Certified Public Accountant CPA Questions + Answers Part 15

Post by **answerhappygod** » Tue Feb 22, 2022 6:20 pm

QUESTION 352
For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management:
A. W ants to use equity funding exclusively.
B. Believesbankloansareriskierthancapitalinvestments.
C. Believes capital investment proposals involve average risk.
D. Wants to factor risk into its consideration of projects.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation

Explanation/Reference:
Explanation:
Choice "d" is correct. Management would select a high hurdle rate for certain projects to factor risk into its consideration of projects. The higher hurdle rate discounts future cash flows more, creating a smaller present value. By "devaluing" the cash flows of certain projects, risk has been compensated for. Choices "a" and "b" are incorrect. The method and cost of funding are independent of the hurdle rate for screening investments.
Choice "c" is incorrect. If capital investment proposals involve average risk, no adjustment upward is needed for risk.
QUESTION 353
McLean Inc. is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of three years. Assume for simplicity that the equipment will be fully depreciated 30, 40, and 30 percent in each of the three years, respectively. The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40 percent estimated income tax rate and a 16 percent hurdle rate to evaluate capital projects.
Discount rates for a 16 percent rate are as follows.
What is the net present value of this project?
A. $15,842 B. $13,278 C. $9,432 D. $(35,454)
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. $13,278 net present value.

QUESTION 354
Barker Inc. has no capital rationing constraint and is analyzing many independent investment alternatives. Barker should accept all investment proposals:
A. Ifdebtfinancingisavailableforthem.
B. Thathavepositivecashflows.
C. That provide returns greater than the after-tax cost of debt. D. That have a positive net present value.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:

Explanation:
Choice "d" is correct. Accept all investment alternatives that have a positive net present value (NPV). A positive NPV means the return on the investment exceeds the hurdle rate (the minimum acceptable rate of return).
Choice "a" is incorrect. The cost of debt financing is a factor in determining the hurdle rate. Choice "b" is incorrect. The cash flow may be positive but the return on investment may be unacceptable.
Choice "c" is incorrect. The cost of debt financing is a factor in determining the hurdle rate.
QUESTION 355
The net present value (NPV) of a project has been calculated to be $215,000. Which one of the following changes in assumptions would decrease the NPV?
A. Decreasetheestimatedeffectiveincometaxrate. B. Extendtheprojectlifeandassociatedcashinflows. C. Increase the estimated salvage value.
D. Increase the discount rate.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. An increase in the discount rate will decrease the present value of future cash inflows and, therefore, decrease the net present value of the project.
Each of the other options would increase the NPV:
Choice "a" is incorrect. A decrease in the estimated effective income tax rate will reduce the depreciation tax shield and therefore increase the cash inflow. A larger cash inflow in the future will increase the present value of the cash inflows and therefore increase the net present value of the project. Choice "b" is incorrect. Increasing the project life and associated cash inflows will increase the present value of the cash inflows and therefore increase the net present value. Choice "c" is incorrect. An increase in the estimated salvage value will decrease the present value of the cash outflow and therefore increase the net present value.
QUESTION 356
The net present value method of capital budgeting assumes that cash flows are reinvested at:
A. Therisk-freerate.
B. Thecostofdebt.
C. The rate of return of the project.
D. The discount rate used in the analysis.
Correct Answer: D

Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The net present value method of capital budgeting assumes that cash flows are reinvested at the discount rate used in the analysis. Choices "a", "b", and "c" are incorrect, per the above Explanation:.
QUESTION 357
Willis, Inc. has a cost of capital of 15 percent and is considering the acquisition of a new machine, which costs $400,000 and has a useful life of five years. Willis projects that earnings and cash flow will increase as follows.
The net present value of this investment is:
A. Negative,$64,000 B. Negative,$14,000 C. Positive, $18,600 D. Positive, $200,000
Correct Answer: C

Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Positive NPV, $18,600.
QUESTION 358
The net present value of a proposed investment is negative; therefore, the discount rate used must be:
A. Greaterthantheproject'sinternalrateofreturn. B. Lessthantheproject'sinternalrateofreturn. C. Greater than the firm's cost of equity.
D. Less than the incremental borrowing rate.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. If the NPV of a proposed investment is negative, the discount rate used must be greater than the project's internal rate of return (IRR). The

IRR is the discount rate that results in a NPV of zero. If a discount rate used is greater than the project's IRR, the present value of future cash inflows will be lower resulting in a negative net present value.
If a discount rate used is less than the project's IRR, the present value of future cash inflows will be higher resulting in a positive net present value.
Choices "b", "c", and "d" are incorrect, per the above discussion.
QUESTION 359
A disadvantage of the net present value method of capital expenditure evaluation is that it:
A. Iscalculatedusingsensitivityanalysis.
B. Doesnotprovidethetruerateofreturnoninvestment.
C. Is difficult to apply because it uses a trial and error approach. D. Is difficult to adapt for risk.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The net present value (NPV) method of capital expenditure evaluation does not provide the true rate of return on investment. The NPV indicates whether or not an investment will earn the "hurdle rate" used in the NPV calculation. If the NPV is positive, the return on investment will exceed the hurdle rate. If the NPV is negative, the return on investment will be less than the hurdle rate. If the NPV is zero, the return on investment will be exactly equal to the hurdle rate. Choice "a" is incorrect. Sensitivity analysis is a "what if" technique that asks how a given organization will change if the original estimates used in the capital budgeting model are changed. Choice "c" is incorrect. NPV calculations do not use a trial and error approach. Choice "d" is incorrect. NPV method is not difficult to adapt for risk. To adapt for increased risk, a higher hurdle rate is used. To adapt for less risk, a lower hurdle rate is used.
QUESTION 360
Andrew Corporation is evaluating a capital investment that would result in a $30,000 higher contribution margin benefit and increased annual personnel costs of $20,000. The effects of income taxes on the net present value computation on these benefits and costs for the project are to:
A. Decreasebothbenefitsandcosts.
B. Decreasebenefitsbutincreasecosts. C. Increase benefits but decrease costs. D. Increase both benefits and costs.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation

Explanation/Reference:
Explanation:
Choice "a" is correct. The effects of income taxes on the net present value computations will decrease both benefits and costs for the project. Net present value computations focus of the present value of cash flows. Income taxes decrease both the benefit and the cost of cash flows. Choices "b", "c", and "d" are incorrect, per the above Explanation:.
QUESTION 361
The Keego Company is planning a $200,000 equipment investment, which has an estimated five-year life with no estimated salvage value. The company has projected the following annual cash flows for the investment.
The net present value for the investment is:
A. $18,800 B. $196,200 C. $(3,800) D. $91,743
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. $18,800 net present value. The net present value of an investment is calculated as the present value of the cash inflows minus the present value of the cash outflows. In this case, there is only one cash outflow (at the purchase date), and that amount ($200,000) is already at present value (or, is multiplied by a present value factor of 1.0).

QUESTION 362
The use of an accelerated method instead of the straight-line method of depreciation in computing the net present value of a project has the effect of:
A. Raisingthehurdleratenecessarytojustifytheproject.
B. Loweringthenetpresentvalueoftheproject.
C. Increasing the present value of the depreciation tax shield. D. Increasing the cash outflows at the initial point of the project.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Rule: The greater the depreciation expense, the greater the depreciation tax shield.
Deprecation Tax Shield =
Depreciation Expense × Marginal Tax Rate
Choice "c" is correct. Use of an accelerated method instead of the straight-line method of depreciation in computing the NPV of a project has the effect of increasing the PV of the deprecation tax shield. Choice "a" is incorrect. Depreciation method does not affect the hurdle rate. The hurdle rate is independently selected by management.
Choice "b" is incorrect. Using an accelerated method instead of the straight-line method of depreciation will increase the present value of the deprecation tax shield and therefore increase the net present value of the project.
Choice "d" is incorrect. Depreciation method does not affect cash outflows at the initial point of the project.

QUESTION 363
The internal rate of return for a project can be determined:
A. Onlyiftheprojectcashflowsareconstant.
B. Byfindingthediscountratethatyieldsanetpresentvalueofzerofortheproject. C. By subtracting the firm's cost of capital from the project's profitability index.
D. Only if the project's profitability index is greater than one.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The internal rate of return (IRR) is the discount rate that produces a NPV of zero. Choice "a" is incorrect. IRR valuation does not require cash flows that are constant. Choice "c" is incorrect. Cost of capital is a percentage, profitability index is a ratio; this won't work. Choice "d" is incorrect. IRR can be determined even if the profitability index is less than 1.0. A profitability index of less than 1.0 means a negative NPV, which means the IRR is less than the discount rate being used.
QUESTION 364
The internal rate of return is the:
A. Rateofinterestthatequatesthepresentvalueofcashoutflowsandthepresentvalueofcashinflows. B. Risk-adjustedrateofreturn.
C. Required rate of return.
D. Weighted average rate of return generated by internal funds.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. The internal rate of return is defined as the technique that determines the present value factor such that the present value of the after-tax cash flows equals the initial investment on the project. Alternately, the internal rate of return (IRR) is the discount rate that produces a NPV of zero. Choices "b", "c", and "d" are incorrect, per the above Explanation:.

QUESTION 365
The internal rate of return (IRR) is the:
A. Hurdlerate.
B. Rateofinterestwherethenetpresentvalueisgreaterthan1.0. C. Rate of interest where the net present value is equal to zero.
D. Rate of return generated from the operational cash flows.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. IRR is the rate of interest where the NPV is zero. Choice "a" is incorrect. The hurdle rate is a desired or minimum rate of return, set by management, to evaluate investments.
Choice "b" is incorrect. NPV will be greater than zero when the IRR is higher than the hurdle rate. Choice "d" is incorrect. IRR is the rate of return of all cash flows produced by the investment.
QUESTION 366
The method that divides a project's annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment is the:
A. Internalrateofreturnmethod.
B. Accountingrateofreturnmethod. C. Payback method.
D. Net present value method.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Accounting rate of return divides annual after-tax net income by average investment amount. Choices "a", "c", and "d" are incorrect. IRR, NPV and payback all use cash flows, not net income.
QUESTION 367

The length of time required to recover the initial cash outlay of a capital project is determined by using the:
A. Discountedcashflowmethod.
B. Payback method.
C. Net present value method.
D. Accounting rate of return method.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The payback method measures the time required to recover the initial investment. Choice "a" is incorrect. Discounted cash flows are used for several methods of capital budgeting; this is a generic term.
Choice "c" is incorrect. The NPV method does not measure the length of time required to recover the initial cash outlay.
Choice "d" is incorrect. The accounting rate of return does not measure the time to recover the initial investment.
QUESTION 368
A characteristic of the payback method (before taxes) is that it:
A. Incorporatesthetimevalueofmoney.
B. Neglectstotalprojectprofitability.
C. Uses accrual accounting inflows in the numerator of the calculation.
D. Uses the estimated expected life of the asset in the denominator of the calculation.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The payback method neglects total project profitability. It simply looks at the time required to recover the initial investment; subsequent receipts are ignored. Choice "a" is incorrect. Payback does not incorporate the time value of money. Choice "c" is incorrect. Payback uses cash flow, not accrual accounting income. Choice "d" is incorrect. The denominator is the annual cash inflows.
QUESTION 369
McLean Inc. is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of three years. Assume for simplicity

that the equipment will be fully depreciated 30, 40, and 30 percent in each of the three years, respectively. The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40 percent estimated income tax rate and a 16 percent hurdle rate to evaluate capital projects.
Discount rates for a 16 percent rate are as follows:
The payback period for this investment would be:
A. 2.95years B. 1.76years C. 2.09 years D. 2.94 years
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. 2.09 years payback period.

At the beginning of year 3, $6,000 is needed to recover the investment. Because an inflow of $69,000 is expected throughout the year, only 6,000 ÷ 69,000 = .09 years is needed to recover the $6,000. Thus, the payback is 2.09 years. The $6,000 in salvage is excluded from the totals for year 3. Amounts are not realized until the end of the year while savings and depreciation tax shield occur throughout the year and are relevant to the partial year payback.
QUESTION 370
Which one or the following statements about the payback method of investment analysis is correct? The payback method:
A. Doesnotconsiderthetimevalueofmoney.
B. Usesdiscountedcashflowtechniques.
C. Generally leads to the same decision as other methods for long-term projects. D. Is rarely used in practice.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. The payback method does not consider the time value of money. Choice "b" is incorrect. The payback method does not use discounted cash flow techniques. The time value of money is ignored.

Choice "c" is incorrect. The payback method may or may not lead to the same decision as other methods for long-term projects. Choice "d" is incorrect. The payback method is frequently used in practice because of its simplicity.
QUESTION 371
Willis, Inc. has a cost of capital of 15 percent and is considering the acquisition of a new machine, which costs $400,000 and has a useful life of five years. Willis projects that earnings and cash flow will increase as follows.
What is the payback period of this investment?
A. 1.50years B. 3.00years C. 3.33 years D. 4.00 years
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:

Choice "b" is correct. 3.00 year payback period.
Note: After 3 years, the initial investment is recovered, as the cumulative cash inflows equal $400,000. The cash flows are not discounted when the payback method is used.
QUESTION 372
Whatney Co. is considering the acquisition of a new, more efficient press. The cost of the press is $360,000, and the press has an estimated six-year life with zero salvage value. Whatney uses straightline depreciation for both financial reporting and income tax reporting purposes and has a 40 percent corporate income tax rate. In evaluating equipment acquisitions of this type, Whatney uses a goal of a four-year payback period. To meet Whatney's desired payback period, the press must produce a minimum annual before-tax, operating cash savings of:
A. $90,000 B. $110,000 C. $114,000 D. $150,000
Correct Answer: B
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. $110,000 minimum annual before-tax operating cash savings.
Step 1: Determine the after-tax annual cash savings. The question provides the cash outflow and the desired payback period (which is calculated using after-tax cash flows). The $90,000 annual after-tax cash flows is calculated as follows:

Step 2: Determine the amount of the annual depreciation expense. Because the question asks for annual before-tax cash savings, we will need to convert the $90,000 after-tax cash savings we calculated in Step 1,above, to a before-tax amount. The depreciation tax shield plays a role in the after-tax cash flows, so the annual depreciation of $60,000 must be calculated, as follows:
Step 3: Use algebra to determine the before-tax cash savings. Before-tax cash savings is equal to the after-tax cash savings plus the taxes paid. So: Let B = annual before-tax operating cash savings
$90,000 after tax cash savings + [(B - $60,000 depreciation expense ) (.40 tax rate)] = B $90,000 + [(B - $60,000) (.40)] = B $90,000 + [.40B - $24,000] = B
$90,000 - $24,000 = .60B
$66,000 = .60B
$110,000 = B = annual before-tax operating cash savings
QUESTION 373
When evaluating capital budgeting analysis techniques, the payback period emphasizes: A. Liquidity.

B. Profitability.
C. Net income.
D. The accounting period.
Correct Answer: A
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. The payback period is the time period required for cash inflows to recover the initial investment. The emphasis of the technique is on liquidity (i.e., cash flow). Choices "b", "c", and "d" are incorrect, per the above Explanation:.
QUESTION 374
The term underwriting spread refers to the:
A. Commissionpercentageaninvestmentbankerreceivesforunderwritingasecuritylease.
B. Discountinvestmentbankersreceiveonsecuritiestheypurchasefromtheissuingcompany.
C. Difference between the price the investment banker pays for a new security issue and the price at which the securities are resold. D. Commission a broker receives for either buying or selling a security on behalf of an investor.
Correct Answer: C
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Investment bankers are paid their fees partly by being allowed to purchase the new securities they are underwriting for a discount and then reselling those securities on the market.
This is known as the underwriting spread.
Choices "a" and "d" are incorrect, as both of these describe either fees or commissions and not an underwriting spread.
Choice "b" is incorrect. The underwriting spread is the difference between the discount price paid and the resale price.
QUESTION 375
The principle measure of non-diversifiable risk included in the CAPM formula is the beta coefficient. The beta coefficient measures the volatility or risk inherent in an investment by:
A. Computingtheratioofchangesinearningspersharetochangesinsales.

B. Computingtheratioofstockpricetoearningspershare.
C. Computing the ratio of percentage changes in a stock's price to percentage changes in overall market values during the same period. D. Computing the ratio of percentage changes in the expected value of alpha equivalents to derivative fluctuations.
Correct Answer: C
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The beta coefficient represents the measure of a particular stock's percentage change compared to the percentage change in the market over the same perioD. The equation for the beta coefficient is as follows:
% in Stock Price % in Market price
Choice "a" is incorrect. The percentage change in earnings per share related to a percentage change in sales represents the degree of combined leverage. Choice "b" is incorrect. The ratio of stock price to earnings per share is the price earnings ratio. Choice "d" is incorrect. Choice "d" represents a word salad distracter of nonsense terms.
QUESTION 376
Carlisle Company presently sells 400,000 bottles of perfume each year. Each bottle costs $.84 to produce and sells for $1.00. Fixed costs are $28,000 per year. The firm has annual interest expense of $6,000, preferred stock dividends of $2,000 per year, and a 40 percent tax rate. Carlisle uses the following formulas to determine the company's leverage.

The degree of operating leverage for Carlisle Company is:
A. 2.4 B. 1.78 C. 1.35 D. 2.3
Correct Answer: B
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Calculation of operating leverage is:

Choices "a", "c", and "d" are incorrect, per the above calculation.
QUESTION 377
Carlisle Company presently sells 400,000 bottles of perfume each year. Each bottle costs $.84 to produce and sells for $1.00. Fixed costs are $28,000 per year. The firm has annual interest expense of $6,000, preferred stock dividends of $2,000 per year, and a 40 percent tax rate. Carlisle uses the following formulas to determine the company's leverage.
The degree of financial leverage for Carlisle Company is:
A. 2.4 B. 1.78 C. 1.35

D. 2.3
Correct Answer: C
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. To calculate financial leverage, EBIT must first be calculated:
Choices "a", "b", and "d" are incorrect, per the above calculation.
QUESTION 378
Carlisle Company presently sells 400,000 bottles of perfume each year. Each bottle costs $.84 to produce and sells for $1.00. Fixed costs are $28,000 per year. The firm has annual interest expense of $6,000, preferred stock dividends of $2,000 per year, and a 40 percent tax rate. Carlisle uses the following formulas to determine the company's leverage.

If Carlisle Company did not have preferred stock, the degree of total leverage would:
A. Decreaseinproportiontoadecreaseinfinancialleverage.
B. Increaseinproportiontoanincreaseinfinancialleverage.
C. Decrease but not be proportional to the decrease in financial leverage. D. Decrease but not have an effect on financial leverage.
Correct Answer: A
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. Without preferred stock, the denominator in the total leverage calculation would be larger (because preferred stock is subtracted to arrive at the denominator). The same holds true for financial leverage. Therefore, both financial and total leverage would decrease in proportion. Choices "b", "c", and "d" are incorrect, per above Explanation:.
QUESTION 379

A firm with a higher degree of operating leverage when compared to the industry average implies that the:
A. Firmhashighervariablecosts.
B. Firm'sprofitsaremoresensitivetochangesinsalesvolume. C. Firm is more profitable.
D. Firm uses a significant amount of debt financing.
Correct Answer: B
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Rule: Operating leverage is the presence of fixed costs in operations, which allows a small change in sales to produce a larger relative change in profits.
Choice "b" is correct. A firm with a higher degree of operating leverage when compared to the industry average implies that the firm's profits are more sensitive to changes in sales volume. Choice "a" is incorrect. Higher variable costs imply a lower degree of operating leverage. Choice "c" is incorrect. Profits will depend upon sales. Choice "d" is incorrect. A firm using a significant amount of debt financing has a higher degree of "financial leverage."
QUESTION 380
Datacomp Industries, which has no current debt, has a beta of .95 for its common stock. Management is considering a change in the capital structure to 30% debt and 70% equity. This change would increase the beta on the stock to 1.05, and the after-tax cost of debt will be 7.5%. The expected return on equity is 16%, and the risk-free rate is 6%. Should Datacomp's management proceed with the capital structure change?
A. No,becausethecostofequitycapitalwillincrease.
B. Yes,becausethecostofequitycapitalwilldecrease.
C. Yes, because the weighted average cost of capital will decrease. D. No, because the weighted average cost of capital will increase.
Correct Answer: C
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. First, compute Datacomp's current weighted average cost of capital by using the capital asset pricing model (CAPM):

Because there is no debt, the WACC is equal to the CAPM formula for equity or 15.5%. When debt is introduced, the WACC is calculated by first using the CAPM to determine the required return on equity:
Assuming an after tax cost of debt is equal to 7.5%, the WACC becomes:
(.165 × (.70)) + (.075 × (.3)) = 13.8%
Therefore, Datacomp should change its capital structure because its WACC will decrease (Choice "c"). Choices "a", "b", and "d" are incorrect, per above.
QUESTION 381
The three elements needed to estimate the cost of equity capital for use in determining a firm's weighted average cost of capital are:
A. Currentdividendspershare,expectedgrowthrateinearningspershare,andcurrentmarketpricepershareofcommonstock. B. Currentearningspershare,expectedgrowthrateindividendspershare,andcurrentmarketpricepershareofcommonstock. C. Current earnings per share, expected growth rate in earnings per share, and current book value per share of common stock.
D. Current dividends per share, expected growth rate in dividends per share, and current market price per share of common stock.
Correct Answer: D
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The three elements needed to estimate the cost of equity capital are:
1. Current dividends per share (D)
2. Expected growth rate in dividends (g) and

3. Current market price per share of common stock (P)
The question asks the candidate to identify the three elements needed to estimate the cost of equity capital for use in determining a firm's weighted average cost of capital. The cost of equity capital is defined by the following mathematical expression where the cost of capital or return (R) is: R = D/P + g
Choice "d" is consistent with our text, the Explanation: and the Gordon Growth Model. Use of earnings per share, as suggested by choice "a" is sometimes referred to as the constant growth model and assumes that all earnings per share are either ultimately distributed or reinvested for the benefit of the shareholder. Earnings are anticipated to grow to infinity.
QUESTION 382
A firm's target or optimal capital structure is consistent with which one of the following?
A. Minimumcostofdebt.
B. Minimum risk.
C. Minimum cost of equity.
D. Minimum weighted average cost of capital.
Correct Answer: D
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. Minimum weighted average cost of capital is consistent with a firm's target or optimal capital structure.
Choice "a" is incorrect. Minimum cost of debt is a component of minimum weighted average cost of capital.
Choice "b" is incorrect. Minimum risk results in a cost of capital heavily weighted in equity. Choice "c" is incorrect. Minimum cost of equity results in a cost of capital heavily weighted in debt.
QUESTION 383
Williams, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments.
· Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. · Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. · Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share. · Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
· Williams' preferred capital structure is: Long-term debt 30%
Preferred stock 20

Common stock 50
The cost of funds from the sale of common stock for Williams, Inc. is:
A. 7.0percent. B. 7.6percent. C. 7.4 percent. D. 7.8 percent.
Correct Answer: B
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. 7.6%. Williams would receive $92 per share ($100 less $5 flotation cost and $3 underpricing) and pay an annual dividend of $7/share. The annual cost is:
This question purely asks the cost of new common shares issued. The problem gives you the expected dividend to be paid annually ($7) and the net proceeds after issue costs and market adjustments $92 (current selling price of $100 minus the $3 market adjustment and the $5 floatation costs). The cost of common shares issued is the finance charge (dividend) divided by the net proceeds of the issue $92 or 7.6%.
Choices "a", "c", and "d" are incorrect, per above.
QUESTION 384
Williams, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments.
· Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. · Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. · Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share. · Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
· Williams' preferred capital structure is:

Long-term debt 30% Preferred stock 20 Common stock 50
If Williams, Inc. needs a total of $200,000, the firm's weighted-average cost of capital would be closest to:
A. 4.8percent. B. 6.6percent. C. 6.8 percent. D. 7.3 percent.
Correct Answer: B
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. 6.6%. Williams' after tax cost of debt is 4.8% and cost of preferred stock is 8.4% ($105/share less issue costs of $5/share). The cost of equity (as calculated in a prior question) is 7.0%. This question pertains to the manner in which changes in the required amount of capital will impact the weighted average cost of capital governed by the target capital structure. The rates are given, and you must derive the weights.
The company needs a total of $200,000. The question gives you the amount of Retained Earnings at $100,000, the source of 7% dividend payments on common shares. If all that is needed is $200,000, then, by definition, the target capital structure is "priced out" as shown with 7% common equity of $100,000 being equal to 50% of the target capital structure totaling $200,000 without any modification:
Choices "a", "c", and "d" are incorrect, per the above Explanation:.
QUESTION 385
Williams, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments.

· Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent. · Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share. · Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share. · Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.
· Williams' preferred capital structure is: Long-term debt 30%
Preferred stock 20
Common stock 50
If Williams, Inc. needs a total of $1,000,000, the firm's weighted-average cost of capital would be:
A. 6.8percent. B. 4.8percent. C. 6.5 percent. D. 9.1 percent.
Correct Answer: A
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. 6.8%.
This question pertains to the manner in which changes in the required amount of capital will impact the weighted average cost of capital governed by the target capital structure. The rates are given, and you must derive the weights.
The company needs a total of $1,000,000. The total Retained Earnings is $100,000, which will only represent 10% of the total amount needed. In J92-1.01, we computed the cost of new common share issues at 7.6%, and we know that we can issue unlimited amounts of each security. Based on these assumptions, we know that the target capital structure will remain unchanged but that the components of common equity will be priced differently because Retained Earnings only equals $100/$1,000 (or 10%).
If the target capital structure calls for 50% common stock and only 10% is available from retained earnings, then 40% must come from the issuance of new common shares. The weighted average is computed as follows:

Choices "b", "c", and "d" are incorrect, per the above calculcation.
QUESTION 386
Osgood Products has announced that it plans to finance future investments so that the firm will achieve an optimum capital structure. Which one of the following corporate objectives is consistent with the announcement?
A. Maximizeearningspershare.
B. Minimizethecostofdebt.
C. Maximize the net worth of the firm. D. Minimize the cost of equity.
Correct Answer: C
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The optimal capital structure is the financial structure that would theoretically maximize shareholder wealth by maximizing the net worth of the company. Choices "a", "b", and "d" are incorrect. Strategies (not objectives) for creating an optimal capital structure to maximize net worth include:
1. Maximizing earnings per share (choice "a"). 2. Minimizing the cost of debt (choice "b").
3. Minimizing the cost of equity (choice "d"). 4. Maximizing cash flow (choice not given).
QUESTION 387
Youngsten Electric is contemplating new projects for the next year that will require $30,000,000 of new financing. In keeping with its capital structure, Youngsten plans to use debt & equity financing as follows:
* Issue $10,000,000 of 20-year bonds at a price of 101.5, with a coupon of 10%, and flotation costs of 2.5% of par value.

* Use internal funds generated from earnings of $20,000,000.
The equity market is expected to earn 15%. U.S. treasury bonds currently are yielding 9%. The beta coefficient for Youngsten's common stock is estimated to be .8. Youngsten is subject to a 40% corporate income tax rate. Youngsten has a price/earnings ratio of 10, a constant dividend payout ratio of 40%, and an expected growth rate of 12%.
An analysis of Youngsten's planned equity financing using Capital Asset Pricing Model (or Security Market Line) would incorporate only the:
A. Expectedmarketearnings,thecurrentU.S.Treasurybondyield,andthebetacoefficient. B. Expectedmarketearningsandtheprice'earningsratio.
C. Current U.S. Treasury bond yield, the price/earnings ratio, and the beta coefficient.
D. Current U.S. Treasury bond yield and the dividend payout ratio.
Correct Answer: A
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. The capital asset pricing model formula is: R = RF + B (RM-RF)
Where:
R = Required return rate on equity
RF = Risk free rate earned on U.S. treasury bonds. B = Beta coefficient
RM = Expected market return (earnings).
Choices "b", "c", and "d" are incorrect, per the above Explanation:.
QUESTION 388

Additional Data
· The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.
· Martin Corporation can now issue debt at 150 basis points over U.S. treasury bonds. · The current risk-free rate (U.S. treasury bonds) is 7 percent. · Martin's common stock is currently selling at $32 per share.
· The expected market return is currently 15 percent.
· The beta value for Martin is 1.25.
· Martin's effective corporate income tax rate is 40 percent.
Using the Capital Asset Pricing Model (CAPM), Corporation's current cost of common equity is:
A. 10.00percent. B. 15.00percent. C. 17.00 percent. D. 18.75 percent.
Correct Answer: C

Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. 17.00 percent. Using the CAPM model, Martin's current cost of common equity would be:
Cost of equity = Capital risk free rate + Beta (market rate - risk free rate) Cost of equity = 7% + 1.25 (15% - 7%) Cost of equity = 7% + 1.25 (8%)
Cost of equity = 7% + 10%
Cost of equity = 17%
QUESTION 389
DQZ Telecom is considering a project for the coming year, which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment.
· Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8 percent, and flotation costs of 2 percent of par. · Use $35 million of funds generated from earnings.
The equity market is expected to earn 12 percent. U.S. treasury bonds are currently yielding 5 percent. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40 percent.
The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first year is:
A. 11.80percent. B. 8.08percent. C. 10.00 percent. D. 7.92 percent.

Correct Answer: B
Section: Business Environment and Concepts (Volume D) Explanation

Explanation/Reference:
Explanation:
Choice "b" is correct. 8.08 percent before-tax cost of debt financing, net of flotation costs.
QUESTION 390
Assume the following facts about Martin Corporation:
· The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.
· Martin Corporation can now issue debt at 150 basis points over U.S. treasury bonds. · The current risk-free rate (U.S. treasury bonds) is 7 percent. · Martin's common stock is currently selling at $32 per share.
· The expected market return is currently 15 percent.
· The beta value for Martin is 1.25.
· Martin's effective corporate income tax rate is 40 percent.
Based on these assumptions, what is the current net after-tax cost of debt for Martin Corporation?
A. 5.5percent. B. 7.0percent. C. 5.1 percent.

D. 8.5 percent.
Correct Answer: C
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. 5.1 percent current net cost of debt. The fact pattern states that debt can be currently secured at 150 basis points above the Treasury bond rate. A basis point is equal to 1/100 of 1% (1% of 1%).
Applying the decimals it's:
150 basis points x 1/100 of 1% (or .0001)
this yields .015 or 1.5%
Add the additional basis points converted to percentage (1.5%) to the Treasury bond rate of 7% to arrive at the pre-tax debt cost of 8.5%. Apply 1 - tax rate to arrive at the current net cost of debt as follows:
QUESTION 391
When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying:
A. Workingcapitalmanagement. B. Returnmaximization.
C. Financial leverage.
D. Operating leverage.
Correct Answer: A

Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. Appropriate working capital management matches the maturity life of each asset with the length of the financial instrument used to finance that asset. Choice "b" is incorrect. Return maximization seeks to obtain the optimal return rate by asset utilization. It is not necessarily related to the maturity of the asset. Choice "c" is incorrect. Financial leverage is the amount of debt used to finance an asset. Higher leverage equals more debt. It is unrelated to the maturity life of an asset. Choice "d" is incorrect. Operating leverage is the degree that fixed costs are used in the production process. Operating leverage is unrelated to the methods used to finance assets.
QUESTION 392
Net working capital is the difference between:
A. Currentassetsandcurrentliabilities. B. Fixedassetsandfixedliabilities.
C. Total assets and total liabilities.
D. Total assets and current liabilities.
Correct Answer: A
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. Current assets minus current liabilities equals net working capital. Choices "b", "c", and "d" are incorrect, per the above Explanation:.
QUESTION 393
Which one of the following would increase the working capital of a firm?
A. Purchaseofanewplantfinancedbya20-yearmortgage.
B. Cashcollectionofaccountsreceivable.
C. Payment of a 20-year mortgage payable with cash.
D. Refinancing a short-term note payable with a two-year note payable.
Correct Answer: D
Section: Business Environment and Concepts (Volume D) Explanation

Explanation/Reference:
Explanation:
Choice "d" is correct. Refinancing a short-term note payable with a two-year note payable would increase the working capital of a firm.
Choice "a" is incorrect. The purchase of a new plant (fixed asset) financed by a 20-year mortgage (longterm debt with a one-year current portion) would reduce working capital because current liabilities would be increased.
Choice "b" is incorrect. The cash collection of accounts receivable has no effect on working capital- cash increases by the amount that A/R decreases.
Choice "c" is incorrect. The payment of a 20-year mortgage payable (long-term debt) would reduce cash and have no effect on current liabilities, thereby reducing working capital.
QUESTION 394
If a firm increases its cash balance by issuing additional shares of common stock, working capital:
A. Remainsunchangedandthecurrentratioremainsunchanged. B. Increasesandthecurrentratioremainsunchanged.
C. Increases and the current ratio decreases.
D. Increases and the current ratio increases.
Correct Answer: D
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. If a firm increases its cash balance by issuing additional shares of common stock, working capital increases and the current ratio increases.

QUESTION 395
A firm has daily cash receipts of $100,000. A bank has offered to reduce the collection time on the firm's deposits by two days for a monthly fee of $500. If money market rates are expected to average 6 percent during the year, the net annual benefit (loss) from having this service is:
A. $3,000 B. $12,000 C. $6,000 D. $(6,000)
Correct Answer: C
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. $6,000 net annual benefit from using a lockbox system.

QUESTION 396
Determining the appropriate level of working capital for a firm requires:
A. Changingthecapitalstructureanddividendpolicyofthefirm.
B. Maintainingshort-termdebtatthelowestpossiblelevelbecauseitisgenerallymoreexpensivethanlong-termdebt. C. Offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.
D. Maintaining a high proportion of liquid assets to total assets in order to maximize the return on total investments.
Correct Answer: C
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Determining the appropriate level of working capital for a firm requires offsetting the benefit of current assets and current liabilities against the probability of technical insolvency. Choice "a" is incorrect. Changing the capital structure (common stock vs. preferred stock vs. long-term debt) and dividend policy has nothing to do with the level of working capital required for day-to-day operations of the business.
Choice "b" is incorrect. The relative interest cost of short-term vs. long-term debt does not determine the appropriate level of working capital.
Choice "d" is incorrect. Because profitability varies inversely with liquidity, maximizing the return on total investments would require a low (not high) level of liquid assets and a high level of liquid assets does nothing to determine the required level of working capital.
QUESTION 397
As a company becomes more conservative in its working capital policy, it would tend to have a (n):

A. Decreaseinitsacid-testratio.
B. Increaseintheratioofcurrentassetstounitsofoutput.
C. Increase in funds invested in common stock and a decrease in funds invested in marketable securities. D. Decrease in its level of permanent working capital.
Correct Answer: B
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. As a company becomes more conservative in its working capital policy, it would tend to have an increase in the ratio of current assets to units of output. Choice "a" is incorrect. Acid-test ratio would tend to increase with conservatism. Choice "c" is incorrect. Marketable securities investments would tend to increase while common stock investments would tend to decrease.
Choice "d" is incorrect. Permanent working capital would tend to increase.
QUESTION 398
Which of the following transactions does not change the current ratio and does not change the total current assets?
A. Acashadvanceismadetoadivisionaloffice.
B. Acashdividendisdeclared.
C. Short-term notes payable are retired with cash.
D. Equipment is purchased with a three-year note and a 10 percent cash down payment.
Correct Answer: A
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. This does not change the current ratio because the reduction of cash is offset by an increase in accounts receivable.
Choice "b" is incorrect. A cash dividend increases current liabilities without increasing current assets. Although current assets remain unchanged (until the payment happens), the current ratio will change. Choice "c" is incorrect. Cash is reduced and current liabilities are reduceD. Total current assets will change (they will be reduced).
Choice "d" is incorrect. The payment of cash reduces current assets. Long-term assets are increased, as well as long-term and short-term liabilities. The current ratio is reduced.
QUESTION 399

The working capital financing policy that subjects the firm to the greatest risk of being unable to meet the firm's maturing obligations is the policy that finances:
A. Fluctuatingcurrentassetswithlong-termdebt. B. Permanentcurrentassetswithlong-termdebt. C. Permanent current assets with short-term debt. D. Fluctuating current assets with short-term debt.
Correct Answer: C
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The working capital financing policy that finances permanent current assets with short-term debt subjects the firm to the greatest risk of being unable to meet the firm's maturing obligations.
Choices "a" and "b" are incorrect because the use of long-term debt financing produces the smallest risk of being unable to meet maturing obligations.
Choice "d" is incorrect because, although financing fluctuating current assets with short-term debt exposes the firm to some risk, it is not the greatest or the smallest.
QUESTION 400
When managing cash and short-term investments, a corporate treasurer is primarily concerned with:
A. Maximizingrateofreturn.
B. Minimizingtaxes.
C. Investing in common stock due to the dividend exclusion for federal income tax purposes. D. Liquidityandsafety.
Correct Answer: D
Section: Business Environment and Concepts (Volume D) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. When managing cash and short-term investments, a corporate treasurer is primarily concerned with liquidity and safety.
Choice "a" is incorrect. The board of directors and general management would be interested in maximizing rate of return on company operations.
Choices "b" and "c" are incorrect. The tax manager would be interested in minimizing taxes, and investing in common stock due to the dividend exclusion for federal income tax purposes.