices. Here is the logic:
- Recognize that all of the choices are for the same amount, $100. Therefore, the amount of the principal will not create a difference in present values for the choices.
- Next, notice that choices A, B, and D are for annuities; choice C is for a single amount to be received in four years, longer than choices B and D, and as long as choice A. Since the present value of a single amount has to be less than the present value of a series of equal amounts due within the same or less time, choice C cannot result in the highest present value.
- Next, since choices A, B, and D are all for annuities of the same amount, the longer the annuity, the higher the present value. Choices B and D are for three years; choice A is for four years.
- Therefore, choice A will result in the highest present value.
Which one of the following is interest earned on both an initial principal and the unpaid accrued interest that accumulated on that principal from prior periods? A. Annual interest. B. Simple interest. C. Compound interest. D. Discount interest.
C. Compound interest.
Compound interest is the interest earned on both an initial principal and the unpaid accrued interest that accumulated on that principal from prior periods. In effect, with compound interest, interest is paid on interest.
The following information is available on market interest rates:
The risk-free rate of interest 2% Inflation premium 1% Default risk premium 3% Liquidity premium 2% Maturity risk premium 1%
What is the market rate of interest on a one-year U.S. Treasury bill? A. 3%. B. 5%. C. 6%. D. 7%.
A. 3%
The market rate of interest on a one-year U.S. Treasury bill would be 3%. Notice that the risk-free rate of interest and the various premiums are for the general market rate of interest, not for the rate on a one-year U.S. Treasury bill. Treasury bills are considered risk free in an environment where zero inflation is expected. Therefore, the market rate of interest on a one-year U.S. Treasury bill would be the risk-free rate plus the inflation premium (for the expected rate of inflation during the life of the security), or 2% + 1% = 3%. One-year U.S. Treasury bills are considered free of default risk, liquidity risk (because there is a very large and active secondary market for T-bills), and maturity risk (because they are for only one year).
On November 1, Year 1, a company purchased a new machine that it does not have to pay for until November 1, Year 3. The total payment on November 1, Year 3 will include both principal and interest. Assuming interest at a 10% rate, the cost of the machine would be the total payment multiplied by what time value of money concept? A. Present value of annuity of 1. B. Present value of 1. C. Future amount of annuity of 1. D. Future amount of 1.
B. Present value of 1.
A present value of 1 factor is used because only one payment is to be made. Present value (which also is cost) = (present value of 1 factor) x (future payment). The future payment is being discounted to its present value.
Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are:
Period 1 0.88 2 1.65 3 2.32 Using a 14% cost of capital, what is the present value of these future savings? A. $59,600 B. $60,800 C. $62,900 D. $69,500
C. $62,900
Since only present values of an annuity factor are given, the correct answer can be determined only by converting the values given into two annuities. An annuity is a series of equal payments. The given values are:
$30,000 for years 1 and 2, and $20,000 for year 3.
Those values are not equal for every year (therefore not an annuity), so the annuity factors given cannot be used with those values (as given). But, they can be converted into two series of equal payments comprised of:
$20,000 for years 1, 2 and 3, and $10,000 for years 1 and 2.
Those two cash flow streams would look like:
YEAR STREAM 1 STREAM 2 STREAM 3
Year 1 $20,000 $10,000 = $30,000
Year 2 $20,000 $10,000 = $30,000
Year 3 $20,000 = $20,000
Note that now there are two series, each of equal amounts, but which total to the same amounts as the values given. The present value of an annuity for 3 years can now be applied to $20,000 and the present value of an annuity for 2 years can be applied to $10,000. The results would be:
(1) $10,000 annuity for two years: $10,000(1.65) = $16,500
(2) $20,000 annuity for three years $20,000(2.32) 46,400
Total present value $62,900
Which one of the following is the annual rate of interest applicable when not taking trade credit terms of "2/10, net 30?" A. 2.00% B. 24.00% C. 36.00% D. 36.73%
D. 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 ______ = .0204 x (360/20) =
.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.
On August 31, Year 1, Ashe Corp. adopted a plan to accumulate $1,000,000 by September 1, Year 5. Ashe plans to make four equal annual deposits to a fund that will earn interest at 10% compounded annually.
Ashe will make the first deposit on September 1, Year 1. Future value and future amount factors are as follows:
Future value of $1.00 at 10% for 4 periods 1.46
Future amount of ordinary annuity of $1.00 at 10% for 4 periods 4.64
Future amount of annuity due of $1.00 at 10% for 4 periods 5.11
Present value of ordinary annuity of $1.00 @ 10% for 4 periods 3.17
Which one of the following would be the amount of annual deposits Ashe should make (rounded)? A. $250,000 B. $215,500 C. $195,700 D. $146,000
C. $195,700
While the payments in an annuity can be made as frequently as every week, in practice, ordinary annuity payments are made monthly, quarterly, semi-annually or annually. The opposite of an ordinary annuity is an annuity due, where payments are made at the beginning of each period.
The question is concerned with determining a series of equal deposit amounts that would total $1,000,000 at the end of four years, a future amount. Thus, a future value table, not a present value table, should be used.
Because Ashe will make a series of payments, not a single lump-sum payment, the future value of $1.00 table (1.46) is not appropriate. Finally, since Ashe will make the first payment at the beginning of the first year of the four year period (9/1/Year 1 - 9/1/Year 5), the appropriate future value (or amount) table is for an annuity due—payments are made at the beginning of each period.
Thus, the correct factor is 5.11 and the calculation would be:
$X (annual deposit) x 5.11 = $1,000,000
$X = $1,000,000/5.1 = $195,700 (rounded)
So, $195,700 deposited on September 1 of Year 1, Year 2, Year 3 and Year 4 at an interest rate of 10% would accumulate to $1,000,000 by September 1, Year 5.
A corporation obtains a loan of $200,000 at an annual rate of 12%. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but it normally does not have a cash balance account with the bank. What is the effective cost of the loan? A. 12.0% B. 13.3% C. 15.0% D. 16.0%
C. 15.0%
The effective cost of the loan (i.e., the effective interest rate on the loan) is determined as the annual dollar cost of the loan divided by the net useable proceeds of the loan. The annual dollar cost is the principal multiplied by the annual rate, or $200,000 x .12 = $24,000. The net useable proceeds of the loan is the principal amount less the amount of the compensating balance that must be maintained with the bank, or $200,000 - ($200,000 x .20) = $200,000 - $40,000 = $160,000. Therefore, the effective cost of the loan is $24,000/$160,000 = .15 (or 15%).
Which one of the following U.S. GAAP approaches to determining fair value converts future amounts to current amounts? A. Market approach. B. Sales comparison approach. C. Income approach. D. Cost approach.
C. 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.
Assume the following rates exist in the U.S.:
Prime interest rate = 6%
Fed discount rate = 4%
U.S. Treasury Bond rate = 2%
Inflation rate = 1%
Which one of the following is most likely the nominal risk-free rate of return in the U.S.? A. 1% B. 2% C. 4% D. 6%
B. 2%
In the U.S., the rate paid on U.S. Treasury Bonds (2%) is considered the risk-free rate of return; that is, the rate of return that is paid for delayed use of funds by investing them, without any risk premium attached to or paid for default risk.
Which one of the following is not an element in the capital asset pricing model formula? A. Risk-free rate of return. B. Expected rate of return for the class of item being valued. C. Prime interest rate. D. A measure of volatility for the item being valued.
C. Prime interest rate.
*The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.
The prime interest rate is not an element in the capital asset pricing model formula. The elements used in the formula include the risk-free rate of return, beta (a measure of volatility for the asset being valued) and the expected rate of return for the entire class of the asset being valued.
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? A. 9.0% B. 9.8% C. 11.8% D. 12.6%
C. 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%
A business with a net book value of $150,000 has an appropriate fair value of $120,000. Charles Harvey, one of three owners, has decided to sell his 10% interest in the business. Which one of the following is most likely the amount at which Harvey can sell his interest? A. $40,000 B. $15,000 C. $12,000 D. < $12,000
D. < $12,000
Harvey would likely receive less than $12,000 upon sale of his interest. While Harvey has a claim to 10% of the fair value of the business, because his ownership interest is very minor, the value of his interest upon sale would likely be less than $12,000 due to a noncontrolling interest discount.
