Section 3: Financial Management & Capital Budeting

Question 1

Yarrow Co. is considering the purchase of a new machine that costs $450,000. The new machine will generate net cash flow of $150,000 per year and net income of $100,000 per year for five years. Yarrow’s desired rate of return is 6%. The present value factor for a five-year annuity of $1, discounted at 6%, is 4.212. The present value factor of $1, at compound interest of 6% due in five years, is 0.7473. What is the new machine’s net present value?

a. $450,000
b. $373,650
c. $181,800
d. $110,475

Answer 1

C. $181,800

Net present value is the difference between the present value of cash inflows and the present value of cash outflows.
Present value of cash inflows: $150,000 x 4.212 = $631,800
Present value of cash outflows: $450,000
Net present value: $631,800 - $450,000 = $181,800

Question 2

A company has the following financial information:
Source of capital Proportion of
capital structure Cost of capital
Long-term debt 60% 7.1%
Preferred stock 20% 10.5%
Common stock 20% 14.2%
To maximize shareholder wealth, the company should accept projects with returns greater than what percent?

a. 7.1%
b. 9.2%
c. 10.6%
d. 14.2%

Answer 2

B. 9.2%

To maximize shareholder wealth, the company should accept projects with an internal rate of return greater than the hurdle rate. The weighted-average cost of capital (WACC) is often used as the hurdle rate. WACC = 60% X 7.1% + 20% X 10.5% + 20% X 14.2% = 9.2%. Therefore, the company should only accept projects with returns greater than 9.2%.

Question 3

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 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%

Answer 3

C. 15.0%

The effective cost of the loan is calculated by dividing the cost of the loan by the proceeds.
Interest: $200,000 x 0.12 = $24,000
Compensating balance: $200,000 x 0.20 = $40,000
Proceeds: $200,000 - $40,000 = $160,000
Effective cost: $24,000 / $160,000 = 15%

Question 4

Which of the following phrases defines the internal rate of return on a project?

a. The number of years it takes to recover the investment.
b. The discount rate at which the net present value of the project equals zero.
c. The discount rate at which the net present value of the project equals one.
d. The weighted-average cost of capital used to finance the project.

Answer 4

B. Discount rate @ which NPV of project = 0

The internal rate of return is the discount rate at which the net present value of the project equals zero. Net present value is the difference between the present value of the investment returns and the present value of the investment costs.

Question 5

Galax, Inc. had operating income of $5,000,000 before interest and taxes. Galax’s net book value of plant assets at January 1 and December 31 were $22,000,000 and $18,000,000, respectively. Galax achieved a 25 percent return on investment for the year, with an investment turnover of 2.5. What were Galax’s sales for the year?

a. $55,000,000
b. $50,000,000
c. $45,000,000
d. $20,000,000

Answer 5

B. $50,000,000

Galax’s sales for the year is computed as follows:
Investment turnover = Sales / Average investment
2.5 = Sales / (($22,000,000 + $18,000,000) / 2)
2..5 = Sales / $20,000,000
Sales = $50,000,000

Question 6

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

Answer 6

c. Economic Value-Added

The economic value-added is a financial measure of the value being created in a company in excess of its required return on capital. It is the income that remains after the cost of all capital. The cost of debt is included in the calculation of income, which is further reduced by the required return on assets to provide the economic value added

Question 7

Which of the following decision-making models equates the initial investment with the present value of the future cash inflows?

a. Accounting rate of return.
b. Payback period.
c. Internal rate of return.
d. Cost-benefit ratio.

Answer 7

C. Internal Rate of Return

The internal rate of return approach measures the effective rate at which the present value of future cash flows is equal to the initial net investment.

Question 8

What is the formula for calculating the profitability index of a project?

a. Subtract actual after-tax net income from the minimum required return in dollars.
b. Divide the present value of the annual after-tax cash flows by the original cash invested in the project.
c. Divide the initial investment for the project by the net annual cash inflow.
d. Multiply net profit margin by asset turnover

Answer 8

B. Divide PV of Annual after-tax CF by original cash invested in the project

The profitability index is calculated by dividing the present value of annual after tax cash flows by the original amount invested in the project

Question 9

The profitability index is a variation on which of the following capital budgeting models?

a. Internal rate of return.
b. Economic value-added.
c. Net present value.
d. Discounted payback

Answer 9

C. NPV

The profitability index is computed by dividing the net present value of an investment alternative by the amount of the initial investment and is a variation of the net present value technique.

Question 10

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 10

A. Materials requirements planning

Materials requirements planning (MRP) uses demand forecasts to manage inventory, consistent with demand-dependent inventory types.

Question 11

What is an internal rate of return?

a. A net present value.
b. An accounting rate of return.
c. A payback period expected from an investment.
d. A time-adjusted rate of return from an investment.

Answer 11

D. A time-adjusted rate of return from an investment

An internal rate of return is the time adjusted rate of return, or the actual return on an investment measured as the rate at which the present value of the future cash flows from an investment is equal to the amount of the initial investment.

Question 12

Which of the following inventory management approaches orders at the point where carrying costs equate nearest to restocking costs in order to minimize total inventory cost?

a. Economic order quantity.
b. Just-in-time.
c. Materials requirements planning.
d. ABC.

Answer 12

A. Economic Order Quanity

The economic order quantity is the amount of inventory that should be ordered each time the company places an order so that the total of the cost of carrying inventory and the cost of placing orders for inventory is minimized.

Question 13

Which of the following events would decrease the internal rate of return of a proposed asset purchase?

a. Decrease tax credits on the asset.
b. Decrease related working capital requirements.
c. Shorten the payback period.
d. Use accelerated, instead of straight-line depreciation.

Answer 13

A. Decrease tax credits on the asset

A decrease in tax credits related to an asset will increase the taxes that will be paid on the income generated by that asset, reducing its cash flows and its internal rate of return.

Question 14

The following information was taken from the income statement of Hadley Co.:
Beginning inventory: 	17,000 
Purchases:	56,000 
Ending inventory:	13,000 
What is Hadley Co.'s inventory turnover?
a.  3
b.  4
c.  5
d.  6

Answer 14

B. 4

With beginning inventory of $17,000 and purchase of $56,000, cost of goods available for sale is $73,000. Subtracting ending inventory of $13,000 gives cost of sales of $60,000. Average inventory is the total of beginning plus ending inventory, divided by 2 or ($17,000 + $13,000)/2 or $15,000. Inventory turnover is cost of sales divided by average inventory or $60,000/$15,000 or 4 times.

Question 15

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%

Answer 15

A. 3%

US Treasury bills (T bills) bear interest at the risk-free rate of interest plus an inflation premium. In this case, it will be 2% + 1% or 3%.

Question 16

Oak Company bought a machine which they will depreciate on the straight-line basis over an estimated useful life of seven years. The machine has no salvage value. They expect the machine to generate after-tax net cash inflows from operations of $110,000 in each of the seven years. Oak’s minimum rate of return is 12%. Information on present value factors is as follows:
Present value of $1 at 12% at the end of seven periods .0452
Present value of an ordinary annuity of $1 at 12% for seven periods 4.564
Assuming a positive net present value of $12,000, what was the cost of the machine?
a. $480,000
b. $490,040
c. $502,040
d. $514,040

Answer 16

B. $490,040

The $12,000 net present value of the machine is the excess of the present value of the future cash flows over the cost of the machine. If the machine has cash flows of $110,000 per year for 7 years, it is considered an annuity and the present value would be $110,000 x 4.564 or $502,040. The investment cost $12,000 less than that or $490,040

Question 17

Salem Co. is considering a project that yields annual net cash inflows of $420,000 for years 1 through 5, and a net cash inflow of $100,000 in year 6. The project will require an initial investment of $1,800,000. Salem’s cost of capital is 10%. Present value information is presented below:
• Present value of $1 for 5 years at 10% is .62.
• Present value of $1 for 6 years at 10% is .56.
• Present value of an annuity of $1 for 5 years at 10% is 3.79.
What was Salem’s expected net present value for this project?
a. $83,000
b. ($108,200)
c. ($152,200)
d. ($442,000)

Answer 17

C. ($152,200)

The net present value of a project is the difference between the present value of its future net cash flows and the initial net investment. This investment has future cash flows of $420,000 per year for 5 years. The present value is $420,000 x 3.79 or $1,591,800. In addition, it will provide $100,000 in the 6th year at a present value of $100,000 x .56 or $56,000, indicating that the present value of future cash flows will be ($1,591,800 + $56,000) $1,647,800. This will be compared to the initial investment of $1,800,000 to give a net present value of $(152,200).

Question 18

A corporation is considering purchasing a machine that costs $100,000 and has a $20,000 salvage value. The machine will provide net annual cash inflows of $25,000 per year and has a six-year life. The corporation uses a discount rate of 10%. The discount factor for the present value of a single sum six years in the future is 0.564. The discount factor for the present value of an annuity for six years is 4.355. What is the net present value of the machine?

a. ($2,405)
b. $8,875
c. $20,155
d. $28,875

Answer 18

C. $20,155

The net present value of the project is the difference between the present value of its future cash inflows and the initial investment. The annual cash inflows of $25,000 per year for 6 years has a present value of $25,000 x 4.355 or $108,875. The salvage value to be received at the end of year 6 is $20,000 x .564 or $11,280, resulting in a total present value of $11,280 + $108,875 = $120,155, which is compared to the initial investment of $100,000 to give a net present value of $20,155.

Question 19

A lender and a borrower signed a contract for a $1,000 loan for one year. The lender asked the borrower to pay 3% interest. Inflation occurred and prices rose by 2% over the next year. The borrower repaid $1,030. What is the amount worth in real terms, after inflation?

a. $1,060.90
b. $1,050.60
c. $1,019.80
d. $1,009.80

Answer 19

D. $1,009.80

At a rate of inflation of 2%, $102 dollars at the end of the period are equivalent to $100 at the beginning. As a result, $1,030 at the end of the year would be equivalent to $1,030 x 100/102 or $1009.89.

Question 20

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

Answer 20

D. 20%, $2,000

ROI is net income divided by the amount invested, This division has net income of $100,000 - $45,000 - $15,000 or $20,000. Based on an average investment of $100,000, ROI is $20,000/$100,000 or 20%. Residual income is net income minus the required return on investment. At 18%, the required return on investment is $100,000 x 18% or $18,000, giving residual income of $20,000 - $18,000 or $2,000.

Question 21

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 21

D. 10.0

Times interest earned is equal to earnings before interest and taxes (EBIT) divided by the amount of interest. If net income is $5.4 million with a tax rate of 40%, $5.4 million represents 60% of income before taxes, which would equal ($5.4million/60%) $9 million. With interest of $1 million, EBIT is $9 million + $1 million or $10 million and times interest earned is $10,000,000/$1,000,000 or

Question 22

Which of the following metrics equates the present value of a project’s expected cash inflows to the present value of the project’s expected costs?

a. Net present value.
b. Return on assets.
c. Internal rate of return.
d. Economic value-added.

Answer 22

C. Internal Rate of Return

The internal rate of return approach measures the interest rate at which the net present value of a project’s cash flows is zero. This approach calculates the rate at which the initial investment and the present value of the future cash inflows are equal.

Question 23

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 23

D. Selling obsolete inventory at a loss

Quick ratio = Quick assets / Current liabilities, where Quick assets = Cash + Marketable securities + Accounts receivable. It is used to evaluate short-term liquidity. Farrow’s current quick ratio is 0.8 (less than one), indicating it has difficulty in meeting its current obligations. Selling obsolete inventory at a loss would increase its quick ratio, because the increase in cash would improve the quick ratio, where the reduction of inventory and the loss would not affect the quick assets.

Question 24

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 24

B. 5.1%

The company’s cost of preferred stock is computed as follows:
Cost of preferred stock = scheduled dividend / (Current stock price – floatation cost)
Cost of preferred stock = ($20 X 9%) / ($40 – $5) = $1.8 / $35 = 5.1%

Question 25

45. The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?
    a. The decline in the value of the investment should be reflected in the determination of net present value.
    b. Depreciation adjusts the book value of the investment.
    c. Depreciation represents cash outflow that must be added back to net income.
    d. Depreciation increases cash flow by reducing income taxes.

Answer 25

D. Depreciation increases cash flow by reducing income taxes.

Depreciation is a “tax shield” that reduces income taxes. As a result, cash flows increase, and this is has a positive impact on used the net present value.

Question 26

Which of the following limitations is common to the calculations of payback period, discounted cash flow, internal rate of return, and net present value?

a. They do not consider the time value of money.
b. They require multiple trial and error calculations.
c. They require knowledge of a company’s cost of capital.
d. They rely on the forecasting of future data.

Answer 26

D. They rely on the forecasting of future data.

The calculations of payback period, discounted cash flow, internal rate of return, and net present value all have future cash flows. Therefore, the common limitation is that they all rely on forecasting of future data to get information about future cash flows.

Question 27

A company invested in a new machine that will generate revenues of $35,000 annually for seven years. The company will have annual operating expenses of $7,000 on the new machine. Depreciation expense, included in the operating expenses, is $4,000 per year. The expected payback period for the new machine is 5.2 years. What amount did the company pay for the new machine?

a. $145,600
b. $161,200
c. $182,000
d. $166,400

Answer 27

D. $166,400

Payback period is the length of time it takes for the initial cash outflow for the investment to be recovered in cash. If cash flow is the same each year, then payment period equals the initial investment divided by the annual cash flow. Therefore, the initial investment is the annual cash flow times the payback period. Since the tax rate is not given, we must assume the pretax amount approximates the after-tax cash flow.
Annual cash flow = $35,000 – $7,000 + $4,000 = $32,000
Initial investment = $32,000 X 5.2 = $166,400

Question 28

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
Period 2 	1.65
Period 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

Answer 28

C. $62,900

The present value of the cost savings for the first 2 years is $30,000 x 1.65 or $49,500. The present value for the savings in the 3rd year is the factor for an annuity of 3 years, 2.32, minus the factor for 2 years, 1.65, or 0.67,or a present value of 0.67 x $20,000 = $13,400. The present value of the total cost savings is $62,900.

Question 29

Tam Co. is negotiating for the purchase of 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 is
a.  $ 5,760
b.  $ 6,440
c.  $12,200
d.  $13,000

Answer 29

D. $13,000

Net present value (NPV) is the excess of the present value of the cash inflows over cash outflows (including the initial investment). Since the investment will result in an after-tax cash savings of $20,000 per year for 10 years, the present value of the investment would be $20,000 x 5.65 = $113,000. At an initial cost of $100,000, the investment has a net present value of $13,000.If income taxes are ignored, depreciation expense would not affect the calculation.