BEC - Financial Management Questions

A company has the following information in its financial records: Beginning Ending Balance Balance Cash $ 3,900 $ 3,000 Marketable Securities 3,800 4,400 Accounts Receivable 14,600 12,900 Total current assets $ 22,300 $20,300 Net sales $103,200 Expenses 20,430 Net Income $ 82,770 What is the company's receivable turnover ratio?

A company's accounts receivable turnover ratio measures the number of times that its accounts receivable are incurred and collected (turnover) within a period. It is computed as net sales (or net credit sales) divided by the average of net accounts receivable outstanding for the period. The average accounts receivable for the period normally is determined by summing the beginning and ending accounts receivable balance and dividing by 2. In this question the beginning and ending accounts receivable balances are $14,600 and $12,900, respectively. Thus, the correct calculation would have been net sales $103,200/($14,600 + $12,900/2) = $103,200/$13,750 = 7.5.

Green, Inc., a financial investment-consulting firm, was engaged by Maple Corp. to provide technical support for making investment decisions. Maple, a manufacturer of ceramic tiles, was in the process of buying Bay, Inc., its prime competitor. Green's financial analyst made an independent detailed analysis of Bay's average collection period to determine which of the following?

A detailed analysis of average collection period most likely would be used to assess or determine liquidity. An analysis of average collection period would measure how long, on average, it takes an entity to collects its receivables -- how long it takes to convert accounts receivable to cash.

A start-up company plans to offer shares of its common stock through a SEC-registered online funding portal. Assuming the company meets the requirements for crowdfunding, which one of the following is the maximum amount, if any, it may raise through crowdfunding during its first year?

A firm is limited to raising a maximum of $1,000,000 during a 12-month period through crowdfunding.

Which one of the following is least likely to enter into a firm's decision in setting the rate and period of its discount terms for early payment?

A firm will be least likely concerned with minimizing the firm's losses on accounts receivable in setting the rate and period of its discount terms for early payment. First, the objective in setting account receivable policies is not to minimize losses, but to maximize net income. A firm could minimize its losses on accounts receivable by being a cash only business, but it would lose sales and net income. Secondly, setting the rate and period of discount terms is concerned with accelerating the collection of cash, not with minimizing losses.

Which of the following corporate characteristics would favor debt financing versus equity financing?

A high tax rate. Other things being equal, the higher the tax rate of a firm, the greater the benefit from debt financing because the cost of debt (interest expense) is tax deductible and therefore generates a tax savings. That tax savings offsets the nominal cost of the debt. Since interest is not paid on dividends to equity holders and since dividends are not tax deductible, there is no comparable savings related to equity financing.

An increase in which of the following should cause management to reduce the average inventory?

An increase in the cost of carrying inventory should cause management to reduce average inventory so as to avoid the increased cost of carrying the inventory (e.g., warehousing cost, insurance costs, etc.).

A production cycle of long duration would be expected to have which one of the following effects on working capital?

As the term implies, the production cycle is the time needed to convert raw materials into finished goods. The longer the duration (time) of this cycle, the higher the level of working capital that would be expected to be devoted to the process. For example, more work-in-process inventory would be incurred in a long production cycle than would be involved in a short production cycle.

Which one of the following is most likely not a major concern when selecting short-term investment opportunities?

Because funds invested in short-term investments will earn a return for only a short period of time, the rate of return earned is normally not a major concern. More important concerns are safety of principal, price stability, and marketability of the investment.

related to loans involving inventory?

Blanket liens. Trust receipts. Warehousing.

Each of the following periods is included when computing a firm's target cash conversion cycle, except the

Cash discount period. You Answered Correctly! The cash discount period is not included when computing a firm's target cash conversion cycle. The cash discount period is the period of time during which a debtor is offered a discount for early payments of an account and does not establish when cash is actually received. The actual collection of cash could be any time during or after the discount period and it is that actual date of collection that enters into the measurement of the cash conversion cycle.

Which of the following statements concerning the sale of equity securities through crowdfunding are correct? Crowdfunding must take place through a SEC-registered broker-dealer or funding portal. Any company registered with the SEC may use crowdfunding. An investor is limited in the amount that can be invested through crowdfunding during a 12-month period.

Crowdfunding must take place through a SEC-registered broker-dealer or funding portal (Statement I) and an investor is limited in the amount that can be invested through crowdfunding during a 12-month period to $100,000 (Statement III).

Which one of the following provides a source of spontaneous financing for a firm?

Accounts payable are a source of spontaneous financing. Spontaneous financing occurs when credit is provided in the course of day-to-day operations; In general, the level of financing goes up concurrent with the purchase of goods or services or the carrying out of other day-to-day activities.

Regarding financial resources, financial management is concerned with the efficiency and effectiveness of which of the following?

Financial management is concerned with the efficiency and effectiveness of both the acquisition of financial resources and the use of these resources.

What impact will the issuing of new preferred stock have on the following for the issuing entity?

Since preferred stock is not debt, there will be no effect on long-term debt; however, since preferred stock is equity, the debt-to-equity ratio will decrease.

short term financing that can restrict use of proceeds

Trade accounts payable. Accrued taxes payable. Accrued salaries payable.

Which of the following statements concerning preferred stock is/are generally correct? I. Requires dividends be paid. II. Grants ownership interest. III. Grants voting rights.

2 Preferred stock, like common stock, conveys an ownership interest in the entity. Preferred stock does not require the payment of dividends nor does it normally convey voting rights.

A project has an initial outlay of $1,000. The projected cash inflows earned evenly over each year are: Year 1 $200 Year 2 200 Year 3 400 Year 4 400 What is the investment's payback period?

3.5 years The payback period is 3.5 years, computed as follows: Year Annual Amount Cumulative Amount Balance Needed 1 $200 $ 200 $800 2 $200 $ 400 $600 3 $400 $ 800 $200 4 $200/$400 = ½ Year $1,000 $ ‐0‐

Assume the following abbreviated Income Statement: Revenues $100,000 Cost of Goods Sold 60,000 Gross Profit $ 40,000 Operating Expenses 20,000 Finance Expense 5,000 Net Income $ 15,000 In a common‐size income statement, which one of the following percentages would be shown for Finance Expense?

5% In a common‐size income statement, each item is measures as a percentage of total revenues. Thus, the correct calculation is: $5,000/$100,000 = 5.00%.

Each of the following periods is included when computing a firm's target cash conversion cycle

inventory conversion period. Payables deferral period. Average collection period.

In which one of the following areas is preferred stock most likely to differ from common stock?

voting rights Preferred stock and common stock are most likely to be different in terms of voting rights; preferred stock typically does not have voting rights and virtually all common stock does.

Which one of the following would be considered a long‐term financial management activity or concern?

Dividend policy is a long‐term financial management activity or concern

Which of the following is not related to loans involving inventory?

Factoring involves the sale of accounts receivable.

Bonds Payable, which mature in 10 years, would be included as part of a firm's

Financial Structure includes all items of liabilities and owners' equity, and capital structure includes long-term liabilities and owners' equity. Since bonds payable, which mature in 10 years, are a long-term liability, they are included in both financial and capital structure of a firm.

According to the hedging principle (or the principle of self-liquidating debt), in making decisions concerning the maturity structure of an entity's financing, which one of the following guidelines would be most appropriate?

Fund a permanent expansion in accounts receivable by issuing long-term bonds. You Answered Correctly! The hedging principle states that the maturity structure of an entity's financing should be consistent with the cash flow produced by the asset being financed. Assets or projects that provide short-term benefits should be financed with short-term financing and assets or projects of long-term duration or benefit should be financed with long-term or permanent financing. Therefore, a permanent expansion in accounts receivable, which will require a permanent increase in financing, should be financed by issuing long-term bonds (or, if the option is provided, common stock issuance).

Neu Co. is considering the purchase of capital equipment that has a positive net present value based on Neu's 12% hurdle rate. The internal rate of return would be:

Greater than 12% Since the internal rate of return determines the discount rate, which equates the present value of future cash inflows with the cost of the investment, if the project has a positive net present value, the discount rate (or internal rate of return) must be greater than the hurdle rate.

A business with a net book value of $150,000 has an appropriate fair value of $120,000. Charles Harvey, one of three owners, has decided to sell his 10% interest in the business. Which one of the following is most likely the amount at which Harvey can sell his interest?

Harvey would likely receive less than $12,000 upon sale of his interest. While Harvey has a claim to 10% of the fair value of the business, because his ownership interest is very minor, the value of his interest upon sale would likely be less than $12,000 due to a noncontrolling interest discount.

Which of the following statements concerning the use of short-term financing by an entity is/are correct? I. Short-term financing generally offers greater financial flexibility than long-term financing. II. Short-term financing generally has a lower interest rate than long-term financing. III. Short-term financing generally has a lower risk of illiquidity than long-term financing.

I and II In general, short-term financing offers a firm greater financial flexibility than does long-term financing. With short-term financing, the level of borrowing can be more readily expanded or contracted with changes in the need for funds. With long-term financing, the level of borrowing cannot be readily adjusted with changes in needs, especially when there is a contraction in the need for debt. Short-term financing is generally cheaper than long-term financing. For a given borrower at a particular point in time, interest rates on short-term borrowings, in general, are lower than interest rates on long-term borrowings. Finally, III is not correct because short-term financing generally has a higher (not lower) risk of illiquidity than does long-term financing. By its nature, short-term borrowing must be repaid or refinanced in the near term and, on an on-going basis, more often than long-term debt. Changes in the economic environment or within the entity, may make it impossible for the firm to either repay or refinance the debt. In that case, the firm would be technically insolvent.

Which of the following statements concerning long-term financing is/are correct? I. Long-term financing consists of sources that constitute capital structure. II. Long-term financing consists of sources on which the weighted-average cost of capital is based. III. Long-term financing consists only of equity sources of capital.

I and II Statements I and II are correct; Statement III is not correct. Long-term financing consists of sources that constitute capital structure (as opposed to financial structure). These are the sources of financing that are used to calculate the weighted-average cost of capital (Statements I and II, respectively). Statement III is not correct because long-term financing includes long-term debt, as well as equity.

Which of the following statements concerning common stock is/are generally correct? I. Requires dividends be paid. II. Grants ownership interest. III. Grants voting rights.

II and III Common stock grants both an ownership interest and a voting right. It does not require the payment of dividends, which are at the discretion of the Board of Directors and require profitable operations.

In general, does the use of short-term financing require collateral and/or impose restrictive terms on the borrower?

In general, items of short-term financing do not require collateral from or impose restrictive terms on the borrower. Accounts payable and accrued payables, for example, do not require either collateral or have restrictive terms. Similarly, most short-term notes do not require collateral or have restrictive terms.

Which one of the following forms of collateral is most commonly used as security for short-term loans?

Inventory secured loans are most commonly used for short-term financing. Such loans may be in the form of a revolving line of credit that is related directly to the value of the inventory that serves as security. In fact, the short-term financing may be for the inventory itself.

evaluating working capital management?

Inventory turnover ratio. Quick ratio. Days' sales in average receivables

Why would a firm generally choose to finance temporary assets with short-term debt?

Matching the maturities of assets and liabilities reduces risk. The hedging principle of financing (also called the principle of self-liquidating debt) holds that long-term or permanent investments in assets should be financed with long-term or permanent sources of capital and short-term needs should be financed with short-term sources of financing. Thus, long-term assets (e.g., property, plant, and equipment, among others) and permanent amounts of current assets (e.g., level of accounts receivable and inventory generally on-hand) should be financed with long-term debt or equity. Conversely, temporary investments in assets (e.g., a temporary increase in inventory to meet seasonal demand) should be financed with temporary sources of financing. The objective of this principle is to match cash flows from assets with the cash requirements need to satisfy the related financing.

if a firm's accounts payable, its only current liability, exceeds the sum of cash, accounts receivable and, inventory, the firm's only current assets, then net working capital will be:

Net working capital is computed as: Current Assets - Current Liabilities. If current liabilities exceed current assets, net working capital is negative.

selecting short-term investment opportunities?

Price stability. Marketability. safety of principal

Which one of the following measures would be least appropriate in evaluating working capital management?

Return on assets. You Answered Correctly! The management of working capital is concerned with the effective and efficient use of current assets and current liabilities, not with all assets. The return on assets measures the rate of return earned on total assets or total equity and, therefore, is not useful in evaluating just current assets (or current liabilities).

Which one of the following forms of short-term financing is least likely to be considered a spontaneous source of funding?

Spontaneous financing occurs automatically in the carrying out of day-to-day operations. Financing through the use of short-term notes payable does not occur automatically as a result of carrying out day-to-day operations, but rather requires negotiation with a lending institution, usually a commercial bank, and the execution of a promissory note. The other forms of payable occur spontaneously as a result of normal business operations.

The time between paying cash for raw materials and collecting cash from the sale of products made with those raw materials is called which one of the following?

The cash conversion cycle is concerned with the period beginning with paying cash for inventory and ending with the collection of cash from the sale of products made with that inventory.

A company has $650,000 of 10% debt outstanding and $500,000 of equity financing. The required return of current equity holders is 15%, and there are no retained earnings currently available for investment purposes. If new outside equity is raised, it will cost the firm 16%. New debt would have before-tax cost of 9%, and the corporate tax rate is 50%. When calculating the marginal cost of capital, what cost should the company assign to equity capital and to the after-tax cost of debt financing?

The cost of new (marginal) equity is 16%, which would include the cost associated with flotation of the new issue. The after-tax cost of new debt would be the before-tax cost of 9% less the tax savings resulting from the deductibility of interest on the debt, which would be computed as 9%× (1.00 - .50) = .09× .50 = .045 (or 4.5%).

A company recently issued 9% preferred stock. The preferred stock sold for $40 a share, with a par of $20. The cost of issuing the stock was $5 a share. What is the company's cost of preferred stock?

The current cost of capital for newly issued preferred stock is computed as the net proceeds per share divided into the annual cost (dividends) of the newly issued shares. In this question, the net proceeds per share is given as $40 sales price less $5 per share issue cost, or $35 per share net proceeds. The annual cost of the newly issued shares is the par value, $20, multiplied by the preferred dividend rate, 9%, or $20 x .09 = $1.80 annual dividend per share. Therefore, the cost of capital for the newly issued preferred stock is $1.80/$35.00 = 5.1%

The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What percentage represents the firm's cost of common equity?

The firm's cost of common equity is the rate of return currently expected by potential investors in the firm's common stock. When it is assumed that the dividends are expected to grow at a constant rate, that rate of return is calculated as: Common Stock Expected Return (CSER) = (Dividend in 1st Year/Market Price) + Growth Rate Using the values given: CSER = ($4.25/$85.00) + .07 CSER = .05 + .07 = .12 (or 12%) The CSER of 12% is the cost of capital through common stock financing.

Larson Corp. issued $20 million of long-term debt in the current year. What is a major advantage to Larson with the debt issuance?

The issuance of debt results in interest expense, which is deductible for tax purposes. Therefore, the effective cost of debt is less than its stated interest rate by the amount of taxes saved by that interest deduction. The effective cost of debt is its interest cost x (1 - tax rate). The relatively low after-tax cost due to the interest deduction.

Apollo Inc.'s common stock is currently selling for $100 per share and will pay a $4.00 per share dividend. If Apollo's dividend is expected to grow indefinitely at 5%, what is the market's required rate of return on a prospective investment in Apollo's stock?

The market's required rate of return on a prospective investment in Apollo's stock is 9%. The answer is computed as: (Current dividend/Current market price) + Growth rate, or ($4/$100) + 5% = 4% + 5% = 9%.

Cyco, Inc. determined the following concerning its operating activities: Accounts receivable conversion cycle 18 days Accounts payable conversion cycle 21 days Inventory conversion cycle 24 days Which one of the following is the length of Cyco's operating cycle?

The operating cycle is the average length of time between the acquisition of inventory and the collection of cash from the sale of that inventory. It is measured by the inventory conversion cycle + the accounts receivable conversion cycle. Cyco's inventory conversion cycle is 24 days and its accounts receivable conversion cycle is 18 days. Thus its operation cycle is 24 + 18 = 42 days.

Which one of the following bond issues, with different terms and stated rates of interest, would have the highest interest rate risk, all other things being equal?

This issue has the longest maturity (with the lowest stated interest rate). Therefore, it will have the highest interest rate risk.

to be restricted as to use of proceeds?

Trade accounts payable. Accrued taxes payable. Accrued salaries payable.

An accountant has been retained by a company as an investment advisor for its employees. Research of historical rates of return yields the following information: Type of Investment Mean Return Standard Deviation Common stocks 12% 20% Long-term corporate bonds 6% 8% Intermediate-term government bonds 5% 5% U.S. Treasury bills 4% 3% Which of the following investments has the greatest reward/risk ratio if a return's standard deviation is an accurate assessment of investment risk?

U.S. treasury bills have the greatest reward/risk ratio. The risk/reward ratio, known as the Sharpe ratio, is calculated as the mean return on the instrument divided by the standard deviation, which is a measure of the risk associated with the investment instrument. Using the Sharpe ratio, the higher the ratio, the greater the reward per unit of risk. The risk/reward ratio for U.S. Treasury bills is 1.333

Carter Co. paid $1,000,000 for land three years ago. Carter estimates it can sell the land for $1,200,000, net of selling costs. If the land is not sold, Carter plans to develop the land at a cost of $1,500,000. Carter estimates net cash flow from the development in the first year of operations would be $500,000. What is Carter's opportunity cost of the development?

$1,200,000 Opportunity cost is the (discounted) dollar value of benefits lost from an alternative (opportunity) as a result of choosing another alternative (opportunity). By choosing to develop the land, Carter would give up the opportunity to sell the land for $1,200,000, the opportunity cost.

A company wants to approximate the 12% annual interest rate based on a 365-day year it pays on its working capital loan. Which of the following terms should the company offer its customers?

1.00%, 15, net 45 These terms would provide the desired 12% annual interest rate. The interest rate associated with discount terms is computed as: [Discount Rate/Principal] × [1/(Length of discount period/365)]; where: Principal = Amount after discount Length of discount period = Difference between discount date and net date Using the facts in this question: [.01/.99] × [1/(30/365)] = .0101 × (365/30) = .0101 × 12.16 = 12.28 (or 12% rounded) annual interest rate, the correct answer. (NOTE: An easier and quicker approximation can be made by dividing the discount period into the days in a year, or 45 - 15 = 30 days; 365/30 = 12.1, and multiplying that by the discount amount = 12.1 × .01 = .121 (or 12% rounded), the correct answer.)

Which of the following categories of risk does an investment's beta measure?

An investment's beta measures the investment's systematic risk; it shows how the value of an investment changes with changes in the entire class of similar investments. Systematic risk is the uncertain inherent in the entire market; it cannot be avoided through diversification

Which of the following risks can be hedged?

Foreign Exchange Risk Interest Rate Risk Default Risk

The discounted payback period approach to project evaluation is better than the payback period approach because I. It considers the time value of money. II. It is useful in evaluating the liquidity of a project. III. It uses expected cash flows

I The discounted payback period approach to project evaluation is better than the payback period approach because it considers the time value of money and the payback period approach does not (Statement I). Both methods are useful in evaluating the liquidity of a project and use expected cash flows (Statements II and III, respectively), so there is no difference between the approaches for those characteristics.

Which of the following scenarios would encourage a company to use short-term loans to retire its 10-year fixed-rate callable bonds that have five years until maturity?

Interest rates have declined over the last five years. If interest rates have declined over the last five years, a company can currently borrow at a lower interest rate than that on the older, fixed-rate debt. Thus, a company would be encouraged to replace the outstanding fixed-rate bonds with short-term borrowings that have a lower interest cost.

Which of the following could be used to hedge a net receivable denominated in British pounds by a U.S. company?

Purchase a currency put option in British pounds A currency put option would enable the U.S. company to lock in the price at which it could sell (put) the British pounds when received.

Strobel Company has a large amount of variable rate financing due in one year. Management is concerned about the possibility of increases in short-term rates. Which one of the following would be an effective way of hedging this risk?

Selling Treasury notes futures contract would hedge the risk of increases in the short-term interest rates. If the interest rates increase, the value of the Treasury notes contract will decline, which would enable the firm to acquire the notes at the new lower value and sell them at the higher futures contract price, resulting in a gain. The gain would serve to offset the effects of an increase in short-term interest rates on the variable rate financing.

Which one of the following most likely would not be considered when computing the weighted average cost of capital?

Short-term debt likely would not be considered when computing the weighted average cost of capital. Short-term debt is not considered part of the capital structure of an entity.

The best reason corporations issue Eurobonds rather than domestic bonds is that

These bonds are normally a less expensive form of financing because of the absence of government regulation. Eurobonds are issued in a currency other than the currency of the country in which they are issued. For example, U.S dollar-denominated bonds issued in an EEU country would be Eurobonds. Because they are not issued in the country of the currency in which they are denominated, these bonds are not subject to the government regulations of the country of the currency and, thus, avoid expense and disclosure requirements of that country.

Which of the following statements concerning short-term financing is/are correct? I. Accounts payable can provide short-term financing. II. Accounts receivable can provide short-term financing. III. Inventory can provide short-term financing.

all three

Which of the following financial management‐related areas are considered long‐term issues?

capital budgeting is considered a long‐term issue.

On November 1, Year 1, a company purchased a new machine that it does not have to pay for until November 1, Year 3. The total payment on November 1, Year 3 will include both principal and interest. Assuming interest at a 10% rate, the cost of the machine would be the total payment multiplied by what time value of money concept?

pv of 1 A present value of 1 factor is used because only one payment is to be made. Present value (which also is cost) = (present value of 1 factor) x (future payment). The future payment is being discounted to its present value.

A corporation is considering purchasing a machine that costs $100,000 and has a $20,000 salvage value. The machine will provide net annual cash inflows of $25,000 per year and has a six‐year life. The corporation uses a discount rate of 10%. The discount factor for the present value of a single sum six years in the future is 0.564. The discount factor for the present value of an annuity for six years is 4.355. What is the net present value of the machine?

$20,155 The net present value of the new machine is determined as the present value of future cash inflows less the present value of the current costs of the machine. The facts of this question contain two cash inflows: (1) the cash inflow of $25,000 per year for six years; and (2) the cash inflow from the salvage value of $20,000 at the end of the asset's life. The present values of those inflows are $25,000 x 4.355 (the present value of an annuity for six years) = $108,875 and $20,000 x .564 (the present value of $1 discounted for six years) = $11,280, for a total of $108,875 + $11,280 = $120,155. The present value of the cost of the new machine is $100,000. Thus, the net present value of the machine is $120,155 ‐ $100,000 = $20,155.

Lin Co. is buying machinery it expects will increase average annual operating income by $40,000. The initial increase in the required investment is $60,000, and the average increase in required investment is $30,000. To compute the accrual accounting rate of return, what amount should be used as the numerator in the ratio?

$40,000 The accounting rate of return (ARR) is calculated as: ARR = Average annual incremental income/Initial (or Average) investment. For the facts given, the equation would be: ARR = $40,000/$60,000 (or $30,000). Thus, the numerator is given as $40,000.

If a firm purchases raw materials from its supplier on a 2/10, net 40, cash discount basis, the equivalent annual interest rate (using a 360-day year) of forgoing the cash discount and making payment on the 40th day is:

(Correct!) The annual interest rate of forgoing the cash discount is calculated as: [Discount %/(1.00 - Discount %)] × [360/(40 - 10)] For the facts given, the calculation would be: [.02/(1.00 - .02)] × [360/30] = .02041 × 12 = .2449 (or 24.49%)

Josey maintained a $10,000 balance in his savings account throughout Year 1, the first year of the account. The savings account paid 2% interest compounded annually. For Year 1, the inflation rate was 3%. For Year 1, what is Josey's real interest rate on the savings account?

-1% The real interest rate is the stated (or nominal) rate of interest for a period less the rate of inflation for that period. Since Josey earned 2% on the checking account for the year and inflation for the year was 3%, Josey's real interest rate was: 2% - 3% = -1%.

Assume the following values for an investment: Risk-free rate of return = 2% Expected rate of return = 9% Beta = 1.4 Which one of the following is the required rate of return for the investment?

11.8% The required rate of return for the investment is 11.8% calculated as: Required rate = Risk-free rate + Beta(Expected rate - Risk-free rate), or Required rate = .02 + 1.4(.09 - .02), or Required rate = .02 + 1.4(.07), or Required rate = .02 + .098, or Required rate = .118, or 11.8%

Beta Company has arranged to borrow $10,000 for 180 days. Beta will repay the principal amount plus $600 in interest at the maturity of the note. Which one of the following is the annual percentage rate (APR) of interest that Beta is paying on the loan?

12% The calculation of annual percentage rate (APR) is a function of the basic equation: Interest = Principal x Interest Rate x Time period of loan. Rearranged, the interest rate on an annual basis (APR) is: Interest (cost) APR = ________________________ , or Principal x Time fraction of year Interest (cost) 1 APR = ____________ x ________________ Principal Time fraction of year Using the facts above, the APR is computed as: $600 1 APR = _______ x ________ $10,000 180/360 APR = .06 x 360/180 = .06 x 2 = 12%

Phillips Company is considering the acquisition of a new machine that would cost $66,000, has an expected life of 6 years, and an expected salvage value of $16,000. The company expects the machine to provide annual incremental income before taxes of $7,200. Phillips has a tax rate of 30%. If Phillips uses average values in its calculations, which one of the following will be the average accounting rate of return on the machine?

12.29% The (average) accounting rate of return is determined by dividing the average annual after‐tax net income by the average cost of the investment. The after‐tax income would be $7,200 x .70 = $5,040. The average cost of the investment would be beginning book value ($66,000) + ending book value of ($16,000), or $82,000/2 = $41,000. Therefore, the accounting rate of return is: $5,040/$41,000 = 12.29%.

A corporation obtains a loan of $200,000 at an annual rate of 12%. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but it normally does not have a cash balance account with the bank. What is the effective cost of the loan?

15% The effective cost of the loan (i.e., the effective interest rate on the loan) is determined as the annual dollar cost of the loan divided by the net useable proceeds of the loan. The annual dollar cost is the principal multiplied by the annual rate, or $200,000 x .12 = $24,000. The net useable proceeds of the loan is the principal amount less the amount of the compensating balance that must be maintained with the bank, or $200,000 ‐ ($200,000 x .20) = $200,000 ‐ $40,000 = $160,000. Therefore, the effective cost of the loan is $24,000/$160,000 = .15 (or 15%).

Charles Allen was granted options to buy 100 shares of Dean Company stock. The options expire in one year and have an exercise price of $60.00 per share. An analysis determines that the stock has an 80% probability of selling for $72.50 at the end of the one-year option period and a 20% probability of selling for $65.00 at the end of the year. Dean Company's cost of funds is 10%. Which one of the following is most likely the current value of the 100 stock options?

1k The stock has an 80% chance of selling at $72.50 at the end of the option period. That is $12.50 above the option price. The stock has a 20% chance of selling at $65.00 at the end of the option period. That is $5.00 above the option price. Therefore, the value of the option is: [(.80 x $12.50) + (.20 x $ 5.00)]/1.10, or [($10.00) + ($1.00)]/1.10, or $11.00/1.10 = $10.00 x 100 shares = $1,000

Assume the following rates exist in the U.S.: Prime interest rate = 6% Fed discount rate = 4% U.S. Treasury Bond rate = 2% Inflation rate = 1% Which one of the following is most likely the nominal risk‐free rate of return in the U.S.?

2% In the U.S., the rate paid on U.S. Treasury Bonds (2%) is considered the risk‐free rate of return; that is, the rate of return that is paid for delayed use of funds by investing them, without any risk premium attached to or paid for default risk.

Which of the following statements concerning debenture bonds and secured bonds is/are correct? I. Debenture bonds are likely to have a greater par value than comparable secured bonds. II. Debenture bonds are likely to be of longer duration than comparable secured bonds. III. Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds

3 Debenture bonds are unsecured bonds. Because they are unsecured, they are likely to have a higher coupon rate (interest rate) than comparable secured bonds.

Which of the following statements concerning debenture bonds and secured bonds is/are correct? I. Debenture bonds are likely to have a greater par value than comparable secured bonds. II. Debenture bonds are likely to be of longer duration than comparable secured bonds. III. Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds.

3 Debenture bonds are unsecured bonds. Because they are unsecured, they are likely to have a higher coupon rate (interest rate) than comparable secured bonds.

The following information is available on market interest rates: The risk-free rate of interest 2% Inflation premium 1% Default risk premium 3% Liquidity premium 2% Maturity risk premium 1% What is the market rate of interest on a one-year U.S. Treasury bill?

3% The market rate of interest on a one-year U.S. Treasury bill would be 3%. Notice that the risk-free rate of interest and the various premiums are for the general market rate of interest, not for the rate on a one-year U.S. Treasury bill. Treasury bills are considered risk free in an environment where zero inflation is expected. Therefore, the market rate of interest on a one-year U.S. Treasury bill would be the risk-free rate plus the inflation premium (for the expected rate of inflation during the life of the security), or 2% + 1% = 3%. One-year U.S. Treasury bills are considered free of default risk, liquidity risk (because there is a very large and active secondary market for T-bills), and maturity risk (because they are for only one year).

The following information is available on market interest rates: The risk‐free rate of interest 2% Inflation premium 1% Default risk premium 3% Liquidity premium 2% Maturity risk premium 1% What is the market rate of interest on a one‐year U.S. Treasury bill?

3% The market rate of interest on a one‐year U.S. Treasury bill would be 3%. Notice that the risk‐free rate of interest and the various premiums are for the general market rate of interest, not for the rate on a one‐year U.S. Treasury bill. Treasury bills are considered risk free in an environment where zero inflation is expected. Therefore, the market rate of interest on a one‐year U.S. Treasury bill would be the risk‐free rate plus the inflation premium (for the expected rate of inflation during the life of the security), or 2% + 1% = 3%. One‐year U.S. Treasury bills are considered free of default risk, liquidity risk (because there is a very large and active secondary market for T‐bills), and maturity risk (because they are for only one year).

The following information pertains to Krel Co.'s computation of net present value relating to a contemplated project: Discounted expected cash inflows $1,000,000 Discounted expected cash outflows 700,000 Net present value is:

300k Net present value (NPV) is computed as: NPV = present value of cash inflows ‐ present value of cash outflows. Using the facts in this question: NPV = $1,000,000 ‐ $700,000 = $300,000.

Pole Co. is investing in a machine with a 3‐year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are: Period 1 0.88 2 1.65 3 2.32 Using a 14% cost of capital, what is the present value of these future savings?

62900 Since only present values of an annuity factor are given, the correct answer can be determined only by converting the values given into two annuities. An annuity is a series of equal payments. The given values are: $30,000 for years 1 and 2, and $20,000 for year 3. Those values are not equal for every year (therefore not an annuity), so the annuity factors given cannot be used with those values (as given). But, they can be converted into two series of equal payments comprised of: $20,000 for years 1, 2 and 3, and $10,000 for years 1 and 2. Those two cash flow streams would look like: YEAR STREAM 1 STREAM 2 STREAM 3 Year 1 $20,000 $10,000 = $30,000 Year 2 $20,000 $10,000 = $30,000 Year 3 $20,000 = $20,000 Note that now there are two series, each of equal amounts, but which total to the same amounts as the values given. The present value of an annuity for 3 years can now be applied to $20,000 and the present value of an annuity for 2 years can be applied to $10,000. The results would be: (1) $10,000 annuity for two years: $10,000(1.65) = $16,500 (2) $20,000 annuity for three years $20,000(2.32) 46,400 Total present value $62,900

Which of the following changes would result in the highest present value?

A $100 decrease in taxes each year for four years. This question is intended to test a candidate's understanding of the conceptual relationships between present values of single amounts and present values of annuities, and the impact of length of time on present value amounts. Getting the correct answer does not require (or expect) the actual calculation of present values for each of the four choices. Here is the logic: 1. Recognize that all of the choices are for the same amount, $100. Therefore, the amount of the principal will not create a difference in present values for the choices. 2. Next, notice that choices A, B, and D are for annuities; choice C is for a single amount to be received in four years, longer than choices B and D, and as long as choice A. Since the present value of a single amount has to be less than the present value of a series of equal amounts due within the same or less time, choice C cannot result in the highest present value. 3. Next, since choices A, B, and D are all for annuities of the same amount, the longer the annuity, the higher the present value. Choices B and D are for three years; choice A is for four years. 4. Therefore, choice A will result in the highest present value.

A company has the following financial information: Source of capital Proportion of capital structure Cost of capital Long‐term debt 60% 7.1% Preferred stock 20% 10.5% Common stock 20% 14.2% To maximize shareholder wealth, the company should accept projects with returns greater than what percent?

An entity should accept projects which have an estimated return (equal to or) greater than the entity's weighted average cost of capital (WACC). The WACC with the facts given is computed as: .60 x 7.1% = 4.26% .20 x 10.5% = 2.10% .20 x 14.2% = 2.84% WACC = 9.20%

A graph that plots beta would show the relationship between

Asset return and benchmark return A graph which plots beta would show the relationship between the return of an individual asset and the return of the entire class of that asset, as reflected in a benchmark return for the class.

Which one of the following risks relates to the possibility that a derivative might not be effective at hedging a particular asset?

Basis risk is the risk that relates to the possibility that a derivative might not be effective at hedging a particular. Basis risk is a measure of the ineffectiveness of a hedge.

Which of the following characteristics, if any, should be taken into account in valuing a specific item?

Both location and condition of an item should be taken into account in assigning value to the item.

Which of the following types of active markets, if any, would be considered as providing level 1 inputs under the U.S. GAAP hierarchy of inputs for fair value determination?

Both the New York Stock Exchange and Over-the-Counter Market are the basis for level 1 inputs under the U.S. GAAP hierarchy of inputs for fair value determination. Both are active markets for the trading of securities.

An American importer of English clothing has contracted to pay an amount fixed in British pounds three months from now. If the importer worries that the U.S. dollar may depreciate sharply against the British pound in the interim, it would be well advised to:

Buy pounds in the forward exchange market. Buying pounds in the forward exchange market would hedge a decrease in the dollar against the pound. Buying pounds now through a forward contract would lock in the dollar cost of the pounds need to pay the obligation when it comes due and, thus, protect the American importer against depreciation of the dollar against the pound.

Joe Going has arranged to become an Uber driver and will acquire a new vehicle to use strictly for that business purpose. He has the choice of either buying a new vehicle or leasing one. If he buys a new vehicle, he would pay cash from his personal savings, which is currently earning 2% per year, not compounded. The vehicle would cost $18,000, have a 5-year life with no residual value, and generate $3,000 per year in tax-deductible depreciation at year-end. Maintenance cost of $500 would be incurred at the end of each year. Routine operating cost (gasoline, fluids, etc.) of $6,000 per year would be the responsibility of Goings and would be the same under either the buy or lease alternatives. If Going elects to lease a vehicle, the annual tax-deductible lease expense would be $5,000 per year, payable at the beginning of each year, with the first payment due at execution of the lease. The lease would provide that the lessor be responsible for maintenance during the lease. Going's tax rate is 25%, and his cost of borrowing is 8%. The following selected present value and future value factors for 8% are available: Present value of $1 for 5 periods .681 Present value of an ordinary annuity for 5 periods 3.993 Present value of an annuity due for 5 periods 4.312 Future value of $1 for 5 periods 1.469 Future value of an ordinary annuity for 5 periods 5.867 Future value of an annuity due for 5 periods 6.336 Which one of the following sets indicates the method Goings should use to acquire the vehicle (purchase or lease) and most closely approximates the absolute amount of the difference between the two alternatives? Better Alternative Difference between Alternatives A. Purchase $7,114 B. Purchase $127 C. Lease $1,870 D. Lease $433

C This answer is correct. Leasing is the better alternative by $1,870, correctly computed as follows: Purchase Alternative Description of Cash Flows PV factor PV of Cash Flows Purchase price = $18,000 1.000 −$18,000 (Outflow) Tax shield = $3,000/yr × .25 tax rate = $750/yr 3.993 + 2,995 (Savings) Maintenance cost = $500/yr 3.993 −1,997 (Outflow) Opportunity cost of savings $18,000 × .02 = $360/yr 3.993 −1,437 (Lost income) Present Value of Purchasing Alternative −$18,439 (Net outflow) Leasing Alternative Description of Cash Flows PV factor PV of Cash Flows Lease payments = $5,000/yr 4.312 −$21,560 (Outflow) Tax shield = $5,000/yr × .25 tax rate = $1,250 3.993 + 4,991 (Savings) Present Value of Leasing Alternative −$16,569 (Net outflow) Difference between Alternatives—Excess Cost of Purchasing over Leasing $1,870 (Correct)

A company had a choice between project X and project Y. The net present value of project X is $1,000,000, and the net present value of project Y is $750,000. The company chose project X. What is the opportunity cost of that decision?

CORRECT! As a result of selecting project X with a net present value of $1,000,000, the company gives up the opportunity to select project Y with a net present value of $750,000. Thus, $750,000 is the opportunity cost associated with selecting project X.

Which of the following alternative financing arrangements has the lowest effective annual percentage rate if each has a quoted nominal rate of 9.5%?

Calculation of the effective annual percentage rate incorporates compounding of interest. For a given quoted (stated) rate, the more frequent the compounding the higher the effective interest rate will be, regardless of the length of the loan (the effective annual percentage rate annualized the rate, so the length is not relevant). A loan compounded annually will have a lower effective percentage interest rate than a loan that is compounded semiannually, quarterly or monthly.

Which one of the following is the annual rate of interest applicable when not taking trade credit terms of "2/10, net 30?"

Credit terms of "2/10, net 30" mean that the debtor may take a 2% discount from the amount owed if payment is made within 10 days of the bill, otherwise the full amount is due within 30 days. The 2% discount is the interest rate for the period between the 10th day and the 30th day; it is not the effective annual rate of interest. The computation of the annual rate of interest using $1.00 would be: Interest 1 APR = _______ x ________________ Principal Time fraction of year .02 1 APR = ___ x ______ = .0204 x (360/20) = .98 20/360 APR = .0204 x 18 = 36.73% Thus, the effective annual interest rate for not taking the 2% (.02) discount is 36.73%. The 20 days in the 360/20 fraction is (30 - 10), the period of time over which the discount was lost as a result of not paying early.

income approach to the valuation of a business?

Earnings multiple. Free cash flow discounted CF The use of comparable sales is not an income approach to valuation of a business, it is a market approach. Under the comparable sales approach, the value of a business is determined by comparing it to other entities with comparable characteristics for which the value is more readily determinable.

Which one of the following sets of interest (or discount) rates will give the greater present value of $1.00 and greater future value of $1.00?

For present value, the higher the interest or discount rate, the lower the present value of a future amount. Since the higher the interest or discount rate, the more that is counted as interest, the less there is in present value. For future value, the higher the interest rate, the greater the future value of a present amount. Since future value is computed as principal plus compounded interest, the higher the interest rate, the greater the amount of interest earned each period and, therefore, the greater the accumulated future amount. Greater Present Value 8% Greater Future Value 10%

A company uses its company‐wide cost of capital to evaluate new capital investments. What is the implication of this policy when the company has multiple operating divisions, each having unique risk attributes and capital costs?

High‐risk divisions will over‐invest in new projects and low‐risk divisions will under‐invest in new projects. The use of a company‐wide cost of capital to evaluate new capital investments will result in high‐risk divisions over‐investing in new projects and low‐risk divisions under‐investing in new projects. Because the company has multiple operating divisions, each having unique risk attributes and related capital costs, the use of a company‐wide cost of capital to evaluate new capital investments applies a common, average hurdle rate to all projects, regardless of the risk or cost of capital of the particular division for which the capital investment is being considered. Thus, for example, a high‐risk division will use the company‐wide average cost of capital that will be less than the cost of capital appropriate for its risk and separate cost of capital. Similarly, a low‐risk division will use a cost of capital that is greater than the cost of capital appropriate for its risk and separate cost of capital.

Assume the following abbreviated Balance Sheet: Current Assets $100,000 Current Liabilities $ 30,000 Investments 25,000 Long-term Liabilities 75,000 Fixed Assets 75,000 Common Stock 70,000 _________ Retained Earnings 25,000 Total Assets $200,000 Total L + Equity $200,000 In a common-sized balance sheet, which one of the following percentages would be shown for current liabilities?

In a common-size balance sheet, each item is measured as a percentage of total assets (or total liabilities plus equity). Thus, the calculation would be: $30,000/$200,000 = 15.0%

Assume the following abbreviated Income Statement: Revenues $100,000 Cost of Goods Sold 60,000 Gross Profit $ 40,000 Operating Expenses 20,000 Finance Expense 5,000 Net Income $ 15,000 In a common-size income statement, which one of the following percentages would be shown for Finance Expense?

In a common-size income statement, each item is measures as a percentage of total revenues. Thus, the correct calculation is: $5,000/$100,000 = 5.00%.

Which one of the following is a form of inventory secured loan in which the inventory is placed under the control of an independent third party?

In a field warehouse agreement, the inventory that serves as security for a borrowing remains with the borrower, but is place under the control of an independent third party. (Also, in a terminal warehouse agreement, the inventory is moved to a public warehouse and placed under the control of an independent third party.)

to be the reason an entity would seek a valuation of the entity as a going concern?

In connection with developing a buy-sell agreement among the owners. In connection with developing a settlement with the estate of a recently deceased owner. In connection with a planned sale of the entity NOT - An entity would not seek to determine the value of an entity as a going concern in connection with a property tax determination. Valuation for property tax purposes would be concerned only with the value of the separate taxable assets of the entity, not with the value of the entity as a going concern.

Assume the following rates exist in the U.S.: Prime interest rate = 6% Fed discount rate = 4% U.S. Treasury Bond rate = 2% Inflation rate = 1% Which one of the following is most likely the nominal risk-free rate of return in the U.S.?

In the U.S., the rate paid on U.S. Treasury Bonds (2%) is considered the risk-free rate of return; that is, the rate of return that is paid for delayed use of funds by investing them, without any risk premium attached to or paid for default risk.

For the year ended December 31, 2004, Abel Co. incurred direct costs of $500,000 based on a particular course of action during the year. If a different course of action had been taken, direct costs would have been $400,000. In addition, Abel's 2004 fixed costs were $90,000. The incremental cost was

Incremental costs are those that are different between two or more alternatives under consideration. In this case, the incremental cost is the difference between the direct costs of taking one action ($400,000) versus another ($500,000). The $100,000 difference in cost is the only cost that differs between the two courses of action. The fixed costs are present regardless of which action is taken.

Banner Electronics has subsidiaries in several international locations and is concerned about its exposure to foreign exchange risk. In countries where currency values are likely to fall, Banner should encourage all of the following

Investing excess cash in inventory or other real assets. Purchasing materials and supplies on a trade credit basis. Borrowing local currency funds if an appropriate interest rate can be obtained. Banner would not encourage the granting of trade credit whenever possible if currency values are expected to fall. By doing so, Banner would recognize accounts receivable that will be collected with a currency that has less value than when the receivable was recognized.

An entity is examining potential investments and notes that 1-year maturity yields are higher than those for 10-year maturities. Which of the following explanations for this occurrence is best?

Investors are expecting reduced inflation in the future as reflected in the lower long-term returns. When investors expect reduced inflation in the future, a lower risk premium will be assessed on an investment (often called the "expectation theory"). The inflation risk premium compensates investors for the expected adverse effects of future inflation on the security. That premium is based on the expected average inflation rate over the life of the security. Therefore, an expected reduction in inflation in the future would be reflected in a lower long-term rate of return.

Bander Co. is determining how to finance some long-term projects. Bander has decided it prefers the benefits of no fixed charges, no fixed maturity date, and an increase in the credit-worthiness of the company. Which of the following would best meet Bander's financing requirements?

Issuing common stock to finance its projects would best meet Bander's financing strategy. Specifically, issuing common stock would (1) not result in fixed charges, since dividends are at the discretion of the Board of Directors, (2) not result in a fixed maturity date, since common stock does not mature, and (3) would likely increase the credit-worthiness of the company because the issuance of additional common stock would reduce its debt to equity ratio by increasing equity.

Black-Sholes Limits

It assumes the stock does not pay dividends. It assumes the risk-free rate of return used for discounting remains constant during the option period. It assumes the option can be exercised only at the expiration date. Failing to consider the probability that the option will be exercised is not a limitation of the basic Black-Sholes option pricing model. The basic Black-Scholes option pricing model does consider the probability (likelihood) that the option will be exercised.

Which of the following level(s) of input in the U.S. GAAP hierarchy of inputs for fair value determination is/are likely to be most appropriate for valuing basic agricultural commodities?

L1 Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Agricultural commodities of identical nature are widely traded in active commodities markets. The prices from those transactions would be the best measure of the value of identical agricultural commodities.

Which of the following levels of the U.S. GAAP hierarchy of inputs used for determining fair value can be based on inputs not directly observable for the item being valued?

L2 &3 Level 1 inputs in the U.S. GAAP hierarchy are based exclusively on observable quoted prices in active markets, not on unobservable inputs. Both level 2 and level 3 can include inputs not directly observable for the item being valued.

relevant when determining the risk premium on a specific security

Length of maturity Relative liquidity Relative seniority

Which of the following U.S. GAAP levels of inputs for valuation purposes is/are based on observable inputs?

Level 1 and level 2 inputs are based on observable inputs, but level 3 inputs are not based on observable inputs.

Quoted prices in which of the following types of markets could be level 2 inputs in determining fair value under the U.S. GAAP hierarchy of inputs for fair value determination?

Level 2 inputs in the U.S. GAAP hierarchy of inputs for fair value determination include quoted prices in active markets for similar (but not identical) assets or liabilities as well as quoted prices for identical or similar assets or liabilities in inactive markets.

The presence of risk for a portfolio of projects means:

More than one outcome is possible for any project. Risk is the possibility of loss or other unfavorable result that derives from the uncertainty implicit in future outcomes. In the context of a portfolio of projects, it is the uncertain outcome associated with any project.

Which one of the following options, A through D, is most likely to have the greatest value (all other things being equal)?

Option D is most likely to have the greatest value. The value of a stock option generally increases the longer the time to expiration, the higher the risk-free interest rate, and the higher the volatility of the stock. Of the options A through D, option D has the longest time to expiration, is in the highest risk-free interest rate environment, and the related stock has the highest beta.

An individual received an inheritance from a grandparent's estate. The money can be invested and the individual can either (a) receive a $20,000 lump‐sum amount at the end of 10 years or (b) receive $1,400 at the end of each year for the next 10 years. The individual wants a rate of return of 12% and uses the following information: Present value of $1 = 0.322 Present value of annuity of $1 = 5.650. What is the preferred investment option and what is its net present value?

Option b, $7,910. Option B, the present value of a $1,400 annual annuity for 10 years, provides the greater net present value, $7,910. That present value is computed as: $1,400 × 5.650 = $7,910. The present value of option A is $20,000 × .322 = $6,440, which is less than the present value of option B, $7,910.

Which of the following is assigned to goods that were either purchased or manufactured for resale?

Product cost is the cost assigned to goods that were either purchased or manufactured for resale. Product cost also is often referred to as "inventoriable cost."

A company has recently purchased some stock of a competitor as part of a long-term plan to acquire the competitor. However, it is somewhat concerned that the market price of this stock could decrease over the short run. The company could hedge against the possible decline in the stock's market price by

Purchasing a put option on the stock would hedge against the possible decline in the stock's market price. A put option would give the company the option to sell the stock at a specified price in the future. If the price of the stock declines, the value of the put option will increase by a like amount.

Strobel Company has a large amount of variable rate financing due in one year. Management is concerned about the possibility of increases in short‐term rates. Which one of the following would be an effective way of hedging this risk?

Selling Treasury notes futures contract would hedge the risk of increases in the short‐term interest rates. If the interest rates increase, the value of the Treasury notes contract will decline, which would enable the firm to acquire the notes at the new lower value and sell them at the higher futures contract price, resulting in a gain. The gain would serve to offset the effects of an increase in short‐term interest rates on the variable rate financing.

Whipco has determined that its pre-tax cost of preferred stock is 12%. If its tax rate is 30%, which one of the following is its after-tax cost of preferred stock?

Since dividends on preferred stock are not tax deductible, no adjustment to the pre-tax cost needs to be made. Therefore, the after-tax cost of preferred stock is the same as the pre-tax cost, 12%.

On January 23, Inco Company received from one of its suppliers a statement with terms of "2/10, n/30." Because the statement was misfiled, it was not located for payment until February 5. On which one of the following dates should the bill be paid?

Since the date for taking the discount has passed, there is no financial benefit from paying the statement until the final due date, February 22. Payment on that date would assure no penalty for late payment.

Which of the following statements concerning the leasing of an asset is/are correct? If the net present value of purchasing an asset is not positive, then leasing the asset should not be considered as an alternative. In a net-net lease, the lessee is responsible for executory costs and residual value of the leased asset.

Statement I is not correct. If the net present value of purchasing an asset is not positive, which shows that it is not economically feasible to purchase the asset and earn a positive return, it still may be economically feasible to lease the asset. In fact, in the final analysis, the basic reason for leasing, rather than buying, is that leasing an asset costs less than purchasing it. Therefore, while the cost of purchasing an asset may result in a negative net present value, the cost savings associated with leasing the asset may be such that leasing the asset is economically feasible. Statement II is correct. In a net-net lease agreement, the lessee assumes responsibility for both executory costs (i.e., insurance, taxes, maintenance, etc.) of the asset and for the asset having a preestablished residual value at the end of the lease

Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days: Value of receivables to be held in reserve for contingencies 10% Following costs are deducted at time accounts are factored: Interest rate on amounts provided 12% Factor fee on total receivables factored 2% If Nexco factors $200,000 of its accounts receivable due in 30 days with Factorco and, during that 30 days, $10,000 of those accounts receivable are reversed because the related goods were return or allowances were granted, which one of the following is the amount that Nexco will receive from Factorco at the end of the 30 day period?

The amount held in reserve was .10 x $200,000, or $20,000. During the 30-day period of the factor agreement, $10,000 of the accounts receivable factored had to be reversed because of sales returns and allowances. Therefore, at the end of the 30-day period, Factorco would pay Nexco the remaining $10,000 ($20,000 reserve - $10,000 reversed = $10,000).

Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days: Value of receivables to be held in reserve for contingencies 10% Following costs are deducted at time accounts are factored: Interest rate on amounts provided before deducting interest (annual rate) 12% Factor fee on total receivables factored 2% If Nexco plans to factor $200,000 of accounts receivable due in 30 days, which one of the following is the amount it will receive from Factorco at the time the accounts are factored?

The amount provided would be $200,000 accounts receivable - $20,000 reserve - $4,000 factor fee = $176,000, for which interest would be charged for 30 days, or 1% (i.e., 1/12 of 12%). Therefore, the correct amount received would be $176,000 - ($176,000 x .01) = $176,000 - $1,760 = $174,240.

Alpha Company borrowed $20,000 from High Bank, giving a one-year note. The terms of the note provided for 6% interest and required a 10% compensating balance. Which one of the following is the effective rate of interest on the loan?

The effective rate of interest on the loan is 6.7% and is computed as the net proceeds from the loan divided into the cost of the loan. The cost of the loan is $1,200 ($20,000 x .06 = $1,200) and the net proceeds is $18,000 ($20,000 - [.10 x $20,000] = $18,000; the remaining $2,000 must be maintained as a compensating balance. Thus, the effective interest is: $1,200/$18,000 = 6.666%.

major approach for assigning a value to an entire going business?

The market approach, the income approach and the asset approach are the major approaches to assigning value to an entire going business.

The ABC Company is trying to decide between keeping an existing machine and replacing it with a new machine. The old machine was purchased just two years ago for $50,000 and had an expected life of 10 years. It now costs $1,000 a month for maintenance and repairs, due to a mechanical problem. A new replacement machine is being considered, with a cost of $60,000. The new machine is more efficient and it will only cost $200 a month for maintenance and repairs. The new machine has an expected life of 10 years. In deciding to replace the old machine, which of the following factors, ignoring income taxes, should ABC not consider?

The original cost of the old machine should not be considered in deciding whether or not to replace it with a new machine. The original cost of the old machine is a sunk cost, i.e., a cost that has been incurred in the past, cannot be changed by current decisions, and is irrelevant to making current and future replacement decisions.

Which one of the following methods of evaluating investment projects is most likely to be least acceptable for making project ranking decisions?

The payback period method is least likely to be used for ranking projects because of its serious shortcomings, including its failure to use discounted amounts and the fact that it is only concerned with the period required to recover the initial investment, not with the entire life of a project.

element in the capital asset pricing model formula?

The prime interest rate is not an element in the capital asset pricing model formula. The elements used in the formula include the risk-free rate of return, beta (a measure of volatility for the asset being valued) and the expected rate of return for the entire class of the asset being valued.

Management at MDK Corp. is deciding whether to replace a delivery van. A new delivery van costing $40,000 can be purchased to replace the existing delivery van, which cost the company $30,000 and has accumulated depreciation of $20,000. An employee of MDK has offered $12,000 for the old delivery van. Ignoring income taxes, which of the following correctly states relevant costs when making the decision whether to replace the delivery vehicle?

The purchase price of the new van and disposal price of the old van are the (only) relevant costs in making the decision whether to replace the delivery van. The other factors given in the facts are not relevant. The purchase price of the old van and related depreciation are sunk costs and the gain that would be recognized on the sale of the van ($12,000 ‐ $10,000 = $2,000) would be incorporated in the disposal price (selling price) of the old van.

As the perceived risk of an undertaking increases, what would be the expected effect on the risk‐free rate of return and the risk premium rate of return?

The risk‐free rate is the reward expected for deferring current consumption and does not change as the perceived risk of an undertaking increases (or decreases). Therefore, no change would be expected in the risk‐free rate. An increase in the risk premium would be expected as a result of an increase in perceived risk; it is the "reward" for risk. Thus, the greater the risk, the greater the expected reward (or risk premium).

Alpha Corporation has the following capital structure and related cost of capital for each source: Capital Component Amount Percent of Total Cost of Capital Bonds Payable $300,000 30% 8% Preferred Stock 100,000 10% 10% Common Stock 600,000 60% 12% Totals $1,000,000 100% Which one of the following is Alpha's weighted average cost of capital?

The weighted average cost of capital (sometimes called weighted cost of capital) is equal to the cost of each source of capital multiplied by the percentage of the total capital provided by each source. For the above facts, the calculation would be: Capital Component Percent of Total x Cost of Capital Weighted Cost Bonds Payable .30 x .08 2.4% Preferred Stock .10 x .10 1.0% Common Stock .60 x .12 7.2% Totals 1.00 10.6% Thus, the weighted average cost of capital is 10.6%, and generally is used as the hurdle rate of return (or discount rate) in evaluating capital projects.

A company with a combined federal and state tax rate of 30% has the following capital structure: Weight Instrument Cost of capital 40% Bonds 10% 50% Common stock 10% 10% Preferred stock 20% What is the weighted‐average after‐tax cost of capital for this company?

This correct answer properly assumes a 30% tax savings on the bonds and no tax savings on the common or preferred stock. Thus, the correct answer is: Bonds .40 x .10 = .04 x .70 = 2.8% C/S .50 x .10 = .05 = 5.0% P/S .10 x .20 = .02 = 2.0% Weighted Average 9.8%

What would be the primary reason for a company to agree to a debt covenant on new bonds limiting the percentage of the company's long-term debt?

To reduce the interest rate on the bonds being sold. You Answered Correctly! The primary reason a company would agree to a debt covenant limiting the percentage of its long-term debt would be to reduce the interest rate on the bonds being sold. A debt covenant limiting the percentage of its long-term debt would give the bondholders greater certainty of repayment and, thus, reduce the risk associated with the new bond issue. The reduced risk would lower the interest rate demanded by investors.

What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?

To reduce the interest rate on the debt being issued. You Answered Correctly! The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt would be to reduce the risk, and therefore the interest rate, on debt being issued. Debt covenants place contractual limitations on activities of the borrower to help protect the lender. As such, they reduce the default risk associated with a debt issue and, therefore, reduce the interest rate on that debt.

Po Co. plans to use its inventory as collateral for a short-term loan. Which one of the following types of loan agreements with its lender would provide Po Co. the most flexibility in the use of the inventory it pledges as collateral?

Under a floating lien agreement the borrower gives the lender a lien against its inventory, but retains control of the inventory and can continuously sell and replace the inventory.

Under which of the following described lease terms would the lessee be responsible during the term of the lease for executory costs associated with the leased asset?

Under a net lease, the lessee assumes the executory costs associated with the asset during the lease, including such elements as maintenance, taxes and insurance. In a net-net lease, the lessee assumes responsibility for the executory costs during the life of the lease, as well as for a residual value at the end of the lease.

The land and building that constitute a strip shopping mall were valued using the recent sales price of a comparable strip shopping mall located across the street. The method of valuation would be an example of the

Using the recent sales price of a comparable asset as a basis for valuing another asset is an example of the market approach to business valuation. The market approach values a business by comparing it to other entities with highly comparable characteristics for which the value is readily determinable. For example, the value of a publicly traded entity with a readily determinable value may be used as the basis for establishing the value of a highly comparable private entity.

Which of the following statements, if any, concerning the valuation of business enterprises is/are correct? I. Nonpublic entities are likely to be more difficult to value than publicly traded entities. II. The conditions in the macroeconomic environment should be considered in valuing an entity. III. The status of the industry in which a business operates should be considered in valuing the entity.

all All three statements are correct. Nonpublic entities are likely to be more difficult to value than publicly traded entities (Statement I), the conditions in the macroeconomic environment should be considered in valuing an entity (Statement II) and the status of the industry should be considered in valuing an entity (Statement III).

Which one of the following beta values indicates the least volatility?

beta = .5 A beta of .5 indicates that the item to which it relates is one-half as volatile as the benchmark for all comparable items. A beta of .5 is less volatile than any higher beta. lowest

Buff Co. is considering replacing an old machine with a new machine. Which of the following items is economically relevant to Buff's decision? (Ignore income tax considerations.)

disposal value of new machine The carrying amount of the old machine is a sunk cost; the cost of that machine has already been incurred and is not economically relevant to Buff's decision whether or not to replace the old machine with a new one. Buff's decision should not be affected by the historical (sunk) cost of the old machine. The disposal value of the new machine (appropriately discounted) is relevant to Buff's decision whether or not to replace the old machine with the new machine. Specifically, the disposal value of the new machine (at the end of its useful life) is an element that enters into the determination of the net cost of the new machine, and it is an element that will not occur if the new machine is not acquired.

Assuming they are traded in an active market, which of the following types of investments, if any, could be valued using level 1 inputs of the U.S. GAAP hierarchy of inputs for determining fair value?

equity and debt securities Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Either equity securities or debt securities that are traded in an active market could be valued using the prices established in those markets.

Egan Co. owns land that could be developed in the future. Egan estimates it can sell the land for $1,200,000, net of all selling costs. If it is not sold, Egan will continue with its plans to develop the land. As Egan evaluates it options for development or sale of the property, what type of cost would the potential selling price represent in Egan's decision?

opportunity Egan's potential selling price of the land is its opportunity cost when deciding whether to develop or sell the land. Opportunity cost is the benefit lost from an opportunity (selling the land) as a result of choosing another opportunity (developing the land).