Test Prep Test Prep Certifications BUSINESS-ENVIRONMENT-AND-CONCEPTS Questions & Answers

• Question 1:

  Williams, Inc. is interested in measuring its overall cost of capital and has gathered the following data. Under the terms described below, the company can sell unlimited amounts of all instruments.

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  Williams can raise cash by selling $1,000, 8 percent, 20-year bonds with annual interest payments. In selling the issue, an average premium of $30 per bond would be received, and the firm must pay floatation costs of $30 per bond. The after-tax cost of funds is estimated to be 4.8 percent.

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  Williams can sell 8 percent preferred stock at par value, $105 per share. The cost of issuing and selling the preferred stock is expected to be $5 per share.

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  Williams' common stock is currently selling for $100 per share. The firm expects to pay cash dividends of $7 per share next year, and the dividends are expected to remain constant. The stock will have to be underpriced by $3 per share, and floatation costs are expected to amount to $5 per share.

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  Williams expects to have available $100,000 of retained earnings in the coming year; once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.

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  Williams' preferred capital structure is:

  Long-term debt 30% Preferred stock 20 Common stock 50

  The cost of funds from retained earnings for Williams, Inc. is:

  A. 7.0 percent.

  B. 7.4 percent.

  C. 8.1 percent.

  D. 7.8 percent.

  Correct Answer: A

  Choice "a" is correct. 7.0 percent cost of funds from retained earnings.

  The cost of retained earnings is equal to the rate of return required by the firm's common shareholders (or,

  in effect, the return "lost" by them when the firm chooses to fund with retained earnings). While oftentimes

  this rate is somewhat subjective, we are given the facts to exactly answer the question in this case. The

  stock is currently selling for $100/share, and the dividend is given at $7/share.

  $7 / $100 = 7%

  Choices "b", "c", and "d" are incorrect, per the above Explanation/calculation.

• Question 2:

  The following information pertains to Quest Co.'s Gold Division for 1993:

  

  Quest's return on investment was: A. 10.00 percent.

  B. 13.33 percent.

  C. 27.50 percent.

  D. 30.00 percent.

  Correct Answer: C

  Choice "c" is correct. Return on investment equals net income divided by average invested capital:

  

  Choices "a", "b", and "d" are incorrect, per the above calculation.

• Question 3:

  Select Co. had the following 1994 financial statement relationships:

  Asset turnover 5 Profit margin on sales 0.02

  What was Select's 1994 percentage return on assets?

  A. 0.1 percent.

  B. 0.4 percent.

  C. 2.5 percent.

  D. 10.0 percent.

  Correct Answer: D

  Choice "d" is correct. Return on assets equals income divided by average assets. This formula can be further divided into the components of profit margin times asset turnover (referred to as the Dupont formula):

  

  Choices "a", "b", and "c" are incorrect, per the above calculation.

• Question 4:

  The following selected data pertain to the Darwin Division of Beagle Co. for 1994:

  

  What was Darwin's 1994 residual income?

  A. $0

  B. $4,000

  C. $10,000

  D. $30,000

  Correct Answer: D

  Choice "d" is correct. Residual income is income less the imputed interest rate times average invested capital. Capital turnover is equal to sales / average invested capital.

  

  Choice "a" is incorrect. Residual income is greater than zero. The imputed interest rate times average

  invested capital needs to be compared with operating income.

  Choice "b" is incorrect. Residual income is not simply the imputed interest rate times operating income.

  The imputed interest rate times average invested capital needs to be compared with operating income.

  Choice "c" is incorrect. Residual income is not simply imputed interest rate times average invested capital.

  The operating income must be considered.

• Question 5:

  One approach to measuring divisional performance is return on investment. Return on investment is expressed as operating income:

  A. Divided by the current year's capital expenditures plus cost of capital.

  B. Divided by fixed assets.

  C. Divided by current assets.

  D. Divided by total assets.

  Correct Answer: D

  Choice "d" is correct. Return on investment is operating income divided by total assets.

  Choice "a" is incorrect. Current year's capital expenditures plus cost of capital would be a meaningless

  denominator.

  Choice "b" is incorrect. This omits the current assets employed by the division.

  Choice "c" is incorrect. This omits fixed assets.

• Question 6:

  The imputed interest rate used in the residual income approach to performance evaluation can best be described as the:

  A. Historical weighted average cost of capital for the company.

  B. Target return on investment set by the company's management.

  C. Average return on investments for the company over the last several years.

  D. Marginal after-tax cost of capital on new equity capital.

  Correct Answer: B

  Choice "b" is correct. The imputed interest rate used in the residual income approach can best be described as the target return on investment set by the company's management. Choice "a" is incorrect, but it is a close second. The historical weighted average cost of capital may be how management sets the target return on investment. Choice "c" is incorrect. The average return on investments for past years may not be a good indication of management's future intentions. Choice "d" is incorrect. Marginal after-tax cost of capital on new equity may be how management sets its targets, but it may not be, too.

• Question 7:

  Managerial performance can be measured in many different ways including return on investment (ROI) and residual income (RI). A good reason for using RI instead of ROI is that:

  A. RI can be computed without regard to identifying an investment base.

  B. Goal congruence is more likely to be promoted by using RI.

  C. RI is well understood and often used in the financial press.

  D. ROI does not take into consideration both the investment turnover ratio and return-on-sales percentage.

  Correct Answer: B

  Choice "b" is correct. Goal congruence is promoted through the use of the residual income approach. The

  ROI approach may cause segments that achieve high returns to reject investments that may benefit the

  company but lower the segment's rate of return.

  Choices "a", "c", and "d" are incorrect, per the above Explanation.

• Question 8:

  Micro Manufacturers uses a performance reporting system that combines both financial and nonfinancial measures to evaluate division performance. All of the following measure operational efficiency, except:

  A. Operating leverage.

  B. Days' sales in accounts receivables.

  C. Inventory turnover.

  D. Residual income.

  Correct Answer: D

  Choice "d" is correct. Residual income measures profitability in excess of a target rate of return.

  Operational efficiency is not considered.

  Choices "a", "b", and "c" are incorrect. Operating leverage, days' sales in accounts receivable, and

  inventory are all measures of operational efficiency, specifically, efficiency in managing working capital.

• Question 9:

  The selection of the denominator in the return on investment (ROI) formula is critical to the measure's effectiveness. Which denominator is criticized because it combines the effects of operating decisions made

  at one level of the organization with financing decisions made at another organization level?

  A. Total assets available.

  B. Total assets employed.

  C. Working capital plus other assets.

  D. Shareholder's equity.

  Correct Answer: D

  Choice "d" is correct. Shareholders' equity is the ROI denominator that has been criticized because it

  combines the effects of operating decisions made at another organization level.

  Choices "a", "b", and "c" are incorrect, per the above Explanation.

• Question 10:

  Of the following items, the one item that would not be considered in evaluating the adequacy of the budgeted annual operating income for a company is:

  A. Return on assets.

  B. Long-range profit objectives.

  C. Industry average for earnings on sales.

  D. Internal rate of return.

  Correct Answer: D

  Choice "d" is correct. In evaluating the adequacy of the budgeted annual operating income, you would not use the internal rate of return calculation. The internal rate of return is used for capital budgeting. Choices "a", "b", and "c" are incorrect. Return on assets, long range profit objectives, industry average for earnings on sales, and earnings per share [not mentioned as an option] are all measures for evaluating the adequacy of the budgeted annual operating income.