69. For managerial purposes, i.e., making decisions regarding the firm’s
operations, the standard financial statements as prepared by
accountants under generally accepted accounting principles (GAAP) are
often modified and used to create alternative data and metrics that
provide a somewhat different picture of a firm’s operations. Related
to these modifications, which of the following statements is CORRECT?
a. The standard statements make adjustments to reflect the effects of
inflation on asset values, and these adjustments are normally
carried into any adjustment that managers make to the standard
statements.
b. The standard statements focus on accounting income for the entire
corporation, not cash flows, and the two can be quite different
during any given accounting period. However, the firm’s value is
based on its future cash flows. After all, future cash flows tells
us how much the firm can distribute to its investors.
c. The standard statements provide useful information on the firm’s
individual operating units, but management needs more information on
the firm’s overall operations than the standard statements provide.
d. The standard statements focus on cash flows, but managers should be
less concerned with cash flows than with accounting income as
defined by GAAP.
e. The best feature of standard statements is that, if they are
prepared under GAAP, the data are always consistent from firm to
firm. Thus, under GAAP, there is no room for accountants to
“adjust” the results to make earnings look better.
70. Which of the following statements is CORRECT?
a. Since depreciation increases the firm’s net cash provided by
operating activities, the more depreciation a company has, the
larger its retained earnings will be, other things held constant.
b. A firm can show a large amount of retained earnings on its balance
sheet yet need to borrow cash to make required payments.
c. Common equity includes common stock and retained earnings, less
accumulated depreciation.
d. The retained earnings account as reported on the balance sheet shows
the amount of cash that is available for paying dividends.
e. If a firm reports a loss on its income statement, then the retained
earnings account as shown on the balance sheet will be negative.
71. The CFO of Daves Industries plans to have the company issue $300
million of new common stock and use the proceeds to pay off some of its
outstanding bonds that carry a 7% interest rate. Assume that the
company, which does not pay any dividends, takes this action, and that
total assets, operating income (EBIT), and its tax rate all remain
constant. Which of the following would occur?
a. The company’s taxable income would fall.
b. The company’s interest expense would remain constant.
c. The company would have less common equity than before.
d. The company’s net income would increase.
e. The company would have to pay less taxes.
72. Last year Besset Company’s operations provided a negative cash flow,
yet the cash shown on its balance sheet increased. Which of the
following statements could explain the increase in cash, assuming the
company’s financial statements were prepared under generally accepted
accounting principles (GAAP)?
a. The company repurchased some of its common stock.
b. The company dramatically increased its capital expenditures.
c. The company retired a large amount of its long-term debt.
d. The company sold some of its fixed assets.
e. The company had high depreciation expenses.
73. Which of the following statements is CORRECT?
a. Assume that two firms are both following generally accepted
accounting principles. Both firms commenced operations two years
ago with $1 million of identical fixed assets, and neither firm
either sold any of those assets or purchased any new fixed assets.
The two firms would be required to report the same amount of net
fixed assets on their balance sheets as those statements are
presented to investors.
b. Assets other than cash are expected to produce cash over time, and
the amount of cash they eventually produce must be the same as the
amounts at which the assets are carried on the books.
c. The income statement shows the difference between a firm’s income
and its costs–i.e., its profits–during a specified period of time.
However, all reported income comes in the form of cash, and reported
costs likewise are consistent with cash outlays. Therefore, there
will not be a substantial difference between a firm’s reported
profits and its actual cash flow for the same period.
d. The primary reason the annual report is important in finance is that
it is used by investors when they form expectations about the firm’s
future earnings and dividends, and the riskiness of those cash
flows.
e. EPS stands for earnings per share, while DPS stands for dividends
per share. We would normally expect to see DPS exceed EPS.
74. Which of the following statements is CORRECT?
a. An increase in accounts receivable is added to net income in the
operating activities section because if accounts receivable
increase, then when they are collected cash will come into the firm.
b. In finance, we are generally more interested in cash flows than in
accounting profits. Free cash flow (FCF) is calculated as after-tax
operating income plus depreciation less the sum of capital
expenditures and net operating working capital. Free cash flow is
the amount of cash that could be withdrawn without harming the
firm’s ability to operate and to produce future cash flows.
c. The first major section of a typical statement of cash flows is
“Operating Activities,” and the first entry in this section is “Net
Income.” Then, also in the first section, we show some items that
add to or subtract from cash, and the last entry is called “Net Cash
Provided by Operating Activities.” This number can be either
positive or negative, but if it is negative, the firm is almost
certain to soon go bankrupt.
d. The next-to–last line on the income statement shows the firm’s
earnings, while the last line shows the dividends the company paid.
Therefore, the dividends are frequently called “the bottom line.”
e. Most rapidly growing companies have positive free cash flows because
cash flows from existing operations will exceed fixed assets and
working capital needed to support the growth.
75. Which of the following statements is CORRECT?
a. Free cash flow (FCF) is, essentially, the cash flow that is
available for interest and dividends after the company has made the
investments in current and fixed assets that are necessary to
sustain ongoing operations.
b. After-tax operating income is calculated as EBIT(1 – T) + Depreciation.
c. Two firms with identical sales and operating costs but with
different amounts of debt and tax rates will have different
operating incomes by definition.
d. If a firm is reporting its income in accordance with generally
accepted accounting principles, then its net income as reported on
the income statement should be equal to its free cash flow.
e. Retained earnings as reported on the balance sheet represent cash
and, therefore, are available to distribute to stockholders as
dividends or any other required cash payments to creditors and
suppliers.
76. Which of the following statements is CORRECT?
a. The current cash flow from existing assets is highly relevant to
investors. However, since the value of the firm depends primarily
upon its growth opportunities, accounting net income projections
from those opportunities are the only relevant future flows with
which investors are concerned.
b. Two metrics that are used to measure a company’s financial
performance are net income and free cash flow. Accountants tend to
emphasize net income as calculated in accordance with generally
accepted accounting principles. Finance people generally put at
least as much weight on free cash flows as they do on net income.
c. To estimate the net cash provided by operations, depreciation must
be subtracted from net income because it is a non-cash charge that
has been added to revenue.
d. Interest paid by a corporation is a tax deduction for the paying
corporation, but dividends paid are not deductible. This treatment,
other things held constant, tends to discourage the use of debt
financing by corporations.
e. If Congress changed depreciation allowances so that companies had to
report higher depreciation levels for tax purposes in 2012, this
would lower their free cash flows for 2012.
Multiple Choice: Problems
A good bit of relatively simple arithmetic is involved in some of these problems, and although the
calculations are simple, it will take students some time to set up the problem and do the
arithmetic. We allow for this when assigning problems for a timed test.
Also, students must use a number of definitions to answer some of the questions. To
avoid excessive memorization, we provide students with a list of formulas and definitions for use
on exams. Problems with * in the topic line are nonalgorithmic.
77. Bauer Software’s current balance sheet shows total common equity of
$5,125,000. The company has 530,000 shares of stock outstanding, and
they sell at a price of $27.50 per share. By how much do the firm’s
market and book values per share differ?
a. $17.83
b. $18.72
c. $19.66
d. $20.64
e. $21.67
78. Brown Fashions Inc.’s December 31, 2012 balance sheet showed total
common equity of $4,050,000 and 200,000 shares of stock outstanding.
During 2012, the firm had $450,000 of net income, and it paid out
$100,000 as dividends. What was the book value per share at 12/31/12,
assuming no common stock was either issued or retired during 2012?
a. $20.90
b. $22.00
c. $23.10
d. $24.26
e. $25.47
79. Prezas Company’s balance sheet showed total current assets of $4,250,
all of which were required in operations. Its current liabilities
consisted of $975 of accounts payable, $600 of 6% short-term notes
payable to the bank, and $250 of accrued wages and taxes. What was its
net operating working capital?
a. $2,874
b. $3,025
c. $3,176
d. $3,335
e. $3,502
80. Rao Construction recently reported $20.50 million of sales, $12.60
million of operating costs other than depreciation, and $3.00 million of
depreciation. It had $8.50 million of bonds outstanding that carry a
7.0% interest rate, and its federal–plus-state income tax rate was 40%.
What was Rao’s operating income, or EBIT, in millions?
a. $3.21
b. $3.57
c. $3.97
d. $4.41
e. $4.90
81. Brown Office Supplies recently reported $15,500 of sales, $8,250 of
operating costs other than depreciation, and $1,750 of depreciation. It
had $9,000 of bonds outstanding that carry a 7.0% interest rate, and
its federal-plus-state income tax rate was 40%. How much was the
firm’s earnings before taxes (EBT)?
a. $4,627
b. $4,870
c. $5,114
d. $5,369
e. $5,638
82. Vasudevan Inc. recently reported operating income of $2.75 million,
depreciation of $1.20 million, and had a tax rate of 40%. The firm’s
expenditures on fixed assets and net operating working capital totaled
$0.6 million. How much was its free cash flow, in millions?
a. $1.93
b. $2.03
c. $2.14
d. $2.25
e. $2.36
83. Over the years, O’Brien Corporation’s stockholders have provided
$20,000,000 of capital, when they purchased new issues of stock and
allowed management to retain some of the firm’s earnings. The firm now
has 1,000,000 shares of common stock outstanding, and it sells at a
price of $38.50 per share. How much value has O’Brien’s management
added to stockholder wealth over the years, i.e., what is O’Brien’s
MVA?
a. $18,500,000
b. $18,870,000
c. $19,247,400
d. $19,632,348
e. $20,024,995
84. Emery Mining Inc. recently reported $150,000 of sales, $75,500 of
operating costs other than depreciation, and $10,200 of depreciation.
The company had $16,500 of outstanding bonds that carry a 7.25%
interest rate, and its federal-plus-state income tax rate was 35%. How
much was the firm’s net income? The firm uses the same depreciation
expense for tax and stockholder reporting purposes.
a. $35,167.33
b. $37,018.24
c. $38,966.57
d. $41,017.44
e. $43,068.31
85. On 12/31/12, Hite Industries reported retained earnings of $525,000 on
its balance sheet, and it reported that it had $135,000 of net income
during the year. On its previous balance sheet, at 12/31/11, the
company had reported $445,000 of retained earnings. No shares were
repurchased during 2012. How much in dividends did the firm pay during
2012?
a. $49,638
b. $52,250
c. $55,000
d. $57,750
e. $60,638
86. During 2012, Bascom Bakery paid out $33,525 of common dividends. It
ended the year with $197,500 of retained earnings versus the prior
year’s retained earnings of $159,600. How much net income did the firm
earn during the year?
a. $71,425
b. $74,996
c. $78,746
d. $82,683
e. $86,818
87. Hayes Corporation has $300 million of common equity, with 6 million
shares of common stock outstanding. If Hayes’ Market Value Added (MVA)
is $162 million, what is the company’s stock price?
a. $66.02
b. $69.49
c. $73.15
d. $77.00
e. $80.85
88. Byrd Lumber has 2 million shares of common stock outstanding that sell
for $17 a share. If the company has $40 million of common equity on
its balance sheet, what is the company’s Market Value Added (MVA)?
a. -$5,415,000
b. -$5,700,000
c. -$6,000,000
d. -$6,300,000
e. -$6,615,000
89. Scranton Shipyards has $20 million in total investor-supplied operating
capital, and its WACC is 10%. Scranton has the following income
statement:
Sales $10.0 million
Operating costs 6.0 million
Operating income (EBIT) $ 4.0 million
Interest expense 2.0 million
Earnings before taxes (EBT) $ 2.0 million
Taxes (40%) 0.8 million
Net income $ 1.2 million
What is Scranton’s EVA?
a. $400,000
b. $420,000
c. $441,000
d. $463,050
e. $486,203
90. Your corporation has the following cash flows:
Operating income $250,000
Interest received $ 10,000
Interest paid $ 45,000
Dividends received $ 20,000
Dividends paid $ 50,000
If the applicable income tax rate is 40% (federal and state combined),
and if 70% of dividends received are exempt from taxes, what is the
corporation’s tax liability?
a. $ 83,980
b. $ 88,400
c. $ 92,820
d. $ 97,461
e. $102,334
91. Your corporation has a marginal tax rate of 35% and has purchased
preferred stock in another company. The before-tax dividend yield on
the preferred stock is 12%. What is the company’s after-tax return on
the preferred, assuming a 70% dividend exclusion?
a. 10.20%
b. 10.74%
c. 11.28%
d. 11.84%
e. 12.43%
92. Lovell Co. purchased preferred stock in another company. The preferred
stock’s before–tax yield was 8.4%. The corporate tax rate is 40%. What
is the after-tax return on the preferred stock, assuming a 70% dividend
exclusion?
a. 7.02%
b. 7.39%
c. 7.76%
d. 8.15%
e. 8.56%
93. A company with a 15% tax rate buys preferred stock in another company.
The preferred stock has a before-tax yield of 8%. What is the
preferred stock’s after-tax return?
a. 6.90%
b. 7.26%
c. 7.64%
d. 8.02%
e. 8.42%
94. Van Dyke Corporation has a corporate tax rate equal to 30%. The company
recently purchased preferred stock in another company. The preferred
stock has an 8% before-tax yield. What is Van Dyke’s after-tax yield
on the preferred stock?
a. 6.57%
b. 6.92%
c. 7.28%
d. 7.64%
e. 8.03%
95. Granville Co. recently purchased several shares of Kalvaria
Electronics’ preferred stock. The preferred stock has a before-tax
yield of 8.6%. If the company’s tax rate is 40%, what is Granville
Co.’s after-tax yield on the preferred stock?
a. 6.49%
b. 6.83%
c. 7.19%
d. 7.57%
e. 7.95%
96. Wu Systems has the following balance sheet. How much net operating
working capital does the firm have?
Cash $ 100 Accounts payable $ 200
Accounts receivable 650 Accruals 350
Inventory 550 Notes payable 350
Current assets $1,300 Current liabilities $ 900
Net fixed assets 1,000 Long-term debt 600
Common equity 300
Retained earnings 500
Total assets $2,300 Total liab. & equity $2,300
a. $675
b. $750
c. $825
d. $908
e. $998
97. Last year Almazan Software reported $10.50 million of sales, $6.25
million of operating costs other than depreciation, and $1.30 million
of depreciation. The company had $5.00 million of bonds that carry a
6.5% interest rate, and its federal–plus-state income tax rate was 35%.
This year’s data are expected to remain unchanged except for one item,
depreciation, which is expected to increase by $0.70 million. By how
much will net income change as a result of the change in depreciation?
The company uses the same depreciation calculations for tax and
stockholder reporting purposes.
a. –$0.432
b. –$0.455
c. –$0.478
d. –$0.502
e. –$0.527
98. C. F. Lee Inc. has the following income statement. How much after-tax
operating income does the firm have?
Sales $2,850.00
Costs 1,850.00
Depreciation 192.00
EBIT $ 808.00
Interest expense 285.00
EBT $ 523.00
Taxes (35%) 183.05
Net income $ 339.95
a. $427.78
b. $450.29
c. $473.99
d. $498.94
e. $525.20
99. Kwok Enterprises has the following income statement. How much after–
tax operating income does the firm have?
Sales $2,250
Costs 1,400
Depreciation 250
EBIT $ 600
Interest expense 70
EBT $ 530
Taxes (40%) 212
Net income $ 318
a. $325
b. $342
c. $360
d. $378
e. $397
100. Hartzell Inc. had the following data for 2011, in millions: Net income
= $600; after-tax operating income [EBIT(1 – T)] = $700; and Total
assets = $2,000. Information for 2012 is as follows: Net income =
$825; after-tax operating income [EBIT(1 – T)] = $925; and Total assets
= $2,500. How much free cash flow did the firm generate during 2012?
a. $383
b. $425
c. $468
d. $514
e. $566
101. Shrives Publishing recently reported $10,750 of sales, $5,500 of
operating costs other than depreciation, and $1,250 of depreciation.
The company had $3,500 of bonds that carry a 6.25% interest rate, and
its federal-plus-state income tax rate was 35%. During the year, the
firm had expenditures on fixed assets and net operating working capital
that totaled $1,550. These expenditures were necessary for it to
sustain operations and generate future sales and cash flows. What was
its free cash flow?
a. $1,873
b. $1,972
c. $2,076
d. $2,185
e. $2,300
102. Houston Pumps recently reported $185,250 of sales, $140,500 of
operating costs other than depreciation, and $9,250 of depreciation.
The company had $35,250 of outstanding bonds that carry a 6.75%
interest rate, and its federal-plus–state income tax rate was 35%. In
order to sustain its operations and thus generate future sales and cash
flows, the firm was required to spend $15,250 to buy new fixed assets
and to invest $6,850 in net operating working capital. What was the
firm’s free cash flow?
a. $10,225
b. $10,736
c. $11,273
d. $11,837
e. $12,429
103. Casey Motors recently reported the following information:
• Net income = $600,000.
• Tax rate = 40%.
• Interest expense = $200,000.
• Total investor-supplied operating capital employed = $9 million.
• After-tax cost of capital = 10%.
What is the company’s EVA?
a. -$171,000
b. –$180,000
c. -$189,000
d. -$198,450
e. -$208,373
104. Appalachian Airlines began operating in 2008. The company lost money
the first year but has been profitable ever since. The company’s
taxable income (EBT) for its first five years is listed below. Each
year the company’s corporate tax rate has been 40%.
Year Taxable Income
2008 –$4,000,000
2009 $1,000,000
2010 $2,000,000
2011 $3,000,000
2012 $5,000,000
Assume that the company has taken full advantage of the Tax Code’s
carry-back, carry-forward provisions and that the current provisions
were applicable in 2008. How much did the company pay in taxes in
2011?
a. $ 688,500
b. $ 765,000
c. $ 800,000
d. $ 930,000
e. $1,023,000
105. Garner Grocers began operations in 2009. Garner has reported the
following levels of taxable income (EBT) over the past several years.
The corporate tax rate was 34% each year. Assume that the company has
taken full advantage of the Tax Code’s carry-back, carry-forward
provisions, and assume that the current provisions were applicable in
2009. What is the amount of taxes the company paid in 2012?
Year Taxable Income
2009 –$3,200,000
2010 $ 200,000
2011 $ 500,000
2012 $2,800,000
a. $ 92,055
b. $ 96,900
c. $102,000
d. $107,100
e. $112,455
106. A corporation recently purchased some preferred stock that has a
before-tax yield of 7%. The company has a tax rate of 38%. What is
the after-tax return on the preferred stock?
a. 5.32%
b. 5.60%
c. 5.89%
d. 6.20%
e. 6.51%
107. A corporate bond currently yields 8.5%. Municipal bonds with the same
risk, maturity, and liquidity currently yield 5.5%. At what tax rate
would investors be indifferent between the two bonds?
a. 35.29%
b. 37.06%
c. 38.91%
d. 40.86%
e. 42.90%
108. A 7-year municipal bond yields 4.8%. Your marginal tax rate (including
state and federal taxes) is 27%. What interest rate on a 7-year
corporate bond of equal risk would provide you with the same after-tax
return?
a. 5.64%
b. 5.93%
c. 6.25%
d. 6.58%
e. 6.90%
109. A bond issued by the State of Pennsylvania provides a 9% yield. What
yield on a Synthetic Chemical Company bond would cause the two bonds to
provide the same after-tax rate of return to an investor in the 35% tax
bracket?
a. 13.85%
b. 14.54%
c. 15.27%
d. 16.03%
e. 16.83%
110. Carter Corporation has some money to invest, and its treasurer is
choosing between City of Chicago municipal bonds and U.S. Treasury
bonds. Both have the same maturity, and they are equally risky and
liquid. If Treasury bonds yield 6%, and Carter’s marginal income tax
rate is 40%, what yield on the Chicago municipal bonds would make
Carter’s treasurer indifferent between the two?
a. 3.42%
b. 3.60%
c. 3.78%
d. 3.97%
e. 4.17%
111. A 5-year corporate bond yields 9%. A 5-year municipal bond of equal
risk yields 6.5%. Assume that the state tax rate is zero. At what
federal tax rate are you indifferent between the two bonds?
a. 27.78%
b. 29.17%
c. 30.63%
d. 32.16%
e. 33.76%
112. Allen Corporation can (1) build a new plant that should generate a
before-tax return of 11%, or (2) invest the same funds in the preferred
stock of Florida Power & Light (FPL), which should provide Allen with a
before-tax return of 9%, all in the form of dividends. Assume that
Allen’s marginal tax rate is 25%, and that 70% of dividends received
are excluded from taxable income. If the plant project is divisible
into small increments, and if the two investments are equally risky,
what combination of these two possibilities will maximize Allen’s
effective return on the money invested?
a. All in the plant project.
b. All in FPL preferred stock.
c. 60% in the project; 40% in FPL.
d. 60% in FPL; 40% in the project.
e. 50% in each.
113. Solarcell Corporation has $20,000 that it plans to invest in marketable
securities. It is choosing between AT&T bonds that yield 11%, State of
Florida municipal bonds that yield 8%, and AT&T preferred stock with a
dividend yield of 9%. Solarcell’s corporate tax rate is 40%, and 70%
of the preferred stock dividends it receives are tax exempt. Assuming
that the investments are equally risky and that Solarcell chooses
strictly on the basis of after-tax returns, which security should be
selected? Answer by giving the after-tax rate of return on the highest
yielding security.
a. 7.80%
b. 8.00%
c. 8.20%
d. 8.41%
e. 8.62%
114. A corporation can earn 7.5% if it invests in municipal bonds. The
corporation can also earn 8.5% (before-tax) by investing in preferred
stock. Assume that the two investments have equal risk. What is the
break-even corporate tax rate that makes the corporation indifferent
between the two investments?
a. 35.39%
b. 37.25%
c. 39.22%
d. 41.18%
e. 43.24%
115. Mantle Corporation is considering two equally risky investments:
• A $5,000 investment in preferred stock that yields 7%.
• A $5,000 investment in a corporate bond that yields 10%.
What is the break-even corporate tax rate that makes the company
indifferent between the two investments?
a. 34.27%
b. 36.08%
c. 37.97%
d. 39.87%
e. 41.87%
116. West Corporation has $50,000 that it plans to invest in marketable
securities. The corporation is choosing between the following three
equally risky securities: Alachua County tax-free municipal bonds
yielding 8.5%; Exxon Mobil bonds yielding 10.5%; and GM preferred stock
with a dividend yield of 9.25%. West’s corporate tax rate is 35%.
What is the after-tax return on the best investment alternative?
(Assume the company chooses on the basis of after-tax returns.)
a. 8.500%
b. 8.925%
c. 9.371%
d. 9.840%
e. 10.332%
117. Arvo Corporation is trying to choose between three alternative
investments. The three securities that the company is considering are
as follows:
• Tax-free municipal bonds with a return of 8.8%.
• Wooli Corporation bonds with a return of 11.75%.
• CFI Corp. preferred stock with a return of 9.8%.
The company’s tax rate is 25%. What is the after-tax return on the
best investment alternative?
a. 7.383%
b. 7.772%
c. 8.181%
d. 8.612%
e. 9.065%
118. Collins Co. began operations in 2009. The company lost money the first
two years, but has been profitable ever since. The company’s taxable
income (EBT) for its first four years is summarized below:
Year EBT
2009 –$3,000,000
2010 –$5,200,000
2011 $4,200,000
2012 $8,300,000
The corporate tax rate has remained at 34%. Assume that the company
has taken full advantage of the Tax Code’s carry-back, carry-forward
provisions, and assume that the current provisions were applicable in
2009. What is Collins’ tax liability for 2012?
a. $1,069,848
b. $1,188,720
c. $1,320,800
d. $1,462,000
e. $1,617,200
119. Salinger Software was founded in 2009. The company lost money each of
its first three years, but was able to turn a profit in 2012.
Salinger’s operating income (EBIT) for its first four years of
operations is reported below.
Year EBIT
2009 -$ 50,000,000
2010 –$150,000,000
2011 –$100,000,000
2012 $700,000,000
The company has no debt, so operating income equals earnings before
taxes. The corporate tax rate has remained constant at 35%. Assume
that the company took full advantage of the carry-back, carry-forward
provisions in the Tax Code, and assume that the current provisions were
applicable in 2009. How much tax did the company pay in 2012?
a. $114,030,875
b. $120,032,500
c. $126,350,000
d. $133,000,000
e. $140,000,000