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

• Question 181:

  Listed below is selected financial information for the Western Division of the Hinzel Company for last year.

  

  If Hinzel treats the Western Division as an investment center for performance measurement purposes, what is the before-tax return on investment for last year?

  A. 26.76 percent.

  B. 22.54 percent.

  C. 19.79 percent.

  D. 16.67 percent.

  Correct Answer: D

  Choice "d" is correct. 16.67% return on investment.

  

• Question 182:

  James Webb is the general manager of the Industrial Product Division, and his performance is measured using the residual income method. Webb is reviewing the following forecasted information for his division for next year.

  

  If the imputed interest charge is 15 percent and Webb wants to achieve a residual income target of $2 million, what will costs have to be in order to achieve the target?

  A. $10,800,000

  B. $23,620,000

  C. $25,150,000

  D. $25,690,000

  Correct Answer: C

  Choice "c" is correct. $25,150,000 costs to achieve residual income target of $2 million.

  

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

• Question 183:

  The segment margin of an investment center after deducting the imputed interest on the assets used by the investment center is known as:

  A. Return on investment.

  B. Residual income.

  C. Operating income.

  D. Return on assets.

  Correct Answer: B

  Choice "b" is correct. Residual income is the segment margin of an investment center after deducting the

  imputed interest (hurdle rate) on the assets used by the investment center.

  Choice "a" is incorrect. Return on investment is the ratio of income earned to the investment.

  Choice "c" is incorrect. Operating income is not well defined, but is generally the income from operations

  for the entire organization, not a segment.

  Choice "d" is incorrect. Return on assets is the ratio of income produced to assets employed (not the

  amount invested).

• Question 184:

  The theory underlying the cost of capital is primarily concerned with the cost of:

  A. Long-term funds and old funds.

  B. Short-term funds and new funds.

  C. Long-term funds and new funds.

  D. Any combination of old or new, short-term or long-term funds.

  Correct Answer: D

  Choice "d" is correct. The cost of capital considers the cost of all funds - whether they are short-term, longterm, new or old.

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

• Question 185:

  Which one of a firm's sources of new capital usually has the lowest after tax cost?

  A. Retained earnings.

  B. Bonds.

  C. Preferred stock.

  D. Common stock.

  Correct Answer: B

  Choice "b" is correct. Because debt is a cheaper source of financing than equity, bonds will be the

  cheapest form of financing. In addition, the company issuing bonds receives a tax deduction for interest

  paid. This further reduces the cost of bond financing.

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

• Question 186:

  Youngsten Electric is contemplating new projects for the next year that will require $30,000,000 of new financing. In keeping with its capital structure, Youngsten plans to use debt and equity financing as follows:

  •

  Issue $10,000,000 of 20-year bonds at a price of 101.5, with a coupon of 10%, and flotation costs of 2.5% of par value.

  •

  Use internal funds generated from earnings of $20,000,000.

  The equity market is expected to earn 15%. U.S. treasury bonds currently are yielding 9%. The beta coefficient for Youngsten's common stock is estimated to be .8. Youngsten is subject to a 40% corporate income tax rate. Youngsten has a price/earnings ratio of 10, a constant dividend payout ratio of 40%, and an expected growth rate of 12%.

  Assume Youngsten has an after-tax cost of debt of 9% and an after-tax cost of equity of 15%. Youngsten's weighted average cost of capital is:

  A. 11.0%

  B. 13.0%

  C. 12.0%

  D. 11.8%

  Correct Answer: B

  Choice "b" is correct. The WACC is computed by multiplying the required returns on equity and debt by the percentage of equity and debt used to finance that particular project. Youngsten will use 33% debt ($10 million of $30 million total project cost) and 67% equity ($20 million of $30 million total project cost).

  

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

• Question 187:

  Sylvan Corporation has the following capital structure:

  

  The financial leverage of Sylvan Corp. would increase as a result of:

  A. Issuing common stock and using the proceeds to retire preferred stock.

  B. Issuing common stock and using the proceeds to retire debenture bonds.

  C. Financing its future investments with a higher percentage of bonds.

  D. Financing its future investments with a higher percentage of equity funds.

  Correct Answer: C

  Choice "c" is correct. Financial leverage increases when the debt to equity ratio increases. Using a higher percentage of debt (bonds) for future investments would increase financial leverage. Choice "a" is incorrect. This results in no change in total equity and, consequently, no change in financial

  leverage.

  Choice "b" is incorrect. This would result in increased equity and decreased debt, which would decrease

  financial leverage.

  Choice "d" is incorrect. This would increase equity, decrease the debt to equity ratio and decrease financial

  leverage.

• Question 188:

  DQZ Telecom is considering a project for the coming year, which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment.

  •

  Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8 percent, and flotation costs of

  2 percent of par.

  •

  Use $35 million of funds generated from earnings.

  The equity market is expected to earn 12 percent. U.S. treasury bonds are currently yielding 5 percent.

  The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40 percent. The Capital Asset Pricing Model (CAPM) computes the expected return on a security by adding the riskfree rate of return to the incremental yield of the expected market return, which is adjusted by the company's beta. Compute DQZ's expected rate of return.

  A. 9.20 percent.

  B. 12.20 percent.

  C. 7.20 percent.

  D. 10.00 percent.

  Correct Answer: A

  

  Choice "a" is correct. 9.20 percent expected rate of return. Choices "b", "c", and "d" are incorrect, per the above calculation.

• Question 189:

  By using the discounted cash flow model, estimate the cost of equity capital for a firm with a stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10 percent.

  A. 21.1 percent.

  B. 12.2 percent.

  C. 11.0 percent.

  D. 20.0 percent.

  Correct Answer: D

  

  Choice "d" is correct. 20.0 percent cost of equity capital by using the discounted cash flow model.

• Question 190:

  Which one of the following factors might cause a firm to increase the debt in its financial structure?

  A. An increase in the corporate income tax rate.

  B. Increased economic uncertainty.

  C. An increase in the price/earnings ratio.

  D. A decrease in the times interest earned ratio.

  Correct Answer: A

  Choice "a" is correct. An increase in the corporate income tax rate might cause a firm to increase the debt in its financial structure because interest is tax deductible, while dividends are paid after-tax. Choice "b" is incorrect. Increased economic uncertainty would cause a firm to decrease debt (and interest cost). Choice "c" is incorrect. An increase in the price/earnings ratio would encourage the issuance of equity rather than debt. Choice "d" is incorrect. A decrease in the times interest earned ratio indicates that earnings have declined compared with interest, and that more debt would be unwise (and more difficult to negotiate).