FinMgmt-Hard Qs Flashcards
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%
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%.
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%
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%.
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%
D. 10.4%
The correct calculation is the annual dividend divided by the net proceeds of the stock issuance. Therefore, the calculation would be $10 annual dividend/$101 selling price - $5 underwriter’s fee = $96 proceeds, or $10/$96 = 10.4%
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.
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.
The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What percentage represents the firm's cost of common equity? A. 12.0% B. 8.4% C. 7.0% D. 5.0%
A. 12.0%
The firm’s cost of common equity is the rate of return currently expected by potential investors in the firm’s common stock. When it is assumed that the dividends are expected to grow at a constant rate, that rate of return is calculated as:
Common Stock Expected Return (CSER) = (Dividend in 1st Year/Market Price) + Growth Rate
Using the values given: CSER = ($4.25/$85.00) + .07
CSER = .05 + .07 = .12 (or 12%)
The CSER of 12% is the cost of capital through common stock financing.
Bander Co. is determining how to finance some long-term projects. Bander has decided it prefers the benefits of no fixed charges, no fixed maturity date, and an increase in the credit-worthiness of the company. Which of the following would best meet Bander's financing requirements? A. Bonds. B. Common stock. C. Long-term debt. D. Short-term debt.
B. Common stock.
Issuing common stock to finance its projects would best meet Bander’s financing strategy. Specifically, issuing common stock would (1) not result in fixed charges, since dividends are at the discretion of the Board of Directors, (2) not result in a fixed maturity date, since common stock does not mature, and (3) would likely increase the credit-worthiness of the company because the issuance of additional common stock would reduce its debt to equity ratio by increasing equity.
Which of the following formulas should be used to calculate the historic economic rate of return on common stock?
A. (Dividends + change in price) divided by beginning price.
B. (Net income - preferred dividend) divided by common shares outstanding.
C. Market price per share divided by earnings per share.
D. Dividends per share divided by market price per share.
A. (Dividends + change in price) divided by beginning price.
For common stock, expected returns are from dividends and stock price appreciation. Thus, the rate of return on the common stock would be (dividends paid during the period + change in the stock price)/price of the stock at beginning of the period.
Green, Inc., a financial investment-consulting firm, was engaged by Maple Corp. to provide technical support for making investment decisions. Maple, a manufacturer of ceramic tiles, was in the process of buying Bay, Inc., its prime competitor. Green's financial analyst made an independent detailed analysis of Bay's average collection period to determine which of the following? A. Financing. B. Return on equity. C. Liquidity. D. Operating profitability.
C. Liquidity.
A detailed analysis of average collection period most likely would be used to assess or determine liquidity. An analysis of average collection period would measure how long, on average, it takes an entity to collects its receivables – how long it takes to convert accounts receivable to cash.
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
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.
A company has cash of $100 million, accounts receivable of $600 million, current assets of $1.2 billion, accounts payable of $400 million, and current liabilities of $900 million. What is its acid-test (quick) ratio? A. 0.11 B. 0.78 C. 1.75 D. 2.11
B. 0.78
The acid-test ratio (also known as the quick ratio) is computed as the relationship between highly liquid assets and current liabilities. Highly liquid assets include cash, accounts receivable, and marketable securities. In this case, the company has only cash and accounts receivable. Therefore, the correct calculation is $100m (cash) + $600m (accounts receivable) = $700m/$900 (current liabilities) = 0.777 (or 0.78).
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.
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.
Would the following accounts be included in the computation of the quick ratio?
Accounts Receivable Marketable Securities Inventories
Yes Yes Yes
Yes Yes No
Yes No Yes
Yes No No
Yes Yes No
The quick ratio (also called the acid-test ratio) measures the relationship between current assets that are cash or can be converted to cash quickly and the total of current liabilities.
Current assets that can be converted to cash quickly include (in addition to cash) accounts receivable and marketable securities (expected to be sold in the near term). Inventories are not included in the quick ratio because normally they cannot be converted to cash quickly.
By excluding inventories (and other current assets that cannot be converted to cash quickly – e.g., prepaid assets), the measure of assets available to pay current liabilities in the quick ratio is more conservative than the measure of assets used in working capital (or current) ratio, thus the quick ratio also is called the acid-test ratio.
Information that relates to a firm’s solvency is used primarily to assess a firm’s ability to
A. Convert assets to cash.
B. Pay its debts.
C. Generate profits.
D. Collect its receivables in a timely manner.
B. Pay its debts.
Measures related to the solvency of a firm are primarily concerned with the ability of a firm to pay its debts as they become due.
Which combination of changes in asset turnover and income as a percentage of sales will maximize the return on investment?
Asset turnover Income as a percentage of sales
Increase Decrease
Increase Increase
Decrease Increase
Decrease Decrease
Increase Increase
Return on investment = income/investment = (sales/investment x [income/sales]) = (asset turnover) x (income as a percent of sales). This disaggregation of return on investment allows an analysis of the effect of turnover and income as a percent of sales on return on investment. An increase in either or both of the component ratios will result in an increase in return on investment. This makes intuitive sense. The more times assets “turn over” or produce sales in the amount of assets in a period, the higher will be the return on those assets. Similarly, the larger percentage of sales kept by the firm as income, the higher will be return to investment.
A company has two divisions. Division A has operating income of $500 and total assets of $1,000. Division B has operating income of $400 and total assets of $1,600. The required rate of return for the company is 10%. The company's residual income would be which of the following amounts? A. $0 B. $260 C. $640 D. $900
C. $640
Residual income is the difference between the actual income and the required return on investment. For the facts given actual income is $900 ($500 + $400) and the required return is of $260 [($1,000 + $1,600) * 10%], resulting in residual income of $640 ($900 - $260).
