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# Financial Management Theory and Practice 12th Edition By Eugene F. Brigham – Test Bank

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Financial Management Theory and Practice 12th Edition By Eugene F. Brigham – Test Bank

Sample Questions

CHAPTER 2

TIME VALUE OF MONEY

True/False

Easy:

 (2.2) Compounding Answer: a EASY [i]. One potential benefit from starting to invest early for retirement is that the investor can expect greater benefits from the compounding of interest. a. True b. False (2.3) PV versus FV Answer: b EASY [ii]. If the discount (or interest) rate is positive, the present value of an expected series of payments will always exceed the future value of the same series. a. True b. False (2.3) PV versus FV Answer: a EASY [iii]. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value. a. True b. False (2.15) Effective annual rate Answer: b EASY [iv]. If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate. a. True b. False (2.17) Amortization Answer: a EASY [v]. The payment made each period on an amortized loan is constant, and it consists of some interest and some principal.  The closer we are to the end of the loan’s life, the greater the percentage of the payment that will be a repayment of principal. a. True b. False

[i].    (2.2) Compounding                                        Answer: a  EASY

[ii].   (2.3) PV versus FV                                       Answer: b  EASY

[iii].  (2.3) PV versus FV                                       Answer: a  EASY

[iv].   (2.15) Effective annual rate                             Answer: b  EASY

[v].    (2.17) Amortization                                      Answer: a  EASY

CHAPTER 4

ANALYSIS OF FINANCIAL STATEMENTS

True/False

Easy:

 We tell our students (1) that to answer some of these questions it is useful to write out the relevant ratio or ratios, then think about how the ratios would change if the accounting data changed, and (2) that sometimes it is useful to make up illustrative data to help see what would happen. (4.1) Ratio analysis Answer: a EASY [1]. Ratio analysis involves analyzing financial statements in order to appraise a firm’s financial position and strength. a. True b. False (4.2) Liquidity ratios Answer: a EASY [2]. The current ratio and inventory turnover ratios both help us measure the firm’s liquidity.  The current ratio measures the relationship of a firm’s current assets to its current liabilities, while the inventory turnover ratio gives us an indication of how long it takes the firm to convert its inventory into cash. a. True b. False (4.2) Liquidity ratios Answer: a EASY [3]. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easy-to-use measures of a firm’s liquidity position. a. True b. False (4.2) Current ratio Answer: b EASY [4]. High current and quick ratios always indicate that a firm is managing its liquidity position well. a. True b. False

 (4.3) Asset management ratios Answer: a EASY [5]. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its assets. a. True b. False (4.3) Inventory turnover ratio Answer: b EASY [6]. A decline in a firm’s inventory turnover ratio suggests that it is managing its inventory more efficiently and also that its liquidity position is improving, i.e., it is becoming more liquid. a. True b. False (4.4) Debt management ratios Answer: a EASY [7]. Debt management ratios show the extent to which a firm’s managers are attempting to magnify returns on owners’ capital through the use of financial leverage. a. True b. False (4.4) TIE ratio Answer: a EASY [8]. The times-interest-earned ratio is one, but not the only, indication of a firm’s ability to meet its long-term and short-term debt obligations. a. True b. False (4.5) Profitability ratios Answer: a EASY [9]. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results. a. True b. False (4.6) Market value ratios Answer: a EASY [10]. Market value ratios provide management with an indication of how investors view the firm’s past performance and especially its future prospects. a. True b. False

 (4.7) Trend analysis Answer: a EASY [11]. Determining whether a firm’s financial position is improving or deteriorating requires analyzing more than the ratios for a given year.  Trend analysis is one method of measuring changes in a firm’s performance over time. a. True b. False (4.10) Balance sheet changes Answer: a EASY [12]. The “apparent,” but not the “true,” financial position of a company whose sales are seasonal can differ dramatically, depending on the time of year when the financial statements are constructed. a. True b. False (4.10) Limitations of ratio analysis Answer: a EASY [13]. Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods. a. True b. False

Easy/Medium:

 (4.5) Basic earning power ratio Answer: b EASY/MEDIUM [14]. The basic earning power ratio (BEP) reflects the earning power of a firm’s assets after giving consideration to financial leverage and tax effects. a. True b. False

Medium:

 (4.3) Inventory turnover ratio Answer: a MEDIUM [15]. The inventory turnover and current ratio are related.  The combination of a high current ratio and a low inventory turnover ratio, relative to industry norms, suggests that the firm has an above-average inventory level and/or that part of the inventory is obsolete or damaged. a. True b. False

 (4.3) Fixed assets turnover Answer: b MEDIUM [16]. It is appropriate to use the fixed assets turnover ratio to appraise firms’ effectiveness in managing their fixed assets if and only if all the firms being compared have the same proportion of fixed assets to total assets. a. True b. False (4.5) ROA Answer: b MEDIUM [17]. Since the ROA measures the firm’s effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA. a. True b. False (4.5) Profit margin and leverage Answer: b MEDIUM [18]. Other things held constant, a decline in sales and a simultaneous increase in financial leverage must result in a lower profit margin. a. True b. False (4.8) Du Pont equation Answer: b MEDIUM [19]. Suppose firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets.  Under these conditions, then firms that have high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios. a. True b. False

Hard:

 (4.2) Liquidity ratios Answer: b HARD [20]. Even though Firm A’s current ratio exceeds that of Firm B, Firm B’s quick ratio might exceed that of A.  However, if A’s quick ratio exceeds B’s, then we can be certain that A’s current ratio is also larger than that of B. a. True b. False

 (4.2) Liquidity ratios Answer: b HARD [21]. Firms A and B have the same current ratio, 0.75, the same amount of sales, and the same amount of current liabilities.  However, Firm A has a higher inventory turnover ratio than B.  Therefore, we can conclude that A’s quick ratio must be smaller than B’s. a. True b. False (4.4) TIE ratio Answer: a HARD [22]. Suppose a firm wants to maintain a specific TIE ratio.  It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs.  With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio. a. True b. False (4.5) BEP and ROE Answer: a HARD [23]. Suppose Firms A and B have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate.  However, Firm A has a higher debt ratio.  If BEP is greater than the interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio. a. True b. False (4.8) Equity multiplier Answer: a HARD [24]. If a firm finances with only debt and common equity, and if its equity multiplier is 3.0, then its debt ratio must be 0.667. a. True b. False (4.10) Limitations of ratio analysis Answer: b HARD [25]. One problem with ratio analysis is that relationships can be manipulated.  For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to increase. a. True b. False

 (4.10) Limitations of ratio analysis Answer: b HARD [26]. One problem with ratio analysis is that relationships can be manipulated.  For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and thus make the firm look stronger. a. True b. False

Multiple Choice:  Conceptual

Easy:

 We tell our students (1) that to answer some of these questions it is useful to write out the relevant ratio or ratios, then think about how the ratios would change if the accounting data changed, and (2) that sometimes it is useful to make up illustrative data to help see what would happen. (4.2) Current ratio Answer: d EASY [27]. Considered alone, which of the following would increase a company’s current ratio? a. An increase in net fixed assets. b. An increase in accrued liabilities. c. An increase in notes payable. d. An increase in accounts receivable. e. An increase in accounts payable. (4.2) Current ratio Answer: c EASY [28]. Which of the following would, generally, indicate an improvement in a company’s financial position, holding other things constant? a. The TIE declines. b. The DSO increases. c. The EBITDA coverage ratio increases. d. The current and quick ratios both decline. e. The total assets turnover decreases. (4.2) Current ratio Answer: d EASY [29]. A firm wants to strengthen its financial position.  Which of the following actions would increase its current ratio? a. Reduce the company’s days’ sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. b. Use cash to repurchase some of the company’s own stock. c. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year. d. Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash. e. Use cash to increase inventory holdings. (4.3) Inventories Answer: c EASY [30]. Which of the following statements is CORRECT? a. A reduction in inventories held would have no effect on the current ratio. b. An increase in inventories would have no effect on the current ratio. c. If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase. d. A reduction in the inventory turnover ratio will generally lead to an increase in the ROE. e. If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will decrease. (4.6) Financial statement analysis Answer: e EASY [31]. Companies E and P each reported the same earnings per share (EPS), but Company E’s stock trades at a higher price. Which of the following statements is CORRECT? a. Company E probably has fewer growth opportunities. b. Company E is probably judged by investors to be riskier. c. Company E must have a higher market-to-book ratio. d. Company E must pay a lower dividend. e. Company E trades at a higher P/E ratio. (4.6) Market value ratios Answer: d EASY [32]. Which of the following statements is CORRECT? a. If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. b. If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. c. Other things held constant, the higher a firm’s expected future growth rate, the lower its P/E ratio is likely to be. d. The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA). e. If a firm has a history of high Economic Value Added (EVA) numbers each year, and if investors expect this situation to continue, then its market/book ratio and MVA are both likely to be below average.

 (4.10) Window dressing Answer: b EASY [33]. Which of the following statements is CORRECT? a. Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt is an example of “window dressing.” Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is another example of “window dressing.” b. Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of “window dressing.” c. Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is an example of “window dressing.” d. Using some of the firm’s cash to reduce long-term debt is an example of “window dressing.” e. “Window dressing” is any action that improves a firm’s fundamental, long-run position and thus increases its intrinsic value. (Comp: 4.2,4.4-4.6) Miscellaneous ratios Answer: a EASY [34]. Casey Communications recently issued new common stock and used the proceeds to pay off some of its short-term notes payable.  This action had no effect on the company’s total assets or operating income.  Which of the following effects would occur as a result of this action? a. The company’s current ratio increased. b. The company’s times interest earned ratio decreased. c. The company’s basic earning power ratio increased. d. The company’s equity multiplier increased. e. The company’s debt ratio increased. (Comp: 4.2,4.3,4.5) Miscellaneous ratios Answer: b EASY [35]. A firm’s new president wants to strengthen the company’s financial position.  Which of the following actions would make it financially stronger? a. Increase accounts receivable while holding sales constant. b. Increase EBIT while holding sales constant. c. Increase accounts payable while holding sales constant. d. Increase notes payable while holding sales constant. e. Increase inventories while holding sales constant.

 (Comp: 4.3-4.5) Miscellaneous ratios Answer: a EASY [36]. If the CEO of a large, diversified, firm were filling out a fitness report on a division manager (i.e., “grading” the manager), which of the following situations would be likely to cause the manager to receive a better grade?  In all cases, assume that other things are held constant. a. The division’s basic earning power ratio is above the average of other firms in its industry. b. The division’s total assets turnover ratio is below the average for other firms in its industry. c. The division’s debt ratio is above the average for other firms in the industry. d. The division’s inventory turnover is 6, whereas the average for its competitors is 8. e. The division’s DSO (days’ sales outstanding) is 40, whereas the average for its competitors is 30. (Comp: 4.2-4.5) Miscellaneous ratios Answer: e EASY [37]. Which of the following would indicate an improvement in a company’s financial position, holding other things constant? a. The inventory and total assets turnover ratios both decline. b. The debt ratio increases. c. The profit margin declines. d. The EBITDA coverage ratio declines. e. The current and quick ratios both increase. (Comp: 4.2,4.4) Miscellaneous ratios Answer: c EASY [38]. If a bank loan officer were considering a company’s request for a loan, which of the following statements would you consider to be CORRECT? a. The lower the company’s EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm. b. Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm. c. Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm. d. The lower the company’s TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm. e. Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm.

 (Comp: 4.4,4.5,4.8) Effects of leverage Answer: b EASY [39]. Which of the following statements is CORRECT? a. The use of debt financing will tend to lower the basic earning power ratio, other things held constant. b. A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure. c. If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE. d. Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favorable basis than income from stock. e. All else equal, increasing the debt ratio will increase the ROA.

Easy/Medium:

 (4.2) Quick ratio Answer: a EASY/MEDIUM [40]. A firm wants to strengthen its financial position.  Which of the following actions would increase its quick ratio? a. Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2)lead to an increase in accounts receivable. b. Issue new common stock and use the proceeds to increase inventories. c. Speed up the collection of receivables and use the cash generated to increase inventories. d. Use some of its cash to purchase additional inventories. e. Issue new common stock and use the proceeds to acquire additional fixed assets.

Medium:

 (4.2) Current ratio Answer: b MEDIUM [41]. Amram Company’s current ratio is 1.9.  Considered alone, which of the following actions would reduce the company’s current ratio? a. Borrow using short-term notes payable and use the proceeds to reduce accruals. b. Borrow using short-term notes payable and use the proceeds to reduce long-term debt. c. Use cash to reduce accruals. d. Use cash to reduce short-term notes payable. e. Use cash to reduce accounts payable.

 (4.3) Accounts receivable Answer: e MEDIUM [42]. Which of the following statements is CORRECT? a. If a security analyst saw that a firm’s days’ sales outstanding (DSO) was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength. b. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days’ sales outstanding (DSO) will increase. c. There is no relationship between the days’ sales outstanding (DSO) and the average collection period (ACP).  These ratios measure entirely different things. d. A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio. e. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days’ sales outstanding will decline. (4.4) Leverage effects; debt management Answer: c MEDIUM [43]. Which of the following statements is CORRECT? a. If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses. b. A firm’s use of debt will have no effect on its profit margin on sales. c. If two firms differ only in their use of debt—i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates—but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales. d. The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable. e. If two firms differ only in their use of debt—i.e., they have identical assets, sales, operating costs, and tax rates—but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales.

 (4.6) Market value ratios Answer: b MEDIUM [44]. Which of the following statements is CORRECT? a. If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be the same. b. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same. c. If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same price earnings ratio. d. If Firm X’s P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and also to be expected to grow at a faster rate. e. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their market-to-book ratios must also be the same. (4.8) Du Pont analysis Answer: a MEDIUM [45]. Which of the following statements is CORRECT? a. Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%.  Under these conditions, the ROE will increase. b. Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%.  Without additional information, we cannot tell what will happen to the ROE. c. The modified Du Pont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE. d. Other things held constant, an increase in the debt ratio will result in an increase in the profit margin on sales. e. Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10%, and its debt increases from 40% of total assets to 60%.  Under these conditions, the ROE will decrease. (4.8) Du Pont analysis Answer: a MEDIUM [46]. You observe that a firm’s ROE is above the industry average, but its profit margin and debt ratio are both below the industry average.  Which of the following statements is CORRECT? a. Its total assets turnover must be above the industry average. b. Its return on assets must equal the industry average. c. Its TIE ratio must be below the industry average. d. Its total assets turnover must be below the industry average. e. Its total assets turnover must equal the industry average.

 (4.8) Du Pont analysis Answer: d MEDIUM [47]. Companies HD and LD are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company HD has the higher debt ratio.  Which of the following statements is CORRECT? a. Company HD has a lower total assets turnover than Company LD. b. Company HD has a lower equity multiplier than Company LD. c. Company HD has a higher fixed assets turnover than Company B. d. Company HD has a higher ROE than Company LD. e. Company HD has a lower operating income (EBIT) than Company LD. (Comp: 4.4,4.5) Financial statement analysis Answer: c MEDIUM [48]. Taggart Technologies is considering issuing new common stock and using the proceeds to reduce its outstanding debt.  The stock issue would have no effect on total assets, the interest rate Taggart pays, EBIT, or the tax rate.  Which of the following is likely to occur if the company goes ahead with the stock issue? a. The ROA will decline. b. Taxable income will decrease. c. The tax bill will increase. d. Net income will decrease. e. The times interest earned ratio will decrease. (Comp: 4.3-4.5) Financial statement analysis Answer: e MEDIUM [49]. Which of the following statements is CORRECT? a. The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either the DSO or the inventory turnover ratio. b. If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE. c. An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio. d. An increase in the DSO, other things held constant, could be expected to increase the ROE. e. An increase in a firm’s debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin.

 (Comp: 4.4,4.5,4.8) Financial statement analysis Answer: d MEDIUM [50]. HD Corp. and LD Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT.  However, HD uses more debt than LD.  Which of the following statements is CORRECT? a. Without more information, we cannot tell if HD or LD would have a higher or lower net income. b. HD would have the lower equity multiplier for use in the Du Pont equation. c. HD would have to pay more in income taxes. d. HD would have the lower net income as shown on the income statement. e. HD would have the higher net income as shown on the income statement. (Comp: 4.2,4.3) Cash flows Answer: c MEDIUM [51]. Other things held constant, which of the following alternatives would increase a company’s cash flow for the current year? a. Increase the number of years over which fixed assets are depreciated for tax purposes. b. Pay down the accounts payables. c. Reduce the days’ sales outstanding (DSO) without affecting sales or operating costs. d. Pay workers more frequently to decrease the accrued wages balance. e. Reduce the inventory turnover ratio without affecting sales or operating costs. (Comp: 4.4,4.5,4.8) Leverage, taxes, and ratios Answer: a MEDIUM [52]. Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power.  Both companies have positive net incomes.  Company HD has a higher debt ratio and, therefore, a higher interest expense.  Which of the following statements is CORRECT? a. Company HD pays less in taxes. b. Company HD has a lower equity multiplier. c. Company HD has a higher ROA. d. Company HD has a higher times interest earned (TIE) ratio. e. Company HD has more net income. (Comp: 4.4,4.5,4.8) Leverage, taxes, and ratios Answer: e MEDIUM [53]. Companies HD and LD have the same tax rate, sales, total assets, and basic earning power.  Both companies have positive net incomes.  Company HD has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Company HD has a lower equity multiplier. b. Company HD has more net income. c. Company HD pays more in taxes. d. Company HD has a lower ROE. e. Company HD has a lower times interest earned (TIE) ratio.

Medium/Hard:

 (4.2) Current ratio Answer: a MEDIUM/HARD [54]. Walter Industries’ current ratio is 0.5.  Considered alone, which of the following actions would increase the company’s current ratio? a. Borrow using short-term notes payable and use the cash to increase inventories. b. Use cash to reduce accruals. c. Use cash to reduce accounts payable. d. Use cash to reduce short-term notes payable. e. Use cash to reduce long-term bonds outstanding. (4.2) Current ratio Answer: b MEDIUM/HARD [55]. Safeco’s current assets total to \$20 million versus \$10 million of current liabilities, while Risco’s current assets are \$10 million versus \$20 million of current liabilities.  Both firms would like to “window dress” their end-of-year financial statements, and to do so they tentatively plan to borrow \$10 million on a short-term basis and to then hold the borrowed funds in their cash accounts.  Which of the statements below best describes the results of these transactions? a. The transactions would raise Safeco’s financial strength as measured by its current ratio but lower Risco’s current ratio. b. The transactions would lower Safeco’s financial strength as measured by its current ratio but raise Risco’s current ratio. c. The transaction would have no effect on the firm’ financial strength as measured by their current ratios. d. The transaction would lower both firm’ financial strength as measured by their current ratios. e. The transaction would improve both firms’ financial strength as measured by their current ratios. (Comp: 4.4,4.5) Effects of financial leverage Answer: e MEDIUM/HARD [56]. Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt.  However, company HD has a higher debt ratio. Which of the following statements is CORRECT? a. Given this information, LD must have the higher ROE. b. Company LD has a higher basic earning power ratio (BEP). c. Company HD has a higher basic earning power ratio (BEP). d. If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company HD will have the higher ROE. e. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company HD will have the higher ROE.

Multiple Choice:  Problems

 A good bit of relatively simple arithmetic is involved in some of these problems, and although the calculations are simple, it will take students time to set up the problems and do the arithmetic.  We allow for this when assigning problems for a timed test.  Also, note that students must know the definitions of a number of ratios to answer the questions.  We provide our students with a formula sheet on exams, using the relevant sections of Appendix D at the end of the text. The difficulty of the problems depends on (1) whether or not students are provided with a formula sheet and (2) the amount of time they have to work the problems.  Our difficulty assessments assume that they have a formula sheet and a “reasonable” amount of time for the test.  Note that some problems are trivially easy if students have formula sheets. To work some of the problems, students must transpose equations and solve for items that are normally inputs.  For example, the equation for the profit margin is given as Profit margin = Net income/Sales.  We might have a problem where sales and the profit margin are given and then require students to find the firm’s net income.  We explain to students in class before the exam that they will have to transpose terms in the formulas to work some problems. Problems 57 to 86 are all stand-alone problems with individualized data, but problems 87 through 105 are all based on a common set of data, and they require students to calculate ratios and find items like EPS, TIE, and the like using this data set.  The statements can be changed algorithmically, and this changes the calculated ratios and other items.

Easy:

 (4.3) Total assets turnover Answer: d EASY [lvii]. Arshadi Corp.’s sales last year were \$52,000, and its total assets were \$22,000.  What was its total assets turnover ratio (TATO)? a. 2.03 b. 2.13 c. 2.25 d. 2.36 e. 2.48 (4.4) Debt ratio: find the debt, given the D/A ratio Answer: b EASY [lviii]. Beranek Corp. has \$410,000 of assets, and it uses no debt–it is financed only with common equity.  The new CFO wants to employ enough debt to bring the debt/assets ratio to 40%, using the proceeds from the borrowing to buy back common stock at its book value.  How much must the firm borrow to achieve the target debt ratio? a. \$155,800 b. \$164,000 c. \$172,200 d. \$180,810 e. \$189,851 (4.4) Times interest earned Answer: e EASY [lix]. Orono Corp.’s sales last year were \$435,000, its operating costs were \$362,500, and its interest charges were \$12,500.  What was the firm’s times interest earned (TIE) ratio? a. 4.72 b. 4.97 c. 5.23 d. 5.51 e. 5.80 (4.5) Profit margin on sales Answer: c EASY [lx]. Rappaport Corp.’s sales last year were \$320,000, and its net income after taxes was \$23,000.  What was its profit margin on sales? a. 6.49% b. 6.83% c. 7.19% d. 7.55% e. 7.92% (4.5) Return on total assets (ROA) Answer: a EASY [lxi]. Branch Corp.’s total assets at the end of last year were \$315,000 and its net income after taxes was \$22,750.  What was its return on total assets? a. 7.22% b. 7.58% c. 7.96% d. 8.36% e. 8.78% (4.5) Basic earning power (BEP) Answer: c EASY [lxii]. Chambliss Corp.’s total assets at the end of last year were \$305,000 and its EBIT was 62,500.  What was its basic earning power (BEP)? a. 18.49% b. 19.47% c. 20.49% d. 21.52% e. 22.59% (4.5) Return on equity (ROE) Answer: d EASY [lxiii]. Nikko Corp.’s total common equity at the end of last year was \$305,000 and its net income after taxes was \$60,000.  What was its ROE? a. 16.87% b. 17.75% c. 18.69% d. 19.67% e. 20.66%

 (4.5) Return on equity (ROE): finding net income Answer: e EASY [lxiv]. An investor is considering starting a new business.  The company would require \$475,000 of assets, and it would be financed entirely with common stock.  The investor will go forward only if she thinks the firm can provide a 13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%.  How much net income must be expected to warrant starting the business? a. \$52,230 b. \$54,979 c. \$57,873 d. \$60,919 e. \$64,125 (4.6) Price/Earnings ratio (P/E) Answer: b EASY [lxv]. Vang Corp.’s stock price at the end of last year was \$33.50 and its earnings per share for the year were \$2.30.  What was its P/E ratio? a. 13.84 b. 14.57 c. 15.29 d. 16.06 e. 16.86 (4.6) Price/Earnings ratio (P/E) Answer: a EASY [lxvi]. Lindley Corp.’s stock price at the end of last year was \$33.50, and its book value per share was \$25.00.  What was its market/book ratio? a. 1.34 b. 1.41 c. 1.48 d. 1.55 e. 1.63 (4.8) Du Pont equation: basic calculation Answer: c EASY [lxvii]. Northwest Lumber had a profit margin of 5.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8.  What was the firm’s ROE? a. 12.79% b. 13.47% c. 14.18% d. 14.88% e. 15.63%

Easy/Medium:

 (4.4) Debt ratio Answer: a EASY/MEDIUM [lxviii]. Pace Corp.’s assets are \$625,000, and its total debt outstanding is \$185,000.  The new CFO wants to employ a debt ratio of 55%.  How much debt must the company add or subtract to achieve the target debt ratio? a. \$158,750 b. \$166,688 c. \$175,022 d. \$183,773 e. \$192,962 (4.6) EPS, DPS, and payout Answer: d EASY/MEDIUM [lxix]. Helmuth Inc.’s latest net income was \$1,250,000, and it had 225,000 shares outstanding.  The company wants to pay out 45% of its income.  What dividend per share should it declare? a. \$2.14 b. \$2.26 c. \$2.38 d. \$2.50 e. \$2.63

Medium:

 (4.3) Effect of lowering the DSO on net income Answer: e MEDIUM [lxx]. Aziz Industries has sales of \$100,000 and accounts receivable of \$11,500, and it gives its customers 30 days to pay.  The industry average DSO is 27 days, based on a 365-day year.  If the company changes its credit and collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any cash freed-up by this change, how would that affect its net income, assuming other things are held constant? a. \$267.34 b. \$281.41 c. \$296.22 d. \$311.81 e. \$328.22

[1].    (4.1) Ratio analysis                                     Answer: a  EASY

[2].    (4.2) Liquidity ratios                                   Answer: a  EASY

[3].    (4.2) Liquidity ratios                                   Answer: a  EASY

[4].    (4.2) Current ratio                                      Answer: b  EASY

[5].    (4.3) Asset management ratios                            Answer: a  EASY

[6].    (4.3) Inventory turnover ratio                           Answer: b  EASY

[7].    (4.4) Debt management ratios                             Answer: a  EASY

[8].    (4.4) TIE ratio                                          Answer: a  EASY

[9].    (4.5) Profitability ratios                               Answer: a  EASY

[10].   (4.6) Market value ratios                                Answer: a  EASY

[11].   (4.7) Trend analysis                                     Answer: a  EASY

[12].   (4.10) Balance sheet changes                             Answer: a  EASY

Many of the ratios show sales over some past period such as the last 12 months divided by an asset such as inventories as of a specific date.  Assets like inventories vary at different times of the year for a seasonal business, thus leading to big changes in the ratio.

[13].   (4.10) Limitations of ratio analysis                     Answer: a  EASY

[14].   (4.5) Basic earning power ratio                   Answer: b  EASY/MEDIUM

BEP = EBIT/Assets.  This is before the effects of leverage (interest) and taxes, so the statement is false.

[15].   (4.3) Inventory turnover ratio                         Answer: a  MEDIUM

A high current ratio is consistent with a lot of inventory.  A low inventory turnover is also consistent with a lot of inventory.  If the CR exceeds industry norms and the turnover is below the norms, then the firm has more inventory than most other firms, given its sales.  It could just be carrying a lot of good inventory, but it might also have a normal amount of “good” inventory plus some “bad” inventory that has not been written off.  So the statement is true.

[16].   (4.3) Fixed assets turnover                            Answer: b  MEDIUM

The FA turnover is Sales/FA, and it gives an indication of how effectively the firm utilizes its FA.  The proportion of FA to TA is not relevant to this usage.

[17].   (4.5) ROA                                              Answer: b  MEDIUM

EBIT = Sales revenues – Operating costs

Net income = EBIT – Interest – Taxes = (EBIT – Interest) ´ (1 – T)

ROA = Net income after taxes/Assets

Two firms could have identical EBITs but very different amounts of interest, different tax rates, and different assets, and thus very different ROAs.

[18].   (4.5) Profit margin and leverage                       Answer: b  MEDIUM

PM = NI/Sales.  A decrease in sales would, other things held constant, increase the PM.  An increase in financial leverage would lead to higher interest charges, which would decrease net income, which would decrease the PM.  So, the net effect could be either an increase or a decrease in the PM.

[19].   (4.8) Du Pont equation                                 Answer: b  MEDIUM

Think about the Du Pont equation:  ROE = PM ´ TATO ´ Equity multiplier.  Similar financing policies will lead to similar Equity multipliers.  Moreover, competition in the capital markets will cause ROEs to be similar, because otherwise capital would flow to industries with high ROEs and drive returns down toward the average, given similar risks.  To have similar ROEs, firms with relatively high PMs must have relatively low TATOs, and vice versa.  Therefore, the statement is false.

[20].   (4.2) Liquidity ratios                                   Answer: b  HARD

Demonstration that the            CR = C + A/R + Inv         A > B              QR =            C + A/R            B > A

first sentence is true:                                                                 CL                                          CL

A:              1 + 1 + 3                    1.67                                       1 +  1               0.67

QR(B) > QR(A)                                           3                                                                              3

B:              1 + 1 + 1                    1.50                                       1 +  1               1.00

2                                                                              2

Demonstration that the            CR = C + A/R + Inv         A > B              QR =            C + A/R            B > A

second sentence                                                                        CL                                          CL

is false:                                A:              1 + 1 + 1                     1.0                                        1 +  1               0.67

QR(B) < QR(A)                                           3                                                                              3

B:              1 + 1 + 4                     1.5                                        1 +  1               0.50

4                                                                              4

The key is inventory, which is in the CR but not in the QR.  The firm with more inventory can have the higher CR but the lower QR.

[21].   (4.2) Liquidity ratios                                   Answer: b  HARD

Firm A has the higher inventory turnover, so given the same sales, it must have less inventory.  Thus, since the two firms have the same CR, then A must have the higher QR, not the lower one.  Therefore, the statement is false.

[22].   (4.4) TIE ratio                                          Answer: a  HARD

TIE = EBIT/Interest = (Sales – Op cost)/(Debt ´ Interest rate).  If we know the op. costs, the amount of debt, and the interest rate, then we can solve for the sales level required to achieve the target TIE.

[23].   (4.5) BEP and ROE                                        Answer: a  HARD

The easiest way to think about this is to realize that you can borrow at a cost of 10% and invest the proceeds to earn 11%, you’ll earn a surplus.  If you were previously earning an ROE of 10%, then after raising and investing additional funds, your income will be higher, your equity will be the same, and thus your ROE will increase.  Similarly, if a firm earns more on assets than the interest rate, there will be a surplus after paying interest on the debt that will go to the equity, thus increasing the ROE. So, if BEP > rd, then the firm can increase its expected ROE by using more debt leverage.

The answer can also be seen by working out an example.  The one below shows that leverage increases ROE if BEP >  rd, but it could be varied to show no difference in ROE if interest rates and BEP are the same, and a reduction in ROE if the interest rate exceeds the BEP.

Firm A                                                                                                    Firm B

Assets                                                          100%                                Assets                                                          100%

Debt                                                               60%                                Debt                                                                 0%

Equity                                                            40%                                Equity                                                         100%

BEP                                                               15%                                BEP                                                               15%

Interest rate, rd                                             10%                                Interest rate, rd                                             10%

Tax rate                                                        40%                                Tax rate                                                        40%

EBIT = BEP´ Assets                                   15.0                                EBIT = BEP ´ Assets                                  15.0

Interest                                                             6.0                                Interest                                                                0

Taxable income                                             9.0                                Taxable income                                           15.0

Taxes                                                               3.6                                Taxes                                                               6.0

NI                                                                      5.4                                NI                                                                      9.0

ROE                                                         13.50%                                ROE                                                           9.00%

[24].   (4.8) Equity multiplier                                  Answer: a  HARD

Equity multiplier = Assets/Equity = 3.0, so Assets/Equity = 1/3.0 = 0.333.

By definition, Equity/Assets + Debt/Assets = 1.00, so

0.333 + Debt/Assets = 1.0.

Therefore, Debt/Assets = 1.0 – 0.333 = 0.667.  Thus, the statement is true.

[25].   (4.10) Limitations of ratio analysis                     Answer: b  HARD

The key here is to recognize that if the CR is greater than 1.0, then a given increase in both current assets and current liabilities would lead to a decrease in the CR.  The reverse would hold if the initial CR were less than 1.0. Here the initial CR is greater than 1.0, so borrowing on a short-term basis to build the cash account would lower the CR.  For example:

Original                                     New

CA/CL           Plus \$1           CA/CL           Old CR          New CR

3/2                  1/1                  4/3                 1.50                1.33            CR falls if initial CR is greater than 1.0

2/3                  1/1                  3/4                 0.67                0.75            CR rises if initial CR is less than 1.0

[26].   (4.10) Limitations of ratio analysis                     Answer: b  HARD

The key here is to recognize that if the CR is less than 1.0, then a given reduction in both current assets and current liabilities would lead to a decrease in the CR.  The reverse would hold if the initial CR were greater than 1.0.  In the question, the initial CR is less than 1.0, so using cash to reduce current liabilities would lower the CR.  If the CR were greater than 1.0, the statement would have been true. Here’s an illustration:

Original                                     New

CA/CL           Less \$1           CA/CL           Old CR          New CR

2/3                 -1/-1                 1/2                 0.67                0.50            CR falls if initial CR is less than 1.0

3/2                 -1/-1                 2/1                  1.5                  2.0             CR rises if initial CR is greater than 1.0

[27].   (4.2) Current ratio                                      Answer: d  EASY

[28].   (4.2) Current ratio                                      Answer: c  EASY

[29].   (4.2) Current ratio                                      Answer: d  EASY

[30].   (4.3) Inventories                                        Answer: c  EASY

[31].   (4.6) Financial statement analysis                       Answer: e  EASY

[32].   (4.6) Market value ratios                                Answer: d  EASY

[33].   (4.10) Window dressing                                   Answer: b  EASY

[34].   (Comp: 4.2,4.4-4.6) Miscellaneous ratios                 Answer: a  EASY

[35].   (Comp: 4.2,4.3,4.5) Miscellaneous ratios                 Answer: b  EASY

[36].   (Comp: 4.3-4.5) Miscellaneous ratios                     Answer: a  EASY

[37].   (Comp: 4.2-4.5) Miscellaneous ratios                     Answer: e  EASY

[38].   (Comp: 4.2,4.4) Miscellaneous ratios                     Answer: c  EASY

[39].   (Comp: 4.4,4.5,4.8) Effects of leverage                  Answer: b  EASY

[40].   (4.2) Quick ratio                                 Answer: a  EASY/MEDIUM

[41].   (4.2) Current ratio                                    Answer: b  MEDIUM

a would leave the CR unchanged.

b would indeed reduce the CR.

c is false, given that the initial CR > 1.0.

d is false, given that the initial CR > 1.0.

e is false, given that the initial CR > 1.0.

Original                                     New

CA/CL          Minus .5          CA/CL           Old CR          New CR

1.9/1               0/0.5             1.9/1.5              1.90                1.27            CR falls if initial CR is greater than 1.0

[42].   (4.3) Accounts receivable                              Answer: e  MEDIUM

[43].   (4.4) Leverage effects; debt management                Answer: c  MEDIUM

a is false, because the TIE also depends on the interest rate and EBIT.

b is false, because interest affects the profit margin.

c is correct, because the more interest the lower the profits, hence the lower the profit margin.

d is simply incorrect.

e is incorrect.  The reverse is true.

[44].   (4.6) Market value ratios                              Answer: b  MEDIUM

No reason for a to be true.

b must be true, as EPS and P will be the same.

No reason for c to be true.

Wrong, because high risk and low growth lead to low P/Es.

No reason for e to be true.

[45].   (4.8) Du Pont analysis                                 Answer: a  MEDIUM

PM                ´             TATO             ´           Eq mult.           =              ROE

Old                     9%                                1.0                             1.666667                          15%

New                 10%                                0.9                             2.5                                      23%

We see that a is true, thus b must be false.

We can also see that c, d, and e are all false.

[46].   (4.8) Du Pont analysis                                 Answer: a  MEDIUM

Thinking through the Du Pont equation, we can see that if the firm’s PM and Equity multiplier are below the industry average, the only way its ROE can exceed the industry average is if its equity multiplier exceeds the industry average.  The following data illustrate this point:

ROE               =                PM                ´             TATO             ´           Eq mult.                    ROA

Firm                 30%                                  9%                                2.0                                   1.67                      18%

Industry          25%                               10%                                1                                      2.50                      10%

The above demonstrates that a is correct, and that makes d and e incorrect.

Now consider the following:

NI/Assets = NI/Sales × Sales/Assets

ROA = PM × TATO

If its ROA were equal to the industry average, then with its low debt ratio (hence low equity multiplier) its ROE would also be below the industry average.  So b is incorrect.  With its debt ratio below the industry average, its interest charges should also be low, which would increase its TIE ratio, making c incorrect.

[47].   (4.8) Du Pont analysis                                 Answer: d  MEDIUM

Rule out all answers except d because they are false.

Alternative answer explanation using the Du Pont equation:

ROE = PM ´ TATO ´ Eq mult.

ROE = NI/S ´ S/TA ´ TA/Equity

The first two terms are the same, but HD has higher equity multiplier, hence higher ROE.

[48].   (Comp: 4.4,4.5) Financial statement analysis           Answer: c  MEDIUM

a is false because reducing debt will lower interest, raise income, and thus raise ROA.

b is false for the above reason.

c is true for the above reason.

d is false.

The TIE will increase, not decrease.

[49].   (Comp: 4.3-4.5) Financial statement analysis           Answer: e  MEDIUM

1. Sales fluctuations would have more effects on the DSO and S/Inventory ratios.
2. ROE = ROA ´ Equity multiplier, so more debt, higher ROE for given ROA.
3. DSO = Receivables/Sales per day. With sales constant, an increase in DSO would mean an increase in receivables, hence a decline, not a rise, in the TATO.
4. An increase in the DSO might increase or decrease ROE, depending on how it affected sales and costs.
5. ore debt would mean more interest, hence a lower NI, given a constant EBIT. This would lower the profit margin = NI/Sales.

[50].   (Comp: 4.4,4.5,4.8) Financial statement analysis       Answer: d  MEDIUM

More debt would mean more interest, hence a lower NI, given a constant EBIT, so d is correct.  Also, we can rule out a and e, and HD would also have the higher multiplier, which rules out b.  And with more interest, HD would have to pay less taxes, not more.

[51].   (Comp: 4.2,4.3) Cash flows                             Answer: c  MEDIUM

1. Lengthening depreciable lives would lower depreciation, increase taxable income and taxes, and thus lower cash flow.
2. Paying down accounts payable would use cash and thus reduce cash flow.
3. Reducing the DSO would require collecting receivables faster, which would indeed increase cash flow.
4. Decreasing accruals would lower cash flow.
5. Reducing inventory turnover would mean increasing inventories, which would use cash.

[52].   (Comp: 4.4,4.5,4.8) Leverage, taxes, and ratios        Answer: a  MEDIUM

Under the stated conditions, HD would have more interest charges, thus lower taxable income and taxes.  Thus, a is correct.  All of the other statements are incorrect.

[53].   (Comp: 4.4,4.5,4.8) Leverage, taxes, and ratios        Answer: e  MEDIUM

HD has higher interest charges.  Basic earning power equals EBIT/Assets, and since assets are equal, EBIT

must also be equal.  TIE = EBIT/Interest.  Therefore, HD’s higher interest charges means that its TIE must be lower.  Thus, e is correct.  All of the other statements are incorrect.

[54].   (4.2) Current ratio                               Answer: a  MEDIUM/HARD

The key here is to recognize that if the CR is less than 1.0, then a given increase in both current assets and

current liabilities would lead to an increase in the CR.  The reverse would hold if the initial CR were greater than 1.0. Here the initial CR is less than 1.0, so borrowing on a short-term basis to build inventories would increase the CR.  For example:

Original                                     New

CA/CL           Plus \$1           CA/CL           Old CR          New CR

1/2                  1/1                  2/3                 0.50                0.67            CR rises if initial CR is less than 1.0

All of the other statements are incorrect, although b, c, and d would be correct if the initial CR had been >1.0.

[55].   (4.2) Current ratio                               Answer: b  MEDIUM/HARD

The key here is to recognize that if the CR is less than 1.0, then a given increase to both current assets and current liabilities will increase the CR, while the reverse will hold if the initial CR is greater than 1.0.  Thus, the transaction would make Risco look stronger but Safeco look weaker. Here’s an illustration:

Original                             New

CA/CL      Plus \$10      CA/CL       Old CR      New CR

Safeco      20/10         10/10         30/20           2.00            1.50    CR falls because initial CR is greater than 1.0

Original                             New

CA/CL      Plus \$10      CA/CL       Old CR      New CR

Risco         10/20         10/10         20/30           0.50            0.67    CR rises because initial CR is less than 1.0

All of the statements except b are incorrect.

[56].   (Comp: 4.4,4.5) Effects of financial leverage     Answer: e  MEDIUM/HARD

The companies have the same EBIT and assets, hence the same BEP ratio.  If the interest rate is less than the BEP, then using more debt will raise the ROE. Therefore, statement e is correct.  The others are all incorrect.

[lvii]. (4.3) Total assets turnover                              Answer: d  EASY

Sales                                        \$52,000

Total assets                            \$22,000

TATO                                             2.36

[lviii].                    (4.4) Debt ratio: find the debt, given the D/A ratio      Answer: b  EASY

Total assets                                                                                         \$410,000

Target debt ratio                                                                                          40%

Debt to achieve target ratio = amount borrowed                         \$164,000

[lix].  (4.4) Times interest earned                              Answer: e  EASY

Sales                                                     \$435,000

Operating costs                                     362,500

Operating income (EBIT)                      72,500

Interest charges                                   \$  12,500

TIE ratio                                                        5.80

[lx].   (4.5) Profit margin on sales                             Answer: c  EASY

Sales                                     \$320,000

Net income                            \$23,000

Profit margin                            7.19%

[lxi].  (4.5) Return on total assets (ROA)                       Answer: a  EASY

Total assets                         \$315,000

Net income                            \$22,750

ROA                                           7.22%

[lxii]. (4.5) Basic earning power (BEP)                          Answer: c  EASY

Total assets                         \$305,000

EBIT                                       \$62,500

BEP                                         20.49%

[lxiii].                                            (4.5) Return on equity (ROE)      Answer: d  EASY

Common equity                 \$305,000

Net income                            \$60,000

ROE                                         19.67%

[lxiv]. (4.5) Return on equity (ROE): finding net income         Answer: e  EASY

Assets = equity                    \$475,000

Target ROE                               13.5%

Required net income            \$64,125

[lxv].  (4.6) Price/Earnings ratio (P/E)                         Answer: b  EASY

Stock price                               \$33.50

EPS                                              \$2.30

P/E                                               14.57

[lxvi]. (4.6) Price/Earnings ratio (P/E)                         Answer: a  EASY

Stock price                               \$33.50

Book value per share             \$25.00

M/B ratio                                      1.34

[lxvii].                               (4.8) Du Pont equation: basic calculation      Answer: c  EASY

Profit margin                             5.25%

TATO                                             1.50

Equity multiplier                          1.80

ROE                                         14.18%

[lxviii].                                                       (4.4) Debt ratio      Answer: a  EASY/MEDIUM

Total assets                                                                         \$625,000

Present debt                                                                         \$185,000

Target debt ratio                                                                          55%

Target amount of debt                                                      \$343,750

Change in amount of debt outstanding                         \$158,750

[lxix]. (4.6) EPS, DPS, and payout                        Answer: d  EASY/MEDIUM

Net income                       \$1,250,000

Shares outstanding               225,000

Payout ratio                                 45%

EPS                                              \$5.56

DPS                                              \$2.50

[lxx].  (4.3) Effect of lowering the DSO on net income         Answer: e  MEDIUM

Rate of return on cash generated                            8.0%

Sales                                                                     \$100,000

A/R                                                                          \$11,500

Days in year                                                                  365

Sales/day                                                               \$273.97

Company DSO                                                            42.0

Industry DSO                                                               27.0

Excess DSO                                                                  15.0

Cash flow from reducing the DSO                 \$4,102.74

Alternative calculation:

A/R at industry DSO                                         \$7,397.26

Change in A/R                                                   \$4,102.74