FIN 304

Sample Exam #1
Chapters 1, 3, 4
____ 1. The primary operating goal of a publicly-owned firm interested in serving its stockholders
should be to
a. Maximize its expected total corporate income.
b. Maximize its expected EPS.
c. Minimize the chances of losses.
d. Maximize the stock price per share over the long run, which is the stock's
intrinsic value.
e. Maximize the stock price on a specific target date.

____ 2. Which of the following statements is CORRECT?

a. One drawback of forming a corporation is that it generally subjects the firm
to additional regulations.
b. One drawback of forming a corporation is that it subjects the firm's
investors to increased personal liabilities.
c. One drawback of forming a corporation is that it makes it more difficult for
the firm to raise capital.
d. One advantage of forming a corporation is that it subjects the firm's
investors to fewer taxes.
e. One disadvantage of forming a corporation is that it is more difficult for the
firm's investors to transfer their ownership interests.

____ 3. Which of the following statements is CORRECT?

a. Due to limited liability, unlimited lives, and ease of ownership transfer, the
vast majority of U.S. businesses (in terms of number of businesses) are
organized as corporations.
b. Most businesses (by number and total dollar sales) are organized as
proprietorships or partnerships because it is easier to set up and operate one
of these forms rather than as a corporation. However, if the business gets
very large, it becomes advantageous to convert to a corporation, primarily
because corporations have important tax advantages over proprietorships and
partnerships.
c. Due to legal considerations related to ownership transfers and limited
liability, which affect the ability to attract capital, most business (measured
by dollar sales) is conducted by corporations in spite of large corporations'

less favorable tax treatment.

d. Large corporations are taxed more favorably than sole proprietorships.
e. Corporate stockholders are exposed to unlimited liability.

____ 4. The primary operating goal of a publicly-owned firm trying to best serve its stockholders
should be to
a. Maximize managers' own interests, which are by definition consistent with
maximizing shareholders' wealth.
b. Maximize the firm's expected EPS, which must also maximize the firm's
price per share.
c. Minimize the firm's risks because most stockholders dislike risk. In turn,
this will maximize the firm's stock price.
d. Use a well-structured managerial compensation package to reduce conflicts
that may exist between stockholders and managers.
e. Since it is impossible to measure a stock's intrinsic value, the text states
that it is better for managers to attempt to maximize the current stock
price than its intrinsic value.

____ 5. Which of the following actions would be likely to reduce potential conflicts of interest
between stockholders and managers?
a. Congress passes a law that severely restricts hostile takeovers.
b. A firm's compensation system is changed so that managers receive larger
cash salaries but fewer long-term options to buy stock.
c. The company changes the way executive stock options are handled, with all
options vesting after 2 years rather than having 20% of the options awarded
vest every 2 years over a 10-year period.
d. The company's outside auditing firm is given a lucrative year-by-year
consulting contract with the company.
e. The composition of the board of directors is changed from all inside
directors to all outside directors, and the directors are compensated with
stock rather than cash.

____ 6. Which of the following statements is CORRECT?

a. One disadvantage of organizing a business as a corporation rather than a
partnership is that the equity investors in a corporation are exposed to
unlimited liability.
b. Using restrictive covenants in debt agreements is an effective way to reduce
conflicts between stockholders and managers.
c. Managers generally welcome hostile takeovers since the "raider" generally

offers a price for the stock that is higher than the price before the
takeover action started.
d. The managers of established, stable companies sometimes attempt to get
their state legislatures to impose rules that make it more difficult for
raiders to succeed with hostile takeovers.
e. The managers of established, stable companies sometimes attempt to get
their state legislatures to remove rules that make it more difficult for
raiders to succeed with hostile takeovers.

____ 7. Which of the following statements is CORRECT?

a. One disadvantage of operating as a corporation rather than as a partnership
is that corporate shareholders are exposed to more personal liability than
are partners.
b. Relative to sole proprietorships, corporations generally face fewer
regulations, and they also find it easier to raise capital.
c. There is no good reason to expect a firm's stockholders and bondholders to
react differently to the types of assets in which it invests.
d. Stockholders should generally be happier than bondholders to have managers
invest in risky projects with high potential returns as opposed to safe
projects with lower expected returns.
e. Bondholders should generally be happier than stockholders to have managers
invest in risky projects with high potential returns as opposed to safe
projects with lower expected returns.

____ 8. Assume that the corporate tax rate is 34% and the personal tax rate is 30%. The founders
of a newly formed business are debating between setting up the firm as a partnership versus
a corporation. The firm will not need to retain any earnings, so all of its after-tax income will
be paid out to its investors, who will have to pay personal taxes on whatever they receive.
What is the difference in the percentage of the firm's pre-tax income that investors actually
receive and can spend under the corporate and partnership forms of organization?
a. 26.42%
b. 23.8%
c. 23.09%
d. 25.70%
e. 18.56%

____ 9. Which of the following statements is CORRECT?

a. Assets other than cash are expected to produce cash over time, and the
amounts of cash they eventually produce should be exactly the same as the

amounts at which the assets are carried on the books.

b. 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.
c. The annual report is an internal document prepared by a firm's managers
solely for the use of its creditors/lenders.
d. The four most important financial statements provided in the annual report
are the balance sheet, income statement, cash budget, and statement of
stockholders' equity.
e. Prior to the Enron scandal in the early 2000s, companies would put verbal
information in their annual reports, along with the financial statements. That
verbal information was often misleading, so today annual reports can contain
only quantitative information--audited financial statements.

____ 10. Other things held constant, which of the following actions would increase the amount of cash
on a companys balance sheet?
a. The company repurchases common stock.
b. The company pays a dividend.
c. The company issues new common stock.
d. The company gives customers more time to pay their bills.
e. The company purchases a new piece of equipment.

____ 11. Which of the following items is NOT normally considered to be a current asset?
a. Accounts receivable.
b. Inventory.
c. Bonds.
d. Cash.
e. Short-term, highly-liquid, marketable securities.

____ 12. Which of the following items cannot be found on a firms balance sheet under current
liabilities?
a. Accounts payable.
b. Short-term notes payable to the bank.
c. Accrued wages.
d. Cost of goods sold.
e. Accrued payroll taxes.

____ 13. A loss incurred by a corporation

a. Must be carried forward unless the company has had 2 loss years in a row.
b. Can be carried back 2 years, then carried forward up to 20 years following
the loss.
c. Can be carried back 5 years and forward 3 years.
d. Cannot be used to reduce taxes in other years except with special permission
from the IRS.
e. Can be carried back 3 years or forward 10 years, whichever is more
advantageous to the firm.

____ 14. Below are the 2010 and 2011 year-end balance sheets for Tran Enterprises:
Assets:
Cash
Accounts receivable
Inventories
Total current assets
Net fixed assets
Total assets
Liabilities and equity:
Accounts payable
Notes payable
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total common equity
Total liabilities and equity

2011
$ 200,000
864,000
2,000,000
$3,064,000
6,000,000
$9,064,000

2010
$ 170,000
700,000
1,400,000
$2,270,000
5,600,000
$7,870,000

$1,400,000
1,600,000
$3,000,000
2,400,000
3,000,000
664,000
$3,664,000
$9,064,000

$1,090,000
1,800,000
$2,890,000
2,400,000
2,000,000
580,000
$2,580,000
$7,870,000

The firm has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year,
non-callable, long-term debt in 2010. As of the end of 2011, none of the principal on this debt
had been repaid. Assume that the companys sales in 2010 and 2011 were the same. Which of
the following statements must be CORRECT?
a.
b.
c.
d.
e.

The firm
The firm
The firm
The firm
The firm

increased its short-term bank debt in 2011.

issued long-term debt in 2011.
issued new common stock in 2011.
repurchased some common stock in 2011.
had negative net income in 2011.

____ 15. Which of the following statements is CORRECT?

a. The statement of cash flows reflects cash flows from operations, but it does
not reflect the effects of buying or selling fixed assets.
b. The statement of cash flows shows where the firms cash is located; indeed,
it provides a listing of all banks and brokerage houses where cash is on
deposit.
c. The statement of cash flows reflects cash flows from continuing operations,
but it does not reflect the effects of changes in working capital.
d. The statement of cash flows reflects cash flows from operations and from
borrowings, but it does not reflect cash obtained by selling new common
stock.
e. The statement of cash flows shows how much the firms cash--the total of
currency, bank deposits, and short-term liquid securities (or cash
equivalents)--increased or decreased during a given year.

____ 16. Which of the following statements is CORRECT?

a. MVA stands for market value added, and it is defined as follows:
MVA = (Shares outstanding)(Stock price) + Book value of common equity.
b. The primary difference between EVA and accounting net income is that when
net income is calculated, a deduction is made to account for the cost of
common equity, whereas EVA represents net income before deducting the
cost of the equity capital the firm uses.
c. MVA gives us an idea about how much value a firms management has added
during the last year.
d. EVA gives us an idea about how much value a firms management has added
over the firms life.
e. EVA stands for economic value added, and it is defined as follows:
EVA = NOPAT (Investor-supplied oper. capital)(AT cost of capital %)

____ 17. Which of the following statements is CORRECT?

a. The income of certain small corporations that qualify under the Tax Code is
completely exempt from corporate income taxes. Thus, the federal
government receives no tax revenue from these businesses, even though they
report high accounting profits.
b. All businesses, regardless of their legal form of organization, are taxed
under the Business Tax Provisions of the Internal Revenue Code.
c. Small corporations that qualify under the Tax Code can elect not to pay
corporate taxes, but then each stockholder must report his or her pro rata
shares of the firms income as personal income and pay taxes on that income.

d. Congress recently changed the tax laws to make dividend income received by
individuals exempt from income taxes. Prior to the enactment of that law,
corporate income was subject to double taxation, where the firm was first
taxed on the corporation's income and stockholders were taxed again on this
income when it was paid to them as dividends.
e. All corporations other than non-profits are subject to corporate income
taxes, which are 15% for the lowest amounts of income and 38% for the
highest amounts.

____ 18. Which of the following statements is most correct?

a. Retained earnings, as reported on the balance sheet, represents the amount
of cash a company has available to pay out as dividends to shareholders.
b. 70% of the interest received by corporations is excluded from taxable
income.
c. 70% of the dividends received by corporations is excluded from taxable
income.
d. Because taxes on long-term capital gains are not paid until the gain is
realized, investors must pay the top individual tax rate on that gain.
e. The corporate tax system favors equity financing, as dividends paid are
deductible from corporate taxes.

____ 19. Last year, Delip Industries had (1) negative cash flow from operations, (2) a negative free
cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following
factors could explain this situation?
a. The company had a sharp increase in its inventories.
b. The company had a sharp increase in its accrued liabilities.
c. The company sold a new issue of common stock.
d. The company made a large capital investment early in the year.
e. The company had a sharp increase in depreciation expenses.

____ 20. The Nantell Corporation just purchased an expensive piece of equipment. Assume that the
firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress
then passed a provision that requires the company to depreciate the equipment on a straightline basis over 7 years. Other things held constant, which of the following will occur as a
result of this Congressional action? Assume that the company uses the same depreciation
method for tax and stockholder reporting purposes.
a. Nantells taxable income will be lower.
b. Nantells operating income (EBIT) will increase.
c. Nantells cash position will improve (increase).

d. Nantells reported net income for the year will be lower.

e. Nantells tax liability for the year will be lower.

____ 21. Assume that Besley Golf Equipment commenced operations on January 1, 2011, and it was
granted permission to use the same depreciation calculations for shareholder reporting and
income tax purposes. The company planned to depreciate its fixed assets over 15 years, but in
December 2011 management realized that the assets would last for only 10 years. The firm's
accountants plan to report the 2011 financial statements based on this new information. How
would the new depreciation assumption affect the companys financial statements?
a. The firms reported net fixed assets would increase.
b. The firms EBIT would increase.
c. The firms reported 2011 earnings per share would increase.
d. The firms cash position in 2011 and 2012 would increase.
e. The provision will increase the company's tax payments.

____ 22. 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 companys taxable income would fall.
b. The companys interest expense would remain constant.
c. The company would have less common equity than before.
d. The companys net income would increase.
e. The company would have to pay less taxes.

____ 23. Brown Fashions Inc.'s December 31, 2011 balance sheet showed total common equity of
$4,050,000 and 295,000 shares of stock outstanding. During 2011, the firm had $450,000 of
net income, and it paid out $100,000 as dividends. What was the book value per share at
12/31/11, assuming no common stock was either issued or retired during 2011?
a. $11.34
b. $13.87
c. $16.56
d. $12.38
e. $14.92

____ 24. On 12/31/11, Hite Industries reported retained earnings of $502,500 on its balance sheet,
and it reported that it had $135,000 of net income during the year. On its previous balance
sheet, at 12/31/10, the company had reported $445,000 of retained earnings. No shares were
repurchased during 2011. How much in dividends did the firm pay during 2011?
a. $78,275
b. $89,125
c. $83,700
d. $96,100
e. $77,500

____ 25. Your corporation has the following cash flows: 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?
Operating income
Interest received
Interest paid
Dividends received
Dividends paid
a.
b.
c.
d.
e.

$250,000
$10,000
$45,000
$15,000
$50,000

$71,118
$87,800
$86,044
$102,726
$98,336

____ 26. Wu Systems has the following balance sheet. How much net operating working capital does the
firm have?
Cash
Accounts receivable
Inventory
Current assets
Net fixed assets

$ 100
650
550
$ 1,300
$ 1,000

Total assets

$ 2,300

a. $1,025

Accounts payable
Accruals
Notes payable
Current liabilities
Long-term debt
Common equity
Retained earnings
Total liab. & equity

$ 200
75
625
$ 900
600
300
500
$ 2,300

b.
c.
d.
e.

$1,138
$1,179
$933
$1,169

____ 27. Hartzell Inc. had the following data for 2010, in millions: Net income = $600; after-tax
operating income [EBIT (1-T)] = $700; and Total assets = $2,000. Information for 2011 is as
follows: Net income = $825; after-tax operating income [EBIT (1-T)] = $1,125; and Total
assets = $2,500. How much free cash flow did the firm generate during 2011?
a. $644
b. $494
c. $481
d. $675
e. $625

____ 28. Casey Motors recently reported the following information:

Net income = $850,000
Tax rate = 40%
Interest expense = $200,000
Total investor-supplied operating capital employed = $9 million
After-tax cost of capital = 10%

What is the companys EVA?

a.
b.
c.
d.
e.

$67,200
$82,600
$64,400
$70,000
$83,300

____ 29. Garner Grocers began operations in 2008. 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 Codes carry-back, carry-forward
provisions, and assume that the current provisions were applicable in 2008. What is the
amount of taxes the company paid in 2011?
Year

Taxable Income

2008
2009
2010
2011
a.
b.
c.
d.
e.

-$2,750,000
$200,000
$500,000
$2,800,000

$295,800
$272,850
$288,150
$255,000
$201,450

____ 30. A 7-year municipal bond yields 4.8%. Your marginal tax rate (including state and federal
taxes) is 28%. What interest rate on a 7-year corporate bond of equal risk would provide you
with the same after-tax return?
a. 5.20%
b. 6.20%
c. 5.40%
d. 5.80%
e. 6.67%

____ 31. 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 Allens
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 Allens effective
return on the money invested?
a. All in FPL preferred stock.
b. 60% in FPL; 40% in the project.
c. All in the plant project.
d. 60% in the project; 40% in FPL.
e. 50% in each.

____ 32. 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%. Wests corporate tax rate is 15%. What is the after-tax
return on the best investment alternative? Assume a 70% dividend exclusion for Tax on
Dividends. (Assume the company chooses on the basis of after-tax returns.)

a.
b.
c.
d.
e.

8.747%
9.461%
8.657%
8.925%
7.765%

____ 33. Uniontown Books began operating in 2007. The company lost money its first three years of
operations, but has had an operating profit during the past two years. The companys
operating income (EBIT) for its first five years was as follows:
Year
2007
2008
2009
2010
2011

EBIT
-$5,000,000
-$2,000,000
-$1,000,000
$1,200,000
$7,000,000

The company has no debt, and therefore, pays no interest expense. Its corporate tax rate has
remained at 34% during this 5-year period. What was Uniontowns tax liability for 2011?
(Assume that the company has taken full advantage of the carry-back and carry-forward
provisions, and assume that the current provisions were applicable in 2007.)
a. $85,000
b. $77,520
c. $65,960
d. $68,000
e. $78,200

____ 34. Mays Industries was established in 2006. Since its inception, the company has generated the
following levels of taxable income (EBT):
Year
2006
2007
2008
2009
2010
2011

Taxable Income
$50,000
$40,000
$30,000
$20,000
-$92,500
$60,000

Assume that each year the company has faced a 40% income tax rate. Also, assume that the
company has taken full advantage of the Tax Codes carry-back, carry-forward provisions, and
assume that the current provisions were applicable in 2006. What is the companys tax
liability for 2011?
a. $5,810
b. $6,790
c. $7,000
d. $7,420
e. $5,740

____ 35. Last year, Martyn Company had $140,000 in taxable income from its operations, $50,000 in
interest income, and $100,000 in dividend income. Using the corporate tax rate table given
below, what was the companys tax liability for the year?
Taxable Income
$0-$50,000
$50,000-$75,000
$75,000-$100,000
$100,000-$335,000
$335,000$10,000,000
$10,000,000$15,000,000
$15,000,000$18,333,333
Over $18,333,333
a.
b.
c.
d.
e.

$69,050
$75,265
$64,907
$70,431
$80,098

Tax on Base of
Bracket
$0
7,500
13,750
22,250
113,900

Percentage on Excess above

Base
15%
25
34
39
34

3,400,000

35

5,150,000

38

6,416,667

35

____ 36. Last year, Stewart-Stern Inc. reported $11,250 of sales, $4,500 of operating costs other
than depreciation, and $1,250 of depreciation. The company had $3,500 of bonds outstanding
that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. During
last year, the firm had expenditures on fixed assets and net operating working capital that
totaled $2,000. These expenditures were necessary for it to sustain operations and generate
future sales and cash flows. This year's data are expected to remain unchanged except for
one item, depreciation, which is expected to increase by $1,350. By how much will the
depreciation change cause (1) the firm's net income and (2) its free cash flow to change?
Note that the company uses the same depreciation for tax and stockholder reporting
purposes.
Net Income
a.
b.
c.
d.
e.

-$877.50
-$1,044.23
-$1,070.55
-$693.23
-$658.13

Free Cash Flow

$472.50
$368.55
$354.38
$420.53
$491.40

____ 37. Companies E and P each reported the same earnings per share (EPS), but Company Es stock
trades at a higher price. Which of the following statements is CORRECT?
a. Company E probably has fewer growth opportunities.
b. Company E is probably judged by investors to be riskier.
c. Company E must have a higher market-to-book ratio.
d. Company E must pay a lower dividend.
e. Company E trades at a higher P/E ratio.

____ 38. You observe that a firms ROE is above the industry average, but its profit margin and debt
ratio are both below the industry average. Which of the following statements is CORRECT?
a. Its total assets turnover must be above the industry average.
b. Its return on assets must equal the industry average.
c. Its TIE ratio must be below the industry average.
d. Its total assets turnover must be below the industry average.
e. Its total assets turnover must equal the industry average.

____ 39. Companies HD and LD have the same tax rate, sales, total assets, and basic earning power.
Both companies have positive net incomes. Company HD has a higher debt ratio and,
therefore, a higher interest expense. Which of the following statements is CORRECT?
a. Company HD has a lower equity multiplier.

b.
c.
d.
e.

Company
Company
Company
Company

HD has more net income.

HD pays more in taxes.
HD has a lower ROE.
HD has a lower times-interest-earned (TIE) ratio.

____ 40. Which of the following statements is CORRECT?

a. If a firm has high current and quick ratios, this always indicate that the firm
is managing its liquidity position well.
b. If a firm sold some inventory for cash and left the funds in its bank account,
its current ratio would probably not change much, but its quick ratio would
decline.
c. If a firm sold some inventory on credit, its current ratio would probably not
change much, but its quick ratio would decline.
d. If a firm sold some inventory on credit as opposed to cash, there is no reason
to think that either its current or quick ratio would change.
e. The inventory turnover ratio and days sales outstanding (DSO) are two ratios
that are used to assess how effectively a firm is managing its current assets.

____ 41. Which of the following statements is CORRECT?

a. In general, if investors regard a company as being relatively risky and/or
having relatively poor growth prospects, then it will have relatively high P/E
and M/B ratios.
b. The basic earning power ratio (BEP) reflects the earning power of a firm's
assets after giving consideration to financial leverage and tax effects.
c. The "apparent," but not necessarily the "true," financial position of a company
whose sales are seasonal can change dramatically during a given year,
depending on the time of year when the financial statements are constructed.
d. The market/book (M/B) ratio tells us how much investors are willing to pay
for a dollar of accounting book value. In general, investors regard companies
with higher M/B ratios as being more risky and/or less likely to enjoy higher
future growth.
e. It is appropriate to use the fixed assets turnover ratio to appraise firms'
effectiveness in managing their fixed assets if and only if all the firms being
compared have the same proportion of fixed assets to total assets.

____ 42. Walter Industries current ratio is 0.5. Considered alone, which of the following actions would
INCREASE the companys current ratio?
a. Borrow using short-term notes payable and use the cash to increase
inventories.

b.
c.
d.
e.

Use cash
Use cash
Use cash
Use cash

to reduce accruals.
to reduce accounts payable.
to reduce short-term notes payable.
to reduce long-term bonds outstanding.

____ 43. Meyer Inc's assets are $745,000, and its total debt outstanding is $185,000. The new CFO
wants to establish a debt/assets ratio of 55%. The size of the firm does not change. How
much debt must the company add or subtract to achieve the target debt ratio?
a. $168,563
b. $224,750
c. $191,038
d. $211,265
e. $271,948

____ 44. Last year Ann Arbor Corp had $110,000 of assets, $305,000 of sales, $20,000 of net income,
and a debt-to-total-assets ratio of 37.5%. The new CFO believes a new computer program will
enable it to reduce costs and thus raise net income to $33,000. Assets, sales, and the debt
ratio would not be affected. By how much would the cost reduction improve the ROE?
a. 22.12%
b. 23.26%
c. 19.67%
d. 21.18%
e. 18.91%

____ 45. Last year Kruse Corp had $420,000 of assets, $403,000 of sales, $28,250 of net income, and
a debt-to-total-assets ratio of 39%. The new CFO believes the firm has excessive fixed
assets and inventory that could be sold, enabling it to reduce its total assets to $252,500.
Sales, costs, and net income would not be affected, and the firm would maintain the same
debt ratio (but with less total debt). By how much would the reduction in assets improve the
ROE?
a. 7.31%
b. 7.46%
c. 7.17%
d. 5.78%
e. 6.00%

Following information applies to questions 46-50.

The balance sheet and income statement shown below are for Koski Inc. Note that the firm
has no amortization charges, it does not lease any assets, none of its debt must be retired
during the next 5 years, and the notes payable will be rolled over.
Balance Sheet (Millions of $)
Assets
Cash and securities
Accounts receivable
Inventories
Total current assets
Net plant and
equipment
Total assets
Liabilities and Equity
Accounts payable
Notes payable
Accruals
Total current
liabilities
Long-term bonds
Total debt
Common stock
Retained earnings
Total common equity
Total liabilities and equity

2010
$1,290
9,890
13,760
$24,940
$18,060
$43,000
$8,170
6,020
4,730
$18,920
$8,815
$27,735
$5,805
9,460
$15,265
$43,000

Income Statement (Millions of $)

2010
Net sales
$51,600
Operating costs except depreciation
48,246
Depreciation
903
Earnings bef interest and taxes (EBIT) $2,451
Less interest
927
Earnings before taxes (EBT)
$1,524
Taxes
533
Net income
$990
Other data:
Shares outstanding (millions)
Common dividends (millions of $)
Int rate on notes payable & L-T bonds
Federal plus state income tax rate
Year-end stock price

500.00
$346.67
6.25%
35%
$23.77

____ 46. What is the firm's inventory turnover ratio?

a. 3.75
b. 3.98
c. 3.19
d. 3.23
e. 3.79

____ 47. What is the firm's debt/assets ratio?

a. 65.15%
b. 76.11%
c. 49.67%
d. 78.05%
e. 64.50%

____ 48. What is the firm's ROA?

a. 2.30%
b. 1.96%
c. 2.44%
d. 2.51%
e. 1.87%

____ 49. What is the firm's ROE?

a. 7.92%
b. 6.49%
c. 6.16%
d. 6.94%
e. 5.77%

____ 50. What is the firm's P/E ratio?

a. 12.0
b. 12.6
c. 13.2
d. 13.9
e. 14.6

1.
2.
3.
4.
5.
6.
7.
8.

D
A
C
D
E
D
D
B
Corporate tax rate
(TC):
Personal tax rate
(TP):

Corporate
net
Investors'
net

34%
30%

= Business pre-tax income

(1 - TC)
= Corporate net (1 - TP)

= Business pre-tax net

(1 - TC) (1 - TP)
= Business pre-tax net 66%
70%

46.2%

The business pays no tax, but investors pay tax on business income.
Investors'
net
Difference

9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.

B
C
C
D
B
C
E
E
C
C
C
B

= Business pre-tax net

TP)

(1 -

= Business pre-tax net

TP)

(1 -

70%

23.8%

21. D
22. D
23. E
12/31/11 common equity
2011 net income
2011 dividends
2011 addition to retained earnings
12/31/11 common equity
Shares outstanding
12/31/11 BVPS $14.92

$4,050,000
$450,000
$100,000
$350,000
$4,400,000
295,000

24. E
12/31/11 RE
$502,500
12/31/10 RE
$445,000
Change in RE
$57,500
Net income for 2011
$135,000
Dividends = Net income - Change $77,500
25. B
Operating income
$250,000
Interest received
$10,000
Interest paid
$45,000
Dividends received
$15,000
Divdend exclusion %
70%
Dividends paid
$50,000
Tax rate (T)
40%
Taxable income = Oper. income + Interest received Interest paid + Taxable dividends
received
Taxable income = Oper. income + Interest received Interest paid + dividends received
(1 Div exclusion %)
Taxable income = $219,500
Taxes paid = Taxable income Tax rate
Taxes paid = $87,800
26. A
Cash
Accounts receivable
Inventory
Current assets
Net fixed assets

$100
650
550
$1,300
1,000

Accounts payable
Accruals
Notes payable
Current liabilities
Long-term debt
Common equity

$200
75
625
$ 900
600
300

Total assets

Retained earnings
Total liab. & equity

$ 2,300

Net operating working capital = Current assets

NOWC = $1,300.00 - $275.00
NOWC = $1,025
27. E
EBIT(1 - T)
Total assets

2010
$2,000

2011
$2,500

2011 FCF =
EBIT(1 - T)
2011 FCF =
$1,125
2011 FCF = $625

EBT
$1,616,667

Interest

EVA

EBIT(1
T)
$970,000

(WACC

EVA

Change = Net invest. in FA + NOWC

$500

$850,000
$200,000
$9,000,000
40%
10%

Net income / (1 T)
$1,416,667

EBIT
EBIT

EVA

(Current liabilities Notes payable)

Net investment in FA + NOWC

$500

28. D
Net income
Interest expense
Investor-supplied operating capital
Tax rate
After-tax cost of capital
EBT
EBT

500
$2,300

$900,000

Total investor-supplied
capital)

$70,000

29. D
Tax rate

34%
CarryForward

EBT After
Forward

Unused
Carryable

Year
2008
2009
2010
2011
2011
2011

Tax. Income
Used
-$2,750,000
$0
$200,000
$200,000
$500,000
$500,000
$2,800,000 $2,050,000
Tax liability =
Tax liability =

30. E
Municipal bond yield
Tax rate
Municipal yield
4.80%
4.80%
BT yield
31. A
BT project return
BT preferred return
Tax rate
Dividend exclusion %

Applied
$0
$0
$0
$750,000

Amount
$2,750,000
$2,550,000
$2,050,000
$0

EBT Tax rate

$255,000

4.80%
28.00%
=
=
=
=

After-tax bond yield

BT yield
BT yield
6.67%

(1 T)
72.00%

11.00%
9.00%
25.00%
70.00%

After-tax return on project = BT project return

After-tax return on project = 8.25%

(1 T)

After-tax return on pref. = BT pref. return [1 (1 Div exclusion%)(T)]

After-tax return on pref. = 8.33%
32. D
BT municipal bond yield
BT bond yield
BT preferred yield
Tax rate
Dividend exclusion %

8.50%
10.50%
9.25%
15.00%
70.00%

Since municipal bonds are exempt from federal taxes, its BT return = AT return
AT municipal bond yield 8.500%
AT bond yield =
BT bond yield
AT bond yield = 8.925%

(1 T)

AT preferred yield = BT pref. return [1 (1 Div exclusion%)(T)]

AT preferred yield = 8.834%
Highest AT yield = 8.925%
33. D
Tax rate

34%

Year
Tax. Income
2007 -$5,000,000
2008 -$2,000,000
2009 -$1,000,000
2010
$1,200,000
2011
$7,000,000

CarryForward
Used
$0
$0
$0
$1,200,000
$6,800,000

EBT After
Forward
Applied
$0
$0
$0
$0
$200,000

Unused
Carryable
Amount
$5,000,000
$7,000,000
$8,000,000
$6,800,000
$0

2011 Tax liability = EBT Tax rate

2011 Tax liability = $68,000

34. C
Tax rate

40%

Year
Tax. Income
2006
$50,000
2007
$40,000
2008
$30,000
2009
$20,000
2010
-$92,500
2011
$60,000
2011 Tax liability = EBT
2011 Tax liability = $7,000

35. A
Operating income
Interest income
Dividend income

Carry-Forward
Used
$0
$0
$0
$0
$0
$92,500
Tax rate

$140,000
$50,000
$100,000

EBT After
Unused
Forward
Carryable
Applied
Amount
$50,000
$0
$40,000
$0
$30,000
$0
$20,000
$0
$0
$92,500
$17,500
$0

Dividend exclusion %

70%

Taxable income = Operating income + Interest income + Taxable dividend income

Taxable income = Operating income + Interest income + Dividend income
(1 Dividend exclusion%)
Taxable income = $220,000
Taxable Tax on Base of Bracket % on Excess above Base
Income
$0
$0
15%
$50,000
7,500
25%
$75,000
13,750
34%
$100,000
22,250
39%
$335,000
113,900
34%
$10,000,000
3,400,000
35%
$15,000,000
5,150,000
38%
$18,333,333
6,416,667
35%
Tax on base =
Tax on excess base =
Tax liability =

$22,250
$46,800
$69,050

36. A
This problem can be worked very easily--just multiply the increase in depreciation by (1-T) to
get the decrease in net income, and then subtract this value from the change in depreciation
to get the change in free cash flow:
Change in depreciation
Tax rate
Reduction in net income = Change in Depr'n (1 - Tax rate)
Increase in free cash flow = Change in Depr'n - Reduction
in NI

$1,350
35.00%
-$877.50
$472.50

You can also get the answer the long way, which explains things in more detail:
Old
New
Change
Bonds
$3,500 $3,500
$0.00
Interest rate
6.50% 6.50%
0.00
Tax rate
35%
35%
0.00
Capex + NOWC
$2,000 $2,000
$0.00
Sales
$11,250 $11,250
$0.00
Operating costs excluding depreciation
$4,500 $4,500
$0.00

Depreciation
Operating income (EBIT)

Taxes

$1,250 $2,600 $1,350.00

$5,500 $4,150
$1,350.00
$228
$228
$0.00
$5,273 $3,923
$1,350.00
$1,845 $1,373 -$472.50

Net income

$3,427 $2,550 -$877.50

Free cash flow = EBIT(1 - T) + Deprec - [Capex +

NOWC]

$2,825 $3,298 $472.50

Interest charges
Taxable income

Check on FCF: - FCF = Change in depreciation

rate

Tax

$472.50

I like this problem because it illustrates that an increase in depreciation will decrease
the firm's net income yet increase its free cash flow, and cash is king.

37. E
38. A
39. E
HD has higher interest charges. Basic earning power equals EBIT/Assets, and since assets
and BEP are equal, EBIT must also be equal. TIE = EBIT/Interest. Therefore, HD's higher
interest charges means that its TIE must be lower.
40.
41.
42.
43.

E
C
A
B
Total assets
Old debt
Target debt ratio
Target amount of debt = Target debt% Total
assets =
Change in amount of debt outstanding = Target debt - Old
debt =

44. E
Assets
Debt ratio
Debt = Assets Debt% =
Equity = Assets - Debt =

$745,000
$185,000
55%
$409,750
$224,750

$110,000
37.5%
$41,250
$68,750

Sales
Old net income
New net income
New ROE = New NI / Equity =
Old ROE = Old NI / Equity =
Increase in ROE = New ROE Old ROE
=

$305,000
$20,000
$33,000
48.00%
29.09%
18.91%

45. A
Original
New
$420,000 $252,500
$403,000 $403,000
$28,250 $28,250
39.00% 39.00%
$163,800 $98,475
$256,200 $154,025
11.03%
18.34%
7.31%

Assets
Sales
Net income
Debt ratio
Debt = Assets debt% =
Equity = Assets - Debt =
ROE = NI / Equity =
Increase in ROE

46. A
Inventory turnover ratio = Sales/Inventory =
47. E
Debt ratio = Total debt/Total assets
=

3.75

64.5%

48. A
ROA = Net income/Total assets =

2.30%

49. B
ROE = Net income/Common equity =

6.49%

50. A
P/E ratio = Price per share/Earnings per share
=

12.0