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

• Question 191:

  If Brewer Corporation's bonds are currently yielding 8 percent in the marketplace, why would the firm's cost of debt be lower?

  A. Market interest rates have increased.

  B. Additional debt can be issued more cheaply that the original debt.

  C. Interest is deductible for tax purposes.

  D. There is a mixture of old and new debt.

  Correct Answer: C

  Choice "c" is correct. Because interest expense is a tax deduction, the cost to Brewer is lower than the market yield rate on debt. Choice "a" is incorrect. If market interest rates increase, then Brewer's bonds would have to be offered at a discount to stay competitive with the market. This discount would increase (not lower) Brewer's cost of debt. Choice "b" is incorrect. Issuance of cheaper additional debt will lower future cost of debt, but have no impact on current cost of debt. Choice "d" is incorrect. Presumably, the 8% yield already includes new and old debt.

• Question 192:

  Investment managers develop portfolios of different investments to combine, offset, and thereby reduce overall risk. Not all risks can be eliminated by development of a portfolio. Risks that cannot be eliminated through a portfolio are called:

  A. Non-market risks.

  B. Unsystematic risks.

  C. Firm-specific risks.

  D. Systematic risks.

  Correct Answer: D

  Rule: Portfolio theory is concerned with construction of an investment portfolio that efficiently balances its

  risk with its rate of return. Risk is often reduced by diversification, the process of mixing investments of

  different or offsetting risks. The broad categories of risk are summarized in the following mnemonic to get

  us DUNS.

  Diversifiable

  Unsystematic (non market/firm-specific)

  Non-diversifiable

  Systematic (market)

  Choice "d" is correct. Non-diversifiable risk cannot be eliminated by the application of portfolio theory. Nondiversifiable risk is also referred to as systematic risk. (DUNS) Choice "a" is incorrect. Diversifiable risk can

  be eliminated through effective application of portfolio theory. Diversifiable risks are also termed non-

  market risk. Choice "b" is incorrect. Diversifiable risk can be eliminated through effective application of

  portfolio theory. Diversifiable risks are also termed unsystematic risk. Choice "c" is incorrect. Diversifiable

  risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed

  firm-specific risk.

• Question 193:

  Residco, Inc. expects net income of $800,000 for the next fiscal year. Its targeted and current capital structure is 40 percent debt and 60 percent common equity. The director of capital budgeting has determined that the optimal capital spending for next year is $1.2 million. Residco does not plan to issue any new common equity next year. If Residco follows a strict residual dividend policy, what is the expected dividend payout ratio for next year?

  A. 90.0 percent.

  B. 66.7 percent.

  C. 40.0 percent.

  D. 10.0 percent.

  Correct Answer: D

  Choice "d" is correct. A strict dividend policy guides a company's management to pay no more (and no

  less) in dividends from net income to generate a change in equity that produces or maintains a targeted

  capital structure. The dividend pay out ratio is the ratio of dividends to income.

  The call of the question requires the calculation of the ratio of dividends to income assuming income,

  capital projects and capital structure amounts as follows:

  

  Assuming the company is in compliance with the 40/60 Debt/Equity capital structure to begin with, 60% of

  the $1,200,000 in capital projects will be financed by additions to equity the come from new earnings of

  $800,000. The equity funded portion of capital projects is $720,000 ($1,200,000 x 60%).

  Following a strict residual dividend policy, the company will pay out the difference between is additions to

  equity ($800,000 in income) and the amounts reinvested in the business ($720,000). The dividend will be

  $80,000. ($800,000 - $720,000).

  The dividend payout ratio is, therefore, 10% ($80,000 in dividends/ $800,000 in income).

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

• Question 194:

  A project has an initial outlay of $1,000. The projected cash inflows are:

  

  What is the investment's payback period?

  A. 4.0 years.

  B. 3.5 years.

  C. 3.4 years.

  D. 3.0 years.

  Correct Answer: B

  Choice "b" is correct. The payback period is computed as the number of years required to fully recover the original investment with out respect to the time value of money. With uneven cash flows, the payback period is computed by development of a cumulative payback balance converted to years as follows:

  

  Choice "a" is incorrect. Although the payback occurs in the fourth year, only half the year is required. The payback period is 3.5, not 4.0 years. Choice "c" is incorrect. Although the payback occurs in the fourth year, half the year is required. The payback period is 3.5, not 3.4 years. Choice "d" is incorrect. The payback occurs in the fourth year. The payback period is 3.5, not 3.0 years. Strategies for Short-term and Long-term Financing

• Question 195:

  If an investor's certainty equivalent is greater than the expected value of an investment alternative, the investor is said to be:

  A. Risk indifferent.

  B. Risk averse.

  C. Risk seeking.

  D. Cautious.

  Correct Answer: C

  Choice "c" is correct. If an investor's certainty equivalent, the point at which they are indifferent to risk,

  exceeds the expected return on an investment, then the investor is actually seeking lower return for higher

  risk. This behavior represents risk seeking behavior.

  Choice "a" is incorrect. Risk indifferent behavior occurs when an investor's certainty equivalent is equal to

  the expected return on the investment. Choice "b" is incorrect. Risk averse behavior occurs when an

  investor's certainty equivalent is less than the expected rate of return. The investor seeks higher returns for

  more risk.

  Choice "d" is incorrect. Cautious is not a technical term used in risk behavior classifications.

• Question 196:

  In considering the payback period for three projects, Fly Corp. gathered the following data about cash flows:

  

  Which of the projects will achieve payback within three years?

  A. Projects A, B, and C.

  B. Projects B and C.

  C. Project B only.

  D. Projects A and C.

  Correct Answer: B

  Choice "b" is correct. Projects B and C achieve payback in three years. The payback period for Project A is somewhere between the end of Year 4 and Year 5. For all three projects, Year 1 appears to be a combination of cash outflows (initial cost) and cash inflows (return of investment), but it really does not make any difference. When the cumulative cash flow (both inflow and outflow) is zero, the project has paid back. Choice "a" is incorrect. Project A does not pay back within 3 years even though Projects B and C do. Choice "c" is incorrect. Projects B and C, not just Project B, pay back within 3 years. Choice "d" is incorrect. Project A does not pay back within 3 years even though Project C does.

• Question 197:

  Harvey Co. is evaluating a capital investment proposal for a new machine. The investment proposal shows the following information:

  

  If acquired, the machine will be depreciated using the straight-line method. The payback period for this investment is:

  A. 3.25 years.

  B. 2.67 years.

  C. 2.5 years.

  D. 2 years.

  Correct Answer: C

  Choice "c" is correct. With even cash flows, payback period is calculated as initial cost / annual net cash inflows. That is, $500,000 / $200,000 = 2.5. Choice "a" is incorrect. We could not determine an obvious approach to obtain this answer. It is incorrect per the calculation above. Choice "b" is incorrect. This answer is calculated as follows: (initial cost - salvage value) / (annual net cash inflows - annual depreciation) or ($500,000 - $100,000) / ($200,000 - $50,000) = $400,000 / $150,000 = 2.67. With the payback period, depreciation should only be considered to the extent that it represents a tax shield. Choice "d" is incorrect. This answer appears to be the initial cost less salvage value divided by the annual net cash inflows (($500,000 - $100,000) / $200,000 = 2.0). Salvage value is not included in the correct calculation.

• Question 198:

  Net present value as used in investment decision-making is stated in terms of which of the following options?

  A. Net income.

  B. Earnings before interest, taxes, and depreciation.

  C. Earnings before interest and taxes.

  D. Cash flow.

  Correct Answer: D

  Choice "d" is correct. Net present value, like most capital budgeting techniques, focuses on cash flow. Cash flow is a pure measure of financial performance that isolates relevant information for decision making. The amount of cash the firm takes in and pays out for an investment affects the amount of cash the firm has available for operations and other activities. Choice "a" is incorrect. Net present value focuses on cash flows. Net income distorts financial results useful for capital budgeting decisions with non-cash items, such as depreciation, as well as with sunk costs. Choice "b" is incorrect. Net present value focuses on cash flows. Earnings before interest, taxes, and depreciation often approximates cash flow but still distorts financial results with earnings rather than the cash flow data most useful for capital budgeting. Choice "c" is incorrect. Net present value focuses on cash flows. Earnings before interest and taxes distort financial results with non-cash data (depreciation) as well as earnings data rather than the cash flow data most useful for capital budgeting.

• Question 199:

  RLF Corporation had income before taxes of $60,000 for the year 1991. Included in this amount was depreciation of $5,000, a charge of $6,000 for the amortization of bond discounts, and $4,000 for interest expense. The estimated cash flow for the period is:

  A. $66,000

  B. $49,000

  C. $71,000

  D. $65,000

  Correct Answer: C

  Choice "c" is correct. Cash flow is computed from net income by adding back non-cash expenses like depreciation and amortization. Presumably, interest expense has been paid (i.e., is not "accrued" interest) and should not be added back.

  

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

• Question 200:

  A depreciation tax shield is:

  A. An after-tax cash outflow.

  B. A reduction in income taxes.

  C. The expense caused by depreciation.

  D. Caused by the fact that depreciation does not affect cash flow.

  Correct Answer: B

  Choice "b" is correct. Whenever depreciation protects income from taxation, it is known as a depreciation

  tax shield.

  Choice "a" is incorrect. A depreciation tax shield may result in after-tax cash inflow, but not outflow.

  Choice "c" is incorrect, per above.

  Choice "d" is incorrect. A depreciation tax shield is caused by the tax deductibility of the depreciation

  expense, not by the fact that depreciation does not affect cash flow.