V - Capital Budgeting

Question 1

What is Capital Budgeting? How is it used?

Answer 1

Managerial Accounting technique used to evaluate different investment options

Helps management make decisions

Uses both accounting and non-accounting information

Internal focus

GAAP is not mandatory

Question 2

What values are used in Capital Budgeting?

Answer 2

Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.

Question 3

When is the Present Value of $1 table used?

Answer 3

For ONE payment- ONE time.

Question 4

When is the Present Value of an Annuity Due used?

Answer 4

Multiple payments made over time- where the payments are made at the START of the period.

Question 5

When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?

Answer 5

Multiple payments over time- where payments are made at the END of the period.

Think A for Arrears.

Question 6

What is the calculation for the Present Value of $1?

Answer 6

1 / (( 1+i )^n)

i : interest rate
n : number of periods

Question 7

What is Net Present Value (NPV)?

Answer 7

A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money
: PV of Future Cash Flows - Investment

Question 8

How is NPV used to calculate future benefit?

Answer 8

NPV : PV Future Cash Flows - Investment

If NPV is Negative- Cost is greater than benefits (bad investment)

If NPV is Positive- Cost is less than benefit (good investment)

If NPV : 0- Cost : Benefit (Management is indifferent)

Question 9

What is the rate of return on an investment called?

Answer 9

The Discount Rate.

Question 10

What does the Discount Rate represent?

Answer 10

The rate of return on an investment used.

It represents the minimum rate of return required.

Question 11

What are the strengths of the Net Present Value system?

Answer 11

Uses the Time Value of Money

Uses all cash flows- not just the cash flows to arrive at Payback

Takes risks into consideration

Question 12

What are the weaknesses of the Net Present Value system?

Answer 12

Not as simple as the Accounting Rate of Return.

Question 13

How do Salvage Value and Depreciation affect Net Present Value?

Answer 13

NPV includes Salvage Value because it is a future cash inflow.

NPV does NOT include depreciation because it is non-cash.

Exception - If a CPA Exam question says to include tax considerations- then you have to include depreciation because of income tax savings generated by depreciation.

Question 14

If multiple potential rates of return are available- which is used to calculate Net Present Value?

Answer 14

The minimum rate of return is used.

Question 15

What is the Internal Rate of Return (IRR)?

Answer 15

It calculates a project’s actual rate of return through the project’s expected cash flows.

IRR is the rate of return required for PV of future cash flows to EQUAL the investment.

Investment / After Tax Annual Cash Inflow : PV Factor

Question 16

Which rate of return is used to re-invest cash flows for Internal Rate of Return?

Answer 16

Cash flows are re-invested at the rate of return earned by the original investment.

Question 17

How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?

Answer 17

Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate.

Question 18

What are the strengths and weaknesses of the Internal Rate of Return system?

Answer 18

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

Question 19

When is NPV on an Investment positive?

Answer 19

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

Question 20

When is NPV on an Investment Negative?

Answer 20

When Costs are greater than Benefits

IRR is less than the Discount Rate

Question 21

When is NPV Zero?

Answer 21

When benefits equal the Costs

IRR : Discount Rate

Question 22

What is the Payback Method? How is it calculated?

Answer 22

It measures an investment in terms of how long it takes to recoup the initial investment via Annual Cash Inflow

Investment / Annual Cash Inflow : Payback Method

Compare to a targeted timeframe; if payback is shorter than target- it’s a good investment. If payback is longer than target- it’s a bad investment.

Question 23

What are the strengths of the Payback Method?

Answer 23

Takes risk into consideration

2 year payback is less risky than a 5 year payback

Question 24

What are the weaknesses of the payback method?

Answer 24

Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back

Question 25

What is the Accounting Rate of Return?

Answer 25

An approximate rate of return on assets

ARR : Net Income / Average Investment

Compare to a targeted return rate; if ARR greater than target- good investment. If ARR less than target- bad investment.

Question 26

What are the strengths of the Accounting Rate of Return (ARR)?

Answer 26

Simple to use

People understand easily

Question 27

What are the weaknesses of the Accounting Rate of Return (ARR)?

Answer 27

Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.

Question 28

What is an Expected Return?

Answer 28

An approximate rate of return on assets.

Question 29

The presence of risk for a portfolio of projects means:
More than one outcome is possible for any project
OR Some project will lose money.

Answer 29

More than one outcome is possible for any project

Risk means there is uncertainty about outcome

Question 30

A graph of the relationship between financial risk and expected financial reward would show a curve that has…

Answer 30

Positive slope

To demonstrate Risk - Reward relationship

Question 31

As the perceived risk of an undertaking increases, what would be the expected effect on (1) risk-free rate of return and (2) risk premium rate of return?

Answer 31

RF RoR - No change

Risk Premium - Increase

Question 32

Capital budgeting is concerned with capital investments that have Short or Long term benefits?

Answer 32

Long Term

Question 33

Which one of the following is a strength of the payback method of evaluating an investment project?
A. It considers cash flows for all years
B. It distinguishes the sources of cash inflows.
C. It considers the time value of money.
D. It is easy to compute and understand.

Answer 33

It is easy to compute and understand

Want Payback period to be less than Max payback period

Question 34

A company invested in a new machine that will generate revenues of $35,000 annually for 7 yr, Annual operating expenses of $7,000, Depreciation expense (included in the operating expenses) is $4,000 per year, expected payback period is 5.2 years. What was paid for the machine?

Answer 34

166,400
The expected payback period is the length of time needed for net cash flows to recover the initial cash inv. The annual revenue is $35k and the annual cash exp are $3,000, which is the total operating expenses less the amount of depreciation expense included (since it is a non-cash expense). Therefore: $35,000 - $3,000 = $32,000 x 5.2 = $166,400

Question 35

Which of the following approaches to capital project evaluation is concerned with relative economic ranking of projects? 	
Net present value approach.
Profitability index approach.
Accounting rate of return approach.
Internal rate of return approach.

Answer 35

Profitability Index Approach

Question 36

Which one of the following is not a technique or approach for evaluating capital budgeting opportunities?
Discounted payback period approach
Payback period approach
Profitability index approach
Regression analysis approach

Answer 36

Regression analysis approach

Question 37

Main difference between normal payback method and discounted payback?

Answer 37

Discounted payback uses the time value of money.

It discounts cash flows to PV amounts

Question 38

Which of the following statements about discounted payback period method are correct?
I. It is useful in evaluating the liquidity of a project.
II. It measures total project profitability.
III. It results in a longer computed payback period than does the undiscounted payback period method.

Answer 38

I and III are correct
Statement II is not. The discounted payback period method does not measure the total project profitability, it measures only the period required to recover the initial investment. The total profitability or loss of the project is not assessed.

Question 39

T/F?
Any project economically acceptable under the discounted payback period approach will be acceptable under the payback period approach.

Answer 39

True, the discounted method lowers the cash flows to PV amounts, so if that has an acceptable amount then a normal PBP will also be acceptable

Question 40

Is salvage value used in payback period calculations?

Answer 40

NO!!! Only use initial investment amounts, along with cash flows

Question 41

Which of the following is correct regarding the payback method as a capital budgeting technique?
1The payback method considers the time value of money.
2An advantage of the payback method is that it indicates if an investment will be profitable.
3The payback method provides the years needed to recoup the investment in a project.
4Payback is calculated by dividing the annual cash inflows by the net investment.

Answer 41

3 The payback method provides the years needed to recoup the investment in a project.

Question 42

What PV chart do you use for PV cash flows in a Discounted payback period calculation?
Annuity or Single payment

Answer 42

Single payment, use this on each cash flow separately. You do not have equal payments, therefore not an annuity

Question 43

Which of the following concerning the accounting rate of return to evaluating capital projects is/are correct?
I. It considers the entire life of a project.
II. It considers the time value of money.
III. It assumes that the incremental net income is the same each year.

Answer 43

I and III

2 is not correct

Question 44

T Co. purchased 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 is acquired. The equipment’s useful life is 10 years, with no residual value, and it would be depreciated by the straight-line method. What is your ARR (%)?

Answer 44

10%
The ARR= (Change in) Annual accounting income/Initial Investment. For the facts given, the annual change in accounting income will be $20,000 - ($100,000/10 years) = $10,000. The accounting rate of return would be: $10,000/$100,000 = 10%.

Question 45

P Co acquired a machine that would cost $66,000, has a life of 6 years, and an expected salvage value of $16,000. The company expects the machine to provide annual incremental income before taxes of $7,200. Phillips has a tax rate of 30%. If Phillips uses average values in its calculations, what is the ARR?

Answer 45

The (average) accounting rate of return is determined by dividing the average annual after-tax net income by the average cost of the investment. The after-tax income would be $7,200 x .70 = $5,040. The average cost of the investment would be beginning book value ($66,000) + ending book value of ($16,000), or $82,000/2 = $41,000. Therefore, the accounting rate of return is: $5,040/$41,000 = 12.29%.

Question 46

Which one of the following methods of evaluating potential capital projects would take into account depreciation expense that was non-deductible for tax purposes?

Answer 46

ARR
The accounting rate of return measures the expected annual incremental accounting income from a project as a percent of the initial (or average) investment in the project. Since it uses accounting income, it takes into account depreciation expense in computing the annual incremental income.

Question 47

Y Co. purchased a new machine that costs $450,000. It will generate net cash flow of $150,000 per year and net income of $100,000 per year for 5 yrs. Y’s desired rate of return is 6%. The PV factor for a five-year annuity of $1, discounted at 6%, is 4.212. The PV factor of $1, at compound interest of 6% due in five years, is 0.7473. What is the net present value?

Answer 47

The NPV is determined as the [present value of future cash inflows] less [present value of the current costs of the machine]. Net income is not relevant in computing the NPV. The cash inflow is $150,000 per year for 5 years. The PV of that is $150,000 x 4.212 (the PV of an annuity for 5yr) = $631,800. The PV of the cost of the new machine is $450,000. Thus, the NPV is $631,800 - $450,000 = $181,800.

Question 48

Does NPV use regular annuities or an annuity due for calculations?

Answer 48

The present value of an ordinary annuity due is NOT used because the cash inflow payments will be received at the end of each year, not at the beginning of each year.

Question 49

For NPV what chart amount do you multiply the cash inflows by?

Answer 49

Present value of an ordinary annuity

of $1

Question 50

Project info:
Expected sales $1,500
Cash operating expense 700
Depreciation 250
Tax rate	30%
What is the after-tax cash inflow?

Answer 50

$635
The net cash inflow would be computed as: $1,500 - $700 = $800 x (1 - .30) = $800 x .70 = $560 + ($250 x .30) = $560 + $75 = $635. The ($250 x .30) is the tax savings from the deductibility of the depreciation for tax purposes.

Question 51

A project’s NPV, ignoring income tax, is normally affected by the:

• Proceeds from the sale of the asset to be replaced.
• Carrying amount of the asset to be replaced by the project.
• Amount of annual depreciation on the asset to be replaced.
• Amount of annual depreciation on fixed assets used directly on the project.

Answer 51

Proceeds from the sale of the asset to be replaced.
The net present value approach is based on cash flows. Only the proceeds from sale of the asset to be replaced is a cash flow. The remaining alternatives are not cash flows, and do not cause cash flows to change when income tax effects are ignored. In the equipment replacement decision, the proceeds from the sale of the old asset (not its carrying value) increase the net present value of the replacement alternative.

Question 52

Which of the following is an advantage of net present value modeling?
It is measured in time, not dollars.
It uses accrual basis, not cash basis accounting for a project.
It uses the accounting rate of return.
It accounts for compounding of returns.

Answer 52

It accounts for compounding of returns.
The NPV assesses projects by comparing the PV of the expected cash flows (revenues or savings) of the project with the initial cash investment in the project. The use of PV provides for the compounding of amounts over time.

Question 53

S Co. yields annual net cash inflows of $420,000 for years 1 through 5, and net cash inflow of $100,000 in year 6. The project will require an initial investment of $1,800,000. S’s cost of capital is 10%. PV info:
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 S’s expected NPV?

Answer 53

($152,200)
[420k x 3.79] + ($100,000 x .56) = 1,647,800
1,647,800 - 1.8M = ($152,200)

Question 54

The calculation of depreciation is used in the determination of the net present value of an investment for which of the following reasons?

• The decline in the value of the investment should be reflected in the determination of net present value.
• Adjusts the book value of the investment.
• Represents cash outflow that must be added back to net income.
• Increases cash flow by reducing income taxes.

Answer 54

Increases cash flow by reducing income taxes.
Since the amount of depreciation expense taken reduces taxes due, it reduces cash outflow by the amount of taxes saved. The present value of that saving enters into the determination of present values for net present value assessment purposes.

Question 55

Net present value as used in investment decision-making is stated in terms of which of the following options?
1 Net income.
2 Earnings before interest, taxes, and depreciation.
3 Earnings before interest and taxes.
4 Cash flow.

Answer 55

Cash Flow
NPV as used in investment decision-making is stated in terms of cash flow; specifically, in terms of the present value of cash flow. If the net present value of cash flow is zero or positive, an investment project is economically feasible.

Question 56

For salvage value in NPV calculations you use which table for PV?

Answer 56

Salvage value uses the discount factor for the present value of a single sum N years in the future. Amount is a lower than 1 decimal

Question 57

Which of the following statements about investment decision models is true?

• The discounted payback rate takes into account cash flows for all periods.
• The payback rule ignores all cash flows after the end of the payback period.
• NPV says to accept investment opportunities when their rates of return exceed the company’s incremental borrowing rate.
• The IRR rule is to accept the investment if the opportunity cost of capital is greater than the internal rate of return.

Answer 57

The payback rule ignores all cash flows after the end of the payback period.
The payback (period) rule or approach to assessing investments (e.g., capital projects) determines the number of years or other periods needed for future cash flows from an investment to recover the initial cost of the investment

Question 58

T/F: NPV and IRR implicitly assume that all cash inflows are immediately reinvested to earn a return for the company

Answer 58

True, 1) The net present value method implicitly assumes that reinvestment of cash inflows earns the hurdle rate of return, the same rate used to discount future cash flows to get present value.
2) The internal rate of return method implicitly assumes that reinvestment of cash inflows earns a rate of return equal to the internal rate of return.

Question 59

A client wants to know how many years it will take before the accumulated cash flows from an investment exceeds the initial investment, without taking the time value of money into account. Which of the financial models should be used?

Answer 59

Payback period

Question 60

In evaluating the economic feasibility of a capital project, the discount rate (or hurdle rate of return) must be determined in advance when using the…

Answer 60

The net present value method of evaluating capital projects uses a discount rate (also called hurdle rate) to discount future cash flows (or savings) to their PV. Thus, the discount rate must be established in advance of using the method.

Question 61

Which of the following rates is most commonly compared to the internal rate of return to evaluate whether to make an investment?
Short-term rate on U.S. Treasury bonds.
Prime rate of interest.
Weighted-average cost of capital.
Long-term rate on U.S. Treasury bonds.

Answer 61

Weighted-average cost of capital is the cost of financing with each source of capital weighted by the proportion of total capital provided by each source, with the resulting weighted cost summed to get the total weighted-average cost of capital. The weighted-average cost also is the minimum rate of return that a firm must earn on its investments

Question 62

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

Answer 62

IRR

equates the present value of a project’s expected cash inflows to the present value of the project’s expected costs

Question 63

Neu Co. is considering the purchase of capital equipment that has a positive net present value based on Neu’s 12% hurdle rate.
The internal rate of return would be:
Less, equal, greater than 12?

Answer 63

Greater than 12%
Since the IRR determines the discount rate, which equates the PV of future cash inflows with the cost of the investment, if the project has a positive net present value, the discount rate (or internal rate of return) must be greater than the hurdle rate.

Question 64

Does Acct Rate of Return and/or IRR uses depreciation expense?

Answer 64

Only Accounting Rate of Return does

Question 65

Does IRR use “residual sales value” of a project?

Answer 65

Yes, but not depreciation

Question 66

When estimating cash flow for use in capital budgeting, depreciation is
Included as a cash or other cost.
Excluded for all purposes in the computation.
Utilized to estimate the salvage value of an investment.
Utilized in determining the tax costs or benefit.

Answer 66

Utilized in determining the tax costs or benefit.

Question 67

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

Answer 67

IRR

Question 68

Which of the following characteristics represent an advantage of the internal rate of return technique over the accounting rate of return technique in evaluating a project?
I. Recognition of the project’s salvage value.
II. Emphasis on cash flows.
III. Recognition of the time value of money.

Answer 68

Statements II and III are advantages of the IRR over ARR because ARR does not emphasize (use) cash flows, and does not consider the time value of money (discounted cash flow computations). ARR relates a project’s annual accrual-based income (as opposed to net cash inflow) to its investment. Furthermore, both approaches consider the project’s salvage value, although IRR uses the present value of the salvage amount.

Question 69

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

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

Answer 69

The discount rate at which the net present value of the project equals one. The internal rate of return on a project is defined as the discount rate at which the net present value of the project equals zero.

Question 70

NPV / Project Cost = ??? what model

Answer 70

Profitability Index

Question 71

If it is determined that a project investment is expected to generate $1.20 in present value for each $1.00 invested, which one of the models was used to reach that?

Answer 71

Profitability Index, NPV / cost

Question 72

Which of the following is a limitation of the profitability index?

• It uses free cash flows.
• It ignores the time value of money.
• It is inconsistent with the goal of shareholder wealth maximization.
• It requires detailed long-term forecasts of the project’s cash flows.

Answer 72

It requires detailed long-term forecasts of the project’s cash flows

Question 73

Which one of the methods of evaluating investment projects is most likely to be used to rank projects competing for limited capital investment funds?

Answer 73

PI Method
The profitability index method is specifically designed to rank projects by taking into account both the time value of money and the initial cost of the project.

Question 74

Which one of the methods of evaluating investment projects is most likely to be LEAST acceptable for making project ranking decisions?

Answer 74

Payback period, because of all of its shortcomings

Question 75

Which of the methods should be used if capital rationing needs to be considered when comparing capital projects?

Answer 75

Profitability Index
The PI method (also called the cost/benefit ratio) is primarily intended for use in ranking projects. It does so by taking into account both the present value and the cost of each project.

Question 76

Which one of the following forms of short-term financing is LEAST likely to be considered a spontaneous source of funding?
Short-term notes payable.
Accrued taxes payable.
Accrued salaries payable.
Trade accounts payable.

Answer 76

ST Notes payable, not a day to day activity

Question 77

On Jan 23, K Co received from one of its suppliers a statement with terms of “2/10, n/30.” Because the statement was misfiled, it was not located for payment until Feb 5. On what date must the bill be paid?

Answer 77

Feb 22, Net 30 is the day its due, 10 days would be the discount period

Question 78

Which of the following generally is NOT an advantage associated with use of trade accounts payable and accrued A/P for short-term financing needs?
Flexibility.
Ease of use.
Available for all short-term needs.
Absence of collateral required.

Answer 78

Available for all short-term needs.

They have limited use/capabilities

Question 79

Which one of the following would an importer of goods from a new foreign supplier most likely use to assure the supplier of payment?
Line of credit.
Letter of credit.
Trade account application
Commercial paper.

Answer 79

Letter of credit
A letter of credit would be used to assure a foreign supplier of payment. A letter of credit is a conditional commitment to pay a third party in accordance with specified terms.

Question 80

Which one of the following is a formal legal commitment to extend credit up to some maximum amount to a borrower over a stated period?
Line of credit.
Letter of credit.
Revolving credit agreement.
Trade credit.

Answer 80

Revolving credit agreement.
A revolving credit agreement is a formal legal commitment, usually by a bank, to extend credit up to some maximum amount to a borrower over a stated period.

Question 81

An amount that a bank requires a firm to maintain in a demand deposit account with the bank in return for a line of credit or loan is called:

Answer 81

Compensating balance

Question 82

Which one of the following typically is NOT a characteristic of commercial paper?
Matures in the short-term.
Loans are secured.
Users have high credit ratings.
Provide cash for operating use.

Answer 82

Loans are secured

They are unsecured

Question 83

Po Co. plans to use its inventory as collateral for a short-term loan. Which one of the following loan agreements with its lender provides Po Co. the most flexibility in the use of the inventory it pledges as collateral?
Field warehouse agreement.
Floating lien agreement.
Chattel mortgage agreement.
Terminal warehouse agreement.

Answer 83

Floating lien, maintains control (can sell and replenish), just has a lien on the inventory

Question 84

If X plans to factor $200,000 of accounts receivable due in 30 days, which one of the following is the amount it will receive from F at the time the accounts are factored?
Value of receivables to be held in reserve for contingencies 10%
Following costs are deducted at time accounts are factored:
Interest rate on amounts provided (annual rate) 12%
Factor fee on total receivables factored 2%

Answer 84

174,240
The amount provided would be $200,000 accounts receivable - $20,000 reserve - $4,000 factor fee = $176,000, for which interest would be charged for 30 days, or 1% (i.e., 1/12 of 12%). Therefore, the correct amount received would be $176,000 - ($176,000 x .01) = $176,000 - $1,760 = $174,240.

Question 85

Which one of the following forms of collateral is most commonly used as security for short-term loans?
Inventory.
Property, plant, and equipment.
Real estate.
Investments.

Answer 85

Inventory is most commonly used for ST loans

Question 86

The weighted average cost of capital for a firm is determined by its cost of its:
Short Term Financing or Long Term Financing

Answer 86

Long Term

LT = “capital”

Question 87

Under which of the following described lease terms would the lessee be responsible during the term of the lease for executory costs associated with the leased asset?
Net Lease
Net-Net Lease
Both

Answer 87

Both
Under a net lease, the lessee assumes the executory costs associated with the asset during the lease, including such elements as maintenance, taxes and insurance. In a net-net lease, the lessee assumes responsibility for the executory costs during the life of the lease, as well as for a residual value at the end of the lease.

Question 88

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

Answer 88

To reduce the interest rate on the debt being issued.
The primary reason for a company to agree to a debt covenant limiting the % of its long-term debt would be to reduce the risk, and therefore the interest rate, on debt being issued. Debt covenants place contractual limitations on activities of the borrower to help protect the lender. As such, they reduce the default risk associated with a debt issue and, therefore, reduce the interest rate on that debt.

Question 89

Which of the following long-term notes would best facilitate financial leverage for the borrowing firm?
Fixed Rate Note
Variable Rate Note
Both

Answer 89

Fixed Rate
The cost of variable rate debt can change, thereby making the degree of leverage more uncertain over the life of the debt.

Question 90

T/F:
If the net present value of purchasing an asset is not positive, then leasing the asset should NOT be considered as an alternative.

Answer 90

False
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.

Question 91

The market price of a bond issued at a premium is equal to the present value of its principal amount

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

Answer 91

-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 92

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

• Debenture bonds are likely to have a greater par value than comparable secured bonds.
• Debenture bonds are likely to be of longer duration than comparable secured bonds.
• Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds.

Answer 92

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

Question 93

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

Answer 93

Indenture

An indenture is the term given to a bond contract.

Question 94

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

Answer 94

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, so they remain stable

Question 95

What impact will the issuing of new preferred stock have on the following for the issuing entity?

• LT Debt (Up, down, no change)
• Debt to Equity Ratio (Up, down, no change)

Answer 95

LT Debt, no change, Debt/Equity Ratio, Decrease

Question 96

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%. What is the cost of preferred stock financing to Allen?

Answer 96

Calculation would be $10 annual dividend OVER ($101 selling price - $5 underwriter’s fee) = $96 proceeds, or $10/$96 = 10.4%

Question 97

In which one of the following areas is preferred stock most likely to differ from common stock?
Ownership status.
Maturity date
Tax deductibility of dividends paid.
Voting rights.

Answer 97

Voting rights

Question 98

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?

Answer 98

The current cost of capital for preferred stock is: net proceeds per share divided into the annual cost (dividends) of the newly issued shares. In this question, the net proceeds per share is $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. So, the cost of capital for the newly issued preferred stock is $1.80/$35.00 = 5.1%.

Question 99

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?

Answer 99

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 100

Which of the following formulas should be used to calculate the historic economic rate of return on common stock?

• (Dividends + change in price) divided by beginning price.
• (Net income - preferred dividend) divided by common shares outstanding.
• Market price per share divided by earnings per share.
• Dividends per share divided by market price per share.

Answer 100

(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.

Question 101

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?

Answer 101

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.

Question 102

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.

Answer 102

II and III

Question 103

Larson Corp. issued $20 million of long-term debt in the current year. What is a major advantage to Larson with the debt issuance?

• The reduced earnings per share possible through financial leverage.
• The relatively low after-tax cost due to the interest deduction.
• The increased financial risk resulting from the use of the debt.
• The reduction of Larson’s control over the company.

Answer 103

The relatively low after-tax cost due to the interest deduction.
The issuance of debt results in interest expense, which is deductible for tax purposes. Therefore, the effective cost of debt is less than its stated interest rate by the amount of taxes saved by that interest deduction. The effective cost of debt is its interest cost x (1 - tax rate).

Question 104

The cost of debt most frequently is measured as

• Actual interest rate.
• Actual interest rate adjusted for inflation.
• Actual interest rate plus a risk premium.
• Actual interest rate minus tax savings.

Answer 104

-Actual interest rate minus tax savings.
For example, if the stated (actual) interest rate is 10% and the tax rate is 40%, the effective interest rate (actual interest rate minus tax savings) will be 10% x (1.00 - .40), or 10% x .60 = 6% effective cost of debt.

Question 105

Which one of the following sources of new capital usually has the lowest after-tax cost?

• Bonds.
• Preferred stock.
• Common stock.
• Retained earnings.

Answer 105

Bonds

Goes: Bonds, P Stock, C stock

Question 106

Which of the following 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.

Answer 106

I and II
I/II- With short-term financing, the level of borrowing can be more readily expanded or contracted with changes in the need for funds. Int rates are usually lower as well.
III- not correct because ST 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.

Question 107

The optimal capitalization for an organization usually can be determined by the

• Maximum degree of financial leverage.
• Maximum degree of total leverage.
• Lowest total weighted-average cost of capital.
• Intersection of the marginal cost of capital and the marginal efficiency of investment.

Answer 107

Lowest total weighted-average cost of capital.
The WACC determines the average cost of a corporation’s capital by weighting each component, both debt and equity. The lowest total weighted-average cost of capital usually would be the optimal capitalization and would maximize the value of the firm’s stock.

Question 108

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?

• Fund a project with short-term benefits by issuing common stock.
• Fund a seasonal expansion in inventory by issuing bonds.
• Fund a project that will benefit eight years with a short-term note.
• Fund a permanent expansion in accounts receivable by issuing long-term bonds.

Answer 108

Fund a permanent expansion in accounts receivable by issuing long-term bonds.
Hedging - use LT debt for LT assets, use ST debt for ST assets. Gives Lower risk!

Question 109

Why would a firm generally choose to finance temporary assets with short-term debt?

• Matching the maturities of assets and liabilities reduces risk.
• Short-term interest rates have traditionally been more stable than long-term interest rates.
• A firm that borrows heavily long-term is more apt to be unable to repay the debt than a firm that borrows heavily short-term.
• Financing requirements remain constant.

Answer 109

Matching the maturities of assets and liabilities reduces risk.
AKA hedging, match ST debt with ST assets

Question 110

Working Capital is: (simple equation)

Answer 110

Current Assets less Current Liabilities

Question 111

When a financial manager takes action to minimize the firm’s investment in current assets, which one of the following risks is likely to increase?

• Accounts receivable defaults may increase.
• Inventory spoilage may increase.
• Inventory shortages may increase.
• Inventory obsolescence may increase.

Answer 111

Inventory shortages may increase.
Reducing investment in current assets is likely to increase the risk that inventory shortages will increase. Excessive reductions in inventory may result in inventory shortages

Question 112

Which of the following statements concerning working capital management is/are correct?
I. A firm can be over invested in net working capital.
II. A firm can be under invested in net working capital.

Answer 112

BOTH, A firm can over/under invested in net working capital. If over invested, typically it will earn a lower return than would be possible if the assets were invested in capital projects. If under invested in net working capital, a firm maybe unable to meet current operating and financial needs, including having inadequate cash, and incurring inventory shortages.

Question 113

A production cycle of long duration would be expected to have which effect on working capital?

• A higher working capital requirement than a shorter production cycle.
• A lower working capital requirement than a shorter production cycle.
• The same working capital requirement

Answer 113

Higher working capital req.
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 ex, more work-in-process inventory would be incurred in a long production cycle than would be involved in a short production cycle.

Question 114

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

Answer 114

PPE, it is not a current asset/liab

Question 115

If a firm’s accounts payable, its only current liability, exceeds all current assets, Net working capital would be:
+, -, 0

Answer 115

Negative, Net working capital is Assets less Liab, more liab makes a neg working capital

Question 116

Which one of the following would most likely be used to manage a bank account used exclusively for payment of monthly salary checks?

• Electronic funds transfer.
• Zero-balance account.
• Concentration banking.
• Remote disbursing.

Answer 116

Zero balance Acct
Only an amount equal to the amount of salary checks would be deposited into the specified account. As a result, the account would always have a zero real balance. This facilitates the management of the account, including its reconciliation.

Question 117

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

Answer 117

Receipt float - decrease (want faster inflows)

Disbursement float - increase (slower outflows)

Question 118

A lock-box system improves control over cash received because the lock-box is accessed directly by which one of the following?
Company’s Treasurer.
Post office.
Company’s bank.

Answer 118

Company bank

In a lock-box system, customer payments are made to a post office box that is accessed directly by the company’s bank.

Question 119

Which one of the following cash management techniques focuses on cash disbursements?

• Lock-box system.
• Zero-balance account.
• Pre-authorized checks.
• Depository transfer checks.

Answer 119

Zero-balance account

Money is put in when needed to be disbursed. Could be used for salaries

Question 120

The time between paying cash for raw materials and collecting cash from the sale of products made with those raw materials is called which one of the following?
Inventory cycle.
Accounts receivable cycle.
Cash conversion cycle.
Business cycle.

Answer 120

Cash conversion cycle

Question 121

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

Answer 121

Corp 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 122

Common stocks	12%	20%
Long-term corporate bonds	6%	8%
Intermediate-term government bonds	5%	5%
U.S. Treasury bills	4%	3%
Which of these investments has the greatest reward/risk ratio if a return's standard deviation is an accurate assessment of investment risk?

Answer 122

Treasury bills, they are 4% / 3% = 1.3333
All others are lower, this is the Sharpe ratio
(ROI over Stnd Deviation) = risk-return ratio

Question 123

The overall objective of accounts receivable management is to:
Maximize sales.
Minimize credit losses.
Maximize profits.
Minimize uncollectible accounts.

Answer 123

Maximize profits

Question 124

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 firm’s margin of profit.
• The rate and period offered by competitors.
• Minimizing the firm’s losses on account receivable.
• A firm’s cost of financing its accounts receivable.

Answer 124

Minimizing the firm’s losses on account receivable.
Main goal is to maximize profits, not minimize losses. Also setting the rate of payment is trying to accelerate collection first, not minimize the losses.

Question 125

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 $1M
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.
What is the dollar amount of net benefit or cost that Moe would obtain if the proposed 2% discount plan is implemented?

Answer 125

$3500
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

Question 126

Accounts receivable management is concerned with:
I. Policies related to the recognition of accounts receivable.
II. Policies related to the collection of accounts receivable.

Answer 126

Both
Policies concerned with the recognition of accounts receivable would include general terms under which credit will be granted and criteria for determining eligibility/limits. Policies concerned with the collection of A/R would cover monitoring accounts receivable and plans for collection action.

Question 127

Which of the 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?

• Materials requirements planning.
• Cycle counting.
• Safety stock reorder point.
• Economic order quantity.

Answer 127

Materials req planning
MRP 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
The alternative, just-in-time inventory, seeks to eliminate excess raw material, work-in-process and finished goods inventories.

Question 128

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.

Answer 128

II and III, cost is not a factor. You need to know your usage and the time it’ll take for delivery

Question 129

Which one of the following is not a characteristic of a just-in-time inventory system?

• Reducing distance and time between related production operations.
• Establishing close, long-term relationships with suppliers.
• Decreasing the number of deliveries from suppliers.
• Reducing raw material safety stock.

Answer 129

Decreasing the number of deliveries from suppliers.
Under a just-in-time inventory system, a firm reduces its inventory on-hand and relies on suppliers to make more frequent deliveries

Question 130

Which of the inventory management approaches seeks to minimize total inventory costs by considering both the restocking (reordering) cost and the carrying costs?

• Economic order quantity.
• Just-in-time.
• Materials requirements planning.

Answer 130

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.

Question 131

Which of the following assumptions is associated with the economic order quantity formula?

• The carrying cost per unit will vary with quantity ordered.
• The cost of placing an order will vary with quantity ordered.
• Periodic demand is known.
• The purchase cost per unit will vary based on quantity discounts.

Answer 131

Assumes demand is know (as well as costs)

Question 132

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

Answer 132

No, ST borrowing usually doesn’t include either collateral or restrictive terms

Question 133

A Co learns that it may have an opportunity to acquire a large quantity of its raw material in the near future at a significant discount. It would require that A Co make an immediate decision and that it pay for the inventory at that time. Which one of the following would A Co most likely employ in anticipation of such an opportunity so that funds would be available when needed?

• Execute a short-term note.
• Arrange to issue additional shares of authorized common stock.
• Arrange a line of credit.
• Execute documents to enable it to issue bonds.

Answer 133

Arranging a line of credit would provide “stand-by” financing that could be used if and when the opportunity to acquire the inventory materializes. Such an arrangement would avoid incurring interest cost and other costs unless and until the credit is actually used.

Question 134

Which of the following statements concerning ratio analysis is/are correct?
I. Ratio analysis uses only monetary measures for analysis purposes.
II. Ratio analysis uses only measures from financial statements for analysis purposes.

Answer 134

Neither

Ratio analysis uses monetary measures as well as other quantitative measures

Question 135

Titles of ratios frequently include the terms “on” and “to.” When used in ratio titles, these terms imply the use of which mathematical function?

Answer 135

Division

EX, Debt to Equity = debt / equity

Question 136

Ratio analysis and related measures can be used to compare:
I. A firm over time
II. Across firms

Answer 136

Both

Question 137

Bobcat Co has a current ratio of 2:1. If Bobcat has current liabilities of $120,000, what is the amount of Bobcat’s current assets?

Answer 137

$240K

Current ratio - Curr Assets / Current Liab

Question 138

Which of the following ratios would most likely be used by management to evaluate short-term liquidity?

• Return on total assets.
• Sales to Cash.
• Accounts receivable turnover.
• Acid test ratio.

Answer 138

Acid Test ratio

Acid Test Ratio = (Cash + Net Receivables + Marketable Securities) / Current Liabilities

Question 139

Green, Inc., a financial investment-consulting firm, was engaged by Maple Corp. to provide technical support for making investment decisions. Maple was in the process of buying Bay, Inc. a competitor. Green’s financial analyst made a detailed analysis of Bay’s average collection period to determine which of the following?

• Financing.
• Return on equity.
• Liquidity.
• Operating profitability.

Answer 139

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.

Question 140

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?

Answer 140

The acid-test ratio (quick) is the relationship between highly liquid assets and current liabilities. Highly liquid assets include cash, A/R, and marketable securities. In this case, the company has only cash and A/R. Therefore, the correct calculation is $100m (cash) + $600m (A/R) = $700m/$900 (current liabilities) = 0.777 (or 0.78).

Question 141

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?

Answer 141

10.0
Times-Interest-Earned Ratio = (NI + Interest Exp + Income Tax Exp) / Interest Exp
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.)

Question 142

Which of the following actions would increase your quick ratio?

• Purchasing inventory through the issuance of a long-term note.
• Implementing stronger procedures to collect accounts receivable at a faster rate.
• Paying an existing account payable.
• Selling obsolete inventory at a loss.

Answer 142

Selling obsolete inventory at a loss.
Selling obsolete inventory would increase cash, in the numerator, without changing current liabilities, the denominator, which would increase the quick ratio.
QUICK RATIO DOESN’T USE INVENTORY, WORKING CAPITAL DOES

Question 143

At the end of its fiscal year, Krist, Inc. had the following account balances:
Cash $ 5,000
Accounts receivable 10,000
Inventory	 20,000
Accounts payable	15,000
Short-term note payable 5,000
Long-term note payable 35,000
What is Krist's quick (acid-test) ratio?

Answer 143

.75
Acid-test Ratio = (Cash + (Net) Receivables + Marketable Securities) / Current Liab

For the facts given, the calculation is:
$5,000 + $10,000/$15,000 + $5,000, or
$15,000/$20,000 = .750 quick (acid-test) ratio

Question 144

Which of the following accounts be included in the computation of the quick ratio?
I. A/R
II. Marketable Securities
III. Inventory

Answer 144

I and II

Inventory is NOT in quick/acid-test ratio

Question 145

C’s quick ratio is better than the industry average. Which one of these factors should Bank consider as a possible limitation with this ratio when evaluating C’s creditworthiness?

• Fluctuating market prices of short-term investments may adversely affect the ratio.
• Increasing market prices for Belle’s inventory may adversely affect the ratio.
• Belle may need to sell its available-for-sale investments to meet its current obligations.
• Belle may need to liquidate its inventory to meet its long-term obligations.

Answer 145

Fluctuating market prices of short-term investments may adversely affect the ratio.
Because short-term investments are reported on the balance sheet at fair market value at the balance sheet date, fluctuations in the market price over time would change the quick ratio.

Question 146

Information that relates to a firm’s solvency is used primarily to assess a firm’s ability to

• Convert assets to cash.
• Pay it debts.
• Generate profits.
• Collect its receivables in a timely manner.

Answer 146

Pay its debts
Solvency = pay debts when due
Liquidity = convert assets to cash

Question 147

Each of the following is included when computing a firm’s target cash conversion cycle, except:

• Inventory conversion period.
• Payables deferral period.
• Average collection period.
• Cash discount period.

Answer 147

Cash Discount Period
The cash discount period is the period of time during which a debtor is offered a discount for early payments of an account and does not establish when cash is actually received

Question 148

Accounts receivable conversion cycle 18 days
Accounts payable conversion cycle 21 days
Inventory conversion cycle 24 days
What is the length of Cyco’s operating cycle?

Answer 148

42 days
Operating cycle is the avg length of time between the acquisition of inventory and the collection of cash from the sale of that inventory. It is measured by the inventory conversion cycle + A/R conversion cycle. Cyco’s inv conversion cycle is 24 days and its A/R conversion cycle is 18 days. Its operation cycle is 24 + 18 = 42 days.

Question 149

Which one of the following is not used in determining the operating cycle of an entity?

• Accounts payable conversion cycle.
• Inventory conversion cycle.
• Fixed asset conversion cycle.
• Cash conversion cycle.

Answer 149

Fixed asset conversion
The fixed asset cycle is not commonly used, but when used refers to the period that covers the acquisition, use and disposal of fixed assets. Fixed asset life is not an element included in measuring the operating cycle.

Question 150

Beginning inventory 17,000
Purchases 56,000
Ending inventory 13,000
What is Hadley Co.’s inventory turnover?

Answer 150

4
Computed as: BI $17,000 + P $56,000 = COGAS $73,000 - (EI) $13,000 = (COGS) $60,000. Average inventory (AI) is computed as (BI) $17,000 + (EI) $13,000/2, or (AI) $30,000/2 = $15,000. Thus, inventory turnover is (COGS) $60,000/(AI) $15,000 = 4.

Question 151

Which one of the following measures would be least appropriate in evaluating working capital management?

• Inventory turnover ratio.
• Quick ratio.
• Days’ sales in average receivables.
• Return on assets.

Answer 151

RoA
The management of working capital is concerned with the effective and efficient use of current assets and current liabilities, not with all assets. The return on assets measures the rate of return earned on total assets or total equity, therefore, is not for evaluating current assets.

Question 152

Accounts receivable conversion cycle 18 days
Accounts payable conversion cycle 21 days
Inventory conversion cycle 24 days
Which one of the following is the length of Cyco’s cash cycle?

Answer 152

21 days
The cash cycle can be determined as the operating cycle (i.e., inventory conversion cycle [24 days] + A/R conversion cycle [18 days]) less the accounts payable conversion cycle [21 days]. Thus, Cyco’s cash cycle would be computed as 24 + 18 = 42 - 21 = 21 days, the correct answer.

Question 153

Which one of the following measures the operating cycle of an entity?

• Accounts payable conversion cycle + accounts . receivable conversion cycle.
• Inventory conversion cycle + accounts payable conversion cycle.
• Inventory conversion cycle + cash conversion cycle.
• Inventory conversion cycle + accounts receivable conversion cycle.

Answer 153

Inventory conversion cycle + accounts receivable conversion cycle.
Operating cycle measures the average length of time between the acquisition of inventory and the collection of cash from the sale of that inventory. It is measured by the inventory conversion cycle + the accounts receivable conversion cycle.

Question 154

Net cash sales $ 3,000
Cost of goods sold	 18,000
Inventory at beginning of year 6,000
Purchases 24,000
What was Lore's average days' sales in inventory?

Answer 154

180 days
Average days’ sales in inv is: 360 days/Inv Turnover.
Inv Turnover = COGS/Avg Inv
Average inv is BegInv = $6,000 + EndInv = $12,000 = $18,000/2 = $9,000.
The EI is BI = $6,000 + Purchases = $24,000 = $30,000 - COGS = $18,000 = $12,000.
Therefore, inventory turnover is COGS = $18,000/Avg Inven = $9,000 = 2.
Then, 360/2=180.

Question 155

T Co. had total assets of $760,000, capital stock of $150,000, and retained earnings of $215,000. What was T’s debt-to-equity ratio?

Answer 155

1.08
Debt-to-equity ratio is: Tot Liabilities/Tot Equity. First compute both.
Total Equity = Capital Stock ($150,000) + Retained Earnings ($215,000) = $365,000
Total Liabilities = Assets ($760,000) - Total Equity ($365,000) = $395,000
Debt-to Equity Ratio = Total Liabilities ($395,000)/Total Equity ($365,000) = 1.0821.

Question 156

Debt-paying ability of a company might be assessed using the “debt ratio” or the “debt to equity ratio”. For each of these ratios, is the company’s debt-paying ability (debt position) better if the ratio is higher or lower?

Answer 156

Lower for both, Debt/Assets and Debt/Equity. You want a lower percentage for each to show they aren’t financed with debt and that they can pay of debts easily/quickly

Question 157

B Co. has total debt of $420,000 and stockholders’ equity of $700,000. B is planning to issue an additional $300,000 in common stock and is negotiating with a bank to borrow more funds. The bank is requiring a debt-to-equity ratio of .75. What is the max amount B will be able to borrow if the stock is issued?

Answer 157

330,000
Cross multiply - 420/1M = .75/1
750,000 = 420,000, subtract the 420 = $330K

Question 158

Will the capitalization of a lease by the lessee increase or decrease the 1. debt to equity and 2. asset turnover ratios?

Answer 158

Debt to equity - Increase, Asset turnover - decrease
Capitalization of a lease results in the lessee recording an asset and a liability. Increase in a liability, w/o change in equity, will increase the D-E ratio. Since capitalization of a lease increases assets, the asset turnover ratio will decrease (Net sales / assets)

Question 159

Minon, Inc. purchased a long-term asset on the last day of the current year. What are the effects of this purchase on 1) return on investment and 2) residual income?

Answer 159

Decrease both
RoI because a larger asset base would be divided into the NI 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 160

A Co. has two divisions. Div A has operating income of $500, total assets of $1,000. Div B has operating income of $400, total assets of $1,600. The req rate of return for the company is 10%. The company’s residual income would be?

Answer 160

$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 $260: [(1,000 + 1,600) * 10%], resulting in residual income of $640 (900 - 260).

Question 161

Based on potential sales of 500 units per year, a new product has estimated traceable costs of $990,000. What is the target price to obtain a 15% profit margin on sales?

Answer 161

$2329
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.

Question 162

Sales $ 100,000
Pretax Income 20,000
Average Total Assets 200,000
Average Total Debt 40,000
Income Tax Rate 40%
What is D's return on total equity?

Answer 162

7.5%
Return on total equity is computed as: ROE = Net income/Average owners’ equity. For D the calculation of NI would be pretax income minus tax expense, or $20,000 - ($20,000 x .40) = $20,000 - $8,000 = $12,000 net income. Average owners’ equity would be calculated as Assets - Debt = Owners’ equity, or $200,000 - $40,000 = $160,000. With those values, ROE can be computed as: ROE = $12,000/$160,000 = .075, or 7.5%