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Sample Test Chapter 03 Test Bank – Static Key Multiple Choice Questions 1. A lump sum of $5,000 is invested at 10% per year for five years. The company’s cost of capital is 8%. Which is true? 1. The investment has a future value of $7,347 1. The investment has a future value of $8,053
1. The investment has a present value of $5,000 1. The investment has a net present value of $5,000 1. None of the above $5,000 (1 + 0.1)5 = $8,053 AACSB: Knowledge Application Accessibility: Keyboard Navigation Accessibility: Screen Reader Compatible AICPA: BB Industry AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Future Values Topic: Present Values
2. Cash of $12,000 will be received in year 6. Assuming an opportunity cost of capital of 7.2%, which of the following is true? 1. The future value is $18,212 1. The present value is $7,996 1. The present value is $7,907 1. Provide data for tax purposes 1. None of the above $12,000 × (1 + 0.072)−6 = $7,907 AACSB: Knowledge Application Accessibility: Keyboard Navigation Accessibility: Screen Reader Compatible AICPA: BB Industry
AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Future Values Topic: Present Values 3. Gorgeous George is evaluating a fiveyear investment in an oilchange franchise, which costs $120,000 paid up front. Projected net operating cash flows are $60,000 per year. If Gorgeous George buys shares instead of the franchise, he expects an annual return of 12%. Which is true? 1. The future value of the franchise is $216,287 1. The net present value of the franchise is $216,287 1. The future value of the franchise is $138,900 1. The net present value of the franchise is $96,287 1. None of the above
NPV
=
Sum PV(Op Cash Flows) − Investment
$96,287
=
$216,287 − $120,000
AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Annuities Topic: Decision to Open a Day Spa Topic: Future Values Topic: Present Values
4. Furious Fred expects cash flows from an investment as follows: Yr 1 $3,000, Yr 2 $5,000, Yr 3 $8,000 Using an opportunity cost of capital of 5.6%, the present value is: 1. $14,118 1. $14,523 1. $14,361 1. $14,909 1. none of the above PVi
=
FVi × PVFi
$14,118
=
$3,000 × (1 + 0.056)−1 + $5,000 × (1.056)−2 + $8,000 × (1.056)−3
AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry
AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Present Value of a Cash Flow Stream 5. Which is true? 1. The present value of a 20year annuity of $1,900 at 8% is $16,854 1. A $100,000 bond with a 5% coupon will sell at a premium when the market rate of interest is 6% 1. The issue price of a $150,000 zero coupon bond that matures in 6 years when the market rate of interest is 6% is $105,744 1. The present value of a perpetual income stream of $4,000 when the market rate of interest is 8% is $50,000 1. None of the above
PV of perpetuity
=
Annual income/interest rate
$50,000
=
$4,000/0.08
AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Annuities Topic: Present Values
6. Harriet Harvester (HH) plans to buy a haymaker. It costs $180,000 and is expected to last for five years. She presently hires 10 workers at $3,000 per month for each of the six harvesting months each year. The equipment would eliminate the need for six workers. HH uses straight line depreciation and projects a salvage value of $23,000. Her tax rate is 21% and opportunity cost of funds is 8.0%. Which is true? 1. The present value of cash flows in year 5 is $24,466
1. NPV is −$24,466 1. NPV is $155,534 1. NPV is −$155,534 1. None of the above
Yr 0
1
2
INV
−$
180,000
Labor savings*
$
36,000
$
36,000
Tax @ 21%
−
7,560
−
7,560
Tax shield of depreciation**
6,594
6,594
Salvage value
Net cash flows
−$
180,000
$
35,034
$
35,034
NPV @ 8%
−$
24,466
*$3,000 × 6 × 6 **SL depreciation = (HC − Salvage)/Life = ($180,000 − $23,000)/5 = $31,400
AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Annuities Topic: Essential Points about Capital Budgeting Topic: Multiple Cash Flows per Year Topic: Present Values 7. Samuel Survivor is planning to save for retirement 35 years from now. He expects to live 25 years beyond that, and would like an annual retirement income of $38,500 after tax of 30%. What is the lump sum needed to fund retirement, at an expected annual return of 11.2%? 1. $357,888
1. $319,561 1. $456,515 1. $479,118 1. None of the above Annual pretax income
=
Target income/(1 − ta
$55,000
=
$38,500/(1 − 0.3)
PV Annuity
=
Annuity × PVFAn
$456,515
=
$55,000 × 8.30028
PVFAn
=
(1 − (1 + 0.112)−25)/0.1
AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: FN Measurement
Blooms: Apply Difficulty: 3 Hard Topic: Annuities
8. Samuel Survivor is planning to save for retirement 35 years from now. He expects to live 25 years beyond that, and would like an annual retirement income of $38,500 after tax of 30%. How much must Samuel Survivor save each year to accumulate the lump sum needed to fund retirement, at an expected annual return of 11.2%? 1. $893 1. $4,062 1. $1,339 1. $937 1. None of the above Annual pre-tax income
=
Target income/(1 − tax rate)
$55,000
=
$38,500/(1 − 0.3)
PV Annuity
=
Annuity × PVF
$456,515
=
$55,000 × 8.30028
PVFAn
=
(1 − (1 + 0.112)
Annuity
=
FV/FVFAn
$1,275
=
$456,515/357.888
FVFAn
=
((1 + 0.112)35 − 1)/0.112
AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Annuities Topic: Taxes and Depreciation Tax Shields
9. Mirtha Mudflat has sufficient funds to choose one of two investments. The same amount will be invested in either case. Choice one: ten year $100,000 5% Treasury bonds issued to yield 4% per annum, the market rate. Choice two: a risky bond of the same amount that has expected cash flows of $9,000 per year for the same period. What is the issue price of the Treasury bond? 1. $100,000 2. $108,110 3. $92,278 4. $125,000 5. None of the above Issue price of the bond: Par value × PVF
=
$100,000 × (1.04)10
Annuity × PVFAn
=
$5,000 × (1 − (1.04)10)/0.04
AACSB: Knowledge Application Accessibility: Keyboard Navigation
AICPA: BB Industry AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Annuities Topic: Present Values 10. Mirtha Mudflat has sufficient funds to choose one of two investments. The same amount will be invested in either case. Choice one: ten year $100,000 5% Treasury bonds issued to yield 4% per annum, the market rate. Choice two: a risky bond of the same amount that has expected cash flows of $9,000 per year for the same period. What is the risk premium that makes Mirtha indifferent between the two investments? 7. 7.80% 5. 5.66%
3. 3.80% 5. 5.00% 1. None of the above First, solve for the issue price of the bond: Par value × PVF
=
$100,000 × (1.04)10
Annuity × PVFAn
=
$5,000 × (1 − (1.04)10)/0.04
Then, solve for the IRR, then subtract riskless rate: INV
=
Annuity × PVFAn + Bond maturity × PVF
PVFAn
=
(INV – PV bond)/Annuity
=
($108,110 − $47,171)/$9,000 = 6.77104(IRR = x%, t =
IRR – riskless
=
7.8% − 4% = 3.8%
AACSB: Knowledge Application
Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Annuities Topic: Internal Rate of Return (IRR) Topic: Present Values 11. Mirtha Mudflat has sufficient funds to choose one of two investments. The same amount will be invested in either case. Choice one: ten year $100,000 5% Treasury bonds issued to yield 4% per annum, the market rate. Choice two: a risky bond of the same amount that has expected cash flows of $9,000 per year for the same period. Assume Mirtha purchased the risky bond for $105,000 and the market rate is 6%. Which is false? 1. Net present value is $17,080 1. Payback occurs at the end of year 10
8. IRR is 8.25% 1. Present value of the cash flows is $122,080 2. None of the above All are true.
Yr 0
1
INV
$
105,000
OPCF
$
9,000
Par
Net cash flows
$
105,000
$
9,000
NPV $17,080; PV $122,080; IRR 8.25% Payback is not accomplished by the annual cash flows ($9,000; 10 years). The payback shortfall is covered by the redemption of the bond. AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry
AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Annuities Topic: Decision to Open a Day Spa Topic: Internal Rate of Return (IRR) Topic: Payback Topic: Present Values 12. Peter Pontificator is proposing to purchase a paddle machine, which will cost $5 million, last ten years and have a salvage value of $80,000. Given a tax rate of 21%, and a cost of capital of 8%: What is the present value of the tax shield if straightline depreciation is used? 1. $600,000 1. $643,234
1. $745,671 1. $693,286 1. None of the above SL depreciation = (HC − Salvage)/Life = ($5,000,000 − $80,000)/10 = $492,000 Annual tax shield = 21% × $492,000 = $103,320 per year PV of Annuity of $103,320 per year at 8% for 10 years = $693,286 AACSB: Knowledge Application Accessibility: Keyboard Navigation Accessibility: Screen Reader Compatible AICPA: BB Industry AICPA: FN Measurement Blooms: Apply
Difficulty: 3 Hard Topic: Annuities Topic: Taxes and Depreciation Tax Shields 13. Peter Pontificator is proposing to purchase a paddle machine, which will cost $1 million, last eight years and have a salvage value of20%. Given a tax rate of 35%, and a cost of capital of 6%:
If doubledeclining balance depreciation is used, and PP switches to straight line depreciation in year 6, the present value of the depreciation tax shield is:
1. $287,506 1. $230,005 1. $286,513 1. $229,211 1. none of the above Double declining rate = 2 × (1/life) = 2 × (1/8) = 25%
The depreciable amount = purchase price. Salvage value is ignored in this method.
Yr 1
Yr 2
Double declining dep
$
250,000
$
187,500
Depreciation tax shield
35
%
$
87,500
$
65,625
Yr 5
Yr 6
Double declining dep
$
79,102
$
79,102
Depreciation tax shield
$
27,686
$
27,686
NPV
$
287,506
AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard
Topic: Annuities Topic: Present Values Topic: Taxes and Depreciation Tax Shields Essay Questions 14.
Annuity
Suppose the opportunity cost of capital is 10 percent and you have just won a $1 million lottery that entitles you to $100,000 at the end of each of the next ten years.
Required:
1. What is the minimum lump sum cash payment you would be willing to take now in lieu of the tenyear annuity? 1. What is the minimum lump sum you would be willing to accept at the end of the ten years in lieu of the annuity? 1. Suppose three years have passed and you have just received the third payment and you have seven left when the lottery promoters approach you with an offer to “settleup for cash.” What is the minimum you would accept (the end of year three)?
2. How would your answer to part (a) change if the first payment came immediately (at t = 0) and the remaining payments were at the beginning instead of at the end of each year? Feedback: 1. The minimum lump sum you should take is the present value of the cash payments. PV
=
$100,000 × Annuity Factor (i = 0.10, t = 10)
=
$100,000 × 6.145
=
$614,500
15. This question is essentially (a) in reverse. You are looking for the future value of the cash payments. Looking in the future value in arrears table, the annuity factor is 15.937. PV
=
$100,000 × 15.937
=
$1,593,700
7. This is similar to (a). This time, t = 7. PV
=
$100,000 × Annuity Factor (i = 0.10, t = 7)
=
$100,000 × 4.868
=
$486,800
1. To convert an endofyear payment schedule to a beginningofyear schedule, we need only multiply by 1 + r. The minimum payment is $614,500 × 1.10 = $675,950. AACSB: Analytical Thinking AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: FN Decision Making AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Annuities Topic: Future Values
Topic: Opportunity Cost of Capital Topic: Present Values 15.
Identifying the Opportunity Cost of Capital
Don Phelps recently started a dry cleaning business. He would like to expand the business and have a coinoperated laundry also. The expansion of the building and the washing and drying machines will cost $100,000. The bank will lend the business $100,000 at 12 percent interest rate. Don could get a 10 percent interest rate loan if he uses his personal house as collateral. The lower interest rate reflects the increased security of the loan to the bank, because the bank could take Don’s home if he doesn’t pay back the loan. Don currently can put money in the bank and receive 6 percent interest.
Required:
Provide arguments for using 12 percent, 10 percent, and 6 percent as the opportunity cost of capital for evaluating the investment.
Feedback: The 12 percent rate that the bank wants to charge without the security of the home mortgage probably best reflects the risk of the project. Therefore, the 12 percent interest rate is probably the most appropriate discount rate to use. The 10 percent rate reflects the interest rate that Don Phelps would have to pay if he uses his personal house as collateral. This rate reflects the interest rate for Don’s total portfolio of assets including his house. The 6 percent rate reflects the interest rate that Don receives in interest for his bank deposits. If Don decided to use his own cash and not borrow money for the investment, Don’s forgone opportunity of using the cash would be the 6 percent interest if no other investment were available.
AACSB: Analytical Thinking AACSB: Communication Accessibility: Keyboard Navigation Accessibility: Screen Reader Compatible AICPA: BB Industry AICPA: FN Risk Analysis Blooms: Understand Difficulty: 2 Medium Topic: Opportunity Cost of Capital 16.
Financing Charges and Net Present Value
The president of the company is not convinced that the interest expense should be excluded from the calculation of the net present value. He points out that, “Interest is a cash flow. You are supposed to discount cash flows. We borrowed money to completely finance this project. Why not discount interest
expenditures?” The president is so convinced that he asks you, the controller, to calculate the net present value including the interest expense. How can you adjust the net present value analysis to compensate for the inclusion of the interest expense? Feedback: Many possible ways exist for examining this problem. From a theoretical perspective, of course, interest expense (like dividends) is excluded because it is captured in the discount rate. But here is another way of viewing an investment. An investment that is entirely debtfinanced is a positive NPV project if, at the end of the project, there is excess cash after paying the interest and the principal of the debt. This can be seen in the following equation where early cash flows are re invested at a rate “r” to pay off the principal of the loan at the end of n periods, which is also the length of the project. (CF1)(1 + r)n−1 + (CF2)(1 + r)n−2 + …. + (CFn) > or < Investment (= Principal) where CFi = Cash flows in period i including interest payments.
If the left hand side of the equation is greater than the right hand side of the equation, the investment has a positive NPV and is acceptable. This analysis assumes complete debt financing to capture all of the opportunity cost of using cash. AACSB: Analytical Thinking AACSB: Communication
Accessibility: Keyboard Navigation Accessibility: Screen Reader Compatible AICPA: BB Industry AICPA: FN Decision Making AICPA: FN Measurement Blooms: Analyze Blooms: Apply Blooms: Understand Difficulty: 3 Hard Topic: Decision to Open a Day Spa Topic: Essential Points about Capital Budgeting Topic: Opportunity Cost of Capital
17.
Asset Replacement
The Baltic Company is considering the purchase of a new machine tool to replace an obsolete one. The machine being used for the operation has a tax book value of $80,000, with an annual depreciation expense of $8,000. It has a salvage value (resale value) of $40,000, is in good working order, and will last, physically, for at least 10 more years. The proposed machine will perform the operation so much more efficiently that Baltic engineers estimate that labor, material, and other direct costs of the operation will be reduced $60,000 a year, if it is installed. The proposed machine costs $240,000 delivered and installed, and its economic life is estimated at 10 years, with zero salvage value. The company expects to earn 14 percent on its investment after taxes (14 percent is the firm’s cost of capital). The tax rate is 21 percent, and the firm uses straightline depreciation. Any gain or loss on the machine is subject to tax at 21 percent. Should Baltic buy the new machine? Feedback: This problem is best solved via the incremental method. Initial investment
(240,000 )
Disposal of old machine
$ 40,000
Reduction in tax liability from selling old machine 8,400 [$40,000 – $80,000] × 21% NET COST OF NEW MACHINE Depreciation on new machine Depreciation on old machine
(191,600 )
Increase in depreciation Increase in depreciation tax shield (21% × $16,000) Reduction in operating expenses [$60,000 × (1 – 0.21)] Increase in depreciation tax shield (from above) Total annual cash flows Present value of annual cash flows ($50,760/yr., r = 14%, t = 10) NET COST OF NEW MACHINE Present value of annual cash flows ($50,760/yr., r = 14%, t = 10) Net present value Baltic should purchase the new machine. AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry
AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Annuities Topic: Decision to Open a Day Spa Topic: Present Values Topic: Taxes and Depreciation Tax Shields Chapter 03 Test Bank – Static Summary Category
# of Ques tions
AACSB: Analytical Thinking
3
AACSB: Communication
2
AACSB: Knowledge Application
15
Accessibility: Keyboard Navigatio n
17
Accessibility: Screen Reader Com 5 patible AICPA: BB Industry
17
AICPA: FN Decision Making
2
AICPA: FN Measurement
16
AICPA: FN Risk Analysis
1
Blooms: Analyze
1
Blooms: Apply
16
Blooms: Understand
2
Difficulty: 2 Medium
1
Difficulty: 3 Hard
16
Topic: Annuities
12
Topic: Decision to Open a Day Sp 4 a Topic: Essential Points about Capi 2 tal Budgeting Topic: Future Values
4
Topic: Internal Rate of Return (IR R)
2
Topic: Multiple Cash Flows per Ye 1 ar
Topic: Opportunity Cost of Capital 3 Topic: Payback
1
Topic: Present Value of a Cash Fl 1 ow Stream Topic: Present Values
11
Topic: Taxes and Depreciation Ta 4 x Shields Chapter 05 Test Bank – Static Key Multiple Choice Questions 1. Each of the following responsibility centers and decision rights are correctly matched, except: 1. Cost center—input mix 1. Investment center—capital invested 1. Profit center—capital invested 1. Investment center—product mix
1. Profit center—input mix Cost centers have decision rights for the input mix; profit centers for input mix, product mix, and selling prices; investment centers for input mix, product mix, selling prices and capital invested. AACSB: Analytical Thinking AACSB: Knowledge Application Accessibility: Keyboard Navigation Accessibility: Screen Reader Compatible AICPA: BB Industry AICPA: BB Resource Management AICPA: FN Decision Making Blooms: Understand Difficulty: 2 Medium Topic: Responsibility Accounting
2. Mesopotamian Materials Inc. (MMI) has two decentralized divisions (Ur and Babylon) that have decision making responsibility over the amount of resources invested in their divisions. Recent financial extracts for both divisions are presented below:
Ur
Fixed assets, gross
$
Accumulated depreciation
$
Other assets
$
Liabilities
$
Sales
$
Net income after tax*
$
Average age of fixed assets (years)
*Net income is after tax but before interest MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125. Using historical costs, which is true? 1. Ur’s return on sales (net income percentage) is 14%
1. Ur’s return on net assets (RONA) is 74% 6. Babylon’s net asset turnover is 6.75 1. Babylon’s return on assets (ROA) is 40% 1. None of the choices are correct
Ur
Gross fixed assets
$
2,500
Accumulated depreciation
−$
1,500
Net fixed assets
$
1,000
Other assets
$
500
Total assets
$
1,500
Liabilities
−$
500
Net assets
$
1,000
RONA = Net income
$
743
Net assets
$
1,000
Return on net assets (historical)
74.3
AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: BB Resource Management AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Investment Centers 3. Mesopotamian Materials Inc. (MMI) has two decentralized divisions (Ur and Babylon) that have decision making responsibility over the amount of resources invested in their divisions. Recent financial extracts for both divisions are presented below: Ur Fixed assets, gross
$
Accumulated depreciation
$
Other assets
$
Liabilities
$
Sales
$
Net income after tax*
$
Average age of fixed assets (years)
*Net income is after tax but before interest MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125. Ur can increase its ROI by: 1. increasing product contribution margin 1. increasing sales volume 1. reducing discretionary expenses 1. taking on debt 1. all of the choices are correct
All of these strategies can be utilized to increase ROI. However, not all of these are necessarily beneficial to the parent company or the shareholders. Thus it is customary to supplement ROI performance measures with constraints and minimum performance or expenditure targets. AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Industry AICPA: BB Resource Management AICPA: FN Measurement Blooms: Remember Difficulty: 1 Easy Topic: Investment Centers 4. Mesopotamian Materials Inc. (MMI) has two decentralized divisions (Ur and Babylon) that have decision making responsibility over the amount of resources invested in their divisions. Recent financial extracts for both divisions are presented below:
5. Fixed assets, gross
$
Accumulated depreciation
$
Other assets
$
Liabilities
$
Sales
$
Net income after tax*
$
Average age of fixed assets (years)
*Net income is after tax but before interest MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125. Using historical costs, which is true? 1. Babylon is a profit center 1. At a WACC of 5%, Ur’s residual income is lower than Babylon’s by $123
Ur
11. At the planned WACC (11.5%), Ur’s residual income is higher than Babylon’s by $87 1. At a WACC of 25%, Ur’s residual income is higher than Babylon’s by $123 1. None of the choices are correct 2.
Ur
Babylon
Diff
Net income after tax
$
743 $
1,008
Cost of capital (WACC @ 25% on net assets)
− $
250 −$ 638
Residual income
$
493 $
$ 123
370
Note that the magnitude (and, therefore, relative ranking) of residual income is critically dependent on the WACC. A lower WACC favors divisions with higher net assets (such as Babylon), whereas a high charge for the use of corporate funds favors divisions with lower net assets (such as Ur). Because managers have decision making responsibility over the amount of resources invested in their divisions, both Ur and Babylon are investment centers. AACSB: Knowledge Application Accessibility: Keyboard Navigation
AICPA: BB Resource Management AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Investment Centers Topic: Profit Centers 5. Honolulu Enterprises has two decentralized divisions (Coconut and Guava) that have decision making responsibility over the amount of resources invested in their divisions. Recent financial extracts for both divisions are presented below:
Cocon Fixed assets, gross
$
4
Accumulated depreciation
$
2
Other assets
$
9
Liabilities
$
9
Sales
$
1
Net income after tax*
$
1
Average age of fixed assets (years) *Net income is after tax but before interest Honolulu’s weighted average cost of capital (WACC) is 15% and the company uses residual income as a method to evaluate performance. Which of the following statements is correct? 1. Coconut’s ROI will be raised by divesting of a project with a 20% ROI but its RI will be lower. 3. Coconut’s RI will decrease by taking on a project with a $12 cost and net income before interest of $3. 1. Guava’s RI will increase by taking on a project with an $8 cost and net income before interest of $1.1. 1. Coconut’s RI is less than Guava’s RI. 1. None of the choices are correct Coconut’s current ROI is 49.3% [$1,330 ÷ ($4,500 − $2,700 + $900)]. If Coconut divests of a project with a 20% ROI its current ROI will increase. But, since the project’s ROI exceeds the WACC, its RI will decrease. If Coconut takes on a project with a $12 cost and net income before interest of $3, its RI will increase by $1.2 ($12 × 0.15 = $1.8; $3 − $1.8 = $1.2). If Guava takes on a project with an $8 cost and net income before interest of $1.1, its RI will
1
decrease by $.1 ($8 × 0.15 = $1.2; $1.1 − $1.2 = − $0.1. Coconut’s RI is $925 [($4,500 − $2,700 + $900) × 0.15] = $405; $1,330 − $405 = $925. Guava’s RI is $851.5 [($7,200 − $2,160 + $1,350) × 0.15] = $958.5; $1,810 − $958.5 = $851.5 AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Resource Management AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard Topic: Investment Centers 6. Economic value added (EVA): 1. uses the same basic formula as return on investment (ROI) 1. ignores R&D spending 1. decreases a manager’s incentive to maximize firm value
1. is easy to administer 1. measures the total return after deducting the cost of all capital employed by the firm The formula is based on the residual income, not ROI, approach. It utilizes a taxadjusted WACC (for which advocate recommend adding back R&D spending) and is complex to administer. Where it is adopted in incentive plans, managers have increased incentives to maximize firm value. EVA measures the total return after deducting the cost of all capital. AACSB: Knowledge Application Accessibility: Keyboard Navigation Accessibility: Screen Reader Compatible AICPA: BB Resource Management AICPA: FN Measurement Blooms: Remember Difficulty: 2 Medium Topic: Economic Value Added (EVA®)
7. Given the following division performance indicators, which is true?
Division
A
Sales
$
500
Net profit
$
10
$
2
Net assets
Return on sales
6
Asset turnover
10
5
Return on assets
1. A’s return on assets is double that of B 1. C is the best division at managing its assets 66.
A’s sales are 66.7% bigger than C’s
1. B would benefit least from a 10% increase in sales
B
1. All of the choices are correct Division A’s sales of $500 are 66.7% bigger than C’s sales of $300. Division
A
B
Sales
$
500.0
$
333.3
Net profit
$
10.0
$
20.0
Net assets
$
50.0
$
66.7
Return on sales
2.0
%
6.0
Asset turnover
10.0
5.0
Return on assets
20.0
%
30.0
Return on sales = Net profit/Sales Asset turnover = Sales/Net assets Return on assets = Net profit/assets AACSB: Knowledge Application Accessibility: Keyboard Navigation AICPA: BB Critical Thinking AICPA: BB Resource Management AICPA: FN Measurement Blooms: Apply Difficulty: 3 Hard
Topic: Investment Centers