Financial Management & Capital Budgeting Missed Questions Flashcards
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?
A. 7.4
B. 6.4
C. 5.4
D. 10.0
D. 10.0
The times-interest-earned ratio is earnings before interest and taxes divided by interest expense. The after-tax income is given as $5.4 million. Therefore, the before-tax income is $9 million ($5.4 million ÷ 0.6). Adding the $1 million interest expense results in $10 million earnings before interest and taxes. This amount divided by the $1 million interest expense results in a times-interest-earned ratio of 10.0 ($10 million ÷ $1 million).
What is the after-tax cost of preferred stock that sells for $5 per share and offers a $0.75 dividend when the tax rate is 35%?
A. 10.50%
B. 9.75%
C. 15%
D. 5.25%
C. 15%
The component cost of preferred stock is the dividend yield, i.e., the cash dividend divided by the market price of the stock ($.75 ÷ $5.00 = 15%). Preferred dividends are not deductible for tax purposes.
An appreciation of the U.S. dollar against the Japanese yen would
A. Make travel in Japan more expensive for U.S. citizens.
B. Increase the cost of buying supplies for U.S. firms in Japan.
C. Increase the translated earnings of U.S. subsidiaries domiciled in Japan.
D. Make U.S. goods more expensive to Japanese consumers.
D. Make U.S. goods more expensive to Japanese consumers.
When one currency appreciates, other currencies lose buying power. Thus, if the dollar appreciates against the yen, Japanese customers lose buying power when they shop for American goods.
The following information was taken from Culver Co.’s financial statements for the current year ending December 31:
Current assets $11,000,000
Noncurrent assets 14,000,000
Total stockholders’ equity 10,000,000
Total operating expenses 20,000,000
What was Culver’s debt ratio as of December 31?
A. 50%
B. 250%
C. 40%
D. 60%
D. 60%
The total debt ratio (also called the debt to total assets ratio) reports the total debt burden carried by a firm per dollar of assets. Culver Co. has total assets of $25,000,000 ($11,000,000 current assets + $14,000,000 noncurrent assets) and total debt of $15,000,000 ($25,000,000 total assets – $10,000,000 total stockholders’ equity). The debt ratio, then, is calculated as follows:
Debt ratio
= Total debt ÷ Total assets
= $15,000,000 ÷ $25,000,000
= 60%
A firm has sold 1,000 shares of $100 par, 8% preferred stock at an issue price of $92 per share. Stock issue costs were $5 per share. The firm pays taxes at the rate of 40%. What is the firm’s cost of preferred stock capital?
A. 8.25%
B. 9.20%
C. 8.00%
D. 8.70%
B. 9.20%
Because the dividends on preferred stock are not deductible for tax purposes, the effect of income taxes is ignored. Thus, the relevant calculation is to divide the $8 annual dividend by the quantity of funds received from the issuance. In this case, the funds received equal $87 ($92 proceeds – $5 issue costs). Thus, the cost of capital is 9.2% ($8 ÷ $87).
Which one of the following is not a determinant in valuing a call option?
A. Exercise price.
B. Expiration date.
C. Forward contract price.
D. Underlying asset price.
C. Forward contract price.
The price of an option is equal to its intrinsic value (exercise price – underlying asset price) plus the time premium that depends on the expiration date of an option.
A corporation has $50,000 in equity and a debt-to-total-assets ratio of 0.5. The firm wants to reduce this ratio to 0.2 by selling new common stock and using the proceeds to repay principal on outstanding long-term debt. What amount of additional equity financing must the corporation obtain to accomplish this objective?
A. $100,000
B. $30,000
C. $20,000
D. $80,000
B. $30,000
Using the equation Total assets = Liabilities + Equity and a debt-to-total-assets ratio of 0.5, set x = Total assets. Thus, x = 0.5x + $50,000. Solving for x, x = $100,000. Since the debt-to-total-assets ratio is reduced to 0.2 and total assets equal $100,000, liabilities equal $20,000. The new equation using a debt-to-total-assets ratio of 0.2 is $100,000 = $20,000 + equity; thus, equity = $80,000. To achieve a debt-to-total-assets ratio of 0.2, the corporation must increase equity by $30,000 ($80,000 – $50,000).
Which of the following observations regarding the valuation of bonds is correct?
A. When interest rates rise so that the required rate of return increases, the market value of the bond will increase.
B. The market value of a discount bond is greater than its face value during a period of rising interest rates.
C. When the market rate of return is less than the stated coupon rate, the market value of the bond will be more than its face value, and the bond will be selling at a premium.
D. For a given change in the required return, the shorter its maturity, the greater the change in the market value of the bond.
C. When the market rate of return is less than the stated coupon rate, the market value of the bond will be more than its face value, and the bond will be selling at a premium.
When the bonds’ stated rate is higher than the market rate, investors are willing to pay more for the bonds since their periodic interest payments are higher than those currently available in the market. In this case, the issuer receives more cash than the par value and the bonds are said to be sold at a premium.
The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate is 14%. The corporate tax rate is 30%. What is the firm’s net cost of debt?
A. 12%
B. 14%
C. 9.8%
D. 8.4%
C. 9.8%
Because of the tax deductibility of interest payments, the cost of debt equals the effective interest rate times one minus the marginal tax rate. The effective rate is used rather than the coupon rate (stated rate) because the effective rate is the actual cost of the amount borrowed. Thus, the net cost of debt is 9.8% [14% × (1.0 – .30)].
A company manufactures goods in Esland for sale to consumers in Woostland. Currently, the economy of Esland is booming and imports are rising rapidly. Woostland is experiencing an economic recession, and its imports are declining. How will the Esland currency, $E, react with respect to the Woostland currency, $W?
A. The $E will remain constant with respect to the $W.
B. The $E will decline with respect to the $W.
C. Changes in imports and exports will not affect currency changes.
D. The $E will increase with respect to the $W.
B. The $E will decline with respect to the $W.
As incomes rise in a given country, consumers in that country purchase more domestic and foreign goods. The greater demand for foreign goods results in greater demand for foreign currency. When demand increases for a foreign currency, its price increases, and the domestic currency depreciates as a result.
Company ABC and Company XYZ have the same income-generating capacity and amount of assets, and their average tax rate is 30%. Only their capital structures differ. ABC is fully equity-financed, but XYZ is financed by permanent debt and equity. ABC has a value of $5,000,000, and its equity is $2,000,000 greater than XYZ’s. If XYZ has an incremental borrowing rate of 6% and an interest rate on debt of 5%, its value is
A. $3,000,000
B. $5,600,000
C. $7,000,000
D. $5,000,000
B. $5,600,000
The value of a levered firm is the value of an unlevered firm plus the present value of the tax savings from deductions of interest. ABC is unlevered because it is fully equity-financed. Given that ABC is unlevered, its value of $5,000,000 equals its equity (assets – $0 liabilities = equity). Given also that ABC’s equity is $2,000,000 greater than XYZ’s, and the two companies have the same amount of assets ($5,000,000), XYZ must have $2,000,000 of permanent debt. For permanent debt, the present value of tax savings is the product of the amount of debt and the tax rate. The value of the tax savings therefore is $600,000 ($2,000,000 × 30%). The value of XYZ is $5,600,000 ($5,000,000 value of ABC + $600,000).
Which of the following correctly matches the relationship between the trade-related factor and the domestic currency value?
A. Inflation rate; direct.
B. Demand for goods; indirect.
C. Real interest rate; indirect.
D. Demand for currency; direct.
D. Demand for currency; direct.
The relationship between the demand for the domestic currency and its value is direct. The domestic currency value increases or decreases as demand for it increases or decreases, respectively.
Fact Pattern: Dzyubenko Co. reported these data at year end:
Pre-tax operating income $ 4,000,000
Current assets 4,000,000
Long-term assets 16,000,000
Current liabilities 2,000,000
Long-term liabilities 5,000,000
The long-term debt has an interest rate of 8%, and its fair value equaled its book value at year-end. The fair value of the equity capital is $2 million greater than its book value. Dzyubenko’s income tax rate is 25%, and its cost of equity capital is 10%.
What is Dzyubenko’s weighted-average cost of capital (WACC)?
A. 8%
B. 9%
C. 8.89%
D. 10%
B. 9%
The WACC is an after-tax rate determined using the fair values of the sources of long-term funds. Thus, the appropriate cost of debt is 6% [(1.0 – .25 tax rate) × 8%] because interest is tax deductible. However, the given equity rate (10%) is not adjusted because distributions to shareholders are not deductible. The fair value of long-term debt is given as $5 million. The book value of equity must be $13 million ($20 million of assets – $7 million of liabilities), and its fair value is $15 million ($13 million + $2 million). Accordingly, the WACC is calculated as follows:
Bates Corp. has $100,000 in bonds payable with a fair market value of $120,000. It also has 1,000 shares of common stock issued at $50 per share with a fair market value of $80 per share. What amount represents the corporation’s market capitalization?
A. $80,000
B. $180,000
C. $50,000
D. $170,000
A. $80,000
The market capitalization of a company is equal to the shares of common stock outstanding times the fair market value per share. Thus, Bates has a market capitalization of $80,000 (1,000 × $80).
Fact Pattern: Selected data from Ostrander Corporation’s financial statements for the years indicated are presented in thousands.
Year 2 Operations
Net credit sales $4,175
Cost of goods sold 2,880
Interest expense 50
Income tax 120
Gain on disposal of a segment (net of tax) 210
Administrative expense 950
Net income 385
December 31
Year 2 Year 1
Cash $ 32 $ 28
Trading securities 169 172
Accounts receivable (net) 210 204
Merchandise inventory 440 420
Tangible fixed assets 480 440
Total assets 1,397 1,320
Current liabilities 370 368
Total liabilities 790 750
Common stock outstanding 226 210
Retained earnings 381 360
The total debt-to-equity ratio for Ostrander Corporation in Year 2 is
A. 3.49
B. 1.30
C. 2.07
D. 0.77
B. 1.30
Total equity consists of the $226 of capital stock and $381 of retained earnings, or $607. Debt is given as the $790 of total liabilities. Thus, the ratio is 1.30 ($790 ÷ $607).
Current-year earnings are $2.00 per share. Using a discounted cash flow model, the controller determines that the common stock is worth $14 per share. Assuming a 5% long-term growth rate, the required rate of return is which one of the following?
A. 15%
B. 7%
C. 10%
D. 20%
D. 20%
The current-year earnings per share are $2.00. In order to calculate the correct dividend per share amount when given only the amount of the last annual dividend paid, it is necessary to adjust to the expected dividend using the growth rate of the company. Thus, the dividends per share equal $2.10 [$2 × (1 + .05)].
The dividend discount model (also known as the dividend growth model) is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The formula is as follows:
The rate of return can now be solved for as follows:
$2.10 ÷ (x – .05) = $14
$2.10 = $14x – .70
$2.80 = $14x
x = 20%
What is the weighted-average cost of capital for a firm using 65% common equity with a return of 15%, 25% debt with a return of 6%, 10% preferred stock with a return of 10%, and a tax rate of 35%?
A. 11.275%
B. 11.725%
C. 10.333%
D. 12.250%
B. 11.725%
The cost for common equity capital is given as 15%, and preferred stock is 10%. The before-tax rate for debt is given as 6%, which translates to an after-tax cost of 3.9% [6% × (1.0 – .35)]. The rates are weighted as follows:
Component Weighted Component Cost Weighted Cost
Long-term debt 25% × 3.9% = .975%
Preferred stock 10% × 10.0% = 1.000%
Common stock 65% × 15.0% = 9.750%
11.725%
The profitability index is a variation on which of the following capital budgeting models?
A. Economic value-added.
B. Discounted payback.
C. Net present value.
D. Internal rate of return.
C. Net present value.
The profitability or excess present value index is the ratio of the present value of the future net cash inflows to the present value of the initial net investment. The weighted-average cost of capital is frequently specified. These amounts are the same ones used in the calculation of the net present value. This variation of the net present value method facilitates comparison of different-sized investments.
An exporter enters into a contract to supply goods to a foreign buyer. The contract requires the payment in foreign currency 120 days after delivery. Recently the foreign currency has experienced many fluctuations. The exporter may incur a loss on this contract at the time payment is received due to such fluctuations. Which of the following actions should the exporter take to avoid such loss?
A. Cancel the export contract.
B. Enter into a forward contract with a bank.
C. Wait for the settlement date to see if the foreign currency actually fluctuates.
D. Invest the foreign currency in the buyer’s country to avoid short-term fluctuations.
B. Enter into a forward contract with a bank.
Fluctuations in currency between the contract date and the settlement date may cause a loss on a contract. Hedging is a common way to avoid or reduce such losses. When an exporter is required to pay a foreign currency amount at some time in the future, there is a risk that the foreign currency will appreciate. To hedge against risk, the exporter should purchase a foreign currency forward to fix a definite price.
Fact Pattern: Tam Co. is negotiating to purchase 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 were acquired. The equipment’s estimated useful life is 10 years, with no residual value, and 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.
Net present value to Tam Co. is
A. $6,440
B. $12,200
C. $13,000
D. $5,760
C. $13,000
The net present value of this investment can be calculated as follows:
On January 1, Year 1, Linda decides to retire in 10 years. She wants to receive $30,000 annually for 5 years, with the first payment made on January 1, Year 10. For this purpose, she invests in a financial security that requires contributions of equal amounts annually, with the first payment due January 1, Year 1, and the last payment due January 1, Year 9. Assuming an interest rate of 2% per annum, what is the annual contribution to the security?
A. $12,919
B. $14,201
C. $16,667
D. $14,503
D. $14,503
The monthly payments to and by Linda are equal payments at equal intervals of time occurring at the beginning of each period (annuities due). On January 1, Year 10, the present value of the five payments of $30,000 is $144,300 ($30,000 × 4.81). This amount equals the future value of the nine equal contributions ($144,300 = Equal amount × 9.95). Thus, the annual contribution is $14,503 ($144,300 ÷ 9.95).
When the rate of inflation in country A rises relative to the rates of foreign countries, which of the following will occur?
C. Decrease Increase
Jodi purchases a financial security on January 1, Year 1. The security pays $3,000 monthly for a year, with the first payment due on February 1, Year 1. Assuming a monthly interest rate of 1%, what is the price of the security?
A. $34,110
B. $36,000
C. $33,780
D. $2,970
C. $33,78
The financial security provides a series of equal payments at equal intervals of time occurring at the end of each period (ordinary annuity). The price of the security is the present value of the ordinary annuity. The price of the security is $33,780 ($3,000 × 11.26).
Kielly Machines, Inc., is planning an expansion program estimated to cost $100 million. Kielly is going to raise funds according to its target capital structure shown below.
What is Kielly’s weighted-average cost of capital?
A. 13.54%
B. 14.00%
C. 12.22%
D. 13.00%
C. 12.22%
The effective rate for Kielly’s debt is the after-tax cost [11% × (1.0 – .40 tax rate) = 6.6%]. The weighted-average cost of capital (WACC) therefore can be calculated as follows:
Conrad has leased an apartment. The interest rate stated in the lease is 1% per month, and rent is due at the first of each month. At the beginning of every year, the landlord estimates the price of the apartment a year from the date of assessment. Total rent payments for the year will have a future value equal to 10% of the assessment. At the beginning of the year, with the first rent payment of $2,000 due immediately, what is the estimated price of the apartment in 1 year?
A. $256,200
B. $253,600
C. $240,000
D. $227,400
A. $256,200
The monthly rent payments are a series of equal payments at equal intervals of time occurring at the beginning of each period (annuity due). The future value of the rent payments is $25,620 ($2,000 × 12.81). Thus, the estimated price of the apartment is $256,200 ($25,620 FV of rent payments ÷ 10%).
Henry is saving for a new-model car to be delivered in 1 year. He signed an agreement with a car dealer to pay $1,500 monthly for 12 months at a monthly interest rate of 2%. The first payment is due in 1 month. What is the price of the car?
A. $18,000
B. $20,115
C. $18,255
D. $15,870
B. $20,115
The monthly payments to the dealer are a series of equal payments at equal intervals of time occurring at the end of each period (ordinary annuity). The price of the car is the future value of the 12 monthly payments, or $20,115 ($1,500 × 13.41).
Daniel Co. purchased a new truck with an estimated useful life of 8 years for $82,000 in Year 1. The estimated salvage value of the truck is $2,000. The depreciation schedule of Daniel Co. is as follows:
Assuming a tax rate of 40%, what is the depreciation tax shield for the second year?
A. $6,400
B. $10,496
C. $6,560
D. $10,240
B. $10,496
The periodic tax benefit (shield) relating to a fixed asset equals periodic depreciation expense times the applicable tax rate. In the second year, the annual depreciation expense recognized on the truck is $26,240 ($82,000 × 32%), and the depreciation tax shield is $10,496 ($26,240 × 40%).
What is the weighted-average cost of capital for a firm with equal amounts of debt and equity financing, a 15% company cost of equity capital, a 35% tax rate, and a 12% coupon rate on its debt that is selling at par value?
A. 11.40%
B. 9.60%
C. 8.775%
D. 13.50%
A. 11.40%
The 12% debt coupon rate is reduced by the 35% tax shield, resulting in a cost of debt of 7.8% [12% × (1.0 – .35)]. The company’s weighted-average cost of capital can thus be calculated as follows:
Dividends are equal to $5, and the current share price is $50. Dividends are expected to grow at 2% forever. According to the dividend growth model, what is the investor’s required rate of return?
A. 8.2%
B. 10.0%
C. 12.2%
D. 12.0%
C. 12.2%
The dividend growth model assumes that dividends per share and price per share increase at the same constant rate (which can be positive or negative). The required rate of return (the cost of common stock) can be derived from the dividend growth model.
Rice, Inc., uses the allowance method to account for uncollectible accounts. An account receivable that was previously determined uncollectible and written off was collected during May. The effect of the collection on Rice’s current ratio and total working capital is
B. None None
Clifford’s pension fund will pay $40,000 per year for the next 5 years at the end of each year, after which the pension fund balance will be zero. The annual interest rate for the first 3 years is 3%, and the rate for the remaining 2 years is 4%. What is the current pension fund balance?
A. $178,000
B. $188,800
C. $183,200
D. $182,374
D. $182,374
The five payments can be separated into two series of equal payments at equal intervals of time occurring at the end of each period (ordinary annuities). One is for 3 years at 3% and the other for 2 years at 4%. For the annuity for 3 years at 3% (Years 1-3), the present value currently is $113,200 ($40,000 × 2.83). For the annuity for 2 years at 4% (Years 4 and 5), the present value at the end of the third year is $75,600 ($40,000 × 1.89). The present value of this annuity currently is $69,174 ($75,600 × 0.915). The current pension fund balance therefore is $182,374 ($69,174 + $113,200).
Fact Pattern: The following inventory and sales data are available for the current year for Volpone Company. Volpone uses a 365-day year when computing ratios.
Volpone Company’s days sales in inventory for Year 1 is
A. 51.18
B. 72.50
C. 65.00
D. 71.51
B. 72.50
The average days to sell inventory equals ending inventory divided by the quotient of the cost of goods sold over the days in year. Thus, average number of days to sell inventory for Year 1 is 72.50 [$870,000 ÷ ($4,380,000 ÷ 365 days)].
