Certified Public Accountant CPA Questions + Answers Part 13
Posted: Tue Feb 22, 2022 6:16 pm
QUESTION 258
A vendor offered Wyatt Co. $25,000 compensation for losses resulting from faulty raw materials. Alternately, a lawyer offered to represent Wyatt in a lawsuit against the vendor for a $12,000 retainer and 50% of any award over $35,000. Possible court awards with their associated probabilities are:
Compared to accepting the vendor's offer, the expected value for Wyatt to litigate the matter to verdict provides a:
A. $4,000loss. B. $18,200gain. C. $21,000 gain. D. $38,000 gain.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct.
Choices "b", "c", and "d" are incorrect based on the above Explanation:.
QUESTION 259
Under frost-free conditions, Cal Cultivators expects its strawberry crop to have a $60,000 market value. An unprotected crop subject to frost has an expected market value of $40,000. If Cal protects the strawberries against frost, then the market value of the crop is still expected to be $60,000 under frostfree conditions and $90,000 if there is a frost. What must be the probability of a frost for Cal to be indifferent to spending $10,000 for frost protection?
A. .167 B. .200 C. .250 D. .333
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. If there is no frost, then there is no difference between Cal's income with or without the insurance-the crop is worth $60,000 either way. However, if the insurance is purchased and a frost occurs, Cal earns $50,000 more with insurance ($90,000 - $40,000) than he would without the insurance.
The expected value of having the insurance is therefore:
Probability of frost x $50,000 + Probability of no frost x $0 Cal will be indifferent to spending $10,000 for frost protection when the expected value of the insurance equals the cost of the insurance:
Probability of frost x $50,000 = $10,000
Probability = 20%
Choices "a", "c", and "d" are incorrect based on the above Explanation:.
QUESTION 260
During 1994, Deet Corp. experienced the following power outages:
Each power outage results in out-of-pocket costs of $400. For $500 per month, Deet can lease an auxiliary generator to provide power during outages. If Deet leases an auxiliary generator in 1995, the estimated savings (or additional expenditures) for 1995 would be:
A. ($3,600) B. ($1,200) C. $1,600 D. $1,900
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct.
Choice "a" is incorrect. The estimated savings is dependent on the number of outages and on the number of months, since there are two costs involved. Choice "b" is incorrect. The estimated savings is not the difference between the out-of-pocket costs and cost of generator, times 12 months.
Choice "d" is incorrect. The cost of the generator is a monthly cost, not dependent on the number of power outages.
QUESTION 261
What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
A. Tocausethepriceofthecompany'sstocktorise.
B. T o lower the company's bond rating.
C. To reduce the risk for existing bondholders.
D. To reduce the interest rate on the bonds being sold.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Note: The material tested in this question does not appear specifically on-point in our textbook, as the topic has rarely shown up on the CPA exam. The topics are covered in general in parts of our textbook, so we believe that our students would have answered this question correctly given the information they had. However, we have expanded our Explanation: of this question to provide you with more detailed information.
Choice "d" is correct. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is to reduce the interest rate on NEW bonds being sold. A debt covenant is a provision in a bond indenture (contract between the bond issuer and the bond holders) that the bond issuer will either do (affirmative covenants) or not do (negative covenants) certain things. In this question, the issuer would agree not to issue bonds in the future over a certain percentage of its long-term debt.
Such a provision would be good for the potential bondholders and would probably reduce the interest rate on the bonds being sold.
Choice "a" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to cause the price of the company's stock to rise. Bond covenants affect bonds, not equity (at least not directly).
Choice "b" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to lower the company's bond rating. Such a covenant might raise, not lower, a company's bond rating because there would be less risk. Besides, why would a bond covenant be signed if it would lower the company's bond rating?
Choice "c" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to reduce the risk of existing bondholders, although a reduction in the risk of the existing bondholders certainly might result from such a covenant. As a general rule, more debt means more risk, less debt means less risk. So less debt would reduce the risk of all bondholders.
This answer is a very close second.
QUESTION 262
Super Sets, Inc. manufactures and sells television sets. All sales are finalized on credit with terms of 2/10, n/30. Seventy percent of Super Set customers take discounts and pay on day 10, while the remaining 30% pay on day 30. What is the average collection period in days?
A. 10 B. 16 C. 24 D. 40
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The average collection period represents the weighted average of the periods that accounts receivable are outstanding and is computed as follows:
Choice "a" is incorrect, per the above computation.
Choice "c" is incorrect. This proposed solution mismatches the percentages and the days and represents the sum of the products of 30 x 70 % and 10 x 30%. Choice "d" is incorrect. This proposed solution is purely the sum of the two customer payment patterns presented, 10 and 30.
Financial Modeling for Capital Decisions
QUESTION 263
All of the following capital budgeting analysis techniques use cash flows as the primary basis for the calculation, except for the:
A. Netpresentvalue.
B. Internalrateofreturn.
C. Discounted payback period. D. Accounting rate of return.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The accounting rate of return does not use cash flows as the primary basis for the calculation. It measures the accrual accounting return instead of cash flows:
Choice "a" is incorrect. Net present value method discounts cash flows for an investment over its life to time period zero using a desired or minimum rate of return. Choice "b" is incorrect. Internal rate of return (IRR) determines the compound interest rate of an investment where the present value of the cash inflows equals the present value of the cash outflows. The IRR is the discount rate that results in a net present value of zero. Choice "c" is incorrect. The discounted payback period is the time period required for discounted cash inflows to equal the initial investment. The time value of money is considered.
QUESTION 264
Under which one of the following conditions is the internal rate of return method less reliable than the net present value technique?
A. Whenthenetpresentvalueoftheprojectisequaltozero. B. Whenincometaxesareconsideredintheanalysis.
C. When both benefits and costs are included, but each is separately discounted to the present. D. When there are several alternating periods of net cash inflows and net cash outflows.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The internal rate of return (IRR) method is less reliable than the net present value (NPV) technique when there are several alternating periods of net cash inflows and net cash outflows or the amounts of cash flows differ significantly. The IRR is strictly a percentage measure of return, while the NPV is an absolute measure. Due to this difference, the timing or amount of cash flows under IRR can be misleading when compared to the NPV method.
Example: If an investment of $50 earns $100. Then, 100/50 = 200% return If an investment of $50,000 earns $25,000 then, 25,000/50,000 = 50% return IRR suggests it is best to invest $50 to earn $100 and a 200% return while the NPV method will indicate a larger NPV for the $50,000 investment.
Choices "a", "b", and "c" are incorrect. These conditions do not make the IRR method less reliable than the NPV method.
QUESTION 265
In order to increase production capacity, Gunning Industries is considering replacing an existing production machine with a new technologically improved machine effective January 1, 1997. The following information is being considered by Gunning Industries.
· The new machine would be purchased for $160,000 in cash. Shipping, installation, and testing would cost an additional $30,000.
· The new machine is expected to increase annual sales by 20,000 units at a sales price of $40 per unit. Incremental operating costs are comprised of $30 per unit in variable costs and total fixed costs of $40,000 per year.
· The investment in the new machine will require an immediate increase in working capital of $35,000. · Gunning uses straight-line depreciation for financial reporting and tax reporting purposes. The new machine has an estimated useful life of five years and zero salvage value. · Gunning is subject to a 40 percent corporate income tax rate.
Gunning uses the net present value method to analyze investments and will employ the following factors and rates.
The overall discounted cash flow impact of Gunning Industries' working capital investment for the new production machine would be:
A. $(7,959) B. $(10,680) C. $(13,265) D. $(35,000)
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. $(13,265) overall discounted cash flow impact of working capital investment.
QUESTION 266
The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40 percent.
What is the net cash outflow at the beginning of the first year that Moore Corporation should use in a capital budgeting analysis?
A. $(85,000) B. $(90,000) C. $(96,000) D. $(105,000)
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. $(105,000) net cash outflow at the beginning of the first year.
QUESTION 267
The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40 percent.
What is the net cash flow for the third year that Moore Corporation should use in a capital budgeting analysis?
A. $68,400 B. $64,200 C. $53,700 D. $47,400
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. $68,400 net cash flow for the third year.
Alternate Computation:
In year 3, Moore will generate a $100,000 profit from the incremental sales (2000 units × ($500 - $450)). This profit will be taxed at 40%, so the net after-tax increase in cash flow is $60,000 BEFORE the depreciation tax shield is considered. Depreciation is not a cash outflow, but it will reduce the amount of tax the company has to pay (by 40% of the depreciation), and this has an effect on the cash- flow for the company. Depreciation, as calculated above, is $21,000 per year ($105,000 cost of the machine divided by 5 years). The depreciation tax shield is $8,400 ($21,000 × 40%), so the total after- tax cash flows in year 3 for the new machine is $60,000 + $8,400 = $68,400.
QUESTION 268
For the next 2 years, a lease is estimated to have an operating net cash inflow of $7,500 per annum, before adjusting for $5,000 per annum tax basis lease amortization, and a 40% tax rate. The present value of an ordinary annuity of $1 per year at 10% for 2 years is $1.74. What is the lease's after-tax present value using a 10% discount factor?
A. $2,610 B. $4,350
C. $9,570 D. $11,310
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. Present value is based on the cash flows of an activity. Amortization is a non- cash expense that is considered only for its tax shield; therefore, the only relevant amounts are the $7,500 operating net cash inflow and the tax paid.
After-tax PV $11,310 Choice "a" is incorrect. Amortization expense of $5,000 is a non-cash expense and is not used to compute after-tax present value. It is used to determine the cash paid for taxes. Choice "b" is incorrect. Amortization is a non-cash expense. It is not considered in the calculation, expecpt to the extent it creates a tax shield. The tax shield reduces the amount of taxes paid out by the company.
Choice "c" is incorrect. Present value is based on the cash flows of an activity. Amortization is a noncash expense that is considered only for its tax shield; therefore, the only relevant amounts are the $7,500 operating net cash inflow and the tax paid.
QUESTION 269
Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are:
Using a 14% cost of capital, what is the present value of these future savings?
A. $59,600 B. $60,800 C. $62,900 D. $69,500
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The facts of the question provide annuity factors, yet the question only provides one "annuity" - the $30,000 for the first two years. Therefore, to calculate the present value of the savings for years 1 and 2, the factor for the present value of an annuity of $1 for two periods (1.65) is used. To calculate the present value of the savings for year 3, the factor for the lump sum of a present value of $1 for three periods is required; however, it is not directly provided. The factor must be calculated as the difference between the factors for the present value of an annuity of $1 for three periods (2.32) and for two periods (1.65), or .67.
Review your knowledge of how the annuity and lump sum factors work together, as follows:
QUESTION 270
An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method:
A. Computesadesiredrateofreturnforcapitalprojects.
B. Canbeusedwhenthereisnoconstantrateofreturnrequiredforeachyearoftheproject. C. Uses a discount rate that equates the discounted cash inflows with the outflows.
D. Uses discounted cash flows whereas the internal rate of return model does not.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. When using the net present value method of capital budgeting, different hurdle rates can be used for each year of the project.
Choice "a" is incorrect. The desired rate of return for capital projects is established by management. Choice "c" is incorrect. The internal rate of return determines the discount rate that will equate the discounted cash inflows with the outflows, thus resulting in no gain or loss (breakeven). Choice "d" is incorrect. Both the net present value method and the internal rate of return model are discounted cash flow methods.
QUESTION 271
In evaluating a capital budget project, the use of the net present value model is generally not affected by the:
A. Methodoffundingtheproject.
B. Initialcostoftheproject.
C. Amount of added working capital needed for operations during the term of the project. D. Amount of the project's associated depreciation tax allowance.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. The method of funding the project has no effect on the net present value model. NPV uses a hurdle rate to discount cash flows. If the NPV is positive, the project is acceptable. The method of financing the project, and the cost, are independent of the process of screening the project for acceptability. Choice "b" is incorrect. The initial cost is one of the most important items in the calculation of NPV. Choice "c" is incorrect. Added working capital requirements and salvage value affect cash flow. All cash flows are used in the NPV model.
Choice "d" is incorrect. The tax depreciation allowance will provide a "tax shield" or tax savings that impacts cash flow and must be considered in NPV analysis.
QUESTION 272
The capital budgeting model that is generally considered the best model for long-range decision making is the:
A. Payback model.
B. Accountingrateofreturnmodel. C. Unadjusted rate of return model. D. Discounted cash flow model.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The discounted cash flow model is the best for long-term decisions. Discounted cash flow methods include NPV, IRR, and profitability index. Choice "a" is incorrect. Payback and bailout payback do not consider the time value of money or the return after the initial investment is recovered. The difference between the two methods is that bailout payback takes salvage value into account in calculating cash flows. Choice "b" is incorrect. Accounting rate of return is based on accrual income rather than cash flows. It does not consider the time value of money and is considered inferior to the discounted cash flow methods. Choice "c" is incorrect. There is no unadjusted rate of return model.
QUESTION 273
Para Co. is reviewing the following data relating to an energy saving investment proposal:
What would be the annual savings needed to make the investment realize a 12% yield?
A. $8,189 B. $11,111 C. $12,306 D. $13,889
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The annual savings needed to make the investment realize a 12% yield is where the present value of the cash savings/inflows equals the present value of the net cash outflows. Use algebra to calculate the annual savings, as follows:
Choice "a" is incorrect. The annual savings needed to make the investment realize a 12% yield is where the present value of the cash savings/inflows equal the present value of the net cash outflows. Choice "b" is incorrect. Subtract the present value of $10,000 due in 5 years at 12%, or $10,000 × .57 = $5,700. Don't subtract the entire $10,000.
Choice "d" is incorrect. Subtract the present value of the $10,000 residual value from the $50,000 cost.
QUESTION 274
A project's net present value, ignoring income tax considerations, is normally affected by the:
A. Proceedsfromthesaleoftheassettobereplaced.
B. Carryingamountoftheassettobereplacedbytheproject.
C. Amount of annual depreciation on the asset to be replaced.
D. Amountofannualdepreciationonfixedassetsuseddirectlyontheproject.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. A project's net present value is a function of current and future cash flows, including proceeds from the sale of the old asset.
Choice "b" is incorrect. A project's net present value is a function of current and future cash flows. The carrying amount of the asset does not affect cash flows. Choice "c" is incorrect. A project's net present value is a function of current and future cash flows. Depreciation is a noncash item and does not affect cash flows. Choice "d" is incorrect. A project's net present value is a function of current and future cash flows. Depreciation is a noncash item and does not affect cash flows.
QUESTION 275
The profitability index is a variation on which of the following capital budgeting models?
A. Internalrateofreturn. B. Economicvalue-added. C. Net present value.
D. Discounted payback.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The profitability index is a variation on the net present value capital budgeting model.
RULE: The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability index is also referred to as the "excess present value index" or simply the "present value index." Companies hope that this ratio will be over 1.0, which means that the present value of the inflows is greater than the present value of the outflows.
Choice "a" is incorrect. The profitability index is a companion computation to net present value, not internal rate of return, which measures percentage return. Choice "b" is incorrect. The profitability index is a companion computation to net present value, not economic value added.
Choice "d" is incorrect. The profitability index is a companion computation to net present value, not the discounted payback method, which measures years to payback.
QUESTION 276
A divisional manager receives a bonus based on 20% of the residual income from the division. The results of the division include: Divisional revenues, $1,000,000; divisional expenses, $500,000; divisional assets, $2,000,000; and the required rate of return is 15%. What amount represents the manager's bonus?
A. $200,000 B. $140,000 C. $100,000 D. $40,000
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct as shown in the computation below:
Choice "a" is incorrect. The amount of the residual income itself is not the amount of the bonus. Choice "b" is incorrect. The difference between revenues (before consideration of divisional expenses) and the hurdle amount is not residual income. The bonus would be improperly calculated if residual income were to be inflated by divisional expenses as suggested by this answer. Choice "c" is incorrect. The difference between the hurdle amount and the residual income ($100,000) is not the bonus amount.
QUESTION 277
A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?
A. Lessthanthecompany'sweightedaveragecostofcapital.
B. Lessthantheproject'sinternalrateofreturn.
C. Greater than the company's weighted average cost of capital. D. Greater than the project's internal rate of return.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.
Choice "a" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). A positive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likely
equal.
Choice "c" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). A positive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likely equal.
Choice "d" is incorrect. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.
QUESTION 278
In order to increase production capacity, Gunning Industries is considering replacing an existing production machine with a new technologically improved machine effective January 1, 1997. The following information is being considered by Gunning Industries.
· The new machine would be purchased for $160,000 in cash. Shipping, installation, and testing would cost an additional $30,000.
· The new machine is expected to increase annual sales by 20,000 units at a sales price of $40 per unit. Incremental operating costs are comprised of $30 per unit in variable costs and total fixed costs of $40,000 per year.
· The investment in the new machine will require an immediate increase in working capital of $35,000. · Gunning uses straight-line depreciation for financial reporting and tax reporting purposes. The new machine has an estimated useful life of five years and zero salvage value. · Gunning is subject to a 40 percent corporate income tax rate. Gunning uses the net present value method to analyze investments and will employ the following factors and rates.
The acquisition of the new production machine by Gunning Industries will contribute a discounted net- oftax contribution margin of:
A. $242,624 B. $303,280 C. $363,936 D. $454,920
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. $454,920 discounted net-of-tax contribution margin.
Choices "a", "b", and "c" are incorrect based on the above Explanation:.
QUESTION 279
RLF Corporation had income before taxes of $60,000 for the year 1991. Included in this amount was depreciation of $5,000, a charge of $6,000 for the amortization of bond discounts, and $4,000 for interest expense. The estimated cash flow for the period is:
A. $66,000 B. $49,000 C. $71,000 D. $65,000
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Cash flow is computed from net income by adding back non-cash expenses like depreciation and amortization. Presumably, interest expense has been paid (i.e., is not "accrued" interest) and should not be added back.
Choices "a", "b", and "d" are incorrect, per above.
QUESTION 280
A depreciation tax shield is:
A. Anafter-taxcashoutflow.
B. Areductioninincometaxes.
C. The expense caused by depreciation.
D. Caused by the fact that depreciation does not affect cash flow.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Whenever depreciation protects income from taxation, it is known as a depreciation tax shield.
Choice "a" is incorrect. A depreciation tax shield may result in after-tax cash inflow, but not outflow.
Choice "c" is incorrect, per above.
Choice "d" is incorrect. A depreciation tax shield is caused by the tax deductibility of the depreciation expense, not by the fact that depreciation does not affect cash flow.
QUESTION 281
Wendy's Sandwich Shop purchased an asset for $100,000 that has no salvage value and a 10-year life. Wendy's effective income tax rate is 40 percent, and it uses the straight-line depreciation method for income tax reporting purposes. Wendy's annual depreciation tax shield from the asset would be:
A. $10,000 B. $6,000 C. $4,000 D. $2,000
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. $4,000 annual depreciation tax shield.
Choices "a", "b", and "d" are incorrect, per the above calculation.
QUESTION 282
In considering the payback period for three projects, Fly Corp. gathered the following data about cash flows:
Which of the projects will achieve payback within three years?
A. ProjectsA,B,andC. B. ProjectsBandC.
C. Project B only.
D. Projects A and C.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Projects B and C achieve payback in three years. The payback period for Project A is somewhere between the end of Year 4 and Year 5. For all three projects, Year 1 appears to be a combination of cash outflows (initial cost) and cash inflows (return of investment), but it really does not make any difference. When the cumulative cash flow (both inflow and outflow) is zero, the project has paid back.
Choice "a" is incorrect. Project A does not pay back within 3 years even though Projects B and C do. Choice "c" is incorrect. Projects B and C, not just Project B, pay back within 3 years. Choice "d" is incorrect. Project A does not pay back within 3 years even though Project C does.
QUESTION 283
Harvey Co. is evaluating a capital investment proposal for a new machine. The investment proposal shows the following information:
If acquired, the machine will be depreciated using the straight-line method. The payback period for this investment is:
A. 3.25years. B. 2.67years. C. 2.5 years. D. 2 years.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. With even cash flows, payback period is calculated as initial cost / annual net cash inflows. That is, $500,000 / $200,000 = 2.5.
Choice "a" is incorrect. We could not determine an obvious approach to obtain this answer. It is incorrect per the calculation above.
Choice "b" is incorrect. This answer is calculated as follows: (initial cost - salvage value) / (annual net cash inflows - annual depreciation) or ($500,000 - $100,000) / ($200,000 - $50,000) = $400,000 / $150,000 = 2.67. With the payback period, depreciation should only be considered to the extent that it represents a tax shield. Choice "d" is incorrect. This answer appears to be the initial cost less salvage value divided by the annual net cash inflows (($500,000 - $100,000) / $200,000 = 2.0). Salvage value is not included in the correct calculation.
QUESTION 284
Net present value as used in investment decision-making is stated in terms of which of the following options?
A. Netincome.
B. Earningsbeforeinterest,taxes,anddepreciation. C. Earnings before interest and taxes.
D. Cash flow.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. Net present value, like most capital budgeting techniques, focuses on cash flow. Cash flow is a pure measure of financial performance that isolates relevant information for decision making. The amount of cash the firm takes in and pays out for an investment affects the amount of cash the firm has available for operations and other activities. Choice "a" is incorrect. Net present value focuses on cash flows. Net income distorts financial results useful for capital budgeting decisions with non-cash items, such as depreciation, as well as with sunk costs.
Choice "b" is incorrect. Net present value focuses on cash flows. Earnings before interest, taxes, and depreciation often approximates cash flow but still distorts financial results with earnings rather than the cash flow data most useful for capital budgeting.
Choice "c" is incorrect. Net present value focuses on cash flows. Earnings before interest and taxes distort financial results with non-cash data (depreciation) as well as earnings data rather than the cash flow data most useful for capital budgeting.
QUESTION 285
A project has an initial outlay of $1,000. The projected cash inflows are:
What is the investment's payback period?
A. 4.0years. B. 3.5years. C. 3.4 years. D. 3.0 years.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The payback period is computed as the number of years required to fully recover the original investment with out respect to the time value of money. With uneven cash flows, the payback period is computed by development of a cumulative payback balance converted to years as follows:
Choice "a" is incorrect. Although the payback occurs in the fourth year, only half the year is required.
The payback period is 3.5, not 4.0 years.
Choice "c" is incorrect. Although the payback occurs in the fourth year, half the year is required. The payback period is 3.5, not 3.4 years. Choice "d" is incorrect. The payback occurs in the fourth year. The payback period is 3.5, not 3.0 years.
Strategies for Short-term and Long-term Financing
QUESTION 286
If an investor's certainty equivalent is greater than the expected value of an investment alternative, the investor is said to be:
A. Risk indifferent. B. Risk averse.
C. Risk seeking. D. Cautious.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. If an investor's certainty equivalent, the point at which they are indifferent to risk, exceeds the expected return on an investment, then the investor is actually seeking lower return for higher risk. This behavior represents risk seeking behavior. Choice "a" is incorrect. Risk indifferent behavior occurs when an investor's certainty equivalent is equal to the expected return on the investment.
Choice "b" is incorrect. Risk averse behavior occurs when an investor's certainty equivalent is less than the expected rate of return. The investor seeks higher returns for more risk. Choice "d" is incorrect. Cautious is not a technical term used in risk behavior classifications.
QUESTION 287
Investment managers develop portfolios of different investments to combine, offset, and thereby reduce overall risk. Not all risks can be eliminated by development of a portfolio. Risks that cannot be eliminated through a portfolio are called:
A. Non-marketrisks. B. Unsystematicrisks. C. Firm-specific risks. D. Systematic risks.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Rule: Portfolio theory is concerned with construction of an investment portfolio that efficiently balances its risk with its rate of return. Risk is often reduced by diversification, the process of mixing investments of different or offsetting risks. The broad categories of risk are summarized in the following mnemonic to get us DUNS.
Diversifiable
Unsystematic (non market/firm-specific) Non-diversifiable
Systematic (market)
Choice "d" is correct. Non-diversifiable risk cannot be eliminated by the application of portfolio theory. Non-diversifiable risk is also referred to as systematic risk. (DUNS) Choice "a" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed non-market risk. Choice "b" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed unsystematic risk. Choice "c" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed firm-specific risk.
QUESTION 288
Residco, Inc. expects net income of $800,000 for the next fiscal year. Its targeted and current capital structure is 40 percent debt and 60 percent common equity. The director of capital budgeting has determined that the optimal capital spending for next year is $1.2 million. Residco does not plan to issue any new common
equity next year. If Residco follows a strict residual dividend policy, what is the expected dividend payout ratio for next year?
A. 90.0percent. B. 66.7percent. C. 40.0 percent. D. 10.0 percent.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. A strict dividend policy guides a company's management to pay no more (and no less) in dividends from net income to generate a change in equity that produces or maintains a targeted capital structure. The dividend pay out ratio is the ratio of dividends to income. The call of the question requires the calculation of the ratio of dividends to income assuming income, capital projects and capital structure amounts as follows:
Assuming the company is in compliance with the 40/60 Debt/Equity capital structure to begin with, 60% of the $1,200,000 in capital projects will be financed by additions to equity the come from new earnings of $800,000. The equity funded portion of capital projects is $720,000 ($1,200,000 x 60%). Following a strict residual dividend policy, the company will pay out the difference between is additions to equity ($800,000 in income) and the amounts reinvested in the business ($720,000). The dividend will be $80,000. ($800,000 - $720,000).
The dividend payout ratio is, therefore, 10% ($80,000 in dividends/ $800,000 in income). Choices "a", "b", and "c" are incorrect, per the above calculation.
QUESTION 289
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 Capital Asset Pricing Model (CAPM) computes the expected return on a security by adding the riskfree rate of return to the incremental yield of the expected market return, which is adjusted by the company's beta. Compute DQZ's expected rate of return.
A. 9.20percent. B. 12.20percent. C. 7.20 percent. D. 10.00 percent.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. 9.20 percent expected rate of return. Choices "b", "c", and "d" are incorrect, per the above calculation.
QUESTION 290
By using the discounted cash flow model, estimate the cost of equity capital for a firm with a stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10 percent.
A. 21.1percent.
B. 12.2percent. C. 11.0 percent. D. 20.0 percent.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. 20.0 percent cost of equity capital by using the discounted cash flow model.
QUESTION 291
Which one of the following factors might cause a firm to increase the debt in its financial structure?
A. Anincreaseinthecorporateincometaxrate. B. Increasedeconomicuncertainty.
C. An increase in the price/earnings ratio.
D. A decrease in the times interest earned ratio.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. An increase in the corporate income tax rate might cause a firm to increase the debt in its financial structure because interest is tax deductible, while dividends are paid after-tax. Choice "b" is incorrect. Increased economic uncertainty would cause a firm to decrease debt (and interest cost). Choice "c" is incorrect. An increase in the price/earnings ratio would encourage the issuance of equity rather than debt.
Choice "d" is incorrect. A decrease in the times interest earned ratio indicates that earnings have declined compared with interest, and that more debt would be
unwise (and more difficult to negotiate).
QUESTION 292
If Brewer Corporation's bonds are currently yielding 8 percent in the marketplace, why would the firm's cost of debt be lower?
A. Marketinterestrateshaveincreased.
B. Additionaldebtcanbeissuedmorecheaplythattheoriginaldebt. C. Interest is deductible for tax purposes.
D. There is a mixture of old and new debt.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Because interest expense is a tax deduction, the cost to Brewer is lower than the market yield rate on debt.
Choice "a" is incorrect. If market interest rates increase, then Brewer's bonds would have to be offered at a discount to stay competitive with the market. This discount would increase (not lower) Brewer's cost of debt.
Choice "b" is incorrect. Issuance of cheaper additional debt will lower future cost of debt, but have no impact on current cost of debt.
Choice "d" is incorrect. Presumably, the 8% yield already includes new and old debt.
QUESTION 293
The theory underlying the cost of capital is primarily concerned with the cost of:
A. Long-termfundsandoldfunds.
B. Short-termfundsandnewfunds.
C. Long-term funds and new funds.
D. Any combination of old or new, short-term or long-term funds.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The cost of capital considers the cost of all funds - whether they are short-term, long-term, new or old. Choices "a", "b", and "c" are incorrect, per above.
QUESTION 294
Which one of a firm's sources of new capital usually has the lowest after tax cost?
A. Retainedearnings. B. Bonds.
C. Preferred stock. D. Common stock.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Because debt is a cheaper source of financing than equity, bonds will be the cheapest form of financing. In addition, the company issuing bonds receives a tax deduction for interest paid. This further reduces the cost of bond financing.
Choices "a", "c", and "d" are incorrect, per Explanation: above.
QUESTION 295
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%.
Assume Youngsten has an after-tax cost of debt of 9% and an after-tax cost of equity of 15%. Youngsten's weighted average cost of capital is:
A. 11.0% B. 13.0% C. 12.0% D. 11.8%
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The WACC is computed by multiplying the required returns on equity and debt by the percentage of equity and debt used to finance that particular project. Youngsten will use 33% debt ($10 million of $30 million total project cost) and 67% equity ($20 million of $30 million total project cost).
Choices "a", "c", and "d" are incorrect, per the above calculation.
QUESTION 296
Sylvan Corporation has the following capital structure:
The financial leverage of Sylvan Corp. would increase as a result of:
A. Issuingcommonstockandusingtheproceedstoretirepreferredstock. B. Issuingcommonstockandusingtheproceedstoretiredebenturebonds. C. Financing its future investments with a higher percentage of bonds.
D. Financing its future investments with a higher percentage of equity funds.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Financial leverage increases when the debt to equity ratio increases. Using a higher percentage of debt (bonds) for future investments would increase financial leverage. Choice "a" is incorrect. This results in no change in total equity and, consequently, no change in financial leverage.
Choice "b" is incorrect. This would result in increased equity and decreased debt, which would decrease financial leverage.
Choice "d" is incorrect. This would increase equity, decrease the debt to equity ratio and decrease financial leverage.
QUESTION 297
Colt Inc. is planning to use retained earnings to finance anticipated capital expenditures. The beta coefficient for Colt's stock is 1.15, the risk-free rate of interest is 8.5 percent, and the market return is estimated at 12.4%. If a new issue of common stock was used in this model, the flotation costs would be 7%. By using the Capital Asset Pricing Model equation C = R + B (M - R), the cost of using retained earnings to finance the capital expenditures is:
A. 13.96percent. B. 12.99percent. C. 14.26 percent. D. 13.21 percent.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The capital asset pricing model (CAPM) is:
QUESTION 298
Listed below is selected financial information for the Western Division of the Hinzel Company for last year.
If Hinzel treats the Western Division as an investment center for performance measurement purposes, what is the before-tax return on investment for last year?
A. 26.76percent. B. 22.54percent. C. 19.79 percent. D. 16.67 percent.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. 16.67% return on investment.
QUESTION 299
James Webb is the general manager of the Industrial Product Division, and his performance is measured using the residual income method. Webb is reviewing the following forecasted information for his division for next year.
If the imputed interest charge is 15 percent and Webb wants to achieve a residual income target of $2 million, what will costs have to be in order to achieve the target?
A. $10,800,000 B. $23,620,000 C. $25,150,000 D. $25,690,000
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. $25,150,000 costs to achieve residual income target of $2 million.
Choices "a", "b", and "d" are incorrect, per the above calculation.
QUESTION 300
The segment margin of an investment center after deducting the imputed interest on the assets used by the investment center is known as:
A. Returnoninvestment. B. Residualincome.
C. Operating income.
D. Return on assets.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Residual income is the segment margin of an investment center after deducting the imputed interest (hurdle rate) on the assets used by the investment center. Choice "a" is incorrect. Return on investment is the ratio of income earned to the investment. Choice "c" is incorrect. Operating income is not well defined, but is generally the income from operations for the entire organization, not a segment.
Choice "d" is incorrect. Return on assets is the ratio of income produced to assets employed (not the amount invested).
QUESTION 301
The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate is 14%. The corporate tax rate is 30%. What is the firm's net cost of debt?
A. 8.4% B. 9.8% C. 12.0% D. 14.0%
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%. The question is trying to trick the candidate into using the coupon rate of 12% rather than the effective interest rate. The coupon rate is used only if it is the same as the effective interest rate and there are no flotation costs.
Choice "a" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the coupon rate of 12% x .70 = 8.4%. Choice "c" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the coupon rate of 12% by itself. The cost of debt is computed on an after-tax basis and uses the effective interest rate instead of the coupon rate. Choice "d" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the effective interest rate of 14% by itself. The cost of debt is computed on an after- tax basis.
A vendor offered Wyatt Co. $25,000 compensation for losses resulting from faulty raw materials. Alternately, a lawyer offered to represent Wyatt in a lawsuit against the vendor for a $12,000 retainer and 50% of any award over $35,000. Possible court awards with their associated probabilities are:
Compared to accepting the vendor's offer, the expected value for Wyatt to litigate the matter to verdict provides a:
A. $4,000loss. B. $18,200gain. C. $21,000 gain. D. $38,000 gain.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct.
Choices "b", "c", and "d" are incorrect based on the above Explanation:.
QUESTION 259
Under frost-free conditions, Cal Cultivators expects its strawberry crop to have a $60,000 market value. An unprotected crop subject to frost has an expected market value of $40,000. If Cal protects the strawberries against frost, then the market value of the crop is still expected to be $60,000 under frostfree conditions and $90,000 if there is a frost. What must be the probability of a frost for Cal to be indifferent to spending $10,000 for frost protection?
A. .167 B. .200 C. .250 D. .333
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. If there is no frost, then there is no difference between Cal's income with or without the insurance-the crop is worth $60,000 either way. However, if the insurance is purchased and a frost occurs, Cal earns $50,000 more with insurance ($90,000 - $40,000) than he would without the insurance.
The expected value of having the insurance is therefore:
Probability of frost x $50,000 + Probability of no frost x $0 Cal will be indifferent to spending $10,000 for frost protection when the expected value of the insurance equals the cost of the insurance:
Probability of frost x $50,000 = $10,000
Probability = 20%
Choices "a", "c", and "d" are incorrect based on the above Explanation:.
QUESTION 260
During 1994, Deet Corp. experienced the following power outages:
Each power outage results in out-of-pocket costs of $400. For $500 per month, Deet can lease an auxiliary generator to provide power during outages. If Deet leases an auxiliary generator in 1995, the estimated savings (or additional expenditures) for 1995 would be:
A. ($3,600) B. ($1,200) C. $1,600 D. $1,900
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct.
Choice "a" is incorrect. The estimated savings is dependent on the number of outages and on the number of months, since there are two costs involved. Choice "b" is incorrect. The estimated savings is not the difference between the out-of-pocket costs and cost of generator, times 12 months.
Choice "d" is incorrect. The cost of the generator is a monthly cost, not dependent on the number of power outages.
QUESTION 261
What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
A. Tocausethepriceofthecompany'sstocktorise.
B. T o lower the company's bond rating.
C. To reduce the risk for existing bondholders.
D. To reduce the interest rate on the bonds being sold.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Note: The material tested in this question does not appear specifically on-point in our textbook, as the topic has rarely shown up on the CPA exam. The topics are covered in general in parts of our textbook, so we believe that our students would have answered this question correctly given the information they had. However, we have expanded our Explanation: of this question to provide you with more detailed information.
Choice "d" is correct. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is to reduce the interest rate on NEW bonds being sold. A debt covenant is a provision in a bond indenture (contract between the bond issuer and the bond holders) that the bond issuer will either do (affirmative covenants) or not do (negative covenants) certain things. In this question, the issuer would agree not to issue bonds in the future over a certain percentage of its long-term debt.
Such a provision would be good for the potential bondholders and would probably reduce the interest rate on the bonds being sold.
Choice "a" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to cause the price of the company's stock to rise. Bond covenants affect bonds, not equity (at least not directly).
Choice "b" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to lower the company's bond rating. Such a covenant might raise, not lower, a company's bond rating because there would be less risk. Besides, why would a bond covenant be signed if it would lower the company's bond rating?
Choice "c" is incorrect. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt is not to reduce the risk of existing bondholders, although a reduction in the risk of the existing bondholders certainly might result from such a covenant. As a general rule, more debt means more risk, less debt means less risk. So less debt would reduce the risk of all bondholders.
This answer is a very close second.
QUESTION 262
Super Sets, Inc. manufactures and sells television sets. All sales are finalized on credit with terms of 2/10, n/30. Seventy percent of Super Set customers take discounts and pay on day 10, while the remaining 30% pay on day 30. What is the average collection period in days?
A. 10 B. 16 C. 24 D. 40
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The average collection period represents the weighted average of the periods that accounts receivable are outstanding and is computed as follows:
Choice "a" is incorrect, per the above computation.
Choice "c" is incorrect. This proposed solution mismatches the percentages and the days and represents the sum of the products of 30 x 70 % and 10 x 30%. Choice "d" is incorrect. This proposed solution is purely the sum of the two customer payment patterns presented, 10 and 30.
Financial Modeling for Capital Decisions
QUESTION 263
All of the following capital budgeting analysis techniques use cash flows as the primary basis for the calculation, except for the:
A. Netpresentvalue.
B. Internalrateofreturn.
C. Discounted payback period. D. Accounting rate of return.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The accounting rate of return does not use cash flows as the primary basis for the calculation. It measures the accrual accounting return instead of cash flows:
Choice "a" is incorrect. Net present value method discounts cash flows for an investment over its life to time period zero using a desired or minimum rate of return. Choice "b" is incorrect. Internal rate of return (IRR) determines the compound interest rate of an investment where the present value of the cash inflows equals the present value of the cash outflows. The IRR is the discount rate that results in a net present value of zero. Choice "c" is incorrect. The discounted payback period is the time period required for discounted cash inflows to equal the initial investment. The time value of money is considered.
QUESTION 264
Under which one of the following conditions is the internal rate of return method less reliable than the net present value technique?
A. Whenthenetpresentvalueoftheprojectisequaltozero. B. Whenincometaxesareconsideredintheanalysis.
C. When both benefits and costs are included, but each is separately discounted to the present. D. When there are several alternating periods of net cash inflows and net cash outflows.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The internal rate of return (IRR) method is less reliable than the net present value (NPV) technique when there are several alternating periods of net cash inflows and net cash outflows or the amounts of cash flows differ significantly. The IRR is strictly a percentage measure of return, while the NPV is an absolute measure. Due to this difference, the timing or amount of cash flows under IRR can be misleading when compared to the NPV method.
Example: If an investment of $50 earns $100. Then, 100/50 = 200% return If an investment of $50,000 earns $25,000 then, 25,000/50,000 = 50% return IRR suggests it is best to invest $50 to earn $100 and a 200% return while the NPV method will indicate a larger NPV for the $50,000 investment.
Choices "a", "b", and "c" are incorrect. These conditions do not make the IRR method less reliable than the NPV method.
QUESTION 265
In order to increase production capacity, Gunning Industries is considering replacing an existing production machine with a new technologically improved machine effective January 1, 1997. The following information is being considered by Gunning Industries.
· The new machine would be purchased for $160,000 in cash. Shipping, installation, and testing would cost an additional $30,000.
· The new machine is expected to increase annual sales by 20,000 units at a sales price of $40 per unit. Incremental operating costs are comprised of $30 per unit in variable costs and total fixed costs of $40,000 per year.
· The investment in the new machine will require an immediate increase in working capital of $35,000. · Gunning uses straight-line depreciation for financial reporting and tax reporting purposes. The new machine has an estimated useful life of five years and zero salvage value. · Gunning is subject to a 40 percent corporate income tax rate.
Gunning uses the net present value method to analyze investments and will employ the following factors and rates.
The overall discounted cash flow impact of Gunning Industries' working capital investment for the new production machine would be:
A. $(7,959) B. $(10,680) C. $(13,265) D. $(35,000)
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. $(13,265) overall discounted cash flow impact of working capital investment.
QUESTION 266
The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40 percent.
What is the net cash outflow at the beginning of the first year that Moore Corporation should use in a capital budgeting analysis?
A. $(85,000) B. $(90,000) C. $(96,000) D. $(105,000)
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. $(105,000) net cash outflow at the beginning of the first year.
QUESTION 267
The Moore Corporation is considering the acquisition of a new machine. The machine can be purchased for $90,000; it will cost $6,000 to transport to Moore's plant and $9,000 to install. It is estimated that the machine will last 10 years, and it is expected to have an estimated salvage value of $5,000. Over its 10-year life, the machine is expected to produce 2,000 units per year with a selling price of $500 and combined material and labor costs of $450 per unit. Federal tax regulations permit machines of this type to be depreciated using the straight-line method over 5 years with no estimated salvage value. Moore has a marginal tax rate of 40 percent.
What is the net cash flow for the third year that Moore Corporation should use in a capital budgeting analysis?
A. $68,400 B. $64,200 C. $53,700 D. $47,400
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. $68,400 net cash flow for the third year.
Alternate Computation:
In year 3, Moore will generate a $100,000 profit from the incremental sales (2000 units × ($500 - $450)). This profit will be taxed at 40%, so the net after-tax increase in cash flow is $60,000 BEFORE the depreciation tax shield is considered. Depreciation is not a cash outflow, but it will reduce the amount of tax the company has to pay (by 40% of the depreciation), and this has an effect on the cash- flow for the company. Depreciation, as calculated above, is $21,000 per year ($105,000 cost of the machine divided by 5 years). The depreciation tax shield is $8,400 ($21,000 × 40%), so the total after- tax cash flows in year 3 for the new machine is $60,000 + $8,400 = $68,400.
QUESTION 268
For the next 2 years, a lease is estimated to have an operating net cash inflow of $7,500 per annum, before adjusting for $5,000 per annum tax basis lease amortization, and a 40% tax rate. The present value of an ordinary annuity of $1 per year at 10% for 2 years is $1.74. What is the lease's after-tax present value using a 10% discount factor?
A. $2,610 B. $4,350
C. $9,570 D. $11,310
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. Present value is based on the cash flows of an activity. Amortization is a non- cash expense that is considered only for its tax shield; therefore, the only relevant amounts are the $7,500 operating net cash inflow and the tax paid.
After-tax PV $11,310 Choice "a" is incorrect. Amortization expense of $5,000 is a non-cash expense and is not used to compute after-tax present value. It is used to determine the cash paid for taxes. Choice "b" is incorrect. Amortization is a non-cash expense. It is not considered in the calculation, expecpt to the extent it creates a tax shield. The tax shield reduces the amount of taxes paid out by the company.
Choice "c" is incorrect. Present value is based on the cash flows of an activity. Amortization is a noncash expense that is considered only for its tax shield; therefore, the only relevant amounts are the $7,500 operating net cash inflow and the tax paid.
QUESTION 269
Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are:
Using a 14% cost of capital, what is the present value of these future savings?
A. $59,600 B. $60,800 C. $62,900 D. $69,500
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The facts of the question provide annuity factors, yet the question only provides one "annuity" - the $30,000 for the first two years. Therefore, to calculate the present value of the savings for years 1 and 2, the factor for the present value of an annuity of $1 for two periods (1.65) is used. To calculate the present value of the savings for year 3, the factor for the lump sum of a present value of $1 for three periods is required; however, it is not directly provided. The factor must be calculated as the difference between the factors for the present value of an annuity of $1 for three periods (2.32) and for two periods (1.65), or .67.
Review your knowledge of how the annuity and lump sum factors work together, as follows:
QUESTION 270
An advantage of the net present value method over the internal rate of return model in discounted cash flow analysis is that the net present value method:
A. Computesadesiredrateofreturnforcapitalprojects.
B. Canbeusedwhenthereisnoconstantrateofreturnrequiredforeachyearoftheproject. C. Uses a discount rate that equates the discounted cash inflows with the outflows.
D. Uses discounted cash flows whereas the internal rate of return model does not.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. When using the net present value method of capital budgeting, different hurdle rates can be used for each year of the project.
Choice "a" is incorrect. The desired rate of return for capital projects is established by management. Choice "c" is incorrect. The internal rate of return determines the discount rate that will equate the discounted cash inflows with the outflows, thus resulting in no gain or loss (breakeven). Choice "d" is incorrect. Both the net present value method and the internal rate of return model are discounted cash flow methods.
QUESTION 271
In evaluating a capital budget project, the use of the net present value model is generally not affected by the:
A. Methodoffundingtheproject.
B. Initialcostoftheproject.
C. Amount of added working capital needed for operations during the term of the project. D. Amount of the project's associated depreciation tax allowance.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. The method of funding the project has no effect on the net present value model. NPV uses a hurdle rate to discount cash flows. If the NPV is positive, the project is acceptable. The method of financing the project, and the cost, are independent of the process of screening the project for acceptability. Choice "b" is incorrect. The initial cost is one of the most important items in the calculation of NPV. Choice "c" is incorrect. Added working capital requirements and salvage value affect cash flow. All cash flows are used in the NPV model.
Choice "d" is incorrect. The tax depreciation allowance will provide a "tax shield" or tax savings that impacts cash flow and must be considered in NPV analysis.
QUESTION 272
The capital budgeting model that is generally considered the best model for long-range decision making is the:
A. Payback model.
B. Accountingrateofreturnmodel. C. Unadjusted rate of return model. D. Discounted cash flow model.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The discounted cash flow model is the best for long-term decisions. Discounted cash flow methods include NPV, IRR, and profitability index. Choice "a" is incorrect. Payback and bailout payback do not consider the time value of money or the return after the initial investment is recovered. The difference between the two methods is that bailout payback takes salvage value into account in calculating cash flows. Choice "b" is incorrect. Accounting rate of return is based on accrual income rather than cash flows. It does not consider the time value of money and is considered inferior to the discounted cash flow methods. Choice "c" is incorrect. There is no unadjusted rate of return model.
QUESTION 273
Para Co. is reviewing the following data relating to an energy saving investment proposal:
What would be the annual savings needed to make the investment realize a 12% yield?
A. $8,189 B. $11,111 C. $12,306 D. $13,889
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The annual savings needed to make the investment realize a 12% yield is where the present value of the cash savings/inflows equals the present value of the net cash outflows. Use algebra to calculate the annual savings, as follows:
Choice "a" is incorrect. The annual savings needed to make the investment realize a 12% yield is where the present value of the cash savings/inflows equal the present value of the net cash outflows. Choice "b" is incorrect. Subtract the present value of $10,000 due in 5 years at 12%, or $10,000 × .57 = $5,700. Don't subtract the entire $10,000.
Choice "d" is incorrect. Subtract the present value of the $10,000 residual value from the $50,000 cost.
QUESTION 274
A project's net present value, ignoring income tax considerations, is normally affected by the:
A. Proceedsfromthesaleoftheassettobereplaced.
B. Carryingamountoftheassettobereplacedbytheproject.
C. Amount of annual depreciation on the asset to be replaced.
D. Amountofannualdepreciationonfixedassetsuseddirectlyontheproject.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. A project's net present value is a function of current and future cash flows, including proceeds from the sale of the old asset.
Choice "b" is incorrect. A project's net present value is a function of current and future cash flows. The carrying amount of the asset does not affect cash flows. Choice "c" is incorrect. A project's net present value is a function of current and future cash flows. Depreciation is a noncash item and does not affect cash flows. Choice "d" is incorrect. A project's net present value is a function of current and future cash flows. Depreciation is a noncash item and does not affect cash flows.
QUESTION 275
The profitability index is a variation on which of the following capital budgeting models?
A. Internalrateofreturn. B. Economicvalue-added. C. Net present value.
D. Discounted payback.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. The profitability index is a variation on the net present value capital budgeting model.
RULE: The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment. The profitability index is also referred to as the "excess present value index" or simply the "present value index." Companies hope that this ratio will be over 1.0, which means that the present value of the inflows is greater than the present value of the outflows.
Choice "a" is incorrect. The profitability index is a companion computation to net present value, not internal rate of return, which measures percentage return. Choice "b" is incorrect. The profitability index is a companion computation to net present value, not economic value added.
Choice "d" is incorrect. The profitability index is a companion computation to net present value, not the discounted payback method, which measures years to payback.
QUESTION 276
A divisional manager receives a bonus based on 20% of the residual income from the division. The results of the division include: Divisional revenues, $1,000,000; divisional expenses, $500,000; divisional assets, $2,000,000; and the required rate of return is 15%. What amount represents the manager's bonus?
A. $200,000 B. $140,000 C. $100,000 D. $40,000
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct as shown in the computation below:
Choice "a" is incorrect. The amount of the residual income itself is not the amount of the bonus. Choice "b" is incorrect. The difference between revenues (before consideration of divisional expenses) and the hurdle amount is not residual income. The bonus would be improperly calculated if residual income were to be inflated by divisional expenses as suggested by this answer. Choice "c" is incorrect. The difference between the hurdle amount and the residual income ($100,000) is not the bonus amount.
QUESTION 277
A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?
A. Lessthanthecompany'sweightedaveragecostofcapital.
B. Lessthantheproject'sinternalrateofreturn.
C. Greater than the company's weighted average cost of capital. D. Greater than the project's internal rate of return.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.
Choice "a" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). A positive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likely
equal.
Choice "c" is incorrect. Typically, a company will use its own weighted-average cost of capital (WACC) as the hurdle rate for computing net present value (NPV). A positive NPV would not likely give any indication of the relationship between required rate of return and WACC. The required rate of return and WACC are likely equal.
Choice "d" is incorrect. The required rate of return must be less than the project's internal rate of return (IRR). The IRR is the rate earned by an investment that equates to a net present value (NPV) of zero. By definition, a project with a positive NPV will have an IRR greater than the required rate of return used to compute that NPV.
QUESTION 278
In order to increase production capacity, Gunning Industries is considering replacing an existing production machine with a new technologically improved machine effective January 1, 1997. The following information is being considered by Gunning Industries.
· The new machine would be purchased for $160,000 in cash. Shipping, installation, and testing would cost an additional $30,000.
· The new machine is expected to increase annual sales by 20,000 units at a sales price of $40 per unit. Incremental operating costs are comprised of $30 per unit in variable costs and total fixed costs of $40,000 per year.
· The investment in the new machine will require an immediate increase in working capital of $35,000. · Gunning uses straight-line depreciation for financial reporting and tax reporting purposes. The new machine has an estimated useful life of five years and zero salvage value. · Gunning is subject to a 40 percent corporate income tax rate. Gunning uses the net present value method to analyze investments and will employ the following factors and rates.
The acquisition of the new production machine by Gunning Industries will contribute a discounted net- oftax contribution margin of:
A. $242,624 B. $303,280 C. $363,936 D. $454,920
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. $454,920 discounted net-of-tax contribution margin.
Choices "a", "b", and "c" are incorrect based on the above Explanation:.
QUESTION 279
RLF Corporation had income before taxes of $60,000 for the year 1991. Included in this amount was depreciation of $5,000, a charge of $6,000 for the amortization of bond discounts, and $4,000 for interest expense. The estimated cash flow for the period is:
A. $66,000 B. $49,000 C. $71,000 D. $65,000
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Cash flow is computed from net income by adding back non-cash expenses like depreciation and amortization. Presumably, interest expense has been paid (i.e., is not "accrued" interest) and should not be added back.
Choices "a", "b", and "d" are incorrect, per above.
QUESTION 280
A depreciation tax shield is:
A. Anafter-taxcashoutflow.
B. Areductioninincometaxes.
C. The expense caused by depreciation.
D. Caused by the fact that depreciation does not affect cash flow.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Whenever depreciation protects income from taxation, it is known as a depreciation tax shield.
Choice "a" is incorrect. A depreciation tax shield may result in after-tax cash inflow, but not outflow.
Choice "c" is incorrect, per above.
Choice "d" is incorrect. A depreciation tax shield is caused by the tax deductibility of the depreciation expense, not by the fact that depreciation does not affect cash flow.
QUESTION 281
Wendy's Sandwich Shop purchased an asset for $100,000 that has no salvage value and a 10-year life. Wendy's effective income tax rate is 40 percent, and it uses the straight-line depreciation method for income tax reporting purposes. Wendy's annual depreciation tax shield from the asset would be:
A. $10,000 B. $6,000 C. $4,000 D. $2,000
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. $4,000 annual depreciation tax shield.
Choices "a", "b", and "d" are incorrect, per the above calculation.
QUESTION 282
In considering the payback period for three projects, Fly Corp. gathered the following data about cash flows:
Which of the projects will achieve payback within three years?
A. ProjectsA,B,andC. B. ProjectsBandC.
C. Project B only.
D. Projects A and C.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Projects B and C achieve payback in three years. The payback period for Project A is somewhere between the end of Year 4 and Year 5. For all three projects, Year 1 appears to be a combination of cash outflows (initial cost) and cash inflows (return of investment), but it really does not make any difference. When the cumulative cash flow (both inflow and outflow) is zero, the project has paid back.
Choice "a" is incorrect. Project A does not pay back within 3 years even though Projects B and C do. Choice "c" is incorrect. Projects B and C, not just Project B, pay back within 3 years. Choice "d" is incorrect. Project A does not pay back within 3 years even though Project C does.
QUESTION 283
Harvey Co. is evaluating a capital investment proposal for a new machine. The investment proposal shows the following information:
If acquired, the machine will be depreciated using the straight-line method. The payback period for this investment is:
A. 3.25years. B. 2.67years. C. 2.5 years. D. 2 years.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. With even cash flows, payback period is calculated as initial cost / annual net cash inflows. That is, $500,000 / $200,000 = 2.5.
Choice "a" is incorrect. We could not determine an obvious approach to obtain this answer. It is incorrect per the calculation above.
Choice "b" is incorrect. This answer is calculated as follows: (initial cost - salvage value) / (annual net cash inflows - annual depreciation) or ($500,000 - $100,000) / ($200,000 - $50,000) = $400,000 / $150,000 = 2.67. With the payback period, depreciation should only be considered to the extent that it represents a tax shield. Choice "d" is incorrect. This answer appears to be the initial cost less salvage value divided by the annual net cash inflows (($500,000 - $100,000) / $200,000 = 2.0). Salvage value is not included in the correct calculation.
QUESTION 284
Net present value as used in investment decision-making is stated in terms of which of the following options?
A. Netincome.
B. Earningsbeforeinterest,taxes,anddepreciation. C. Earnings before interest and taxes.
D. Cash flow.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. Net present value, like most capital budgeting techniques, focuses on cash flow. Cash flow is a pure measure of financial performance that isolates relevant information for decision making. The amount of cash the firm takes in and pays out for an investment affects the amount of cash the firm has available for operations and other activities. Choice "a" is incorrect. Net present value focuses on cash flows. Net income distorts financial results useful for capital budgeting decisions with non-cash items, such as depreciation, as well as with sunk costs.
Choice "b" is incorrect. Net present value focuses on cash flows. Earnings before interest, taxes, and depreciation often approximates cash flow but still distorts financial results with earnings rather than the cash flow data most useful for capital budgeting.
Choice "c" is incorrect. Net present value focuses on cash flows. Earnings before interest and taxes distort financial results with non-cash data (depreciation) as well as earnings data rather than the cash flow data most useful for capital budgeting.
QUESTION 285
A project has an initial outlay of $1,000. The projected cash inflows are:
What is the investment's payback period?
A. 4.0years. B. 3.5years. C. 3.4 years. D. 3.0 years.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The payback period is computed as the number of years required to fully recover the original investment with out respect to the time value of money. With uneven cash flows, the payback period is computed by development of a cumulative payback balance converted to years as follows:
Choice "a" is incorrect. Although the payback occurs in the fourth year, only half the year is required.
The payback period is 3.5, not 4.0 years.
Choice "c" is incorrect. Although the payback occurs in the fourth year, half the year is required. The payback period is 3.5, not 3.4 years. Choice "d" is incorrect. The payback occurs in the fourth year. The payback period is 3.5, not 3.0 years.
Strategies for Short-term and Long-term Financing
QUESTION 286
If an investor's certainty equivalent is greater than the expected value of an investment alternative, the investor is said to be:
A. Risk indifferent. B. Risk averse.
C. Risk seeking. D. Cautious.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. If an investor's certainty equivalent, the point at which they are indifferent to risk, exceeds the expected return on an investment, then the investor is actually seeking lower return for higher risk. This behavior represents risk seeking behavior. Choice "a" is incorrect. Risk indifferent behavior occurs when an investor's certainty equivalent is equal to the expected return on the investment.
Choice "b" is incorrect. Risk averse behavior occurs when an investor's certainty equivalent is less than the expected rate of return. The investor seeks higher returns for more risk. Choice "d" is incorrect. Cautious is not a technical term used in risk behavior classifications.
QUESTION 287
Investment managers develop portfolios of different investments to combine, offset, and thereby reduce overall risk. Not all risks can be eliminated by development of a portfolio. Risks that cannot be eliminated through a portfolio are called:
A. Non-marketrisks. B. Unsystematicrisks. C. Firm-specific risks. D. Systematic risks.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Rule: Portfolio theory is concerned with construction of an investment portfolio that efficiently balances its risk with its rate of return. Risk is often reduced by diversification, the process of mixing investments of different or offsetting risks. The broad categories of risk are summarized in the following mnemonic to get us DUNS.
Diversifiable
Unsystematic (non market/firm-specific) Non-diversifiable
Systematic (market)
Choice "d" is correct. Non-diversifiable risk cannot be eliminated by the application of portfolio theory. Non-diversifiable risk is also referred to as systematic risk. (DUNS) Choice "a" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed non-market risk. Choice "b" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed unsystematic risk. Choice "c" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed firm-specific risk.
QUESTION 288
Residco, Inc. expects net income of $800,000 for the next fiscal year. Its targeted and current capital structure is 40 percent debt and 60 percent common equity. The director of capital budgeting has determined that the optimal capital spending for next year is $1.2 million. Residco does not plan to issue any new common
equity next year. If Residco follows a strict residual dividend policy, what is the expected dividend payout ratio for next year?
A. 90.0percent. B. 66.7percent. C. 40.0 percent. D. 10.0 percent.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. A strict dividend policy guides a company's management to pay no more (and no less) in dividends from net income to generate a change in equity that produces or maintains a targeted capital structure. The dividend pay out ratio is the ratio of dividends to income. The call of the question requires the calculation of the ratio of dividends to income assuming income, capital projects and capital structure amounts as follows:
Assuming the company is in compliance with the 40/60 Debt/Equity capital structure to begin with, 60% of the $1,200,000 in capital projects will be financed by additions to equity the come from new earnings of $800,000. The equity funded portion of capital projects is $720,000 ($1,200,000 x 60%). Following a strict residual dividend policy, the company will pay out the difference between is additions to equity ($800,000 in income) and the amounts reinvested in the business ($720,000). The dividend will be $80,000. ($800,000 - $720,000).
The dividend payout ratio is, therefore, 10% ($80,000 in dividends/ $800,000 in income). Choices "a", "b", and "c" are incorrect, per the above calculation.
QUESTION 289
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 Capital Asset Pricing Model (CAPM) computes the expected return on a security by adding the riskfree rate of return to the incremental yield of the expected market return, which is adjusted by the company's beta. Compute DQZ's expected rate of return.
A. 9.20percent. B. 12.20percent. C. 7.20 percent. D. 10.00 percent.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. 9.20 percent expected rate of return. Choices "b", "c", and "d" are incorrect, per the above calculation.
QUESTION 290
By using the discounted cash flow model, estimate the cost of equity capital for a firm with a stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10 percent.
A. 21.1percent.
B. 12.2percent. C. 11.0 percent. D. 20.0 percent.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. 20.0 percent cost of equity capital by using the discounted cash flow model.
QUESTION 291
Which one of the following factors might cause a firm to increase the debt in its financial structure?
A. Anincreaseinthecorporateincometaxrate. B. Increasedeconomicuncertainty.
C. An increase in the price/earnings ratio.
D. A decrease in the times interest earned ratio.
Correct Answer: A
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "a" is correct. An increase in the corporate income tax rate might cause a firm to increase the debt in its financial structure because interest is tax deductible, while dividends are paid after-tax. Choice "b" is incorrect. Increased economic uncertainty would cause a firm to decrease debt (and interest cost). Choice "c" is incorrect. An increase in the price/earnings ratio would encourage the issuance of equity rather than debt.
Choice "d" is incorrect. A decrease in the times interest earned ratio indicates that earnings have declined compared with interest, and that more debt would be
unwise (and more difficult to negotiate).
QUESTION 292
If Brewer Corporation's bonds are currently yielding 8 percent in the marketplace, why would the firm's cost of debt be lower?
A. Marketinterestrateshaveincreased.
B. Additionaldebtcanbeissuedmorecheaplythattheoriginaldebt. C. Interest is deductible for tax purposes.
D. There is a mixture of old and new debt.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Because interest expense is a tax deduction, the cost to Brewer is lower than the market yield rate on debt.
Choice "a" is incorrect. If market interest rates increase, then Brewer's bonds would have to be offered at a discount to stay competitive with the market. This discount would increase (not lower) Brewer's cost of debt.
Choice "b" is incorrect. Issuance of cheaper additional debt will lower future cost of debt, but have no impact on current cost of debt.
Choice "d" is incorrect. Presumably, the 8% yield already includes new and old debt.
QUESTION 293
The theory underlying the cost of capital is primarily concerned with the cost of:
A. Long-termfundsandoldfunds.
B. Short-termfundsandnewfunds.
C. Long-term funds and new funds.
D. Any combination of old or new, short-term or long-term funds.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. The cost of capital considers the cost of all funds - whether they are short-term, long-term, new or old. Choices "a", "b", and "c" are incorrect, per above.
QUESTION 294
Which one of a firm's sources of new capital usually has the lowest after tax cost?
A. Retainedearnings. B. Bonds.
C. Preferred stock. D. Common stock.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Because debt is a cheaper source of financing than equity, bonds will be the cheapest form of financing. In addition, the company issuing bonds receives a tax deduction for interest paid. This further reduces the cost of bond financing.
Choices "a", "c", and "d" are incorrect, per Explanation: above.
QUESTION 295
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%.
Assume Youngsten has an after-tax cost of debt of 9% and an after-tax cost of equity of 15%. Youngsten's weighted average cost of capital is:
A. 11.0% B. 13.0% C. 12.0% D. 11.8%
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The WACC is computed by multiplying the required returns on equity and debt by the percentage of equity and debt used to finance that particular project. Youngsten will use 33% debt ($10 million of $30 million total project cost) and 67% equity ($20 million of $30 million total project cost).
Choices "a", "c", and "d" are incorrect, per the above calculation.
QUESTION 296
Sylvan Corporation has the following capital structure:
The financial leverage of Sylvan Corp. would increase as a result of:
A. Issuingcommonstockandusingtheproceedstoretirepreferredstock. B. Issuingcommonstockandusingtheproceedstoretiredebenturebonds. C. Financing its future investments with a higher percentage of bonds.
D. Financing its future investments with a higher percentage of equity funds.
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. Financial leverage increases when the debt to equity ratio increases. Using a higher percentage of debt (bonds) for future investments would increase financial leverage. Choice "a" is incorrect. This results in no change in total equity and, consequently, no change in financial leverage.
Choice "b" is incorrect. This would result in increased equity and decreased debt, which would decrease financial leverage.
Choice "d" is incorrect. This would increase equity, decrease the debt to equity ratio and decrease financial leverage.
QUESTION 297
Colt Inc. is planning to use retained earnings to finance anticipated capital expenditures. The beta coefficient for Colt's stock is 1.15, the risk-free rate of interest is 8.5 percent, and the market return is estimated at 12.4%. If a new issue of common stock was used in this model, the flotation costs would be 7%. By using the Capital Asset Pricing Model equation C = R + B (M - R), the cost of using retained earnings to finance the capital expenditures is:
A. 13.96percent. B. 12.99percent. C. 14.26 percent. D. 13.21 percent.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The capital asset pricing model (CAPM) is:
QUESTION 298
Listed below is selected financial information for the Western Division of the Hinzel Company for last year.
If Hinzel treats the Western Division as an investment center for performance measurement purposes, what is the before-tax return on investment for last year?
A. 26.76percent. B. 22.54percent. C. 19.79 percent. D. 16.67 percent.
Correct Answer: D
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "d" is correct. 16.67% return on investment.
QUESTION 299
James Webb is the general manager of the Industrial Product Division, and his performance is measured using the residual income method. Webb is reviewing the following forecasted information for his division for next year.
If the imputed interest charge is 15 percent and Webb wants to achieve a residual income target of $2 million, what will costs have to be in order to achieve the target?
A. $10,800,000 B. $23,620,000 C. $25,150,000 D. $25,690,000
Correct Answer: C
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "c" is correct. $25,150,000 costs to achieve residual income target of $2 million.
Choices "a", "b", and "d" are incorrect, per the above calculation.
QUESTION 300
The segment margin of an investment center after deducting the imputed interest on the assets used by the investment center is known as:
A. Returnoninvestment. B. Residualincome.
C. Operating income.
D. Return on assets.
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. Residual income is the segment margin of an investment center after deducting the imputed interest (hurdle rate) on the assets used by the investment center. Choice "a" is incorrect. Return on investment is the ratio of income earned to the investment. Choice "c" is incorrect. Operating income is not well defined, but is generally the income from operations for the entire organization, not a segment.
Choice "d" is incorrect. Return on assets is the ratio of income produced to assets employed (not the amount invested).
QUESTION 301
The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate is 14%. The corporate tax rate is 30%. What is the firm's net cost of debt?
A. 8.4% B. 9.8% C. 12.0% D. 14.0%
Correct Answer: B
Section: Business Environment and Concepts (Volume C) Explanation
Explanation/Reference:
Explanation:
Choice "b" is correct. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%. The question is trying to trick the candidate into using the coupon rate of 12% rather than the effective interest rate. The coupon rate is used only if it is the same as the effective interest rate and there are no flotation costs.
Choice "a" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the coupon rate of 12% x .70 = 8.4%. Choice "c" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the coupon rate of 12% by itself. The cost of debt is computed on an after-tax basis and uses the effective interest rate instead of the coupon rate. Choice "d" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the effective interest rate of 14% by itself. The cost of debt is computed on an after- tax basis.