Disclaimer and prelude
Hi guys. I’m Cao-Nguyen Phan your friendly friend from SFR. This test bank is for my
fellow SFR peeps, taking English Corporate Finance this term. I know corporate finance
alone is distressing and complicated, and now, processing this knowledge all in English is
even thornier of a task. On compiling this file, I am hoping all members of SFR will find
this helpful, regardless of your major and minor. “Corporate Finance is the backbone of
the Financial industry and learning it well is indeed the key to a brighter future” (Pham
Tien Dac - SFR Alumnus).
Ace your final well !!
Courtesy to Tran Duc Thuan (mr.) for sending me missing banks, and other websites. Finding that this kind of file
is way beyond the legality line, I suggest keeping this file hidden and for internal uses only. With that being said, I
won’t put any trademarks of our group SFR, nor claim this file to rightfully be mine. Enjoy folks.
Cao-Nguyen Phan
Chapter 1: Introduction to Corporate Finance (excluding 1.6)
1.
The person generally directly responsible for overseeing the tax management, cost accounting, financial
accounting, and information system functions is the:
A. treasurer.
B. director.
C. controller.
D. chairman of the board.
E. chief executive officer.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: What is Corporate Finance?
2.
The person generally directly responsible for overseeing the cash and credit functions, financial planning,
and capital expenditures is the:
A. treasurer.
B. director.
C. controller.
D. chairman of the board.
E. chief operations officer.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: What is Corporate Finance?
3.
The process of planning and managing a firm's long-term investments is called:
A. working capital management.
B. financial depreciation.
C. agency cost analysis.
D. capital budgeting.
E. capital structure.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: What is Corporate Finance?
4.
The mixture of debt and equity used by a firm to finance its operations is called:
A. working capital management.
B. financial depreciation.
C. cost analysis.
D. capital budgeting.
E. capital structure.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: What is Corporate Finance?
5.
The management of a firm's short-term assets and liabilities is called:
A. working capital management.
B. debt management.
C. equity management.
D. capital budgeting.
E. capital structure.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: What is Corporate Finance?
6.
A business owned by a single individual is called a:
A. corporation.
B. sole proprietorship.
C. general partnership.
D. limited partnership.
E. limited liability company.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Corporate Firm
7.
A business formed by two or more individuals who each have unlimited liability for business debts is
called a:
A. corporation.
B. sole proprietorship.
C. general partnership.
D. limited partnership.
E. limited liability company.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Corporate Firm
8.
The division of profits and losses among the members of a partnership is formalized in the:
A. indemnity clause.
B. indenture contract.
C. statement of purpose.
D. partnership agreement.
E. group charter.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Corporate Firm
9.
A business created as a distinct legal entity composed of one or more individuals or entities is called a:
A. corporation.
B. sole proprietorship.
C. general partnership.
D. limited partnership.
E. unlimited liability company.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Corporate Firm
10.
The corporate document that sets forth the business purpose of a firm is the:
A. indenture contract.
B. state tax agreement.
C. corporate bylaws.
D. debt charter.
E. articles of incorporation.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Corporate Firm
11.
The rules by which corporations govern themselves are called:
A. indenture provisions.
B. indemnity provisions.
C. charter agreements.
D. bylaws.
E. articles of incorporation.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Corporate Firm
12.
A business entity operated and taxed like a partnership, but with limited liability for the owners, is called
a:
A. limited liability company.
B. general partnership.
C. limited proprietorship.
D. sole proprietorship.
E. corporation.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Corporate Firm
13.
The primary goal of financial management is to:
A. maximize current dividends per share of the existing stock.
B. maximize the current value per share of the existing stock.
C. avoid financial distress.
D. minimize operational costs and maximize firm efficiency.
E. maintain steady growth in both sales and net earnings.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Goal of Financial Management
14.
A conflict of interest between the stockholders and management of a firm is called:
A. stockholders' liability.
B. corporate breakdown.
C. the agency problem.
D. corporate activism.
E. legal liability.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Agency Problem and Control of the Corporation
15.
Agency costs refer to:
A. the total dividends paid to stockholders over the lifetime of a firm.
B. the costs that result from default and bankruptcy of a firm.
C. corporate income subject to double taxation.
D. the costs of any conflicts of interest between stockholders and management.
E. the total interest paid to creditors over the lifetime of the firm.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Agency Problem and Control of the Corporation
16.
A stakeholder is:
A. any person or entity that owns shares of stock of a corporation.
B. any person or entity that has voting rights based on stock ownership of a corporation.
C. a person who initially started a firm and currently has management control over the cash flows of the
firm due to his/her current ownership of company stock.
D. a creditor to whom the firm currently owes money and who consequently has a claim on the cash flows
of the firm.
E. any person or entity other than a stockholder or creditor who potentially has a claim on the cash flows
of the firm.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Agency Problem and Control of the Corporation
17.
The Sarbanes Oxley Act of 2002 is intended to:
A. protect financial managers from investors.
B. not have any effect on foreign companies.
C. reduce corporate revenues.
D. protect investors from corporate abuses.
E. decrease audit costs for U.S. firms.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Regulation
18.
The treasurer and the controller of a corporation generally report to the:
A. board of directors.
B. chairman of the board.
C. chief executive officer.
D. president.
E. chief financial officer.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: What is Corporate Finance?
19.
Which one of the following statements is correct concerning the organizational structure of a corporation?
A. The vice president of finance reports to the chairman of the board.
B. The chief executive officer reports to the board of directors.
C. The controller reports to the president.
D. The treasurer reports to the chief executive officer.
E. The chief operations officer reports to the vice president of production.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: What is Corporate Finance?
20.
Which one of the following is a capital budgeting decision?
A. Determining how much debt should be borrowed from a particular lender
B. Deciding whether or not to open a new store
C. Deciding when to repay a long-term debt
D. Determining how much inventory to keep on hand
E. Determining how much money should be kept in the checking account
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: What is Corporate Finance?
21.
The Sarbanes Oxley Act was enacted in:
A. 1952.
B. 1967.
C. 1998.
D. 2002.
E. 2006.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Regulation
22.
Since the implementation of Sarbanes-Oxley, the cost of going public in the United States has:
A. increased.
B. decreased.
C. remained about the same.
D. been erratic, but over time has decreased.
E. It is impossible to tell since Sarbanes-Oxley compliance does not involve direct cost to the firm.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Regulation
23.
Working capital management includes decisions concerning which of the following?
I. accounts payable
II. long-term debt
III. accounts receivable
IV. inventory
A. I and II only
B. I and III only
C. II and IV only
D. I, II, and III only
E. I, III, and IV only
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: What is Corporate Finance?
24.
Working capital management:
A. ensures that sufficient equipment is available to produce the amount of product desired on a daily basis.
B. ensures that long-term debt is acquired at the lowest possible cost.
C. ensures that dividends are paid to all stockholders on an annual basis.
D. balances the amount of company debt to the amount of available equity.
E. is concerned with the upper portion of the balance sheet.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: What is Corporate Finance?
25.
Which one of the following statements concerning a sole proprietorship is correct?
A. A sole proprietorship is the least common form of business ownership.
B. The profits of a sole proprietorship are taxed twice.
C. The owners of a sole proprietorship share profits as established by the partnership agreement.
D. The owner of a sole proprietorship may be forced to sell his/her personal assets to pay company debts.
E. A sole proprietorship is often structured as a limited liability company.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
26.
Which one of the following statements concerning a sole proprietorship is correct?
A. The life of the firm is limited to the life span of the owner.
B. The owner can generally raise large sums of capital quite easily.
C. The ownership of the firm is easy to transfer to another individual.
D. The company must pay separate taxes from those paid by the owner.
E. The legal costs to form a sole proprietorship are quite substantial.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
27.
Which one of the following best describes the primary advantage of being a limited partner rather than a
general partner?
A. Entitlement to a larger portion of the partnership's income
B. Ability to manage the day-to-day affairs of the business
C. No potential financial loss
D. Greater management responsibility
E. Liability for firm debts limited to the capital invested
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
28.
A general partner:
A. has less legal liability than a limited partner.
B. has more management responsibility than a limited partner.
C. faces double taxation whereas a limited partner does not.
D. cannot lose more than the amount of his/her equity investment.
E. is the term applied only to corporations which invest in partnerships.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
29.
A partnership:
A. is taxed the same as a corporation.
B. agreement defines whether the business income will be taxed like a partnership or a corporation.
C. terminates at the death of any general partner.
D. has less of an ability to raise capital than a proprietorship.
E. allows for easy transfer of interest from one general partner to another.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
30.
Which of the following are disadvantages of a partnership?
I. Limited life of the firm
II. Personal liability for firm debt
III. Greater ability to raise capital than a sole proprietorship
IV. Lack of ability to transfer partnership interest
A. I and II only
B. III and IV only
C. II and III only
D. I, II, and IV only
E. I, III, and IV only
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Corporate Firm
31.
Which of the following are advantages of the corporate form of business ownership?
I. limited liability for firm debt
II. double taxation
III. ability to raise capital
IV. unlimited firm life
A. I and II only
B. III and IV only
C. I, II, and III only
D. II, III, and IV only
E. I, III, and IV only
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Corporate Firm
32.
Which one of the following statements is correct concerning corporations?
A. The largest firms are usually corporations.
B. The majority of firms are corporations.
C. The stockholders are usually the managers of a corporation.
D. The ability of a corporation to raise capital is quite limited.
E. The income of a corporation is taxed as personal income of the stockholders.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
33.
Which one of the following statements is correct?
A. Both partnerships and corporations incur double taxation.
B. Both sole proprietorships and partnerships are taxed in a similar fashion.
C. Partnerships are the most complicated type of business to form.
D. Both partnerships and corporations have limited liability for general partners and shareholders.
E. All types of business formations have limited lives.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Corporate Firm
34.
The articles of incorporation:
A. can be used to remove company management.
B. are amended annually by the company stockholders.
C. set forth the number of shares of stock that can be issued.
D. set forth the rules by which the corporation regulates its existence.
E. can set forth the conditions under which the firm can avoid double taxation.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Corporate Firm
35.
The bylaws:
A. establish the name of the corporation.
B. are rules which apply only to limited liability companies.
C. set forth the purpose of the firm.
D. mandate the procedure for electing corporate directors.
E. set forth the procedure by which the stockholders elect the senior managers of the firm.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Corporate Firm
36.
The owners of a limited liability company prefer:
A. being taxed like a corporation.
B. having liability exposure similar to that of a sole proprietor.
C. being taxed personally on all business income.
D. having liability exposure similar to that of a general partner.
E. being taxed like a corporation with liability like a partnership.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Corporate Firm
37.
Which one of the following business types is best suited to raising large amounts of capital?
A. sole proprietorship
B. limited liability company
C. corporation
D. general partnership
E. limited partnership
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
38.
Which type of business organization has all the respective rights and privileges of a legal person?
A. sole proprietorship
B. general partnership
C. limited partnership
D. corporation
E. limited liability company
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
39.
Financial managers should strive to maximize the current value per share of the existing stock because:
A. doing so guarantees the company will grow in size at the maximum possible rate.
B. doing so increases the salaries of all the employees.
C. the current stockholders are the owners of the corporation.
D. doing so means the firm is growing in size faster than its competitors.
E. the managers often receive shares of stock as part of their compensation.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Goal of Financial Management
40.
The decisions made by financial managers should all be ones which increase the:
A. size of the firm.
B. growth rate of the firm.
C. marketability of the managers.
D. market value of the existing owners' equity.
E. financial distress of the firm.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Goal of Financial Management
41.
Which one of the following actions by a financial manager creates an agency problem?
A. Refusing to borrow money when doing so will create losses for the firm
B. Refusing to lower selling prices if doing so will reduce the net profits
C. Agreeing to expand the company at the expense of stockholders' value
D. Agreeing to pay bonuses based on the book value of the company stock
E. Increasing current costs in order to increase the market value of the stockholders' equity
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Agency Problem and Control of the Corporation
42.
Which of the following help convince managers to work in the best interest of the stockholders?
I. compensation based on the value of the stock
II. stock option plans
III. threat of a proxy fight
IV. threat of conversion to a partnership
A. I and II only
B. II and III only
C. I, II and III only
D. I and III only
E. I, II, III, and IV
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Agency Problem and Control of the Corporation
43.
Which form of business structure faces the greatest agency problems?
A. sole proprietorship
B. general partnership
C. limited partnership
D. corporation
E. limited liability company
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Agency Problem and Control of the Corporation
44.
A proxy fight occurs when:
A. the board solicits renewal of current members.
B. a group solicits proxies to replace the board of directors.
C. a competitor offers to sell their ownership in the firm.
D. the firm files for bankruptcy.
E. the firm is declared insolvent.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Agency Problem and Control of the Corporation
45.
Which one of the following parties is considered a stakeholder of a firm?
A. employee
B. short-term creditor
C. long-term creditor
D. preferred stockholder
E. common stockholder
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Agency Problem and Control of the Corporation
46.
Which of the following are key requirements of the Sarbanes-Oxley Act?
I. Officers of the corporation must review and sign annual reports.
II. Officers of the corporation must now own more than 5% of the firm's stock.
III. Annual reports must list deficiencies in internal controls.
IV. Annual reports must be filed with the SEC within 30 days of year end.
A. I only.
B. II only.
C. I and III only.
D. II and III only.
E. II and IV only.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Regulation
47.
Insider trading is:
A. legal.
B. illegal.
C. impossible to have in our efficient market.
D. discouraged, but legal.
E. list only the securities of the largest firms.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Regulation
48.
Sole proprietorships are predominantly started because:
A. they are easily and cheaply setup.
B. the proprietorship life is limited to the business owner's life.
C. all business taxes are paid as individual tax.
D. All of these.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
49.
Managers are encouraged to act in shareholders' interests by:
A. shareholder election of a board of directors who select management.
B. the threat of a takeover by another firm.
C. compensation contracts that tie compensation to corporate success.
D. Both shareholder election of a board of directors who select management; and the threat of a takeover
by another firm.
E. All of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: GOVERNANCE
50.
The Securities Exchange Act of 1934 focuses on:
A. all stock transactions.
B. sales of existing securities.
C. issuance of new securities.
D. insider trading.
E. Federal Deposit Insurance Corporation (FDIC) insurance.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Regulation
51.
The basic regulatory framework in the United States was provided by:
A. the Securities Act of 1933.
B. the Securities Exchange Act of 1934.
C. the monetary system.
D. the Securities Act of 1933 and the Securities Exchange Act of 1934.
E. All of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Regulation
52.
The Securities Act of 1933 focuses on:
A. all stock transactions.
B. sales of existing securities.
C. issuance of new securities.
D. insider trading.
E. Federal Deposit Insurance Corporation (FDIC) insurance.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Regulation
53.
In a limited partnership:
A. each limited partner's liability is limited to his net worth.
B. each limited partner's liability is limited to the amount he put into the partnership.
C. each limited partner's liability is limited to his annual salary.
D. there is no limitation on liability; only a limitation on what the partner can earn.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
54.
Accounting profits and cash flows are:
A. generally the same since they reflect current laws and accounting standards.
B. generally the same since accounting profits reflect when the cash flows are received.
C. generally not the same since GAAP allows for revenue recognition separate from the receipt of cash
flows.
D. generally not the same because cash inflows occur before revenue recognition.
E. Both generally not the same since GAAP allows for revenue recognition separate from the receipt of
cash flows; and generally not the same because cash inflows occur before revenue recognition.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Importance of Cash Flows
55.
The Chief Executive Officer typically reports to the
A. Board of Director's
B. Granting authority
C. President
D. CFO
E. None of these
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: What is Corporate Finance?
56.
The cheapest business to form is typically the
A. General corporation
B. Sub-chapter S Corporation
C. General Partnership
D. Limited Partnership
E. Sole proprietorship
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Corporate Firm
57.
In a general partnership, the general partners have
A. Limited liability
B. Unlimited liability
C. No liability
D. Minimal liability
E. It depends on the partners' decision
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Corporate Firm
58.
Managers that are successful in pursuing stockholder goals can
A. See very little reward
B. See no financial gain through raises and bonuses
C. Never become stockholders
D. Reap enormous rewards
E. Start a proxy fight with stockholders
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Agency Problem and Control of the Corporation
Essay Questions
59.
List and briefly describe the three basic questions addressed by a financial manager.
The three areas are:
1. Capital budgeting: The financial manager tries to identify investment opportunities that are worth more
to the firm than they cost to acquire.
2. Capital structure: This refers to the specific mixture of long-term debt and equity a firm uses to finance
its operations.
3. Working capital management: This refers to a firm's short-term assets and short-term liabilities.
Managing the firm's working capital is a day-to-day activity that ensures the firm has sufficient resources
to continue its operations and avoid costly interruptions.
AACSB: Reflective Thinking
Blooms: Understand
Difficulty level: 2 Medium
Topic: What is Corporate Finance?
60.
What advantages does the corporate form of organization have over sole proprietorships or partnerships?
The advantages of the corporate form of organization over sole proprietorships and partnerships are the
ease of transferring ownership, the owners' limited liability for business debts, the ability to raise more
capital, and the opportunity of an unlimited life of the business.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: The Corporate Firm
61.
If the corporate form of business organization has so many advantages over the sole proprietorship, why is
it so common for small businesses to initially be formed as sole proprietorships?
A significant advantage of the sole proprietorship is that it is cheap and easy to form. If the sole proprietor
has limited capital to start with, it may not be desirable to spend part of that capital forming a corporation.
Also, limited liability for business debts may not be a significant advantage if the proprietor has limited
capital, most of which is tied up in the business anyway. Finally, for a typical small business, the heart and
soul of the business is the person who founded it, so the life of the business may effectively be limited to
the life of the founder during its early years.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: The Corporate Firm
62.
What should be the goal of the financial manager of a corporation? Why?
The correct goal is to maximize the current value of the outstanding stock. This goal focuses on enhancing
the returns to stockholders who are the owners of the firm. Other goals, such as maximizing earnings,
focus too narrowly on accounting income and ignore the importance of market values in managerial
finance.
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 2 Medium
Topic: The Goal of Financial Management
63.
Do you think agency problems arise in sole proprietorships and/or partnerships?
Agency conflicts typically arise when there is a separation of ownership and management of a business. In
a sole proprietorship and a small partnership, such separation is not likely to exist to the degree it does in a
corporation. However, there is still potential for agency conflicts. For example, as employees are hired to
represent the firm, there is once again a separation of ownership and management.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: The Agency Problem and Control of the Corporation
64.
Assume for a moment that the stockholders in a corporation have unlimited liability for corporate debts. If
so, what impact would this have on the functioning of primary and secondary markets for common stock?
With unlimited liability, you would be very careful which stocks you invest in. In particular, you would
not invest in companies you expected to be unable to satisfy their financial obligations. Both the primary
and secondary markets for common stock would be severely hampered if this rule existed. It would be very
difficult for a young, untested business to acquire enough capital to grow.
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 2 Medium
Topic: The Corporate Firm
65.
Suppose you own 100 shares of IBM stock which you intend to sell today. Since you will sell it in the
secondary market, IBM will receive no direct cash flows as a consequence of your sale. Why, then, should
IBM's management care about the price you get for your shares?
The current market price of IBM stock reflects, among other things, market opinion about the quality of
firm management. If the shareholder's sale price is low, this indirectly reflects on the reputation of the
managers, as well as potentially impacting their standing in the employment market. Alternatively, if the
sale price is high, this indicates that the market believes current management is increasing firm value and
therefore doing a good job.
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 2 Medium
Topic: The Goal of Financial Management
66.
One thing lenders sometimes require when loaning money to a small corporation is an assignment of the
common stock as collateral on the loan. Then, if the business fails to repay its loan, the ownership of the
stock certificates can be transferred directly to the lender. Why might a lender want such an assignment?
What advantage of the corporate form of organization comes into play here?
In the event of a loan default, a lender may wish to liquidate the business. Often it is time consuming and
difficult to take title of all of the business assets individually. By taking control of the stock, the lender is
able to sell the business simply by reselling the stock in the business. This illustrates once again the ease of
transfer of ownership of a corporation.
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 2 Medium
Topic: The Corporate Firm
67.
Why might a corporation wish to list its shares on a national exchange such as the NYSE as opposed to a
regional exchange or NASDAQ?
Being listed on a regional exchange effectively limits the capital access for the business. Plus, there is a
prestige factor in being listed on one of the national exchanges. There is still a perceived prestige factor in
moving from NASDAQ to the NYSE since the NYSE has more restrictive membership requirements.
However, the lure of greater prestige certainly hasn't prompted some major corporations, such as
Microsoft, to move to the NYSE.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: The Corporate Firm
Chapter 2: Financial Statements and cash flow (excluding 2.7)
Multiple Choice Questions
1.
The financial statement showing a firm's accounting value on a particular date is the:
A. income statement.
B. balance sheet.
C. statement of cash flows.
D. tax reconciliation statement.
E. shareholders' equity sheet.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Balance Sheet
2.
A current asset is:
A. an item currently owned by the firm.
B. an item that the firm expects to own within the next year.
C. an item currently owned by the firm that will convert to cash within the next 12 months.
D. the amount of cash on hand the firm currently shows on its balance sheet.
E. the market value of all items currently owned by the firm.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Balance Sheet
3.
The long-term debts of a firm are liabilities:
A. that come due within the next 12 months.
B. that do not come due for at least 12 months.
C. owed to the firm's suppliers.
D. owed to the firm's shareholders.
E. the firm expects to incur within the next 12 months.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Balance Sheet
4.
Net working capital is defined as:
A. total liabilities minus shareholders' equity.
B. current liabilities minus shareholders' equity.
C. fixed assets minus long-term liabilities.
D. total assets minus total liabilities.
E. current assets minus current liabilities.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Net Working Capital
5.
A(n) ____ asset is one which can be quickly converted into cash without significant loss in value.
A. current
B. fixed
C. intangible
D. liquid
E. long-term
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Balance Sheet
6.
The financial statement summarizing a firm's accounting performance over a period of time is the:
A. income statement.
B. balance sheet.
C. statement of cash flows.
D. tax reconciliation statement.
E. shareholders' equity sheet.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Income Statement
7.
Noncash items refer to:
A. the credit sales of a firm.
B. the accounts payable of a firm.
C. the costs incurred for the purchase of intangible fixed assets.
D. expenses charged against revenues that do not directly affect cash flow.
E. all accounts on the balance sheet other than cash on hand.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Income Statement
8.
Your _____ tax rate is the amount of tax payable on the next taxable dollar you earn.
A. deductible
B. residual
C. total
D. average
E. marginal
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Taxes
9.
Your _____ tax rate is the total taxes you pay divided by your taxable income.
A. deductible
B. residual
C. total
D. average
E. marginal
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Taxes
10.
_____ refers to the cash flow that results from the firm's ongoing, normal business activities.
A. Cash flow from operating activities
B. Capital spending
C. Net working capital
D. Cash flow from assets
E. Cash flow to creditors
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Cash Flow
11.
_____ refers to the changes in net capital assets.
A. Operating cash flow
B. Cash flow from investing
C. Net working capital
D. Cash flow from assets
E. Cash flow to creditors
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Cash Flow
12.
_____ refers to the difference between a firm's current assets and its current liabilities.
A. Operating cash flow
B. Capital spending
C. Net working capital
D. Cash flow from assets
E. Cash flow to creditors
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Net Working Capital
13.
_____ is calculated by adding back noncash expenses to net income and adjusting for changes in current
assets and liabilities.
A. Operating cash flow
B. Capital spending
C. Net working capital
D. Cash flow from operations
E. Cash flow to creditors
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Cash Flow
14.
_____ refers to the firm's interest payments less any net new borrowing.
A. Operating cash flow
B. Capital spending
C. Net working capital
D. Cash flow from shareholders
E. Cash flow to creditors
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Cash Flow
15.
_____ refers to the firm's dividend payments less any net new equity raised.
A. Operating cash flow
B. Capital spending
C. Net working capital
D. Cash flow from creditors
E. Cash flow to stockholders
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Cash Flow
16.
Earnings per share is equal to:
A. net income divided by the total number of shares outstanding.
B. net income divided by the par value of the common stock.
C. gross income multiplied by the par value of the common stock.
D. operating income divided by the par value of the common stock.
E. net income divided by total shareholders' equity.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: The Income Statement
17.
Dividends per share is equal to dividends paid:
A. divided by the par value of common stock.
B. divided by the total number of shares outstanding.
C. divided by total shareholders' equity.
D. multiplied by the par value of the common stock.
E. multiplied by the total number of shares outstanding.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: The Income Statement
18.
Which of the following are included in current assets?
I. equipment
II. Inventory
III. accounts payable
IV. cash
A. II and IV only
B. I and III only
C. I, II, and IV only
D. III and IV only
E. II, III, and IV only
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
19.
Which of the following are included in current liabilities?
I. Note payable to a supplier in eighteen months
II. Debt payable to a mortgage company in nine months
III. Accounts payable to suppliers
IV. Loan payable to the bank in fourteen months
A. I and III only
B. II and III only
C. III and IV only
D. II, III, and IV only
E. I, II, and III only
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
20.
An increase in total assets:
A. means that net working capital is also increasing.
B. requires an investment in fixed assets.
C. means that shareholders' equity must also increase.
D. must be offset by an equal increase in liabilities and shareholders' equity.
E. can only occur when a firm has positive net income.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
21.
Which one of the following assets is generally the most liquid?
A. inventory
B. buildings
C. accounts receivable
D. equipment
E. patents
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
22.
Which one of the following statements concerning liquidity is correct?
A. If you sold an asset today, it was a liquid asset.
B. If you can sell an asset next year at a price equal to its actual value, the asset is highly liquid.
C. Trademarks and patents are highly liquid.
D. The less liquidity a firm has, the lower the probability the firm will encounter financial difficulties.
E. Balance sheet accounts are listed in order of decreasing liquidity.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
23.
Liquidity is:
A. a measure of the use of debt in a firm's capital structure.
B. equal to current assets minus current liabilities.
C. equal to the market value of a firm's total assets minus its current liabilities.
D. valuable to a firm even though liquid assets tend to be less profitable to own.
E. generally associated with intangible assets.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
24.
Which of the following accounts are included in shareholders' equity?
I. interest paid
II. retained earnings
III. capital surplus
IV. long-term debt
A. I and II only
B. II and IV only
C. I and IV only
D. II and III only
E. I and III only
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
25.
Book value:
A. is equivalent to market value for firms with fixed assets.
B. is based on historical cost.
C. generally tends to exceed market value when fixed assets are included.
D. is more of a financial than an accounting valuation.
E. is adjusted to market value whenever the market value exceeds the stated book value.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
26.
When making financial decisions related to assets, you should:
A. always consider market values.
B. place more emphasis on book values than on market values.
C. rely primarily on the value of assets as shown on the balance sheet.
D. place primary emphasis on historical costs.
E. only consider market values if they are less than book values.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
27.
As seen on an income statement:
A. interest is deducted from income and increases the total taxes incurred.
B. the tax rate is applied to the earnings before interest and taxes when the firm has both depreciation and
interest expenses.
C. depreciation is shown as an expense but does not affect the taxes payable.
D. depreciation reduces both the pretax income and the net income.
E. interest expense is added to earnings before interest and taxes to get pretax income.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Income Statement
28.
The earnings per share will:
A. increase as net income increases.
B. increase as the number of shares outstanding increase.
C. decrease as the total revenue of the firm increases.
D. increase as the tax rate increases.
E. decrease as the costs decrease.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Income Statement
29.
Dividends per share:
A. increase as the net income increases as long as the number of shares outstanding remains constant.
B. decrease as the number of shares outstanding decrease, all else constant.
C. are inversely related to the earnings per share.
D. are based upon the dividend requirements established by Generally Accepted Accounting Procedures.
E. are equal to the amount of net income distributed to shareholders divided by the number of shares
outstanding.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Income Statement
30.
Earnings per share
A. will increase if net income increases and number of shares remains constant.
B. will increase if net income decreases and number of shares remains constant.
C. is number of shares divided by net income.
D. is the amount of money that goes into retained earnings on a per share basis.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Income Statement
31.
According to Generally Accepted Accounting Principles, costs are:
A. recorded as incurred.
B. recorded when paid.
C. matched with revenues.
D. matched with production levels.
E. expensed as management desires.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Income Statement
32.
Depreciation:
A. is a noncash expense that is recorded on the income statement.
B. increases the net fixed assets as shown on the balance sheet.
C. reduces both the net fixed assets and the costs of a firm.
D. is a non-cash expense which increases the net operating income.
E. decreases net fixed assets, net income, and operating cash flows.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Income Statement
33.
When you are making a financial decision, the most relevant tax rate is the __________ rate.
A. average
B. fixed
C. marginal
D. total
E. variable
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Taxes
34.
An increase in which one of the following will cause the operating cash flow to increase?
A. depreciation
B. changes in the amount of net fixed capital
C. net working capital
D. taxes
E. costs
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Financial Cash Flow
35.
A firm starts its year with a positive net working capital. During the year, the firm acquires more shortterm debt than it does short-term assets. This means that:
A. the ending net working capital will be negative.
B. both accounts receivable and inventory decreased during the year.
C. the beginning current assets were less than the beginning current liabilities.
D. accounts payable increased and inventory decreased during the year.
E. the ending net working capital can be positive, negative, or equal to zero.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Net Working Capital
36.
The cash flow to creditors includes the cash:
A. received by the firm when payments are paid to suppliers.
B. outflow of the firm when new debt is acquired.
C. outflow when interest is paid on outstanding debt.
D. inflow when accounts payable decreases.
E. received when long-term debt is paid off.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Financial Cash Flow
37.
Cash flow to stockholders must be positive when:
A. the dividends paid exceed the net new equity raised.
B. the net sale of common stock exceeds the amount of dividends paid.
C. no income is distributed but new shares of stock are sold.
D. both the cash flow to assets and the cash flow to creditors are negative.
E. both the cash flow to assets and the cash flow to creditors are positive.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Financial Cash Flow
38.
Which equality is the basis for the balance sheet?
A. Fixed Assets = Stockholder's Equity + Current Assets
B. Assets = Liabilities + Stockholder's Equity
C. Assets = Current Long-Term Debt + Retained Earnings
D. Fixed Assets = Liabilities + Stockholder's Equity
E. None of these
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
39.
Assets are listed on the balance sheet in order of:
A. decreasing liquidity.
B. decreasing size.
C. increasing size.
D. relative life.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
40.
Debt is a contractual obligation that:
A. requires the payout of residual flows to the holders of these instruments.
B. requires a repayment of a stated amount and interest over the period.
C. allows the bondholders to sue the firm if it defaults.
D. Both requires the payout of residual flows to the holders of these instruments; and requires a repayment
of a stated amount and interest over the period.
E. Both requires a repayment of a stated amount and interest over the period; and allows the bondholders
to sue the firm if it defaults.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
41.
The carrying value or book value of assets:
A. is determined under GAAP and is based on the cost of the asset.
B. represents the true market value according to GAAP.
C. is always the best measure of the company's value to an investor.
D. is always higher than the replacement cost of the assets.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
42.
Under GAAP, a firm's assets are reported at:
A. market value.
B. liquidation value.
C. intrinsic value.
D. cost.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Balance Sheet
43.
Which of the following statements concerning the income statement is true?
A. It measures performance over a specific period of time.
B. It determines after-tax income of the firm.
C. It includes deferred taxes.
D. It treats interest as an expense.
E. All of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Income Statement
44.
According to generally accepted accounting principles (GAAP), revenue is recognized as income when:
A. a contract is signed to perform a service or deliver a good.
B. the transaction is complete and the goods or services are delivered.
C. payment is requested.
D. income taxes are paid.
E. All of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Income Statement
45.
Which of the following is not included in the computation of operating cash flow?
A. Earnings before interest and taxes
B. Interest paid
C. Depreciation
D. Current taxes
E. All of these are included
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Financial Cash Flow
46.
Net capital spending is equal to:
A. net additions to net working capital.
B. the net change in fixed assets.
C. net income plus depreciation.
D. total cash flow to stockholders less interest and dividends paid.
E. the change in total assets.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Financial Cash Flow
47.
Cash flow to stockholders is defined as:
A. interest payments.
B. repurchases of equity less cash dividends paid plus new equity sold.
C. cash flow from financing less cash flow to creditors.
D. cash dividends plus repurchases of equity minus new equity financing.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Financial Cash Flow
48.
Free cash flow is:
A. without cost to the firm.
B. net income plus taxes.
C. an increase in net working capital.
D. cash that the firm is free to distribute to creditors and stockholders.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Financial Cash Flow
49.
The cash flow of the firm must be equal to:
A. cash flow to stockholders minus cash flow to debtholders.
B. cash flow to debtholders minus cash flow to stockholders.
C. cash flow to governments plus cash flow to stockholders.
D. cash flow to stockholders plus cash flow to debtholders.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Financial Cash Flow
50.
Which of the following are all components of the statement of cash flows?
A. Cash flow from operating activities, cash flow from investing activities, and cash flow from financing
activities
B. Cash flow from operating activities, cash flow from investing activities, and cash flow from divesting
activities
C. Cash flow from internal activities, cash flow from external activities, and cash flow from financing
activities
D. Cash flow from brokering activities, cash flow from profitable activities, and cash flow from nonprofitable activities
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Accounting Statement of Cash Flows
51.
One of the reasons why cash flow analysis is popular is because:
A. cash flows are more subjective than net income.
B. cash flows are hard to understand.
C. it is easy to manipulate, or spin the cash flows.
D. it is difficult to manipulate, or spin the cash flows.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Financial Cash Flow
52.
A firm has $450 in inventory, $700 in fixed assets, $210 in accounts receivable, $50 in accounts payable,
and $60 in cash. What is the amount of the current assets?
A. $510
B. $560
C. $600
D. $660
E. $720
Current assets = $450 + $210 + $60 = $720
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Balance Sheet
53.
Total assets are $1000, fixed assets are $700, long-term debt is $250, and short-term debt is $300. What is
the amount of net working capital?
A. $0
B. $50
C. $300
D. $650
E. $700
Net working capital = $1000 - $700 - $300 = $0
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Net Working Capital
54.
Brad's Company has equipment with a book value of $500 that could be sold today at a 50% discount. Its
inventory is valued at $450 and could be sold to a competitor for that amount. The firm has $100 in cash
and customers owe it $250. What is the accounting value of its liquid assets?
A. $100
B. $550
C. $800
D. $1,050
E. $1,300
Liquid assets = $450 + $100 + $250 = $800
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Balance Sheet
55.
Martha's Enterprises spent $2,500 to purchase equipment three years ago. This equipment is currently
valued at $2,000 on today's balance sheet but could actually be sold for $2,200. Net working capital is
$300 and long-term debt is $900. Assuming the equipment is the firm's only fixed asset, what is the book
value of shareholders' equity?
A. $1,100
B. $1,400
C. $1,600
D. $1,900
E. The answer cannot be determined from the information provided
Book value of shareholders' equity = $2,000 + $300 - $900 = $1,400
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Balance Sheet
56.
Mart's Boutique has sales of $670,000 and costs of $460,000. Interest expense is $50,000 and depreciation
is $55,000. The tax rate is 34%. What is the net income?
A. $35,700
B. $69,300
C. $105,000
D. $138,600
E. $210,000
Taxable income = $670,000 - $460,000 - $50,000 - $55,000 = $105,000; Tax = .34($105,000) = $35,700;
Net income = $105,000 - $35,700 = $69,300
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Income Statement
57.
Given the tax rates as shown, what is the average tax rate for a firm with taxable income of $126,500?
A. 21.38%
B. 23.88%
C. 25.76%
D. 34.64%
E. 39.00%
Tax = .15($50,000) + .25($25,000) + .34($25,000) + .39($126,500 - $100,000) = $32,585; Average tax
rate = $32,585 ÷ $126,500 = .2576 = 25.76%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Taxes
58.
The tax rates are as shown. Your firm currently has taxable income of $79,400. How much additional tax
will you owe if you increase your taxable income by $21,000?
A. $7,004
B. $7,014
C. $7,140
D. $7,160
E. $7,174
Additional tax = .34($100,000 - $79,400) + .39($79,400 + $21,000 - $100,000) = $7,160
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Taxes
59.
Your firm has net income of $198 on total sales of $1,200. Costs are $715 and depreciation is $145. The
tax rate is 34%. The firm does not have interest expenses. What is the operating cash flow?
A. $93
B. $241
C. $340
D. $383
E. $485
Earnings before interest and taxes = $1,200 - $715 - $145 = $340; Tax = [$198 ÷ (1 - .34)] - $198 = $102;
Operating cash flow = $340 + $145 - $102 = $383
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
60.
Awnings Incorporated has beginning net fixed assets of $560 and ending net fixed assets of $720. Assets
valued at $210 were sold during the year. Depreciation was $50. What is the amount of capital spending?
A. $110
B. $160
C. $210
D. $300
E. $420
Net capital spending = $720 - $560 + $50 = $210
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
61.
At the beginning of the year, a firm has current assets of $420 and current liabilities of $380. At the end of
the year, the current assets are $500 and the current liabilities are $410. What is the change in net working
capital?
A. -$80
B. -$50
C. $0
D. $50
E. $80
Change in net working capital = ($500 - $410) - ($420 - $380) = $50
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Net Working Capital
62.
At the beginning of the year, long-term debt of a firm is $310 and total debt is $350. At the end of the year,
long-term debt is $280 and total debt is $370. The interest paid is $50. What is the amount of the cash flow
to creditors?
A. -$30
B. $0
C. $20
D. $30
E. $80
Cash flow to creditors = $50 - ($280 - $310) = $80
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
63.
Pete's Boats has beginning long-term debt of $180 and ending long-term debt of $210. The beginning and
ending total debt balances are $340 and $360, respectively. The interest paid is $20. What is the amount of
the cash flow to creditors?
A. -$10
B. $0
C. $10
D. $40
E. $50
Cash flow to creditors = $20 - ($210 - $180) = -$10
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
64.
Peggy Grey's Cookies has net income of $360. The firm pays out 40% of the net income to its shareholders
as dividends. During the year, the company sold $80 worth of common stock. What is the cash flow to
stockholders?
A. $64
B. $136
C. $144
D. $224
E. $296
Cash flow to stockholders = .40($360) - $80 = $64
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
65.
Thompson's Jet Skis has operating cash flow of $218. Depreciation is $45 and interest paid is $35. A net
total of $69 was paid on long-term debt. The firm spent $180 on fixed assets and increased net working
capital by $38. What is the amount of the cash flow to stockholders?
A. -$104
B. -$28
C. $28
D. $114
E. $142
Cash flow of the firm = $218 - $38 - $180 = $0; Cash flow to creditors = $35 - (-$69) = $104; Cash flow to
stockholders = $0 - $104 = -$104
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
66.
What is the change in the net working capital from 2010 to 2011?
A. $1,235
B. $1,035
C. $1,335
D. $3,405
E. $4,740
Change in net working capital = ($7,310 - $2,570) - ($6,225 - $2,820) = $1,335
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Net Working Capital
67.
What is the amount of the non-cash expenses for 2011?
A. $570
B. $630
C. $845
D. $1,370
E. $2,000
The non-cash expense is depreciation in the amount of $1,370.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Income Statement
68.
What is the amount of the net capital spending for 2011?
A. -$290
B. $795
C. $1,080
D. $1,660
E. $2,165
Net capital spending = $10,670 - $10,960 + $1,370 = $1,080
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
69.
What is the operating cash flow for 2011?
A. $845
B. $1,930
C. $2,215
D. $2,845
E. $3,060
Operating cash flow = $1,930 + $1,370 - $455 = $2,845
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
70.
What is the cash flow of the firm for 2011?
A. $430
B. $485
C. $1,340
D. $2,590
E. $3,100
Operating cash flow = $1,930 + $1,370 - $455 = $2,845; Change in net working capital = ($7,310 $2,570) - ($6,225 - $2,820) = $1,335; Net capital spending = $10,670 - $10,960 + $1,370 = $1,080; Cash
flow of the firm = $2,845 - $1,335 - $1,080 = $430
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
71.
What is the amount of net new borrowing for 2011?
A. -$225
B. -$25
C. $0
D. $25
E. $225
Net new borrowing = $8,100 - $7,875 = $225
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
72.
What is the cash flow to creditors for 2011?
A. -$405
B. -$225
C. $225
D. $405
E. $630
Cash flow to creditors = $630 - ($8,100 - $7,875) = $405
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
73.
What is the net working capital for 2011?
A. $345
B. $405
C. $805
D. $812
E. $1,005
Net working capital = $75 + $502 + $640 - $405 = $812
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Net Working Capital
74.
What is the change in net working capital from 2010 to 2011?
A. -$93
B. -$7
C. $7
D. $85
E. $97
Change in net working capital = ($75 + $502 + $640 - $405) - ($70 + $563 + $662 - $390) = -$93
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Net Working Capital
75.
What is net capital spending for 2011?
A. -$250
B. -$57
C. $0
D. $57
E. $477
Net capital spending = $1,413 - $1,680 + $210 = -$57
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
76.
What is the operating cash flow for 2011?
A. $143
B. $297
C. $325
D. $353
E. $367
Earnings before interest and taxes = $785 - $460 - $210 = $115; Taxable income = $115 - $35 = $80;
Taxes = .35($80) = $28; Operating cash flow = $115 + $210 - $28 = $297
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
77.
What is the cash flow of the firm for 2011?
A. $50
B. $247
C. $297
D. $447
E. $517
Cash flow of the firm = $297 - (-$93) - (-$57) = $447
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
78.
What is net new borrowing for 2011?
A. -$70
B. -$35
C. $35
D. $70
E. $105
Net new borrowing = $410 - $340 = $70
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
79.
What is the cash flow to creditors for 2011?
A. -$170
B. -$35
C. $135
D. $170
E. $205
Cash flow to creditors = $35 - ($410 - $340) = -$35
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
80.
What is the cash flow to stockholders for 2011?
A. $408
B. $417
C. $452
D. $482
E. $503
Cash flow to stockholders = $447 - (-$35) = $482; or, Cash flow to stockholders = $17 - ($235 - $700) =
$482
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
81.
What is the taxable income for 2011?
A. $360
B. $520
C. $640
D. $780
E. $800
Net income = $160 + $360 = $520; Taxable income = $520 ÷ (1 - .35) = $800
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Taxes
82.
What is the operating cash flow for 2011?
A. $520
B. $800
C. $1,015
D. $1,110
E. $1,390
Earnings before interest and taxes = $800 + $215 = $1,015; Operating cash flow = $1,015 + $375 - ($800 $520) = $1,110
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Cash Flow
83.
What are the sales for 2011?
A. $4,225
B. $4,385
C. $4,600
D. $4,815
E. $5,000
Sales = $1,015 + $375 + $3,210 = $4,600
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Income Statement
84.
Calculate net income based on the following information. Sales are $250, cost of goods sold is $160,
depreciation expense is $35, interest paid is $20, and the tax rate is 34%.
A. $11.90
B. $23.10
C. $35.00
D. $36.30
E. $46.20
((Sales - COGS) - Depreciation - Interest) - Taxes = Net Income (($250 - $160) - $35 - $20) - $11.9 =
$23.10
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Income Statement
Essay Questions
85.
What is a liquid asset and why is it necessary for a firm to maintain a reasonable level of liquid assets?
Liquid assets are those that can be sold quickly with little or no loss in value. A firm that has sufficient
liquidity will be less likely to experience financial distress.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 1 Easy
Topic: The Balance Sheet
86.
Why is interest expense excluded from the operating cash flow calculation?
Operating cash flow is designed to represent the cash flow a firm generates from its day-to-day operating
activities. Interest expense arises from a financing decision and thus should be considered as a cash flow to
creditors.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: Financial Cash Flow
87.
Explain why the income statement is not a good representation of cash flow.
Most income statements contain some noncash items, so these must be accounted for when calculating
cash flows. More importantly, however, since GAAP is used to create income statements, revenues and
expenses are booked when they accrue, not when their corresponding cash flows occur.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: The Accounting Statement
88.
Discuss the difference between book values and market values on the balance sheet and explain which is
more important to the financial manager and why.
The accounts on the balance sheet are generally carried at historical cost, not market values. Although the
book value of current assets and current liabilities may closely approximate market values, the same cannot
be said for the rest of the balance sheet accounts. Ultimately, the financial manager should focus on the
firm's stock price, which is a market value measure. Hence, market values are more meaningful than book
values.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: The Balance Sheet
89.
Note that in all of our cash flow computations to determine cash flow of the firm, we never include the
addition to retained earnings. Why not? Is this an oversight?
The addition to retained earnings is not a cash flow. It is simply an accounting entry that reconciles the
balance sheet. Any additions to retained earnings will show up as cash flow changes in other balance sheet
accounts.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 3 Hard
Topic: Financial Cash Flow
90.
Note that we added depreciation back to operating cash flow and to additions to fixed assets. Why add it
back twice? Isn't this double-counting?
In both cases, depreciation is added back because it was previously subtracted when obtaining ending
balances of net income and fixed assets. Also, since depreciation is a noncash expense, we need to add it
back in both instances, so there is no double counting.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 3 Hard
Topic: Financial Cash Flow
91.
Sometimes when businesses are critically delinquent on their tax liabilities, the tax authority comes in and
literally seizes the business by chasing all of the employees out of the building and changing the locks.
What does this tell you about the importance of taxes relative to our discussion of cash flow? Why might a
business owner want to avoid such an occurrence?
Taxes must be paid in cash, and in this case, they are one of the most important components of cash flow.
The reputation of a business can undergo irreparable harm if word gets out that the tax authorities have
confiscated the business, even if only for a couple of hours until the business owner can come up with the
money to clear up the tax problem. The bottom line is if the owner can't come up with the cash, the tax
authority has effectively put them out of business.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: Taxes
92.
Interpret, in words, what cash flow of the firm represents by discussing operating cash flow, changes in net
working capital, and additions to fixed assets.
Operating cash flow is the cash flow a firm generates from its day-to-day operations. In other words, it is
the cash inflow generated as a result of putting the firm's assets to work. Changes in net working capital
and fixed assets represent investments a firm makes in these assets. That is, a firm typically takes some of
the cash flow it generates from using assets and reinvests it in new assets. Cash flow of the firm, then, is
the cash flow a firm generates by employing its assets, net of any acquisitions.
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 2 Medium
Topic: Financial Cash Flow
93.
Why is cash flow management important?
Cash flow management is important because managers could manipulate cash flows which present
inaccurate information about the firm. Second, GAAP accounting principles allow significant subjective
decisions to be made in many key areas. The use of cash flow as a metric to evaluate a company comes
from the idea that there is less subjectivity involved and therefore, harder to spin the numbers.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: Financial Cash Flow
94.
What is operating cash flow and how does it different from the total cash flow to the firm?
Several types of cash flow are relevant to understanding the financial situation of the firm. Operating cash
flow, defined as earnings before interest plus depreciation minus taxes, measures the cash generated from
operations not counting capital spending or working capital requirements. It is usually positive; a firm is in
trouble if operating cash flow is negative for a long time because the firm is not generating enough cash to
pay operating costs. Total cash flow of the firm includes adjustments for capital spending and additions to
net working capital. It will frequently be negative. When a firm is growing at a rapid rate, spending on
inventory and fixed assets can be higher than operating cash flow.
We start with net income and add back non-cash expenses and adjust for changes in current assets +
liabilities (other than cash & notes payable). The result is operating cash flow)
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: Financial Cash Flow
Chapter 3: Financial Statement Analysis and Financial Models (excluding 3.6)
Multiple Choice Questions
1.
One key reason a long-term financial plan is developed is because:
A. the plan determines your financial policy.
B. the plan determines your investment policy.
C. there are direct connections between achievable corporate growth and the financial policy.
D. there is unlimited growth possible in a well-developed financial plan.
E. None of these.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Financial Statements Analysis
2.
Projected future financial statements are called:
A. plug statements.
B. pro forma statements.
C. reconciled statements.
D. aggregated statements.
E. None of these.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Financial Models
3.
The percentage of sales method:
A. requires that all accounts grow at the same rate.
B. separates accounts that vary with sales and those that do not vary with sales.
C. allows the analyst to calculate how much financing the firm will need to support the predicted sales
level.
D. Both requires that all accounts grow at the same rate; and separates accounts that vary with sales and
those that do not vary with sales.
E. Both separates accounts that vary with sales and those that do not vary with sales; and allows the
analyst to calculate how much financing the firm will need to support the predicted sales level.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Models
4.
A ________ standardizes items on the income statement and balance sheet as a percentage of total sales
and total assets, respectively.
A. tax reconciliation statement
B. statement of standardization
C. statement of cash flows
D. common-base year statement
E. common-size statement
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Financial Statements Analysis
5.
Relationships determined from a firm's financial information and used for comparison purposes are known
as:
A. financial ratios.
B. comparison statements.
C. dimensional analysis.
D. scenario analysis.
E. solvency analysis.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
6.
Financial ratios that measure a firm's ability to pay its bills over the short run without undue stress are
known as _____ ratios.
A. asset management
B. long-term solvency
C. short-term solvency
D. profitability
E. market value
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
7.
The current ratio is measured as:
A. current assets minus current liabilities.
B. current assets divided by current liabilities.
C. current liabilities minus inventory, divided by current assets.
D. cash on hand divided by current liabilities.
E. current liabilities divided by current assets.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
8.
The quick ratio is measured as:
A. current assets divided by current liabilities.
B. cash on hand plus current liabilities, divided by current assets.
C. current liabilities divided by current assets, plus inventory.
D. current assets minus inventory, divided by current liabilities.
E. current assets minus inventory minus current liabilities.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
9.
The cash ratio is measured as:
A. current assets divided by current liabilities.
B. current assets minus cash on hand, divided by current liabilities.
C. current liabilities plus current assets, divided by cash on hand.
D. cash on hand plus inventory, divided by current liabilities.
E. cash on hand divided by current liabilities.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
10.
Ratios that measure a firm's financial leverage are known as ________ ratios.
A. asset management
B. long-term solvency
C. short-term solvency
D. profitability
E. market value
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
11.
The financial ratio measured as total assets minus total equity, divided by total assets, is the:
A. total debt ratio.
B. equity multiplier.
C. debt-equity ratio.
D. current ratio.
E. times interest earned ratio.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
12.
The debt-equity ratio is measured as total:
A. equity minus total debt.
B. equity divided by total debt.
C. debt divided by total equity.
D. debt plus total equity.
E. debt minus total assets, divided by total equity.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
13.
The equity multiplier ratio is measured as total:
A. equity divided by total assets.
B. equity plus total debt.
C. assets minus total equity, divided by total assets.
D. assets plus total equity, divided by total debt.
E. assets divided by total equity.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
14.
The financial ratio measured as earnings before interest and taxes, divided by interest expense is the:
A. cash coverage ratio.
B. debt-equity ratio.
C. times interest earned ratio.
D. gross margin.
E. total debt ratio.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
15.
The financial ratio measured as earnings before interest and taxes, plus depreciation, divided by interest
expense, is the:
A. cash coverage ratio.
B. debt-equity ratio.
C. times interest earned ratio.
D. gross margin.
E. total debt ratio.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
16.
Ratios that measure how efficiently a firm uses its assets to generate sales are known as _______ ratios.
A. asset management
B. long-term solvency
C. short-term solvency
D. profitability
E. market value
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
17.
The inventory turnover ratio is measured as:
A. total sales minus inventory.
B. inventory times total sales.
C. cost of goods sold divided by inventory.
D. inventory times cost of goods sold.
E. inventory plus cost of goods sold.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
18.
The financial ratio days' sales in inventory is measured as:
A. inventory turnover plus 365 days.
B. inventory times 365 days.
C. inventory plus cost of goods sold, divided by 365 days.
D. 365 days divided by the inventory.
E. 365 days divided by the inventory turnover.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
19.
The receivables turnover ratio is measured as:
A. sales plus accounts receivable.
B. sales divided by accounts receivable.
C. sales minus accounts receivable, divided by sales.
D. accounts receivable times sales.
E. accounts receivable divided by sales.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
20.
The financial ratio days' sales in receivables is measured as:
A. receivables turnover plus 365 days.
B. accounts receivable times 365 days.
C. accounts receivable plus sales, divided by 365 days.
D. 365 days divided by the receivables turnover.
E. 365 days divided by the accounts receivable.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
21.
The total asset turnover ratio is measured as:
A. sales minus total assets.
B. sales divided by total assets.
C. sales times total assets.
D. total assets divided by sales.
E. total assets plus sales.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
22.
Ratios that measure how efficiently a firm's management uses its assets and equity to generate bottom line
net income are known as _______ ratios.
A. asset management
B. long-term solvency
C. short-term solvency
D. profitability
E. market value
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
23.
The financial ratio measured as net income divided by sales is known as the firm's:
A. profit margin.
B. return on assets.
C. return on equity.
D. asset turnover.
E. earnings before interest and taxes.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
24.
The financial ratio measured as net income divided by total assets is known as the firm's:
A. profit margin.
B. return on assets.
C. return on equity.
D. asset turnover.
E. earnings before interest and taxes.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
25.
The financial ratio measured as net income divided by total equity is known as the firm's:
A. profit margin.
B. return on assets.
C. return on equity.
D. asset turnover.
E. earnings before interest and taxes.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
26.
The financial ratio measured as the price per share of stock divided by earnings per share is known as the:
A. return on assets.
B. return on equity.
C. debt-equity ratio.
D. price-earnings ratio.
E. Du Pont identity.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Ratio Analysis
27.
The market-to-book ratio is measured as:
A. total equity divided by total assets.
B. net income times market price per share of stock.
C. net income divided by market price per share of stock.
D. market price per share of stock divided by earnings per share.
E. market value of equity per share divided by book value of equity per share.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
28.
The _______ breaks down return on equity into three component parts.
A. Du Pont identity
B. return on assets
C. statement of cash flows
D. asset turnover ratio
E. equity multiplier
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: The DuPont Identity
29.
The External Funds Needed (EFN) equation does not measure the:
A. additional asset requirements given a change in sales.
B. additional total liabilities raised given the change in sales.
C. rate of return to shareholders given the change in sales.
D. net income expected to be earned given the change in sales.
E. None of these.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Models
30.
To calculate sustainable growth rate without using return on equity, the analyst needs the:
A. profit margin.
B. payout ratio.
C. debt-to-equity ratio.
D. total asset turnover.
E. All of these.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: External Financing and Growth
31.
Growth can be reconciled with the goal of maximizing firm value:
A. because greater growth always adds to value.
B. because growth must be an outcome of decisions that maximize NPV.
C. because growth and wealth maximization are the same.
D. because growth of any type cannot decrease value.
E. None of these.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: External Financing and Growth
32.
Sustainable growth can be determined by the:
A. profit margin, total asset turnover and the price to earnings ratio.
B. profit margin, the payout ratio, the debt-to-equity ratio, and the asset requirement or asset turnover
ratio.
C. Total growth less capital gains growth.
D. Either profit margin, total asset turnover and the price to earnings ratio or profit margin, the payout
ratio, the debt-to-equity ratio, and the asset requirement or asset turnover ratio.
E. None of these.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: External Financing and Growth
33.
Which of the following will increase sustainable growth?
A. Buy back existing stock
B. Decrease debt
C. Increase profit margin
D. Increase asset requirement or asset turnover ratio
E. Increase dividend payout ratio
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: External Financing and Growth
34.
The main objective of long-term financial planning models is to:
A. determine the asset requirements given the investment activities of the firm.
B. plan for contingencies or uncertain events.
C. determine the external financing needs.
D. All of these.
E. None of these.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
35.
On a common-size balance sheet, all _______ accounts are shown as a percentage of _______.
A. income; total assets
B. liability; net income
C. asset; sales
D. liability; total assets
E. equity; sales
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
36.
Which one of the following statements is correct concerning ratio analysis?
A. A single ratio is often computed differently by different individuals.
B. Ratios do not address the problem of size differences among firms.
C. Only a very limited number of ratios can be used for analytical purposes.
D. Each ratio has a specific formula that is used consistently by all analysts.
E. Ratios can not be used for comparison purposes over periods of time.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
37.
Which of the following are liquidity ratios?
I. cash coverage ratio
II. current ratio
III. quick ratio
IV. inventory turnover
A. II and III only
B. I and II only
C. II, III, and IV only
D. I, III, and IV only
E. I, II, III, and IV
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
38.
An increase in which one of the following accounts increases a firm's current ratio without affecting its
quick ratio?
A. accounts payable
B. cash
C. inventory
D. accounts receivable
E. fixed assets
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
39.
A supplier, who requires payment within ten days, is most concerned with which one of the following
ratios when granting credit?
A. current
B. cash
C. debt-equity
D. quick
E. total debt
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
40.
A firm has a total debt ratio of .47. This means that that firm has 47 cents in debt for every:
A. $1 in equity.
B. $1 in total sales.
C. $1 in current assets.
D. $.53 in equity.
E. $.53 in total assets.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
41.
The long-term debt ratio is probably of most interest to a firm's:
A. credit customers.
B. employees.
C. suppliers.
D. mortgage holder.
E. shareholders.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
42.
A banker considering loaning a firm money for ten years would most likely prefer the firm have a debt
ratio of _______ and a times interest earned ratio of _______.
A. .75; .75
B. .50; 1.00
C. .45; 1.75
D. .40; 2.50
E. .35; 3.00
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
43.
From a cash flow position, which one of the following ratios best measures a firm's ability to pay the
interest on its debts?
A. times interest earned ratio
B. cash coverage ratio
C. cash ratio
D. quick ratio
E. Interval measure
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
44.
The higher the inventory turnover measure, the:
A. faster a firm sells its inventory.
B. faster a firm collects payment on its sales.
C. longer it takes a firm to sell its inventory.
D. greater the amount of inventory held by a firm.
E. lesser the amount of inventory held by a firm.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
45.
Which one of the following statements is correct if a firm has a receivables turnover measure of 10?
A. It takes a firm 10 days to collect payment from its customers.
B. It takes a firm 36.5 days to sell its inventory and collect the payment from the sale.
C. It takes a firm 36.5 days to pay its creditors.
D. The firm has an average collection period of 36.5 days.
E. The firm has ten times more in accounts receivable than it does in cash.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
46.
A total asset turnover measure of 1.03 means that a firm has $1.03 in:
A. total assets for every $1 in cash.
B. total assets for every $1 in total debt.
C. total assets for every $1 in equity.
D. sales for every $1 in total assets.
E. long-term assets for every $1 in short-term assets.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
47.
Puffy's Pastries generates five cents of net income for every $1 in sales. Thus, Puffy's has a _______ of
5%.
A. return on assets
B. return on equity
C. profit margin
D. Du Pont measure
E. total asset turnover
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
48.
If a firm produces a 10% return on assets and also a 10% return on equity, then the firm:
A. has no debt of any kind.
B. is using its assets as efficiently as possible.
C. has no net working capital.
D. also has a current ratio of 10.
E. has an equity multiplier of 2.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
49.
If shareholders want to know how much profit a firm is making on their entire investment in the firm, the
shareholders should look at the:
A. profit margin.
B. return on assets.
C. return on equity.
D. equity multiplier.
E. earnings per share.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
50.
BGL Enterprises increases its operating efficiency such that costs decrease while sales remain constant. As
a result, given all else constant, the:
A. return on equity will increase.
B. return on assets will decrease.
C. profit margin will decline.
D. equity multiplier will decrease.
E. price-earnings ratio will increase.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
51.
The only difference between Joe's and Moe's is that Joe's has old, fully depreciated equipment. Moe's just
purchased all new equipment which will be depreciated over eight years. Assuming all else equal:
A. Joe's will have a lower profit margin.
B. Joe's will have a lower return on equity.
C. Moe's will have a higher net income.
D. Moe's will have a lower profit margin.
E. Moe's will have a higher return on assets.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
52.
Last year, Alfred's Automotive had a price-earnings ratio of 15. This year, the price earnings ratio is 18.
Based on this information, it can be stated with certainty that:
A. the price per share increased.
B. the earnings per share decreased.
C. investors are paying a higher price for each share of stock purchased.
D. investors are receiving a higher rate of return this year.
E. either the price per share, the earnings per share, or both changed.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
53.
Turner's Inc. has a price-earnings ratio of 16. Alfred's Co. has a price-earnings ratio of 19. Thus, you can
state with certainty that one share of stock in Alfred's:
A. has a higher market price than one share of stock in Turner's.
B. has a higher market price per dollar of earnings than does one share of Turner's.
C. sells at a lower price per share than one share of Turner's.
D. represents a larger percentage of firm ownership than does one share of Turner's stock.
E. earns a greater profit per share than does one share of Turner's stock.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
54.
Which two of the following are most apt to cause a firm to have a higher price-earnings ratio?
I. slow industry outlook
II. high prospect of firm growth
III. very low current earnings
IV. investors with a low opinion of the firm
A. I and II only
B. II and III only
C. II and IV only
D. I and III only
E. III and IV only
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
55.
Vinnie's Motors has a market-to-book ratio of 3. The book value per share is $4.00. Holding market-tobook constant, a $1 increase in the book value per share will:
A. cause the accountants to increase the equity of the firm by an additional $2.
B. increase the market price per share by $1.
C. increase the market price per share by $12.
D. tend to cause the market price per share to rise.
E. only affect book values but not market values.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
56.
Which one of the following sets of ratios applies most directly to shareholders?
A. Return on assets and profit margin
B. Quick ratio and times interest earned
C. Price-earnings ratio and debt-equity ratio
D. Market-to-book ratio and price-earnings ratio
E. Cash coverage ratio and times equity multiplier
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
57.
The three parts of the Du Pont identity can be generally described as:
I. operating efficiency, asset use efficiency and firm profitability.
II. financial leverage, operating efficiency and asset use efficiency.
III. the equity multiplier, the profit margin and the total asset turnover.
IV. the debt-equity ratio, the capital intensity ratio and the profit margin.
A. I and II only
B. II and III only
C. I and IV only
D. I and III only
E. III and IV only
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: The DuPont Identity
58.
If a firm decreases its operating costs, all else constant, then:
A. the profit margin increases while the equity multiplier decreases.
B. the return on assets increases while the return on equity decreases.
C. the total asset turnover rate decreases while the profit margin increases.
D. both the profit margin and the equity multiplier increase.
E. both the return on assets and the return on equity increase.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: The DuPont Identity
59.
Which one of the following statements is correct?
A. Book values should always be given precedence over market values.
B. Financial statements are frequently the basis used for performance evaluations.
C. Historical information has no value when predicting the future.
D. Potential lenders place little value on financial statement information.
E. Reviewing financial information over time has very limited value.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
60.
It is easier to evaluate a firm using its financial statements when the firm:
A. is a conglomerate.
B. is global in nature.
C. uses the same accounting procedures as other firms in its industry.
D. has a different fiscal year than other firms in its industry.
E. tends to have one-time events such as asset sales and property acquisitions.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
61.
Which two of the following represent the most effective methods of directly evaluating the financial
performance of a firm?
I. comparing the current financial ratios to those of the same firm from prior time periods
II. comparing a firm's financial ratios to those of other firms in the firm's peer group who have similar
operations
III. comparing the financial statements of the firm to the financial statements of similar firms operating in
other countries
IV. comparing the financial ratios of the firm to the average ratios of all firms located in the same
geographic area
A. I and II only
B. II and III only
C. III and IV only
D. I and IV only
E. I and III only
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
62.
In the financial planning model, external funds needed (EFN) is equal to changes in
A. assets - (liabilities - equity).
B. assets - (liabilities + equity).
C. (assets + liabilities - equity).
D. (assets + equity - liabilities).
E. assets - equity.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Models
63.
Which of the following represent problems encountered when comparing the financial statements of one
firm with those of another firm?
I. Either one, or both, of the firms may be conglomerates and thus have unrelated lines of business.
II. The operations of the two firms may vary geographically.
III. The firms may use differing accounting methods for inventory purposes.
IV. The two firms may be seasonal in nature and have different fiscal year ends.
A. I and II only
B. II and III only
C. I, III, and IV only
D. I, II, and III only
E. I, II, III, and IV
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
64.
A firm's sustainable growth rate in sales directly depends on its:
A. debt to equity ratio.
B. profit margin.
C. dividend policy.
D. asset efficiency.
E. All of these.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: External Financing and Growth
65.
The sustainable growth rate will be equivalent to the internal growth rate when:
A. a firm has no debt.
B. the growth rate is positive.
C. the plowback ratio is positive but less than 1.
D. a firm has a debt-equity ratio exactly equal to 1.
E. net income is greater than zero.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: External Financing and Growth
66.
The sustainable growth rate:
A. assumes there is no external financing of any kind.
B. is normally higher than the internal growth rate.
C. assumes the debt-equity ratio is variable.
D. is based on receiving additional external debt and equity financing.
E. assumes that 100% of all income is retained by the firm.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: External Financing and Growth
67.
If a firm bases its growth projection on the rate of sustainable growth, and shows positive net income, then
the:
A. fixed assets will have to increase at the same rate, regardless of the current capacity level.
B. number of common shares outstanding will increase at the same rate of growth.
C. debt-equity ratio will have to increase.
D. debt-equity ratio will remain constant while retained earnings increase.
E. fixed assets, debt-equity ratio, and number of common shares outstanding will all increase.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: External Financing and Growth
68.
Marcie's Mercantile wants to maintain its current dividend policy, which is a payout ratio of 40%. The firm
does not want to increase its equity financing but is willing to maintain its current debt-equity ratio. Given
these requirements, the maximum rate at which Marcie's can grow is equal to:
A. 40% of the internal rate of growth.
B. 60% of the internal rate of growth.
C. the internal rate of growth.
D. the sustainable rate of growth.
E. 60% of the sustainable rate of growth.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: External Financing and Growth
69.
One of the primary weaknesses of many financial planning models is that they:
A. rely too much on financial relationships and too little on accounting relationships.
B. are iterative in nature.
C. ignore the goals and objectives of senior management.
D. are based solely on best case assumptions.
E. ignore the size, risk, and timing of cash flows.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Models
70.
Financial planning, when properly executed:
A. ignores the normal restraints encountered by a firm.
B. ensures that the primary goals of senior management are fully achieved.
C. reduces the necessity of daily management oversight of the business operations.
D. helps ensure that proper financing is in place to support the desired level of growth.
E. eliminates the need to plan more than one year in advance.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Financial Models
71.
When examining the EBITDA ratio, lower numbers are:
A. considered good.
B. considered mediocre.
C. considered poor.
D. indifferent to higher numbers.
E. it is impossible to garner information from this ratio.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
72.
A firm's market capitalization is equal to:
A. total book value of assets less book value of debt.
B. par value of common equity.
C. firm's stock price multiplied by number of shares outstanding.
D. firm's stock price multiplied by the number of shares authorized.
E. the maximum value an acquirer would pay for a firm in an acquisition.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
73.
Enterprise value focused on:
A. market values of debt and equity.
B. book values of debt and assets.
C. market value of equity and book value of debt.
D. book value if debt and market value of equity.
E. book values of debt and equity.
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Ratio Analysis
74.
A firm has sales of $1,200, net income of $200, net fixed assets of $500, and current assets of $300. The
firm has $200 in inventory. What is the common-size statement value of inventory?
A. 10.0%
B. 16.67%
C. 25.0%
D. 40.0%
E. 67.67%
Common-size inventory = $200 ÷ ($500 + $300) = 25%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
75.
A firm has sales of $1,500, net income of $100, total assets of $1,000, and total equity of $700. Interest
expense is $50. What is the common-size statement value of the interest expense?
A. 3.3%
B. 5.0%
C. 7.1%
D. 16.7%
E. 50.0%
Common-size interest = $50 ÷ $1,500 = .033 = 3.3%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
76.
Jessica's Boutique has cash of $50, accounts receivable of $60, accounts payable of $400, and inventory of
$100. What is the value of the quick ratio?
A. .125
B. .15
C. .275
D. .525
E. 1.525
Quick ratio = ($50 + $60) ÷ $400 = .275
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
77.
A firm has a debt-equity ratio of .40. What is the total debt ratio?
A. .29
B. .33
C. .67
D. 1.40
E. 1.50
The debt-equity ratio is .40. Thus, if total debt is $40, total equity is $100 and total assets are $140. Total
debt ratio = $40 ÷ $140 = .29
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
78.
A firm has total debt of $1,200 and a debt-equity ratio of .40. What is the value of the total assets?
A. $1,680
B. $3,000
C. $3,520
D. $4,200
E. $5,300
Total equity = $1,200 ÷ .40 = $3,000; Total assets = $1,200 + $3,000 = $4,200
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
79.
A firm has sales of $4,000, costs of $3,000, interest paid of $100, and depreciation of $400. The tax rate is
34%. What is the value of the cash coverage ratio?
A. 3
B. 4
C. 6
D. 7
E. 10
Cash coverage ratio = ($4,000 - $3,000) ÷ $100 = 10
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
80.
Rosita's Resources paid $250 in interest and $130 in dividends last year. The times interest earned ratio is
3.8 and the depreciation expense is $80. What is the value of the cash coverage ratio?
A. 2.71
B. 3.64
C. 4.12
D. 5.78
E. 6.10
EBIT = 3.8 × $250 = $950; Cash coverage ratio = ($950 + $80) ÷ $250 = 4.12
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
81.
Mario's Home Systems has sales of $2,800, cost of goods sold of $2,100, inventory of $600, and accounts
receivable of $600. How many days, on average, does it take Mario's to sell its inventory?
A. 42.10 days
B. 66.37 days
C. 78.21 days
D. 104.29 days
E. 273.75 days
Inventory turnover = $2,100 ÷ $600 = 3.5; Days in inventory = 365 ÷ 4.2 = 104.29 days
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
82.
Syed's Industries has accounts receivable of $700, inventory of $1,200, sales of $4,200, and cost of goods
sold of $3,500. How long does it take Syed's to both sell its inventory and then collect the payment on the
sale?
A. 110 days
B. 131 days
C. 145 days
D. 186 days
E. 210 days
Inventory turnover = $3,500 ÷ $1,200 = 2.92; Days in inventory = 365 ÷ 2.92 = 125; Accounts receivable
turnover = $4,200 ÷ $700 = 6; Days' sales in receivables = 365 ÷ 6 = 60.83; Total days in inventory and
receivables = 125 + 60.83 = 185.83 days = 186 days (rounded)
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
83.
A firm has net working capital of $600, net fixed assets of $2,400, sales of $8,000, and current liabilities of
$800. How many dollars worth of sales are generated from every $1 in total assets?
A. $2.11
B. $2.32
C. $3.73
D. $4.52
E. $6.70
Total asset turnover = $8,000 ÷ [($600 + $800) + $2,400] = 2.11; Every $1 in total assets generates $2.11
in sales.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
84.
Rosita's Restaurant has sales of $5,000, total debt of $1,300, total equity of $2,400, and a profit margin of
6%. What is the return on assets?
A. 8.11%
B. 12.50%
C. 23.08%
D. 27.13%
E. 135.13%
Return on assets = (.06 × $5,000) ÷ ($1,300 + $2,400) = $300 ÷ $3,700 = .08108 = 8.108%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
85.
Lee Sun's has sales of $3,000, total assets of $3,000, and a profit margin of 5%. The firm has a total debt
ratio of 60%. What is the return on equity?
A. 5%
B. 12.5%
C. 23.2%
D. 41.3%
E. 250%
Return on equity = (.05 × $3,000) ÷ [$3,000 × (1 - .60)] = $150 ÷ $1,200 = 12.5%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
86.
Jupiter Explorers has $6,400 in sales. The profit margin is 4%. There are 6,400 shares of stock outstanding.
The market price per share is $1.20. What is the price-earnings ratio?
A. 13
B. 14
C. 21
D. 30
E. 48
Earnings per share = (.04 × $6,400) ÷ 6,400 = .04; Price-earnings ratio = $1.20 ÷ .04 = 30
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
87.
Patti's has net income of $1,800, a price-earnings ratio of 12, and earnings per share of $1.20. How many
shares of stock are outstanding?
A. 1,200
B. 1,400
C. 1,500
D. 1,600
E. 1,800
Number of shares = $1,800 ÷ $1.20 = 1,500
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
88.
A firm has 5,000 shares of stock outstanding, sales of $6,000, net income of $800, a price-ratio of 10, and a
book value per share of $.50. What is the market-to-book ratio?
A. 1.6
B. 2.4
C. 3.0
D. 3.2
E. 3.6
Earnings per share = $800 ÷ 5,000 = $.16; Price per share = $.16 × 10 = $1.60; Market-to-book ratio =
$1.60 ÷ $.50 = 3.2
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
89.
A firm has 5,000 shares of stock outstanding, sales of $6,000, an enterprise value of $5 million and an
EBITDA of 1 million. What is the enterprise value multiple?
A. 2.2
B. 2.4
C. 3.0
D. 4.0
E. 5.0
Enterprise value multiple = enterprise value/EBITDA = $5 million/$1 million = 5.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
90.
A firm has a market capitalization of $2 million, market value of interest bearing debt of $1 million, book
value of interest bearing debt of $500,000 and cash of $100,000. What is the enterprise value?
A. $2.5 million
B. $2.9 million
C. $3.0 million
D. $3.5 million
E. $3.6 million
Enterprise value = $2 million + $1 million - $100,000 = 2.9 million
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
91.
Frederico's has a profit margin of 6%, a return on assets of 8%, and an equity multiplier of 1.4. What is the
return on equity?
A. 6.7%
B. 8.4%
C. 11.2%
D. 14.6%
E. 19.6%
Return on equity = 8% × 1.4 = 11.2%, using the Du Pont Identity
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The DuPont Identity
92.
Samuelson's has a debt-equity ratio of 40%, sales of $8,000, net income of $600, and total debt of $2,400.
What is the return on equity?
A. 6.25%
B. 7.50%
C. 9.75%
D. 10.00%
E. 11.25%
Return on equity = $600 ÷ ($2,400 ÷ .40) = .10 = 10%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The DuPont Identity
93.
A firm has a return on equity of 15%. The debt-equity ratio is 50%. The total asset turnover is 1.25 and the
profit margin is 8%. The total equity is $3,200. What is the amount of the net income?
A. $480
B. $500
C. $540
D. $600
E. $620
Using the Du Pont identity: Total assets = (1 + .50) × $3,200 = $4,800; Total sales = $4,800 × 1.25 =
$6,000; Net income = $6,000 × .08 = $480
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The DuPont Identity
94.
What is the quick ratio for 2011?
A. .82
B. .95
C. 1.36
D. 2.18
E. 2.28
Quick ratio for 2011 = ($2,440 - $1,520) ÷ $1,120 = .82
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: Ratio Analysis
95.
What is the days' sales in receivables in 2011?
A. 31.8 days
B. 33.7 days
C. 38.4 days
D. 41.9 days
E. 47.4 days
Accounts receivable turnover for 2011 = $8,450 ÷ $780 = 10.83; Days' sales in receivables for 2011 = 365
÷ 10.83 = 33.7
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
96.
What is the equity multiplier for 2011?
A. 1.6
B. 1.8
C. 2.0
D. 2.3
E. 2.5
Equity multiplier for 2011 = $6,040 ÷ ($3,000 + $710) = 1.6
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
97.
What is the cash coverage ratio for 2011?
A. 11.6
B. 12.8
C. 13.7
D. 17.3
E. 18.8
Cash coverage ratio for 2011 = ($810 + $400) ÷ $70 = 17.3
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
98.
What is the return on equity for 2011?
A. 5.7%
B. 6.8%
C. 13.0%
D. 15.3%
E. 16.0%
Return on equity for 2011 = $481 ÷ ($3,000 + $710) = .13 = 13%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
99.
Windswept, Inc. has 90 million shares of stock outstanding. Its price-earnings ratio for 2011 is 12. What is
the market price per share of stock?
A. $57.12
B. $59.94
C. $62.82
D. $64.13
E. $65.03
Earnings per share for 2011 = $481 million ÷ 90 million = $5.3444; Market price per share = $5.3444 × 12
= $64.13
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
100.
In 2011, how many days on average did it take Bayside to sell its inventory?
A. 126.1 days
B. 127.9 days
C. 153.8 days
D. 176.5 days
E. 178.9 days
Inventory turnover for 2011 = $4,060 ÷ $1,990 = 2.04; Days' sales in inventory = 365 ÷ 2.04 = 178.9 days
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
101.
What is the debt-equity ratio for 2011?
A. 22.5%
B. 26.2%
C. 35.5%
D. 45.1%
E. 47.7%
Debt-equity ratio for 2011 = ($1,170 + $500) ÷ ($3,500 + $1,200) = .355 = 35.5%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
102.
What is the times interest earned ratio for 2011?
A. 30
B. 36
C. 40
D. 50
E. 54
Times interest earned for 2011 = $1,200 ÷ $30 = 40
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
103.
What is the equity multiplier for 2011?
A. 1.21
B. 1.36
C. 1.44
D. 1.82
E. 1.91
Equity multiplier for 2011 = $6,370 ÷ ($3,500 + $1,200) = 1.36
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
104.
What is the return on equity for 2011?
A. 16.2%
B. 20.9%
C. 21.7%
D. 22.1%
E. 23.3%
Return on equity for 2011 = $760 ÷ ($3,500 + $1,200) = .162 = 16.2%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
105.
The Green Giant has a 5% profit margin and a 40% dividend payout ratio. The total asset turnover is 1.40
and the equity multiplier is 1.50. What is the sustainable rate of growth?
A. 6.30%
B. 6.53%
C. 6.72%
D. 6.80%
E. 6.83%
Return on equity = .05 × 1.40 × 1.50 = .105; Sustainable growth = {.105 × (1 - .40)} ÷ {1 - [.105 × (1 .40)]} = .06724 = 6.72%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: External Financing and Growth
106.
Neal's Nails has an 11% return on assets and a 30% dividend payout ratio. What is the internal growth
rate?
A. 7.11%
B. 7.70%
C. 8.34%
D. 8.46%
E. 11.99%
Internal growth rate = {.11 × (1 - .30)} ÷ {1 - [.11 × (1 - .30)]} = 8.34%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: External Financing and Growth
107.
Katelyn's Kites has net income of $240 and total equity of $2,000. The debt-equity ratio is 1.0 and the
plowback ratio is 40%. What is the internal growth rate?
A. 2.46%
B. 3.00%
C. 4.92%
D. 5.88%
E. 6.00%
Total assets = $2,000 + $2,000 = $4,000 (The debt-equity ratio of 1.0 means TD = TE.); Return on assets =
$240 ÷ $4,000 = .06; Internal growth = [.06 × .40] ÷ [1 - (.06 × .40)] = 2.46%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: External Financing and Growth
108.
Fleur International had a 3% profit margin and a 35% dividend payout ratio. The total asset turnover is
1.25 and the equity multiplier is 1.30. What is the sustainable growth rate?
A. 3.27%
B. 3.67%
C. 4.27%
D. 5.60%
E. None of these
Return on equity = 0.03 * 1.25 * 1.30 = .04875
Sustainable growth = {.04875 * (1 - .35)}/{1 - [.04875 * (1 - .35)]} = .03169/.96831 = .0327 = 3.27%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: External Financing and Growth
109.
Moulton Incorporated has a 10% return on assets and a 20% dividend payout ratio. What is the internal
growth rate?
A. 8.2%
B. 8.7%
C. 9.4%
D. 10%
E. None of these
Internal growth rate = {.10 * (1-.20)}/{1-[.10 * (1-.20)]} = .08/.92 = 8.7%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: External Financing and Growth
110.
Catherine's Consulting has a net income of $1,400 and a total equity of $12,000. The debt-equity ratio is
1.0 and the plowback is 30%. What is the return on assets?
A. 4.24%
B. 4.64%
C. 5.23%
D. 5.83%
E. None of these
Total assets = 12,000 + 12,000 = 24,000 (The debt-equity ratio of 1.0 mean total debt = total equity)
Return on assets = 1400/24,000 = 5.83%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Ratio Analysis
111.
Catherine's Consulting has a net income of $1,400 and a total equity of $12,000. The debt-equity ratio is
1.0 and the plowback is 30%. What is the internal growth rate for Catherine's consulting?
A. 1.6%
B. 1.78%
C. 1.98%
D. 2.21%
E. None of these
Internal growth rate = [.0583 * .30]/[1 - .0583 * .30] = 1.78%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: External Financing and Growth
Essay Questions
112.
Why is it important for managers to understand the importance of both the internal and the sustainable
rates of growth?
One reason that causes firms to go out of business is the lack of external funding to support the growth of
the firm. Understanding the implications of both the internal and sustainable growth rates can help
management know when to limit firm growth such that the growth does not exceed the availability of the
necessary financing to fund that growth.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: External Financing and Growth
113.
State the assumptions that underlie the sustainable growth rate and interpret what the sustainable growth
rate means.
The usual assumptions are: Costs and assets increase proportionately with sales, the dividend payout ratio
is fixed (or is given), the current debt-equity ratio is optimal, and no new equity sales are possible. The
sustainable growth rate is the maximum rate at which sales can increase with the restriction that no new
equity sales are possible and long-term debt increases only in an amount that keeps the debt-equity ratio
fixed.
AACSB: Reflective Thinking
Blooms: Understand
Difficulty level: 2 Medium
Topic: External Financing and Growth
114.
Suppose a firm calculates its external funding needs and finds that it is negative. What are the firm's
options in this case?
With a negative external financing need, the firm has a surplus of funds that it can use to reduce current
liabilities, reduce long-term debt, buy back common stock, or increase dividends. If acceptable
opportunities exist, firms might also use the extra funds to add assets.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: External Financing and Growth
115.
Robert Morris Associates publishes peer group financial information for a host of industries, yet the
numbers typically only appear in common-size form. Why not report average dollar amounts instead?
The common-size numbers are inherently more useful since they can be directly compared to the financial
statements of any firm. If average dollar figures were presented, these numbers would have to be converted
to common-size numbers to facilitate comparisons. Plus, since RMA also publishes average sales and
average total assets, the user can always work backwards to figure out the dollar amounts represented by
each category.
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
116.
A firm has days' sales in inventory of 105 days, an average collection period of 35 days, and takes 42 days,
on average, to pay its accounts payable. Taken together, what do these three figures imply about the firm's
operations and its cash flows?
It takes, on average, 105 days to sell inventory once it is purchased by the firm, then it takes another 35
days to collect on the receivables. Thus, the firm must finance the inventory and receivables for 140 days.
The first 42 days are financed with payables, on average, leaving 98 days' worth of inventory and
receivables that it must finance using other sources. In terms of cash flow, the average cash outflow occurs
42 days after inventory is purchased while the average cash inflow occurs 98 days later, which is 140 days
after the inventory is purchased by the firm.
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 2 Medium
Topic: Ratio Analysis
117.
Suppose you calculated the following ratio for a firm: The sum of the compensation paid to the owners,
directors, and managers, divided by total sales. Which class of financial ratios should this be included in
and why? Who might be interested in such a ratio?
This doesn't fit well into any of the five categories presented in the book although it would most likely be
included as a profitability ratio because it is a measure of how much of each dollar in sales is used to pay
these salaries. The ratio would likely be important to all of the three groups (owners, directors, managers)
included in the ratio, plus it would likely be important to lenders as a measure of how much of the firm's
income these groups draw out of the business.
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 2 Medium
Topic: Ratio Analysis
118.
Which is a more meaningful measure of profitability for a firm, return on assets or return on equity? Why?
Most would argue ROE since it measures returns relative to the amount of money shareholders have
invested in the firm. In addition, since shareholder wealth maximization is a firm's primary goal, it makes
more sense to look at this measure.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 3 Hard
Topic: The DuPont Identity
119.
It is often said that anyone with a pencil can calculate financial ratios, but it takes a brain to interpret them.
What kinds of things should an analyst keep in mind when evaluating the financial statements of a given
firm?
This question is totally open-ended and allows students to call into play knowledge gleaned from other
courses, this course, and personal experience. As a minimum, students should include some of these
considerations: type of industry, accounting methods, fiscal year end, cyclical nature of the business,
industry trends and the state of the economy.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 2 Medium
Topic: Financial Statements Analysis
120.
List and interpret two liquidity ratios.
Choose any two of the following:
1. Current ratio: a firm's ability to meet its financial obligations as they come due over the coming year
2. Quick ratio: a firm's ability to meet its near-term financial obligations without selling any inventory
3. Cash ratio: a firm's ability to meet its near-term financial obligations without depending on the
liquidation of inventory or accounts receivable
Chapter 4: Discounted Cash Flow Valuation (excluding 4.5; 4.6)
Multiple Choice Questions
1.
An annuity stream of cash flow payments is a set of:
A. level cash flows occurring each time period for a fixed length of time.
B. level cash flows occurring each time period forever.
C. increasing cash flows occurring each time period for a fixed length of time.
D. increasing cash flows occurring each time period forever.
E. arbitrary cash flows occurring each time period for no more than 10 years.
AACSB: Analytic
Blooms: Remember
Difficulty Level: 1 Easy
Topic: Simplifications
2.
Annuities where the payments occur at the end of each time period are called _____, whereas _____ refer
to annuity streams with payments occurring at the beginning of each time period.
A. ordinary annuities; early annuities
B. late annuities; straight annuities
C. straight annuities; late annuities
D. annuities due; ordinary annuities
E. ordinary annuities; annuities due
AACSB: Analytic
Blooms: Remember
Difficulty Level: 1 Easy
Topic: Simplifications
3.
An annuity stream where the payments occur forever is called a(n):
A. annuity due.
B. indemnity.
C. perpetuity.
D. amortized cash flow stream.
E. amortization table.
AACSB: Analytic
Blooms: Remember
Difficulty Level: 1 Easy
Topic: Simplifications
4.
The interest rate expressed in terms of the interest payment made each period is called the _____ rate.
A. stated annual interest
B. compound annual interest
C. effective annual interest
D. periodic interest
E. daily interest
AACSB: Analytic
Blooms: Remember
Difficulty Level: 1 Easy
Topic: Compounding Periods
5.
The interest rate expressed as if it were compounded once per year is called the _____ rate.
A. stated interest
B. compound interest
C. effective annual
D. periodic interest
E. daily interest
AACSB: Analytic
Blooms: Remember
Difficulty Level: 1 Easy
Topic: Compounding Periods
6.
The interest rate charged per period multiplied by the number of periods per year is called the _____ rate.
A. effective annual
B. annual percentage
C. periodic interest
D. compound interest
E. daily interest
AACSB: Analytic
Blooms: Remember
Difficulty Level: 1 Easy
Topic: Compounding Periods
7.
Paying off long-term debt by making installment payments is called:
A. foreclosing on the debt.
B. amortizing the debt.
C. funding the debt.
D. calling the debt.
E. None of these.
AACSB: Analytic
Blooms: Remember
Difficulty Level: 1 Easy
Topic: Loan Amortization
8.
You are comparing two annuities which offer monthly payments for ten years. Both annuities are identical
with the exception of the payment dates. Annuity A pays on the first of each month while annuity B pays
on the last day of each month. Which one of the following statements is correct concerning these two
annuities?
A. Both annuities are of equal value today.
B. Annuity B is an annuity due.
C. Annuity A has a higher future value than annuity B.
D. Annuity B has a higher present value than annuity A.
E. Both annuities have the same future value as of ten years from today.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 2 Medium
Topic: Simplifications
9.
You are comparing two investment options. The cost to invest in either option is the same today. Both
options will provide you with $20,000 of income. Option A pays five annual payments starting with
$8,000 the first year followed by four annual payments of $3,000 each. Option B pays five annual
payments of $4,000 each. Which one of the following statements is correct given these two investment
options?
A. Both options are of equal value given that they both provide $20,000 of income.
B. Option A is the better choice of the two given any positive rate of return.
C. Option B has a higher present value than option A given a positive rate of return.
D. Option B has a lower future value at year 5 than option A given a zero rate of return.
E. Option A is preferable because it is an annuity due.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 2 Medium
Topic: Valuation: The One-Period Case
10.
You are considering two projects with the following cash flows:
Which of the following statements are true concerning these two projects?
I. Both projects have the same future value at the end of year 4, given a positive rate of return.
II. Both projects have the same future value given a zero rate of return.
III. Both projects have the same future value at any point in time, given a positive rate of return.
IV. Project A has a higher future value than project B, given a positive rate of return.
A. II only
B. IV only
C. I and III only
D. II and IV only
E. I, II, and III only
AACSB: Analytic
Blooms: Understand
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
11.
A perpetuity differs from an annuity because:
A. perpetuity payments vary with the rate of inflation.
B. perpetuity payments vary with the market rate of interest.
C. perpetuity payments are variable while annuity payments are constant.
D. perpetuity payments never cease.
E. annuity payments never cease.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 1 Easy
Topic: Simplifications
12.
Which one of the following statements concerning the annual percentage rate is correct?
A. The annual percentage rate considers interest on interest.
B. The rate of interest you actually pay on a loan is called the annual percentage rate.
C. The effective annual rate is lower than the annual percentage rate when an interest rate is compounded
quarterly.
D. When firms advertise the annual percentage rate they are violating U.S. truth-in-lending laws.
E. The annual percentage rate equals the effective annual rate when the rate on an account is designated as
simple interest.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 2 Medium
Topic: Compounding Periods
13.
Which one of the following statements concerning interest rates is correct?
A. The stated rate is the same as the effective annual rate.
B. An effective annual rate is the rate that applies if interest were charged annually.
C. The annual percentage rate increases as the number of compounding periods per year increases.
D. Banks prefer more frequent compounding on their savings accounts.
E. For any positive rate of interest, the effective annual rate will always exceed the annual percentage rate.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
14.
Which of the following statements concerning the effective annual rate are correct?
I. When making financial decisions, you should compare effective annual rates rather than annual
percentage rates.
II. The more frequently interest is compounded, the higher the effective annual rate.
III. A quoted rate of 6% compounded continuously has a higher effective annual rate than if the rate were
compounded daily.
IV. When borrowing and choosing which loan to accept, you should select the offer with the highest
effective annual rate.
A. I and II only
B. I and IV only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV
AACSB: Analytic
Blooms: Understand
Difficulty Level: 2 Medium
Topic: Compounding Periods
15.
The highest effective annual rate that can be derived from an annual percentage rate of 9% is computed as:
A. .09e - 1.
B. e.09 × q.
C. e × (1 + .09).
D. e.09 - 1.
E. (1 + .09)q.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 2 Medium
Topic: Compounding Periods
16.
The time value of money concept can be defined as:
A. the relationship between the supply and demand of money.
B. the relationship between money spent versus money received.
C. the relationship between a dollar to be received in the future and a dollar today.
D. the relationship between interest rate stated and amount paid.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
17.
Discounting cash flows involves:
A. discounting only those cash flows that occur at least 10 years in the future.
B. estimating only the cash flows that occur in the first 4 years of a project.
C. multiplying expected future cash flows by the cost of capital.
D. discounting all expected future cash flows to reflect the time value of money.
E. taking the cash discount offered on trade merchandise.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
18.
Compound interest:
A. allows for the reinvestment of interest payments.
B. does not allow for the reinvestment of interest payments.
C. is the same as simple interest.
D. provides a value that is less than simple interest.
E. Both allows for the reinvestment of interest payments and provides a value that is less than simple
interest.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 1 Easy
Topic: The Multi-Period Case
19.
An annuity:
A. is a debt instrument that pays no interest.
B. is a stream of payments that varies with current market interest rates.
C. is a level stream of equal payments through time.
D. has no value.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 1 Easy
Topic: Simplifications
20.
The stated rate of interest is 10%. Which form of compounding will give the highest effective rate of
interest?
A. annual compounding
B. monthly compounding
C. daily compounding
D. continuous compounding
E. It is impossible to tell without knowing the term of the loan.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 1 Easy
Topic: The Multi-Period Case
21.
The present value of future cash flows minus initial cost is called:
A. the future value of the project.
B. the net present value of the project.
C. the equivalent sum of the investment.
D. the initial investment risk equivalent value.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
22.
Find the present value of $5,325 to be received in one period if the rate is 6.5%.
A. $5,000.00
B. $5,023.58
C. $5,644.50
D. $5,671.13
E. None of these.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
23.
If you have a choice to earn simple interest on $10,000 for three years at 8% or annually compounded
interest at 7.5% for three years which one will pay more and by how much?
A. Simple interest by $50.00
B. Compound interest by $22.97
C. Compound interest by $150.75
D. Compound interest by $150.00
E. None of these.
Simple Interest = $10,000 (.08)(3) = $2,400;
Compound Interest = $10,000((1.075)3 - 1) = $2,422.97;
Difference = $2,422.97 - $2,400 = $22.97
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: The Multi-Period Case
24.
Bradley Snapp has deposited $6,000 in a guaranteed investment account with a promised rate of 6%
compounded annually. He plans to leave it there for 4 full years when he will make a down payment on a
car after graduation. How much of a down payment will he be able to make?
A. $2,397.00
B. $3,288.00
C. $6,321.32
D. $7,574.86
E. $8,857.59
$6,000 (1.06)4 = $7,574.86
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
25.
Your parents are giving you $100 a month for four years while you are in college. At a 6% discount rate,
what are these payments worth to you when you first start college?
A. $3,797.40
B. $4,167.09
C. $4,198.79
D. $4,258.03
E. $4,279.32
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
26.
You just won the lottery! As your prize you will receive $1,200 a month for 100 months. If you can earn
8% on your money, what is this prize worth to you today?
A. $87,003.69
B. $87,380.23
C. $87,962.77
D. $88,104.26
E. $90,723.76
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
27.
Todd is able to pay $160 a month for five years for a car. If the interest rate is 4.9%, how much can Todd
afford to borrow to buy a car?
A. $6,961.36
B. $8,499.13
C. $8,533.84
D. $8,686.82
E. $9,588.05
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
28.
You are the beneficiary of a life insurance policy. The insurance company informs you that you have two
options for receiving the insurance proceeds. You can receive a lump sum of $50,000 today or receive
payments of $641 a month for ten years. You can earn 6.5% on your money. Which option should you take
and why?
A. You should accept the payments because they are worth $56,451.91 today.
B. You should accept the payments because they are worth $56,523.74 today.
C. You should accept the payments because they are worth $56,737.08 today.
D. You should accept the $50,000 because the payments are only worth $47,757.69 today.
E. You should accept the $50,000 because the payments are only worth $47,808.17 today.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
29.
Your employer contributes $25 a week to your retirement plan. Assume that you work for your employer
for another twenty years and that the applicable discount rate is 5%. Given these assumptions, what is this
employee benefit worth to you today?
A. $13,144.43
B. $15,920.55
C. $16,430.54
D. $16,446.34
E. $16,519.02
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
30.
You have a sub-contracting job with a local manufacturing firm. Your agreement calls for annual payments
of $50,000 for the next five years. At a discount rate of 12%, what is this job worth to you today?
A. $180,238.81
B. $201,867.47
C. $210,618.19
D. $223,162.58
E. $224,267.10
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
31.
The Ajax Co. just decided to save $1,500 a month for the next five years as a safety net for recessionary
periods. The money will be set aside in a separate savings account which pays 3.25% interest compounded
monthly. It deposits the first $1,500 today. If the company had wanted to deposit an equivalent lump sum
today, how much would it have had to deposit?
A. $82,964.59
B. $83,189.29
C. $83,428.87
D. $83,687.23
E. $84,998.01
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
32.
You need some money today and the only friend you have that has any is your ‘miserly' friend. He agrees
to loan you the money you need, if you make payments of $20 a month for the next six months. In keeping
with his reputation, he requires that the first payment be paid today. He also charges you 1.5% interest per
month. How much money are you borrowing?
A. $113.94
B. $115.65
C. $119.34
D. $119.63
E. $119.96
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
33.
You buy an annuity which will pay you $12,000 a year for ten years. The payments are paid on the first
day of each year. What is the value of this annuity today at a 7% discount rate?
A. $84,282.98
B. $87,138.04
C. $90,182.79
D. $96,191.91
E. $116,916.21
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
34.
You are scheduled to receive annual payments of $10,000 for each of the next 25 years. Your discount rate
is 8.5%. What is the difference in the present value if you receive these payments at the beginning of each
year rather than at the end of each year?
A. $8,699
B. $9,217
C. $9,706
D. $10,000
E. $10,850
Difference = $111,040.97 - $102,341.91 = $8,699.06 = $8,699 (rounded)
Note: The difference = .085 × $102,341.91 = $8,699.06
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
35.
You are comparing two annuities with equal present values. The applicable discount rate is 7.5%. One
annuity pays $5,000 on the first day of each year for twenty years. How much does the second annuity pay
each year for twenty years if it pays at the end of each year?
A. $4,651
B. $5,075
C. $5,000
D. $5,375
E. $5,405
Because each payment is received one year later, then the cash flow has to equal: $5,000 × (1 + .075) =
$5,375
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
36.
Martha receives $100 on the first of each month. Stewart receives $100 on the last day of each month.
Both Martha and Stewart will receive payments for five years. At an 8% discount rate, what is the
difference in the present value of these two sets of payments?
A. $32.88
B. $40.00
C. $99.01
D. $108.00
E. $112.50
Difference = $4,964.72 - $4,931.84 = $32.88
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
37.
What is the future value of $1,000 a year for five years at a 6% rate of interest?
A. $4,212.36
B. $5,075.69
C. $5,637.09
D. $6,001.38
E. $6,801.91
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
38.
What is the future value of $2,400 a year for three years at an 8% rate of interest?
A. $6,185.03
B. $6,847.26
C. $7,134.16
D. $7,791.36
E. $8,414.67
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
39.
Janet plans on saving $3,000 a year and expects to earn 8.5%. How much will Janet have at the end of
twenty-five years if she earns what she expects?
A. $219,317.82
B. $230,702.57
C. $236,003.38
D. $244,868.92
E. $256,063.66
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
40.
Toni adds $3,000 to her savings on the first day of each year. Tim adds $3,000 to his savings on the last
day of each year. They both earn a 9% rate of return. What is the difference in their savings account
balances at the end of thirty years?
A. $35,822.73
B. $36,803.03
C. $38,911.21
D. $39,803.04
E. $40,115.31
Difference = $445,725.65 - $408,922.62 = $36,803.03
Note: Difference = $408,922.62 × .09 = $36,803.03
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
41.
You borrow $5,600 to buy a car. The terms of the loan call for monthly payments for four years at a 5.9%
rate of interest. What is the amount of each payment?
A. $103.22
B. $103.73
C. $130.62
D. $131.26
E. $133.04
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
42.
You borrow $149,000 to buy a house. The mortgage rate is 7.5% and the loan period is 30 years. Payments
are made monthly. If you pay for the house according to the loan agreement, how much total interest will
you pay?
A. $138,086
B. $218,161
C. $226,059
D. $287,086
E. $375,059
Total interest = ($1,041.83 × 30 × 12) - $149,000 = $226,058.80 = $226,059 (rounded)
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
43.
The Great Giant Corp. has a management contract with its newly hired president. The contract requires a
lump sum payment of $25 million be paid to the president upon the completion of her first ten years of
service. The company wants to set aside an equal amount of funds each year to cover this anticipated cash
outflow. The company can earn 6.5% on these funds. How much must the company set aside each year for
this purpose?
A. $1,775,042.93
B. $1,798,346.17
C. $1,801,033.67
D. $1,852,617.25
E. $1,938,018.22
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
44.
You retire at age 60 and expect to live another 27 years. On the day you retire, you have $464,900 in your
retirement savings account. You are conservative and expect to earn 4.5% on your money during your
retirement. How much can you withdraw from your retirement savings each month if you plan to die on
the day you spend your last penny?
A. $2,001.96
B. $2,092.05
C. $2,398.17
D. $2,472.00
E. $2,481.27
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
45.
The McDonald Group purchased a piece of property for $1.2 million. It paid a down payment of 20% in
cash and financed the balance. The loan terms require monthly payments for 15 years at an annual
percentage rate of 7.75% compounded monthly. What is the amount of each mortgage payment?
A. $7,440.01
B. $8,978.26
C. $9,036.25
D. $9,399.18
E. $9,413.67
Amount financed = $1,200,000 × (1 - .2) = $960,000
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
46.
You estimate that you will have $24,500 in student loans by the time you graduate. The interest rate is
6.5%. If you want to have this debt paid in full within five years, how much must you pay each month?
A. $471.30
B. $473.65
C. $476.79
D. $479.37
E. $480.40
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
47.
You are buying a previously owned car today at a price of $6,890. You are paying $500 down in cash and
financing the balance for 36 months at 7.9%. What is the amount of each loan payment?
A. $198.64
B. $199.94
C. $202.02
D. $214.78
E. $215.09
Amount financed = $6,890 - $500 = $6,390
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
48.
The Good Life Insurance Co. wants to sell you an annuity which will pay you $500 per quarter for 25
years. You want to earn a minimum rate of return of 5.5%. What is the most you are willing to pay as a
lump sum today to buy this annuity?
A. $26,988.16
B. $27,082.94
C. $27,455.33
D. $28,450.67
E. $28,806.30
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
49.
Your car dealer is willing to lease you a new car for $299 a month for 60 months. Payments are due on the
first day of each month starting with the day you sign the lease contract. If your cost of money is 4.9%,
what is the current value of the lease?
A. $15,882.75
B. $15,906.14
C. $15,947.61
D. $16,235.42
E. $16,289.54
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
50.
Your great-aunt left you an inheritance in the form of a trust. The trust agreement states that you are to
receive $2,500 on the first day of each year, starting immediately and continuing for fifty years. What is
the value of this inheritance today if the applicable discount rate is 6.35%?
A. $36,811.30
B. $37,557.52
C. $39,204.04
D. $39,942.42
E. $40,006.09
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
51.
Beatrice invests $1,000 in an account that pays 4% simple interest. How much more could she have earned
over a five-year period if the interest had compounded annually?
A. $15.45
B. $15.97
C. $16.65
D. $17.09
E. $21.67
Ending value at 4% simple interest = $1,000 + ($1,000 × .04 × 5) = $1,200.00; Ending value at 4%
compounded annually = $1,000 × (1 + .04)5 = $1,216.65;
Difference = $1,216.65 - $1,200.00 = $16.65
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: The Multi-Period Case
52.
Your firm wants to save $250,000 to buy some new equipment three years from now. The plan is to set
aside an equal amount of money on the first day of each year starting today. The firm can earn a 4.7% rate
of return. How much does the firm have to save each year to achieve its goal?
A. $75,966.14
B. $76,896.16
C. $78,004.67
D. $81.414.14
E. $83,333.33
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
53.
Today is January 1. Starting today, Sam is going to contribute $140 on the first of each month to his
retirement account. His employer contributes an additional 50% of the amount contributed by Sam. If both
Sam and his employer continue to do this and Sam can earn a monthly rate of ½ of 1 percent, how much
will he have in his retirement account 35 years from now?
A. $199,45.944
B. $200,456.74
C. $249,981.21
D. $299,189.16
E. $300,685.11
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
54.
You are considering an annuity which costs $100,000 today. The annuity pays $6,000 a year. The rate of
return is 4.5%. What is the length of the annuity time period?
A. 24.96 years
B. 29.48 years
C. 31.49 years
D. 33.08 years
E. 38.00 years
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
55.
Today, you signed loan papers agreeing to borrow $4,954.85 at 9% compounded monthly. The loan
payment is $143.84 a month. How many loan payments must you make before the loan is paid in full?
A. 29.89
B. 36.00
C. 38.88
D. 40.00
E. 41.03
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
56.
Winston Enterprises would like to buy some additional land and build a new factory. The anticipated total
cost is $136 million. The owner of the firm is quite conservative and will only do this when the company
has sufficient funds to pay cash for the entire expansion project. Management has decided to save
$450,000 a month for this purpose. The firm earns 6% compounded monthly on the funds it saves. How
long does the company have to wait before expanding its operations?
A. 184.61 months
B. 199.97 months
C. 234.34 months
D. 284.61 months
E. 299.97 months
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
57.
Today, you are retiring. You have a total of $413,926 in your retirement savings and have the funds
invested such that you expect to earn an average of 3%, compounded monthly, on this money throughout
your retirement years. You want to withdraw $2,500 at the beginning of every month, starting today. How
long will it be until you run out of money?
A. 185.00 months
B. 213.29 months
C. 227.08 months
D. 236.84 months
E. 249.69 months
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
58.
The Bad Guys Co. is notoriously known as a slow-payer. It currently needs to borrow $25,000 and only
one company will even deal with Bad Guys. The terms of the loan call for daily payments of $30.76. The
first payment is due today. The interest rate is 21% compounded daily. What is the time period of this
loan?
A. 2.88 years
B. 2.94 years
C. 3.00 years
D. 3.13 years
E. 3.25 years
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
59.
The Robertson Firm is considering a project which costs $123,900 to undertake. The project will yield cash
flows of $4,894.35 monthly for 30 months. What is the rate of return on this project?
A. 12.53%
B. 13.44%
C. 13.59%
D. 14.02%
E. 14.59%
This cannot be solved directly, so it's easiest to just use the calculator method to get an answer. You can
then use the calculator answer as the rate in the formula just to verify that your answer is correct.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
60.
Your insurance agent is trying to sell you an annuity that costs $100,000 today. By buying this annuity,
your agent promises that you will receive payments of $384.40 a month for the next 40 years. What is the
rate of return on this investment?
A. 3.45%
B. 3.47%
C. 3.50%
D. 3.52%
E. 3.55%
This can not be solved directly, so it's easiest to just use the calculator method to get an answer. You can
then use the calculator answer as the rate in the formula just to verify that you answer is correct.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
61.
You have been investing $120 a month for the last 15 years. Today, your investment account is worth
$47,341.19. What is your average rate of return on your investments?
A. 9.34%
B. 9.37%
C. 9.40%
D. 9.42%
E. 9.46%
This can not be solved directly, so it's easiest to just use the calculator method to get an answer. You can
then use the calculator answer as the rate in the formula just to verify that you answer is correct.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
62.
Brinker, Inc. has been investing $136,000 a year for the past 4 years into a business venture. Today,
Brinker sold that venture for $685,000. What is its rate of return on this venture?
A. 9.43%
B. 11.06%
C. 15.59%
D. 16.67%
E. 18.71%
This can not be solved directly, so it's easiest to just use the calculator method to get an answer. You can
then use the calculator answer as the rate in the formula just to verify that you answer is correct.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
63.
Your mother helped you start saving $25 a month beginning on your 10th birthday. She always made you
make your deposit on the first day of each month just to "start the month out right." Today, you turn 21 and
have $4,482.66 in your account. What is your rate of return on your savings?
A. 5.25%
B. 5.29%
C. 5.33%
D. 5.36%
E. 5.50%
This can not be solved directly, so it's easiest to just use the calculator method to get an answer. You can
then use the calculator answer as the rate in the formula just to verify that you answer is correct.
To more decimal places, the answer is 5.28632%.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
64.
Today, you turn 21. Your birthday wish is that you will be a millionaire by your 40 th birthday. In an
attempt to reach this goal, you decide to save $25 a day, every day until you turn 40. You open an
investment account and deposit your first $25 today. What rate of return must you earn to achieve your
goal?
A. 15.07%
B. 15.13%
C. 15.17%
D. 15.20%
E. 15.24%
This can not be solved directly, so it's easiest to just use the calculator method to get an answer. You can
then use the calculator answer as the rate in the formula just to verify that you answer is correct.
To more decimal places, the answer is 15.0697117%.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
65.
Marko, Inc. is considering the purchase of ABC Co. Marko believes that ABC Co. can generate cash flows
of $5,000, $9,000, and $15,000 over the next three years, respectively. After that time, Marko feels ABC
will be worthless. Marko has determined that a 14% rate of return is applicable to this potential purchase.
What is Marko willing to pay today to buy ABC Co.?
A. $19,201.76
B. $21,435.74
C. $23,457.96
D. $27,808.17
E. $31,758.00
Present value = $4,385.96 + $6,925.21 + $10,124.57 = $21,435.74
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
66.
You are considering two savings options. Both options offer a 4% rate of return. The first option is to save
$1,200, $1,500, and $2,000 a year over the next three years, respectively. The other option is to save one
lump sum amount today. If you want to have the same balance in your savings at the end of the three years,
regardless of the savings method you select, how much do you need to save today if you select the lump
sum option?
A. $4,318.67
B. $4,491.42
C. $4,551.78
D. $4,607.23
E. $4,857.92
Present value = $1,153.85 + $1,386.83 + $1,777.99 = $4,318.67
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
67.
You are considering two insurance settlement offers. The first offer includes annual payments of $5,000,
$7,500, and $10,000 over the next three years, respectively. The other offer is the payment of one lump
sum amount today. You are trying to decide which offer to accept given the fact that your discount rate is
5%. What is the minimum amount that you will accept today if you are to select the lump sum offer?
A. $19,877.67
B. $20,203.00
C. $21,213.15
D. $23,387.50
E. $24,556.88
Present value = $4,761.90 + $6,802.72 + $8,638.38 = $20,203.00
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
68.
You are considering a job offer. The job offers an annual salary of $52,000, $55,000, and $60,000 a year
for the next three years, respectively. The offer also includes a starting bonus of $2,000 payable
immediately. What is this offer worth to you today at a discount rate of 6%?
A. $148,283.56
B. $148,383.56
C. $150,283.56
D. $150,383.56
E. $152,983.56
Present value = $2,000 + $49,056.60 + $48,949.80 + $50,377.16 = $150,383.56
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
69.
You are considering a project with the following cash flows:
What is the present value of these cash flows, given a 9% discount rate?
A. $4,713.62
B. $4,855.27
C. $5,103.18
D. $5,292.25
E. $6,853.61
Present value = $1,100.92 + $1,515.02 + $2,239.33 = $4,855.27
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
70.
You are considering a project with the following cash flows:
What is the present value of these cash flows, given an 11% discount rate?
A. $8,695.61
B. $8,700.89
C. $13,732.41
D. $13,812.03
E. $19,928.16
Present value = $5,045.05 + $7,304.60 + $1,462.38 = $13,812.03
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
71.
You are considering a project with the following cash flows:
What is the present value of these cash flows, given a 3% discount rate?
A. $13,732.41
B. $13,812.03
C. $14,308.08
D. $14,941.76
E. $14,987.69
Present value = $4,077.67 + $4,712.98 + $4,941.76 = $13,732.41
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
72.
You have some property for sale and have received two offers. The first offer is for $189,000 today in
cash. The second offer is the payment of $100,000 today and an additional $100,000 two years from today.
If the applicable discount rate is 8.75%, which offer should you accept and why?
A. You should accept the $189,000 today because it has the higher net present value.
B. You should accept the $189,000 today because it has the lower future value.
C. You should accept the second offer because you will receive $200,000 total.
D. You should accept the second offer because you will receive an extra $11,000.
E. You should accept the second offer because it has a present value of $194,555.42.
Present value = $100,000 + $84,555.42 = $184,555.42
You should accept the $189,000 today since it is the higher net present value.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Valuation: The One-Period Case
73.
Your local travel agent is advertising an extravagant global vacation. The package deal requires that you
pay $5,000 today, $15,000 one year from today, and a final payment of $25,000 on the day you leave two
years from today. What is the cost of this vacation in today's dollars if the discount rate is 6%?
A. $39,057.41
B. $41,400.85
C. $43,082.39
D. $44,414.14
E. $46,518.00
Present value = $5,000.00 + $14,150.94 + $22,249.91 = $41,400.85
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Valuation: The One-Period Case
74.
One year ago, the Jenkins Family Fun Center deposited $3,600 in an investment account for the purpose of
buying new equipment four years from today. Today, it is adding another $5,000 to this account. It plans
on making a final deposit of $7,500 to the account next year. How much will be available when it is ready
to buy the equipment, assuming it earns a 7% rate of return?
A. $18,159.65
B. $19,430.84
C. $19,683.25
D. $20,194.54
E. $20,790.99
Future value = $5,049.19 + $6,553.98 + $9,187.82 = $20,790.99
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
75.
What is the future value of the following cash flows at the end of year 3 if the interest rate is 6%? The cash
flows occur at the end of each year.
A. $15,916.78
B. $18,109.08
C. $18,246.25
D. $19,341.02
E. $19,608.07
Future value = $5,820.25 + $10,176.00 + $2,250.00 = $18,246.25
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
76.
What is the future value of the following cash flows at the end of year 3 if the interest rate is 9%? The cash
flows occur at the end of each year.
A. $15,213.80
B. $15,619.70
C. $15,916.78
D. $16,177.14
E. $17,633.08
Future value = $11,667.14 + $0 + $4,510.00 = $16,177.14
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
77.
What is the future value of the following cash flows at the end of year 3 if the interest rate is 7.25%? The
cash flows occur at the end of each year.
A. $8,758.04
B. $8,806.39
C. $10,073.99
D. $10,314.00
E. $10,804.36
Future value = $7,821.74 + $2,252.25 + $0 = $10,073.99
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
78.
Suzette is going to receive $10,000 today as the result of an insurance settlement. In addition, she will
receive $15,000 one year from today and $25,000 two years from today. She plans on saving all of this
money and investing it for her retirement. If Suzette can earn an average of 11% on her investments, how
much will she have in her account if she retires 25 years from today?
A. $536,124.93
B. $541,414.14
C. $546,072.91
D. $570,008.77
E. $595,098.67
Future value = $135,854.64 + $183,587.35 + $275,656.68 = $595,098.67
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
79.
The Bluebird Company has a $10,000 liability it must pay three years from today.
The company is opening a savings account so that the entire amount will be available when this debt needs
to be paid. The plan is to make an initial deposit today and then deposit an additional $2,500 a year for the
next three years, starting one year from today. The account pays a 3% rate of return. How much does the
Bluebird Company need to deposit today?
A. $1,867.74
B. $2,079.89
C. $3,108.09
D. $4,276.34
E. $4,642.28
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Valuation: The One-Period Case
80.
The government has imposed a fine on the Not-So-Legal Company. The fine calls for annual payments of
$100,000, $250,000, and $250,000, respectively over the next three years. The first payment is due one
year from today. The government plans to invest the funds until the final payment is collected and then
donate the entire amount, including investment earnings, to a national health center. The government will
earn 3.5% on the funds held. How much will the national health center receive three years from today?
A. $613,590.00
B. $614,622.50
C. $615,872.50
D. $616,006.00
E. $619,050.05
FV = $107,122.50 + $258,750.00 + $250,000 = $615,872.50
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
81.
George Jefferson established a trust fund that provides $150,000 in scholarships each year for worthy
students. The trust fund earns a 4.25% rate of return. How much money did Mr. Jefferson contribute to the
fund assuming that only the interest income is distributed?
A. $3,291,613.13
B. $3,529,411.77
C. $3,750,000.00
D. $4,328,970.44
E. $6,375,000.00
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
82.
A 9% preferred stock pays an annual dividend of $4.50. What is one share of this stock worth today?
A. $0.41
B. $4.50
C. $5.00
D. $45.00
E. $50.00
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
83.
You would like to establish a trust fund that will provide $50,000 a year forever for your heirs. The trust
fund is going to be invested very conservatively so the expected rate of return is only 2.75%. How much
money must you deposit today to fund this gift for your heirs?
A. $1,333,333.33
B. $1,375,000.00
C. $1,425,000.00
D. $1,666,666.67
E. $1,818,181.82
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
84.
You just paid $350,000 for a policy that will pay you and your heirs $12,000 a year forever. What rate of
return are you earning on this policy?
A. 3.25%
B. 3.33%
C. 3.43%
D. 3.50%
E. 3.67%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
85.
The Eternal Gift Insurance Company is offering you a policy that will pay you and your heirs $10,000 a
year forever. The cost of the policy is $285,000. What is the rate of return on this policy?
A. 2.85%
B. 3.25%
C. 3.46%
D. 3.51%
E. 3.60%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
86.
Your rich uncle establishes a trust in your name and deposits $150,000 in it. The trust pays a guaranteed
4% rate of return. How much will you receive each year if the trust is required to pay you all of the interest
earnings on an annual basis?
A. $3,750
B. $4,000
C. $4,500
D. $5,400
E. $6,000
C = $150,000 × .04; C = $6,000
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
87.
The preferred stock of ABC Co. offers an 8.4% rate of return. The stock is currently priced at $50.00 per
share. What is the amount of the annual dividend?
A. $2.10
B. $4.20
C. $5.00
D. $6.40
E. $8.60
C = $50.00 × .084; C = $4.20
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
88.
Your credit card company charges you 1.5% per month. What is the annual percentage rate on your
account?
A. 12.00%
B. 15.00%
C. 15.39%
D. 18.00%
E. 19.56%
APR = .015 × 12 = .18 = 18%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
89.
What is the annual percentage rate on a loan with a stated rate of 2% per quarter?
A. 2.00%
B. 2.71%
C. 4.04%
D. 8.00%
E. 8.24%
APR = .02 × 4 = .08 = 8%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
90.
You are paying an effective annual rate of 13.8% on your credit card. The interest is compounded monthly.
What is the annual percentage rate on your account?
A. 11.50%
B. 12.00%
C. 13.00%
D. 13.80%
E. 14.71%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
91.
What is the effective annual rate if a bank charges you 7.64% compounded quarterly?
A. 7.79%
B. 7.86%
C. 7.95%
D. 7.98%
E. 8.01%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
92.
Your credit card company quotes you a rate of 14.9%. Interest is billed monthly. What is the actual rate of
interest you are paying?
A. 13.97%
B. 14.90%
C. 15.48%
D. 15.96%
E. 16.10%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
93.
Mr. Miser loans money at an annual rate of 21%. Interest is compounded daily. What is the actual rate Mr.
Miser is charging on his loans?
A. 22.97%
B. 23.08%
C. 23.21%
D. 23.36%
E. 23.43%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
94.
You are considering two loans. The terms of the two loans are equivalent with the exception of the interest
rates. Loan A offers a rate of 7.45% compounded daily. Loan B offers a rate of 7.5% compounded semiannually. Loan _____ is the better offer because ______.
A. A; you will pay less interest
B. A; the annual percentage rate is 7.45%
C. B; the annual percentage rate is 7.64%
D. B; the interest is compounded less frequently
E. B; the effective annual rate is 7.64%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
95.
You have $2,500 that you want to use to open a savings account. You have found five different accounts
that are acceptable to you. All you have to do now is determine which account you want to use such that
you can earn the highest rate of interest possible. Which account should you use based upon the annual
percentage rates quoted by each bank?
A. Account A
B. Account B
C. Account C
D. Account D
E. Account E
Using ex on a financial calculator: EAR = 3.72% On the Texas Instruments BA II Plus, the input is: .0365,
2nd, ex, -1, = .0372 = 3.72%
Account B offers the highest effective annual rate at 3.76%.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
96.
What is the effective annual rate of 14.9% compounded continuously?
A. 15.96%
B. 16.01%
C. 16.05%
D. 16.07%
E. 16.17%
Using ex on a financial calculator: EAR = 16.07% On the Texas Instruments BA II Plus, the input is: .149,
2nd, ex, -1, = .1607 = 16.07%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
97.
What is the effective annual rate of 9.75% compounded continuously?
A. 9.99%
B. 10.11%
C. 10.24%
D. 10.28%
E. 10.30%
Using ex on a financial calculator: EAR = 10.24% On the Texas Instruments BA II Plus, the input is:
.0975, 2nd, ex, -1, = .1024 = 10.24%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
98.
The Smart Bank wants to appear competitive based on quoted loan rates and thus must offer a 7.9 annual
percentage rate. What is the maximum rate the bank can actually earn based on the quoted rate?
A. 7.90%
B. 8.18%
C. 8.20%
D. 8.22%
E. 8.39%
Using ex on a financial calculator: EAR = 8.22% On the Texas Instruments BA II Plus, the input is: .079,
2nd, ex, -1, = .0822 = 8.22%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
99.
You are going to loan your friend $1,000 for one year at a 5% rate of interest. How much additional
interest can you earn if you compound the rate continuously rather than annually?
A. $.97
B. $1.09
C. $1.27
D. $1.36
E. $1.49
Using ex on a financial calculator: EAR = 5.127% On the Texas Instruments BA II Plus, the input is: .05,
2nd, ex, -1, = .05127 = 5.127%
Additional interest = $1,000 × (.05127 - .05) = $1.27
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
100.
Today you earn a salary of $28,500. What will be your annual salary fifteen years from now if you earn
annual raises of 3.5%?
A. $47,035.35
B. $47,522.89
C. $47,747.44
D. $48,091.91
E. $48,201.60
Future value = $28,500 × (1 + .035)15 = $47,747.44
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
101.
You hope to buy your dream house six years from now. Today your dream house costs $189,900. You
expect housing prices to rise by an average of 4.5% per year over the next six years. How much will your
dream house cost by the time you are ready to buy it?
A. $240,284.08
B. $246,019.67
C. $246,396.67
D. $246,831.94
E. $247,299.20
Future value = $189,900 × (1 + .045)6 = $247,299.20
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
102.
Your grandmother invested one lump sum 17 years ago at 4.25% interest. Today, she gave you the
proceeds of that investment which totaled $5,539.92. How much did your grandmother originally invest?
A. $2,700.00
B. $2,730.30
C. $2,750.00
D. $2,768.40
E. $2,774.90
Present value = $5,539.92 × [1 ÷ (1 + .0425)17] = $2,730.30
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Valuation: The One-Period Case
103.
You would like to give your daughter $40,000 towards her college education thirteen years from now.
How much money must you set aside today for this purpose if you can earn 6.3% on your funds?
A. $17,750.00
B. $17,989.28
C. $18,077.05
D. $18,213.69
E. $18,395.00
Present value = $40,000 × [1 ÷ (1 + .063)13] = $18,077.05
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Valuation: The One-Period Case
104.
One year ago, you invested $3,000. Today it is worth $3,142.50. What rate of interest did you earn?
A. 4.63%
B. 4.68%
C. 4.70%
D. 4.73%
E. 4.75%
$3,142.50 = $3,000 × (1 + r)1; r = 4.75%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: The Multi-Period Case
105.
Forty years ago, your father invested $2,500. Today that investment is worth $107,921. What is the
average rate of return your father earned on his investment?
A. 8.50%
B. 9.33%
C. 9.50%
D. 9.87%
E. 9.99%
$107,921 = $2,500 × (1 + r)40; r = 9.87%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: The Multi-Period Case
106.
You want to have $10,000 saved ten years from now. How much less do you have to deposit today to reach
this goal if you can earn 6% rather than 5% on your savings?
A. $555.18
B. $609.81
C. $615.48
D. $928.73
E. $1,046.22
Present value = $10,000 × [1 ÷ (1 + .06)10] = $5,583.95; Present value = $10,000 × [1 ÷ (1 + .05)10] =
$6,139.13; Difference = $6,139.13 - $5,583.95 = $555.18
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Valuation: The One-Period Case
107.
You have deposited $1,500 in an account that promises to pay 8% compounded quarterly for the next five
years. How much will you have in the account at the end?
A. $1,598.33
B. $2,203.99
C. $2,228.92
D. $6,991.44
E. None of these.
$1,500(1.02)20 = $2,228.92
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
108.
What is the future value of investing $9,000 for 7 years at a continuously compounded rate of 11%?
A. $15,930.00
B. $18,685.44
C. $19,369.83
D. $19,437.90
E. None of these.
$9,000(e.11(7)) - 1 = $9,000 (2.15976625) = $19,437.90
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
109.
What is the future value of investing $3,000 for 3/4 year at a continuously compounded rate of 12%?
A. $3,163
B. $3,263
C. $3,283
D. $3,287
E. $3,317
EAR = (er - 1) = e.12 - 1 = 0.1275 (12.75%)
End value after 3/4 year = $3000(1 + 0.1275)3/4 = $3,282.53
AACSB: Analytic
Blooms: Apply
Difficulty Level: 3 Hard
Topic: Compounding Periods
110.
Which of the following amounts is closest to the end value of investing $5,000 for 14 months at a stated
annual interest rate of 6% compounded monthly?
A. $5,293
B. $5,345
C. $5,352
D. $5,362
E. $6,183
EAR = (1 + r/m)m - 1 = [1 + (0.06/12)]12 - 1 = 0.06167781
End value = $5,000(1 + 0.06167781)14/12 = $5,361.61
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
111.
Which of the following amounts is closest to the end value of investing $10,000 for 18 months at a stated
annual interest rate of 12% compounded quarterly?
A. $11,800
B. $11,852
C. $11,940
D. $11,961
E. None of these is within $100 of the correct answer.
EAR = (1 + r/m)m - 1 = [1 + (0.12/4)]4 - 1 = 0.1255
End value = $10,000(1 + 0.1255)1.5 = $11,940.38
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
112.
Which of the following amounts is closest to the end value of investing $7,500 for 2.5 years at an effective
annual interest rate of 12.36%. Interest is compounded semiannually.
A. $7,531
B. $8,427
C. $9,469
D. $9,818
E. $10,037
End value = $7,500(1 + 0.1236)2.5 = $10,036.69
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: The Multi-Period Case
113.
If the stated rate of interest is 12% and it is compounded monthly, what is the effective annual interest
rate?
A. 12.00%
B. 12.25%
C. 12.46%
D. 12.68%
E. 12.92%
(1 + .12/12)12 - 1 = 12.68%
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Compounding Periods
114.
What is the present value of a payment of $21,000 three years from now if the effective annual interest rate
is 4%?
A. $17,951
B. $18,480
C. $18,658
D. $18,669
E. $19,218
PV = FV/(1 + r)n = $21,000/(1 + .04)3 = $18,668.92
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
115.
Thornton will receive an inheritance of $500,000 three years from now. Thorton's discount rate is 10%
compounded semiannually. Which of the following values is closest to the amount that Thornton should
accept today for the right to his inheritance?
A. $373,108.
B. $375,657.
C. $665,500.
D. $670,048.
E. None of these is within $10 of the correct answer.
EAR = (1 + r/m)m - 1 = [1 + (0.1/2)]2 - 1 = 0.1025
PV = $500,000/(1 + 0.1025)3 = $373,107.70
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Valuation: The One-Period Case
116.
A mortgage instrument pays $1.5 million at the end of each of the next two years. An investor has an
alternative investment with the same amount of risk that will pay interest at 8% compounded semiannually.
Which of the following amounts is closest to what the investor should pay for the mortgage instrument?
A. $1,386,834
B. $1,388,889
C. $2,674,897
D. $2,669,041
E. $3,854,512
EAR = (1 + r/m)m - 1 = (1 + 0.08/2)2 - 1 = 0.0816
PV = $1.5/(1.0816)1 + $1.5/(1.0816)2 = $2,669,041
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Valuation: The One-Period Case
117.
You are to receive $75 per year indefinitely. The market rate of interest for these types of payments is 8%.
The price you would pay for this stream is:
A. $9.375.
B. $81.00.
C. $93.75.
D. $937.50.
E. None of these.
PVperpertuity = C/r = $75/.08 = $937.50.
AACSB: Analytic
Blooms: Apply
Difficulty Level: 1 Easy
Topic: Simplifications
118.
Aunt Clarisse has promised to leave you an annuity that will pay $60 next year and grow at an annual rate
of 4%. The payments are expected to go on indefinitely and the interest rate is 9%. What is the value of the
growing perpetuity?
A. $667
B. $693
C. $1,200
D. $1,248
E. None of these
PVgrowing perpetuity = C/(r - g) = $60/(.09 - .04) = $1,200
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
119.
A court settlement awarded an accident victim four payments of $50,000 to be paid at the end of each of
the next four years. Using a discount rate of 4%, calculate the present value of the annuity.
A. $173,255
B. $178,495
C. $181,495
D. $184,095
E. $200,000
PVannuity = PMT(PVIFA4%,4) = $50,000(3.6299) = $181,495
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
120.
What is the present value of 10 annual payments of $500 at a discount rate of 12%?
A. $1,332
B. $1,761
C. $1,840
D. $2,825
E. $3,040
CALC: N = 10 FV = 0 PV = ? I = 12 PMT = $500; PV = $2,825
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
121.
An S&L provides a loan with 15 yearly repayments of $8,000 with the first payment beginning
immediately. Which of the following amounts comes closest to the present value of the loan if the interest
rate is 7%?
A. $72,863
B. $77,964
C. $115,648
D. $120,000
E. Not enough information is given to determine the answer.
PV = Immediate Pmt + Pmt(PVIFA7%,14) = $8,000 + $8,000(8.7455) = $77,964
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Simplifications
122.
The great, great grandparents of one of your classmates sold their factory to the government 104 years ago
for $150,000. If these proceeds had been invested at 6%, how much would this legacy be worth today?
Assume annual compounding.
A. $936,000.00
B. $1,086,000.00
C. $60,467,131.54
D. $60,617,131.54
E. $64,254,159.44
$150,000(1.06)104 = $64,254,159.44
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Valuation: The One-Period Case
123.
If a business takes out a $10,000, 7 year, 12% loan, the annual payment is:
A. $1,976.38
B. $2,000.00
C. $2,111.78
D. $2,191.17
E. $2,456.54
10,000 PV, 7N, 12%, CPT PMT = $2,191.17
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Loan Amortization
124.
If a business takes out a $10,000, 7 year, 12% loan, the decrease in principal in year 1 is: (assume annual
payments).
A. $991.17
B. $1,976.38
C. $1,200.00
D. $2,191.17
E. $2,456.54
$2,191.17 (above) - 1,200 (interest) = $991.17
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Loan Amortization
125.
If a student borrows $20,000 to start a business as a 5 year, 10% loan, the annual payment is
A. $2,000.00
B. $3,275.95
C. $4,000.00
D. $5,275.95
E. None of these
20,000 PV, 5 N 10% 1/Y
CPT PMT = $5,275.95
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Loan Amortization
126.
If a student borrows $20,000 to start a business as a 5 year, 10% loan, assume annual payments, the
decrease in principal in year 1 is
A. $2,000.00
B. $3,275.95
C. $4,000.00
D. $5,275.95
E. None of these
20,000 PV, 5 N 10% 1/Y
CPT PMT = $5,275.95
5,275.95 - 2,000 (interest) = $3,275.95
AACSB: Analytic
Blooms: Apply
Difficulty Level: 2 Medium
Topic: Loan Amortization
Essay Questions
127.
Mr. Miser, who is 35 years old, has just inherited $11,000 and decides to use the windfall towards his
retirement. He places the money in a bank which promises a return of 6% per year until his planned
retirement in 30 years. If his funds earn 6% interest compounded annually, how much will he have at
retirement? Repeat the analysis for both semi-annual and continuous compounding.
$11,000(1.06)30 = $63,178.40
$11,000(1.03)60 = $64,807.63
$11,000 e(.06)(30) = $66,546.12
AACSB: Analytic
Blooms: Analyze
Difficulty Level: 3 Hard
Topic: The Multi-Period Case
128.
Your aunt, in her will, left you the sum of $5,000 a year forever with payments starting immediately.
However, the news is better. She has specified that the amount should grow at 5% per year to maintain
purchasing power. Given an interest rate of 12%, what is the PV of the inheritance?
$5,000 + $5,000(1.05)/(.12 - .05) = $80,000
AACSB: Analytic
Blooms: Analyze
Difficulty Level: 3 Hard
Topic: Simplifications
129.
If you invest $100,000 today at 12% per year over the next 15 years, what is the most you can spend in
equal amounts out of the fund each year over that time.
$100,000 = Annuity Payment * Annuity Factor(.12,15)6.8109 = $14,682.42 or
PV = $-100,000 I/YR = 12 N = 15 PMT = ? = $14,682.42
AACSB: Analytic
Blooms: Analyze
Difficulty Level: 3 Hard
Topic: Simplifications
130.
Using the example of a savings account, explain the difference between the effective annual rate and the
annual percentage rate.
The effective annual rate is what you actually earn, the annual percentage rate is a quoted rate. If interest
is compounded during the year, the ending balance of a savings account cannot be calculated directly
using the annual percentage rate. Also, in the case of the savings account, the effective annual rate will
always be higher than the annual percentage rate as long as the account is compounded more than once a
year and the interest rate is greater than zero.
AACSB: Analytic
Blooms: Analyze
Difficulty Level: 3 Hard
Topic: Compounding Periods
131.
There are three factors that affect the present value of an annuity. Explain what these three factors are and
discuss how an increase in each will impact the present value of the annuity.
The factors are the interest rate, payment amount, and number of payments. An increase in the payment
and number of payments will increase the present value, while an increase in the interest rate will
decrease the present value.
AACSB: Analytic
Blooms: Evaluate
Difficulty Level: 3 Hard
Topic: Simplifications
132.
There are three factors that affect the future value of an annuity. Explain what these three factors are and
discuss how an increase in each will impact the future value of the annuity.
The factors are the interest rate, payment amount, and number of payments. An increase in any of these
three will increase the future value of the annuity.
AACSB: Analytic
Blooms: Evaluate
Difficulty Level: 3 Hard
Topic: Simplifications
133.
A friend who owns a perpetuity that promises to pay $1,000 at the end of each year, forever, comes to you
and offers to sell you all of the payments to be received after the 25th year for a price of $1,000. At an
interest rate of 10%, should you pay the $1,000 today to receive payment numbers 26 and onwards? What
does this suggest to you about the value of perpetual payments?
The present value of the perpetuity is $10,000, and the present value of the first 25 payments is $9,077.04,
thus you should be willing to pay only $922.96 for payments 26 and onwards. This suggests that the value
of a perpetuity is derived primarily from the payments received early in its life, and the payments to be
received later have little worth today.
AACSB: Analytic
Blooms: Evaluate
Difficulty Level: 3 Hard
Topic: Simplifications
134.
What is the different between an ordinary annuity and an annuity due? Which occurs more in practice?
Give a common example of both.
An annuity is a stream of payments to be received in the future. An ordinary annuity is when each payment
occurs at the end of the period and an annuity due is when the payment occurs at the beginning of the
period. From a valuation perspective, one will need to adjust the annuity formula to account for an annuity
due. The most common type of annuity is the ordinary annuity with examples being monthly paychecks,
monthly bills for services performed, or savings deposited at the end of the period. Examples of annuity
due include most leases and mortgages.
AACSB: Analytic
Blooms: Evaluate
Difficulty Level: 3 Hard
Topic: Simplifications
135.
What is meant by "amortizing a loan"?
Amortizing a loan is when the borrower pays back the loan, both in principal and interest, over time. The
process of providing for a loan to be paid off by making regular principal reductions is called amortizing
the loan.
AACSB: Analytic
Blooms: Analyze
Difficulty Level: 3 Hard
Topic: Loan Amortization
Chapter 5: Net Present Value and Other Investment Rules (excluding 5.3; 5.6)
1.
The difference between the present value of an investment and its cost is the:
A. net present value.
B. internal rate of return.
C. payback period.
D. profitability index.
E. discounted payback period.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
2.
Which one of the following statements concerning net present value (NPV) is correct?
A. An investment should be accepted if, and only if, the NPV is exactly equal to zero.
B. An investment should be accepted only if the NPV is equal to the initial cash flow.
C. An investment should be accepted if the NPV is positive and rejected if it is negative.
D. An investment with greater cash inflows than cash outflows, regardless of when the cash flows occur,
will always have a positive NPV and therefore should always be accepted.
E. Any project that has positive cash flows for every time period after the initial investment should be
accepted.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
3.
The length of time required for an investment to generate cash flows sufficient to recover the initial cost of
the investment is called the:
A. net present value.
B. internal rate of return.
C. payback period.
D. profitability index.
E. discounted cash period.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Payback Period Method
4.
Which one of the following statements is correct concerning the payback period?
A. An investment is acceptable if its calculated payback period is less than some pre-specified period of
time.
B. An investment should be accepted if the payback is positive and rejected if it is negative.
C. An investment should be rejected if the payback is positive and accepted if it is negative.
D. An investment is acceptable if its calculated payback period is greater than some pre-specified period
of time.
E. An investment should be accepted any time the payback period is less than the discounted payback
period, given a positive discount rate.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Payback Period Method
5.
The length of time required for a project's discounted cash flows to equal the initial cost of the project is
called the:
A. net present value.
B. internal rate of return.
C. payback period.
D. discounted profitability index.
E. discounted payback period.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Discounted Payback Period Method
6.
The discounted payback rule states that you should accept projects:
A. which have a discounted payback period that is greater than some pre-specified period of time.
B. if the discounted payback is positive and rejected if it is negative.
C. only if the discounted payback period equals some pre-specified period of time.
D. if the discounted payback period is less than some pre-specified period of time.
E. only if the discounted payback period is equal to zero.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Discounted Payback Period Method
7.
The discount rate that makes the net present value of an investment exactly equal to zero is called the:
A. external rate of return.
B. internal rate of return.
C. average accounting return.
D. profitability index.
E. equalizer.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Internal Rate of Return
8.
An investment is acceptable if its IRR:
A. is exactly equal to its net present value (NPV).
B. is exactly equal to zero.
C. is less than the required return.
D. exceeds the required return.
E. is exactly equal to 100%.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Internal Rate of Return
9.
The possibility that more than one discount rate will make the NPV of an investment equal to zero is called
the _______ problem.
A. net present value profiling
B. operational ambiguity
C. mutually exclusive investment decision
D. issues of scale
E. multiple rates of return
AACSB: Analytic
Blooms: Remember
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
10.
A situation in which accepting one investment prevents the acceptance of another investment is called the:
A. net present value profile.
B. operational ambiguity decision.
C. mutually exclusive investment decision.
D. issues of scale problem.
E. multiple choices of operations decision.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: Problems with the IRR Approach
11.
The present value of an investment's future cash flows divided by the initial cost of the investment is called
the:
A. net present value.
B. internal rate of return.
C. average accounting return.
D. profitability index.
E. profile period.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Profitability Index
12.
An investment is acceptable if the profitability index (PI) of the investment is:
A. greater than one.
B. less than one.
C. greater than the internal rate of return (IRR).
D. less than the net present value (NPV).
E. greater than a pre-specified rate of return.
AACSB: Analytic
Blooms: Remember
Difficulty level: 1 Easy
Topic: The Profitability Index
13.
All else constant, the net present value of a typical investment project increases when:
A. the discount rate increases.
B. each cash inflow is delayed by one year.
C. the initial cost of a project increases.
D. the rate of return decreases.
E. all cash inflows occur during the last year of a project's life instead of periodically throughout the life
of the project.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
14.
The primary reason that company projects with positive net present values are considered acceptable is
that:
A. they create value for the owners of the firm.
B. the project's rate of return exceeds the rate of inflation.
C. they return the initial cash outlay within three years or less.
D. the required cash inflows exceed the actual cash inflows.
E. the investment's cost exceeds the present value of the cash inflows.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
15.
If a project has a net present value equal to zero, then:
I. the present value of the cash inflows exceeds the initial cost of the project.
II. the project produces a rate of return that just equals the rate required to accept the project.
III. the project is expected to produce only the minimally required cash inflows.
IV. any delay in receiving the projected cash inflows will cause the project to have a negative net present
value.
A. II and III only
B. II and IV only
C. I, II, and IV only
D. II, III, and IV only
E. I, II, and III only
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
16.
Net present value:
A. cannot be used when deciding between two mutually exclusive projects.
B. is more useful to decision makers than the internal rate of return when comparing different sized
projects.
C. is easy to explain to non-financial managers and thus is the primary method of analysis used by the
lowest levels of management.
D. is not an as widely used tool as payback and discounted payback.
E. is very similar in its methodology to the average accounting return.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
17.
Payback is frequently used to analyze independent projects because:
A. it considers the time value of money.
B. all relevant cash flows are included in the analysis.
C. it is easy and quick to calculate.
D. it is the most desirable of all the available analytical methods from a financial perspective.
E. it produces better decisions than those made using either NPV or IRR.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Payback Period Method
18.
The advantages of the payback method of project analysis include the:
I. application of a discount rate to each separate cash flow.
II. bias towards liquidity.
III. ease of use.
IV. arbitrary cutoff point.
A. I and II only
B. I and III only
C. II and III only
D. II and IV only
E. II, III, and IV only
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Payback Period Method
19.
All else equal, the payback period for a project will decrease whenever the:
A. initial cost increases.
B. required return for a project increases.
C. assigned discount rate decreases.
D. cash inflows are moved earlier in time.
E. duration of a project is lengthened.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Payback Period Method
20.
The discounted payback period of a project will decrease whenever the:
A. discount rate applied to the project is increased.
B. initial cash outlay of the project is increased.
C. time period of the project is increased.
D. amount of each project cash inflow is increased.
E. costs of the fixed assets utilized in the project increase.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Discounted Payback Period Method
21.
The discounted payback rule may cause:
A. some positive net present value projects to be rejected.
B. the most liquid projects to be rejected in favor of less liquid projects.
C. projects to be incorrectly accepted due to ignoring the time value of money.
D. some projects with negative net present values to be accepted.
E. Both some positive net present value projects to be rejected; and some projects with negative net
present values to be accepted.
AACSB: Analytic
Blooms: Understand
Difficulty level: 3 Hard
Topic: The Discounted Payback Period Method
22.
The internal rate of return (IRR):
I. rule states that a typical investment project with an IRR that is less than the required rate should be
accepted.
II. is the rate generated solely by the cash flows of an investment.
III. is the rate that causes the net present value of a project to exactly equal zero.
IV. can effectively be used to analyze all investment scenarios.
A. I and IV only
B. II and III only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
23.
The internal rate of return for a project will increase if:
A. the initial cost of the project can be reduced.
B. the total amount of the cash inflows is reduced.
C. each cash inflow is moved such that it occurs one year later than originally projected.
D. the required rate of return is reduced.
E. the salvage value of the project is omitted from the analysis.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
24.
The internal rate of return is:
A. more reliable as a decision making tool than net present value whenever you are considering mutually
exclusive projects.
B. equivalent to the discount rate that makes the net present value equal to one.
C. difficult to compute without the use of either a financial calculator or a computer.
D. dependent upon the interest rates offered in the marketplace.
E. a better methodology than net present value when dealing with unconventional cash flows.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
25.
The internal rate of return tends to be:
A. easier for managers to comprehend than the net present value.
B. extremely accurate even when cash flow estimates are faulty.
C. ignored by most financial analysts.
D. used primarily to differentiate between mutually exclusive projects.
E. utilized in project analysis only when multiple net present values apply.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Internal Rate of Return
26.
You are trying to determine whether to accept project A or project B. These projects are mutually
exclusive. As part of your analysis, you should compute the incremental IRR by determining:
A. the internal rate of return for the cash flows of each project.
B. the net present value of each project using the internal rate of return as the discount rate.
C. the discount rate that equates the discounted payback periods for each project.
D. the discount rate that makes the net present value of each project equal to 1.
E. the internal rate of return for the differences in the cash flows of the two projects.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
27.
Graphing the NPVs of mutually exclusive projects over different discount rates helps demonstrate:
A. how the incremental IRR varies with changes in the discount rate.
B. how decisions concerning mutually exclusive projects are derived.
C. how the duration of a project affects the decision as to which project to accept.
D. how the payback period and the initial cash outflow of a project are related.
E. how the profitability index and the net present value are related.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
28.
The profitability index is closely related to:
A. payback.
B. discounted payback.
C. average accounting return.
D. net present value.
E. internal rate of return.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Profitability Index
29.
Analysis using the profitability index:
A. frequently conflicts with the accept and reject decisions generated by the application of the net present
value rule.
B. is useful as a decision tool when investment funds are limited.
C. cannot be used to aid capital rationing.
D. utilizes the same basic variables as those used in the average accounting return.
E. produces results which typically are difficult to comprehend or apply.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Profitability Index
30.
If you want to review a project from a benefit-cost perspective, you should use the _______ method of
analysis.
A. net present value
B. payback
C. internal rate of return
D. average accounting return
E. profitability index
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Profitability Index
31.
When the present value of the cash inflows exceeds the initial cost of a project, then the project should be:
A. accepted because the internal rate of return is positive.
B. accepted because the profitability index is greater than 1.
C. accepted because the profitability index is negative.
D. rejected because the internal rate of return is negative.
E. rejected because the net present value is negative.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Profitability Index
32.
Which one of the following is the best example of two mutually exclusive projects?
A. Planning to build a warehouse and a retail outlet side by side.
B. Buying sufficient equipment to manufacture both desks and chairs simultaneously.
C. Using an empty warehouse for storage or renting it entirely out to another firm.
D. Using the company sales force to promote sales of both shoes and socks.
E. Buying both inventory and fixed assets using funds from the same bond issue.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
33.
The Liberty Co. is considering two projects. Project A consists of building a wholesale book outlet on lot
#169 of the Englewood Retail Center. Project B consists of building a sit-down restaurant on lot #169 of
the Englewood Retail Center. When trying to decide whether to build the book outlet or the restaurant,
management should rely most heavily on the analysis results from the _______ method of analysis.
A. profitability index
B. internal rate of return
C. payback
D. net present value
E. accounting rate of return
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
34.
When two projects both require the total use of the same limited economic resource, the projects are
generally considered to be:
A. independent.
B. marginally profitable.
C. mutually exclusive.
D. acceptable.
E. internally profitable.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Problems with the IRR Approach
35.
Matt is analyzing two mutually exclusive projects of similar size and has prepared the following data. Both
projects have 5 year lives.
Matt has been asked for his best recommendation given this information. His recommendation should be to
accept:
A. project B because it has the shortest payback period.
B. both projects as they both have positive net present values.
C. project A and reject project B based on their net present values.
D. project B and reject project A based on other criteria not mentioned in the problem.
E. project B and reject project A based on both the payback period and the average accounting return.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
36.
Given that the net present value (NPV) is generally considered to be the best method of analysis, why
should you still use the other methods?
A. The other methods help validate whether or not the results from the net present value analysis are
reliable.
B. You need to use the other methods since conventional practice dictates that you only accept projects
after you have generated three accept indicators.
C. You need to use other methods because the net present value method is unreliable when a project has
unconventional cash flows.
D. The internal rate of return must always indicate acceptance since this is the best method from a
financial perspective.
E. The discounted payback method must always be computed to determine if a project returns a positive
cash flow since NPV does not measure this aspect of a project.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
37.
In actual practice, managers may use the:
I. IRR because the results are easy to communicate and understand.
II. payback because of its simplicity.
III. net present value because it is considered by many to be the best method of analysis.
A. I and II only
B. II and III only
C. I and III only
D. I, II, and III
E. None of these
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
38.
No matter how many forms of investment analysis you do:
A. the actual results from a project may vary significantly from the expected results.
B. the internal rate of return will always produce the most reliable results.
C. a project will never be accepted unless the payback period is met.
D. the initial costs will generally vary considerably from the estimated costs.
E. only the first three years of a project ever affect its final outcome.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
39.
Which of the following methods of project analysis are biased towards short-term projects?
I. Internal rate of return
II. Net present value
III. Payback
IV. Discounted payback
A. I and II only
B. III and IV only
C. II and III only
D. I and IV only
E. II and IV only
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
40.
If a project is assigned a required rate of return equal to zero, then:
A. the timing of the project's cash flows has no bearing on the value of the project.
B. the project will always be accepted.
C. the project will always be rejected.
D. whether the project is accepted or rejected will depend on the timing of the cash flows.
E. the project can never add value for the shareholders.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
41.
You are considering a project with the following data:
Internal rate of return 8.7%
Profitability ratio .98
Net present value -$393
Payback period 2.44 years
Required return 9.5%
Which one of the following is correct given this information?
A. The discount rate used in computing the net present value must have been less than 8.7%.
B. The discounted payback period will have to be less than 2.44 years.
C. The discount rate used to compute the profitability ratio was equal to the internal rate of return.
D. This project should be accepted based on the profitability ratio.
E. This project should be rejected based on the internal rate of return.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
42.
Accepting positive NPV projects benefits the stockholders because:
A. it is the most easily understood valuation process.
B. the present value of the expected cash flows are equal to the cost.
C. the present value of the expected cash flows are greater than the cost.
D. it is the most easily calculated.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
43.
Which of the following does not characterize NPV?
A. NPV does not explicitly incorporate risk into the analysis.
B. NPV incorporates all relevant cash flow information.
C. NPV uses all of the project's cash flows.
D. NPV discounts all future cash flows.
E. Using NPV will lead to decisions that maximize shareholder wealth.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
44.
The payback period rule:
A. discounts cash flows.
B. ignores initial cost.
C. always uses all possible cash flows in its calculation.
D. Both discounts cash flows; and always uses all possible cash flows in its calculation.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Payback Period Method
45.
The payback period rule accepts all investment projects in which the payback period for the cash flows is:
A. greater than one.
B. greater than the cutoff point.
C. less than the cutoff point.
D. positive.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Payback Period Method
46.
The payback period rule is a convenient and useful tool because:
A. it provides a quick estimate of how rapidly the initial investment will be recouped.
B. results of a short payback rule decision will be quickly seen.
C. it does not have to take into account time value of money.
D. All of these.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Payback Period Method
47.
The discounted payback period rule:
A. considers the time value of money.
B. discounts the cutoff point.
C. ignores uncertain cash flows.
D. is preferred to the NPV rule.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Discounted Payback Period Method
48.
The payback period rule:
A. determines a cutoff point so that all projects accepted by the NPV rule will be accepted by the payback
period rule.
B. determines a cutoff point so that depreciation is just equal to positive cash flows in the payback year.
C. requires an arbitrary choice of a cutoff point.
D. varies the cutoff point with the interest rate.
E. Both determines a cutoff point so that all projects accepted by the NPV rule will be accepted by the
payback period rule; and varies the cutoff point with the interest rate.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Payback Period Method
49.
Modified internal rate of return:
A. handles the multiple IRR problem by combining cash flows until only one change in sign change
remains.
B. requires the use of a discount rate.
C. does not require the use of a discount rate.
D. Both handles the multiple IRR problem by combining cash flows until only one change in sign change
remains; and requires the use of a discount rate.
E. Both handles the multiple IRR problem by combining cash flows until only one change in sign change
remains; and does not require the use of a discount rate.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
50.
A mutually exclusive project is a project whose:
A. acceptance or rejection has no effect on other projects.
B. NPV is always negative.
C. IRR is always negative.
D. acceptance or rejection affects other projects.
E. cash flow pattern exhibits more than one sign change.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Problems with the IRR Approach
51.
The two fatal flaws of the internal rate of return rule are:
A. arbitrary determination of a discount rate and failure to consider initial expenditures.
B. arbitrary determination of a discount rate and failure to correctly analyze mutually exclusive investment
projects.
C. arbitrary determination of a discount rate and the multiple rate of return problem.
D. failure to consider initial expenditures and failure to correctly analyze mutually exclusive investment
projects.
E. failure to correctly analyze mutually exclusive investment projects and the multiple rate of return
problem.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
52.
A project will have more than one IRR if:
A. the IRR is positive.
B. the IRR is negative.
C. the NPV is zero.
D. the cash flow pattern exhibits more than one sign change.
E. the cash flow pattern exhibits exactly one sign change.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Internal Rate of Return
53.
Using internal rate of return, a conventional project should be accepted if the internal rate of return is:
A. equal to the discount rate.
B. greater than the discount rate.
C. less than the discount rate.
D. negative.
E. positive.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Internal Rate of Return
54.
The internal rate of return may be defined as:
A. the discount rate that makes the NPV equal to zero.
B. the difference between the market rate of interest and the NPV.
C. the market rate of interest less the risk-free rate.
D. the project acceptance rate set by management.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
55.
The problem of multiple IRRs can occur when:
A. there is only one sign change in the cash flows.
B. the first cash flow is always positive.
C. the cash flows decline over the life of the project.
D. there is more than one sign change in the cash flows.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: Problems with the IRR Approach
56.
The elements that cause problems with the use of the IRR in projects that are mutually exclusive are:
A. the discount rate and scale problems.
B. timing and scale problems.
C. the discount rate and timing problems.
D. scale and reversing flow problems.
E. timing and reversing flow problems.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
57.
If there is a conflict between mutually exclusive projects due to the IRR, one should:
A. drop the two projects immediately.
B. spend more money on gathering information.
C. depend on the NPV as it will always provide the most value.
D. depend on the payback because it does not suffer from these same problems.
E. None of these.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
58.
The profitability index is the ratio of:
A. average net income to average investment.
B. internal rate of return to current market interest rate.
C. net present value of cash flows to internal rate of return.
D. net present value of cash flows to return on equity.
E. present value of cash flows to initial investment cost.
AACSB: Analytic
Blooms: Understand
Difficulty level: 1 Easy
Topic: The Profitability Index
59.
Which of the following statement is true?
A. One must know the discount rate to compute the NPV of a project but one can compute the IRR
without referring to the discount rate.
B. One must know the discount rate to compute the IRR of a project but one can compute the NPV
without referring to the discount rate.
C. Payback accounts for time value of money.
D. There will always be one IRR regardless of cash flows.
E. Return on equity is the ratio of total assets to total net income.
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
60.
Graham and Harvey (2001) found that _____ and _____ were the two most popular capital budgeting
methods.
A. Internal Rate of Return; Payback Period
B. Internal Rate of Return; Net Present Value
C. Net Present Value; Payback Period
D. Modified Internal Rate of Return; Internal Rate of Return
E. Modified Internal Rate of Return; Net Present Value
AACSB: Analytic
Blooms: Understand
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
61.
What is the net present value of a project with the following cash flows and a required return of 12%?
A. -$287.22
B. -$177.62
C. $177.62
D. $204.36
E. $287.22
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
62.
What is the net present value of a project that has an initial cash outflow of $12,670 and the following cash
inflows? The required return is 11.5%.
A. $218.68
B. $370.16
C. $768.20
D. $1,249.65
E. $1,371.02
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
63.
A project will produce cash inflows of $1,750 a year for four years. The project initially costs $10,600 to
get started. In year five, the project will be closed and as a result should produce a cash inflow of $8,500.
What is the net present value of this project if the required rate of return is 13.75%?
A. -$5,474.76
B. -$1,011.40
C. -$935.56
D. $1,011.40
E. $5,474.76
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
64.
You are considering the following two mutually exclusive projects that will not be repeated. The required
rate of return is 11.25% for project A and 10.75% for project B. Which project should you accept and
why?
A. project A; because its NPV is about $335 more than the NPV of project B.
B. project A; because it has the higher required rate of return.
C. project B; because it has the largest total cash inflow.
D. project B; because it returns all its cash flows within two years.
E. project B; because it is the largest sized project.
Difference in NPVs = $2,326.46 - $1,991.56 = $334.90
The answer states that the NPV of Project A exceeds the NPV of project B by about $335.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
65.
You are considering two mutually exclusive projects with the following cash flows. Will your choice
between the two projects differ if the required rate of return is 8% rather than 11%? If so, what should you
do?
A. yes; Select A at 8% and B at 11%.
B. yes; Select B at 8% and A at 11%.
C. yes; Select A at 8% and select neither at 11%.
D. no; Regardless of the required rate, project A always has the higher NPV.
E. no; Regardless of the required rate, project B always has the higher NPV.
At 8%, Project A has the higher NPV.
At 11%, Project B has the higher NPV.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
66.
What is the internal rate of return on an investment with the following cash flows?
A. 5.93%
B. 5.96%
C. 6.04%
D. 6.09%
E. 6.13%
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: The Internal Rate of Return
67.
An investment has the following cash flows. Should the project be accepted if it has been assigned a
required return of 9.5%? Why or why not?
A. yes; because the IRR exceeds the required return by about 0.39%.
B. yes; because the IRR is less than the required return by about 3.9%.
C. yes; because the IRR is positive.
D. no; because the IRR exceeds the required return by about 3.9%.
E. no; because the IRR is 9.89%.
The project should be accepted because the IRR of 9.89% exceeds the required return of 9.5%.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
68.
You are considering two independent projects with the following cash flows. The required return for both
projects is 10%. Given this information, which one of the following statements is correct?
A. You should accept project B since it has the higher IRR and reject project A because you can not accept
both projects.
B. You should accept project A because it has the lower NPV and reject project B.
C. You should accept project A because it has the higher NPV and you can not accept both projects.
D. You should accept project B because it has the higher IRR and reject project A.
E. You should accept both projects if the funds are available to do so since both NPV's are > 0.
Since these are independent projects and both the IRR and NPV rules say accept, you should accept both
projects if there are sufficient funds to do so.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
69.
You are considering an investment with the following cash flows. If the required rate of return for this
investment is 13.5%, should you accept it based solely on the internal rate of return rule? Why or why not?
A. Yes; because the IRR exceeds the required return.
B. Yes; because the IRR is a positive rate of return.
C. No; because the IRR is less than the required return.
D. No; because the IRR is a negative rate of return.
E. You can not apply the IRR rule in this case because there are multiple IRRs.
Since C03 is a negative value resulting in more than one sign change, there are multiple IRRs. Thus, the
IRR rule does not apply.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
70.
What is the profitability index for an investment with the following cash flows given a 9% required return?
A. .96
B. .98
C. 1.00
D. 1.02
E. 1.04
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: The Profitability Index
71.
Based on the profitability index (PI) rule, should a project with the following cash flows be accepted if the
discount rate is 8%? Why or why not?
A. Yes; because the PI is 1.008.
B. Yes; because the PI is .992.
C. Yes; because the PI is .999.
D. No; because the PI is 1.008.
E. No; because the PI is .992.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Profitability Index
72.
You are considering two independent projects both of which have been assigned a discount rate of 8%.
Based on the profitability index, what is your recommendation concerning these projects?
A. You should accept both projects since both of their PIs are positive.
B. You should accept project A since it has the higher PI.
C. You should accept both projects since both of their PIs are greater than 1.
D. You should only accept project B since it has the largest PI and the PI exceeds 1.
E. Neither project is acceptable.
Because the projects are independent and their PIs exceed 1.0, both projects should be accepted.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Profitability Index
73.
You would like to invest in the following project.
Camille, your boss, insists that only projects that can return at least $1.10 in today's dollars for every $1
invested can be accepted. She also insists on applying a 10% discount rate to all cash flows. Based on these
criteria, you should:
A. accept the project because it returns almost $1.22 for every $1 invested.
B. accept the project because it has a positive PI.
C. accept the project because the NPV is $2,851.
D. reject the project because the PI is 1.05.
E. reject the project because the IRR exceeds 10%.
You should reject the project since the PI of 1.05 is less than Victoria's requirement of 1.10. It is worth
mentioning that the NPV of this project is $2,851.24 and the IRR is 13.71%, both of which would
normally indicate project acceptance. However, neither the NPV nor the IRR meet the requirement of
returning $1.10 for every $1 spent.
AACSB: Analytic
Blooms: Apply
Difficulty level: 3 Hard
Topic: The Profitability Index
74.
It will cost $3,000 to acquire a small ice cream cart. Cart sales are expected to be $1,400 a year for three
years. After the three years, the cart is expected to be worthless as that is the expected remaining life of the
cooling system. What is the payback period of the ice cream cart?
A. .83 years
B. 1.14 years
C. 1.83 years
D. 2.14 years
E. 2.83 years
Payback period = 2 + (3,000 - 2,800)/2,800 = 2.14 years
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: The Payback Period Method
75.
You are considering a project with an initial cost of $4,300. What is the payback period for this project if
the cash inflows are $550, $970, $2,600, and $500 a year over the next four years?
A. 2.04 years
B. 2.36 years
C. 2.89 years
D. 3.04 years
E. 3.36 years
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: The Payback Period Method
76.
A project has an initial cost of $2,100. The cash inflows are $0, $500, $900, and $700 over the next four
years, respectively. What is the payback period?
A. 1 years
B. 2 years
C. 3 years
D. 4 years
E. never
2,100 - 0 - 500 - 900 - 700 = 0
Payback period = 4 years
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: The Payback Period Method
77.
Jack is considering adding toys to his general store. He estimates that the cost of inventory will be $4,200.
The remodeling and shelving costs are estimated at $1,500. Toy sales are expected to produce net cash
inflows of $1,200, $1,500, $1,600, and $1,750 over the next four years, respectively. Should Jack add toys
to his store if he assigns a three-year payback period to this project?
A. Yes; because the payback period is 2.94 years.
B. Yes; because the payback period is 2.02 years.
C. Yes; because the payback period is 3.80 years.
D. No; because the payback period is 2.02 years.
E. No; because the payback period is 3.80 years.
Jack should reject the toy project because the payback period exceeds 3 years.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Payback Period Method
78.
A project has an initial cost of $8,600 and produces cash inflows of $3,200, $4,900, and $1,500 over the
next three years, respectively. What is the discounted payback period if the required rate of return is 8%?
A. 2.05 years
B. 2.13 years
C. 2.33 years
D. 3.00 years
E. never
The project never pays back on a discounted basis.
DCF = 3200/(1 + .08) + 4900/(1 + .08)^2 + 1500/(1 + .08)^3
DCF = $8,354.67, which is less than the initial cost of $8,600
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Discounted Payback Period Method
79.
Homer is considering a project which will produce cash inflows of $950 a year for 4 years. The project has
a 9% required rate of return and an initial cost of $2,900. What is the discounted payback period?
A. 3.05 years
B. 3.74 years
C. 3.81 years
D. 3.92 years
E. never
Discounted payback = 3 + (2,900 - 871.56 - 799.60 - 733.57)/673 = 3.74
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Discounted Payback Period Method
80.
Ginny Trueblood is considering an investment which will cost her $120,000. The investment produces no
cash flows for the first year. In the second year the cash inflow is $35,000. This inflow will increase to
$55,000 and then $75,000 for the following two years before ceasing permanently. Ginny requires a 10%
rate of return and has a required discounted payback period of three years. Ginny should _______ this
project because the discounted payback period is ______.
A. accept; 2.03 years
B. accept; 2.97 years
C. accept; 3.97 years
D. reject; 3.03 years
E. reject; 3.97 years
Ginny should reject the project since the payback period of 3.97 years exceeds the required 3 years.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Discounted Payback Period Method
81.
You are analyzing two mutually exclusive projects and have developed the following information. What is
the incremental IRR?
A. 11.11%
B. 13.01%
C. 14.91%
D. 16.75%
E. 17.90%
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
82.
The Camel Company is considering two mutually exclusive projects with the following cash flows. The
incremental IRR is _______ and if the required rate is higher than the crossover rate then project _______
should be accepted.
A. 13.94%; A
B. 13.94%; B
C. 15.44%; A
D. 15.44%; B
E. 15.86%; A
The crossover rate is 13.94%. At a rate higher than the crossover rate, such as 15%, Project B will have the
higher NPV and should be accepted.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Problems with the IRR Approach
83.
You are analyzing a project and have prepared the following data:
Required payback period 2.5 years
Required return 8.50%
Based on the profitability index of _______ for this project, you should _______ the project.
A. .97; accept
B. 1.05; accept
C. 1.18; accept
D. .97; reject
E. 1.05; reject
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: The Profitability Index
84.
You are analyzing a project and have prepared the following data:
Required payback period 2.5 years
Required return 8.50%
Based on the internal rate of return of _______ for this project, you should _______ the project.
A. 8.95%; accept
B. 10.75%; accept
C. 8.44%; reject
D. 9.67%; reject
E. 10.33%; reject
You should accept because the IRR of 10.75% exceeds the required return of 8.50%.
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: The Internal Rate of Return
85.
You are analyzing a project and have prepared the following data:
Required payback period 2.5 years
Required return 8.50%
Based on the net present value of _______ for this project, you should _______ the project.
A. -$2,021.28; reject
B. -$406.19; reject
C. $7,978.72; accept
D. $9,836.74; accept
E. $12,684.23; accept
You should accept because the NPV is positive.
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: Why Use Net Present Value?
86.
You are analyzing a project and have prepared the following data:
Required payback period 2.5 years
Required return 8.50%
Based on the payback period of _______ for this project, you should _______ the project.
A. 1.87 years; accept
B. 2.87 years; accept
C. 2.87 years; reject
D. 3.13 years; reject
E. 3.87 years; reject
Based on payback, the project should be rejected because the payback period of 2.87 years exceeds the
required period of 2.5 years.
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: The Payback Period Method
87.
You are considering the following two mutually exclusive projects. Both projects will be depreciated using
straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage
value.
Required rate of return 10% 13%
Required payback period 2.0 years 2.0 years
Based on the net present value method of analysis and given the information in the problem, you should:
A. accept both project A and project B.
B. accept project A and reject project B.
C. accept project B and reject project A.
D. reject both project A and project B.
E. accept whichever one you want as they represent equal opportunities.
Project B should be accepted and project A should be rejected.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
88.
You are considering the following two mutually exclusive projects. Both projects will be depreciated using
straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage
value.
Required rate of return 10% 13%
Required payback period 2.0 years 2.0 years
Based upon the internal rate of return (IRR) and the information provided in the problem, you should:
A. accept both project A and project B.
B. reject both project A and project B.
C. accept project A and reject project B.
D. accept project B and reject project A.
E. ignore the IRR rule and use another method of analysis.
Because these are mutually exclusive projects, the IRR rule should not be applied.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
89.
You are considering the following two mutually exclusive projects. Both projects will be depreciated using
straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage
value.
Required rate of return 10% 13%
Required payback period 2.0 years 2.0 years
Based upon the payback period and the information provided in the problem, you should:
A. accept both project A and project B.
B. reject both project A and project B.
C. accept project A and reject project B.
D. accept project B and reject project A.
E. require that management extend the payback period for project A since it has a higher initial cost.
Neither project pays back within 2 years, thus they should both be rejected.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Payback Period Method
90.
You are considering the following two mutually exclusive projects. Both projects will be depreciated using
straight-line depreciation to a zero book value over the life of the project. Neither project has any salvage
value.
Required rate of return 10% 13%
Required payback period 2.0 years 2.0 years
Based upon the profitability index (PI) and the information provided in the problem, you should:
A. accept both project A and project B.
B. accept project A and reject project B.
C. accept project B and reject project A.
D. reject both project A and project B.
E. disregard the PI method in this case.
Because these are mutually exclusive projects, the PI rule should not be applied.
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Profitability Index
91.
A $25 investment produces $27.50 at the end of the year with no risk. Which of the following is true?
A. NPV is positive if the required return is less than 10%.
B. NPV is negative if the required return is less than 10%.
C. NPV is zero if the required return is equal to 10%.
D. Both NPV is positive if the required return is less than 10%; and NPV is zero if the required return is
equal to 10%.
E. None of these.
NPV = ($27.50/1.1) - $25.00 = $0
AACSB: Analytic
Blooms: Apply
Difficulty level: 3 Hard
Topic: Why Use Net Present Value?
92.
Consider an investment with an initial cost of $20,000 and is that expected to last for 5 years. The expected
cash flows in years 1 and 2 are $5,000, in years 3 and 4 are $5,500 and in year 5 is $1,000. The total cash
inflow is expected to be $22,000 or an average of $4,400 per year. Compute the payback period in years.
A. 3.18 years
B. 3.82 years
C. 4.00 years
D. 4.55 years
E. None of these
Payback Period = ($5,000 + $5,000 + $5,500 = $15,500 for 3 years; remainder $20,000 - $15,500 = 4,500.
$4,500/$5,500 = .81818 = .82) = Payback Period = 3.82 years
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Payback Period Method
93.
An investment with an initial cost of $15,000 produces cash flows of $5,000 annually for 5 years. If the
cash flow is evenly spread out over the year and the firm can borrow at 10%, the discounted payback
period is _____ years.
A. 3
B. 3.2
C. 3.75
D. 4
E. 5
Discounted Payback: n = $15,000/$5,000 = 3. PMT = 1 PV = -3 FV = 0 I/YR = 10 N = ? = 3.75
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Discounted Payback Period Method
94.
An investment project has the cash flow stream of $-250, $75, $125, $100, and $50. The cost of capital is
12%. What is the discounted payback period?
A. 3.15 years
B. 3.38 years
C. 3.45 years
D. 3.60 years
E. 4.05 years
$75/1.12 = $66.96, $125/1.12 = $99.65, $100/1.12 = $71.18, $50/1.12 = $31.78
3 yr. CF: $250 - $66.96 - $99.65 - $71.18 = $12.21 Fraction = $12.21/$31.78 = .38
Discounted Payback: 3 + .38 = 3.38 years
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Discounted Payback Period Method
95.
An investment cost $10,000 with expected cash flows of $3,000 for 5 years. The discount rate is
15.2382%. The NPV is ______ and the IRR is ______ for the project.
A. $0; 15.2382%
B. $3.33; 27.2242%
C. $5,000; 0%
D. Can not answer without one or the other value as input.
E. None of these.
NPV = -$10,000 + (3,000 x PVIFA 5, .152382) = $0
AACSB: Analytic
Blooms: Apply
Difficulty level: 1 Easy
Topic: The Internal Rate of Return
96.
An investment with an initial cost of $14,000 produces cash flows of $4,000 annually for 5 years. If the
cash flow is evenly spread out over the year and the firm can borrow at 10%, the discounted payback
period is _____ years.
A. 2.5
B. 2.68
C. 4.53
D. 4.87
E. Never
4 + {(14,000 - 3636.36 - 3305.79 - 3005.25 - 2732.05 - 2483.69)/2483.69} = 4.53
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Payback Period Method
97.
An investment project has the cash flow stream of $-3250, $80, $200, $75, and $90. The cost of capital is
12%. What is the discounted payback period?
A. 1.24 years
B. 1.85 years
C. 2.24 years
D. 2.85 years
E. 3.05 years
2 + (350 - 160.71 - 159.44)/124.56 = 2.24
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Payback Period Method
98.
An investment cost $12,000 with expected cash flows of $4,000 for 4 years. The discount rate is
15.2382%. The NPV is ______ and the IRR is ______ for the project.
A. -$634.89; 12.60%
B. $0; 15.2382%
C. $4,000; 0%
D. Can not answer without one or the other value as input.
E. None of these.
NPV = -$12,000 + (4,000 x PVIFA 4, .152382) = -$634.89
AACSB: Analytic
Blooms: Apply
Difficulty level: 2 Medium
Topic: The Internal Rate of Return
Essay Questions
99.
List and briefly discuss the advantages and disadvantages of the internal rate of return (IRR) rule.
The advantages of the rule are its close relationship with NPV and the ease with which it is understood and
communicated. The two disadvantages are that there may be multiple solutions and the rule may lead to a
ranking conflict in evaluating mutually exclusive investments. The student should add a brief explanation
demonstrating their understanding of each.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 3 Hard
Topic: The Internal Rate of Return
100.
Explain the differences and similarities between net present value (NPV) and the profitability index (PI).
The NPV and PI are basically the same calculation, and both rules lead to the same accept/reject decision.
The main difference between the two is that the PI may be useful in determining which projects to accept if
funds are limited; however, the PI may lead to incorrect decisions in considering mutually exclusive
investments.
AACSB: Reflective Thinking
Blooms: Understand
Difficulty level: 2 Medium
Topic: Why Use Net Present Value?
101.
Given the goal of maximization of firm value and shareholder wealth, we have stressed the importance of
net present value (NPV). And yet, many financial decision-makers at some of the most prominent firms in
the world continue to use less desirable measures such as the payback period and the average accounting
return (AAR). Why do you think this is the case?
This is an open-ended question which allows the creative student to speculate on the value of nondiscounted cash flow evaluation measures. We use it as a springboard to stress that even rational financial
managers sometimes find it expedient to use a group of measures. For example, firms may rely on the IRR
because it is easier to explain to board members than NPV. Also, for large projects, AAR provides
shareholders with some insights as to the project's impact on net income and earnings per share.
AACSB: Reflective Thinking
Blooms: Evaluate
Difficulty level: 3 Hard
Topic: Why Use Net Present Value?
102.
The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset has a three-year
life, will produce a cash flow of $1,200 in the first and second year, and $3,000 in the third year. The
interest rate is 12%. Calculate the project's payback. Also, calculate the project's IRR. Should the project
be taken? Check your answer by computing the project's NPV.
Payback - 2.63 years.
IRR = 10.41%. Do not take project as IRR < 12%
Reject the project NPV = ($136.60)
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 3 Hard
Topic: The Internal Rate of Return
103.
The Ziggy Trim and Cut Company can purchase equipment on sale for $4,300. The asset has a three-year
life, will produce a cash flow of $1,200 in the first and second year, and $3,000 in the third year. The
interest rate is 12%. Calculate the project's Discounted Payback and Profitability Index assuming end of
year cash flows. Should the project be taken? If the Average Accounting Return was positive, how would
this affect your decision?
Time 0 - Cash flows = $-4,300, Present Value of Cash flows = $-4,300
Time 1 and 2 - Cash flows = $1,200 each period, Present Value of Cash flows = $2,028.06 for both
periods, Sum of Present Value of Cash flows = $-2,271.94 at the end of time 2
Time 3 - Cash flows = $3,000, Present Value of Cash flows = $2,135.34, Sum of Present Value of Cash
flows = $-136.60
Discounted Payback cannot be calculated as NPV < 0; NPV = $-136.60
PI = ΣCFATt/Initial Investment = $4,163.40/$4,300 = .968 = .97
Both measures indicate rejection. A positive accounting rate of return should not change the decision. DPP
and PI indicate that the cost of capital is not being covered.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 3 Hard
Topic: The Discounted Payback Period Method; The Profitability Index
104.
The Walker Landscaping Company can purchase a piece of equipment for $3,600. The asset has a twoyear life, and will produce a cash flow of $600 in the first year and $4,200 in the second year. The interest
rate is 15%. Calculate the project's payback assuming steady cash flows. Also calculate the project's IRR.
Should the project be taken? Check your answer by computing the project's NPV.
Payback = 1.714 years
Calculated IRR = 16.67%. Accept the project. NPV = $97.54.
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 3 Hard
Topic: The Internal Rate of Return
105.
The IRR rule is said to be a special case of the NPV rule. Explain why this is so and why it has some
limitations NPV does not?
At some K, NPV = $0; by definition, when NPV = 0, K = IRR.
Problems occur with IRR due to conflicts with mutually exclusive projects, timing and size problems,
multiple sign changes. NPV always the best choice
AACSB: Reflective Thinking
Blooms: Analyze
Difficulty level: 3 Hard
Topic: The Internal Rate of Return
106.
Discuss how frequently publicly traded firms use different capital budgeting tools.
Graham and Dodd (2001) surveyed CFO's of publicly traded firms and found that IRR and NPV were the
most frequently used capital budgeting tools followed by payback, discounted payback, accounting rate of
return, and finally profitability index. More important than the exact ordering is the recognition that NPV
and IRR are the most preferred capital budgeting tools.
AACSB: Analytic
Blooms: Evaluate
Difficulty level: 3 Hard
Topic: The Internal Rate of Return
1.
Chapter 6: Making Capital Investment Decisions (excluding 6.3; 6.5)
The changes in a firm's future cash flows that are a direct consequence of accepting a project are called
_____ cash flows.
A. incremental
B. stand-alone
C. opportunity
D. net present value
E. erosion
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Basic
Ross - Chapter 06 #1
Section: 6.1
Topic: Cash flows
2.
The annual annuity stream of payments with the same present value as a project's costs is called the
project's _____ cost.
A. incremental
B. sunk
C. opportunity
D. erosion
E. equivalent annual
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Basic
Ross - Chapter 06 #2
Section: 6.4
Topic: Special projects
3.
A cost that has already been paid, or the liability to pay has already been incurred, is a(n):
A. salvage value expense.
B. net working capital expense.
C. sunk cost.
D. opportunity cost.
E. erosion cost.
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Basic
Ross - Chapter 06 #3
Section: 6.1
Topic: Cash flows
4.
The most valuable investment given up if an alternative investment is chosen is a(n):
A. salvage value expense.
B. net working capital expense.
C. sunk cost.
D. opportunity cost.
E. erosion cost.
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Basic
Ross - Chapter 06 #4
Section: 6.1
Topic: Opportunity costs
5.
A decrease in a firm’s current cash flows resulting from the implementation of a new project is referred to
as:
A. salvage value expenses.
B. net working capital expenses.
C. sunk costs.
D. opportunity costs.
E. erosion costs.
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Basic
Ross - Chapter 06 #5
Section: 6.1
Topic: Cash flows
6.
The depreciation method currently allowed under U.S. tax law governing the accelerated write-off of
property under various lifetime classifications is called _____ depreciation.
A. FIFO
B. MACRS
C. straight-line
D. sum-of-years digits
E. curvilinear
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Basic
Ross - Chapter 06 #6
Section: 6.2
Topic: Depreciation
7.
The cash flow tax savings generated as a result of a firm's tax-deductible depreciation expense is called
the:
A. aftertax depreciation savings.
B. depreciable basis.
C. depreciation tax shield.
D. operating cash flow.
E. aftertax salvage value.
AACSB: Analytical Thinking
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Basic
Ross - Chapter 06 #7
Section: 6.3
Topic: Operating cash flow
8.
The cash flow from a project is computed as the:
A. net operating cash flow generated by the project, less any sunk costs and erosion costs.
B. sum of the incremental operating cash flow and aftertax salvage value of the project.
C. net income generated by the project, plus the annual depreciation expense.
D. sum of the incremental operating cash flow, capital spending, and net working capital cash flows
incurred by the project.
E. sum of the sunk costs, opportunity costs, and erosion costs of the project.
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Ross - Chapter 06 #8
Section: 6.2
Topic: Cash flows
9.
Interest rates or rates of return on investments that have been adjusted for the effects of inflation are called
_____ rates.
A. real
B. nominal
C. effective
D. stripped
E. coupon
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Ross - Chapter 06 #9
Section: 6.5
Topic: Nominal and real rates
10.
The increase you realize in buying power as a result of owning an investment is referred to as the _____
rate of return.
A. inflated
B. realized
C. nominal
D. real
E. risk-free
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Ross - Chapter 06 #10
Section: 6.5
Topic: Nominal and real rates
11.
The pro forma income statement for a cost reduction project:
A. will reflect a reduction in the sales of the firm.
B. will generally reflect no incremental sales.
C. has to be prepared reflecting the total sales and expenses of the entire firm.
D. cannot be prepared due to the lack of any project related sales.
E. will always reflect a negative project operating cash flow.
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Ross - Chapter 06 #11
Section: 6.4
Topic: Special projects
12.
One purpose of identifying all of the incremental cash flows related to a proposed project is to:
A. isolate the total sunk costs so they can be evaluated to determine if the project will add value to the
firm.
B. eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the
project.
C. make each project appear as profitable as possible for the firm.
D. include both the proposed and the current operations of a firm in the analysis of the project.
E. identify any and all changes in the cash flows of the firm for the past year so they can be included in
the analysis.
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Ross - Chapter 06 #12
Section: 6.1
Topic: Cash flows
13.
Sunk costs include any cost that:
A. will change if a project is undertaken.
B. will be incurred if a project is accepted.
C. has previously been incurred and cannot be changed.
D. will be paid to a third party and cannot be refunded for any reason whatsoever.
E. will occur if a project is accepted and once incurred, cannot be recouped.
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Ross - Chapter 06 #13
Section: 6.1
14.
You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are
trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation,
the $500 you spent fixing the transmission is a(n) _____ cost.
A. opportunity
B. fixed
C. incremental
D. sunk
E. relevant
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Ross - Chapter 06 #14
Section: 6.1
Topic: Cash flows
15.
Erosion can be explained as the:
A. additional income generated from the sales of a newly added product.
B. loss of current sales due to a new project being implemented.
C. loss of revenue due to employee theft.
D. loss of revenue due to customer theft.
E. loss of cash due to the expenses required to fix a parking lot after a heavy rain storm.
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Ross - Chapter 06 #15
Section: 6.1
Topic: Cash flows
16.
Which one of these is an example of erosion that should be included in project analysis?
A. The anticipated loss of current sales when a new product is launched.
B. The expected decline in sales as a new product ages.
C. The reduction in your sales that occurs when a competitor introduces a new product.
D. The sudden loss of sales due to a major employer in your community implementing massive layoffs.
E. The reduction in sales price that will most likely be required to sell inventory that has aged.
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Ross - Chapter 06 #16
Section: 6.1
Topic: Cash flows
17.
Which one of the following should be excluded from the analysis of a project?
A. erosion costs
B. incremental fixed costs
C. incremental variable costs
D. sunk costs
E. opportunity costs
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Ross - Chapter 06 #17
Section: 6.1
Topic: Cash flows
18.
All of the following are anticipated effects of a proposed project. Which of these should be considered
when computing the cash flow for the final year of a project?
A. operating cash flow and salvage values
B. salvage values and net working capital recovery
C. operating cash flow, net working capital recovery, salvage values
D. net working capital recovery and operating cash flow
E. operating cash flow only
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Ross - Chapter 06 #18
Section: 6.2
Topic: Cash flows
19.
Changes in the net working capital:
A. can affect the cash flows of a project every year of the project's life.
B. only affect the initial cash flows of a project.
C. are included in project analysis only if they represent cash outflows.
D. are generally excluded from project analysis due to their irrelevance to the total project.
E. affect the initial and the final cash flows of a project but not the cash flows of the middle years.
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Ross - Chapter 06 #19
Section: 6.2
Topic: Cash flows
20.
The net working capital of a firm will decrease if there is:
A. a decrease in accounts payable.
B. an increase in inventory.
C. a decrease in accounts receivable.
D. an increase in the firm's checking account balance.
E. a decrease in fixed assets.
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Ross - Chapter 06 #20
Section: 6.2
Topic: Net working capital
21.
Net working capital:
A. can be ignored in project analysis because any expenditure is normally recouped by the end of the
project.
B. requirements generally, but not always, create a cash inflow at the beginning of a project.
C. expenditures commonly occur at the end of a project.
D. is frequently affected by the additional sales generated by a new project.
E. is the only expenditure where at least a partial recovery can be made at the end of a project.
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Ross - Chapter 06 #21
Section: 6.2
Topic: Net working capital
22.
A company which uses the MACRS system of depreciation:
A. will have equal depreciation costs each year of an asset's life.
B. will expense the largest percentage of the cost during an asset’s first year of life.
C. can depreciate the cost of land, if it so desires.
D. will write off the entire cost of an asset over the asset's class life.
E. cannot expense any of the cost of a new asset during the first year of the asset's life.
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Ross - Chapter 06 #22
Section: 6.2
Topic: Depreciation
23.
Champion Toys just purchased some MACRS 5-year property at a cost of $230,000. The MACRS rates
are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and 5.76 percent for Years 1 to 6,
respectively. The book value of the asset as of the end of Year 2 can be calculated as:
A. $230,000 × (1 −.20 −.32). B. $230,000 × ([1 - (.20 × .32)].
B. $230,000 × (1 - .20) × (1 - .32).
C. $230,000 / (1 - .20 - .32).
D. $230,000 - ($230,000 × .20 × .32).
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Ross - Chapter 06 #23
Section: 6.2
Topic: Depreciation
24.
Pete’s Garage just purchased some equipment at a cost of $650,000. What is the proper methodology for
computing the depreciation expense for Year 3 if the equipment is classified as 5-year property for
MACRS? The MACRS rates are 20 percent, 32 percent, 19.2 percent, 11.52 percent, 11.52 percent, and
5.76 percent for Years 1 to 6, respectively.
A. $650,000 ×(1 − .20) ×(1 −.32) ×(1 −.192)
B. $650,000 ×(1 − .20) ×(1 −.32)
C. $650,000 ×(1 − .20) ×(1 − .32) × .192)
D. $650,000 ×(1 −.192)
E. $650,000 ×.192
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Ross - Chapter 06 #24
Section: 6.2
Topic: Depreciation
25.
The book value of an asset is primarily used to compute the:
A. annual depreciation tax shield.
B. amount of cash received from the sale of an asset.
C. amount of tax saved annually due to the depreciation expense.
D. amount of tax due on the sale of an asset.
E. change in depreciation needed to reflect the market value of the asset.
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Ross - Chapter 06 #25
Section: 6.2
Topic: Cash flows
26.
The salvage value of an asset creates an aftertax cash flow in an amount equal to the:
A. sales price of the asset.
B. sales price minus the book value.
C. sales price minus the tax due based on the sales price minus the book value.
D. sales price plus the tax due based on the sales price minus the book value.
E. sales price plus the tax due based on the book value minus the sales price.
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Ross - Chapter 06 #26
Section: 6.2
Topic: Cash flows
27.
The pretax salvage value of an asset is equal to the:
A. book value if straight-line depreciation is used.
B. book value if MACRS depreciation is used.
C. market value minus the book value.
D. book value minus the market value.
E. market value.
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Ross - Chapter 06 #27
Section: 6.2
Topic: Cash flows
28.
A project's operating cash flow will increase when the:
A. depreciation expense increases.
B. sales projections are lowered.
C. interest expense is lowered.
D. net working capital requirement increases.
E. earnings before interest and taxes decreases.
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Ross - Chapter 06 #28
Section: 6.3
Topic: Operating cash flow
29.
The cash flows of a project should:
A. be computed on a pretax basis.
B. include all sunk costs and opportunity costs.
C. include all incremental and opportunity costs.
D. be applied to the year when the related expense or income is recognized by GAAP.
E. include all financing costs related to new debt acquired to finance the project.
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Ross - Chapter 06 #29
Section: 6.1
Topic: Cash flows
30.
Assume a firm has no interest expense or extraordinary items. Given this, the operating cash flow can be
computed as:
A. EBIT - Taxes.
B. EBIT × (1 - Tax rate) + Depreciation × Tax rate.
C. (Sales - Costs) × (1 - Tax rate).
D. EBIT - Depreciation + Taxes.
E. Net income + Depreciation.
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Ross - Chapter 06 #30
Section: 6.3
Topic: Operating cash flow
31.
The bottom-up approach to computing the operating cash flow applies only when:
A. both the depreciation expense and the interest expense are equal to zero.
B. the interest expense is equal to zero.
C. the project is a cost-cutting project.
D. no fixed assets are required for the project.
E. taxes are ignored and the interest expense is equal to zero.
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Ross - Chapter 06 #31
Section: 6.3
Topic: Operating cash flow
32.
The top-down approach to computing the operating cash flow:
A. ignores all noncash items.
B. applies only if a project produces sales.
C. can only be used if the entire cash flows of a firm are included.
D. is equal to Sales −Costs −Taxes + Depreciation.
E. includes the interest expense related to a project.
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Ross - Chapter 06 #32
Section: 6.3
Topic: Operating cash flow
33.
For a profitable firm, an increase in which one of the following will increase the operating cash flow?
A. employee salaries
B. office rent
C. building maintenance
D. depreciation
E. equipment rental
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Ross - Chapter 06 #33
Section: 6.3
Topic: Operating cash flow
34.
Tax shield refers to a reduction in taxes created by:
A. a reduction in sales.
B. an increase in interest expense.
C. noncash expenses.
D. a project's incremental expenses.
E. opportunity costs.
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Ross - Chapter 06 #34
Section: 6.3
Topic: Operating cash flow
35.
A project which is designed to improve the manufacturing efficiency of a firm but will generate no
additional sales revenue is referred to as a(n) _____ project.
A. sunk cost
B. opportunity
C. cost-cutting
D. revenue-cutting
E. revenue-generating
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Ross - Chapter 06 #35
Section: 6.4
Topic: Special projects
36.
Toni's Tools is comparing machines to determine which one to purchase. The machines sell for differing
prices, have differing operating costs, differing machine lives, and will be replaced when worn out. These
machines should be compared using:
A. net present value only.
B. both net present value and the internal rate of return.
C. their equivalent annual costs.
D. the depreciation tax shield approach.
E. the replacement parts approach.
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Ross - Chapter 06 #36
Section: 6.4
Topic: Equivalent annual costs
37.
The equivalent annual cost method is useful in determining:
A. the annual operating cost of a machine if the annual maintenance is performed versus when the
maintenance is not performed as recommended.
B. the tax shield benefits of depreciation given the purchase of new assets for a project.
C. operating cash flows for cost-cutting projects of equal duration.
D. which one of two machines to acquire given equal machine lives but unequal machine costs.
E. which one of two machines to purchase when the machines are mutually exclusive, have different
machine lives, and will be replaced once they are worn out.
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Ross - Chapter 06 #37
Section: 6.4
Topic: Equivalent annual costs
38.
Marshall's purchased a corner lot five years ago at a cost of $498,000 and then spent $63,500 on grading
and drainage so the lot could be used for storing outdoor inventory. The lot was recently appraised at
$610,000. The company now wants to build a new retail store on the site. The building cost is estimated at
$1.1 million. What amount should be used as the initial cash flow for this building project?
A. $1,661,500
B. $1,100,000
C. $1,208,635
D. $1,710,000
E. $1,498,000
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Ross - Chapter 06 #38
Section: 6.1
Topic: Cash flows
39.
Samson's purchased a lot four years ago at a cost of $398,000. At that time, the firm spent $289,000 to
build a small retail outlet on the site. The most recent appraisal on the property placed a value of $629,000
on the property and building. Samson’s now wants to tear down the original structure and build a new strip
mall on the site at an estimated cost of $2.3 million. What amount should be used as the initial cash flow
for new project?
A. $2,987,000
B. $2,242,000
C. $2,058,000
D. $2,300,000
E. $2,929,000
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Ross - Chapter 06 #39
Section: 6.1
Topic: Cash flows
40.
Jamestown Ltd. currently produces boat sails and is considering expanding its operations to include
awnings. The expansion would require the use of land the firm purchased three years ago at a cost of
$142,000 that is currently valued at $137,500. The expansion could use some equipment that is currently
sitting idle if $6,700 of modifications were made to it. The equipment originally cost $139,500 six years
ago, has a current book value of $24,700, and a current market value of $39,000. Other capital purchases
costing $780,000 will also be required. What is the amount of the initial cash flow for this expansion
project?
A. $953,400
B. $962,300
C. $948,900
D. $927,800
E. $963,200
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Ross - Chapter 06 #40
Section: 6.1
Topic: Cash flows
41.
The Boat Works currently produces boat sails and is considering expanding its operations to include
awnings. The expansion would require the use of land the firm purchased three years ago at a cost of
$197,000 that is currently valued at $209,500. The expansion could use some equipment that is currently
sitting idle if $7,500 of modifications were made to it. The equipment originally cost $387,500 five years
ago, has a current book value of $132,700, and a current market value of $139,000. Other capital purchases
costing $520,000 will also be required. What is the value of the opportunity costs that should be included
in the initial cash flow for the expansion project?
A. $425,000
B. $485,000
C. $329,700
D. $348,500
E. $537,200
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Ross - Chapter 06 #41
Section: 6.1
Topic: Opportunity costs
42.
Walks Softly sells customized shoes. Currently, it sells 14,800 pairs of shoes annually at an average price
of $59 a pair. It is considering adding a lower-priced line of shoes that will be priced at $39 a pair. Walks
Softly estimates it can sell 6,000 pairs of the lower-priced shoes but will sell 3,500 less pairs of the higherpriced shoes by doing so. What annual sales revenue should be used when evaluating the addition of the
lower-priced shoes?
A. $27,500
B. $24,000
C. $31,300
D. $789,100
E. $900,700
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Ross - Chapter 06 #42
Section: 6.1
Topic: Cash flows
43.
Foamsoft sells customized boat shoes. Currently, it sells 16,850 pairs of shoes annually at an average price
of $79 a pair. It is considering adding a lower-priced line of shoes which sell for $49 a pair. Foamsoft
estimates it can sell 5,000 pairs of the lower-priced shoes but will sell 1,250 less pairs of the higher-priced
shoes by doing so. What is the estimated value of the erosion cost that should be charged to the lowerpriced shoe project?
A. $138,750
B. $146,250
C. $98,750
D. $52,000
E. $123,240
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Ross - Chapter 06 #43
Section: 6.1
Topic: Cash flows
44.
Sue purchased a house for $89,000, spent $56,000 upgrading it, and currently had it appraised at $212,900.
The house is being rented to a family for $1,200 a month, the maintenance expenses average $200 a
month, and the property taxes are $4,800 a year. If she sells the house she will incur $20,000 in expenses.
She is considering converting the house into professional office space. What opportunity cost, if any,
should she assign to this property if she has been renting it for the past two years? A. $178,500
A. $120,000
B. $185,000
C. ANSD. $192,900
D. $232,900
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Ross - Chapter 06 #44
Section: 6.1
45.
Jamie's Motor Home Sales currently sells 1,100 Class A motor homes, 2,200 Class C motor homes, and
2,800 pop-up trailers each year. Jamie is considering adding a mid-range camper and expects that if she
does so she can sell 1,500 of them. However, if the new camper is added, Jamie expects that her Class A
sales will decline to 850 units while the Class C camper sales decline to 2,000. The sales of pop-ups will
not be affected. Class A motor homes sell for an average of $140,000 each. Class C homes are priced at
$59,500 and the pop-ups sell for $5,000 each. The new mid-range camper will sell for $42,900. What is the
erosion cost of adding the mid-range camper?
A. $54,250,000
B. $46,900,000
C. $53,750,000
D. $63,150,000
E. $78,750,000
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Ross - Chapter 06 #45
Section: 6.1
Topic: Cash flows
46.
Ernie's Electrical is evaluating a project which will increase sales by $50,000 and costs by $30,000. The
project will cost $150,000 and will be depreciated straight-line to a zero book value over the 10-year life of
the project. The applicable tax rate is 34 percent. What is the operating cash flow for this project?
A. $19,200
B. $15,000
C. $21,300
D. $17,900
E. $18,300
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Ross - Chapter 06 #46
Section: 6.3
Topic: Operating cash flow
47.
Kurt's Cabinets is looking at a project that will require $80,000 in fixed assets and another $20,000 in net
working capital. The project is expected to produce sales of $110,000 with associated costs of $70,000.
The project has a 4-year life. The company uses straight-line depreciation to a zero book value over the life
of the project. The tax rate is 35 percent. What is the operating cash flow for this project?
A. $7,000
B. $13,000
C. $27,000
D. $33,000
E. $40,000
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Ross - Chapter 06 #47
Section: 6.3
Topic: Operating cash flow
48.
Peter's Boats has sales of $760,000 and a profit margin of 5 percent. The annual depreciation expense is
$80,000. What is the amount of the operating cash flow if the company has no long-term debt?
A. $34,000
B. $86,400
C. $118,000
D. $120,400
E. $123,900
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Ross - Chapter 06 #48
Section: 6.3
Topic: Operating cash flow
49.
Samoa's Tools has sales of $760,000 and a profit margin of 8 percent. The annual depreciation expense is
$50,000. What is the amount of the operating cash flow if the company has no long-term debt?
A. $50,000
B. $60,800
C. $110,800
D. $810,000
E. $930,000
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Ross - Chapter 06 #49
Section: 6.3
Topic: Operating cash flow
50.
Le Place has sales of $439,000, depreciation of $32,000, and net working capital of $56,000. The firm has
a tax rate of 34 percent and a profit margin of 6 percent. The firm has no interest expense. What is the
amount of the operating cash flow?
A. $49,384
B. $52,616
C. $54,980
D. $58,340
E. $114,340
Chapter 15: Long-Term Financing: An Introduction (excluding 15.7)
1. The book capital of a corporation is determined by:
A. the sum of the capital in excess of par and the retained earnings.
B. the par value of preferred stock.
C. the sum of the treasury stock and the preferred stock.
D. the number of shares issued multiplied by the par value of each share.
E. the market price of the company's debt.
Difficulty level: Easy
Topic: BOOK CAPITAL
Type: DEFINITIONS
2. Retained earnings are:
A. the amount of cash that the firm has saved up.
B. the difference between the net income earned and the dividends paid.
C. the difference between the market price of the stock and the book value.
D. the amount of stock repurchased.
E. None of the above.
Difficulty level: Easy
Topic: RETAINED EARNINGS
Type: DEFINITIONS
3. The book value of the shareholders' ownership is represented by:
A. the sum of the par value of common stock, the capital surplus and the accumulated retained earnings.
B. the total assets minus the net worth.
C. the sum of the preferred stock, debt and the capital surplus.
D. the sum of the total assets minus the current liabilities.
E. None of the above.
Difficulty level: Medium
Topic: BOOK VALUE
Type: DEFINITIONS
4. Shares of stock that have been repurchased by the corporation are called:
A. treasury stock.
B. undistributed capital stock.
C. retained equity.
D. capital surplus shares.
E. None of the above.
Difficulty level: Easy
Topic: TREASURY STOCK
Type: DEFINITIONS
5. The market value of the ownership of the firm equals:
A. the market price of the stock times the number of shares outstanding.
B. the sum of the market price of the bonds and the stock.
C. the par value of the stock times the number of shares outstanding.
D. the market price of the stock minus the retained earnings.
E. None of the above.
Difficulty level: Easy
Topic: MARKET VALUE OF EQUITY
Type: DEFINITIONS
6. A grant of authority allowing someone else to vote shares of stock that you own is called:
A. a power-of-share authorization.
B. a proxy.
C. a share authority grant (SAG).
D. a restricted conveyance.
E. None of the above.
Difficulty level: Easy
Topic: PROXY
Type: DEFINITIONS
7. Unsecured corporate debt is called a(n):
A. indenture.
B. debenture.
C. bond.
D. mortgage.
E. None of the above.
Difficulty level: Easy
Topic: DEBENTURE
Type: DEFINITIONS
8. A standard arrangement for the orderly retirement of long-term debt calls for the corporation to make regular
payments into a(n):
A. custodial account.
B. sinking fund.
C. retirement fund.
D. irrevocable trustee fund.
E. None of the above
Difficulty level: Easy
Topic: SINKING FUND
Type: DEFINITIONS
9. Debt that may be extinguished before maturity is referred to as:
A. sinking-fund debt.
B. debentures.
C. callable debt.
D. indenture debt.
E. None of the above.
Difficulty level: Easy
Topic: CALLABLE DEBT
Type: DEFINITIONS
10. If a long-term debt instrument is perpetual, it is called a(n):
A. secured debt issue.
B. subordinated debt issue.
C. consol.
D. capital debt issue.
E. indenture.
Difficulty level: Easy
Topic: CONSOL OR PERPETUAL DEBT
Type: DEFINITIONS
11. The amount of loan a person or firm borrows from a lender is the:
A. creditor.
B. indenture.
C. debenture.
D. principal.
E. amortization.
Difficulty level: Easy
Topic: LOAN PRINCIPAL
Type: DEFINITIONS
12. The written agreement between a corporation and its bondholders is called:
A. the collateral agreement.
B. the deed.
C. the indenture.
D. the deed of conveyance.
E. None of the above.
Difficulty level: Easy
Topic: INDENTURE
Type: DEFINITIONS
13. If cumulative voting is permitted:
A. the total number of votes a shareholder has is equal to the number of shares owned.
B. the total number of votes a shareholder has is equal to the number of shares owned times the average number of
years the shareholder has owned the shares.
C. the total number of votes a shareholder has can be calculated as the number of shares owned times the number
of directors to be elected.
D. the total number of votes a shareholder has is equal to the number of shares times the number of board meetings
the shareholder has attended.
E. None of the above.
Difficulty level: Easy
Topic: CUMULATIVE VOTING
Type: CONCEPTS
14. The market-to-book value ratio is implies growth and success when it is:
A. greater than 0.
B. less than 10.
C. less than 0.
D. less than 1.
E. greater than 1.
Difficulty level: Medium
Topic: MARKET-TO-BOOK RATIO
Type: CONCEPTS
15. There are 3 directors' seats up for election. If you own 1,000 shares of stock and you can cast 3,000 votes for a
particular director, this is illustrative of:
A. cumulative voting.
B. absolute priority voting.
C. sequential voting.
D. straight voting.
E. None of the above.
Difficulty level: Easy
Topic: CUMULATIVE VOTING
Type: CONCEPTS
16. If you own 1,000 shares of stock and you can cast only 1,000 votes for a particular director, then the stock
features:
A. cumulative voting.
B. absolute priority voting.
C. sequential voting.
D. straight voting.
E. None of the above.
Difficulty level: Easy
Topic: STRAIGHT VOTING
Type: CONCEPTS
17. If a group other than management solicits the authority to vote shares to replace management, a _____ is said
to occur.
A. proxy fight
B. stockholder derivative action
C. tender offer
D. vote of confidence
E. None of the above.
Difficulty level: Easy
Topic: PROXY FIGHT
Type: CONCEPTS
18. Shareholders usually have which of the following right(s)?
A. To elect board members, the authorizing of new shares and other matters of great importance to shareholders
such as being acquired.
B. To share proportionally in regular and liquidating dividends.
C. To share proportionally in any new stock sold.
D. All of the above.
E. None of the above.
Difficulty level: Easy
Topic: SHAREHOLDER RIGHTS
Type: CONCEPTS
19. Different classes of stock usually are issued to:
A. maintain ownership control by holding the class of stock with greater voting rights.
B. pay less in dividends between the classes of stock.
C. fool investors into thinking that equity is equity and there is no difference in control or value features.
D. extract perquisites without the other class of stockholders knowing.
E. None of the above.
Difficulty level: Medium
Topic: CLASSES OF STOCK
Type: CONCEPTS
20. Which of the following statements is false?
A. Creditors do not have voting power.
B. Payment on interest on debt in considered an expense, while payment of dividends is a return on capital.
C. Unpaid debt is a liability of the firm, and if not paid, can result in liquidation of the firm. Unpaid common stock
dividends cannot force liquidation.
D. One of the costs of issuing equity is the possibility of financial distress, while no financial distress is associated
with debt.
E. None of the above.
Difficulty level: Medium
Topic: COSTS OF LONG TERM FINANCING
Type: CONCEPTS
21. Corporations try to create hybrid securities that look like equity but are called debt because:
A. debt interest expense is tax deductible.
B. bankruptcy costs are eliminated or reduced.
C. these securities have lower risk than debt.
D. Both A and C.
E. Both A and B.
Difficulty level: Medium
Topic: HYBRID SECURITIES
Type: CONCEPTS
22. Technically speaking, a long-term corporate debt offering that features a specific attachment to corporate
property is generally called:
A. a debenture.
B. a bond.
C. a long-term liability.
D. a preferred liability.
E. None of the above.
Difficulty level: Easy
Topic: BOND
Type: CONCEPTS
23. If a firm retires or extinguishes a debt issue before maturity, the specific amount they pay is:
A. the amortization amount.
B. the call price.
C. the sinking fund amount.
D. the spread premium.
E. None of the above.
Difficulty level: Easy
Topic: CALLABLE DEBT
Type: CONCEPTS
24. If a debenture is subordinated, it:
A. has a higher priority status than specified creditors.
B. is secondary to equity.
C. must give preference to the specified creditor in the event of default.
D. has been issued because the company is in default.
E. None of the above.
Difficulty level: Medium
Topic: SUBORDINATED DEBENTURE
Type: CONCEPTS
25. Not paying the dividends on a cumulative preferred issue may result in:
A. preferred dividend arrears that can be eliminated by the common shareholders only after common dividends are
paid.
B. voting rights are granted to preferred stockholders if preferred dividends are in arrears.
C. no payment of dividends to common shareholders.
D. Both A and B.
E. Both B and C.
Difficulty level: Medium
Topic: PREFERRED STOCK AND DIVIDENDS
Type: CONCEPTS
26. Preferred stock has both a tax advantage and a tax disadvantage. These two are:
A. in default there are no taxes and dividends are taxed in corporate hands at 70%.
B. corporate dividends are taxed on 30% of the dividends received and expenses are deductible.
C. dividends are not a tax-deductible expense but are 70% exempt from corporate taxation.
D. dividends are fully tax deductible but are not equity capital.
E. None of the above.
Difficulty level: Medium
Topic: PREFERRED STOCK
Type: CONCEPTS
27. Preferred stock may be desirable to issue for which of the following reason(s)?
A. If there is no taxable income, preferred stock does not impose a tax penalty.
B. The failure to pay preferred dividends, cumulative or noncumulative, will not cause bankruptcy.
C. Preferred dividends are not tax deductible and therefore will not provide a tax shield but will reduce net income.
D. Both B and C.
E. Both A and B.
Difficulty level: Challenge
Topic: PREFERRED STOCK
Type: CONCEPTS
28. Preferred stock may exist because:
A. losses before income taxes prevent a company from enjoying the tax advantages of debt interest while there is
no tax advantage for preferred dividends.
B. an advantage exists for the firm; preferred shareholders can not force the company into bankruptcy because of
unpaid dividends.
C. corporations get a 70% tax exemption on preferred dividends received.
D. All of the above.
E. None of the above.
Difficulty level: Medium
Topic: PREFERRED STOCK
Type: CONCEPTS
29. The written agreement between a corporation and its bondholders might contain a prohibition against paying
dividends in excess of current earnings. This prohibition is an example of a(n):
A. maintenance of security provision.
B. collateral restriction.
C. affirmative indenture.
D. restrictive covenant.
E. None of the above.
Difficulty level: Easy
Topic: RESTRICTIVE COVENANT
Type: CONCEPTS
30. What percentage of the dividends received by one corporation from another is taxable?
A. 15%
B. 30%
C. 34%
D. 70%
E. 100%
Difficulty level: Easy
Topic: TAXABLE CORPORATE DIVIDENDS
Type: CONCEPTS
31. Which of the following statements about preferred stock is true?
A. Unlike dividends paid on common stock, dividends paid on preferred stock are a tax-deductible expense.
B. Unpaid dividends on preferred stock are a debt of the corporation.
C. If preferred dividends are non-cumulative, then preferred dividends not paid in a particular year will be carried
forward to the next year.
D. There is no difference in the voting rights of preferred and common stockholders.
E. None of the above.
Difficulty level: Medium
Topic: PREFERRED STOCK
Type: CONCEPTS
32. If a debt issue is callable, the call price is generally ____ par.
A. greater than
B. less than
C. equal to
D. unrelated to
E. It varies widely based on the risk of the firm.
Difficulty level: Easy
Topic: CALLABLE DEBT
Type: CONCEPTS
33. There was an upward trend in the ratio of the book value of debt to the book value of debt and equity
throughout the 1990s. Some of this was due to the repurchasing of stock. The market value ratio of debt to debt
and equity exhibited no upward trend. This can be explained by:
A. the change in the accounting rules of the period.
B. the difference between tax accounting and accounting for financial accounting purposes.
C. a large increase in the market value of equity that was greater than the increase in debt.
D. All of the above.
E. None of the above.
Difficulty level: Easy
Topic: DEBT FINANCING TRENDS
Type: CONCEPTS
34. Based on historical experience, which of the following best describes the "pecking order" of long-term
financing strategy in the U.S.?
A. Long-term debt first, new common equity, internal financing last.
B. Long-term debt first, internal financing, new common equity last.
C. Internal financing first, new common equity, long-term borrowing last.
D. Internal financing first, long-term borrowing, new common equity last.
E. None of the above.
Difficulty level: Easy
Topic: PECKING ORDER
Type: CONCEPTS
35. Financial deficits are created when:
A. profits and retained earnings are greater than the capital-spending requirement.
B. profits and retained earnings are less than the capital-spending requirement.
C. profits and retained earnings are equal to the capital-spending requirement.
D. All of the above.
E. None of the above.
Difficulty level: Medium
Topic: FINANCIAL DEFICITS
Type: CONCEPTS
36. Financial economists prefer to use market values when measuring debt ratios because:
A. market values are more stable than book values.
B. market values are a better reflection of current value than historical value.
C. market values are readily available and do not have to be calculated like book values.
D. market values are more difficult to calculate which makes financial economists more valuable.
E. None of the above.
Difficulty level: Medium
Topic: MARKET VALUE OF DEBT
Type: CONCEPTS
37. Corporate financial officers prefer to use book values when measuring debt ratios because:
A. book values are more stable than market values.
B. debt covenant restriction are usually expressed in book value terms.
C. rating agencies measure debt ratios in book values terms.
D. All of the above.
E. None of the above.
Difficulty level: Medium
Topic: BOOK VALUE OF DEBT
Type: CONCEPTS
38. Rockwell Corporation had net income of $150,000 for the year ending 2008. The company decided to payout
40% of earnings per share as a dividend. Rockwell has 120,000 shares issued and outstanding. What are the
retained earnings for 2008?
A. $40,000
B. $60,000
C. $90,000
D. $150,000
E. None of the above
RE = NI (1 - payout ratio) = $150,000 (1 - .4) = $90,000.
Difficulty level: Medium
Topic: RETAINED EARNINGS
Type: PROBLEMS
39. Nelson Company had equity accounts in 2008 as follows:
Projected income is $150,000 and 40% of this amount will be paid out immediately as dividends. What will the
ending retained earnings account be?
A. $90,000
B. $92,000
C. $122,000
D. $210,000
E. $242,000
RE0 = NI (1 - payout ratio) = $150,000 (.6) = $90,000.
RE1 = RE-1 + RE0 = $32,000 + $90,000 = $122,000.
Difficulty level: Medium
Topic: RETAINED EARNINGS
Type: PROBLEMS
40. Holden Bicycles has 1,000 shares outstanding each with a par value of $0.10. If they are sold to shareholders at
$10 each, what would the capital surplus be?
A. $100
B. $900
C. $9,900
D. $10,000
E. $11,000
Capital Surplus: ($10.00 - $0.10) * 1,000 = $9,900.
Difficulty level: Medium
Topic: CAPITAL SURPLUS
Type: PROBLEMS
41. The Lory Bookstore used internal financing as a source of long-term financing for 80% of its total needs in
2008. The company borrowed an additional 27% of its total needs in the long-term debt markets in 2008. What
were Lory's net new stock issues in that year?
A. -20%
B. -7%
C. 7%
D. 20%
E. 27%
Net new issues = - 7%, as more stock was repurchased than issued. (100% - (80 + 27)) = (100 - 107) = -7%.
Difficulty level: Medium
Topic: NET NEW ISSUE
Type: PROBLEMS
42. David's Building Equipment (DBE) had net income of $200,000 for the year ending 2008. The company
decided to payout 30% of earnings per share as a dividend. DBE has 50,000 shares issued and outstanding. What
are the retained earnings for 2008?
A. $60,000
B. $140,000
C. $150,000
D. $200,000
E. None of the above.
RE = NI (1 - payout ratio) = $200,000 (1 - .3) = $140,000.
Difficulty level: Medium
Topic: RETAINED EARNINGS
Type: PROBLEMS
43. Alexandra Investments had equity accounts in 2008 as follows:
Projected income is $200,000 and 20% of this amount will be paid out immediately as dividends. What will the
ending retained earnings account be?
A. $160,000
B. $250,000
C. $270,000
D. $410,000
E. $470,000
RE0 = NI (1 - payout ratio) = $200,000 (.8) = $160,000.
RE1 = RE-1 + RE0 = $250,000 + $160,000 = $410,000.
Difficulty level: Medium
Topic: RETAINED EARNINGS
Type: PROBLEMS
44. Michael's Motor Scooters has 1,000 shares outstanding each with a par value of $0.05. If they are sold to
shareholders at $5 each, what would the capital surplus be?
A. $4,400
B. $4,500
C. $4,750
D. $4,950
E. $5,000
Capital Surplus: ($5.00 - $0.05) * 1,000 = $4,950.
Difficulty level: Medium
Topic: CAPITAL SURPLUS
Type: PROBLEMS
45. Calhoun Computech used internal financing as a source of long-term financing for 80% of its total needs in
2008. The company borrowed an additional 15% of its total needs in the long-term debt markets in 2008. What
were Calhoun's net new stock issues, in percentage terms, for 2008?
A. -10%
B. -5%
C. 5%
D. 10%
E. 15%
Net new issues = 5%, as 100% - (80% + 15%) = 5%.
Difficulty level: Medium
Topic: NET NEW ISSUE
Type: PROBLEMS
Essay Questions
Information on shareholder's equity as currently shown on the books of the Eaton Corporation is given as:
46. From this information, calculate Eaton's book value per share.
Book Value per Share = $8,150,000/175,000 = $46.57
Topic: BOOK VALUE
Type: ESSAYS
47. Rework the shareholder's equity as it appears on the books if the company issues 40,000 new shares of
common at $70 per share.
Topic: BOOK VALUE
Type: ESSAYS
48. Preferred Stock, as a hybrid security, presents somewhat of a puzzle as to why they are issued. What elements
give rise to the puzzle and how is it explained?
There are two offsetting tax effects to consider in evaluating preferred stock. First, dividends are not deducted
from corporate income in computing the tax liability of the issuing corporation. Second, when a corporation
purchases preferred stock, 70% of the dividends received are exempt from corporate taxation.
The three reasons why preferred stock is issued are: regulated public utilities can pass the tax disadvantage of
issuing preferred stock on to their customers, companies reporting losses to the IRS may issue preferred stock, and
firms issuing preferred stock can avoid the threat of bankruptcy that exists with debt financing.
Topic: PREFERRED STOCK
Type: ESSAYS
49. Different countries have different sources of funds. For example, in the United States, internally generated
funds count for over 4/5 of all funds while in Japan, it is about ½ with externally generated funds making up the
remainder. The disparities are less in the United Kingdom and Germany, with about 2/3 of funds coming from
internal sources. Discuss this disparity and why it might exist.
Firms in the United States generate more funding from internally generated cash than firms in other countries.
Firms in Japan, Canada and the United Kingdom rely more on externally generated equity than American firms.
This provides support for the pecking order theory in which firms will first make use of internally generated funds
before moving to the more expensive external equity markets. It is possible that American firms have more
internally generated funds available, thereby making them more able to use less expensive funds for capital
investment.
Topic: INTERNATION AND DOMESTIC CASH FLOWS
Type: ESSAYS
Chapter 16: Capital Structure: Basic Concepts
1.
The use of personal borrowing to change the overall amount of financial leverage to which an individual is
exposed is called:
A. homemade leverage.
B. dividend recapture.
C. the weighted average cost of capital.
D. private debt placement.
E. personal offset.
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Ross - Chapter 16 #1
Section: 16.3
Topic: Homemade leverage
2.
The proposition that the value of the firm is independent of its capital structure is called:
A. the capital asset pricing model.
B. MM Proposition I (no taxes).
C. MM Proposition II (no taxes).
D. the law of one price.
E. the efficient markets hypothesis.
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Ross - Chapter 16 #2
Section: 16.3
Topic: M and M Proposition I without taxes
3.
The proposition that the cost of equity is a positive linear function of capital structure is called:
A. the capital asset pricing model.
B. MM Proposition I (no taxes).
C. MM Proposition II (no taxes).
D. the law of one price.
E. the efficient markets hypothesis.
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Ross - Chapter 16 #3
Section: 16.4
Topic: M and M Proposition II without taxes
4.
The tax savings of the firm derived from the deductibility of interest expense is called the:
A. interest tax shield.
B. depreciable basis.
C. financing umbrella.
D. current yield.
E. tax-loss carry forward savings.
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Ross - Chapter 16 #4
Section: 16.5
Topic: M and M Proposition I with taxes
5.
The unlevered cost of capital is:
A. the cost of capital for a firm with no equity in its capital structure.
B. the cost of capital for a firm with no debt in its capital structure.
C. the interest tax shield times pretax net income.
D. the cost of preferred stock for an all-equity firm.
E. equal to the profit margin for a firm with some debt in its capital structure.
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Ross - Chapter 16 #5
Section: 16.4
Topic: M and M Proposition II without taxes
6.
The firm's capital structure refers to the:
A. mix of current and fixed assets a firm holds.
B. amount of capital invested in the firm.
C. amount of dividends a firm pays.
D. mix of debt and equity used to finance the firm's assets.
E. amount of cash versus receivables the firm holds.
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Ross - Chapter 16 #6
Section: 16.1
Topic: Capital structure
7.
A general rule for managers to follow is to set the firm's capital structure such that the firm’s:
A. size is maximized.
B. value is maximized.
C. bondholders are secured.
D. suppliers of raw materials are satisfied.
E. dividend payout is maximized.
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Ross - Chapter 16 #7
Section: 16.2
Topic: Capital structure and firm valuation
8.
A levered firm is a company that has:
A. accounts payable as its only liability.
B. some debt in its capital structure.
C. an all-equity capital structure.
D. a tax loss carry forward.
E. taxable income.
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Ross - Chapter 16 #8
Section: 16.3
Topic: M and M Proposition I without taxes
9.
A manager should attempt to maximize the value of the firm by changing the capital structure if and only if
the value of the firm increases:
A. as a result of the change.
B. to the sole benefit of the managers.
C. to the sole benefit of the debtholders.
D. while also decreasing shareholder value.
E. while holding stockholder value constant.
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Ross - Chapter 16 #9
Section: 16.2
Topic: Capital structure and firm valuation
10.
The effects of financial leverage depend on the operating earnings of the company. Based on this
relationship, assume you graph the EPS and EBI for a firm, while ignoring taxes. Which one of these
statements correctly states a relationship illustrated by the graph?
A. Financial leverage decreases the slope of the EPS line.
B. Below the break-even point unlevered structures have a lower EPS for every dollar of EBI than levered
structures do.
C. Above the break-even point the increase in EPS for unlevered structures is greater than that of levered
structures for every dollar increase in EBI.
D. Leverage only provides value above the break-even point.
E. Above the break-even point, the unlevered structure is preferred.
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Ross - Chapter 16 #10
Section: 16.3
Topic: Financial and operating leverage
11.
MM Proposition I without taxes proposes that:
A. the value of an unlevered firm exceeds that of a levered firm.
B. there is one ideal capital structure for each firm.
C. leverage does not affect the value of the firm.
D. shareholder wealth is directly affected by the capital structure selected.
E. the value of a levered firm exceeds that of an unlevered firm.
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Ross - Chapter 16 #11
Section: 16.3
Topic: M and M Proposition I without taxes
12.
A key underlying assumption of MM Proposition I without taxes is that:
A. financial leverage increases risk.
B. individuals can borrow at lower rates than corporations.
C. individuals and corporations borrow at the same rate.
D. managers always act to maximize the value of the firm.
E. corporations are all-equity financed.
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Ross - Chapter 16 #12
Section: 16.3
Topic: M and M Proposition I without taxes
13.
In an EPS-EBI graphical relationship, the slope of the debt ray is steeper than the equity ray. The debt ray
has a lower intercept because:
A. more shares are outstanding for the same level of EBI.
B. the break-even point is higher with debt.
C. a fixed interest charge must be paid even at low earnings.
D. the amount of interest per share has only a positive effect on the intercept.
E. the break-even point is lower with debt.
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Ross - Chapter 16 #13
Section: 16.3
Topic: Financial and operating leverage
14.
When comparing levered versus unlevered capital structures, leverage works to increase EPS for high
levels of EBIT because interest payments on the debt:
A. vary with EBIT levels.
B. stay fixed, leaving less income to be distributed over fewer shares.
C. stay fixed, leaving more income to be distributed over fewer shares.
D. stay fixed, leaving less income to be distributed over more shares.
E. stay fixed, leaving more income to be distributed over more shares.
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Ross - Chapter 16 #14
Section: 16.3
Topic: Financial and operating leverage
15.
The increase in risk to shareholders when financial leverage is introduced is best evidenced by:
A. higher EPS as EBIT increases.
B. a higher variability of EPS with debt than with all-equity financing.
C. increased use of homemade leverage.
D. the increase in taxes.
E. decreasing earnings as EBIT increases.
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Ross - Chapter 16 #15
Section: 16.3
Topic: Financial and operating leverage
16.
The reason that MM Proposition I does not hold in the presence of corporate taxation is because:
A. levered firms pay less taxes compared with identical unlevered firms.
B. bondholders require higher rates of return than stockholders do.
C. earnings per share are no longer relevant with taxes.
D. dividends become a tax shield.
E. debt is more expensive than equity.
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Ross - Chapter 16 #16
Section: 16.5
Topic: M and M Proposition I with taxes
17.
MM Proposition I with taxes states that:
A. capital structure does not affect firm value.
B. increasing the debt-equity ratio increases firm value.
C. firm value is maximized when the firm is all-equity financed.
D. the cost of equity rises as the debt-equity ratio increases.
E. the unlevered cost of equity is equal to RWacc.
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Ross - Chapter 16 #17
Section: 16.5
Topic: M and M Proposition I with taxes
18.
A firm should select the capital structure which:
A. produces the highest cost of capital.
B. maximizes the value of the firm.
C. minimizes taxes.
D. is fully unlevered.
E. has no debt.
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Ross - Chapter 16 #18
Section: 16.2
Topic: Capital structure and firm valuation
19.
Bryan invested in Bryco stock when the firm was financed solely with equity. The firm now has a debtequity ratio of .3. To maintain the same level of leverage he originally had, Bryan needs to:
A. borrow some money and purchase additional shares of Bryco stock.
B. maintain his current position in Bryco stock.
C. sell some shares of Bryco stock and hold the proceeds in cash.
D. sell some shares of Bryco stock and loan out the proceeds.
E. sell half of his Bryco stock and invest the proceeds in risk-free securities.
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Ross - Chapter 16 #19
Section: 16.3
Topic: Homemade leverage
20.
In the absence of taxes, the capital structure chosen by a firm doesn't really matter because of:
A. taxes.
B. the interest tax shield.
C. the relationship between dividends and earnings per share.
D. the effects of leverage on the cost of equity.
E. homemade leverage.
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Ross - Chapter 16 #20
Section: 16.3
Topic: M and M Proposition I without taxes
21.
MM Proposition I with no tax supports the argument that:
A. business risk determines the return on assets.
B. the cost of equity rises as leverage rises.
C. it is completely irrelevant how a firm arranges its finances.
D. a firm should borrow money to the point where the tax benefit from debt is equal to the cost of the
increased probability of financial distress.
E. financial risk is determined by the debt-equity ratio.
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Ross - Chapter 16 #21
Section: 16.3
Topic: M and M Proposition I without taxes
22.
The proposition that the value of a levered firm is equal to the value of an unlevered firm is known as:
A. MM Proposition I with no tax.
B. MM Proposition II with no tax.
C. MM Proposition I with tax.
D. MM Proposition II with tax.
E. both MM I with and without tax..
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Ross - Chapter 16 #22
Section: 16.3
Topic: M and M Proposition I without taxes
23.
The concept of homemade leverage is most associated with:
A. MM Proposition I with no tax.
B. MM Proposition II with no tax.
C. MM Proposition I with tax.
D. MM Proposition II with tax.
E. no MM Proposition.
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Ross - Chapter 16 #23
Section: 16.3
Topic: M and M Proposition I without taxes
24.
According to MM Proposition II with no taxes, the:
A. return on assets is determined by financial risk.
B. required return on equity is a linear function of the firm’s debt-equity ratio.
C. cost of equity in inversely related to the firm’s debt-equity ratio.
D. cost of debt must equal the cost of equity.
E. required return on assets exceeds the weighted average cost of capital.
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Ross - Chapter 16 #24
Section: 16.4
Topic: M and M Proposition II without taxes
25.
MM Proposition I with taxes supports the theory that:
A. there is a positive linear relationship between the amount of debt in a levered firm and its value.
B. the value of a firm is inversely related to the amount of leverage used by the firm.
C. the value of an unlevered firm is equal to the value of a levered firm plus the value of the interest tax
shield.
D. a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm.
E. a firm's weighted average cost of capital increases as the debt-equity ratio of the firm rises.
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Ross - Chapter 16 #25
Section: 16.5
Topic: M and M Proposition I with taxes
26.
MM Proposition I with taxes is based on the concept that:
A. the optimal capital structure is the one that is totally financed with equity.
B. the capital structure of the firm does not matter because investors can use homemade leverage.
C. the firm is better off with debt based on the weighted average cost of capital.
D. the value of the firm increases as total debt increases because of the interest tax shield.
E. the cost of equity increases as the debt-equity ratio of a firm increases.
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Ross - Chapter 16 #26
Section: 16.5
Topic: M and M Proposition I with taxes
27.
MM Proposition II with taxes:
A. has the same general implications as MM Proposition II without taxes.
B. reveals how the interest tax shield relates to the value of a firm.
C. supports the argument that business risk is determined by the capital structure employed by a firm.
D. supports the argument that the cost of equity decreases as the debt-equity ratio increases.
E. reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm.
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Ross - Chapter 16 #27
Section: 16.5
Topic: M and M Proposition II with taxes
28.
MM Proposition II is the proposition that:
A. supports the argument that the capital structure of a firm is irrelevant to the value of the firm.
B. the cost of levered equity depends solely on the return on debt, the debt-equity ratio, and the tax rate.
C. a firm's cost of equity capital is a positive linear function of the firm's capital structure.
D. the cost of equity is equivalent to the required return on the total assets of a levered firm.
E. supports the argument that the size of the pie does not depend on how the pie is sliced.
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Ross - Chapter 16 #28
Section: 16.5
Topic: M and M Proposition II with taxes
29.
The interest tax shield has no value for a firm when:
A. the firm’s debt-equity ratio is exactly equal to 1.
B. the firm’s debt-equity ratio is exactly .5.
C. the firm is unlevered.
D. shareholders fully utilize homemade leverage.
E. RWACC equals R0.
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Ross - Chapter 16 #29
Section: 16.5
Topic: M and M Proposition I with taxes
30.
The interest tax shield is a key reason why:
A. the required rate of return on assets rises when debt is added to the capital structure.
B. the value of an unlevered firm is equal to the value of a levered firm.
C. the net cost of debt to a firm is generally less than the cost of equity.
D. the cost of debt is equal to the cost of equity for a levered firm.
E. firms prefer equity financing over debt financing.
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Ross - Chapter 16 #30
Section: 16.5
Topic: M and M Proposition I with taxes
31.
Which one of the following will tend to increase the benefit of the interest tax shield given a progressive
tax rate structure?
A. a reduction in tax rates
B. a large tax loss carryforward
C. a large depreciation tax deduction
D. a sizeable increase in taxable income
E. a catastrophic loss
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Ross - Chapter 16 #31
Section: 16.5
Topic: M and M Proposition I with taxes
32.
Thompson amp; Thomson is an all-equity firm that has 280,000 shares of stock outstanding. The company
is in the process of borrowing $2.4 million at 5.5 percent interest to repurchase 75,000 shares of the
outstanding stock. What is the value of this firm if you ignore taxes?
A. $8,960,000
B. $9,240,000
C. $10,710,000
D. $12,500,000
E. $11,360,000
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Ross - Chapter 16 #32
Section: 16.3
Topic: M and M Proposition I without taxes
33.
Uptown Interior Designs is an all-equity firm that has 40,000 shares of stock outstanding. The company
has decided to borrow $74,000 to buy out the 2,100 shares of a deceased stockholder. What is the total
value of this firm if you ignore taxes?
A. $2,008,157
B. $1,388,056
C. $1,409,524
D. $3,885,000
E. $2,630,620
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Ross - Chapter 16 #33
Section: 16.3
Topic: M and M Proposition I without taxes
34.
You own 25 percent of Unique Vacations, Inc. You have decided to retire and want to sell your shares in
this closely held, all-equity firm. The other shareholders have agreed to have the firm borrow $1.5 million
to purchase your 1,000 shares of stock. What is the total value of this firm today if you ignore taxes?
A. $4.8 million
B. $5.1 million
C. $5.4 million
D. $5.7 million
E. $6.0 million
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Ross - Chapter 16 #34
Section: 16.3
Topic: M and M Proposition I without taxes
35.
A firm has a debt-equity ratio of .64, a pretax cost of debt of 8.5 percent, and a required return on assets of
12.6 percent. What is the cost of equity if you ignore taxes?
A. 8.06%
B. 8.55%
C. 11.12%
D. 15.22%
E. 16.38%
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Ross - Chapter 16 #35
Section: 16.4
Topic: M and M Proposition II without taxes
36.
Bigelow has a levered cost of equity of 14.29 percent and a pretax cost of debt of 7.23 percent. The
required return on the assets is 11 percent. What is the firm's debt-equity ratio based on MM Proposition II
with no taxes?
A. .67
B. .87
C. .72
D. .75
E. .81
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Ross - Chapter 16 #36
Section: 16.4
Topic: M and M Proposition II without taxes
37.
The Backwoods Lumber Co. has a debt-equity ratio of .68. The firm's required return on assets is 11.7
percent and its levered cost of equity is 15.54 percent. What is the pretax cost of debt based on MM
Proposition II with no taxes?
A. 6.76%
B. 6.39%
C. 7.25%
D. 6.05%
E. 7.50%
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Ross - Chapter 16 #37
Section: 16.4
Topic: M and M Proposition II without taxes
38.
The Winter Wear Company has expected earnings before interest and taxes of $3,800, an unlevered cost of
capital of 15.4 percent and a tax rate of 35 percent. The company also has $2,600 of debt with a coupon
rate of 5.7 percent. The debt is selling at par value. What is the value of this firm?
A. $15,585.32
B. $16,948.96
C. $12,115.32
D. $12,055.04
E. $17,700.08
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Ross - Chapter 16 #38
Section: 16.5
Topic: M and M Proposition I with taxes
39.
The Dance Studio is currently an all-equity firm that has 22,000 shares of stock outstanding with a market
price of $27 a share. The current cost of equity is 12 percent and the tax rate is 35 percent. The firm is
considering adding $225,000 of debt with a coupon rate of 6.25 percent to its capital structure. The debt
will sell at par. What will be the levered value of the equity?
A. $325,500
B. $447,750
C. $721,250
D. $672,750
E. $594,000
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Ross - Chapter 16 #39
Section: 16.5
Topic: M and M Proposition I with taxes
40.
The Montana Hills Co. has expected earnings before interest and taxes of $17,100, an unlevered cost of
capital of 12.4 percent, and debt with both a book and face value of $25,000. The debt has an annual 6.2
percent coupon. If the tax rate is 34 percent, what is the value of the firm?
A. $91,016.13
B. $137,903.23
C. $99,516.13
D. $106,666.67
E. $146,403.23
1.
Chapter 26: Short-Term Finance and Planning
The length of time between the acquisition of inventory and the collection of cash from receivables is
called the:
A. operating cycle.
B. inventory period.
C. accounts receivable period.
D. accounts payable period.
E. cash cycle.
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Ross - Chapter 26 #1
Section: 26.2
Topic: Operating and cash cycles
2.
The length of time between the acquisition of inventory and its sale is called the:
A. operating cycle.
B. inventory period.
C. accounts receivable period.
D. accounts payable period.
E. cash cycle.
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Ross - Chapter 26 #2
Section: 26.2
Topic: Operating and cash cycles
3.
The length of time between the sale of inventory and the collection of cash from receivables is called the:
A. operating cycle.
B. inventory period.
C. accounts receivable period.
D. accounts payable period.
E. cash cycle.
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Ross - Chapter 26 #3
Section: 26.2
Topic: Operating and cash cycles
4.
The length of time between the acquisition of inventory by a firm and the payment by the firm for that
inventory is called the:
A. operating cycle.
B. inventory period.
C. accounts receivable period.
D. accounts payable period.
E. cash cycle.
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Ross - Chapter 26 #4
Section: 26.2
Topic: Operating and cash cycles
5.
The length of time between the payment for inventory and the collection of cash from receivables is called
the:
A. operating cycle.
B. inventory period.
C. accounts receivable period.
D. accounts payable period.
E. cash cycle.
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Ross - Chapter 26 #5
Section: 26.2
Topic: Operating and cash cycles
6.
Costs of the firm that rise with increased levels of investment in its current assets are called _____ costs.
A. carrying
B. shortage
C. order
D. safety
E. trading
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Ross - Chapter 26 #6
Section: 26.3
Topic: Carrying and shortage costs
7.
Costs of the firm that fall with increased levels of investment in its current assets are called _____ costs.
A. carrying
B. shortage
C. debt
D. equity
E. payables
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Ross - Chapter 26 #7
Section: 26.3
Topic: Carrying and shortage costs
8.
The forecast of cash receipts and disbursements for the next planning period is called a:
A. pro forma income statement.
B. statement of cash flows.
C. cash budget.
D. receivables analysis.
E. credit analysis.
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Ross - Chapter 26 #8
Section: 26.4
Topic: Cash budget
9.
A prearranged, short-term bank loan made on a formal or informal basis, and typically reviewed for
renewal annually, is called a:
A. letter of credit.
B. cleanup loan.
C. compensating balance.
D. line of credit.
E. roll-over.
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Ross - Chapter 26 #9
Section: 26.5
Topic: Short-term financial policy
10.
A fraction of the available credit on a loan agreement deposited by the borrower with the bank in a low or
non-interest-bearing account is called a:
A. compensating balance.
B. cleanup loan.
C. letter of credit.
D. line of credit.
E. roll-over.
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Ross - Chapter 26 #10
Section: 26.5
Topic: Compensating balances
11.
A short-term loan where the lender holds the borrower's receivables as security is called:
A. a compensating balance.
B. assigned receivables financing.
C. a letter of credit.
D. factored receivables financing.
E. a bond.
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Ross - Chapter 26 #11
Section: 26.5
Topic: Current asset financing
12.
A type of short-term loan where the borrower sells its receivables to the lender up-front, but at a discount
to face value, is called:
A. a compensating balance.
B. assigned receivables financing.
C. a letter of credit.
D. factored receivables financing.
E. a bond.
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Ross - Chapter 26 #12
Section: 26.5
Topic: Current asset financing
13.
A short-term loan which is secured by inventory that is housed and supervised by a third party is referred
to as:
A. a blanket inventory lien.
B. a secured line of credit.
C. banker's acceptance.
D. a trust receipt financing arrangement.
E. field warehousing financing.
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Ross - Chapter 26 #13
Section: 26.5
Topic: Current asset financing
14.
Net working capital is defined as the:
A. current assets of a business.
B. difference between current assets and current liabilities.
C. present value of short-term cash flows.
D. difference between all assets and liabilities.
E. difference between total current assets and cash.
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Ross - Chapter 26 #14
Section: 26.1
Topic: Net working capital
15.
Which one of the following is a source of cash?
A. an increase in accounts receivable
B. an increase in fixed assets
C. a decrease in long-term debt
D. the payment of a cash dividend
E. an increase in accounts payable
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Ross - Chapter 26 #15
Section: 26.1
Topic: Sources and uses of cash
16.
Which one of the following is a use of cash?
A. selling goods from inventory
B. sale of a marketable security held by the firm
C. submitting taxes to the government
D. obtainment of a long-term loan
E. collection of a past-due accounts receivable
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Ross - Chapter 26 #16
Section: 26.1
Topic: Sources and uses of cash
17.
Which one of the following will increase net working capital? Assume the current ratio is greater than 1.0.
A. using cash to pay an accounts payable
B. using cash to pay a long-term debt
C. selling inventory at cost
D. collecting an accounts receivable
E. using a long-term loan to buy inventory
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Ross - Chapter 26 #17
Section: 26.1
Topic: Net working capital
18.
Which one of the following will decrease the net working capital of a firm? Assume the current ratio is
greater than 1.0.
A. selling inventory at a profit
B. collecting an accounts receivable
C. paying a payment on a long-term debt
D. selling a fixed asset for book value
E. paying an accounts payable
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Ross - Chapter 26 #18
Section: 26.1
Topic: Net working capital
19.
The operating cycle can be decreased by:
A. paying accounts payable faster.
B. discontinuing the discount given for early payment of an accounts receivable.
C. decreasing the inventory turnover rate.
D. collecting accounts receivable faster.
E. increasing the accounts payable turnover rate.
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Ross - Chapter 26 #19
Section: 26.2
Topic: Operating and cash cycles
20.
The operating cycle will decrease if you decrease the:
A. days sales in inventory.
B. days in accounts payable.
C. cash cycle by increasing the accounts payable period.
D. accounts receivable turnover rate.
E. speed at which inventory is sold.
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Ross - Chapter 26 #20
Section: 26.2
Topic: Operating and cash cycles
21.
The short-term financial policy a firm adopts will be reflected in:
A. the size of the firm's investment in current assets.
B. the financing of current assets.
C. the financing of fixed assets.
D. both the size and the financing of current assets.
E. both the size and the financing of fixed assets.
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Ross - Chapter 26 #21
Section: 26.3
Topic: Determining short-term financial policy
22.
Which one of the following will not affect the operating cycle?
A. decreasing the payables turnover from 7 times to 6 times
B. increasing the days sales in receivables
C. decreasing the inventory turnover rate
D. increasing the average receivables balance
E. decreasing the credit repayment times for the firm's customers
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Ross - Chapter 26 #22
Section: 26.2
Topic: Operating and cash cycles
23.
You can decrease the cash cycle by:
A. improving the cash discount offered to customers who pay their accounts early.
B. increasing the percentage of customers paying with credit rather than cash.
C. increasing the amount of raw materials kept in inventory.
D. paying your suppliers earlier to receive a discount on your purchases.
E. increasing your inventory to prevent stock-outs.
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Ross - Chapter 26 #23
Section: 26.2
Topic: Operating and cash cycles
24.
The cash cycle will decrease as a result of increasing the:
A. payables turnover.
B. days sales in inventory.
C. operating cycle.
D. inventory turnover rate.
E. accounts receivable period.
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Ross - Chapter 26 #24
Section: 26.2
Topic: Operating and cash cycles
25.
ABC Manufacturing historically produced products that were held in inventory until they could be sold to
a customer. The firm is now changing its policy and only producing a product when it receives an actual
order from a customer. All else equal, this change will:
A. increase the operating cycle.
B. lengthen the accounts receivable period.
C. shorten the accounts payable period.
D. decrease the cash cycle.
E. decrease the inventory turnover rate.
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Ross - Chapter 26 #25
Section: 26.2
Topic: Operating and cash cycles
26.
Which one of these statements concerning the cash cycle is correct?
A. The cash cycle is equal to the operating cycle minus the inventory period.
B. A negative cash cycle is actually preferable to a positive cash cycle.
C. Granting credit to slower paying customers tends to decrease the cash cycle.
D. The cash cycle plus the accounts receivable period is equal to the operating cycle.
E. The most desirable cash cycle is the one that equals zero days.
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Ross - Chapter 26 #26
Section: 26.2
Topic: Operating and cash cycles
27.
Which one of these statements is correct concerning the cash cycle?
A. The longer the cash cycle, the more likely a firm will need external financing.
B. Increasing the accounts payable period increases the cash cycle.
C. A positive cash cycle is preferable to a negative cash cycle.
D. The cash cycle can exceed the operating cycle if the payables period is equal to zero.
E. Adopting a more liberal accounts receivable policy will tend to decrease the cash cycle.
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Ross - Chapter 26 #27
Section: 26.2
Topic: Operating and cash cycles
28.
If The Deli delays paying its suppliers by an additional ten days, then:
A. its payables turnover rate will increase.
B. it should require less bank financing of its daily operations.
C. its cash cycle will increase by ten days.
D. its operating cycle will increase by ten days.
E. its stock-out costs will rise.
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Ross - Chapter 26 #28
Section: 26.2
Topic: Operating and cash cycles
29.
Given a fixed level of sales and a constant profit margin, an increase in the accounts payable period can
result from:
A. an increase in the cost of goods sold account value.
B. an increase in the ending accounts payable balance.
C. an increase in the cash cycle.
D. a decrease in the operating cycle.
E. a decrease in the average accounts payable balance.
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Ross - Chapter 26 #29
Section: 26.2
Topic: Operating and cash cycles
30.
The accounts receivable policy is generally set by the:
A. purchasing manager.
B. credit manager.
C. controller.
D. production manager.
E. payables manager.
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Ross - Chapter 26 #30
Section: 26.2
Topic: Management organization and roles
31.
The manager responsible for applying payments to customer’s accounts is the:
A. controller.
B. payables manager.
C. credit manager.
D. purchasing manager.
E. production manager.
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Ross - Chapter 26 #31
Section: 26.2
Topic: Management organization and roles
32.
Flexible short-term financial policies tend to:
A. maintain low accounts receivable balances.
B. support few investments in marketable securities.
C. minimize the investment in inventory.
D. maintain large cash balances.
E. tightly restrict credit sales.
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Ross - Chapter 26 #32
Section: 26.2
Topic: Determining short-term financial policy
33.
A restrictive short-term financial policy tends to:
A. reduce future sales more so than a flexible policy.
B. grant credit to more customers.
C. incur more carrying costs than a flexible policy does.
D. encourage credit sales over cash sales.
E. reduce order costs as compared to a more flexible policy.
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Ross - Chapter 26 #33
Section: 26.3
Topic: Determining short-term financial policy
34.
A firm that adopts a flexible short-term financial policy is more apt to have:
A. lower carrying costs than shortage costs.
B. lower shortage costs than carrying costs.
C. stricter limits on credit sales than the average firm.
D. a relatively low level of current assets.
E. greater short-term financing needs than if the firm adopted a restrictive policy.
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Ross - Chapter 26 #34
Section: 26.3
Topic: Determining short-term financial policy
35.
A flexible short-term financial policy:
A. increases the likelihood that a firm will face financial distress.
B. incurs an opportunity cost due to the rate of return that applies to short-term assets.
C. advocates a smaller investment in net working capital than a restrictive policy does.
D. increases the probability that a firm will earn high returns on all of its assets.
E. utilizes short-term financing to fund all of the firm's assets.
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Ross - Chapter 26 #35
Section: 26.3
Topic: Determining short-term financial policy
36.
If your accounts receivable period is 30 days, you will collect payment for your _____ sales during the
second quarter of a calendar year.
A. December, January, and February
B. January, February, and March
C. February and March
D. February, March, and April
E. March, April and May
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Ross - Chapter 26 #36
Section: 26.4
Topic: Cash collections
37.
Baxter’s collects 30 percent of its sales in the month of sale, 55 percent in the month following the month
of sale, and 13 percent in the second month following the month of sale. Given this, the company will
collect _____ sales during the month of May.
A. 30 percent of May
B. 55 percent of March
C. 13 percent of April
D. 55 percent of May
E. 13 percent of February
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Ross - Chapter 26 #37
Section: 26.4
Topic: Cash collections
38.
A manufacturing firm has a 90-day collection period. The firm produces seasonal merchandise and thus
has the least sales during the first quarter of a year and the highest level of sales during the third quarter of
a year. The firm maintains a relatively steady level of production which means that its cash disbursements
are fairly equal in all quarters. The firm is most apt to face a cash-out situation in:
A. the first quarter.
B. the second quarter.
C. the third quarter.
D. the fourth quarter.
E. any quarter, equally.
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Ross - Chapter 26 #38
Section: 26.4
Topic: Cash collections
39.
The term maturity hedging refers to:
A. staggering debt so the total amount due remains relatively constant.
B. adjusting all financing to match the lowest available interest rates.
C. increasing financing when interest rates decline and lowering financing when rates increase.
D. matching the life of an asset with the life of the asset’s financing.
E. creating a financial package that has one loan maturing each year over a stated number of years.
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Ross - Chapter 26 #39
Section: 26.4
Topic: Cash collections
40.
A financially solid firm is most apt to have a quarterly cash shortfall when it encounters a:
A. period of relatively constant sales.
B. major fixed asset expenditure.
C. period of rising interest rates.
D. period of declining interest rates.
E. period of increased cash collections.
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Difficulty: 2 Intermediate
Ross - Chapter 26 #40
Section: 26.4
Topic: Cash budget
41.
Which one of these statements is true?
A. The cumulative finance surplus requirement is computed prior to adjusting for the minimum cash
balance.
B. A financially sound firm will always have a positive quarterly net cash flow.
C. A negative cumulative cash surplus indicates a borrowing need.
D. Most firms plan on maintaining a zero cash balance.
E. The minimum cash balance generally increases on a quarterly basis.
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Ross - Chapter 26 #41
Section: 26.4
Topic: Cash budget
42.
A cumulative cash deficit indicates a firm:
A. has at least a short-term need for external funding.
B. is facing long-term financial distress.
C. will go out of business within the year.
D. is capable of funding all of its needs internally.
E. is using its cash wisely.
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Ross - Chapter 26 #42
Section: 26.4
Topic: Cash budget
43.
The most common means of financing a temporary cash deficit is a:
A. long-term secured bank loan.
B. short-term secured bank loan.
C. short-term issue of corporate bonds.
D. long-term unsecured bank loan.
E. short-term unsecured bank loan.
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Ross - Chapter 26 #43
Section: 26.5
Topic: Short-term financial policy
44.
A compensating balance:
A. requirement generally applies to inventory-type loans.
B. is a means of paying for banking services received.
C. requirement is generally set equal to one percent of the amount borrowed.
D. decreases the cost of short-term bank financing.
E. refunds a portion of the borrower’s interest if a loan is repaid early.
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Ross - Chapter 26 #44
Section: 26.5
Topic: Compensating balances
45.
Miller’s Hardware has a flexible short-term financing policy. Over the course of one year, the firm should
expect to have some months that allow it to:
A. repay all of its debts.
B. invest in marketable securities.
C. reduce its total costs below the firm’s normal minimum total cost point.
D. finance all of its assets with short-term loans.
E. earn high returns on all its current assets.
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Ross - Chapter 26 #45
Section: 26.3
Topic: Flexible short-term financial policy
46.
Which one of these statements is correct?
A. A farmer generally uses trust receipt financing to finance operations during the growing season.
B. An auto dealer is most apt to use purchase order financing.
C. A drug store is most apt to use trust receipt financing.
D. Trust receipt financing is most applicable to large, easily identifiable types of inventory.
E. Blanket inventory lien financing is another term for purchase order financing.
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Ross - Chapter 26 #46
Section: 26.5
Topic: Current asset financing
47.
If the average accounts receivable that a firm holds decreases without any decrease in credit sales, the
operating cycle will:
A. remain constant because sales remained constant.
B. remain constant because the change will only affect the cash cycle.
C. decrease because days' sales outstanding will decrease.
D. increase because the accounts receivable turnover will decrease.
E. decrease because the accounts receivable turnover will decrease.
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Ross - Chapter 26 #47
Section: 26.2
Topic: Operating and cash cycles
48.
One use of cash is represented by:
A. an increase in borrowing.
B. an increase in operating cash flow.
C. a decrease in accounts payable.
D. an increase in notes payable.
E. a decrease in inventory.
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Ross - Chapter 26 #48
Section: 26.1
Topic: Sources and uses of cash
49.A use of cash is associated with:
A. a decrease in a liability.
B. an increase in an asset.
C. an increase in retained earnings.
D. both an increase in an asset and an increase in retained earnings.
E. both a decrease in a liability and an increase in an asset.
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Ross - Chapter 26 #49
Section: 26.1
Topic: Sources and uses of cash
50.
The cash cycle is defined as the time between:
A. the arrival of inventory and cash collected from receivables.
B. selling a product and paying the supplier of that product.
C. selling a product and collecting the accounts receivable.
D. cash disbursements and cash collection for an item.
E. the sale of inventory and cash collection.
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Ross - Chapter 26 #50
Section: 26.2
Topic: Operating and cash cycles
Chapter 28: Credit and Inventory Management
Multiple Choice Questions
1. Selling goods and services on credit is:
A. an investment in a customer.
B. never necessary unless customers cannot pay for the goods.
C. a decision independent of customers.
D. permissible if your bank lends the money.
E. None of the above.
Difficulty level: Easy
Topic: CREDIT SALES
Type: DEFINITIONS
2. When credit is granted to another firm this gives rise to a(n):
A. accounts receivable and is called a consumer credit.
B. credit due and is called an installment note.
C. accounts receivable and is called trade credit.
D. trade receivable and is called an installment note.
E. None of the above.
Difficulty level: Easy
Topic: TRADE CREDIT
Type: DEFINITIONS
3. Cash discounts:
A. conveniently separate the pricing of credit and cash customers.
B. lower profit margins on sales.
C. speed the collection of receivables.
D. All of the above.
E. Both A and B.
Difficulty level: Medium
Topic: CASH DISCOUNTS
Type: DEFINITIONS
4. Which of the following is not one of the "five C's of Credit" for credit scoring?
A. Capability
B. Capacity
C. Capital
D. Character
E. Conditions
Difficulty level: Medium
Topic: CREDIT SCORING
Type: DEFINITIONS
5. The average collection period measures:
A. the average time necessary to collect a credit sale.
B. how long the companies money is invested in their customers.
C. the days sales outstanding.
D. All of the above.
E. None of the above.
Difficulty level: Medium
Topic: AVERAGE COLLECTION PERIOD
Type: DEFINITIONS
6. Factoring refers to:
A. determining the aging schedule of the firm's accounts receivable.
B. the sale of a firm's accounts receivable to a financial institution.
C. the determination of the average collection period.
D. scoring a customer based on the 5 C's of credit.
E. All of the above.
Difficulty level: Easy
Topic: FACTORING
Type: DEFINITIONS
7. Captive finance companies are:
A. parent companies to the subsidiary.
B. subsidiaries to the parent company.
C. used by firms with good credit ratings.
D. Both A and B.
E. Both B and C.
Difficulty level: Medium
Topic: CAPTIVE FINANCE COMPANIES
Type: DEFINITIONS
8. When a firm sells its accounts receivables to a financial institution, it is called:
A. captive financing.
B. collateralization.
C. securitization.
D. legalization.
E. None of the above.
Difficulty level: Easy
Topic: SECURITIZATION
Type: DEFINITIONS
9. The three components of credit policy are:
A. collection policy, credit analysis, and interest rate determination.
B. collection policy, credit analysis, and terms of the sale.
C. collection policy, interest rate determination, and repayment analysis.
D. credit analysis, repayment analysis, and terms of the sale.
E. interest rate determination, repayment analysis and terms of sale.
Difficulty level: Easy
Topic: CREDIT POLICY
Type: CONCEPTS
10. On September 1, a firm grants credit with terms of 2/10 net 45. The creditor:
A. must pay a penalty of 2% when payment is made later than September 1st.
B. must pay a penalty of 10% when payment is made later than 2 days after September 1 st.
C. receives a discount of 2% when payment is made at least 10 days before September 1st.
D. receives a discount of 2% when payment is made before September 1st and pays a penalty of 10% if payment is
made after September 1st.
E. receives a discount of 2% when payment is made within 10 days after the effective invoice date of September
1st.
Difficulty level: Easy
Topic: CREDIT TERMS
Type: CONCEPTS
11. The credit period offered is influenced by:
A. the size of the account to receive credit.
B. the collateral value of the goods sold.
C. the probability that the customer will not pay.
D. All of the above.
E. None of the above.
Difficulty level: Medium
Topic: CREDIT PERIOD
Type: CONCEPTS
12. Seasonal dating of accounts receivable:
A. is used by all firms that grant credit.
B. brings the receivable immediately due during the season of the product.
C. makes the effective date of the invoice on a specific date in or around the relevant season of the product.
D. All of the above.
E. None of the above.
Difficulty level: Easy
Topic: ACCOUNTS RECEIVABLE
Type: CONCEPTS
13. Which of the following is not true concerning considerations in setting a credit policy?
A. A firm that supplies a perishable product will tend to offer restrictive credit terms.
B. A firm whose customers are in a high-risk business will tend to offer restrictive credit terms.
C. Lengthening the credit period effectively reduces the price paid by the customer.
D. Small accounts, associated with firms that find it difficult to acquire a line of credit, tend to receive longer credit
periods.
E. None of the above.
Difficulty level: Medium
Topic: CREDIT POLICY
Type: CONCEPTS
14. Lengthening the credit period _____ the price paid by the customer. Generally, this acts to _____ sales.
A. increases; increase
B. increases; decrease
C. decreases; decrease
D. decreases; increase
E. increases; have no effect on
Difficulty level: Easy
Topic: CREDIT POLICY
Type: CONCEPTS
15. When analyzing the NPV of a decision to change cash discounts, the firm would probably not consider:
A. the size of the discount.
B. the expected change in the order size.
C. the firm's cost of debt.
D. the expected change in sales due to the cash discount policy change.
E. All of the above would probably be considered.
Difficulty level: Easy
Topic: CASH DISCOUNTS
Type: CONCEPTS
16. When analyzing the decision to change the cash discount policy, the firm should:
A. choose the policy with the highest order size.
B. choose the policy with the lowest variable cost.
C. choose the policy with the lowest NPV.
D. choose the policy with the highest NPV.
E. choose the policy offering the lowest cash discount.
Difficulty level: Medium
Topic: CASH DISCOUNTS
Type: CONCEPTS
17. When credit is offered with only the invoice as a formal instrument of credit, the credit procedure is called:
A. invoice account.
B. open account.
C. unsecured account.
D. unsecured note.
E. None of the above.
Difficulty level: Easy
Topic: CREDIT TYPE
Type: CONCEPTS
18. Which of the following statements is true?
A. Most credit arrangements use promissory notes.
B. Promissory notes are used when firms do not anticipate a problem with collections.
C. Promissory notes usually involve no cash discount.
D. All of the above.
E. None of the above.
Difficulty level: Easy
Topic: PROMISSORY NOTES
Type: CONCEPTS
19. A commercial draft is useful to a seller because:
A. a specific payment amount and time are set.
B. the customer's bank has the buyer sign the draft before releasing the invoices.
C. the seller gets a credit commitment from a customer before the goods are delivered.
D. All of the above.
E. None of the above.
Difficulty level: Easy
Topic: COMMERCIAL DRAFT
Type: CONCEPTS
20. Which of the following statements is not true?
A. Commercial drafts represent a way to obtain a credit commitment from a customer before the goods are
delivered.
B. When a banker's acceptance is discounted in the secondary market it becomes a commercial note.
C. Sight drafts require immediate payment.
D. Banker's acceptances arise when a bank guarantees payment on a commercial draft.
E. Both A and C.
Difficulty level: Easy
Topic: BANKER'S ACCEPTANCE
Type: CONCEPTS
21. A conditional sales contract is useful to the seller because:
A. the firm retains legal ownership of the goods until they are completely paid for.
B. the firm is compensated for their opportunity cost.
C. there is a sequence of scheduled payments.
D. All of the above.
E. None of the above.
Difficulty level: Medium
Topic: CONDITIONAL SALES CONTRACT
Type: CONCEPTS
22. If a firm refuses to offer credit, the net present value of the transaction is:
A. the cash revenues received minus the cost paid in time period 0.
B. the discounted value of the revenues from time period 0.
C. the net cash flow from the future payments to be received.
D. determined by all of the above.
E. always equal to zero.
Difficulty level: Medium
Topic: CREDIT POLICY
Type: CONCEPTS
23. Risk should be incorporated into the decision to grant credit by:
A. decreasing the discount rate.
B. increasing the credit period to allow for customers in financial distress to reorganize.
C. decreasing the cash inflows, or the numerator of the NPV formula.
D. increasing the cash inflows, or the numerator of the NPV formula.
E. increasing costs per unit.
Difficulty level: Easy
Topic: CREDIT DECISION
Type: CONCEPTS
24. The decision to grant credit does not depend on:
A. delayed revenues from granting credit.
B. the immediate costs of granting credit.
C. the probability of payment.
D. the appropriate required rate of return for delayed cash flows.
E. All of the above are considered in the decision to grant credit.
Difficulty level: Easy
Topic: CREDIT DECISION
Type: CONCEPTS
25. The credit decision usually includes riskier customers. The credit decision should adjust for this by:
A. determining the probability that customers will pay and reducing the expected cash flow.
B. discounting the net cash flows at a lower discount rate.
C. discounting the cash inflow at a higher discount rate.
D. delaying collections on these customers.
E. speeding up deliveries to riskier customers.
Difficulty level: Easy
Topic: CREDIT DECISION
Type: CONCEPTS
26. The optimal credit amount is determined by:
A. the point which minimizes the total credit cost curve.
B. the point which maximizes the carrying costs associated with granting credit.
C. the point which maximizes opportunity costs associated with granting credit.
D. the point where the additional net cash flow from new customers equals the additional carrying costs of the
investment in receivables.
E. Both A and D.
Difficulty level: Medium
Topic: OPTIMAL CREDIT AMOUNT
Type: CONCEPTS
27. Businesses, in deciding to extend credit to new customers, try to reduce defaults by:
A. determining the probability of non-payment.
B. gathering independent credit checks.
C. determining if it is profitable to extend credit.
D. All of the above.
E. None of the above.
Difficulty level: Easy
Topic: CREDIT POLICY
Type: CONCEPTS
28. Determining the optimal credit policy is based on a trade-off of:
A. carrying costs of granting credit and making an investment in receivables.
B. stock out costs of losing sales from not offering credit.
C. the opportunity cost of lost sales from not offering credit.
D. Both A and C.
E. Both B and C.
Difficulty level: Easy
Topic: OPTIMAL CREDIT POLICY
Type: CONCEPTS
29. Which of the following statements is true?
A. Customers in high tax brackets would be more likely to take cash discounts and corporations in high tax
brackets would be more likely to offer credit.
B. Customers in high tax brackets would be more likely to take cash discounts and corporations in low tax brackets
would be more likely to offer credit.
C. Customers in low tax brackets would be more likely to take cash discounts and corporations in high tax brackets
would be more likely to offer credit.
D. Customers in low tax brackets would be more likely to take cash discounts and corporations in low tax brackets
would be more likely to offer credit.
E. Taxes have an effect on the propensity to grant credit, but no effect on the propensity to use credit.
Difficulty level: Medium
Topic: CASH DISCOUNTS AND CREDIT POLICY
Type: CONCEPTS
30. Companies will frequently use information from which of the following sources when conducting their credit
analysis?
A. Financial statements supplied by the customer.
B. Payment history supplied by other firms.
C. Payment history supplied by banks.
D. All of the above.
E. None of the above.
Difficulty level: Easy
Topic: CREDIT ANALYSIS
Type: CONCEPTS
31. Which of the following statements is not true?
A. An aging schedule shows only overdue accounts.
B. An aging schedule shows the probability that a 67-day account will be unpaid when it is a 68-day account.
C. Average collection period data is somewhat flawed if sales are seasonal.
D. Collection efforts may involve legal action.
E. Investments in accounts receivable equal average daily sales times average collection period.
Difficulty level: Medium
Topic: AGING SCHEDULE
Type: CONCEPTS
32. Aging schedules are flawed because they:
A. do not identify specific customers.
B. show the percent of accounts that are past due.
C. only give the yearly or periodic average of account age.
D. All of the above.
E. None of the above.
Difficulty level: Medium
Topic: AGING SCHEDULE
Type: CONCEPTS
33. To collect on the accounts receivable due to the firm, a firm can:
A. send a delinquency letter of past due status to the customer.
B. make personal contact by telephone.
C. employ a collection agency.
D. take legal action against the customer as necessary.
E. All of the above.
Difficulty level: Medium
Topic: COLLECTIONS
Type: CONCEPTS
34. In credit analysis of a customer, commonly used information includes the customer's:
A. financial statements.
B. credit report.
C. payment history with the firm.
D. All of the above.
E. Both B and C.
Difficulty level: Easy
Topic: CREDIT ANALYSIS
Type: CONCEPTS
35. The carrying value of a firm's account receivable is $700,000 and the average collection period is 45 days. The
firm's credit sales per day are:
A. $15,555.56
B. $23,333.33
C. $700,000.00
D. $4,666,666.67
E. None of the above.
Credit sales = Accounts Receivable/Average Collection Period $700,000/45 = $15,555.56
Difficulty level: Easy
Topic: CREDIT SALES PER DAY
Type: PROBLEMS
36. The Ault Company made a credit sale of $15,000. The invoice was sent today with the terms, 3/15 net 60. This
customer normally pays at the net date. If your opportunity cost of funds is 9% the expected payment is worth how
much today?
A. $13,761
B. $14,789
C. $15,000
D. $15,214
E. None of the above.
$15,000/(1.09)60/365 = $14,789
Difficulty level: Medium
Topic: CREDIT SALES
Type: PROBLEMS
37. Edgeworth Heating is selling a commercial heating unit at the price of $100,000 per unit. The variable cost of
producing this unit is $75,000. Edgeworth is considering offering credit terms to their customers, which would
allow payment to be delayed one month. Edgeworth predicts that offering these terms will increase monthly sales
from 50 units to 60 units. Edgeworth does not expect the increased production to change its variable cost and
Edgeworth does not expect to charge a higher price. The default rate on credit customers is predicted to be 2.25%.
Which of the following statements is true?
A. At a monthly interest rate of 1%, Edgeworth is indifferent between extending credit and continuing current
policies. At higher interest rates Edgeworth would prefer granting credit.
B. At a monthly interest rate of 1%, Edgeworth is indifferent between extending credit and continuing current
policies. At lower interest rates Edgeworth would prefer granting credit.
C. At a monthly interest rate of 2%, Edgeworth is indifferent between extending credit and continuing current
policies. At higher interest rates Edgeworth would prefer granting credit.
D. At a monthly interest rate of 2%, Edgeworth is indifferent between extending credit and continuing current
policies. At lower interest rates Edgeworth would prefer granting credit.
E. At a monthly interest rate of 3%, Edgeworth is indifferent between extending credit and continuing current
policies. At lower or higher interest rates Edgeworth would prefer granting credit.
NPV0 = PQ - CQ = 50($100,000 - $75,000) = $1,250,000
$1,250,000 = NPV1 = (hPQ/(1 + rB )) - CQ = (0.9775(60)($100,000))/1 + rB - 60($75,000)  $5,865,000/1 + rB =
$5,750,000 1 + rB = 1.02 rB = 2%
Difficulty level: Challenge
Topic: CREDIT POLICY
Type: PROBLEMS
38. Collegiate Tuxedo rents apparel throughout the year. They have experienced non-payment by about 15% of
their customers with an average loss of $200. Collegiate wants to stem their losses by using an instant electronic
credit check on the customer. These checks will cost them $7 on each of the 1,000 customers. The opportunity cost
is 1.5% for the credit period. Should they pursue the credit check?
A. No, because the $7000 cost is too high.
B. No, because a $200 loss is minor.
C. Yes, because the net gain is $30,000.
D. Yes, because the net gain is $23,000.
E. Yes, because the net gain is $193,000.
NPV of the defaulting customers = 0 - [(200)(.15)(1000)] = $-30,000
Net Gain = gain from not granting - cost of credit check = $30,000 - $7(1000) = $23,000
Difficulty level: Challenge
Topic: CREDIT ANALYSIS
Type: PROBLEMS
39. Delta Distributors has an investment in accounts receivable of $2,750,000. Daily credit sales are $118,280. If
30% of Delta's credit customers receive a discount by paying within 10 days, what is the net period that Delta
maintains?
A. 10 days
B. 23 days
C. 38 days
D. 45 days
E. There is not enough information to tell.
Rationale: E, Actual terms not given.
Difficulty level: Medium
Topic: CREDIT PERIOD
Type: PROBLEMS
40. Delta Distributors has an investment in accounts receivable of $2,750,000. Daily credit sales are $118,280. If
30% of Delta's credit customers receive a discount by paying within 10 days and the remainder of Delta's
customers pay in 40 days, what is the net period that Delta maintains?
A. 19 days
B. 31 days
C. 37 days
D. 40 days
E. None of the above.
.3(10) + .7(40) = 31 days
Difficulty level: Medium
Topic: CREDIT PERIOD
Type: PROBLEMS
41. Delta Distributors has total credit sales of $2,750,000 for the year. Delta's credit sales represent 75% of total
sales. What are total sales?
A. $1,925,000
B. $2,062,500
C. $2,750,000
D. $3,666,667
E. None of the above.
$2,750,000/.75 = $3,666,667
Difficulty level: Easy
Topic: CREDIT SALES
Type: PROBLEMS
42. The net credit period for a company with terms of 3/10, net 60 is:
A. 10 days
B. 50 days
C. 57 days
D. 60 days
E. None of the above.
60 -10 = 50 days
Difficulty level: Medium
Topic: NET CREDIT PERIOD
Type: PROBLEMS
43. If 25% of the customers pay on day 10 and 75% pay on day 30, the average collection period is:
A. 15 days.
B. 20 days.
C. 25 days.
D. 30 days.
E. 40 days.
(.25)(10) + (.75)(30) = 25 days
Difficulty level: Easy
Topic: AVERAGE COLLECTION PERIOD
Type: PROBLEMS
44. The carrying value of a firm's account receivable is $1,000,000 and the average collection period is 55 days.
The firm's credit sales per day are:
A. $33,333.33
B. $18,181.82
C. $1,000,000.00
D. $1,333,333.33
E. None of the above.
Credit sales = Accounts Receivable/Average Collection Period $1,000,000/55 = $18,181.82
Difficulty level: Easy
Topic: CREDIT SALES PER DAY
Type: PROBLEMS
45. The Lemon Company made a credit sale of $20,000. The invoice was sent today with the terms, 3/10 net 30.
This customer normally pays at the net date. If your opportunity cost of funds is 10% the expected payment is
worth how much today?
A. $15,000
B. $15,657
C. $19,843
D. $20,000
E. None of the above.
$20,000/(1.10)30/365 = $19,843
Difficulty level: Medium
Topic: CREDIT SALES
Type: PROBLEMS
46. Collegiate Tuxedo rents apparel throughout the year. They have experienced non-payment by about 20% of
their customers with an average loss of $300. Collegiate wants to stem their losses by using an instant electronic
credit check on the customer. These checks will cost them $12 on each of the 1,000 customers. The opportunity
cost is 2.0% for the credit period. Should they pursue the credit check?
A. No, because the $24,000 cost is too high.
B. No, because a $300 loss is minor.
C. Yes, because the net gain is $30,000.
D. Yes, because the net gain is $48,000.
E. Yes, because the net gain is $60,000.
NPV of the defaulting customers = 0 - [(300)(.20)(1000)] = $-60,000
Net Gain = gain from not granting - cost of credit check = $60,000 - $12(1000) = $48,000
Difficulty level: Challenge
Topic: CREDIT ANALYSIS
Type: PROBLEMS
47. Quattro Incorporated has an investment in accounts receivable of $3,500,000. Daily credit sales are $120,000.
If 20% of Quattro's credit customers receive a discount by paying within 10 days, what is the net period that
Quattro maintains?
A. 10 days
B. 23 days
C. 38 days
D. 45 days
E. There is not enough information to tell.
Rationale: E, Actual terms not given.
Difficulty level: Medium
Topic: CREDIT PERIOD
Type: PROBLEMS
48. If 20% of the customers pay on day 10 and 80% pay on day 30, the average collection period is:
A. 10 days.
B. 15 days.
C. 22.5 days.
D. 24 days.
E. 26 days.
(.20)(10) + (.80)(30) = 26 days
Difficulty level: Easy
Topic: AVERAGE COLLECTION PERIOD
Type: PROBLEMS
Essay Questions
49. Aggie Corporation has been asked by its customers to grant them a 2% discount if they pay their bill within 15
days. The purchase size of the average order is $75,000. Normally, the customer pays within 30 days with no
discount. Aggie's cost of debt capital is 12%. Should the request be granted?
Arithmetic method:
Current Policy: PV = $75,000/[1 + (.12 (30/365))] = $74,267.50
Proposed Policy: PV = $73,500/[1 + (.12 (15/365))] = $73,139.31
They should not grant this request unless sales would increase with the credit policy change. The increase in sales
must at least offset the costs.
Topic: COST OF CREDIT
Type: ESSAYS
50. Lory Corporation has variable costs per unit of $.35 per $1 of sales. The firm offers a 2% discount for orders
paid within 15 days if the customer increases their order size by 5%. A customer normally orders $75,000, and is
considering the discount. Normally, the customer pays within 30 days with no discount. Lory 's cost of debt capital
is 12%. Would Lory be wise to offer the discount? Calculate the NPV of the decision.
Arithmetic method:
Current Policy: PV = -$26,250 + 75,000/[1 + (.12 (30/365))] = $48,017.50
Proposed Policy: PV = $-27,562.50 + 77,175/[1 + (.12 (15/365))] = $49,233.78
The discount should be offered as the NPV of difference between the proposed policy and the current policy is
positive, thus is value enhancing.
Topic: COST OF CREDIT
Type: ESSAYS
51. Rockwell Heating is selling a commercial heating unit at the price of $100,000 per unit. The variable cost of
producing this unit is $75,000. Rockwell is considering offering credit terms to their customers, which would allow
payment to be delayed one month. Rockwell predicts that offering these terms will increase monthly sales from 50
units to 60 units. Rockwell does not expect the increased production to change variable cost and Rockwell does not
expect to charge a higher price. The appropriate discount rate is 1% a month. Determine the probability of payment
that would make Rockwell indifferent between granting credit and the present policy.
Strategy 1 - Refuse Credit: Profit = $100,000(50) - $75,000(50) = $1,250,000
Strategy 2 - Grant Credit: [(b) ($100,000) (60)/1.01] - $75,000(60) = $1,250,000
Solving for B. b = .968
Topic: CREDIT DECISION
Type: ESSAYS
52. Ali Storage Company projects 800 customers next year. Of these, 600 have been profitable and have never
defaulted on past obligations, while 200 have not been profitable. All of the unprofitable accounts are expected to
default if given credit. Ali can pay $0.40 to an agency that will tell them whether a customer has been profitable. If
Ali's price per unit is $10, and its cost per unit is $6, should they allow the credit check to be performed? Assume a
discount rate of 1%.
NPV of granting credit to customers who default = $0 - 200($6) = -$1,200
Cost of determining who is creditworthy = $0.4(800) = $320
NPV savings of not granting credit = $1,200 - $320 = $880
The credit check is worth undertaking.
Topic: CREDIT DECISIONS
Type: ESSAYS
53. United Distributors has an investment in accounts receivable of $2,750,000. Costs of goods sold represent 75%
of the sales price. Daily credit sales are $118,280. Thirty percent of United's credit customers receive a discount by
paying within 10 days. The firm's terms are net 30. How are the other 70% of customers paying; are they meeting
the terms?
Other 70% paying in:
A/R = $2,750,000/.75 = 3,666,667
ACP = $3,666,667/118,280. = 31 days
31 = .3(10) + .7(X); 31 = 3 + .7X 28 = .7X X = 40 days
The other 70% are paying in 40 days on average and implying some customers are stretching their payables and
exceeding the net period.
Topic: AVERAGE COLLECTION PERIOD
Type: ESSAYS