407
Chapter 12—Analysis of Investing Activities
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408 ♦ Chapter 12
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Analysis of Investing Activities ♦ 409
TRUE/FALSE
1. All other things being equal, a highly-automated company is riskier than one with less automation.
2. The use of fixed costs to increase net income as sales increase is known as operating leverage.
3. A high percentage of fixed costs relative to variable costs will reduce the potential for high profits.
4. A firm’s ability to repay creditors is usually directly associated with its ability to use its long-term
assets to generate profits and cash flows.
5. Return on assets is computed as sales divided by total assets.
6. Profit margin is the ratio of net income to sales.
7. Return on assets would be increased by an increase in profit margin assuming that total assets
remained constant.
8. An increase in total assets without a proportionate increase in sales, will result in a decrease in
asset turnover.
9. If a company is able to earn a higher percentage of profits for each additional dollar of product it
sells over its current percentage, then the company’s efficiency has improved.
410 ♦ Chapter 12
10. Accounting rules under GAAP, require plant assets to be reported at market value.
MULTIPLE CHOICE
1. Investment decisions are important to a company because they
a.
always result in higher profits
b.
lessen the impact of merger and acquisition decisions
c.
increase the degree of financial leverage that a company is employing at a given point in
time
d.
commit management to a course of action regarding financing and operating activities
2. A company’s use of fixed costs to increase net income as sales increase is known as
a.
financial leverage
b.
operating leverage
c.
fiscal leverage
d.
efficiency leverage
3. A company can reduce the volatility of its profits that generated from fluctuating levels of sales by
a.
increasing financial leverage
b.
increasing operating leverage
c.
decreasing operating leverage
d.
investing in riskier projects
4. The concept of operating leverage differs from that of financial leverage in that operating leverage
is affected by
Whether assets are The type (or mix) of fixed
financed by debt or equity assets held by the firm
a.
Yes Yes
b.
Yes No
c.
No Yes
d.
No No
Analysis of Investing Activities ♦ 411
5. The relationship of a firm’s fixed costs relative to its variable costs yields information about its
a.
degree of financial leverage
b.
degree of operating leverage
c.
degree of earnings leverage
d.
degree of both financial and operating leverage
6. Solo Company has a higher ratio of fixed to variable costs than Luna Company. The sales
revenues of both companies increased by 10%. If the firms are similar in size and product mix,
you would expect Solo Company’s
a.
expenses to increase more rapidly than Luna Company’s
b.
expenses to decrease while Luna Company’s increase
c.
net income to decrease while Luna Company’s increase
d.
net income to increase more rapidly than Luna Company’s
7. Sylvester Company has a lower ratio of fixed to variable costs than Tweety Company. The sales
revenues of both companies increased by 10%. If the firms are similar in sizeand product mix, you
would expect Sylvester’s
a.
expenses to increase more rapidly than Tweety’s
b.
expenses to decrease while Tweety’s increase
c.
net income to decrease while Tweety’s increase
d.
net income to increase more rapidly than Tweety’s
8. If 80% of a certain firm’s assets are invested in plant, machinery and other long-term assets, then
one would also expect this firm to have a high level of
a.
operating leverage
b.
financial leverage
c.
return on assets
d.
debt
9. Operating leverage affects a company’s return on
a.
assets and return on equity
b.
assets but not return on equity
c.
equity but not return on assets
d.
equity less than its return on assets
412 ♦ Chapter 12
10. Which of the following statements is TRUE concerning financial leverage and operating leverage?
a.
financial leverage is helpful to a firm whereas operating leverage is not
b.
financial leverage increases a firm’s risk whereas operating leverage does not
c.
financial leverage benefits a company most at high sales volumes while operating leverage
benefits a company most at low sales volumes
d.
financial leverage is a measurement of financing choices whereas operating leverage is a
measurement of cost structure choices
11. Samson Company has about 5% of its total assets in current assets with the remainder invested in
fixed assets. Based only on this information, one would expect this firm to have a
a.
high level of operating leverage
b.
high level of financial leverage
c.
low level of operating leverage
d.
low level of financial leverage
12. If Beverly Company has higher operating leverage than Hope, Inc., an equivalent increase in sales
for both companies should result in
a.
a greater increase in operating income for Beverly than Hope
b.
a greater increase in operating income for Hope than Beverly
c.
the same increase in operating income for Beverly and Hope
d.
an increase in operating income for Hope but a decrease for Beverly
13. For which of these firms would you expect to find the least amount of operating leverage?
a.
Federal Express
b.
Boeing
c.
Wal-mart
d.
General Motors
Analysis of Investing Activities ♦ 413
14. Given below is information about four firms:
White
Blue
Red
Brown
Current assets
$2500
$4,000
$1,400
$2,400
Fixed assets
9,500
2,000
1,400
600
Liabilities
5,000
3,000
1,400
2,000
Equity
7,000
3,000
1,400
1,000
Which of these firms is most likely to have the highest operating leverage?
a.
White
b.
Blue
c.
Red
d.
Brown
15. It is quite likely that a company is experiencing (achieving) growth when its records reflect
a.
capital expenditures during a period
b.
straight-line depreciation during a period
c.
straight-line depreciation in excess of capital expenditures during a period
d.
capital expenditures in excess of straight-line depreciation during a period
16. Super Speed Company reports the following selected information as of December 31 for each of
the past five years. (All amounts are in millions of dollars and 2011 is the most recent year.)
2011
2010
2009
2008
2007
Total assets
150
147
151
161
168
Net income
4
5
5
4
6
Dividends
2
3
2
2
3
Retained earnings
52
50
48
45
43
Which of the following is the most reasonable explanation for the trends above?
a.
the company’s products are “leading edge” involving new technologies
b.
management is having a hard time finding the cash necessary to pay dividends
c.
new competition is driving down prices and profitability
d.
the firm is not taking advantage of opportunities for geographic and/or product line growth
17. Magenta Company and Green Company each began operations the same day with similar assets.
Magenta Company purchased the assets while Green Company leased the assets on a yearly basis.
Which of the following is TRUE?
a.
both companies will report the same amount for assets on the balance sheet
b.
both companies will report the same cash flow from investing activities
c.
Green Company will have greater operating leverage
d.
Magenta Company will report a greater amount of assets on the balance sheet
414 ♦ Chapter 12
18. Snowy, Inc. and White Slopes, Inc. are similar in size and in many other respects. The companies
reported the following net cash flow from (used for) investing activities in their annual reports.
($ in millions)
2009
2008
2007
Snowy, Inc.
(250)
(300)
(80)
White Slopes, Inc.
400
54
(30)
From this information, you would expect
a.
Snowy, Inc. to be growing more rapidly than White Slopes, Inc.
b.
White Slopes, Inc. to be growing more rapidly than Snowy, Inc.
c.
White Slopes, Inc. to have many more investment alternatives than Snowy, Inc.
d.
White Slopes, Inc. to be less profitable than Snowy, Inc.
19. Which of the following net cash flow patterns is typical of a company with high growth potential
and strong financial performance?
Cash flow from Cash flow from
operating activities investing activities
a.
outflow outflow
b.
outflow inflow
c.
inflow inflow
d.
inflow outflow
20. Return on assets is computed as
a.
net income / total assets
b.
operating income / total assets
c.
sales / total assets
d.
gross profit / total assets
21. Profit margin is the ratio of
a.
operating income to sales
b.
income before tax to sales
c.
gross profit to sales
d.
net income to sales
Analysis of Investing Activities ♦ 415
22. A firm has a profit margin of 6% and an asset turnover of 2. What is its return on assets?
a.
3%
b.
0.667
c.
12%
d.
cannot be determined from the information given
23. A firm has a profit margin of 5% and a return on assets of 15%. What is its asset turnover?
a.
75
b.
3
c.
.33
d.
cannot be determined from the information given
24. Blue Company has a higher ratio of accumulated depreciation to plant assets than Purple
Company. This may suggest that
a.
Purple Company’s assets are older than Blue Company’s
b.
Purple Company has higher operating leverage than Blue Company
c.
Blue Company’s assets are older than Purple Company’s
d.
Blue Company has higher operating leverage than Purple Company
25. A primary difference between return on assets and return on equity is that return on assets
a.
requires that interest expense be added back to net income (net-of-tax) but return on equity
does not
b.
is affected by how a company chooses to finance investments
c.
is a clearer measure of the quality of investment decisions than is return on equity
d.
requires that preferred dividends be subtracted from net income but not interest expense
26. A clear distinction between return on assets and return on equity is that return on assets
a.
must always be a smaller percentage than is return on equity
b.
is a measure of management’s investment decisions that excludes any consideration of
how the investments were financed
c.
is of greater interest to investors than is return on equity
d.
measures operating leverage while return on equity measures financial leverage
416 ♦ Chapter 12
27. The following information is available for a company:
Total Assets:
Net sales revenue
$1,656,000
Beginning
$640,000
Interest expense
160,000
Ending
640,000
Wages payable
52,000
Net income
48,000
Income tax rate
40%
The firm’s return on assets for the year was
a.
2.6%
b.
6.8%
c.
12.4%
d.
7.5%
28. Canyon Record Company had a higher return on assets this year than it did return on equity. This
means that, during the year, the
a.
balance in the deferred taxes account decreased
b.
firm reduced its interest expense
c.
firm experienced negative financial leverage
d.
cash flow from operations exceeded income from operations
29. You know a firm’s debt to equity ratio and its return on assets. From this information you can
determine whether the firm is
a.
using financial leverage
b.
using financial leverage AND whether the financial leverage is positive or negative
c.
earning a greater return on assets than it is on equity
d.
earning a greater return on assets than it is paying on liabilities
30. Which of the following is TRUE about a firm that has a decreasing return on assets (ROA) each
year?
a.
its cost of capital is increasing
b.
the firm is taking on more and more operating leverage
c.
its executives may be making poor investment decisions
d.
the cash flow from operating activities is also decreasing
31. Asset turnover is a measure of
a.
efficiency
b.
effectiveness
c.
profitability
d.
the ability of the company to generate income from sales
Analysis of Investing Activities ♦ 417
32. Deere Company and Red Fox Co. are similar in size and in many other respects. The companies
reported the following net cash flow from (used for) investing activities in its recent annual
reports:
($ in millions)
2009
2008
2007
Deere Company
404
78
(30)
Red Fox Co.
(257)
(294)
(80)
From this information, which of the following is TRUE
a.
Deere Company appears to be growing more rapidly than Red Fox Co.
b.
Red Fox Co. appears to be growing more rapidly than Deere Company
c.
Deere Company has better investment alternatives than Red Fox Co.
d.
Red Fox Co. is less profitable than Deere Company
33. Refer to the information in Figure 11-1. Which company has the most profit?
a.
Petal Co.
b.
Reel Co.
c.
Sphere Co.
d.
Shade Co.
34. Refer to the information in Figure 11-1. Which company is most effective?
a.
Petal Co.
b.
Reel Co.
c.
Sphere Co.
d.
Shade Co.
35. Refer to the information in Figure 11-1. Which company has the most total assets?
a.
Petal Co.
b.
Reel Co.
c.
Sphere Co.
d.
Shade Co.
0.15
0.05
0.09
0.20
1.10
418 ♦ Chapter 12
36. Refer to the information in Figure 11-1. Which company is most efficient?
a.
Petal Co.
b.
Reel Co.
c.
Sphere Co.
d.
Shade Co.
37. Generally, a company is experiencing a lack of investment opportunities when it has
a.
capital expenditures during a period
b.
straight-line depreciation during a period
c.
straight-line depreciation in excess of capital expenditures during a period
d.
capital expenditures in excess of straight-line depreciation during a period
38. Investment decisions affect profit in which of the following ways?
a.
the amount invested in plant assets (like equipment), will affect the amount of depreciation
expense reported on the income statement
b.
the amount spent on acquiring inventory to sell will affect the amount of cost of goods
sold expense on the income statement
c.
the amount of dividends distributed to stockholders will reduce the retained earnings
d.
investment decisions have no effect on profits
39. Which of the following measures the effectiveness of a company in utilizing its assets to sell its
products?
a.
asset turnover
b.
operating leverage
c.
return on assets
d.
profit margin
40. If an investor concludes that one company is more efficient in generating profits than another
company, that investor is looking at which of the following measures?
a.
return on assets
b.
profit margin
c.
asset turnover
d.
operating leverage
Analysis of Investing Activities ♦ 419
41. Which of the following measures the outcome of a company’s investment decisions by comparing
the profits the company generates from producing and selling goods and services with the total
amount invested in assets?
a.
operating leverage
b.
return on assets
c.
profit margin
d.
asset turnover
42. A company “earned 15.5¢ of profit for every dollar invested in assets.” This statement reflects a
measure of
a.
operating leverage
b.
return on assets
c.
profit margin
d.
asset turnover
43. Which of the following measures the ability of a company to produce profits from its sales?
a.
operating leverage
b.
return on assets
c.
profit margin
d.
asset turnover
44. Which of the following equations is correct?
a.
return on assets = profit margin x asset turnover
b.
profit margin = return on assets x asset turnover
c.
asset turnover = return on assets x profit margin
d.
return on assets = net income x total assets
45. A company “was able to generate $3.75 of sales for every $1 it had invested in assets.” This
statement represents a measure of
a.
operating leverage
b.
return on assets
c.
profit margin
d.
asset turnover
420 ♦ Chapter 12
46. The conclusion that a company “was able to generate 81.5¢ of net income for every $1 of sales”
reflects a measure of
a.
operating leverage
b.
return on assets
c.
profit margin
d.
asset turnover
47. If a company’s profit margin increases, most likely indicates that the company has
a.
become more effective in using its assets to sell its products
b.
become more efficient in controlling its costs
c.
invested in more plant assets
d.
become more competitive
48. Refer to the table in Figure 11-2. Compute profit margin.
a.
12.5%
b.
19.2%
c.
8.0%
d.
15.0%
49. Refer to the table in Figure 11-2. Compute total assets.
a.
$120.0M
b.
$ 15.0M
c.
$ 2.7M
d.
$ 21.6M
50. Refer to the table in Figure 11-2. Compute net income.
a.
$5.76M
b.
$2.25M
c.
$1.44M
d.
$2.70M
Analysis of Investing Activities ♦ 421
51. Effectiveness increases when
a.
a company earns higher amounts of profits
b.
a company is able to earn higher amounts of profits for each additional dollar of product it
sells
c.
the dollar amount of sales increases more rapidly than the dollar amount of additional
investment
d.
the dollar amount of sales increases
52. In the United States, usually plant assets are reported at
a.
lower-of-book value-or-market value
b.
market value
c.
higher-of-cost-or-market
d.
replacement cost
53. Seneca Co. purchased a cargo ship in 1990. Following generally accepted accounting principles,
the book value of the ship in 2007 would most likely be
a.
greater than the amount reported on the balance sheet
b.
greater than or equal to the amount reported on the balance sheet
c.
less than the amount reported on the balance sheet
d.
less than or equal to the 2007 market value of the ship
54. Plant assets are reported at lower of historical cost or market primarily to
a.
protect the interests of external decision makers
b.
protect the interests of internal decision makers
c.
simplify record keeping
d.
ensure that the reported amount is always the same as the market value
55. Comparing different companies can be difficult because of the use of
a.
historical costs
b.
different depreciation methods that may be used
c.
historical cost and different depreciation methods
d.
neither historical cost nor different depreciation methods
422 ♦ Chapter 12
56. In general, one would assume that
Investing activities Financing activities
would generate cash would consume cash
a.
Yes Yes
b.
Yes No
c.
No Yes
d.
No No
57. Efficiency increases when
a.
a company earns higher amounts of profits
b.
a company is able to earn higher amounts of profits for each additional dollar of product it
sells
c.
the dollar amount of sales increases more rapidly than the dollar amount of additional
investment
d.
the dollar amount of sales increases
MATCHING
Using the following letters, indicate the effect of events on effectiveness and efficiency. If both
effectiveness and efficiency are affected, enter two letters.
a.
Increase in effectiveness
b.
Decrease in effectiveness
c.
Increase in efficiency
d.
Decrease in efficiency
e.
No effect on either
f.
Decrease in effectiveness and Increase in efficiency
g.
Increase in effectiveness and Increase in efficiency
1. Cutting expenses by 5% with no effect on revenues
2. Cutting expenses by 5% while cutting revenues by 3%
3. Purchase of land for future plant site
4. Increase in sales without increasing expenses
5. Discontinuance of a division; reduces total assets by 20%, revenues by 10% and expenses by 15%
6. Using refinancing to change short-term liabilities into long-term liabilities
Analysis of Investing Activities ♦ 423
Match each term with the correct definition.
a.
Operating leverage
b.
Asset turnover
c.
Effectiveness
d.
Efficiency
e.
Return on assets
f.
Profit margin
7. Measures a firm’s ability to produce profits from its sales
8. Asset turnover x profit margin
9. Depends on reducing costs relative to the amount sold
10. The use of fixed costs to increase net income as sales increase
11. Ability to produce products it can sell
12. Measures a firm’s ability to use its assets to sell products
424 ♦ Chapter 12
PROBLEM
1. Selected information for two companies is presented below:
Pure Cane Sugar
Ortho-Dental Co.
Sales
$6,000,000
$6,000,000
Total Expenses
3,500,000
3,500,000
Fixed costs
1,550,000
2,700,000
Variable costs
1,950,000
800,000
Required:
a.
Calculate net income for each company.
b.
Which company has higher operating leverage?
c.
Suppose sales decreased by 15%. Which company will report the highest net
income? Why?
d.
Suppose sales increased by 15%. Which company will report the highest net income?
Why?
2. Financial statement information for Heller Company is presented below:
(in millions)
2007
Sales
$2,000
Cost of goods sold
400
Operating expense
800
Interest expense
200
Income tax expense
180
Net income
$ 420
Sales
Expenses
(3,500,000)
(3,500,000)
Net income