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k09 404 Multiple Choice (90’)

Identify the letter of the choice that best completes the statement or answers the question.

____ 1. Last year Aldrin Co. had negative net cash flow, yet its cash on the balance sheet increased. What could
explain these events?
a. Aldrin issued long-term debt.
b. Aldrin repurchased some of its common stock.
c. Aldrin sold some of its assets.
d. Statements a and b are correct.
e. Statements a and c are correct.

____ 2. Holmes Aircraft recently announced an increase in its net income, yet its net cash flow declined relative to last
year. Which of the following could explain this performance?
a. The company's interest expense increased.
b. The company's depreciation expense declined.
c. The company's operating income declined.
d. All of the statements above are correct.
e. None of the statements above is correct.

____ 3. Kramer Corporation recently announced that its net income was lower than last year. However, analysts
estimate that the company's net cash flow increased. What factors could explain this discrepancy?
a. The company's depreciation expense increased.
b. The company's interest expense declined.
c. The company had an increase in its noncash revenues.
d. Answers a and b are correct.
e. Answers b and c are correct.

Page 1 of 20 1
____ 4. Which of the following statements is most correct? không có interest
a. Corporations are allowed to exclude 70 percent of their interest income from corporate taxes.
b. Corporations are allowed to exclude 70 percent of their dividend income from corporate taxes.
c. Individuals pay taxes on only 30 percent of the income realized from municipal bonds.
d. Answers a and b are correct.
e. None of the answers above is correct.

____ 5. Which of the following would not cause an increase in net operating working capital?
a. Inventory increases.
b. Accounts receivable increases.
c. Short-term investments increase.
d. Accounts payables decrease.
e. Accruals decrease.

____ 6. Which of the following best describes free cash flow?

a. Free cash flow is the amount of cash flow available for distribution to all investors after all necessary
investments in operating capital have been made.
b. Free cash flow is the amount of cash flow available for distribution to shareholders after all necessary
investments in operating capital have been made.
c. Free cash flow is the net change in the cash account on the balance sheet.
d. Free cash flow is equal to net income plus depreciation.
e. Free cash flow is equal to the cash flow from non-taxable transactions.

____ 7. The CFO of Mulroney Brothers has suggested that the company should issue $300 million worth of common
stock and use the proceeds to reduce some of the company's outstanding debt. Assume that the company
adopts this policy, and that total assets and operating income (EBIT) remain the same. The company's tax
rate will also remain the same. Which of the following will occur:
a. The company's net income will increase.
b. The company's taxable income will fall.
c. The company will pay less in taxes.
d. All of the answers above are correct.
e. Answers b and c are correct.

____ 8. Your corporation has the following cash flows:

Operating income $250,000
Interest received 10,000
Interest paid 45,000
Dividends received 20,000 divident recieved bằng 20k*0.3=6000
Dividends paid 50,000
If the applicable income tax rate is 40 percent (federal and state combined), and if 70 percent of dividends
received are exempt from taxes, what is the corporation's tax liability?
a. $74,000
b. $88,400
c. $91,600
d. $100,000
e. $106,500

____ 9. A company has the following balance sheet. What is its net operating working capital?
Cash $ 10 Accounts payable $ 30
Short-term investments 30 Accruals 10
Accounts receivable 50 Notes payable 50
Inventory 40 Current liabilities 90
Current assets 130 Long-term debt 60
Net fixed assets 100 Common equity 30
Retained earnings 50
Total assets $230 Total liab. & equity $230

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 a. $40
b. $60
c. $100
d. $130
e. $230

____ 10. Spencer Inc. has the following information for the current year: Net income = $600; Net operating profit after
taxes (NOPAT) = $500; Total assets = $4,000; Short-term investments = $500; Stockholders equity = $2,000;
Debt = $1,000; and Total net operating capital = $2500. If Spencer's cost of capital is 10%, what is its
Economic value added (EVA)?
a. $250
b. $300 ebit*(1-t) - total invest capital nhân aftter tã percentage
c. $350
d. $375
e. $400

____ 11. A firm has notes payable of $1,546,000, long-term debt of $13,000,000, and total interest expense of
$1,300,000. If the firm pays 8 percent interest on its long-term debt, what rate of interest does it pay on its
notes payable?
a. 8.2%
b. 13.1%
c. 16.8%
d. 18.0%
e. 15.3%

____ 12. Garfield Industries is expanding its operations throughout the Southeast United States. Garfield anticipates
that the expansion will increase sales by $1,000,000, and increase the costs of goods sold by $700,000.
Depreciation expenses will rise by $50,000 and interest expense will increase by $150,000. The company's
tax rate will remain at 40 percent. If the company's forecast is correct, how much will net income increase or
decrease, as a result of the expansion?
a. No change.
b. $40,000 increase.
c. $60,000 increase.
d. $100,000 increase.
e. $180,000 increase.

____ 13. New Hampshire Services reported $2.3 million of retained earnings on its balance sheet last year. This year,
the company lost money--its net income was -$500,000 (negative $500,000). Despite the loss, the company
still paid a $1.00 per share dividend this year. The company's earnings per share for this year were -$2.50
(negative $2.50). What was the level of retained earnings on the company's balance sheet this year?
a. $1.2 million
b. $1.6 million
c. $1.8 million
d. $2.6 million
e. $2.8 million

____ 14. A company has the following balance sheet. What is its net operating working capital?
Cash $ 10 Accounts payable $ 20
Short-term investments 20 Accruals 30
Accounts receivable 30 Notes payable 20
Inventory 40 Current liabilities 70
Current assets 100 Long-term debt 30
Net fixed assets 80 Common equity 10
Retained earnings 70
Total assets $180 Total liab. & equity $180

a. $10
Page 3 of 20 3
 b. $20
c. $30
d. $40
e. $50

____ 15. A company has the following income statement. What is its net operating profit after taxes (NOPAT)?
Sales $1,000 ebit nhân 1 trù T
Costs 700
Depreciation 100
EBIT $ 200
Interest expense 50
EBT $ 150
Taxes (40%) 60
Net income $ 90
a. $90
b. $120
c. $150
d. $180
e. $200

____ 16. Bates Motors has the following information for the previous year: Net income = $200; Net operating profit
after taxes (NOPAT) = $300; Total assets = $1,000; and Total net operating capital = $800. The information
for the current year is: Net income = $500; Net operating profit after taxes (NOPAT) = $400; Total assets =
$1,300; and Total net operating capital = $900. What is the free cash flow for the current year?
a. $100
b. $200
c. $300
d. $400
e. $500
____ 17. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external
equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of
investors, and other factors.
a. True
b. False

____ 18. Which of the following statements is most correct?

a. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock for
the tax exclusion of 70 percent of dividend income.
b. We ideally would like to use historical measures of the component costs from prior financings in
estimating the appropriate weighted average cost of capital.
c. The cost of common stock (rs) will increase if the market risk premium and risk-free rate decline by
a substantial amount.
d. Statements b and c are correct.
e. None of the statements above is correct.

____ 19. Which of the following statements is most correct?

a. Although some methods of estimating the cost of equity capital encounter severe difficulties, the CAPM
is a simple and reliable model that provides great accuracy and consistency in estimating the cost of
equity capital.
b. The DCF model is preferred over other models to estimate the cost of equity because of the ease with
which a firm's growth rate is obtained.
c. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but
its advantages are that it is a standardized and objective model.
d. Depreciation-generated funds are an additional source of capital and, in fact, represent the largest
single source of funds for some firms.
e. None of the statements above is correct.
____ 20. In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to
dispute or controversy?
Page 4 of 20 4
 a. The expected rate of return on the market, rM.
b. The stock's beta coefficient, bi.
c. The risk-free rate, rRF.
d. The market risk premium (RPM).
e. All of the above are subject to dispute.

____ 21. Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, and its growth rate is a
constant 5 percent. What is the cost of common stock, rs?
a. 9.0%
b. 9.2% 2*(1+0.05)/50 +0.05

c. 9.6%
d. 9.8%
e. 10.0%

Rollins Corporation:
Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred
stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current
maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12
percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free
rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid
a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use
a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The
firm's marginal tax rate is 40 percent.

____ 22. Refer to Rollins Corporation. What is Rollins' cost of preferred stock? 12/100*0.95
a. 10.0%
b. 11.0%
c. 12.0%
d. 12.6%
e. 13.2%

____ 23. Refer to Rollins Corporation. What is Rollins' cost of common stock using the bond-yield-plus-risk-premium
approach? 12+4
a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%
CGT
You are employed by CGT, a Fortune 500 firm that is a major producer of chemicals and plastic goods:
plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the
Vice-President of Finance. This is a position with high visibility and the opportunity for rapid advancement,
providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of
capital for the company. Following are balance sheets and some information about CGT.
Note: Financial Calculator Required
Assets
Current assets $38,000,000
Net plant, property, and equipment $101,000,000
Total Assets $139,000,000
Liabilities and Equity
Accounts payable $10,000,000
Accruals $9,000,000
Current liabilities $19,000,000
Long term debt (40,000 bonds, $1,000 face value) $40,000,000
Total liabilities $59,000,000
Common Stock 10,000,000 shares) $30,000,000
Retained Earnings $50,000,000
Total shareholders equity $80,000,000
Page 5 of 20 5
 Total liabilities and shareholders equity $139,000,000
You check The Wall Street Journal and see that CGT stock is currently selling for $7.50 per share and that
CGT bonds are selling for $889.50 per bond. These bonds have a 7.25 percent annual coupon rate, with
semi-annual payments. The bonds mature in twenty years. The beta for your company is approximately equal
to 1.1. The yield on a 6-month Treasury bill is 3.5 percent and the yield on a 20-year Treasury bond is 5.5
percent. The expected return on the stock market is 11.5 percent, but the stock market has had an average
annual return of 14.5 percent during the past five years. CGT is in the 40 percent tax bracket.

____ 24. Refer to CGT. Which of the following is the best estimate for the weights to be used when calculating the
WACCC?
a. we = 57.6% and wd = 42.4%
b. we = 65.2% and wd = 34.8%
c. we = 66.7% and wd = 33.3%
d. we = 67.8% and wd = 32.2%
e. we = 72.4% and wd = 27.6%

____ 25. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that can be used to assess how
effectively the firm is managing its assets in consideration of current and projected operating levels.
a. True
b. False

____ 26. The degree to which the managers of a firm attempt to magnify the returns to owners' capital through the use
of financial leverage is captured in debt management ratios.
a. True
b. False

____ 27. Suppose two firms have the same amount of assets, pay the same interest rate on their debt, have the same
basic earning power (BEP), and have the same tax rate. However, one firm has a higher debt ratio. If BEP is
greater than the interest rate on debt, the firm with the higher debt ratio will also have a higher rate of return
on common equity.
a. True
b. False

____ 28. The fixed charge coverage ratio recognizes that firms often lease equipment under contract and thus, some
firms must meet more than just their scheduled interest payments out of earnings. Therefore, the fixed charge
coverage is more inclusive than the TIE ratio.
a. True
b. False

____ 29. Other things held constant, which of the following will not affect the current ratio, assuming an initial current
ratio greater than 1.0?
a. Fixed assets are sold for cash. ca/cl
b. Long-term debt is issued to pay off current liabilities.
c. Accounts receivable are collected.
d. Cash is used to pay off accounts payable.
e. A bank loan is obtained, and the proceeds are credited to the firm's checking account.
____ 30. Company R and Company S each have the same operating income (EBIT) and basic earning power (BEP)
ratio. Company S, however, has a lower times-interest-earned (TIE) ratio. Which of the following statements
is most correct?
a. Company S has a higher ROA.
b. Company S has a higher net income.
c. Company S has a higher interest expense.
d. Statements a and b are correct.
e. Statements a, b, and c are correct.

____ 31. Stennett Corp.'s CFO has proposed that the company issue new debt and use the proceeds to buy back
common stock. Which of the following are likely to occur if this proposal is adopted? (Assume that the
proposal would have no effect on the company's operating earnings.)
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 a. Return on assets (ROA) will decline.
b. The times interest earned ratio (TIE) will increase.
c. Taxes paid will decline.
d. None of the statements above is correct.
e. Statements a and c are correct.

____ 32. If a company increases its debt ratio, but leaves its operating income (EBIT) and total assets unchanged,
which of the following is most likely to occur:
a. The company's tax liability will fall.
b. The company's net income will rise.
c. The company's basic earning power will fall.
d. Answers a and b are correct.
e. None of the answers above is correct.

____ 33. Which of the following statements is most correct?

a. A firm with financial leverage has a larger equity multiplier than an otherwise identical firm
with no debt in its capital structure.
b. The use of debt in a company's capital structure results in tax benefits to the investors who
purchase the company's bonds.
c. All else equal, a firm with a higher debt ratio will have a lower basic earning power ratio.
d. All of the answers above are correct.
e. Answers a and c are correct.

____ 34. Which of the following statements is most correct?

a. If two companies have the same return on equity, they should have the same stock price.
b. If Company A has a higher profit margin and higher total assets turnover relative to Company
B, then Company A must have a higher return on assets.
c. If Company A and Company B have the same debt ratio, they must have the same times
interest earned (TIE) ratio.
d. Answers b and c are correct.
e. None of the answers above is correct.

____ 35. Which of the following statements is most correct?

a. If a firm's ROE and ROA are the same, this implies that the firm is financed entirely with
common equity. (That is, common equity = total assets).
b. If a firm has no lease payments or sinking fund payments, its times-interest-earned (TIE) ratio
and fixed charge coverage ratios must be the same.
c. If Firm A has a higher market to book ratio than Firm B, then Firm A must also have a higher
price earnings ratio (P/E).
d. All of the statements above are correct.
e. Answers a and b are correct.

____ 36. The Meryl Corporation's common stock is currently selling at $100 per share, which represents a P/E ratio of
10. If the firm has 100 shares of common stock outstanding, a return on equity of 20 percent, and a debt ratio
of 60 percent, what is its return on total assets (ROA)?
a. 8.0%
b. 10.0% EQUITY MULTIPLE= 1/1-DEBT RATIO
c. 12.0% DUAPONP
d. 16.7% ROE=ROA NHÂN EQUITY MULTIPLE
e. 20.0%

____ 37. Humphrey Hotels' operating income (EBIT) is $40 million. The company's times-interest-earned (TIE) ratio is
8.0, its tax rate is 40 percent, and its basic earning power (BEP) ratio is 10 percent. What is the company's
return on assets (ROA)?
a. 6.45%
b. 5.97%
c. 4.33%

Page 7 of 20 7
 d. 8.56%
e. 5.25%

____ 38. A firm has total assets of $1,000,000 and a debt ratio of 30 percent. Currently, it has sales of $2,500,000, total
fixed costs of $1,000,000, and EBIT of $50,000. If the firm's before-tax cost of debt is 10 percent and the
firm's tax rate is 40 percent, what is the firm's ROE?
a. 1.7%
b. 2.5%
c. 6.0%
d. 8.3%
e. 9.8%

____ 39. A firm has total interest charges of $10,000 per year, sales of $1 million, a tax rate of 40 percent, and a net
profit margin of 6 percent. What is the firm's times-interest-earned ratio?
a. 16
b. 10
c. 7
d. 11
e. 20

____ 40. Taft Technologies has the following relationships:

Annual sales $1,200,000
Current liabilities $ 375,000
Days sales outstanding (DSO) (365-day year) 40
Inventory Turnover ratio 4.8
Current ratio 1.2
The company's current assets consist of cash, inventories, and accounts receivable. How much cash does
Taft have on its balance sheet?
a. -$8,333
b. $68,493
c. $125,000
d. $200,000
e. $316,667

____ 41. Mondale Motors has forecasted the following year-end balance sheet:
Assets:
Cash and marketable securities $ 300
Inventories 500
Accounts receivable 700
Total current assets $1,500
Net fixed assets 5,000
Total assets $6,500

Liabilities and Equity:

Notes payable $ 800
Accounts payable 400
Total current liabilities $1,200
Long-term debt 3,000
Stockholders' equity 2,300
Total liabilities and equity $6,500
The company also forecasts that its days sales outstanding (DSO) on a 365-day basis will be 35.486 days.
Now, assume instead that Mondale is able to reduce its DSO to the industry average of 30.417 days without
reducing its sales. Under this scenario, the reduction in accounts receivable would generate additional cash.
This additional cash would be used to reduce its notes payable. If this scenario were to occur, what would be
the company's current ratio?
a. 1.35
b. 1.27
c. 1.00
Page 8 of 20 8
 d. 1.17
e. 2.45

____ 42. Southeast Packaging's ROE last year was only 5 percent, but its management has developed a new
operating plan designed to improve things. The new plan calls for a total debt ratio of 60 percent, which will
result in interest charges of $8,000 per year. Management projects an EBIT of $26,000 on sales of $240,000,
and it expects to have a total assets turnover ratio of 2.0. Under these conditions, the average tax rate will be
40 percent. If the changes are made, what return on equity will Southeast earn?
a. 9.00%
b. 11.25%
c. 17.50%
d. 22.50%
e. 35.00%

____ 43. Lombardi Trucking Company has the following data:

Assets: $10,000; Profit margin: 3.0%; Tax rate: 40%; Debt ratio: 60.0%; Interest rate: 10.0%; and Total assets
turnover: 2.0.
What is Lombardi's TIE ratio?
a. 0.95
b. 1.75
c. 2.10
d. 2.67
e. 3.45

____ 44. The percentage of sales method is based on which of the following assumptions?
a. All balance sheet accounts are tied directly to sales.
b. Most balance sheet accounts are tied directly to sales.
c. The current level of total assets is optimal for the current sales level.
d. Answers a and c above.
e. Answers b and c above.

____ 45. Jefferson City Computers has developed a forecasting model to determine the additional funds it needs in the
upcoming year. All else being equal, which of the following factors is likely to increase its additional funds
needed (AFN)?
a. A sharp increase in its forecasted sales and the company's fixed assets are at full capacity.
b. A reduction in its dividend payout ratio.
c. The company reduces its reliance on trade credit that sharply reduces its accounts payable.
d. Statements a and b are correct.
e. Statements a and c are correct.

____ 46. A firm has the following balance sheet:

Cash $ 20 Accounts payable $ 20
Accounts receivable 20 Notes payable 40
Inventory 20 Long-term debt 80
Fixed assets 180 Common stock 80
____ Retained earnings 20
Total assets $240 Total liabilities and equity $240
Sales for the year just ended were $400, and fixed assets were used at 80 percent of capacity, but its current
assets were at optimal levels. Sales are expected to grow by 5 percent next year, the profit margin is 5
percent, and the dividend payout ratio is 60 percent. How much additional funds (AFN) will be needed?
a. $4.6
b. -$6.4 (Surplus)
c. $2.4
d. -$4.6 (Surplus)
e. $0.8

____ 47. Apex Roofing Inc. has the following balance sheet (in millions of dollars):
Current assets $3.0 Accounts payable $1.2
Page 9 of 20 9
 Net fixed assets 4.0 Notes payable 0.8
Accrued wages and taxes 0.3
Total current liabilities $2.3
Long-term debt 1.2
Common equity 1.5
___ Retained earnings 2.0
Total assets $7.0 Total liabilities and equity $7.0
Last year's sales were $10 million, and Apex estimates it will need to raise $2 million in new debt and equity
next year. You have identified the following facts: (1) it pays out 30 percent of earnings as dividends; (2) a
profit margin of 4 percent is projected; (3) fixed assets were used to full capacity; and (4) assets and
spontaneous liabilities as shown on last year's balance sheet are expected to grow proportionally with sales.
If the above assumptions hold, what sales growth rate is the firm anticipating? (Hint: You can use the AFN
equation to help answer this problem.)
a. 187%
b. 51%
c. 97%
d. 44%
e. 26%

____ 48. Jackson Co. has the following balance sheet as of December 31, 2004.
Assets: Claims:
Current assets $ 600,000 Accounts payable $ 100,000
Fixed assets 400,000 Accruals 100,000
Notes payable 100,000
Total current liabilities $ 300,000

Long-term debt 300,000

_________ Total equity 400,000
Total assets $1,000,000 Total claims $1,000,000
In 2004, the company reported sales of $5 million, net income of $100,000, and dividends of $60,000. The
company anticipates its sales will increase 20 percent in 2005 and its dividend payout will remain at 60
percent. Assume the company is at full capacity, so its assets and spontaneous liabilities will increase
proportionately with an increase in sales.
Assume the company uses the AFN formula and all additional funds needed (AFN) will come from issuing
new long-term debt. Given its forecast, how much long-term debt will the company have to issue in 2005?
a. $12,000
b. $60,000
c. $88,000
d. $92,000
e. $112,000

Page 10 of 20 10
____ 49. Gemini Beverage has the following historical balance sheet:
Cash $ 20 Accounts payable $ 200
Accounts receivable 240 Notes payable 130
Inventory 320 Accruals 30
Total current assets $ 580 Current liabilities $ 360

Net plant & equipment $ 420 Long-term bonds $ 260

Common stock 270
_____ Retained earnings 110
Total assets $1,000 Total liab. & equity $1,000
Over the next year Gemini's current assets, accounts payable, and accruals will grow in proportion to sales.
Last year's sales were $800 and this year's sales are expected to increase by 40 percent. The firm will retain
$58 in earnings to fund current asset growth, and the rest of the increase will be funded entirely with notes
payable. The net plant and equipment account will increase to $500 and will be funded directly by a new
equity issue. What will Gemini's new current ratio be after the changes in the firm's financial picture are
complete?
a. 1.52
b. 1.61
c. 1.26
d. 1.21
e. 1.37

____ 50. Snowball & Company has the following balance sheet:
Current assets $ 7,000 A/P & Accruals $ 1,500
Fixed assets 3,000 S-T (3-month) Loans 2,000
Common Stock 1,500
______ Ret. Earnings 5,000
Total assets $10,000 Total claims $10,000

Snowball's after-tax profit margin is 11 percent, and the company pays out 60 percent of its earnings as
dividends. Its sales last year were $10,000; its assets were used to full capacity; no economies of scale exist
in the use of assets; and the profit margin and payout ratio are expected to remain constant. The company
uses the AFN equation to estimate funds requirements, and it plans to raise any required external capital as
short-term bank loans. If sales grow by 50 percent, what will Snowball's current ratio be after it has raised the
necessary expansion funds? (Note: Ignore any financing feedback effects.)
a. 2.36
b. 2.00
c. 1.78
d. 1.50
e. 1.34

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 k09 404
Answer Section

MULTIPLE CHOICE

1. ANS: E
Long-term debt is a source of cash. Companies issue debt to get more cash. Therefore, statement a is true. If
the company repurchases common stock, it must use cash to pay for the repurchases. So, cash on the
balance sheet would decrease. Therefore, statement b is false. If the company sold assets total assets would
be unchanged, but there would be an increase in cash and a decrease in other assets. Therefore, statement c
is true. Since statements a and c are true, the correct choice is statement e.

DIF: Easy OBJ: Conceptual TOP: Net cash flow

2. ANS: B
Statement b is correct. Statement a is false, since it would reduce net income. Statement b is true; a decline
in depreciation expense would increase net income but decrease net cash flow. Statement c is false; since a
decline in operating income would cause net income to decline. The remaining statements are false.

DIF: Easy OBJ: Conceptual TOP: Net cash flow and net income

3. ANS: A DIF: Easy OBJ: Conceptual TOP: Net cash flow and net income

4. ANS: B
Statement b is correct. The other statements are false. Corporations cannot exclude interest income from
corporate taxes and individuals pay no taxes on municipal bond income.

DIF: Easy OBJ: Conceptual TOP: Taxes

5. ANS: C DIF: Easy OBJ: Conceptual TOP: Net operating working capital

6. ANS: A DIF: Easy OBJ: Conceptual TOP: Free cash flow

7. ANS: A
Statement a is correct. Net income will increase because less interest expense will be paid by the company.
Statement b is incorrect because reducing interest expense will increase the amount of EBT (taxable income).
Higher taxable income results in higher taxes; therefore, statement c is incorrect.

DIF: Medium OBJ: Conceptual TOP: Effects of changes in financial leverage

8. ANS: B
Operating income $250,000
Interest received 10,000
Interest paid (45,000)
Dividends received (taxable) 6,000*
Taxable income $221,000

*$20,000(0.30) = $6,000.
Taxes = 0.4($221,000) = $88,400.

DIF: Easy OBJ: Problems TOP: Corporate taxes

9. ANS: B
Net operating working capital = Operating current assets
= (Cash + AR + Inc)
= ($10 + $50 + $40)
= $100 - $40 = $60.
- Operating current liabilities
- (AP + Accruals)
- ($30 + $10)

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 DIF: Medium OBJ: Problems TOP: Net operating working capital

10. ANS: A
EVA = NOPAT - (WACC Total net operating capital)
= $500 - (0.10)($2,500)
= $500 - $250 = $250.

DIF: Medium OBJ: Problems TOP: Return on invested capital (ROIC)

11. ANS: C
Long-term interest = ($13,000,000)(0.08) = $1,040,000.
Short-term interest = $1,300,000 - $1,040,000 = $260,000.
Short-term interest rate = $260,000/$1,546,000 = 16.8%.

DIF: Medium OBJ: Problems TOP: Rate of interest

12. ANS: C
Set up an income statement:

Sales $1,000,000
COGS (700,000)
Depreciation (50,000)
EBIT $ 250,000
Interest (150,000)
EBT $ 100,000
Taxes (40,000) Taxes = 0.4($100,000) = $40,000.
Net Income $ 60,000

DIF: Medium OBJ: Problems TOP: Calculating change in net income

13. ANS: B
EPS = NI/shares.
EPS for this year, -$2.50 = -$500,000/Shares
Shares = -$500,000/-$2.50 = 200,000.
Dividends paid this year = $1.00 200,000 = $200,000.

Looking at additions to retained earnings in for this year:

Last year's retained earnings $2,300,000

This year's dividends (200,000)
Last year's net income (500,000)
This year's retained earnings $1,600,000

DIF: Medium OBJ: Problems TOP: Retained earnings

14. ANS: C
Net operating working capital = Operating current assets - Operating current liabilities
= (Cash + AR + Inc) - (AP + Accruals)
= ($10 + $30 + $40) - ($20 + $30)
= $80 - $50 = $30.

DIF: Medium OBJ: Problems TOP: Net operating working capital

15. ANS: B
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 NOPAT = EBIT(1 - T) = $200(1 - 0.4) = $120.

DIF: Medium OBJ: Problems TOP: Net operating profit after taxes (NOPAT)

16. ANS: C
Free cash flow = NOPAT - Net investment in total net operating capital
= $400 - ($900 - $800)
= $400 - $100 = $300.

DIF: Medium OBJ: Problems TOP: Free cash flow

17. ANS: B DIF: Easy OBJ: True-False TOP: Cost of internal equity

18. ANS: E
Statement e is correct. Unlike interest expense on debt, preferred dividends are not deductible, hence there
are no tax savings associated with the use of preferred stock. The component costs of WACC should reflect
the costs of new financing, not historical measures. The cost of common stock would decline, not increase, if
the market risk premium and risk-free rate decline.

DIF: Medium OBJ: Conceptual TOP: Capital components

19. ANS: D DIF: Medium OBJ: Conceptual TOP: Cost of equity estimation

20. ANS: E DIF: Medium OBJ: Conceptual TOP: CAPM cost of equity estimation

21. ANS: B

rs = + 5% = 9.2%.

DIF: Easy OBJ: Problems TOP: Cost of common stock

22. ANS: D
Cost of preferred stock: rps = $12/$100(0.95) = 12.6%.

DIF: Easy OBJ: Problems TOP: Cost of preferred stock

23. ANS: C
Cost of common stock (Bond yield-plus-risk-premium approach):
rs = 12.0% + 4.0% = 16.0%.

DIF: Easy OBJ: Problems TOP: Cost of common stock: Risk premium

24. ANS: D
Use market values for estimating the weights, since target values are not available.
Market value of equity = Ve = $7.50(10 million) = $75 million.
Market value of debt = Vd = $889.50(40,000) = $35.58 million.
We = $75/($75+$35.58) = 0.678 = 67.8%.
Wd = $35.58/($75+$35.58) = 0.322 = 32.2%.

DIF: Medium OBJ: Financial Calculator Section TOP: Weights for WACC

25. ANS: A DIF: Easy OBJ: True-False TOP: Asset management ratios

26. ANS: A DIF: Easy OBJ: True-False TOP: Debt management ratios

27. ANS: A DIF: Medium OBJ: True-False TOP: BEP and ROE

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28. ANS: A DIF: Medium OBJ: True-False TOP: Fixed charge coverage ratio

29. ANS: C DIF: Easy OBJ: Conceptual TOP: Current ratio

30. ANS: C
Both companies have the same operating income and level of assets. If S has a lower TIE ratio than R this
means that S has more interest expense and consequently, lower net income. Therefore, S has a lower ROA
(NI/A) than R. From this, only statement c is correct.

DIF: Easy OBJ: Conceptual TOP: Miscellaneous ratios

31. ANS: E
Statements a and c are correct. The increase in debt payments will reduce net income and hence reduce
ROA. Also, higher debt payments will result in lower taxable income and less tax. Therefore, statement e is
the best choice.

DIF: Easy OBJ: Conceptual TOP: Leverage and financial ratios

32. ANS: A DIF: Medium OBJ: Conceptual TOP: Increased leverage

33. ANS: A
Statement a is correct. The other statements are false. The use of debt provides tax benefits to the
corporations which issue debt, not to the investors who purchase the debt (in the form of bonds). The basic
earning power ratio would be the same if the only thing that differed between the firms was their debt ratios.

DIF: Medium OBJ: Conceptual TOP: Effects of leverage

34. ANS: B DIF: Medium OBJ: Conceptual TOP: Miscellaneous ratios

35. ANS: E
Statements a and b are correct. Use the Du Pont equation to find that the equity multiplier equals 1, so the
company is 100% equity financed. If a firm has no lease payments or sinking fund payments, then its TIE and
fixed charge coverage ratios are the same.

, while

Therefore, statement e is the correct choice.

DIF: Medium OBJ: Conceptual TOP: Miscellaneous ratios

36. ANS: A
Equity multiplier = 1/(1 - D/A) = 1/(1 - 0.60) = 2.5.
ROE = ROA Equity multiplier.
20% = (ROA)(2.5).
ROA = 8.0%.

DIF: Medium OBJ: Problems TOP: ROA

37. ANS: E
Step 1 We must find TA. We are given BEP and EBIT.

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 and .

Therefore, TA = $40,000,000/0.1, or $400 million.

Step 2 NI/TA = ROA, so now we need to find net income. Net income is found by working
through the income statement:

EBIT $40M
Interest 5M (from TIE ratio: 8 = EBIT/Int)
EBT $35M
Taxes 14M (40% tax rate)
NI $21M

Step 3 ROA = $21M/$400M = 0.0525 = 5.25%.

DIF: Medium OBJ: Problems TOP: ROA

38. ANS: A
Total debt = $300,000.
Total equity = $1,000,000 - $300,000 = $700,000.
Net income = [$50,000 - (0.10)($300,000)]0.60 = $12,000.
ROE = $12,000/$700,000 = 1.7%.

DIF: Medium OBJ: Problems TOP: ROE

39. ANS: D
NI = $1,000,000(0.06) = $60,000.
EBT = $60,000/0.6 = $100,000.
EBIT = $100,000 + $10,000 = $110,000.
TIE = EBIT/I = $110,000/$10,000 = 11 .

DIF: Medium OBJ: Problems TOP: TIE ratio

40. ANS: B
First, find the amount of current assets:
Current ratio = Current assets/Current liabilities
Current assets = (Current liabilities)(Current ratio)
= $375,000(1.2) = $450,000.

Next, find the accounts receivables:

DSO = AR/(Sales/365)
AR = DSO(Sales)(1/365)
= (40)($1,200,000)(1/365) = $131,507.

Next, find the inventories:

Inventory turnover = Sales/Inventory
Inventory = Sales/(Inventory turnover)
= $1,200,000/4.8 = $250,000.

Finally, find the amount of cash:

Cash = Current assets - AR - Inventory
= $450,000 - $131,507 - $250,000 = $68,493.

DIF: Medium OBJ: Problems TOP: Financial ratios

41. ANS: B

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 Step 1 We must find sales using DSO of 35. AR/(Sales/365) = 35.486. If AR is $700,
then Sales = $7,200.

Step 2 Now, to reduce DSO to 30.417, AR/($7,200/365) = 30.417 and AR becomes

$600. Thus, we reduced AR by $100.

Step 3 To find the new CR (CA/CL), it is just ($1,500 - $100)/($1,200 - $100) = 1.2727.
(Remember, notes payable were also reduced by $100.)

DIF: Medium OBJ: Problems TOP: Current ratio

42. ANS: D
ROE = Profit Margin TA Turnover Equity Multiplier

Set up an income statement:

Sales (given) $240,000

Cost na
EBIT (given) $ 26,000
I (given) 8,000
EBT $ 18,000
Taxes (40%) 7,200
NI $ 10,800

Turnover = 2 = S/TA; TA = S/2 = $240,000/2 = $120,000.

D/A = 60%; so E/A = 40%; and, therefore, TA/E = 1/(E/A) = 1/0.4 = 2.50.

Complete the Du Pont equation to determine ROE:

ROE = $10,800/$240,000 $240,000/$120,000 $120,000/$48,000
= 0.045 2 2.5 = 0.225 = 22.5%.

DIF: Tough OBJ: Problems TOP: ROE

43. ANS: D

TA Turnover = S/A = 2
S/$10,000 = 2
S = $20,000.

TD = 0.6($10,000)
Debt = $6,000.

Int = $6,000(0.1) = $600.

NI = $600.

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 EBIT $1,600
Int. 600
EBT $1,000
Taxes (40%) 400
NI $ 600

TIE = $1,600/$600 = 2.67.

DIF: Tough OBJ: Problems TOP: TIE ratio

44. ANS: E DIF: Easy OBJ: Conceptual TOP: Percentage of sales method

45. ANS: E
AFN = (A*/S) S - (L*/S) S - (M)(S1)(RR). Statement a is correct. If the company expects a sharp increase in
sales, then current assets must increase. However, if in addition to that, fixed assets are at full capacity, the
company's fixed assets will also have to increase. (It may need to build a new factory.) Therefore, the first
term in the AFN formula will have a higher value, so AFN will be higher. Statement b is false. If the firm's
dividend payout ratio decreases, (RR) will increase. This will increase the value of the third term in the AFN
formula. Since the third term gets larger, AFN will decrease. Statement c is correct. If the company reduces
its trade credit, it is reducing its accounts payable. If accounts payable decreases (although, usually we
assume it is a spontaneous liability), spontaneous liabilities, L*, will be smaller. If L* is smaller, the entire
second term is smaller; therefore, AFN will increase.

DIF: Easy OBJ: Conceptual TOP: Additional funds needed

46. ANS: B
S0 = $400.
S1 = S0 1.05 = $420.
SCapacity = $400/0.80 = $500. No new fixed assets are needed to support the sales increase.

Pro Forma Balance Sheet

Cash $ 21 Accounts payable $ 21.0
Accounts receivable 21 Notes payable 40.0
Inventory 21 Long-term debt 80.0
Fixed assets 180 Common stock 80.0
____ Retained earnings 28.4
Total assets $243 Total liabilities and equity $249.4

Addition to retained earnings = $420 0.05 0.4 = $8.40.

AFN = $243.0 - $249.4 = -$6.4. Surplus of 6.4.

Formula solution:

= $3.0 - $1.0 - $8.4 = -$6.4.

Fixed assets are not included in the formula equation since full capacity sales ($500) has not been reached.

DIF: Medium OBJ: Problems TOP: AFN with excess capacity

47. ANS: D
Formula solution:
Let S1 = S0(1 + g). Let S/S0 = g or growth rate.

$2 = (A*/S0) S - (L*/S0) S - MS1(1 - d)

$2 = A*(g) - L*(g) - MS0(1 + g)(1 - d)

Page 18 of 20 18
 $2 = $7g - $1.5g - 0.04($10)(1 + g)(0.70)
$2 = $5.5g - $0.28g - $0.28
$5.22g = $2.28
g = 0.437 44%.

DIF: Medium OBJ: Problems TOP: Expected growth rate

48. ANS: E
AFN = (A*/S) S - (L*/S) S - (M)(S1)(RR). A* = $1,000,000 because the firm is at total capacity. (The firm will
need to increase fixed assets as well as current assets.)

Sales = $5,000,000.

S = $5,000,000 20%
= $1,000,000.

L* = $100,000 + $100,000 = $200,000. Only the accounts payable and accruals are spontaneous liabilities.
(Notes payable are not.)

d = 60%; so RR = (1 - 0.6) = 0.4 or 40%.

M = NI/Sales
= $100,000/$5,000,000
= 2%.

S1 = $5,000,000 1.2
= $6,000,000.

AFN = (A*/S) S - (L*/S) S - (M)(S1) (RR)

= ($1,000,000/$5,000,000)($1,000,000) - ($200,000/$5,000,000)
($1,000,000) - (0.02)($6,000,000) (0.4)
= $200,000 - $40,000 - $48,000
= $112,000.

DIF: Medium OBJ: Problems TOP: AFN formula and forecasted debt

49. ANS: A
Frcst 1st Frcst 1st
Actual Basis Pass Actual Basis Pass
Cash $ 20 0.025 $ 28 Acc pay $ 200 0.25 $ 280
Accts rec 240 0.300 336 Notes pay 130 +82 212
Inventory 320 0.400 448 Accruals 30 0.0375 42
Total C.A. $ 580 $ 812 Curr liab $ 360 $ 534
Net plant 420 +80 500 LT bonds 260 260
Common stk 270 +80 350
_____ _____ RE 110 +58 168
Total assets $1,000 $1,312 Total L&E $1,000 $1,312

The old current ratio = $580/$360 = 1.61 .

Calculate new current assets, new LT debt, and equity:

New current assets = $28 + $336 + $448 = $812.
New LT debt and equity = $260 + $350 + $168 = $778.

Calculate new current liabilities and new current ratio:

New current liabilities = New total assets - LT debt and equity
= $1,312 - $778 = $534.
The new current ratio = $812/$534 = 1.52 .
Page 19 of 20 19
 DIF: Medium OBJ: Problems TOP: Forecasting and ratio changes

50. ANS: E
Formula solution
Step 1 AFN = A*/S0( S) - L*/S0( S) - M(S1)(1 - d)

= 1($5,000) - 0.15($5,000) - 0.11($15,000)(0.4)

= $5,000 - $750 - $660 = $3,590.

Step 2 Current assets will increase to $7,000/$10,000 $15,000 = 10,500.

Current liabilities will increase to:

S-T Debt = $2,000 + $3,590 = 5,590

Total C.L. = $7,840
New current ratio = $10,500/$7,840 = 1.34 .

DIF: Tough OBJ: Problems TOP: AFN and current ratio

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