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

• Question 171:

  The optimal capitalization for an organization usually can be determined by the:

  A. Maximum degree of financial leverage (DFL).

  B. Maximum degree of total leverage (DTL).

  C. Lowest total weighted-average cost of capital (WACC).

  D. Intersection of the marginal cost of capital and the marginal efficiency of investment.

  Correct Answer: C

  Choice "c" is correct. The optimal capitalization for an organization usually can be determined by the lowest total weighted-average cost of capital (WACC). Capitalization at WACC serves to maximize shareholder's equity. Choice "a" is incorrect. The degree of financial leverage relates to the risk assumed by a firm using fixed debt service costs to finance operations not comprehensively to capital structure. Choice "b" is incorrect. The degree of total leverage relates the risk assumed by a firm using a combination of both debt services costs to finance operations and fixed costs to operate the business, not comprehensively to capital structure. Choice "d" is incorrect. The intersection of the marginal cost of capital and the marginal efficiency of investment does not indicate optimal capitalization.

• Question 172:

  The benefits of debt financing over equity financing are likely to be highest in which of the following situations?

  A. High marginal tax rates and few noninterest tax benefits.

  B. Low marginal tax rates and few noninterest tax benefits.

  C. High marginal tax rates and many noninterest tax benefits.

  D. Low marginal tax rates and many noninterest tax benefits.

  Correct Answer: A

  Choice "a" is correct. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high (because interest on debt is deductible for tax purposes) and if there are few noninterest tax benefits (because there is little or no reason to depart from debt financing). Choice "b" is incorrect. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high, not low (because interest on debt is deductible for tax purposes), and if there are few noninterest tax benefits. Choice "c" is incorrect. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high (because interest on debt is deductible for tax purposes) and if there are few, not many, noninterest tax benefits. Choice "d" is incorrect. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high, not low (because interest on debt is deductible for tax purposes), and if there are few, not many, noninterest tax benefits.

• Question 173:

  Vested, Inc. made some changes in operations and provided the following information:

  

  What percentage represents the return on investment for year 3?

  A. 28.57%

  B. 25%

  C. 20.31%

  D. 20%

  Correct Answer: B

  Choice "b" is correct. Return on investment is the ratio of operating income to average operating assets and is computed as follows based on Year 2 and Year 3 data:

  

  Choice "a" is incorrect per the above computation.

  Choice "c is incorrect. The year 3 return on investment is not computed by combining revenues, expenses,

  and assets for all year's presented. Choice "d" is incorrect. The year 3 return on investment is based on

  the average assets (($1,200,000 + $2,000,000)/2 = $1,600,000), not simply on the total assets at the end

  of year 3 ($2,000,000).

• Question 174:

  The capital structure of a firm includes bonds with a coupon rate of 12% and an effective interest rate is 14%. The corporate tax rate is 30%. What is the firm's net cost of debt?

  A. 8.4%

  B. 9.8%

  C. 12.0%

  D. 14.0%

  Correct Answer: B

  Choice "b" is correct. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%. The question is trying to trick the candidate into using the coupon rate of 12% rather than the effective interest rate. The coupon rate is used only if it is the same as the effective interest rate and there are no flotation costs. Choice "a" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the coupon rate of 12% x .70 = 8.4%. Choice "c" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the coupon rate of 12% by itself. The cost of debt is computed on an after-tax basis and uses the effective interest rate instead of the coupon rate. Choice "d" is incorrect. The net cost of debt is computed as the effective interest rate net of tax, or 14% x .70 = 9.8%, not the effective interest rate of 14% by itself. The cost of debt is computed on an after-tax basis.

• Question 175:

  What is the primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers?

  A. ROI is a percentage, while RI is a dollar amount.

  B. ROI may lead to rejecting projects that yield positive cash flows.

  C. ROI does not necessarily reflect the company's cost of capital.

  D. ROI does not reflect all economic gains.

  Correct Answer: B

  Choice "b" is correct. The primary disadvantage of using return on investment (ROI) rather than residual

  income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting

  projects that yield positive cash flows. Profitable investment center managers might be reluctant to invest

  in projects that might lower their ROI (especially if their bonuses are based only on their investment

  center's ROI), even though those projects might generate positive cash flows for the company as a whole.

  This characteristic is often known as the "disincentive to invest."

  Choice "a" is incorrect. The primary disadvantage of using return on investment (ROI) rather than residual

  income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting

  projects that yield positive cash flows, not that ROI is a percentage and RI is a dollar amount.

  The fact that one is a percentage and one is a dollar amount might make them a little harder to interpret,

  but this interpretation difficulty would certainly not seem to be the "primary" disadvantage.

  Choice "c" is incorrect. The primary disadvantage of using return on investment (ROI) rather than residual

  income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting

  projects that yield positive cash flows, not that ROI does not necessarily reflect the cost of capital.

  Choice "d" is incorrect. The primary disadvantage of using return on investment (ROI) rather than residual

  income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting

  projects that yield positive cash flows, not that ROI does not reflect all economic gains.

• Question 176:

  Which one of the following statements pertaining to the return on investment (ROI) as a performance measurement is incorrect?

  A. When the average age of assets differs substantially across segments of a business, the use of ROI may not be appropriate.

  B. ROI relies on financial measures that are capable of being independently verified while other forms of performance measures are subject to manipulation.

  C. The use of ROI may lead managers to reject capital investment projects that can be justified by using discounted cash flow models.

  D. The use of ROI can make it undesirable for a skillful manager to take on trouble-shooting assignments such as those involving turning around unprofitable divisions.

  Correct Answer: B

  Choice "b" is correct. ROI is no more and no less capable of being independently verified or manipulated than other performance measure. Choice "a" is incorrect. Old fixed assets may be undervalued and make comparison with a segment with newer assets inappropriate. Choice "c" is incorrect. Investment projects with positive present value may be rejected because ROI is too low. Choice "d" is incorrect. Turning around an unprofitable division would be good for the company but would probably lower a manager's ROI.

• Question 177:

  The basic objective of the residual income approach of performance measurement and evaluation is to have a division maximize its:

  A. Return on investment rate.

  B. Imputed interest rate charge.

  C. Cash flows in excess of a desired minimum amount.

  D. Income in excess of a desired minimum amount.

  Correct Answer: D

  Choice "d" is correct. Residual income is defined as income in excess of a desired minimum return. Choices "a" and "b" are incorrect, as residual income is not a "rate" of return; it is a dollar amount. Choice "c" is incorrect, as residual income is an accrual method.

• Question 178:

  The imputed interest rate used in the residual income approach for performance measurement and evaluation can best be characterized as the:

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

  B. Average return on investment that has been earned by the company over a particular time period.

  C. Average return on assets employed over a particular time period.

  D. Average prime lending rate for the year being evaluated.

  Correct Answer: A

  Choice "a" is correct. Historical weighted average cost of capital is usually used as the target or hurdle rate

  in the residual income approach.

  Choices "b", "c", and "d" are incorrect, per the above definition.

• Question 179:

  Minon, Inc. purchased a long-term asset on the last day of the current year. What are the effects of this purchase on return on investment and residual income?

  

  A. Option A

  B. Option B

  C. Option C

  D. Option D

  Correct Answer: B

  Choice "b" is correct. The addition of an asset at year end serves to reduce both return on investment and residual income. The addition of an asset increases then denominator in the ROI computation and increases the threshold earnings required using the residual income approach. Both measures would suffer as a result of addition of assets. See illustration below:

  

  The purchase of the additional asset reduces ROI from 10% to 8% and produces negative residual

  income.

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

• Question 180:

  Colt Inc. is planning to use retained earnings to finance anticipated capital expenditures. The beta coefficient for Colt's stock is 1.15, the risk-free rate of interest is 8.5 percent, and the market return is estimated at 12.4%. If a new issue of common stock was used in this model, the flotation costs would be 7%. By using the Capital Asset Pricing Model equation C = R + B (M - R), the cost of using retained earnings to finance the capital expenditures is:

  A. 13.96 percent.

  B. 12.99 percent.

  C. 14.26 percent.

  D. 13.21 percent.

  Correct Answer: B

  Choice "b" is correct. The capital asset pricing model (CAPM) is: