corporate finc(1).doc

Corporate Finance, Portfolio Mgt & Equity

InvestmentsLevel 1

Anup Joshi

[ Schweser CD Q & Ans .]

Which of the following steps is least likely to be an administrative step in the capital budgeting process?

A)

Conducting a post-audit to identify errors in the forecasting process.

B) Arranging financing for capital projects.

C) Forecasting cash flows and analyzing project profitability.

Arranging financing is not one of the administrative steps in the capital budgeting process. The four administrative steps in the capital budgeting process are:

1. Idea generation 2. Analyzing project proposals

3. Creating the firm-wide capital budget

4. Monitoring decisions and conducting a post-audit

5.

Which of the following types of capital budgeting projects are most likely to generate little to no revenue?

A) Regulatory projects.

B) Replacement projects to maintain the business.

C) New product or market development.

Mandatory regulatory or environmental projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. The projects typically generate little to no revenue, but they accompany other new revenue producing projects and are accepted by the company in order to continue operating.

Financing costs for a capital project are:

A)

captured in the project’s required rate of return.

B) subtracted from the net present value of a project.

C) subtracted from estimates of a project’s future cash flows.

Financing costs are reflected in a project’s required rate of return. Project specific financing costs should not be included as project cash flows. The firm's overall weighted average cost of capital, adjusted for project risk, should be used to discount expected project cash flows.

Ashlyn Lutz makes the following statements to her supervisor, Paul Ulring, regarding the basic principles of capital budgeting:

Statement 1: The timing of expected cash flows is crucial for determining the profitability of a capital budgeting project.

Statement 2: Capital budgeting decisions should be based on the after-tax net income produced by the capital project.

Which of the following regarding Lutz’s statements is most accurate?

Statement 1 Statement 2

A)

Correct

B) Incorrect Correct

C) Correct Incorrect

Lutz’s first statement is correct. The timing of cash flows is important for making correct capital budgeting decisions. Capital budgeting decisions account for the time value of money. Lutz’s second statement is incorrect. Capital budgeting decisions should be based on incremental after-tax cash flows, not net (accounting) income.

One of the basic principles of capital budgeting is that:

A)

cash flows should be analyzed on a pre-tax basis.

B) opportunity costs should be excluded from the analysis of a project.

C) decisions are based on cash flows, not accounting income.

The five key principles of the capital budgeting process are:

1. Decisions are based on cash flows, not accounting income. 2. Cash flows are based on opportunity costs.

3. The timing of cash flows is important.

4. Cash flows are analyzed on an after-tax basis.

5. Financing costs are reflected in the project’s required rate of return.

Mason Webb makes the following statements to his boss, Laine DeWalt about the principles of capital budgeting.

Statement 1: Opportunity costs are not true cash outflows and should not be considered in a capital budgeting analysis.

Statement 2: Cash flows should be analyzed on an after-tax basis.

Should DeWalt agree or disagree with Webb’s statements?


A)

Agree

B) Disagree Agree

C) Disagree Disagree

DeWalt should disagree with Webb’s first statement. Cash flows are based on opportunity costs. Any cash flows that the firm gives up because a project is undertaken should be charged to the project. DeWalt should agree with Webb’s second statement. The impact of taxes must be considered when analyzing capital budgeting projects.

The CFO of Axis Manufacturing is evaluating the introduction of a new product. The costs of a recently completed marketing study for the new product and the possible increase in the sales of a related product made by Axis are best described (respectively) as:

A)

opportunity cost; externality.

B) sunk cost; externality.

C) externality; cannibalization.

The study is a sunk cost, and the possible increase in sales of a related product is an example of a positive externality.

If two projects are mutually exclusive, a company:

A)

must accept both projects or reject both projects.

B) can accept one of the projects, both projects, or neither project.

C) can accept either project, but not both projects.

Mutually exclusive means that out of the set of possible projects, only one project can be selected. Given two mutually exclusive projects, the company can accept one of the projects or reject both projects, but cannot accept both projects.

Rosalie Woischke is an executive with ColaCo, a nationally known beverage company. Woischke is trying to determine the firm’s optimal capital budget. First, Woischke is analyzing projects Sparkle and Fizz. She has determined that both Sparkle and Fizz are profitable and is planning on having ColaCo accept both projects. Woischke is particularly excited about Sparkle because if Sparkle is profitable over the next year, ColaCo will have the opportunity to decide whether or not to invest in a third project, Bubble. Which of the following terms best describes the type of projects represented by Sparkle and Fizz as well as the opportunity to invest in Bubble?

Sparkle and Fizz Opportunity to invest in Bubble

A)

Independent projects

B) Independent projects Project sequencing

C) Mutually exclusive projects Project sequencing

Independent projects are projects for which the cash flows are independent from one another and can be evaluated based on each project’s individual profitability. Since Woischke is accepting both projects, the projects must be independent. If the projects were mutually exclusive, only one of the two projects could be accepted. The opportunity to invest in Bubble is a result of project sequencing, which means that investing in a project today creates the opportunity to decide to invest in a related project in the future.

Rosalie Woischke is an executive with ColaCo, a nationally known beverage company. Woischke is trying to determine the firm’s optimal capital budget. First, Woischke is analyzing projects Sparkle and Fizz. She has determined that both Sparkle and Fizz are profitable and is planning on having ColaCo accept both projects. Woischke is particularly excited about Sparkle because if Sparkle is profitable over the next year, ColaCo will have the opportunity to decide whether or not to invest in a third project, Bubble. Which of the following terms best describes the type of projects represented by Sparkle and Fizz as well as the opportunity to invest in Bubble?

Sparkle and Fizz Opportunity to invest in Bubble

A)

Independent projects

B) Independent projects Project sequencing

C) Mutually exclusive projects Project sequencing

Independent projects are projects for which the cash flows are independent from one another and can be evaluated based on each project’s individual profitability. Since Woischke is accepting both projects, the projects must be independent. If the projects were mutually exclusive, only one of the two projects could be accepted. The opportunity to invest in Bubble is a result of project sequencing, which means that investing in a project today creates the opportunity to decide to invest in a related project in the future.

Project sequencing is best described as:

A)

arranging projects in an order such that cash flows from the first project fund subsequent projects.

B) prioritizing funds to achieve the maximum value for shareholders, given capital limitations.

C) an investment in a project today that creates the opportunity to invest in other projects in the future.

Projects are often sequenced through time so that investing in a project today may create the opportunity to invest in other projects in the future. Note that funding from the first project is not a requirement for project sequencing.

The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in years 1 through 4, $35,000 per year in years 5 through 9, and $40,000 in year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10%. The payback period for this investment is closest to:

A)

5.23 years.

B) 4.86 years.

C) 6.12 years.

Click for Answer and Explanation

Years 0 1 2 3 4 5

Cash Flows -$150,000 $30,000 $30,000 $30,000 $30,000 $35,000

$150,000 120,000 (4 years)(30,000/year) $30,000

With $30,000 unrecovered cost in year 5, and $35,000 cash flow in year 5; $30,000 / $35,000 = 0.86 years

4 + 0.86 = 4.86 years

The process of evaluating and selecting profitable long-term investments consistent with the firm’s goal of shareholder wealth maximization is known as:

A)

financial restructuring.

B) monitoring.

C) capital budgeting.

In the process of capital budgeting, a manager is making decisions about a firm’s earning assets, which provide the basis for the firm’s profit and value. Capital budgeting refers to investments expected to produce benefits for a period of time greater than one year. Financial restructuring is done as a result of bankruptcy and monitoring is a critical assessment aspect of capital budgeting

Lincoln Coal is planning a new coal mine, which will cost $430,000 to build, with the expenditure occurring next year. The mine will bring cash inflows of $200,000 annually over the subsequent seven years. It will then cost $170,000 to close down the mine over the following year. Assume all

http://127.0.0.1:20501/online_program/test_engine/browse_question.php?question_id=98178&node_id=122410&operation=next&node_sort_order=#question_110045

cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. What minimum price should Lincoln set on the property, given a 16% required rate of return?

A)

$280,913.

B) $325,859.

C) $376,872.

The key to this problem is identifying this as a NPV problem even though the first cash flow will not occur until the following year. Next, the year of each cash flow must be property identified; specifically: CF0 = $0; CF1 = -430,000; CF2-8 = +$200,000; CF9 = -$170,000. One simply has to discount all of the cash flows to today at a 16% rate. NPV = $280,913

Which of the following statements about the discounted payback period is least accurate? The discounted payback:

A)

frequently ignores terminal values.

B) method can give conflicting results with the NPV.

C) period is generally shorter than the regular payback.

The discounted payback period calculates the present value of the future cash flows. Because these present values will be less than the actual cash flows it will take a longer time period to recover the original investment amount.

An analyst has gathered the following data about a company with a 12% cost of capital:

Project A Project BCost $15,000 $25,000Life 5 years 5 yearsCash inflows $5,000/year $7,500/year

Projects A and B are mutually exclusive. What should the company do?

A)

Reject A, Accept B.

B) Reject A, Reject B.

C) Accept A, Reject B.


For mutually exclusive projects accept the project with the highest NPV. In this example the NPV for Project A (3,024) is higher than the NPV of Project B (2,036). Therefore accept Project A and reject Project B.


If the projects are independent, what should the company do? A)

Reject A, Reject B.

B) Accept A, Reject B.

C) Accept A, Accept B.

Project A: N = 5; PMT = 5,000; FV = 0; I/Y = 12; CPT → PV = 18,024; NPV for Project A = 18,024 − 15,000 = 3,024.

Project B: N = 5; PMT = 7,500; FV = 0; I/Y = 12; CPT → PV = 27,036; NPV for Project B = 27,036 − 25,000 = 2,036.

For independent projects the NPV decision rule is to accept all projects with a positive NPV. Therefore, accept both projects.

Landen, Inc. uses several methods to evaluate capital projects. An appropriate decision rule for Landen would be to invest in a project if it has a positive:

A)

profitability index (PI).

B) net present value (NPV).

C) internal rate of return (IRR).


The decision rules for net present value, profitability index, and internal rate of return are to invest in a project if NPV > 0, IRR > required rate of return, or PI > 1.

Which of the following statements about the payback period is NOT correct?

A)

The payback period provides a rough measure of a project's liquidity and risk.

B) The payback method considers all cash flows throughout the entire life of a project.

C) The payback period is the number of years it takes to recover the original cost of the investment.

The payback period does not take any cash flows after the payback point into consideration


A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10 percent and the following cash flow schedule:

Year 1: $3,000 Year 2: $2,000

Year 3: $2,000

Determine the project's NPV and IRR.

NPV IRR

A)

$243

B) $883 15%

C) $883 20%


To determine the NPV, enter the following: PV of $3,000 in year 1 = $2,727, PV of $2,000 in year 2 = $1,653, PV of $2,000 in year 3 = $1,503. NPV = ($2,727 + $1,653 + $1,503) − $5,000 = 883.

You know the NPV is positive, so the IRR must be greater than 10%. You only have two choices, 15% and 20%. Pick one and solve the NPV. If it is not close to zero, then you guessed wrong; select the other one.

[3000 ÷ (1 + 0.2)1 + 2000 ÷ (1 + 0.2)2 + 2000 ÷ (1 + 0.2)3] − 5000 = 46 This result is closer to zero (approximation) than the $436 result at 15%. Therefore, the approximate IRR is 20%.

A firm is considering a $200,000 project that will last 3 years and has the following financial data:

Annual after-tax cash flows are expected to be $90,000. Target debt/equity ratio is 0.4.

Cost of equity is 14%.

Cost of debt is 7%.

Tax rate is 34%.

Determine the project's payback period and net present value (NPV).

Payback Period NPV

A)

2.43 years

B) 2.22 years $21,872

C) 2.22 years $18,716


Payback Period

$200,000 / $90,000 = 2.22 years

NPV Method

First, calculate the weights for debt and equity

wd + we = 1we = 1 − wd

wd / we = 0.40wd = 0.40 × (1 − wd)wd = 0.40 − 0.40wd

1.40wd = 0.40wd = 0.286, we = 0.714

Second, calculate WACC

WACC = (wd × kd) × (1 − t) + (we × ke) = (0.286 × 0.07 × 0.66) + (0.714 × 0.14) = 0.0132 + 0.100 = 0.1132



Third, calculate the PV of the project cash flows

90 / (1 + 0.1132)1 + 90 / (1 + 0.1132)2 + 90 / (1 + 0.1132)3 = $218,716

And finally, calculate the project NPV by subtracting out the initial cash flow

NPV = $218,716 − $200,000 = $18,716

A company is considering a $10,000 project that will last 5 years.

Annual after tax cash flows are expected to be $3,000 Target debt/equity ratio is 0.4

Cost of equity is 12%

Cost of debt is 6%

Tax rate 34%

What is the project's net present value (NPV)?

A)

-$1,460.

B) $+1,245

C) +$1,460.


First, calculate the weights for debt and equity

wd + we = 1

we = 1 − wd

wd / we = 0.40

wd = 0.40 × (1 − wd)

wd = 0.40 − 0.40wd

1.40wd = 0.40

wd = 0.286, we = 0.714

Second, calculate WACC

WACC = (wd × kd) × (1 − t) + (we × ke) = (0.286 × 0.06 × 0.66) + (0.714 × 0.12) = 0.0113 + 0.0857 = 0.0970

Third, calculate the PV of the project cash flows

N = 5, PMT = -3,000, FV = 0, I/Y = 9.7, CPT → PV = 11,460

And finally, calculate the project NPV by subtracting out the initial cash flow

NPV = $11,460 − $10,000 = $1,460


Which of the following statements about NPV and IRR is least accurate?

A)

For independent projects if the IRR is > the cost of capital accept the project.

B) For mutually exclusive projects you should use the IRR to rank and select projects.

C) The NPV method assumes that all cash flows are reinvested at the cost of capital.


For mutually exclusive projects you should use NPV to rank and select projects

As the director of capital budgeting for Denver Corporation, an analyst is evaluating two mutually exclusive projects with the following net cash flows:

Year Project X Project Z

0 -$100,000 -$100,000

1 $50,000 $10,000

2 $40,000 $30,000

3 $30,000 $40,000

4 $10,000 $60,000

If Denver's cost of capital is 15%, which project should be chosen?

A)

Neither project.

B) Project X, since it has the higher IRR.

C) Project X, since it has the higher net present value (NPV).


NPV for Project X = -100,000 + 50,000 / (1.15)1 + 40,000 / (1.15)2 + 30,000 / (1.15)3 + 10,000 / (1.15)4

= -100,000 + 43,478 + 30,246 + 19,725 + 5,718 = -833

NPV for Project Z = -100,000 + 10,000 / (1.15)1 + 30,000 / (1.15)2 + 40,000 / (1.15)3 + 60,000 / (1.15)4



= -100,000 + 8,696 + 22,684 + 26,301 + 34,305 = -8,014

Reject both projects because neither has a positive NPV.

Osborn Manufacturing uses the NPV and IRR methods as its primary tools for evaluating capital projects. Which of the following most likely describes Osborn Manufacturing with regard to firm ownership and company size?

Firm ownership Company size

A)

Public

B) Public Small

C) Private Large

Despite the theoretical superiority of the NPV and IRR methods for determining and ranking project profitability, surveys of corporate managers show that a variety of methods are used. Firms that use the NPV and IRR methods tend to be larger, publicly-traded, companies.

The 6% semiannual coupon, 7-year notes of Woodbine Transportation, Inc. trade for a price of $94.54. What is the company’s after-tax cost of debt capital if its marginal tax rate is 30%?

A) 2.1%.

B) 4.9%.

C) 4.2%.

Your answer: A was incorrect. The correct answer was B) 4.9%.

To determine Woodbine’s before-tax cost of debt, find the yield to maturity on its outstanding notes:

PV = -94.54; FV = 100; PMT = 6 / 2 = 3; N = 14; CPT → I/Y = 3.50 × 2 = 7%

Woodbine’s after-tax cost of debt is kd(1 - t) = 7%(1 - 0.3) = 4.9%

The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be subordinate to the firm’s existing debt. The company’s marginal tax rate is 40%. The most appropriate estimate of the after-tax cost of this new debt is:

A) 5.0%.

B) More than 5.0%.

C) Between 3.3% and 5.0%.

Your answer: A was incorrect. The correct answer was B) More than 5.0%.

The after-tax cost of debt similar to Savanna’s existing debt is kd(1 - t) = 8.33%(1 - 0.4) = 5.0%. Because the anticipated new debt will be subordinated in the company’s debt structure, investors will demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the new debt is more than 5.0%.

Which of the following is least likely to be useful to an analyst when estimating the cost of raising capital through the issuance of non-callable, nonconvertible preferred stock?

A) The stated par value of the preferred issue.

B) The preferred stock’s dividend rate.

C) The firm’s corporate tax rate.

The corporate tax rate is not a relevant factor when calculating the cost of preferred stock.

The cost of preferred stock, kps is expressed as:kps = Dps / P

where:Dps = divided per share = dividend rate × stated par valueP = market price

The after-tax cost of preferred stock is always:

A) equal to the before-tax cost of preferred stock.

B) less than the before-tax cost of preferred stock.

C) higher than the cost of common shares.


The after-tax cost of preferred stock is equal to the before-tax cost of preferred stock, because preferred stock dividends are not tax deductible. The cost of preferred shares is usually higher than the cost of debt, but less than the cost of common shares.

Justin Lopez, CFA, is the Chief Financial Officer of Waterbury Corporation. Lopez has just been informed that the U.S. Internal Revenue Code may be revised such that the maximum marginal corporate tax rate will be increased. Since Waterbury’s taxable income is routinely in the highest marginal tax bracket, Lopez is concerned about the potential impact of the proposed change. Assuming that Waterbury maintains its target capital structure, which of the following is least likely to be affected by the proposed tax change?

A) Waterbury’s return on equity (ROE).

B) Waterbury’s after-tax cost of noncallable, nonconvertible preferred stock.

C) Waterbury’s after-tax cost of corporate debt.


Corporate taxes do not affect the cost of preferred stock to the issuing firm. Waterbury’s after-tax cost of debt, and consequently, its weighted average cost of capital will decrease because the tax savings on interest will increase. Also, since taxes impact net income, Waterbury’s ROE will be affected by the change.

Which of the following statements is most accurate regarding a firm’s cost of preferred shares? A firm’s cost of preferred stock is:

A) the market price of the preferred shares as a percentage of its issuance price.

B) the dividend yield on the firm’s newly-issued preferred stock.

C) approximately equal to the market price of the firm’s debt as a percentage of the market price of its common shares.



The newly-issued preferred shares of most companies generally sell at par. As such, the dividend yield on a firm’s newly-issued preferred shares is the market’s required rate of return. The yield on a BBB corporate bond reflects a pre-tax cost of debt. Both remaining choices make no sense

Axle Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock last year. Its common stock is trading at £40 per share. Axle is expected to have a return on equity of 15%, an effective tax rate of 34%, and to maintain its historic payout ratio going forward. In estimating Axle’s after-tax cost of capital, an analyst’s estimate of Axle’s cost of common equity would be closest to:

A) 8.8%.

B) 9.2%.

C) 9.0%.

The expected dividend one year from today is $2.50 for a share of stock priced at $22.50. The long-term growth in

dividends is projected at 8%. The cost of common equity is closest to:

A)

19.1%.

B) 15.6%.

C) 18.0%.

Kce = ( D1 / P0) + g

Kce = [ 2.50 / 22.50 ] + 0.08 = 0.19111, or 19.1%

The after-tax cost of preferred stock is always:

A)

less than the before-tax cost of preferred stock.

B) higher than the cost of common shares.

C) equal to the before-tax cost of preferred stock.

The after-tax cost of preferred stock is equal to the before-tax cost of preferred stock, because preferred stock dividends are not tax deductible. The cost of preferred shares is usually higher than the cost of debt, but less than the cost of common shares

Which of the following is least likely to be useful to an analyst when estimating the cost of raising capital through the issuance of non-callable, nonconvertible preferred stock?

A)

The firm’s corporat

We can estimate the company’s expected growth rate as ROE × (1 − payout ratio): g = 15% × (1 − 2.40/3.00) = 3%

The expected dividend next period is then £2.40(1.03) = £2.47. Based on dividend discount model pricing, the required return on equity is 2.47 / 40 + 3% = 9.18%.

e tax rate.

B) The stated par value of the preferred issue.

C) The preferred stock’s dividend rate.

The corporate tax rate is not a relevant factor when calculating the cost of preferred stock.

The cost of preferred stock, kps is expressed as:kps = Dps / P

where:Dps = divided per share = dividend rate × stated par valueP = market price

Justin Lopez, CFA, is the Chief Financial Officer of Waterbury Corporation. Lopez has just been informed that the U.S. Internal Revenue Code may be revised such that the maximum marginal corporate tax rate will be increased. Since Waterbury’s taxable income is routinely in the highest marginal tax bracket, Lopez is concerned about the potential impact of the proposed change. Assuming that Waterbury maintains its target capital structure, which of the following is

least likely to be affected by the proposed tax change?

A)

Waterbury’s after-tax cost of noncallable, nonconvertible preferred stock.

B) Waterbury’s return on equity (ROE).

C) Waterbury’s after-tax cost of corporate debt.

Corporate taxes do not affect the cost of preferred stock to the issuing firm. Waterbury’s after-tax cost of debt, and consequently, its weighted average cost of capital will decrease because the tax savings on interest will increase. Also, since taxes impact net income, Waterbury’s ROE will be affected by the change.

Which of the following statements is most accurate regarding a firm’s cost of preferred shares? A firm’s cost of preferred stock is:

A)

the dividend yield on the firm’s newly-issued preferre

d stock.

B) the market price of the preferred shares as a percentage of its issuance price.

C) approximately equal to the market price of the firm’s debt as a percentage of the market price of its common shares.

The newly-issued preferred shares of most companies generally sell at par. As such, the dividend yield on a firm’s newly-issued preferred shares is the market’s required rate of return. The yield on a BBB corporate bond reflects a pre-tax cost of debt. Both remaining choices make no sense.

Degen Company is considering a project in the commercial printing business. Its debt currently has a yield of 12%. Degen has a leverage ratio of 2.3 and a marginal tax rate of 30%. Hodgkins Inc., a publicly traded firm that operates only in the commercial printing business, has a marginal tax rate of 25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. The risk-free rate is 3% and the expected return on the market portfolio is 9%. The

appropriate WACC to use in evaluating Degen’s project is closest to:

A)

8.9%.

B) 9.2%.

C) 8.6%.


Hodgkins’ asset beta:

We are given Degen’s leverage ratio (assets-to-equity) as equal to 2.3. If we assign the value of 1 to equity (A/E = 2.3/1), then debt (and the debt-to-equity ratio) must be 2.3 − 1 = 1.3.

Equity beta for the project:

βPROJECT = 0.52[1 + (1 − 0.3)(1.3)] = 0.9932

Project cost of equity = 3% + 0.9932(9% − 3%) = 8.96%

Degen’s capital structure weight for debt is 1.3/2.3 = 56.5%, and its weight for equity is 1/2.3 = 43.5%.

The appropriate WACC for the project is therefore:0.565(12%)(1 − 0.3) + 0.435(8.96%) = 8.64%.

Utilitarian Co. is looking to expand its appliances division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal tax

rate of 30%, and its debt is currently yielding 7%. JF Black, Inc. is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of 3, a marginal tax rate of 40%, and its debt is currently yielding 6.8%. The risk-free rate is currently 5% and the expected return on the market portfolio is 9%. Using this data, calculate Utilitarian’s weighted average cost of capital for this potential expansion.

A)

5.7%.

B) 4.2%.

C) 7.1%.

http://127.0.0.1:20501/online_program/test_engine/browse_question.php?new_node_id=122424&question_id=0&node_sort_order=1&operation=next#question_113824

Affluence Inc. is considering whether to expand its recreational sports division by embarking on a new project. Affluence’s capital structure consists of 75% debt and 25% equity and its marginal tax rate is 30%. Aspire Brands is a publicly traded firm that specializes in recreational sports products. Aspire has a debt-to-equity ratio of 1.7, a beta of 0.8, and a marginal tax rate of 35%. Using the pure-play method with Aspire as the comparable firm, the project beta

Affluence should use to calculate the cost of equity capital for this project is closest to:

A)

0.38.

B) 0.58.

C) 1.18.

The unlevered asset beta is:

Affluence’s debt-to-equity ratio = 0.75/0.25 = 3. To calculate the project beta, re-lever the asset beta using Affluence’s debt-to-equity ratio and marginal tax rate:

Tony Costa, operations manager of BioChem Inc., is exploring a proposed product line expansion. Costa explains that he estimates the beta for the project by seeking out a publicly traded firm that is engaged exclusively in the same business as the proposed BioChem product line expansion. The beta of the proposed project is estimated from the beta of that firm after appropriate adjustments for capital structure differences. The method that Costa uses is known as the:

A)

build-up method.

B) accounting method.

C) pure-play method.

The method used by Costa is known as the pure-play method. The method entails selection of the pure-play equity beta, unlevering it using the pure-play company’s capital structure, and re-levering using the subject company’s capital structure.

Jamal Winfield is an analyst with Stolzenbach Technologies, a major computer services company based in the U.S. Stolzenbach’s management team is considering opening new stores in Mexico, and wants to estimate the cost of equity capital for Stolzenbach’s investment in Mexico. Winfield has researched bond yields in Mexico and found that the yield on a Mexican government 10-year bond is 7.7%. A similar maturity U.S. Treasury bond has a yield of 4.6%. In the most recent year, the standard deviation of Mexico's All Share Index stock index and the S&P 500 index was 38% and 20% respectively. The annualized standard deviation of the Mexican dollar-denominated 10-year government bond over the last year was 26%. Winfield has also determined that the appropriate beta to use for the project is 1.25, and the market risk premium is 6%. The risk free interest rate is 4.2%. What is the appropriate country risk premium for Mexico and what is the cost of equity that Winfield should use in his analysis?

Country Risk Premium for Mexico Cost of Equity for Project

A)

5.89%

B) 4.53% 17.36%

C) 4.53% 19.06%


CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard deviation of sovereign bond market in terms of the developed market currency)

= (0.077 – 0.046)(0.38 ÷ 0.26) = 0.0453, or 4.53%

Cost of equity = RF + β[E(RMKT) – RF + CRP] = 0.042 + 1.25[0.06 + 0.0453] = 0.1736 = 17.36%

Note that you are given the market risk premium, which equals E(RMKT) – RF.

Jeffery Marian, an analyst with Arlington Machinery, is estimating a country risk premium to include in his estimate of the cost of equity for a project Arlington is starting in India. Marian has compiled the following information for his analysis:

Indian 10-year government bond yield = 7.20% 10-year U.S. Treasury bond yield = 4.60%

Annualized standard deviation of the Bombay Sensex stock index = 40%.

Annualized standard deviation of Indian dollar denominated 10-year government bond = 24%

Annualized standard deviation of the S&P 500 Index = 18%.

The estimated country risk premium for India based on Marian’s research is closest to:

A)

2.6%.

B) 5.8%.

C) 4.3%.

CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard deviation of sovereign bond market in terms of the developed market currency)

= (0.072 – 0.046)(0.40/0.24) = 0.043, or 4.3%.

In order to more accurately estimate the cost of equity for a company situated in a developing market, an analyst should:

A)

use the yield on the sovereign debt of the developing country instead of the

http://127.0.0.1:20501/online_program/test_engine/browse_question.php?question_id=131568&node_id=122424&operation=next&node_sort_order=1#question_110083

risk free rate when using the capital asset pricing model (CAPM).

B) add a country risk premium to the risk-free rate when using the capital asset pricing model (CAPM).

C) add a country risk premium to the market risk premium when using the capital asset pricing model (CAPM).

In order to reflect the increased risk when investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.

Stolzenbach Technologies has a target capital structure of 60% equity and 40% debt. The schedule of financing costs for the Stolzenbach is shown in the table below:

Amount of New Debt (in millions) After-tax Cost of Debt Amount of New Equity (in millions) Cost of Equity $0 to $199 4.5% $0 to $299 7.5%

$200 to $399 5.0% $300 to $699 8.5%$400 to $599 5.5% $700 to $999 9.5%

Stolzenbach Technologies has breakpoints for raising additional financing at both:

A)

$500 million and $700 million.

B) $500 million and $1,000 million.

C) $400 million and $700 million.


Stolzenbach will have a break point each time a component cost of capital changes, for a total of three marginal cost of capital schedule breakpoints.

Break pointDebt > $200mm = ($200 million ÷ 0.4) = $500 million

Break pointDebt > $400mm = ($400 million ÷ 0.4) = $1,000 million

Break pointEquity > $300mm = ($300 million ÷ 0.6) = $500 million

Break pointEquity > $700mm = ($700 million ÷ 0.6) = $1,167 million

Bailey Manufacturing Co. (Bailey) designs and manufactures a hoses and fittings for a wide range of industrial applications. After closing the books on 2004, Bailey’s executive management team had a meeting to discuss their goals and priorities for 2005. This meeting, held every January, is an opportunity for each of Bailey’s division managers to present proposals for the projects that they are considering for investment during the upcoming year. Bradley Conover is the chief financial officer for Bailey Manufacturing Co. He has received proposals for five different projects that are deemed to have the highest priority from Bailey’s division managers.

Before evaluating the projects, Conover must make some pro forma forecasts for 2005. According to Bailey’s 2005 pro forma income statement, Conover expects Bailey to earn a net profit of $7,000. He also expects the firm to maintain its


current dividend payout ratio of 50%. The firm has a target capital structure of 70% equity and 30% debt. Conover estimates the applicable corporate tax rate to be 35%.

Conover’s next step is to evaluate capital market conditions. Because Bailey is in an economically sensitive industry, the firm has a greater than average level of systematic risk. Conover estimates that the beta applicable for a standard project for the firm is 1.5. Over the last three years, the U.S. economy has been in a sustained expansion, and Bailey has enjoyed strong profit growth. This strong growth has allowed Bailey to fund most of its capital budget internally. However, many economists believe that growth will slow in 2005 despite the government’s accommodative fiscal policy. As a result, Conover believes that management’s aggressive goals and objectives imply that Bailey will need to seek external capital.

Conover calls a meeting with Derek Munn, CFA, an investment banker with Lyndon Capital Corp. Using Conover’s forecasts, Munn believes that Bailey will be able to issue new debt at a cost of 9% and new equity at a cost of 18%. Munn also gives Conover a research report that says the 2005 expected return for the market is 11%, and three-month Treasury bills will yield 5%.

The expected cash flows from the top five projects identified by Bailey’s division managers are shown in Figure 1 below. Projects A, C and E are independent projects and projects B and D are mutually exclusive.

Figure 1

Year Project A Project B Project C Project D Project E

0 (1,000) (2,500) (1,750) (4,000) (2,000)

1 100 500 200 1,400 300

2 250 900 300 1,400 400

3 450 1,200 600 1,400 700

4 650 1,200 700 1,400 700

5 0 700 800 1,400 700

Conover starts his analysis by estimating the firm’s current weighted average cost of capital (WACC). What is the firm’s current WACC?

A)

18.00%.

B) 15.30%.

C) 11.56%.


Cost of Equity = 0.05 + 1.5(0.11 − 0.05) = 0.14

WACC = wdkd(1 − t) + weke = 0.30(0.09)(1 − 0.35) + 0.70(0.14) = 0.1156

Assuming all of the projects have equal risk, Conover creates an investment opportunity set (IOS) by ranking the

projects starting with the most favorable to the least favorable project as follows:

A)

DBACE.

B) ABCDE.

C) DBCAE.




Start by calculating the NPV of each project as follows:

NPV(A) = (1,000) + 100 / (1.1156)1 + 250 / (1.1156)2 + 450 / (1.1156)3 + 650 / (1.1156)4 + 0 = 34.26

NPV(B) = (2,500) + 500 / (1.1156)1 + 900 / (1.1156)2 + 1200 / (1.1156)3 + 1200 / (1.1156)4 + 700 / (1.1156)5 = 715.44

NPV(C) = (1,750) + 200 / (1.1156)1 + 300 / (1.1156)2 + 600 / (1.1156)3 + 700 / (1.1156)4 + 800 / (1.1156)5 = 17.34

NPV(D) = (4,000) + 1,400 / (1.1156)1 + 1,400 / (1.1156)2 + 1,400 / (1.1156)3 + 1,400 / (1.1156)4 + 1,400 / (1.1156)5 = 1,102.18

NPV(E) = (2,000) + 300 / (1.1156)1 + 400 / (1.1156)2 + 700 / (1.1156)3 + 700 / (1.1156)4 + 700 / (1.1156)5 = (48.51)

Ranking the projects starting with the highest NPV to lowest NPV: DBACE.

Conover calculates new WACC beyond the retained earnings break-even point as:

A)

15.30%.

B) 14.36%.

C) 18.00%.

Cost to issue new equity is given as 18%.

WACC = wdkd(1 − t) + weke = 0.30(0.09)(1 − 0.35) + 0.70(0.18) = 0.1436.

Based on the investment opportunity schedule (IOS) and marginal cost of capital (MCC) schedule, which projects should be accepted?

A)

A, B, and D.

B) A, B, C, and D.

C) A and D.


Pro forma earnings are $7,000 and the dividend payout ratio is 50%, meaning that Bailey’s retained earnings for 2005 are estimated to be $7,000 (1 – 0.5) = $3,500.

The retained earnings break-even point is calculated as follows: $3,500 / 0.70 = $5,000.

Projects B and D are mutually exclusive therefore only the project with the highest NPV is chosen, NPV(D) = 1,102.18. Project A has the next highest NPV(A) = 34.26. The total investment required for projects D and A is $5,000. Therefore, new equity must be issued before considering other projects. The new WACC is 14.36% including the increased cost of 18% for equity. The remaining projects have IRR below the new WACC and their NPVs are negative using the higher WACC. Projects D and A are the only projects that should be accepted.

Conover uses a technique involving random variables in a simulation to estimate the NPV of the projects. This technique is known as:

A)

Monte Carlo.

B) bootstrapping.

C) scenario analysis.


Monte Carlo simulation requires the analyst to estimate the probability distributions of input variables (e.g., sales, variable cost per unit, etc.), and then generate random values representing possible outcomes for each of these input variables. After the process is repeated many times, these variables are used in a simulation model to generate an expected NPV for a project.

Scenario analysis is a technique that requires the analyst to estimate project NPVs over a range of possible scenarios (such as recession, average, boom). The range of NPVs provides evidence concerning the project’s risk. Bootstrapping describes the effect that can occur when a high-growth, high-P/E firm (high P/E) merges with a low-growth, low-P/E firm.

Project C is similar in risk to a company in their same industry that has an average leveraged beta of 1.2. If Conover uses a pure play method to evaluate project C, what is the appropriate cost of equity capital for the project?

A)

11.2%.

B) 12.2%.

C) 10.3%.

Project C is similar in risk to an industry that has an average beta of 1.2. Therefore, we use the capital asset pricing model and the industry average beta to calculate the cost of equity capital for Project C:

Cost of Equity Capital for Project C = 0.05 + 1.2(0.11 − 0.05) = 0.122.

SS 11 R 37 LOS k

Which one of the following statements about the marginal cost of capital (MCC) is most accurate?

A)

A breakpoint on the MCC curve occurs when one of the components in the weighted average cost of capital changes in cost.

B) The MCC is the cost of the last dollar obtained from bondholders.

http://127.0.0.1:20501/online_program/los.php?new_node_id=122426&operation=next&node_sort_order=1&browse_question_id=96782

C) The MCC falls as more and more capital is raised in a given period.

A breakpoint is calculated by dividing the amount of capital at which a component's cost of capital changes by the weight of that component in the capital structure.

The marginal cost of capital (MCC) is defined as the weighted average cost of the last dollar raised by the company. Typically, the marginal cost of capital will increase as more capital is raised by the firm. The marginal cost of capital is the weighted average rate across all sources of long-term financings—bonds, preferred stock, and common stock—when the final dollar was obtained, regardless of its specific source.

A North American investment society held a panel discussion on the topics of capital costs and capital

budgeting. Which of the following comments made during this discussion is the least accurate?

A)

An increase in the after-tax cost of debt may occur at a break point.

B) Any given project’s NPV will decline when a breakpoint is reached.

C) A project’s internal rate of return decreases when a breakpoint is reached.

The internal rate of return is independent of the firm’s cost of capital. It is a function of the amount and timing of a project’s cash flows.

The before-tax cost of debt for Hardcastle Industries, Inc. is currently 8.0%, but it will increase to 8.25% when debt levels reach $600 million. The debt-to-total assets ratio for Hardcastle is 40% and its capital structure is composed of debt and common equity only. If Hardcastle changes its target capital structure to 50% debt / 50% equity, which of the following describes the effect on the level of new investment at which the cost of debt will increase? The level will:

A)

change, but can either increase or decrease.

B) decrease.

C) increase.

A break point refers to a level of new investment at which a component’s cost of capital changes. The formula for break point is:

As indicated, as the weight of a capital component in the capital structure increases, the break point at which a change in the component’s cost will decline. No computation is necessary, but when Hardcastle has 40% debt, the breakpoint is $600,000,000 / 0.4 = $1.5 billion. If Hardcastle’s debt increases to 50%, the breakpoint will decline to $600,000,000 / 0.5 = $1.2 billion.

Measures of Leverage

All else equal, a firm's business risk is higher when:

A)

the firm has low operating leverage.

B) fixed costs are the highest portion of its expense.

C) variable costs are the highest portion of its expense.

The higher the percentage of a firm's costs that are fixed, the higher the operating leverage, and the greater the firm's business risk and the more susceptible it is to business cycle fluctuations.

Which of the following statements about business risk and financial risk is least accurate?

A)

Business risk is the riskiness of the company's assets if it uses no debt.

B) Factors that affect business risk are demand, sales price, and input price variability.

C) The greater a company's business risk, the higher its optimal debt ratio.

The greater a company’s business risk, the lower its optimal debt ratio

Which of the following factors is least likely to affect business risk?

A)

Interest rate variability.

B) Demand variability.

C) Operating leverage.

Business risk can be defined as the uncertainty inherent in a firm’s return on assets (ROA). While changes in interest rates may impact the demand or input prices, there is a more direct impact on business risk with the other three choices.

Variability in a firm’s operating income is most closely related to its:

A)

business risk.

B) internal risk.

C) financial risk.

Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money.

Hughes Continental is assessing its business risk. Which of the following factors would least likely be considered in the analysis?

A)

Input price variability.

B) Debt-equity ratio.

C) Unit sales levels.

The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Debt levels affect financial risk, not business (operating) risk.

Financial risk is borne by:

A)

creditors.

B) common shareholders.

C) managers.

Common shareholders are the residual owners of the company. As such, they experience the benefits of above-normal gains in good times and the pain of losses when the business is in a slow period. Financial leverage magnifies the variability of earnings per share due to the existence of the required interest payments.

The two major types of risk affecting a firm are:

A)

financial risk and cash

flow risk.

B) business risk and collection risk.

C) business risk and financial risk.

Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money

The uncertainty in return on assets due to the nature of a firm’s operations is known as:

A)

financial leverage.

B) tax efficiency.

C) business risk.

Business risk is a function of the firm's revenue and expenses, resulting in operating income, or earnings before interest and taxes (EBIT). The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Tax efficiency is tied to mutual fund investing, while financial leverage requires the existence of debt.

During a period of expansion in the economy, compared to firms with lower operating expense levels, earnings growth for firms with high operating leverage will be:

A)

lower.

B) unaffected.

C) higher.


If a high percentage of a firm's total costs are fixed, the firm is said to have high operating leverage. High operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Therefore, during an expansionary phase in the economy a highly leveraged firm will have higher earnings growth than a lesser leveraged firm. The opposite will happen during an economic contraction.

As financial leverage increases, what will be the impact on the expected rate of return and financial risk?

A)

Both will fall.

B) One will rise while the other falls.

C) Both will rise.


A higher breakeven point resulting from increased interest costs associated with debt financing increases the risk of the company. Since the risk is tied to firm financing, it is referred to as financial risk. Given the positive risk-return relationship, the expected return of the company’s common stock also rises

As financial leverage increases, what will be the impact on the expected rate of return and financial risk?

A)

Both will fall.

B) One will rise while the other falls.

C) Both will rise.

A higher breakeven point resulting from increased interest costs associated with debt financing increases the risk of the company. Since the risk is tied to firm financing, it is referred to as financial risk. Given the positive risk-return relationship, the expected return of the company’s common stock also rises

The management of Strings & All, Inc., a small, highly leveraged, electric guitar manufacturer, wants to reduce the company’s degree of total leverage (DTL) to 2.0. Currently, the company’s expected operating performance is as follows:

Sales of $500,000. Variable Costs at 60% of sales.

Fixed Costs of $120,000.

Fixed-Interest Debt with annual interest payments of $25,000.

All else constant, to obtain a DTL of 2.0, management must:

A)

increase variable expenses by 30%.

B) reduce variable expenses by 38.5%.

C) reduce variable expenses by 30%.

To obtain this result, we need to calculate the current variable costs, determine the variable costs that will result in a DTL ratio of 2.00, and calculate the percentage change.

Step 1: Calculate current variable costs (VC): VC = 0.6 × 500,000 = 300,000

Step 2: Calculate Variable costs needed to decrease the DTL to 2.0:

Rearranging the formula for DTL:

(Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs − Interest Expense)

results in:

Variable Costs (VC) = Sales − (2 × Fixed Costs) − (2 × Interest Expense)

= 500,000 − (2 × 120,000) − (2 × 25,000) = 210,000

Step 3: Calculate percentage change:

VC = (300,000 − 210,000) / 300,000 = 0.30, or 30%.

The management of Strings & All, Inc., a small, highly leveraged, electric guitar manufacturer, wants to reduce the company’s degree of total leverage (DTL) to 2.0. Currently, the company’s expected operating performance is as follows:

Sales of $500,000. Variable Costs at 60% of sales.

Fixed Costs of $120,000.

Fixed-Interest Debt with annual interest payments of $25,000.

All else constant, to obtain a DTL of 2.0, management must:

A)

increase variable expenses by 30%.

B) reduce variable expenses by 38.5%.

C) reduce variable expenses by 30%.

To obtain this result, we need to calculate the current variable costs, determine the variable costs that will result in a DTL ratio of 2.00, and calculate the percentage change.

Step 1: Calculate current variable costs (VC): VC = 0.6 × 500,000 = 300,000

Step 2: Calculate Variable costs needed to decrease the DTL to 2.0:

Rearranging the formula for DTL:

(Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs − Interest Expense)

results in:

Variable Costs (VC) = Sales − (2 × Fixed Costs) − (2 × Interest Expense)

= 500,000 − (2 × 120,000) − (2 × 25,000) = 210,000

Step 3: Calculate percentage change:

VC = (300,000 − 210,000) / 300,000 = 0.30, or 30%.

Which of the following statements about leverage is most accurate?

A)

If the comp

any has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.

B) An increase in fixed costs (holding sales and variable costs constant) will reduce the company's degree of operating leverage.

C) A decrease in interest expense will increase the company's degree of total leverage.

If debt = 0 then DFL = 1 because DFL = EBIT/(EBIT - I)

If debt = 0 then I = 0 and DFL = EBIT/(EBIT - 0) = EBIT/EBIT = 1

DTL = (DOL)(DFL)

If DFL = 1 then DTL = (DOL)(1) which complies to DTL = DOL

A decrease in interest expense will decrease DFL, which will decrease DTL. An increase in fixed costs will increase the company’s DOL.

***The following information reflects the projected operating results for Opstalan, a catalog printer.

Sales of $5.0 million. Variable Costs at 40% of sales.

Fixed Costs of $1.0 million.

Debt interest payments on $1.5 million issued with an annual 7.0% coupon (current yield is 8.0%).

Tax Rate of 0.0%.

Opstalan’s degree of total leverage (DTL) is closest to:

A)

2.58

.

B) 1.59.

C) 1.41.

First, calculate the operating results:

Opstalan Annual Operating Results Sales $5,000,000 Variable Costs1 2,000,000

3,000,000 Fixed Costs 1,000,000 EBIT 2,000,000 Interest Expense2 105,000

1,895,000 1Variable costs = 0.40 × 5,000,0002Interest Expense = 0.07 × 1,500,000

Second, calculate DOL = (Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs) = 3,000,000 / 2,000,000 = 1.50

Third, calculate DFL = EBIT / (EBIT − I) = 2,000,000 / 1,895,000 = 1.06.

Finally, calculate DTL = DOL × DFL = 1.50 × 1.06 = 1.59.

Stromburg Corporation's sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?

A)

3.75.

B) 4.20.

C) 3.50.

Sales = $100,000,000

VC of 25% of sales = 25,000,000

FC of 40,000,000 + 15,000,000 = 55,000,000

DOL= [100,000,000 – 25,000,000] / [100,000,000 – 25,000,000 – 55,000,000] = 3.75

Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames, what is the degree of operating leverage (DOL) and the degree of financial leverage (DFL)?

Sales of $3.5 million Variable Costs at 45% of sales

Fixed Costs of $1.05 million

Debt interest payments on $750,000 issued with an annual 9.0% coupon (current yield is 7.0%)

Which of the following choices is closest to the correct answer? ArtFrame’s DOL and DFL are:

DOL DFL

A)

2.20

B) 3.00 1.50

C) 2.20 1.50

The calculations are as follows:

First, calculate the operating results:

ArtFrames Annual Operating Results

Sales $3,500,000

Variable Costs1 1,575,000

1,925,000

Fixed Costs 1,050,000

Earnings before interest and taxes (EBIT)

875,000

Interest Expense2 67,500

807,5001Variable costs = 0.45 × 3,500,000 2Interest Expense = 0.09 × 750,000

Second, calculate DOL:

DOL = (Sales – Variable Costs) / (Sales – Variable Costs – Fixed Costs) = (3,500,000 – 1,575,000) / (3,500,000 – 1,575,000 – 1,050,000) = 2.20

Third, calculate DFL:

DFL = EBIT / (EBIT – I) = 875,000 / 807,500 = 1.08

Additional debt should be used in the firm’s capital structure if it increases:

A)

firm earnings.

B) the value of the firm.

C) earnings per share.

The key to finding the optimal capital structure is identifying the level of debt that will maximize firm value. Earnings and earnings per share are not critical in and of themselves when assessing firm value, because they do not consider risk.

Financial leverage magnifies:

A)

taxes.

B) operating income variability.

C) earnings per share variability.

Financial leverage results in the existence of required interest payments and, hence, increased earnings per share variability. Higher debt ratios, given a fixed asset base, result in a greater earnings per share variability. Operating income is based on the products and assets of the firm and not on the firm’s financing and, hence, has no impact on financial leverage. Greater financial leverage is likely to reduce taxes due to the tax deductibility of interest payments.

Which of the following is a key determinant of operating leverage?

A)

The competitive nature of the business.

B) Level and cost of debt.

C) The tradeoff between fixed and variable costs.

Operating leverage can be defined as the trade off between variable and fixed costs

Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate?

A)

If a firm has a positive operating profit margin, using financial leverage will always increase ROE.

B) Using financial leverage increases the volatility of ROE for a level of volatility in operating income.

C) Increasing financial leverage increases both risk and potential return of existing bondholders.

If a firm is financed with 100% equity, there is a direct relationship between changes in the firm’s ROE and changes in operating income. Adding financial leverage (debt) to the firm’s capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE reflects an increase in both risk and potential return for equity holders. Note that financial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged. Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm’s net profit margin negative, which would in turn make ROE negative

Munn Industrial Components currently finances its operations with 100% equity, but is considering changing its target capital structure to 70% equity and 30% debt. Munn has a large asset base, a 20% operating profit margin, and the average interest rate on debt is expected to be 6.0%. If Munn makes the change to its capital structure and EBIT is unchanged, what is most likely the impact on Munn’s net income and return on equity (ROE) respectively?

Impact on Net Income Impact on Return on Equity

A)

No Change

B) Decrease Decrease

C) Decrease Increase


You should be able to figure out this question with logic (without having to use calculations). The interest expense associated with using debt represents a fixed cost that reduces net income. However, the lower net income value is spread over a smaller base of equity capital, serving to increase the ROE.

Which of the following firms is likely to have a higher debt ratio?

A)

Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic


conditions.

B) Critter Care, which has a low debt rating due to the prior financial mismanagement by the chief executive officer.

C) Egg Harbor Furs, which serves as a wholesaler of fine furs and garments.


Bath & Books appears to have relatively little business risk, especially in relation to Egg Harbor Furs, which is likely to be a much more cyclical business. Creditors will be less willing to lend funds to Critter Care whose managers have shown poor money management skills in the past

Wanton’s San Y’isidro Co. manufactures custom door knobs for international clients. Average Revenue is $35 per unit, variable costs are $15 per unit, and total costs are $200,000. If sales are 10,000 units, what is the firm's breakeven sales quantity?

A)

1,750 units.

B) 3,000 units.

C) 2,500 units.

For this problem you need 2 equations.

Break-even quantity = Fixed Costs / (Price - Variable cost)

Q = FC / (P - V)

Fixed Costs = Total Costs - Variable Costs

FC = TC - VC = 200,000 - 150,000 = 50,000

Q = 50,000 / (35 - 15) = 2,500

Jayco, Inc. has a division that makes red ink for the accounting industry. The unit has fixed costs of $10,000 per month, and is expected to sell 40,000 bottles of ink per month. If the variable cost per bottle is $2.00 what price must the division charge in order to breakeven?

A)

$2.25.

B) $2.50.

C) $2.75.


40,000 = $10,000/(P - $2)40,000P – $80,000 = $10,000P = $90,000/40,000 = $2.25.



Annah Korotkin is the sole proprietor of CoverMeUp, a business that designs and sews outdoor clothing for dogs. Each year, she rents a booth at the regional Pet Expo and sells only blankets. Korotkin views the Expo as primarily a marketing tool and is happy to breakeven (that is, cover her booth rental). For the last 3 years, she has sold exactly enough blankets to cover the $750 booth rental fee. This year, she decided to make all blankets for the Expo out of high-tech waterproof/breathable material that is more expensive to produce, but that she believes she can sell for a higher profit margin. Information on the two types of blankets is as follows:

Per Unit Last Year’s (Basic) Blanket This Year’s (New) Blanket

Sales Price $25 $40

Variable Cost $20 $33

Assuming that Korotkin remains most interested in covering the booth cost (which has increased to $840), how many more or fewer blankets (new style) does she need to sell to cover the booth cost? To cover this year’s booth costs, Korotkin needs to sell:

A)

42 fewer blankets than last year.

B) 30 fewer blankets than last year.

C) 42 more blankets than last year.

To obtain this result, we need to calculate Last Year’s Breakeven Quantity, This Year’s Breakeven Quantity, and calculate the difference.

Step 1: Determine Last Year’s (Basic Blanket) breakeven quantity:

QBE = (Fixed Costs) / (Sales Price per unit − Variable Cost per unit) = 750 / (25 − 20) = 150

Step 2: Determine This Year’s (New Blanket) breakeven quantity:

QBE = (Fixed Costs) / (Sales Price per unit – Variable Cost per unit) = 840 / (40 − 33) = 120

Step 3: Determine Change in Units:

Q = QThis Year – QLast Year = 120 − 150 = −30. Korotkin needs to sell 30 fewer blankets.

Annual fixed costs at King Mattress amount to $325,000. The variable cost of raw materials and labor is $120 for the typical mattress. Sales prices for mattresses average $160. How many units must King Mattress sell to break even?

A)

40.

B) 2,708.

C) 8,125.

QBreakeven = Fixed Cost / (Price – Variable Cost) QBreakeven = $325,000 / (160 – 120) = 8,125

Jayco, Inc., sells blue ink for $4.00 a bottle. The ink's variable cost per bottle is $2.00. Ink has fixed cost of $10,000. What is Jayco's breakeven point in units?

A)

2,500.

B) 6,000.

C) 5,000.


QBE = [FC] / (P - V) QBE = [10,000] / (4.00 - 2.00) = 5,000

Dividends and Share Repurchases: Basics

Paying a cash dividend is most likely to result in:

A)

an increase in liquidity ratios.

B) the same impact on liquidity and leverage ratios as a stock dividend.

C) an increase in financial leverage ratios.

A cash dividend will increase leverage ratios such as debt-to-equity and debt-to-assets, reflecting a decrease in the denominator. A cash dividend should decrease liquidity ratios such as the current ratio and cash ratio, due to the decrease in cash in the numerator. Unlike a cash dividend, a stock dividend or a stock split has no impact on liquidity or financial leverage ratios.

Financial managers utilize stock splits and stock dividends because they perceive that:

A)

investors will double the share price if there is a 20% stock dividend.

B) brokerage fees paid by shareholders will be reduced.

C) an optimal trading range exists.


Although there is little empirical evidence to support the contention, there is nevertheless a widespread belief in financial circles that an optimal price range exists for stocks. “Optimal” means that if the price is within this range, the price/earnings ratio, price/sales and other relevant ratios will be maximized. Hence, the value of the firm will be maximized

What is the earliest day on which an investor can currently purchase Amex, Inc., if the investor wants to avoid receiving a dividend and thereby avoid paying tax on the distribution, if the date of record is Thursday, October 31?

A)

Tuesday, October 29.

B) Monday, October 28.

C) Thursday, October 24.

The ex-dividend date is now two business days prior to the date of record. Counting back two business days identifies Tuesday, October 29 as the date when the shares can be purchased without the dividend.

The cut-off date for receiving the dividend is known as the:

A)

ex-dividend date.

B) holder of record date.

C) date of payment.

The cut-off date for receiving the dividend is known as the ex-dividend date. The holder of record date is the date on which the shareholders of record are designated. The date the checks are mailed out is known as the date of payment.

Shareholders selling shares between the ex-dividend date and date of record:

A)

forfeit the dividend, with the proceeds staying with

the company.

B) receive the dividend.

C) forfeit the dividend, with the proceeds going to the buyer.

The date of record is the date on which the shareholders of record are designated to receive the dividend. The ex-dividend date is the cut-off date for receiving the dividend. Shares sold after the ex-dividend date are sold without claim to the dividend, even if they are sold prior to the date of record. The dividend would be paid to the holder as of the close of trading on the day prior to the ex-dividend date.

Which of the following shows the key dividend dates in their proper sequence?

A)

Declaration date, holder-of-record date, ex-dividend date, payment date.

B) Ex-dividend date, holder-of-record date, declaration date, payment date.

C) Declaration date, ex-dividend date, holder-of-record date, payment date.

The board of directors announce the amount of the dividend, the holder-of-record date, and payment date. The ex-dividend date is two business days prior to the holder-of-record date, giving the firm time to identify the rightful owner of the dividends.

Which justification for repurchasing stock is the least valid?

A)

Repurchases offer shareholders more choices than

cash dividends.

B) Shareholders prefer capital gains to cash dividends.

C) A cash dividend increase, in response to short-term excess cash flows, may confuse investors.

Some shareholders prefer capital gains, while others prefer dividends. Repurchases offer shareholders the choice of tendering or not tendering their stock, while cash dividends represent a payment they cannot refuse. Raising dividends is often seen as a positive signal, but an increase funded by short-term cash flows may not be sustainable, forcing the company to reduce the dividend later.

Which of the following statements about a stock repurchase is least accurate?

A)

A stock repurchase occurs when a large block of stock is removed from the marketplace.

B) Disgruntled stockholders are forced to sell their shares, improving management's position.

C) Management can distribute cash to shareholders without signaling about future earnings.


A repurchase gives stockholders a choice. They can sell or not sell

Jim Davis and Thurgood Owen, two equity analysts at Ferguson Capital Management, were reviewing the financial statements of Peregrine Foodstuffs Ltd. Davis and Owen noticed that Peregrine has been repurchasing its common shares in the market over the past three years. Owen thought this was an important issue to look into in greater detail. Upon completion of his review, Owen made the following two statements:

Statement 1: Peregrine has bought back shares in the open market during its repurchase program. This method of repurchase gave the company the flexibility to choose the timing of the transaction.


Statement 2: Peregrine plans to buy back shares by making tender offers during the coming year. By making tender offers, the company will be able to repurchase shares at a discount to the prevailing market price.

With respect to Owen's statements:

A)

only one is correct.

B) both are correct.

C) both are incorrect.


Buying in the open market gives the company the flexibility to choose the timing of the transaction. Thus, Statement 1 is correct. A second way is to buy a fixed number of shares at a fixed price. A company may repurchase stock by making a tender offer to repurchase a specific number of shares at a price that is at a premium to the current market price. They would not be willing to tender their shares for less than the prevailing market price, so Statement 2 is incorrect.

Which of the following is least likely a method by which firms repurchase their shares?

A)

Exercise a call provision.

B) Tender offer.

C) Direct negotiation.


Call provisions are not relevant to common stock and are not considered a repurchase in any case. There are three repurchase methods. The first is to buy in the open market. A company may repurchase stock by making a tender offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price. The third way is to repurchase by direct negotiation. Companies may negotiate directly with a large shareholder to buy back a block of shares, usually at a premium to the market price.

Laura’s Chocolates, Inc. (LC), is a maker of nut-based toffees. LC is considering a share repurchase and prefers the “tender offer” method. Which of the following is also known as a “tender offer”?

A)

Buying in the open market.

B) Buying a fixed number of shares at a fixed price.



C) Repurchasing by direct negotiation.


A tender offer refers to buying a fixed number of shares at a fixed price (usually at a premium to the current market price).

Which of the following statements about a stock repurchase is least accurate?

A)

A stock repurchase occurs when a large block of stock is removed from the marketplace.

B) Disgruntled stockholders are forced to sell their shares, improving management's position.

C) Management can distribute cash to shareholders without signaling about future earnings.


A repurchase gives stockholders a choice. They can sell or not sell.

Francis Investment Inc’s Board of Directors is considering repurchasing $30,000,000 worth of common stock. Francis assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Francis decides to borrow $30 million that it will use to repurchase shares. Francis’ Chief Financial Officer (CFO) has compiled the following information regarding the repurchase of the firm’s common stock:

Share price at the time of buyback = $50 Shares outstanding before buyback = 30,600,000

EPS before buyback = $3.33

Earnings yield = $3.33 / $50 = 6.7%

After-tax cost of borrowing = 4%

Planned buyback = 600,000 shares

Based on the information above, after the repurchase of its common stock, Francis’ EPS will be closest to:



A)

$3.41.

B) $3.39.

C) $3.36.


Total earnings = $3.33 × 30,600,000 = $101,898,000

Since the after-tax cost of borrowing of 4% is less than the 6.7% earnings yield (E/P) of the shares, the share repurchase will increase Francis’s EPS.

Sinclair Construction Company’s Board of Directors is considering repurchasing $30,000,000 worth of common stock. Sinclair assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Sinclair decides to borrow $30 million that it will use to repurchase shares. Sinclair’s Chief Executive Officer (CEO) has compiled the following information regarding the repurchase of the firm’s common stock:

Share price at the time of buyback = $50 Shares outstanding before buyback = 30,600,000

EPS before buyback = $3.33

Earnings yield = $3.33 / $50 = 6.7%

After-tax cost of borrowing = 8.0%

Planned buyback = 600,000 shares

Based on the information above, Sinclair’s earnings per share (EPS) after the repurchase of its common stock will be closest to:

A)

$3.32.

B) $3.18.

C) $3.23.

Total earnings = $3.33 × 30,600,000 = $101,898,000


Since the 8.0% after-tax cost of borrowing is greater than the 6.7% earnings yield (E/P) of the shares, the share repurchase reduces Sinclair’s EPS.

The share price of Solar Automotive Industries is $50 per share. It has a book value of $500 million and 50 million shares outstanding. What is the book value per share (BVPS) after a share repurchase of $10 million?

A)

$9.84.

B) $10.12

C) $10.00.


The share buyback is $10 million / $50 per share = 200,000 shares.Remaining shares: 50 million − 200,000 = 49.8 million shares.

Solar Automotive Industries’ current BVPS = $500 million / 50 million = $10.Book value after repurchase: $500 million − $10 million = $490 million.BVPS = $490 million / 49.8 million = $9.84.BVPS decreased by $0.16.

Book value per share (BVPS) decreased because the share price is greater than the original BVPS. If the share prices were less than the original BVPS, then the BVPS after the repurchase would have increased.

The share prices of Solar Automotive Industries and Winnipeg Auto Unlimited are both $50 per share, and each company has 50 million shares outstanding. On September 30, both companies announced a $10 million stock buyback. Solar has a book value of $500 million, while Winnipeg has a book value of $900 million. How much did the book value per share (BVPS) of each company increase or decrease after the share repurchase?

Solar Automotive Industries Winnipeg Auto Unlimited

A)

Decrease by $0.13

B) Decrease by $0.16 Decrease by $0.13

C) Increase by $0.13 Increase by $0.16

http://127.0.0.1:20501/online_program/test_engine/browse_question.php?question_id=87102&node_id=122437&operation=previous&node_sort_order=1#question_97462

The share buyback for each company is $10 million / $50 per share = 200,000 shares.Remaining shares for each company = 50 million − 200,000 = 49.8 million shares.

For Solar Automotive Industries:Solar Automotive Industries’ current BVPS = $500 million / 50 million = $10.The market price per share of $50 is greater than the BVPS of $10.Book value after repurchase = $500 million – $10 million = $490 millionBVPS = $490 million / 49.8 million = $9.84BVPS decreased by $0.16

For Winnipeg Auto Unlimited:Winnipeg Auto Unlimited’s current BVPS = $900 million / 50 million = $18.The market price per share of $50 is greater than the BVPS of $18.Book value after repurchase = $900 million – $10 million = $890 millionBVPS = $890 million / 49.8 million = $17.87BVPS decreased by $0.13.

In the case of both Solar Automotive Industries and Winnipeg Auto Unlimited, book value per share (BVPS) decreased because the share price is greater than the original BVPS. If the share prices were less than the original BVPS, then the BVPS after the repurchase for each firm would have increased.

The share price of Winnipeg Auto Unlimited is $5 per share. There are 50 million shares outstanding, and Winnipeg has a book value of $900 million. What is the book value per share (BVPS) after the share repurchase of $10 million?

A)

$21.24.

B) $14.76.

C) $18.54.


The share buyback is $10 million / $5 per share = 2,000,000 shares.Remaining shares: 50 million − 2 million = 48 million shares.

Winnipeg Auto Unlimited’s current BVPS = $900 million / 50 million = $18.Book value after repurchase: $900 million − $10 million = $890 million.BVPS = $890 million / 48.0 million = $18.54.BVPS increased by $0.54.

Book value per share (BVPS) increased because the share price is less than the original BVPS. If the share prices were more than the original BVPS, then the BVPS after the repurchase would have decreased

LOS f: Explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders' wealth, all else being equal.

What is the impact on shareholder wealth of a share repurchase versus cash dividend of equal amount when the tax treatment of the two alternatives is the same?

A)

A share repurcha


se will sometimes lead to higher total shareholder wealth than a cash dividend of an equal amount.

B) A share repurchase is equivalent to a cash dividend of an equal amount, so total shareholder wealth will be the same.

C) A share repurchase will always lead to higher total shareholder wealth than a cash dividend of an equal amount.

Assuming that the tax treatment of a share repurchase and a cash dividend of equal amount is the same, a share repurchase is equivalent to a cash dividend payment, and shareholder wealth will be the same.

Pearl City Breweries has 8 million shares outstanding that are currently trading at $34 per share. The company is choosing whether to distribute $22 million as dividends or to use the same amount to repurchase its shares. Ignoring tax effects, what will be the amount of total wealth from owning one share of Pearl City Breweries under each of these alternatives?

Cash dividendShare repurchase

A)

$31.25

B) $31.25 $34.00

C) $34.00 $34.00

If the company pays a cash dividend, the dividend per share will be $22 million/8 million = $2.75. The value of its shares will be:

So the total wealth from owning one share will be $31.25 + $2.75 = $34.00.

If the company repurchases shares, it can buy $22 million/$34 = 647,058 shares. The value of one share would then be:

If you remember that both a cash dividend and a share repurchase for cash leave shareholder wealth unchanged, this question does not require calculations of the amounts.

Paying a cash dividend is most likely to result in:

A)

an increase in liquidity ratios.

B) the same impact on liquidity and leverage ratios as a stock dividend.

C) an increase in financial leverage ratios.


A cash dividend will increase leverage ratios such as debt-to-equity and debt-to-assets, reflecting a decrease in the denominator. A cash dividend should decrease liquidity ratios such as the current ratio and cash ratio, due to the decrease in cash in the numerator. Unlike a cash dividend, a stock dividend or a stock split has no impact on liquidity or financial leverage ratios.

An example of a secondary source of liquidity is:

A)

cash flow management.

B) trade credit and bank lines of credit.

C) negotiating debt contracts.

Secondary sources of liquidity include negotiating debt contracts, liquidating assets, and filing for bankruptcy protection and reorganization. Primary sources of liquidity include ready cash balances, short-term funds (e.g., trade credit and bank lines of credit), and cash flow management.

The condition that occurs when a company disburses cash too quickly, stretching the company’s cash reserves, is best described as a:

A)

drag on liquidity.

B) pull on liquidity.

C) liquidity premium.

When cash payments are made too quickly, the condition is known as a pull on liquidity. A drag on liquidity occurs when cash inflows lag.

An analyst computes the following ratios for Iridescent Carpeting Inc. and compares the results to the industry averages:

Financial Ratio Iridescent Carpeting Industry Average

Current Ratio 2.3x 1.8x

Net Profit Margin 22% 24%

Return on Equity 17% 20%

Total Debt / Total Capital 35% 56%

Times Interest Earned 4.7x 4.1x


Based on the above data, which of the following can the analyst conclude? Iridescent Carpeting:

A)

has stronger profitability than its competitors.

B) is most likely a younger company than its competitors.

C) has better short-term liquidity than its competitors.

Based on the data provided, the analyst can conclude that Iridescent Carpeting has weaker profitability than its competitors based on the net profit margin and return on equity. The analyst can also conclude that the company has less financial leverage (risk) than the industry average based on the total debt / total capital and the times interest earned ratios. The analyst can conclude that the company has better short-term liquidity than the industry average (i.e., its competitors) based on the current ratio.

Which of the following is NOT a limitation to financial ratio analysis?

A)

The need to use judgment.

B) Differences in international accounting practices.

C) A firm that operates in only one industry.

If a firm operates in multiple industries, this would limit the value of financial ratio analysis by making it difficult to find comparable industry ratios.

Working Capital Management

Alton Industries will have better liquidity than its peer group of companies if its:

A)

average trade payables are lower.

B) quick ratio is lower.

C) receivables turnover is higher.

Higher receivables turnover is an indicator of better receivables liquidity since receivables are converted to cash more rapidly. A lower quick ratio is an indication of less liquidity. Lower trade payables could be related to better liquidity, but could also be consistent with very poor liquidity and a requirement from its suppliers of cash payment.

A firm has average days of receivables outstanding of 22 compared to an industry average of 29 days. An analyst would most

likely conclude that the firm:

A)

may have credit policies that are too strict.

B) has better credit controls than its peer companies.

C) has a lower cash conversion cycle than its peer companies.

The firm’s average days of receivables should be close to the industry average. A significantly lower average days receivables outstanding, compared to its peers, is an indication that the firm’s credit policy may be too strict and that sales are being lost to peers because of this. We can not assume that stricter credit controls than the average for the industry are “better.” We cannot conclude that credit sales are less, they may be more, but just made on stricter terms. The average days of receivables are only one component of the cash conversion cycle.

The quick ratio is considered a more conservative measure of liquidity than the current ratio because the quick ratio excludes:

A)

inventories, which are not necessarily liquid.

B) Short-term marketable securities, which may need to be sold at a significant loss.

C) Accounts receivable, which may not be collectible in the short term.

The quick ratio is usually defined as (current assets – inventory) / current liabilities. It is a more restrictive measure of liquidity than the current ratio, which equals current assets / current liabilities. The numerator of the quick ratio includes cash, receivables, and short-term marketable securities.

Which of the following is NOT a limitation to financial ratio analysis?

A)

A firm that operates in only one industry.

B) The need to use judgment.

C) Differences in international accounting practices.

If a firm operates in multiple industries, this would limit the value of financial ratio analysis by making it difficult to find comparable industry ratios.

Which of the following is least likely an indicator of a firm’s liquidity?

No inferences about liquidity are warranted based on this measure. A firm may have higher credit sales than another simply because it has more sales overall. Cash as a proportion of sales and inventory turnover are indicators of liquidity

A)

Inventory turnover.

B) Amount of credit sales.

C) Cash as a percentage of sales.

.

LOS b: Compare a company's liquidity measures with those of peer companies.

Question ID#: 96602

An analyst computes the following ratios for Iridescent Carpeting Inc. and compares the results to the industry averages:

Financial Ratio Iridescent Carpeting Industry Average

Current Ratio 2.3x 1.8x

Net Profit Margin 22% 24%

Return on Equity 17% 20%

Total Debt / Total Capital 35% 56%

Times Interest Earned 4.7x 4.1x

Based on the above data, which of the following can the analyst conclude? Iridescent Carpeting:

A)

has stronger profitability than its competitors.

B) has better short-term liquidity than its competitors.

C) is most likely a younger company than its competitors.


Based on the data provided, the analyst can conclude that Iridescent Carpeting has weaker profitability than its competitors based on the net profit margin and return on equity. The analyst can also conclude that the company has less financial leverage (risk) than the industry average based on

the total debt / total capital and the times interest earned ratios. The analyst can conclude that the company has better short-term liquidity than the industry average (i.e., its competitors) based on the current ratio.

LOS c: Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles, and compare the company's effectiveness with that of peer companies

Compared to the prior period, a firm has greater days of receivables. The effect on the firm’s cash conversion cycle and operating cycle are most likely a(n):


Cash conversion cycle Operating cycle

A)

Increase

B) Decrease Increase

C) Increase Increase


Greater days of receivables will increase both the cash conversion cycle and operating cycle, other things equal.

Which of the following most accurately represents the cash conversion cycle?

A)

average days of receivables + average days of inventory – average days of payables.

B) average days of receivables + average days of inventory + average days of payables.

C) average days of payables + average days of inventory – average days of receivables.

The cash conversion cycle, also called the net operating cycle is:

The cash conversion cycle measures the length of time required to convert a firm’s cash investment in inventory back into cash resulting from the sale of the inventory. A short cash conversion cycle is good because it indicates a relatively low investment in working capital.

An analyst who is evaluating a firm’s working capital management would be least likely to be concerned if the firm’s:

A)

number of days of inventory is higher than

Operating cycle = days of inventory + days of receivables.

Cash conversion cycle = days of inventory + days of receivables − days of payables


that of its peers.

B) total asset turnover is lower than its industry average.

C) operating cycle is shorter than that of its peers.

A shorter operating cycle will lead to a shorter cash conversion cycle, other things equal, which is an indication of better working capital management. Higher days inventory on hand, compared to peer company averages, will lengthen the cash conversion cycle, an indication of poorer working capital management. Good working capital management would tend to increase a firm’s total asset turnover since a given amount of sales can be supported with less working capital (less current assets).

LOS d: Explain the effect of different types of cash flows on a company's net daily cash position

An appropriate cash management strategy for a company that has a seasonally high need for cash prior to the holiday shopping season would least likely include:

A)

allowing short-term securities to mature without reinvestment.

B) investing in U.S. Treasury notes at other times of the year because they are highly liquid.

C) borrowing funds though a bank line of credit.

Treasury notes have maturities between 2 and 10 years and, thus, have maturities longer than those of securities suitable for cash management. Allowing short-term securities to mature without reinvesting the cash generated would be one way to meet seasonal cash needs. Short-term bank borrowing or issuing commercial paper that can be paid off when holiday sales generate cash would be appropriate strategies for dealing with a predictable short-term need for cash

Which yield measure is the most appropriate for comparing a company’s investments in short-term securities?

A)

Money market yield.

B) Discount basis yield.

C) Bond equivalent yield.

When evaluating the performance of its short-term securities investments, a company should compare them on a bond equivalent yield basis

A 30-day bank certificate of deposit has a holding period yield of 1%. What is the annual yield of this CD on a bond-equivalent basis?

A)

12.17%.

B) 11.83%.

C) 12.00%.

The bond-equivalent yield is calculated as the holding period yield times (365 / number of days in the holding period). BEY = 1% × (365/30) = 12.17%.

LOS f: Evaluate a company's management of accounts receivable, inventory, and accounts payable over time and compared to peer companies.

Which of the following strategies is most likely to be considered good payables management?

A)

Taking trade discounts only if the firm’s annual return on short-term investments is less than the discount percentage.

B) Paying trade invoices on the day they arrive.

C) Paying invoices on the last possible day to still get the supplier’s discount for early payment.

Paying invoices on the last day to get a discount (for early payment) is often the most advantageous strategy for a firm. If the annualized percentage cost of not taking advantage of the discount is less than the firm’s short-term cost of funds, it would be advantageous to pay on the due date. However, the discount percentage is not an annualized rate, so it cannot be compared directly to the firm's annual return on short-term investments. Paying prior to the discount cut-off date or prior to the due date sacrifices interest income for no advantage.

With respect to inventory management,:

A)

an

increase in days of inventory on hand can be the result of either good or poor inventory management.

B) a firm with inventory turnover higher than the industry average can be expected to have better profitability as a result.

C) a decrease in a firm’s days of inventory on hand indicates better inventory management and can lead to increased profits.

An increase in inventory could indicate poor sales and an accumulation of obsolete items or could be the result of a conscious effort to have adequate supplies to avoid losses from not having items to satisfy customer orders (stock outs). Higher-than-average inventory turnover could indicate better inventory management or could indicate that a less than optimal inventory is being maintained by the company

Pfluger Company’s accounts payable department receives an invoice from a vendor with terms of 2/10 net 30. If Pfluger pays the invoice on its due date, the cost of trade credit is closest to:

A)

27.9%.

B) 43.5%.

C) 44.6%.

"2/10 net 30" is a discount of 2% of the invoice amount for payment within 10 days, with full payment due in 30 days. Cost of trade credit on day 30 =

A large, creditworthy manufacturing firm would most likely get short-term financing by:

A)

factorin

g its receivables.

B) entering into an agreement for a committed line of credit.

C) issuing commercial paper.

Large, creditworthy firms can get the lowest cost of financing by issuing commercial paper. Selling receivables to a factor is a higher cost source of funds used by firms with poor credit quality. A committed line of credit requires payment of a fee and represents bank borrowing, which would be attractive to a firm that did not have the size or creditworthiness to issue commercial paper.

Which of the following sources of credit would an analyst most likely associate with a borrower of the lowest credit quality?

A)

Committed line of credit.

B) Revolving line of credit.

C) Uncommitted line of credit.

Committed lines and revolving lines of credit all contain a commitment by a lender to lend up to a maximum amount, at the borrower’s option for some period of time. A firm with lower credit quality may have an uncommitted line of credit which offers no guarantee from the lender to provide any specific amount of funds in the future.

Which of the following sources of short-term liquidity is considered reliable enough that it can be listed in the footnotes to a firm’s financial statements as a source of liquidity?

A)

Factoring agreement.

B) Uncommitted line of credit.

C) Revolving line of credit.

With an uncommitted line of credit, the lender is not committed to make loans in any amount. A revolving line of credit is typically for a longer period and involves an agreement to lend funds in the future up to some maximum amount. Factoring does not typically involve an agreement for future receivables purchases.

Which of the following sources of liquidity is the most reliable?

A)

Revolving line of credit.

B) Committed line of credit.

C) Uncommitted line of credit.

A revolving line of credit is typically for a longer term than an uncommitted or committed line of credit and thus is considered a more reliable source of liquidity. With an uncommitted line of credit, the issuing bank may refuse to lend if conditions of the firm change. An overdraft line of credit is similar to a committed line of credit agreement between banks and firms outside of the U.S. Both committed and revolving lines of credit can be verified and can be listed in the footnotes to a firm’s financial statements as sources of liquidity.

Financial Statement Analysis

Jane Epworth, CFA, is preparing pro forma financial statements for Gavin Industries, a mature U.S. manufacturing firm with three distinct geographic divisions in the Midwest, South and West. Epworth prepares estimates of sales for each of Gavin’s divisions using economists’ estimates of next-period GDP growth and sums the three estimates to forecast Gavin’s sales. Epworth’s approach to estimating Gavin’s sales is:

A)

inappropriate, because sales should be forecast on a firm-wide basis and are unlikely to be related to GDP growth.

B) appropriate.

C) inappropriate, because sales should be forecast on a firm-wide basis.


Sales estimates can be more sophisticated than simply estimating a single growth rate. One common approach is to estimate the linear relationship between sales growth and economic growth and use this relationship to estimate sales growth based on economists’ forecasts of GDP growth. Segment-by-segment analysis can also be applied, summing segment or division sales forecasts to produce an overall sales forecast for the firm

Gerome Masseratti, CFA, and Charles Bataglia are working together to develop pro forma financial statements for one of their firm’s clients. During their initial meeting, Bataglia made a statement with which Masseratti did not agree. Which of the following

is most likely the statement that Masseratti objected to?

A)

“A firm’s return on equity (ROE) will not necessarily increase just because the firm’


s total asset turnover increases.”

B) “It is acceptable to forecast future sales using the average compound growth rate of historic sales.”

C) “If sales are forecast accurately, there is no need to reconcile the pro-forma income statement and balance sheet.”

A normal part of constructing pro forma statements is to reconcile the income statement and balance sheet. After the first iteration, there is typically a discrepancy between the total assets account and the total liabilities plus total equity accounts on the firm’s balance sheet. This discrepancy must be resolved through subsequent iterations in the pro forma statement based on assumptions about how a deficit is funded or how a surplus is used.

The Corporate Governance of Listed Companies: A Manual for Investors

During a recent luncheon, Angus Rahamut and Dan Riding became engaged in a discussion of issues related to corporate governance. Neither of these individuals is an expert in the field of corporate governance and either of them may have made an inaccurate statement. Which of the following is most likely to be an inaccurate statement?

A)

“Board members must have the experience and qualifications necessary for them to be able to make decisions independently from the firm’

s management.”

B) “To be independent, a board member must not have any material relationship with the firm’s executive management or their families.”

C) “In order to avoid conflicts of interest, board members should seek management approval prior to hiring external advisors.”

Ideally, independent board members can hire external consultants without management’s approval. This enables the board to obtain advice on specialized issues that is not biased by the interests of management.

Corporate governance defines the appropriate rights, role, and responsibilities of:

A)

management, the board of directors, and shareholders.

B) management only.

C) management and the board of directors.


Corporate governance defines the appropriate rights, roles, and responsibilities of a corporation’s management, the board of directors, and shareholders.

Rochelle Dixon is delivering a presentation on best practices for corporate governance. Two of her recommendations are as follows:

Statement 1: To avoid the potential for harming shareholders’ interests by wasting company resources, the Board of Directors should get management’s approval before it hires outside consultants.

Statement 2: The more members a Board of Directors has, the more likely it is to represent shareholders’ interests fairly.

Are Dixon’s statements CORRECT?


A)

Incorrect

B) Incorrect Correct

C) Correct Correct


Both statements are incorrect. An independent board should have the ability to seek specialized advice by hiring outside consultants without management approval. The size of the board should be appropriate for the facts and circumstances of the firm; having more members does not imply that the board will be more independent if the additional members are aligned closely with management or are less well qualified.

A board of directors is most likely to protect the shareholders’ interests when:

A)

one individual can be identified as the leading board member from outside the firm.

B) the board requires that management attend all meetings.

C) the board includes representatives from the firm’s key customers and suppliers.


Especially in cases where the chairman of the board is closely aligned with the firm, independent board members are more able to protect shareholders’ interests when they have a leading or primary independent member. The board should meet regularly outside the presence of management. Board members who represent the firm’s customers and suppliers may have interests that conflict with those of shareholders

There are a lot of issues to consider in determining board independence. What would be the best definition of true “independence”? Independence, as it relates to board members, refers to:

A)

the degree to which these persons are not


biased or otherwise controlled by firm management or other groups which may have some degree of control over management.

B) the degree to which these persons are not biased or otherwise controlled by firm management or the outside audit group.

C) avoidance of material conflicts of interest.


Avoiding material conflicts of interest is important, but this is not a true definition of independence. Independent board members should be independent from the outside audit group, but this is not part of the actual definition. Benefiting management interests should not be a board priority

Which of the following statements related to corporate governance is least accurate?

A)

Board members should not have any material relationships with


the firm’s advisers, auditors, and their families.

B) It is desirable for board members to have board experience with other boards.

C) It is desirable for the chairman of the board to be the firm’s current CEO or former CEO.

The willingness of independent board members to express opinions that are not aligned with managements’ may be impaired when the chairman is the firm’s current CEO or a former CEO.

A properly qualified board member is of vital importance to proper corporate governance within a firm. Board members who lack the requisite skills, knowledge and expertise to conduct a thorough review of the firm’s activities are:

A)

more likely to defer to management when making decisions.

B) less likely to participate fully in decision-making matters during board meetings.

C) more likely to consult with outside interests to assist in decision-making.

Board members must be properly qualified, having the knowledge and experience which is required to advise management in light of the firm’s specific situations encountered. Both remaining answers are incorrect

Which of the following might be an undesirable trait of a member of the board of directors?

A)

Lack of legal or regulatory problem

s as a result of working with other firms.

B) Experience with the technologies, products, and services the firm offers.

C) Service on the board for more than 10 years.

Service on the board for more than 10 years may indicate knowledge and experience, but may result in a member becoming too close to management.

A critical corporate governance issue is ensuring that the board and its members have the requisite experience needed to properly govern the firm for the shareholders’ benefit. When considering board member qualifications, investors and shareholders should consider whether board members can act with care and competence as a result of their experience with all of the following EXCEPT:

A)

legal issues.

B) technologies, products, services which the firm offers.

C) the competitive landscape the firm faces.

Knowledge of the firm’s competitive landscape is likely beyond what a board member should have intimate knowledge about. The other items are all issues a board member should be knowledgeable about. Other issues board members should have experience with include financial operations, accounting and auditing topics, and business risks the firm faces.

Which of the following practices should be included in a firm’s code of ethics?

A)

Prohibiting board members or other insiders from purchasing stock before shareholders can

make purchases.

B) Providing the board with relevant corporate information in a timely manner and allowing board members or other insiders to purchase stock before shareholders can make purchases.

C)Providing the board with relevant corporate information in a timely manner and prohibiting board members or other insiders from purchasing stock before shareholders can make purchases.

The firm’s code of ethics establishes the basic principles of integrity, trust, and honesty. Two of the practices listed in the reading discuss providing the board with relevant corporate information in a timely manner and prohibiting board members or other insiders from purchasing stock before shareholders can make purchases.

A strong corporate code of ethics is vitally important. Which of the following statements concerning a firm’s code of ethics is least likely accurate?

A)

A firm’s code of ethics sets standards for ethical conduct based on basic principles of integrity, trust and honesty.

B) As part of investor review of the firm’s ethical climate, investors should determine whether the firm gives the board access to relevant corporate information in a timely manner.

C) A firm’s code of ethics should require clear disclosure of any advantages given to the firm’s insiders that are not also offered to shareholders.

The firm’s code of ethics should prohibit practices that give advantages to company insiders that are not also offered to shareholders.

The audit committee of a company’s Board of Directors is most likely to act in the interests of shareholders when:

A)

a company officer other than the CEO controls the audit budget.

B) the committee has authority to prevent the company from engaging in non-audit business relationships with its external auditors.

C) a reliable communication “firewall” is in place between the committee and the company’s internal auditors.

The audit committee is responsible for evaluating the financial information that the company provides to shareholders. This committee should be able to approve or reject the company’s proposed non-audit engagements with its external auditing firm. The audit committee, not management, should control the audit budget, and there should be no restrictions on communication between the committee and the company’s internal auditors.

A special-purpose board committee with which of the following responsibilities would be least likely to act in the best interests of the shareholders?

A)

Corporate governance.

B) Mergers and acquisitions.

C) Takeover defense.

A committee responsible for takeover defense would most likely be acting in the interests of the company's current management rather than in the interests of shareholders

Investors have a duty to determine whether the board has properly established committees of independent board members to help carry out various board functions. Which of the following statements about the “audit committee” is least accurate?

A)

The audit committee should ensure

that the audit is conducted consistent with generally accepted auditing standards (GAAS).

B) Firm management is responsible for hiring and supervising the independent external auditors, but the audit committee has strict oversight responsibilities.

C) The audit committee should ensure that the independent auditors have authority over the audit of the entire corporate group, which includes foreign subs and affiliates.

The audit committee is responsible for hiring and supervising the independent external auditors, in order to ensure that the auditors’ priorities are consistent with the best interests of shareholders. Both remaining statements are correct

Which of the following statements concerning Board committees is least accurate?

A)

The nominations committee is responsible for recruiting qualified board members and preparing an executive managemen

t succession plan.

B) Members of the audit committee should be independent experts in accounting and finance.

C) The audit committee has authority over the procedures used to audit the entire corporate group including subsidiaries and affiliates.

The independent auditor has authority over the audit procedures. The audit committee is responsible for hiring and supervising the independent auditor.

Which of the following policies regarding shareowner rights for equity investors is most likely detrimental to the shareowners’ interests?

A)

Shareowners can approve changes to the corporate structure only with a supermajority vote.

B) The company uses a third-party entity to tabulate shareowner votes.

C) Shareowners are permitted to vote either by paper ballot or a proxy voting service.

Provisions that require a supermajority can even make changes strongly supported by shareowners more difficult to enact.

Shareholder-sponsored resolutions are something investors can consider in order to be “heard”. These resolutions do have implications for investors. Which of the following statements regarding shareholder-sponsored resolutions is least accurate?

A)

The ability

shareholders have to propose needed changes in a firm can serve to erode shareholder value.

B)The right to propose initiatives for consideration at the firm’s annual meeting is one way for shareholders to send a message that they are dissatisfied with the way the board is handling one or more firm matters.

C)The right to propose initiatives for consideration at the firm’s annual meeting is one way for shareholders to send a message that they are dissatisfied with the way management is handling one or more firm matters.

The ability to bring issues in front of the board and/or management can serve to prevent erosion of shareholder value.

Which of the following is least likely to be considered a “best practice” regarding corporate governance?

A)

Use of a third party to tabulate votes and retain voting records.

B) Board members are limited to a six-year term.

C) A code of ethics that is audited and improved periodically.

Anything beyond 2- or 3-year term limits on board membership has the potential to restrict the ability for shareholders to change the composition of the board if its members are not acting in the shareholders’ best interest.

The most likely outcome of adopting a golden parachute, poison pill, or greenmail is a:

A)

negative impact on the stock price and a greater possibility for a successful takeover bid.

B) reduced possibility for a successful takeover bid and a positive impact on the stock price.

C) reduced possibility for a successful takeover bid and a negative impact on the stock price.


Adopting a golden parachute, poison pill, or greenmail are all take-over defenses used to frustrate an acquisition attempt. The barriers created by such defenses are likely to decrease the value of the stock.

Which of the following would NOT be a good source for information about a company’s proxy voting rules?

A)

Company’s articles of organization and by-laws.

B) Firm’s corporate governance statement.

C) Firm’s annual report.

The annual report would typically not contain this detailed information.


One of the issues shareholders should consider is the issue of confidential voting of proxies. Which of the following statements would be considered most accurate in regard to proxy voting and confidential votes?

A)

It is an SEC requirement that the proxy voting process be confidential.

B) Shareholders are more likely to vote conscientiously if allowed to do so confidentially.

C) Confidentiality of voting does not ensure that all votes are counted equally.

Shareholders will be more likely to vote and vote conscientiously if they are sure that board members and/or management will not find out how they voted. There is no SEC requirement of confidentiality regarding proxy voting. Confidentiality of voting does insure that all votes are counted equally.

Which of the following rights concerning shareholder-sponsored board nominations and shareholder-sponsored resolutions would be advantageous to an investor?

A)

The right to propose initiatives for consideration at the annual meeting, but not the right to nominate or remove board me

mbers in certain circumstances.

B) The right to nominate or remove board members in certain circumstances, but not the right to propose initiatives for consideration at the annual meeting.

C) The right to nominate or remove board members in certain circumstances, and the right to propose initiatives for consideration at the annual meeting.

Investors need the power to put forth an independent board nominee. In addition, the right to propose initiatives for consideration at the annual meeting is an important method to send a message to management.

Which of the following actions would most likely have a positive influence on shareholder value?

A)

Executive board members regularly attend the board meetings.

B) Adopting a poison pill.

C) Only one class of common equity has been issued.

Firms with dual classes of equity can have a negative effect on shareholder value as the shareholder may have inferior voting rights. Takeover measures such as poison pills, golden parachutes, and greenmail typically have a negative effect on shareholder value. Annual elections are preferred for board members as it increases accountability. Executive board members regularly attending the meetings can potentially prevent free discussion among the independent members

Which of the following statements regarding company takeover defenses is CORRECT?

A)

Newly created anti-takeover

provisions may or may not require stakeholder authorization/approval.

B) The firm’s annual report contains pertinent details concerning takeover defenses.

C) A firm’s proxy is the most likely place to find information about present takeover defenses.

These provisions may or may not require such approval. In either case, the firm may have to, at a minimum, provide information to its shareholders about any amendments to existing takeover defenses. A firm’s articles of organization are the most likely places to locate information about present takeover defenses.

When examining a firm’s ownership structure, it is imperative to examine any super-voting rights by certain

classes of shareholders. Which of the following statements concerning these voting rights is most accurate?

A)

If a company has a significant minority shareowner group, such as a founding family, cumulative voting to elect board members can be a positive factor for shareholders.

B) Firms with a single class of common equity could encourage prospective acquirers to only deal directly with

shareholders with the supermajority rights.

C) Super-voting rights by certain classes of shareholders impair the firm’s ability to raise capital for the future.

Firms with dual classes of common equity could encourage prospective acquirers to only deal directly with shareholders with the supermajority rights. If the firm has a significant minority ownership group, such as a founding family, use of cumulative voting to elect board members can favor specific interests at the expense of the interests of other shareholders

Which of the following firms is most likely to have a board of directors that considers the best interest of all shareholders?

A)

Firms that assign a single vote to each share, and firms with different classes of common equity with supermajority rights given to one class.

B) Neither firms with different classes of common equity with supermajority rights given to one class, nor firms that assign a single vote to each share.

C) Firms that assign a single vote to each share, but not firms with different classes of common equity with supermajority rights given to one class.

Firms that assign one vote to each share are more likely to have a board that considers the best interest of all shareholders. Firms with dual classes of common equity where supermajority rights are given to one class are likely to have boards that focus on the interests of the supermajority shareholders.

During a recent luncheon, Angus Rahamut and Dan Riding became engaged in a discussion of issues related to corporate governance. Neither of these individuals is an expert in the field of corporate governance and either of

them may have made an inaccurate statement. Which of the following is most likely to be an inaccurate statement?

A)

“Board membe

rs must have the experience and qualifications necessary for them to be able to make decisions independently from the firm’s management.”

B) “To be independent, a board member must not have any material relationship with the firm’s executive management or their families.”

C) “In order to avoid conflicts of interest, board members should seek management approval prior to hiring external advisors.”

Ideally, independent board members can hire external consultants without management’s approval. This enables the board to obtain advice on specialized issues that is not biased by the interests of management.

corporate finc(1).doc

Documents

capital projects

capital budgeting process

expected project cash

timing of cash flows

projects future cash

c forecasting cash flows

timing of expected cash

environmental projects