Question 1

``` 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 ```

Accepted Answer

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).

Question 2

Which of the following performance measures may lead a manager of an investment center to forgo investments that could benefit the company as a whole? A. Return on investment. B. Residual income. C. Profitability index. D. Economic value added.

Accepted Answer

A. Return on investment. The use of (an expected) return on investment (ROI) as a performance measure for an investment center may lead a manager to forgo investments that could benefit the company as a whole. In an investment center, management is responsible for the center's revenues, costs and related investments. The basic ROI calculation for an investment center is Center Operating Income/Average Center Operating Assets. Center management would likely forgo an investment opportunity that may provide a more than adequate ROI for the company as a whole, but which would provide a ROI lower than the center's already existing ROI, which would lower the center's overall ROI.

Question 3

Analysis shows that the gross profit margin of a company has declined substantially over the last two years. This decline could be attributed to which of the following possible causes, if any: I. The cost of inventory has increased faster than selling prices. II. Stiff competition has resulted in lower selling prices with the same cost. A. I only is correct. B. II only is correct. C. Both I and II are correct.

Accepted Answer

C. Both I and II are correct. Gross profit is computed as net sales minus cost of goods sold. Gross profit margin is computed as gross profit/net sales. Therefore, factors that reduce net sales or increase cost of goods sold will adversely affect the gross profit margin. Both the cost of inventory increasing faster than selling prices and lower selling prices resulting from competition (with no change in the cost of goods sold) will cause a decrease in the gross profit margin.

Question 4

The following data pertain to Cowl Inc. for the year ended December 31, 2006: Net sales $ 600,000 Net income 150,000 Total assets, January 1, 2006 2,000,000 Total assets, December 31, 2006 3,000,000 ``` Which one of the following was Cowl's rate of return on assets for 2006? A. 5% B. 6% C. 20% D. 24% ```

Accepted Answer

B. 6% The rate of return on assets (ROA) is computed as: ROA = Net Income + Interest Expense/Average Total Assets Since this question does not provide the amount of interest expense, the unadjusted net income must be used as the numerator. Beginning and ending total assets must be used to get an average total assets for the year. That calculation would be: Beginning assets $2,000,000 + Ending assets $3,000,000 = $5,000,000/2 = $2,500,000 average total assets. The ROA

Question 5

Which of the following ratios would be used to evaluate a company's profitability? A. Current ratio. B. Inventory turnover ratio. C. Debt to total assets ratio. D. Gross margin ratio.

Accepted Answer

D. Gross margin ratio. The gross margin ratio (also the gross profit margin) is used to evaluate a company's profitability. It is computed as: Gross Margin Ratio (or Gross Profit Margin) = Gross Profit/Net Sales

Question 6

``` Ral Co.'s target gross margin is 60% of the selling price of a product that costs $5.00 per unit. The product's selling price per unit should be A. $17.50 B. $12.50 C. $8.33 D. $7.50 ```

Accepted Answer

B. $12.50 Correct! Gross margin is Selling Price - Cost of Sales. Therefore, the formula for solution is: Selling Price - Cost = .60 Selling Price. Rearranged: Selling Price - .60 Selling Price = Cost ($5.00). Therefore, .40 Selling Price = $5.00, or Selling Price = $5.00/.40 = $12.50.

Question 7

``` costs of $990,000. What is the target price to obtain a 15% profit margin on sales? A. $2,329 B. $2,277 C. $1,980 D. $1,935 ```

Accepted Answer

A. $2,329 Two steps are involved in getting the solution. First, the total sales have to be determined using the given "cost" margin (100% - 15% profit margin = 85% cost margin) and the given cost amount. Once the total sales are determined, the given number of units (500) can be used to determine the per unit selling price. Total sales can be computed as: Total Sales - Cost = 15% Total Sales. Rearranged: Total Sales - .15 Total Sales = Cost. Therefore, .85 Total Sales = $990,000, or Total Sales = $990,000/.85 = $1,164,706. Target Price = $1,164,706/500 units (given) = $2,329 sales price per unit. Proof: Profit Margin = Net Income/Sales Net Income = Sales ($1,164,705) - Cost ($990,000) = $174,706 Net Income. Profit Margin = $174,706/$1,164,705 = 15% (the desired profit on sales).

Question 8

SkBound Airlines provided the following information about its two operating divisions: Passenger Cargo Operating profit $ 40,000 $ 50,000 Investment 250,000 500,000 External borrowing rate 6% 8% Measuring performance using return on investment (ROI), which division performed better? A. The Cargo division, with an ROI of 10%. B. The Passenger division, with an ROI of 16%. C. The Cargo division, with an ROI of 18%. D. The Passenger division, with an ROI of 22%.

Accepted Answer

B. The Passenger division, with an ROI of 16%. The Passenger division with an ROI of 16% is the better performing division. Return on investment (ROI) measures the rate of return earned on total assets invested and is computed as operating profit divided by total investment. The greater the ROI, the better the performance. For the facts given: Passenger division = $40,000/$250,000 = 16% = Greater ROI Cargo division = $50,000/$500,000 = 10%

Question 9

The following selected data pertain to the Darwin Division of Beagle Co. for 2005: ``` Sales $400,000 Operating income 40,000 Capital turnover 4 Imputed interest rate 10% What was Darwin's 2005 residual income? A. $0 B. $4,000 C. $10,000 D. $30,000 ```

Accepted Answer

D. $30,000 Residual income is the excess of the division's income over the income that would be required based on the 10% imputed interest rate and the amount invested in divisional assets. This question requires a determination of divisional assets. The division's assets turned over four times, meaning, with sales of $400,000, the division has $100,000 of assets. The expected income for this division is then 10% of that amount, or $10,000. Thus, residual income is: Operating income ($40,000) - expected income ($10,000) = $30,000. This amount represents the excess of actual operating income of the division over the minimum amount that is required for a division with $100,000 worth of assets invested.

Question 10

Kim Co.'s profit center Zee had 2004 operating income of $200,000 before a $50,000 imputed interest charge for using Kim's assets. Kim's aggregate net income from all of its profit centers was $2,000,000. During 2004, Kim declared and paid dividends of $30,000 and $70,000 on its preferred and common stock, respectively. ``` Zee's 2004 residual income was A. $140,000 B. $143,000 C. $147,000 D. $150,000 ```

Accepted Answer

D. $150,000 The dividend information is not relevant to the question. Dividends are a distribution, rather than a determinant, of income. Residual income is computed as: Residual income = operating income - imputed charge = $200,000 - $50,000 = $150,000 The imputed charge is the product of a minimum rate of return and the invested capital in the division. The imputed charge is the minimum income that should be achieved by the division with that much invested capital.

Question 11

Minon, Inc. purchased a long-term asset on the last day of the current year. What are the effects of this purchase on return on investment and residual income? Return on Investment Residual Income Increase Increase Increase Decrease Decrease Increase Decrease Decrease

Accepted Answer

Return on Investment Residual Income Decrease Decrease Acquiring a long-term asset on the last day of the year would decrease the return on investment because a larger asset base would be divided into the net income for the period, and residual income would decrease because the average invested capital, which is multiplied by the hurdle rate of return and subtracted from net income, would increase.

Question 12

Managers of the Doggie Food Co. want to add a bonus component to their compensation plan. They are trying to decide between return on investment (ROI) and residual income (RI) as the performance measure they will use. If Doggie adopts the RI performance measure, the relevant required rate of return would be 18%. One segment of Doggie is the Good Treats division, where the manager has invested in new equipment. The operating results from this equipment are as follows: Revenues $80,000 Cost of goods sold 45,000 General and administrative expenses 15,000 ``` Assuming that there are no income taxes, what would be the ROI and RI, respectively, for this equipment, which has an average value of $100,000? A. $2,000, 20% B. 35%, $3,600 C. $3,600, 35% D. 20%, $2,000 ```

Accepted Answer

D. 20%, $2,000 Correct! The ROI is computed as: Net Income/Average Total Assets. Substituting the values provided, the calculation would be: Net Income ($80,000 - $45,000 - $15,000) = $20,000/Average Equipment Value = $100,000 = $20,000/$100,000 = .20 (or 20%). RI is computed as: Net Income - Required $ Return. Substituting the values provided, the calculation would be: Net Income ($80,000 - $45,000 - $15,000) = $20,000 - (Average Investment ($100,000) x Required or Hurdle Rate (.18)) = $20,000 - ($100,000 x .18) = $20,000 - $18,000 = $2,000. Thus, ROI = 20% and RI = $2,000.

Question 13

A company's return on investment is the A. Profit margin percentage divided by the capital turnover. B. Profit margin percentage multiplied by the capital turnover. C. Capital turnover divided by invested capital. D. Capital turnover multiplied by invested capital.

Accepted Answer

B. Profit margin percentage multiplied by the capital turnover. Return on investment = Income/Investment Profit margin percentage = Income/Sales Capital turnover = Sales/Investment Therefore: Return on investment = (Income/Sales) x (Sales/Investment) = Profit margin percentage x capital turnover. This answer correctly states: Profit margin percentage MULTIPLIED by the capital turnover.

Question 14

Which of the following terms represents the residual income that remains after the cost of all capital, including equity capital, has been deducted? A. Free cash flow. B. Market value-added. C. Economic value-added. D. Net operating capital.

Accepted Answer

C. Economic value-added. Economic value-added (EVA) represents the residual income that remains after the cost of all capital, including equity capital, has been deducted. It is calculated as an entity's net after-tax operating profit less the cost of capital provided by debt holders and shareholders. It is a performance metric intended to measure economic profit, not accounting profit.

Question 15

Return on assets is computed as Net Income (as appropriately adjusted)/Average Total Assets. DuPont Company developed a method of separating the return on assets computation into two component ratios. Which one of the following sets identifies the two component ratios that make up the DuPont return on assets approach? A. Gross profit margin (ratio) and average total asset turnover ratio. B. Net profit margin (ratio) and average total asset turnover ratio. C. Gross profit margin (ratio) and average fixed asset turnover ratio. D. Net profit margin (ratio) and average fixed asset turnover ratio.

Accepted Answer

B. Net profit margin (ratio) and average total asset turnover ratio. The basic return on assets (ROA) calculation is: ROA = Net Income/Total Assets That formula is separated into two components in the DuPont return on assets: ROA = Net Profit Margin (Ratio) x Average Total Asset Turnover Ratio Each of these ratios is defined as: Net Profit Margin Ratio = Net Income/Net Sales and Average Total Asset Turnover Ratio = Net Sales/Average Total Assets. Thus, in its most detailed form the DuPont ROA is: Net Income __________ Net Sales x Net Sales ________________ Average Total Assets

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