Financial Management - Part 2

Question 1

Which of the following types of bonds is most likely to maintain a constant market value?
	A.  	Zero-coupon.
	B.  	Floating-rate.
	C.  	Callable.
	D.  	Convertible.

Answer 1

B. Floating-rate.

Floating-rate bonds are most likely to maintain a constant market value. The rate of interest paid on floating-rate bonds (also called variable-rate bonds/debt) varies with the changes in some underlying benchmark, usually a market interest rate benchmark (e.g., LIBOR or the Fed Funds Rate). Because the interest rate changes with changes in the market rate of interest, they maintain a relatively stable (constant) market value.

Question 2

Which of the following statements concerning debenture bonds and secured bonds is/are correct?

I. Debenture bonds are likely to have a greater par value than comparable secured bonds.

II. Debenture bonds are likely to be of longer duration than comparable secured bonds.

III. Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds.
	A.  	I only.
	B.  	II only.
	C.  	III only.
	D.  	I, II, and III.

Answer 2

C. III only.

Debenture bonds are unsecured bonds. Because they are unsecured, they are likely to have a higher coupon rate (interest rate) than comparable secured bonds.

Question 3

Which one of the following is a contract that states the terms of a bond issued by a corporation?
	A.  	Indenture.
	B.  	Debenture.
	C.  	Advice.
	D.  	Certificate.

Answer 3

A. Indenture.

An indenture is the term given to a bond contract.

Question 4

Which of the following statements concerning preferred stock is/are generally correct?

I. Requires dividends be paid.
II. Grants ownership interest.
III. Grants voting rights.
	A.  	I only.
	B.  	II only.
	C.  	I and II only.
	D.  	I, II and III

Answer 4

B. II only.

Preferred stock, like common stock, conveys an ownership interest in the entity. Preferred stock does not require the payment of dividends nor does it normally convey voting rights.

Question 5

Whipco has determined that its pre-tax cost of preferred stock is 12%. If its tax rate is 30%, which one of the following is its after-tax cost of preferred stock?
	A.  	15.6%
	B.  	12.0%
	C.  	8.4%
	D.  	3.6%

Answer 5

B. 12.0%

Since dividends on preferred stock are not tax deductible, no adjustment to the pre-tax cost needs to be made. Therefore, the after-tax cost of preferred stock is the same as the pre-tax cost, 12%.

Question 6

Which of the following statements concerning common stock is/are generally correct?
I. Requires dividends be paid.
II. Grants ownership interest.
III. Grants voting rights.
	A.  	I only.
	B.  	II only.
	C.  	II and III only.
	D.  	I, II and III.

Answer 6

C. II and III only.

Common stock grants both an ownership interest and a voting right. It does not require the payment of dividends, which are at the discretion of the Board of Directors and require profitable operations.

Question 7

Which one of the following is a contract that states the terms of a bond issued by a corporation?
	A.  	Indenture.
	B.  	Debenture.
	C.  	Advice.
	D.  	Certificate.

Answer 7

A. Indenture.

An indenture is the term given to a bond contract.

Question 8

The market price of a bond issued at a premium is equal to the present value of its principal amount
A. Only, at the stated interest rate.
B. And the present value of all future interest payments, at the stated interest rate.
C. Only, at the market (effective) interest rate.
D. And the present value of all future interest payments, at the market (effective) interest rate.

Answer 8

D. And the present value of all future interest payments, at the market (effective) interest rate.

The market price of a bond, whether issued at par, at a premium, or at a discount, will be the present value of the principal amount plus the present value of future interest payments, all at the market (effective) rate of interest.

Question 9

Which of the following statements concerning debenture bonds and secured bonds is/are correct?

I. Debenture bonds are likely to have a greater par value than comparable secured bonds.

II. Debenture bonds are likely to be of longer duration than comparable secured bonds.

III. Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds.

A. I only.
B. II only.
C. III only.
D. I, II, and III.

Answer 9

C. III only.

Debenture bonds are unsecured bonds. Because they are unsecured, they are likely to have a higher coupon rate (interest rate) than comparable secured bonds.

Question 10

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?
	A.  	4.5%
	B.  	5.1%
	C.  	9.0%
	D.  	10.3%

Answer 10

B. 5.1%

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 11

Allen issues $100 par value preferred stock that is selling for $101 per share, on which the firm has to pay an underwriting fee of $5 per share sold. The stock is paying an annual dividend of $10 per share. Allen's tax rate is 40%. Which one of the following is the cost of preferred stock financing to Allen?
	A.  	4.2%
	B.  	6.2%
	C.  	9.9%
	D.  	10.4%

Answer 11

D. 10.4%

Question 12

Which of the following statements concerning the leasing of an asset is/are correct?

I. If the net present value of purchasing an asset is not positive, then leasing the asset should not be considered as an alternative.

II. In a net-net lease, the lessee is responsible for executory costs and residual value of the leased asset.
	A.  	I only is correct.
	B.  	II only is correct.
	C.  	I and II are correct.
	D.  	Neither I nor II is correct.

Answer 12

B. II only is correct.

Statement I is not correct. If the net present value of purchasing an asset is not positive, which shows that it is not economically feasible to purchase the asset and earn a positive return, it still may be economically feasible to lease the asset.
In fact, in the final analysis, the basic reason for leasing, rather than buying, is that leasing an asset costs less than purchasing it.
Therefore, while the cost of purchasing an asset may result in a negative net present value, the cost savings associated with leasing the asset may be such that leasing the asset is economically feasible.

Statement II is correct.
In a net-net lease agreement, the lessee assumes responsibility for both executory costs (i.e., insurance, taxes, maintenance, etc.) of the asset and for the asset having a pre-established residual value at the end of the lease.

Question 13

What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
A. To cause the price of the company’s stock to rise.
B. To lower the company’s credit rating.
C. To reduce the risk of existing debt holders.
D. To reduce the interest rate on the debt being issued.

Answer 13

D. To reduce the interest rate on the debt being issued.

Question 14

Which of the following statements concerning the use of short-term financing by an entity is/are correct?

I. Short-term financing generally offers greater financial flexibility than long-term financing.

II. Short-term financing generally has a lower interest rate than long-term financing.

III. Short-term financing generally has a lower risk of illiquidity than long-term financing.
	A.  	I only is correct.
	B.  	I and II are correct.
	C.  	II and III are correct.
	D.  	I, II and III are correct.

Answer 14

B. I and II are correct.

In general, short-term financing offers a firm greater financial flexibility than does long-term financing. With short-term financing, the level of borrowing can be more readily expanded or contracted with changes in the need for funds.
With long-term financing, the level of borrowing cannot be readily adjusted with changes in needs, especially when there is a contraction in the need for debt. Short-term financing is generally cheaper than long-term financing.
For a given borrower at a particular point in time, interest rates on short-term borrowings, in general, are lower than interest rates on long-term borrowings.

Finally, III is not correct because short-term financing generally has a higher (not lower) risk of illiquidity than does long-term financing.
By its nature, short-term borrowing must be repaid or refinanced in the near term and, on an on-going basis, more often than long-term debt.
Changes in the economic environment or within the entity, may make it impossible for the firm to either repay or refinance the debt. In that case, the firm would be technically insolvent.

Question 15

Which one of the following sources of new capital usually has the lowest after-tax cost?
	A.  	Bonds.
	B.  	Preferred stock.
	C.  	Common stock.
	D.  	Retained earnings.

Answer 15

A. Bonds.

Bonds usually have the lowest after-tax cost of new capital because investors have less risk when investing in bonds than in equity, and because the interest payments to bondholders is deductible for tax purposes.

Question 16

According to the hedging principle (or the principle of self-liquidating debt), in making decisions concerning the maturity structure of an entity’s financing, which one of the following guidelines would be most appropriate?
A. Fund a project with short-term benefits by issuing common stock.
B. Fund a seasonal expansion in inventory by issuing bonds.
C. Fund a project that will benefit eight years with a short-term note.
D. Fund a permanent expansion in accounts receivable by issuing long-term bonds.

Answer 16

D. Fund a permanent expansion in accounts receivable by issuing long-term bonds.

The hedging principle states that the maturity structure of an entity’s financing should be consistent with the cash flow produced by the asset being financed. Assets or projects that provide short-term benefits should be financed with short-term financing and assets or projects of long-term duration or benefit should be financed with long-term or permanent financing.

Therefore, a permanent expansion in accounts receivable, which will require a permanent increase in financing, should be financed by issuing long-term bonds (or, if the option is provided, common stock issuance).

Question 17

Which one of the following would not be considered an element of concern in working capital management?
	A.  	Accounts receivable.
	B.  	Inventory.
	C.  	Accounts Payable.
	D.  	Property, plant, and equipment.

Answer 17

D. Property, plant, and equipment.

Property, plant, and equipment is not an element of working capital. Although management of property, plant, and equipment would be a management concern, it would not be a factor in the management of working capital, which is comprised of current assets and current liabilities.

Question 18

If a firm's accounts payable, its only current liability, exceeds the sum of cash, accounts receivable and, inventory, the firm's only current assets, then net working capital will be:
	A.  	Zero.
	B.  	Positive.
	C.  	Negative.
	D.  	Adequate.

Answer 18

C. Negative.

Net working capital is computed as: Current Assets - Current Liabilities. If current liabilities exceed current assets, net working capital is negative.

Question 19

A cash management system should be concerned with the float associated with both cash receipts and cash disbursement.

Will efficient practices seek to increase or decrease receipt float and disbursement float?

  Receipt Float  	  Disbursement Float  

 Increase 	 Increase 
 Increase 	 Decrease 
 Decrease 	 Increase 
 Decrease 	 Decrease

Answer 19

Decrease Increase

C is correct.

Float is the length of time between the writing of a check (or other draft instrument) and the actual transfer of the funds. Receipt float is the time between the writing of a check (or other instrument) by a customer and when those funds become available to the party to which the check was made.
Disbursement float is the time between the writing of a check by a firm writes and removal of the funds from the firm’s account. Efficient cash management will seek to decrease receipt float and increase disbursement float.

By reducing receipt float, a firm has cash it is receiving available sooner than it would be available otherwise.

By increasing disbursement float, a firm has cash it is paying available longer than it otherwise would be available. Thus, decreasing receipt float and increasing disbursement float make more cash available to a firm.

Question 20

Which one of the following would most likely be used to manage a bank account used exclusively for payment of monthly salary checks?
	A.  	Electronic funds transfer.
	B.  	Zero-balance account.
	C.  	Concentration banking.
	D.  	Remote disbursing.

Answer 20

B. Zero-balance account.

Under one application of the zero-balance account, only an amount equal to the amount of salary checks would be deposited into the account from which salary payments are made. As a consequence, the account would always have a zero real balance (i.e., after outstanding checks are deducted). This facilitates the management of the account, including its reconciliation.

Question 21

A production cycle of long duration would be expected to have which one of the following effects on working capital?

A.  	A higher working capital requirement than a shorter production cycle.
B.  	A lower working capital requirement than a shorter production cycle.
C.  	The same working capital requirement as a shorter production cycle.
D.  	No effect on the working capital requirement of the firm

Answer 21

A. A higher working capital requirement than a shorter production cycle.

As the term implies, the production cycle is the time needed to convert raw materials into finished goods. The longer the duration (time) of this cycle, the higher the level of working capital that would be expected to be devoted to the process. For example, more work-in-process inventory would be incurred in a long production cycle than would be involved in a short production cycle.

Question 22

Which one of the following is most likely not a major concern when selecting short-term investment opportunities?
	A.  	Safety of principal.
	B.  	Rate of return.
	C.  	Price stability.
	D.  	Marketability.

Answer 22

B. Rate of return.

Because funds invested in short-term investments will earn a return for only a short period of time, the rate of return earned is normally not a major concern. More important concerns are safety of principal, price stability, and marketability of the investment.

Question 23

All other things being equal, which one of the following types of investment securities would be expected to have the highest yield (return)?
	A.  	U.S. Treasury bills
	B.  	Municipal bonds
	C.  	Federal agency securities
	D.  	Corporate bonds

Answer 23

D. Corporate bonds

Since corporate bonds are more risky than U.S. Treasury bills and Federal agency securities, and since the interest they pay is taxable, they would be expected to have the highest yield.

Question 24

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:

Credit sales expected to remain unchanged at $1,000,000
The 2% discount is expected to be taken on 40% of accounts receivable balance amounts.
The average accounts receivable would likely decrease by $ 30,000
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?
	A.  	$ 3,500
	B.  	$ 4,500
	C.  	$ 8,000
	D.  	$20,000

Answer 24

A. $ 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 25

Which one of the following is least likely to enter into a firm’s decision in setting the rate and period of its discount terms for early payment?
A. A firm’s margin of profit.
B. The rate and period offered by competitors.
C. Minimizing the firm’s losses on account receivable.
D. A firm’s cost of financing its accounts receivable.

Answer 25

C. Minimizing the firm’s losses on account receivable.

A firm will be least likely concerned with minimizing the firm’s losses on accounts receivable in setting the rate and period of its discount terms for early payment. First, the objective in setting account receivable policies is not to minimize losses, but to maximize net income. A firm could minimize its losses on accounts receivable by being a cash only business, but it would lose sales and net income. Secondly, setting the rate and period of discount terms is concerned with accelerating the collection of cash, not with minimizing losses.

Question 26

Which of the following assumptions is associated with the economic order quantity formula?
A. The carrying cost per unit will vary with quantity ordered.
B. The cost of placing an order will vary with quantity ordered.
C. Periodic demand is known.
D. The purchase cost per unit will vary based on quantity discounts.

Answer 26

C. Periodic demand is known.

The economic order quantity determines the order size that will minimize total inventory cost – both order cost and carrying cost. The economic order quantity model (formula) assumes that periodic demand is known and constant during the period. It also assumes that order cost and carrying cost per unit are known and constant during the period.

Question 27

In general, does the use of short-term financing require collateral and/or impose restrictive terms on the borrower?

 Collateral Required  	 Restrictive Terms Imposed  

 Yes 	 Yes 
 Yes 	 No 
 No 	 Yes 
 No 	 No

Answer 27

No No

In general, items of short-term financing do not require collateral from or impose restrictive terms on the borrower. Accounts payable and accrued payables, for example, do not require either collateral or have restrictive terms. Similarly, most short-term notes do not require collateral or have restrictive terms.

Question 28

In computing the reorder point for an item of inventory, which of the following factors are used?

I. Cost of inventory.

II. Inventory usage per day.

III. Acquisition lead-time.
	A.  	I and II are correct.
	B.  	II and III are correct.
	C.  	I and III are correct.
	D.  	I, II and III are correct.

Answer 28

B. II and III are correct.

Determining the level of stock (inventory) at which the inventory should be reordered is a function of the minimum level of inventory to be maintained, referred to as the safety stock, and the length of time it takes to receive inventory after it is ordered, referred to as the lead-time or delivery-time stock. Both the safety stock and the lead-time stock are based on the rate of inventory usage. The calculation of the reorder point would be: Reorder point = safety stock + delivery-time stock The cost of inventory does not enter into the determination of the reorder point (but it does enter into the optimum quantity to reorder).

Question 29

Which of the following inventory management techniques focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials?
	A.  	Materials requirements planning.
	B.  	Cycle counting.
	C.  	Safety stock reorder point.
	D.  	Economic order quantity.

Answer 29

A. Materials requirements planning.

The materials requirement planning approach to manufacturing and inventory management focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials. Under this approach, inventories are maintained at every level in the process (as raw materials, work-in-process and finished goods) as buffer against unexpected increases in demand. The alternative approach, just-in-time inventory, seeks to eliminate excess raw material, work-in-process and finished goods inventories.

Question 30

Which of the following inventory management approaches seeks to minimize total inventory costs by considering both the restocking (reordering) cost and the carrying costs?
	A.  	Economic order quantity.
	B.  	Just-in-time.
	C.  	Materials requirements planning.
	D.  	ABC.

Answer 30

A. Economic order quantity.

The economic order quantity model seeks to determine the order size that will minimize total inventory cost, both order cost and carrying costs.

While the question can be answered quite easily, because the economic order quantity answer choice is the only one that is concerned with minimizing total inventory cost by considering carrying cost and restocking cost (reordering costs), the wording of the question is ambiguous at best. It would have been better worded as “Which of the following inventory management approaches seeks to minimize total inventory costs by considering both the restocking (reordering) cost and the carrying costs?” Because it is an actual AICPA exam question, the wording has been left unchanged.

Question 31

Farrow Co. is applying for a loan in which the bank requires a quick ratio of at least 1. Farrow’s quick ratio is 0.8. Which of the following actions would increase Farrow’s quick ratio?
A. Purchasing inventory through the issuance of a long-term note.
B. Implementing stronger procedures to collect accounts receivable at a faster rate.
C. Paying an existing account payable.
D. Selling obsolete inventory at a loss.

Answer 31

D. Selling obsolete inventory at a loss.

Selling obsolete inventory at a loss (or at a gain) would increase Farrow’s quick ratio. The quick ratio (also known as the acid test ratio) measures the number of times that cash and assets that can be converted quickly to cash cover current liabilities. It is calculated as: (Cash + Current Receivables + Marketable Securities)/Current Liabilities. Selling obsolete inventory would increase cash, in the numerator, without changing current liabilities, the denominator, which would increase the quick ratio.

Question 32

Quick Ratio Formula

Answer 32

The acid-test ratio (also known as the quick ratio) is computed as the relationship between highly liquid assets and current liabilities.

It is calculated as: (Cash + Current Receivables + Marketable Securities)/Current Liabilities

Question 33

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.  	5.4
	B.  	6.4
	C.  	7.4
	D.  	10.0

Answer 33

D. 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.