Finance Zutter CH 1 4 REVIEW

Principles of Managerial Finance, 15e (Zutter & Smart)
Table of Contents
Chapter 1 The Role of Managerial Finance..........................................................................................................................2
1.1 Finance and the firm......................................................................................................................................................2
1.2 Managing the firm.........................................................................................................................................................6
1.3 Organization forms, taxation, and the principal-agent relationship...............................................................................9
1.4 Developing skills for your career..................................................................................................................................16
Chapter 2 The Financial Market Environment...................................................................................................................17
2.1 Financial institutions....................................................................................................................................................17
2.2 Financial markets.........................................................................................................................................................18
2.3 Regulation of financial markets and institutions..........................................................................................................24
2.4 The securities issuing process......................................................................................................................................25
2.5 Financial markets in crisis............................................................................................................................................28
Chapter 3 Financial Statements and Ratio Analysis...........................................................................................................30
3.1 The stockholder's report..............................................................................................................................................30
3.2 Using financial ratios....................................................................................................................................................40
3.3 Liquidity ratios.............................................................................................................................................................43
3.4 Activity ratios...............................................................................................................................................................44
3.5 Debt ratios................................................................................................................................................................... 48
3.6 Profitability ratios........................................................................................................................................................49
3.7 Market ratios...............................................................................................................................................................53
3.8 A complete ratio analysis…………………………………………………………………………………………………………………………………………55
Chapter 4 Long- and Short-Term Financial Planning..........................................................................................................67

4.1 The financial planning process.....................................................................................................................................67
4.2 Measuring the firm's cash flow....................................................................................................................................69
4.3 Cash planning: cash budgets........................................................................................................................................84
4.4 Profit planning: pro forma statements.........................................................................................................................92
4.5 Preparing the pro forma income statement................................................................................................................93
4.6 Preparing the pro forma balance sheet.......................................................................................................................97
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Chapter 1 The Role of Managerial Finance

1.1 Finance and the firm.
1) A firm is a business organization that sells goods and services.

Answer: TRUE
2) In finance we say that the goal of the firm ought to be to maximize profits.
Answer: FALSE
3) Other things being equal, it is better to receive money sooner rather than later.
Answer: TRUE
4) Financial managers evaluating decision alternatives or potential actions must consider

________.
A) only risk
B) only return
C) either risk or return
D) risk, return, and the impact on share price
Answer: D
5) If a firm earns a profit, it will necessarily also generate a positive cash flow.
Answer: FALSE
6) If a firm's stockholders are risk averse, the firm can make its stockholders better off by
earning the highest possible returns on its investments.
Answer: FALSE
7) Which of the following is an example of a firm's stakeholder?

A) suppliers
B) Federal Reserve
C) media
D) competitors
Answer: A
8) A financial manager must choose between four alternative Assets: 1, 2, 3, and 4. Each asset
costs $35,000 and is expected to provide earnings over a three-year period as described below.
Based on the wealth maximization goal, the financial manager would choose ________.
A) Asset 1
B) Asset 2
C) Asset 3
D) Asset 4
Answer: A
9) In the most recent year, two different companies generated the same earnings per share. The
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stocks of these two companies should trade at the same price.

Answer: FALSE
10) One reason that firms exist is that most investors are risk averse, so they are not willing to
make the kinds of risky investments that firms typically undertake.
Answer: FALSE
11) Which of the following is TRUE of stakeholders?

A) They are the owners of a firm.
B) They are groups to whom a firm has financial obligations.
C) They are groups having a direct economic link to a firm.
D) They include only the bondholders, common stockholders, and preferred stockholders.
Answer: C
12) Which of the following is TRUE regarding cash flow?

A) Profits do not necessarily result in cash flows available to the stockholders.
B) It is guaranteed that the board of directors will increase dividends when net cash flows
increase.
C) A firm's income statement will never show a positive profit when its cash outflows exceed its
cash inflows.
D) An increase in revenue will always result in an increase in cash flow.
Answer: A
13) Investors who are risk averse will make risky investments as long as they expect
compensation for doing so.
Answer: TRUE
14) Which of the following is TRUE of cash flows and risk?

A) Lower cash flow and lower risk result in an increase in share price.
B) Higher cash flow and lower risk result in an increase in share price.
C) Higher cash flow and higher risk result in an increase in share price.
D) Lower cash flow and higher risk result in an increase in share price.
Answer: B
15) The goal of business ethics is to motivate business and market participants to adhere to
both the letter and the spirit of laws and regulations in all aspects of business and professional
practice.
Answer: TRUE
16) The primary goal of a financial manager is ________.

A) minimizing risk
B) maximizing profit
C) maximizing wealth
D) minimizing return
Answer: C
17) Corporate owners earn a return ________.

A) by realizing gains through increases in share price and interest earnings
B) by realizing gains through increases in share price and cash dividends
C) through capital appreciation and retained earnings
D) through interest earnings and earnings per share
Answer: B
18) The wealth of the owners of a corporation is represented by ________.
A) profits
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B) earnings per share

C) share value
D) cash flow
Answer: C
19) Wealth maximization as the goal of a firm implies enhancing the wealth of ________.
A) the auditors
B) the creditors
C) the federal reserve
D) the firm's stockholders
Answer: D
20) The amount earned during the accounting period on each outstanding share of common
stock is called ________.
A) dividend per share
B) earnings per share
C) net profits after taxes
D) book value per share
Answer: B
21) Firm A generates more cash flow while taking less risk than Firm B. The stock price of
Firm A should be higher than the stock price of Firm B.
Answer: TRUE
22) Which of the following is NOT a reason that a firm that maximizes profits may fail to
maximize shareholder wealth.
A) The timing of profits matters. Shareholders might prefer lower profits that arrive sooner.
B) Risk matters. Shareholders are risk averse, so they prefer less risky investments that
generate lower profits.
C) Shareholder wealth depends on cash flow which is not the same as profit.
D) If a firm maximizes profits by engaging in unethical business practices, it's stock price may
be adversely affected.
Answer: B
23) ________ pool investment capital, make risky investment decisions, and manage risky
investments on behalf of investors who would otherwise not be able to do so own their own.
A) Firms
B) Stockholders
C) Stakeholders
D) Regulators
Answer: A
24) Finance is ________.

A) the system of verifying, analyzing, and recording business transactions
B) the science of the production, distribution, and consumption of goods and services
C) the science and art of how individuals and businesses raise, allocate, and invest money
D) the art of merchandising products and services
Answer: C
25) In March 2017, Amazon and Clorox reported nearly identical earnings per share, but the
stock price of Amazon was more than six times higher than the Clorox stock price. The most
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likely explanation for that difference is that ________.

A) Clorox is bad for the environment
B) Amazon is a riskier company
C) investors see better long-term prospects for Amazon
D) Amazon has more shares of stock outstanding
Answer: C
26) The wealth of corporate owners is measured by the share price of the stock.
Answer: TRUE
27) Risk, the magnitude and timing of cash flows are the key determinants of share price, which
represent the wealth of the owners in the firm.
Answer: TRUE
28) A higher earnings per share (EPS) does not necessarily translate into a higher stock price.
Answer: TRUE
29) The profit maximization goal ignores the timing of returns, does not directly consider cash
flows, and ignores risk.
Answer: TRUE
30) When considering a firm's financial decision alternative, financial managers should accept
only those actions that are expected to maximize shareholder value.
Answer: TRUE
31) An increase in a firm's risk will always result in a higher share price since the stockholder
must be compensated for the greater risk.
Answer: FALSE
32) An objection to managing a firm on behalf of stakeholders rather than shareholders is that
________.
A) stakeholders have no economic interest in the firm
B) stakeholders have an interest only in short-term outcomes
C) there is no clear way to satisfy all stakeholders whose economic interests may be at odds
with each other
D) the goal of managing on behalf of stakeholders is too narrow
Answer: C
33) An effective ethics program ________.

A) can weaken corporate value
B) has no effect on a corporation's value
C) can enhance a corporation's value
D) will result in high employee attrition rate
Answer: C
34) When considering a firm's financial decision alternative, financial managers should accept
only those actions that are expected to increase the firm's profitability.
Answer: FALSE
35) ________ are the standards of conduct or moral judgment that apply to persons engaged in
commerce.
A) Government regulations
B) The Uniform Commercial Codes
C) The rules of fair play
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D) Business ethics
Answer: D
36) Cash flows and risk are the key determinants in share price. Increased risk, other things
remaining the same, results in ________.
A) a lower share price
B) a higher share price
C) an unchanged share price
D) an undetermined share price
Answer: A
37) Cash flows and risk are the key determinants in share price. Increased cash flow results in
________, other things remaining the same.
A) a lower share price
B) a higher share price
C) an unchanged share price
D) an undetermined share price
Answer: B
1.2 Managing the firm.
1) A treasurer is responsible for the firm's accounting activities, such as corporate accounting,
tax management, financial accounting, and cost accounting.
Answer: FALSE
2) ________ decisions focus on how a company will spend its financial resources on long-term
projects that ultimately determine whether the firm successfully creates value for its owners.
A) Investment
B) Financing
C) Working capital
D) Risk management
Answer: A
3) The principle of the time value of money basically says that ________.
A) because firms pay managers a great deal, managers need to use their time very effectively
B) money received today is more valuable than money received in the future because money in
the future is more risky
C) money received today is more valuable than money received in the future because firms and
individuals can invest money they have today and earn a return on that money
D) because of the principal-agent problem, investors cannot trust that money firms promise to
pay in the future will ever arrive
Answer: B
4) The primary principle that finance borrows from economics is ________.

A) generally accepted accounting principles
B) cash is king
C) marginal cost-benefit analysis
D) shareholder value maximization
Answer: C
5) Financing decisions deal with the left-hand side of the firm's balance sheet.
Answer: FALSE
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6) Which of the following activities of a finance manager determines the types of assets the firm
holds?
A) budget allocation
B) investment decisions
C) financing decisions
D) analyzing and planning cash flows
Answer: B
7) You own a building supply store. Today you sold construction materials to a contractor for
$10,000 that you acquired a week ago for $8,000. You paid for the materials in cash, but you
sold them to the contractor on credit, and you expect him to pay his bill in a few months. Based
on this information during the week you earned a positive profit but experienced a negative
cash flow.
Answer: TRUE
8) There is a tendency for CEOs of larger companies to earn more money than CEOs of smaller
companies. Suppose a CEO decides to acquire another company, thus increasing the size of the
CEO's firm. Suppose also that the price of the stock of the acquiring firm falls when it learns of
the upcoming acquisition. This appears to be an example of ________.
A) a CEO pursuing profit maximization rather than wealth maximization
B) the principal-agent problem
C) a CEO behaving unethically
D) the general principal that acquisitions are generally not good investments
Answer: B
9) A corporation's stockholders elect its CEO.

Answer: FALSE
10) The money that firms raise to finance their activities is called ________.
A) the capital budget
B) working capital
C) capital
D) accruals
Answer: C
11) Marginal cost-benefit analysis states that financial decisions should be made and actions
should be taken only when the added benefits exceed the added costs.
Answer: TRUE
12) The treasurer typically manages a firm's cash, investing surplus funds when available and
securing outside financing when needed.
Answer: TRUE
13) A corporate treasurer's focus tends to be more external, while the controller's focus is more
internal.
Answer: TRUE
14) The accrual method recognizes revenue at the point of sale and recognizes expenses when
incurred.
Answer: TRUE
15) A treasurer is commonly responsible for handling ________.

A) tax management
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B) corporate accounting
C) investing surplus funds
D) cost accounting
Answer: C
16) Which of the following is TRUE of accrual basis accounting?

A) Expenses are recognized either when they are incurred or cash is paid.
B) Revenue is recognized when a customer pays cash.
C) Expenses are recognized when they are incurred.
D) Revenue is recognized when a customer pays cash or shows interest to purchase the product
or service.
Answer: C
17) Johnson, Inc. has just ended the calendar year making a sale in the amount of $10,000 of
merchandise purchased during the year at a total cost of $7,000. Although the firm paid in full
for the merchandise during the year, it is yet to collect at year end from the customer. The net
profit and cash flow from this sale for the year are ________.
A) $3,000 and $10,000, respectively
B) $3,000 and -$7,000, respectively
C) $7,000 and -$3,000, respectively
D) $3,000 and $7,000, respectively
Answer: B
18) A firm has just ended its calendar year making a sale in the amount of $150,000 of
merchandise purchased during the year at a total cost of $112,500. Although the firm paid in
full for the merchandise during the year, it is yet to collect at year end from the customer. The
net profit and cash flow from this sale for the year are ________.
A) $0 and $150,000, respectively
B) $37,500 and -$150,000, respectively
C) $37,500 and -$112,500, respectively
D) $150,000 and $112,500, respectively
Answer: C
19) Stockholders expect to earn higher rates of return on investments with lower risk and lower
rates of return on investments with higher risk.
Answer: FALSE
20) As the risk of a stock investment increases, investors' ________.

A) return will increase
B) return will decrease
C) required rate of return will decrease
D) required rate of return will increase
Answer: D
21) The principal-agent problem arises when ________.

A) the owners of the firm are not the people managing the firm
B) the owners of the firm also manage the firm
C) managers serve on a firm's board of directors
D) a firm is organized as a sole proprietorship
Answer: A
22) Which of the following works as a conduit of information between the firm and its investors?
A) the treasurer
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B) the controller
C) the director of internal audit
D) the director of investor relations
Answer: D
23) ________ decisions refer to how a firm manages its short-term resources on a day-to-day
basis.
A) Financing
B) Investment
C) Working capital
D) Managerial finance
Answer: C
24) There is a tradeoff between risk and return (i.e., to earn higher returns you generally have
to take more risk) because ________.
A) investors like risk and return and want more of both
B) investors are risk averse, so they will not accept riskier investments unless they offer higher
returns
C) to earn higher returns you have to make bigger investments and bigger investments are
always riskier than smaller ones
D) investors care about returns but not about risks
Answer: A
25) The time value of money principle implies that all other things being equal, investments that
produce profits faster are preferred over those that produce more distant profits.
Answer: TRUE
26) The ________ has a role that focuses on budgeting, accounting, and tracking the
performance of a single business unit.
A) controller
B) treasurer
C) chief financial officer
D) director of risk management
Answer: A
27) When managers are trying to create value for shareholders, their primary focus should be
on earnings rather than cash flow.
Answer: FALSE
1.3 Organization forms, taxation, and the principal-agent

relationship.
1) Which of the following legal forms of organization is most expensive to organize?

A) sole proprietorships
B) partnerships
C) corporations
D) limited partnership
Answer: C
2) Which of the following legal forms of organization has the ease of dissolution?
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B) partnerships
C) limited partnerships
D) corporations
Answer: A
3) Under which of the following legal forms of organization is ownership readily transferable?
B) partnerships
C) limited partnerships
D) corporations
Answer: D
4) Which of the following forms of organizations is the easiest to form?

B) limited liability corporation
C) limited partnership
D) S-corporations
Answer: A
5) A major weakness of a partnership is ________.

A) the difficulty in maintaining owners' control
B) the difficulty in liquidating or transferring ownership
C) the double taxation of income
D) its high organizational costs
Answer: B
6) Which of the following is a strength of a corporation?

A) low taxes
B) limited liability
C) low organization costs
D) less government regulation
Answer: B
7) Which of the following legal forms of organizations is characterized by unlimited liability?

A) sole proprietorship
B) limited partnership
C) corporation
D) C-corporation
Answer: A
8) Which of the following is TRUE of a partnership and a corporation?

A) In a corporation, income is taxed at the corporate level; whereas, in a partnership, income is
taxed twice.
B) In a partnership, income is taxed once at the individual level; whereas, in a corporation,
income is taxed twice.
C) Income from both forms of organizations are double-taxed.
D) In a partnership, income is exempted from tax up to $10 million; whereas, in a corporation,
income is taxed twice.
Answer: B
9) Which of the following is TRUE of sole proprietorships and corporations?

A) It is difficult to transfer ownership of corporations compared to that of sole proprietorships.
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B) Income from both forms of organizations are taxed only at the corporate level.
C) Both sole proprietorships and corporations are equally scrutinized and regulated by
government bodies.
D) In sole proprietorships, owners have unlimited liability; whereas, in corporations, owners
have limited liability.
Answer: D
10) In partnerships, partners can readily transfer their wealth to other partners.
Answer: FALSE
11) A sole proprietor has unlimited liability; his or her total investment in the business, but not
his or her personal assets, can be taken to satisfy creditors.
Answer: FALSE
12) In a limited partnership, all partners' liabilities are limited to their investment in the
partnership.
Answer: TRUE
13) Under a progressive tax structure in which tax rates rise with income levels ________.
A) the marginal tax rate and the average tax rate are the same
B) the average tax rate is what really matters when an individual or business is making a
financial decision
C) the marginal tax rate is usually less than the average tax rate
D) the marginal tax rate is usually greater than the average tax rate
Answer: D
14) The term "double taxation" means that ________.

A) partnerships and sole proprietorships pay tax on the income that they earn, and then income
distributed from the business to the owner is taxed again at the individual level
B) the highest federal income tax rate faced by corporations is twice the highest tax rate faced
by individuals
C) corporations pay tax on the income they earn and then shareholders pay tax on income that
the corporation distributes to them
D) a corporation pays tax on the interest it pays to bondholders and then bondholders pay tax
again on the interest payments they receive from firms
Answer: C
15) Suppose a certain business pays 10% tax on its first $10,000 in come, 12% tax on income
above $10,000 but below $40,000, and 22% tax on income above $40,000. Suppose the
business earns $50,000 in income this year. It's marginal tax rate is ________.
A) 10%
B) 12%
C) 22%
D) greater than 22%
Answer: C
16) Corporate governance refers to ________.

A) the rules, processes, and laws by which companies are operated, controlled, and regulated
B) the fact that corporations heavily influence the actions of governments through their
lobbying efforts
C) the notion that corporations act like a democracy in the sense that every shareholder has an
equal vote on corporate decisions
D) the idea that a corporate CEO is really accountable to no one and must be constrained by
government action
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Answer: A
17) Agency costs are ________.

A) costs that managers bear when they do not act in the interests of shareholders
B) costs that firms must pay to comply with the regulations imposed by federal government
agencies
C) costs that are exempt from taxation
D) costs that shareholders bear because managers pursue their own interests rather than
acting in the interests of shareholders
Answer: D
18) Firms are legally required to pay dividends to stockholders just as they must make interest
payments to lenders.
Answer: FALSE
business earns $50,000 in income this year. Its average tax rate is closest to ________.
A) 22%
B) 14%
C) 10%
D) 17%
Answer: B
20) Dividends are periodic distributions of cash to the stockholders of a firm.

Answer: TRUE
business earns $50,000 in income this year. It tax liability is ________.
A) $6,800
B) $11,000
C) $9,800
D) $5,800
Answer: A
22) Under a flat tax structure, where the same tax rate applies to all income levels ________.
A) the marginal tax rate is greater than the average tax rate
B) the marginal tax rate is less than the average tax rate
C) the marginal tax rate is equal to the average tax rate
D) the marginal tax rate is irrelevant
Answer: C
23) In partnerships, owners have unlimited liability and may have to cover debts of other less
financially sound partners.
Answer: TRUE
24) The board of directors is responsible for managing day-to-day operations and carrying out
the policies established by the chief executive officer.
Answer: FALSE
25) Institutional investors are professional investors who work on behalf of individuals,
business, and government.
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Answer: TRUE
26) The major purpose of the Sarbanes-Oxley Act of 2002 was to place caps on the
compensation that could be paid to corporate executives.
Answer: FALSE
27) The board of directors is typically responsible for ________.

A) approving strategic goals and plans
B) managing day-to-day operations
C) arranging finance for approved long-term investments
D) maintaining and controlling the firm's daily cash balances
Answer: A
28) The responsibility for managing day-to-day operations and carrying out corporate policies
belongs to the ________.
A) board of directors
B) chief executive officer
C) stockholders
D) creditors
Answer: B
29) Which of the following is an example of agency cost?

A) costs incurred for setting up an agency
B) failure to make an investment that would make shareholders wealthier
C) payment of income tax
D) payment of interest
Answer: B
30) Which of the following is a routine way that boards try to align the interests of managers
and stockholders?
A) fire managers who are inefficient
B) remove management's perquisites
C) tie management compensation to the performance of the company's common stock price
D) tie management compensation to the level of dividend per share
Answer: C
31) The marginal tax rate paid on a firm's ordinary income can be calculated by dividing its
taxes by its net income.
Answer: FALSE
32) The average tax rate paid on the firm's ordinary income can be calculated by dividing its
taxes by its taxable income.
Answer: TRUE
33) The tax deductibility of various expenses such as general and administrative expenses
________.
A) increases their pretax cost
B) reduces their after-tax cost
C) has no effect on their after-tax cost
D) has an unpredictable effect on their after-tax cost
Answer: B
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34) Jennings, Inc. has a tax liability of $170,000 on pretax income of $500,000. What is the
average tax rate for Jennings, Inc.?
A) 34 percent
B) 46 percent
C) 25 percent
D) 40 percent
Answer: A
35) The average tax rate of a corporation with ordinary income of $105,000 and a tax liability of
$24,200 is ________.
A) 46 percent
B) 23 percent
C) 34 percent
D) 15 percent
Answer: B
36) If a corporation sells certain capital equipment for more than its initial purchase price, the
difference between the sale price and the purchase price is called a(n) ________.
A) ordinary gain
B) revenue gain
C) capital gain
D) abnormal gain
Answer: C
37) In general, most corporate capital gains are taxed at ________ tax rate.
A) the average
B) the regular corporate
C) the historic
D) a 30 percent
Answer: B
38) Corporation X needs $1,000,000 and can raise this through debt at an annual rate of 6
percent, or preferred stock at an annual cost of 8 percent. If the corporation has a 21 percent
tax rate, the after-tax cost of each is ________.
A) debt: $60,000; preferred stock: $80,000
B) debt: $47,400; preferred stock: $63,200
C) debt: $47,400; preferred stock: $80,000
D) debt: $60,000; preferred stock: $63,200
Answer: C
39) The marginal tax rate represents the rate at which the next dollar of income is taxed.
Answer: TRUE
40) All dividend income received by a corporation is exempted from taxation.

Answer: FALSE
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41) The tax liability of a sole proprietorship with ordinary income of $105,000 is closest to
________.
Range of taxable income Marginal rate
$ 0 to $ 9,525 10%
9,525 to 38,700 12
38,700 to 82,500 22
82,500 to 157,500 24
A) $25,200
B) $22,050
C) $32,090
D) $19,490
Answer: D
42) The tax liability of a sole proprietorship with ordinary income of $450,000 is closest to
________.
Range of taxable income Marginal rate
$ 0 to $ 9,525 10%
9,525 to 38,700 12
38,700 to 82,500 22
82,500 to 157,500 24
157,500 to 200,000 32
200,000 to 500,000 35
A) $157,500
B) $133,190
C) $94,500
D) $114,700
Answer: B
43) Prior to the Tax Cuts and Jobs Act, corporations faced a progressive tax rate schedule with
rates ranging from 15% to 39%. Under that old tax law, a firm with taxable income of $100
million would have owed taxes of $35 million. Under the Tax Cuts and Jobs Act, the corporate
tax rate is a flat 21%. For a firm that makes $100 million in taxable income, the size of the tax
reduction that the firm enjoys because of the new tax law is closest to ________.
A) $18 million
B) $21 million
C) $14 million
D) $35 million
Answer: C
44) Corporation A owns a small percentage of the stock of corporation B. Corporation B pays
corporation A $100,000 in dividends. Corporation A pays tax at a 21% rate and is allowed to
exclude from taxable income 50% of dividends received from other firms. The incremental taxes
that Corporation A must pay on the dividends received are ________.
A) $21,000
B) $10,500
C) $0
D) $1,050
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Answer: B
45) Consider two firms, Go Debt corporation and No Debt corporation. Both firms are expected
to have earnings before interest and taxes of $100,000 during the coming year. In addition, Go
Debt is expected to incur $40,000 in interest expenses as a result of its borrowings whereas No
Debt will incur no interest expense because it does not use debt financing. Both firms are in the
21 percent tax bracket. Calculate the earnings after tax for both firms. Compare the difference
in after-tax earnings to the difference in interest expense. Can you reconcile that difference?
Answer:
Go Debt has lower earnings after taxes compared to No Debt, and the difference is $31,600
($79,000 - $47,400). The difference in interest expense is $40,000. The recent the difference in
earnings is less than the difference in interest expense is that the interest expense that Go Debt
pays saves the company $8,400 in taxes (a number which you can calculate by multiplying 21%
time the $40,000 interest expense).
1.4 Developing skills for your career.
1) Communication skills are very important to financial and nonfinancial managers because
________.
A) they will be communicating with the investment community regularly
B) they work together in cross-functional teams and need to understand how members of their
teams think
C) they will write reports that are disclosed in the firm's financial reports
D) they are all responsible for selling the firms goods and services to customers
Answer: B
2) Developing financial computing skills, such as expertise with software like Excel, is
important because ________.
A) everyone in the firm must be an Excel expert to have success
B) everyone in the firm needs to understand financial reports and models at some level, and
those are usually constructed and presented in Excel
C) there are no good alternatives to Excel
D) mistakes are more likely to occur when people do financial work by hand rather than using a
product like Excel
Answer: B
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Chapter 2 The Financial Market Environment

2.1 Financial institutions
1) A financial institution is an intermediary that channels the savings of individuals, businesses,

and governments into loans or investments.
Answer: TRUE
2) Commercial banks advise firms on major transactions such as mergers or financial

restructurings.
Answer: FALSE
3) As a key participant in financial transactions, individuals are ________.

A) net demanders of funds because they save more money than they borrow
B) net users of funds because they save less money than they borrow
C) net suppliers of funds because they save more money than they borrow
D) net purchasers of funds because they save more money than they borrow
Answer: C
4) Government is typically a ________.

A) net provider of funds because it borrows more than it saves
B) net demander of funds because it borrows more than it saves
C) net provider of funds because it can print money at will
D) net demander of funds because it saves more than it borrows
Answer: B
5) Government can obtain funds ________.

A) by trading in the equity market
B) by issuing financial instruments such as futures and options
C) through the foreign exchange market
D) by selling debt securities
Answer: D
6) Firms that require funds from external sources can obtain them ________.
A) through financial institutions
B) from central bank directly
C) through the foreign exchange market
D) by issuing T-bills
Answer: A
7) Investment banks are institutions that ________.

A) perform all activities of commercial banks and retail banks
B) are exempted from Securities and Exchange Commission regulations
C) engage in trading and market making activities
D) are only limited to capital market activities
Answer: C
8) Which of the following serves as an intermediary channeling the savings of individuals,

businesses, and governments into loans and investments?
A) financial institutions
B) financial markets
C) Securities and Exchange Commission
17
D) OTC market
Answer: A
9) The shadow banking system describes a group of institutions that engage in lending
activities, much like traditional banks.
Answer: TRUE
10) Which of the following provides savers with a secure place to invest funds and offer both
individuals and companies loans to finance investments?
A) investment banks
B) securities exchanges
C) mutual funds
D) commercial banks
Answer: D
11) Which of the following assists companies in raising capital, advise firms on major
transactions such as mergers or financial restructuring, and engage in trading and market
making activities?
A) investment banks
B) securities exchanges
C) mutual funds
D) commercial banks
Answer: A
2.2 Financial markets
1) Primary and secondary markets are markets for short-term and long-term securities,
respectively.
Answer: FALSE
2) The over-the-counter (OTC) market is a market for trading smaller and unlisted securities.
Answer: TRUE
3) NASDAQ is considered an OTC market since it is not recognized by the SEC as a "listed
exchange."
Answer: FALSE
4) In the OTC market, the ask price is the highest price offered by a dealer to purchase a given
security.
Answer: FALSE
5) In the Eurobond market, corporations and governments typically issue bonds denominated in
dollars and sell them to investors located outside the United States.
Answer: TRUE
6) Capital markets are for investors who want a safe temporary place to deposit funds where
they can earn interest and for borrowers who have a short-term need for funds.
Answer: FALSE
7) Money markets are markets for long-term funds such as bonds and equity.
Answer: FALSE
8) An efficient market is a market that establishes correct prices for the securities that firms
18
sell and allocates funds to their most productive use as a result of the intense competition
among investors.
Answer: TRUE
9) Money markets involve the trading of securities with maturities of one year or less.
Answer: TRUE
10) Eurocurrency deposits arise when a corporation or individual makes a deposit in a bank in a
currency other than the local currency of the country where the bank is located.
Answer: TRUE
11) The Eurocurrency market is a market for short-term bank deposits denominated in U.S.
dollars or other easily convertible currencies.
Answer: TRUE
12) The money market is a financial relationship created by a number of institutions and
arrangements that allows suppliers and demanders of long-term funds to make transactions.
Answer: FALSE
13) The over-the-counter (OTC) market is ________.

A) a highly liquid market as compared to NASDAQ
B) a market in which low risk-high return securities are traded
C) an organized market in which all financial derivatives are traded
D) a market where smaller, unlisted securities are traded
Answer: D
14) Which of the following is TRUE of a primary market?

A) It is an organized market in which all financial derivatives are traded.
B) It is regulated by The Sarbanes-Oxley Act.
C) It is a market where smaller, unlisted securities are traded.
D) It is the only market in which the issuer is directly involved in the transaction.
Answer: D
15) Which of the following is TRUE of a secondary market?

A) It is a market for an unlisted company to raise equity capital.
B) It is a market where securities are issued through private placement.
C) It is a market in which short-term money market instruments such as Treasury bills are
traded.
D) It is a market in which preowned securities are traded.
Answer: D
16) Which of the following is TRUE of preferred stock?

A) It has features of bonds and a common stock.
B) It has a claim on assets prior to creditors in the event of liquidation.
C) Its dividends can be paid only after paying dividends to the common stockholders.
D) It usually has a maturity of thirty years.
Answer: A
17) The key securities traded in the capital markets are ________.
A) commercial papers and Treasury bills
B) Treasury bills and certificates of deposit
C) stocks and bonds
D) bills of exchange and commercial papers
19
Answer: C
18) Which of the following is TRUE of international equity markets?

A) In the international equity market, corporations cannot raise capital through IPOs, instead
they can raise capital by trading in the secondary market.
B) In the international equity market, corporations can easily manipulate the price of the shares
since it is not regulated by any regulatory bodies.
C) In the international equity market, corporations can only sell blocks of shares to institutional
investors from European Union.
D) In the international equity market, corporations can sell blocks of shares to investors in a
number of different countries simultaneously.
Answer: D
19) Which of the following is TRUE of a dealer market?

A) Buyers and sellers are never brought together directly.
B) Brokers execute the buy or sell orders in a dealer market.
C) It has centralized trading floors.
D) It is a part of the broker market.
Answer: A
20) Which of the following is TRUE of a securities exchange?

A) It serves as an intermediary by channeling the savings of individuals, businesses, and
governments into loans or investments.
B) It borrows funds directly from the financial institutions.
C) It is an association of banks who meet to buy and sell stocks and bonds.
D) It provides a marketplace in which firms can raise funds through the sale of new securities
and purchasers can resell securities.
Answer: D
21) A market that establishes correct prices for the securities that firms sell and allocates funds
to their most productive uses is called a(n) ________.
A) future market
B) forex market
C) efficient market
D) weak-form market
Answer: C
22) The ________ is created by a financial relationship between suppliers and demanders of
short-term funds.
A) stock market
B) capital market
C) forex market
D) money market
Answer: D
23) By definition, the money market involves the buying and selling of ________.
A) stocks and bonds
B) short-term securities
C) all financial instruments except derivatives
D) secured premium notes
Answer: B
24) Most money market transactions are made in ________.

20
A) common stock
B) marketable securities
C) commodities market
D) preferred stock
Answer: B
25) The ________ is created by a number of institutions and arrangements that allow the
suppliers and demanders of long-term funds to make transactions.
A) forex market
B) capital market
C) money market
D) commodities market
Answer: B
26) Long-term debt instruments used by both government and business are known as ________.
A) preferred stocks
B) T-bills
C) bonds
D) equities
Answer: C
27) Which of the following is an example of marketable securities?

A) U.S.Treasury bills
B) treasury stock
C) mortgage backed securities
D) loans
Answer: A
28) In a ________ market, the buyer and seller are brought together to trade securities in an
organization called ________.
A) dealer; securities market
B) broker; over-the -counter market
C) broker; securities market
D) dealer; over-the-counter market
Answer: C
29) Financial markets are intermediaries that channel the savings of individuals, businesses,
and government into loans or investments.
Answer: FALSE
30) A public offering is the sale of a new security issue—typically debt or preferred stock—
directly to an investor or group of investors.
Answer: FALSE
31) A primary market is a financial market in which pre-owned securities are traded.
Answer: FALSE
32) Most businesses raise money by selling their securities in a ________.

A) public offering
B) forex market
C) futures market
21
Answer: A
33) Which of the following is a means of selling bonds or stocks to the public?
A) private placement
B) public offering
C) organized selling
D) direct placement
Answer: B
34) Which of the following is a forum in which suppliers and demanders of funds can transact
business directly?
A) shadow banking system
B) financial markets
C) commercial banks
D) financial institutions
Answer: B
35) The sale of a new security directly to an investor or a group of investors is called ________.
A) arbitraging
B) short selling
C) a capital market transaction
D) a private placement
Answer: D
36) The money market is a market where investors trade highly liquid securities with maturities
of 1 year or less.
Answer: TRUE
37) The market for short-term bank deposits denominated in dollars and other currencies is the
________.
A) money market
B) Eurocurrency market
C) primary market
D) broker market
Answer: B
38) The Eurocurrency market is a market where investors can exchange currencies, for
example by trading dollars for euros.
Answer: FALSE
39) The ________ market is where securities are initially issued and the ________ market is where
pre-owned securities (not new issues) are traded.
A) primary; secondary
B) money; capital
C) secondary; primary
D) primary; money
Answer: A
40) An efficient market is one where ________.

A) prices of stocks move up and down widely without apparent reason
B) prices of stocks remain low for long periods of time
C) prices of stocks are unaffected by market news
D) the price of a security is an unbiased estimate of its TRUE value
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Answer: D
41) The ________ represents income to a market maker who helps facilitate securities trading.
A) commission
B) IPO underpricing
C) bid/ask spread
D) cost of doing business
Answer: C
42) You submit an order to buy 100 shares of stock. The price that you pay for the stock is more
likely to be the ask price rather than the bid price.
Answer: TRUE
43) The money market is a market ________.

A) that enables suppliers and demanders of long-term funds to make transactions
B) which brings together suppliers and demanders of short-term funds
C) where smaller, unlisted securities are traded
D) where all derivatives are traded
Answer: B
44) In a securities market, the bid price is typically higher than the ask price.
Answer: FALSE
45) A ________ is someone who helps facilitate securities trading by offering to buy or sell them
at stated bid/ask prices.
A) market maker
B) stockbroker
C) day trader
D) middle man
Answer: A
46) Apex Inc. issues a bond of $1,000 which pays interest semiannually at a coupon interest
rate of 8%. The maturity of the bond is 15 years. Where should this bond be traded?
A) forex market
B) money market
C) capital market
Answer: C
47) One piece of evidence suggesting that the stock market is efficient is that most individual
investors cannot earn returns that beat the overall market average return, but professional
investors such as mutual fund and pension fund managers generally do earn higher-than-
average returns.
Answer: FALSE
48) One sign that the stock market is efficient is that prices in the market move seemingly at
random, display almost no predictable, repeating patterns.
Answer: TRUE
2.3 Regulation of financial markets and institutions
1) The Glass-Steagall Act was imposed to allow commercial and investment banks to combine
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and work together.

Answer: FALSE
2) The Glass-Steagall Act ________.

A) was intended to regulate the activities in the secondary market
B) created the Securities Exchange Commission
C) separated the activities of commercial and investment banks
D) was intended to regulate the activities in the primary market
Answer: C
3) The Securities Act of 1933 focuses on regulating the sale of securities in the primary market,
whereas the 1934 Act deals with the regulations governing the transactions in the secondary
market.
Answer: TRUE
4) The Federal Deposit Insurance Corporation (FDIC) ________.

A) is an agency, created by the Glass-Steagall Act ,that monitors banks on a regular basis to
ensure that they were safe and sound
B) is an agency that monitors business combinations between commercial banks, investment
banks, and insurance companies
C) guarantees individuals will not lose any money held at any type of financial institution that
fails
D) guarantees individuals will not lose any money, up to a specified amount, held at any type of
financial institution that fails
Answer: A
5) The Gramm-Leach-Bliley Act ________.

A) is created to monitor banks on a regular basis to ensure that they were safe and sound
B) allows business combinations between commercial banks and investment banks, but not
insurance companies
C) allows business combinations between commercial banks, investment banks, and insurance
companies
D) was signed during the Great Depression because of the financial crisis
Answer: C
6) Which of the following acts regulates the secondary market?

A) The Securities Act of 1933
B) The Gramm-Leach-Bliley Act
C) The Securities Exchange Act of 1934
D) The Glass-Steagall Act
Answer: C
7) The ________ created new agencies including the Financial Stability Oversight Council and
the Bureau of Consumer Financial Protection.
A) Securities Exchange Act of 1934
B) Dodd-Frank Wall Street Reform and Consumer Protection Act
C) Securities Act of 1933
D) Gramm-Leach-Bliley Act
Answer: B
8) Which of the following acts regulates the primary market in which securities are originally
issued to the public?
A) The Securities Act of 1933
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B) The Gramm-Leach-Bliley Act

C) The Securities Exchange Act of 1934
D) The Glass-Steagall Act
Answer: A
2.4 The securities issuing process
1) A firm conducting an IPO of common stock sold 1 million new shares in the offering at an
offer price of $10 per share. After the offering, the firm had 5 million shares outstanding, and
the price of those shares in the secondary market was $12. The firm's market capitalization is
________.
A) $60 million
B) $50 million
C) $12 million
D) $10 million
Answer: A
the price of those shares in the secondary market was $12. The firm's IPO was underpriced by
________.
A) 0%
B) 100%
C) 20%
D) 16.7%
Answer: C
the price of those shares in the secondary market was $12. The total proceeds from the firm's
IPO were ________.
A) $60 million
B) $50 million
C) $10 million
D) $12 million
Answer: C
4) Small business investment companies (SBICs) are corporations chartered by the federal
government that can borrow at attractive rates from the U.S. Treasury and use the funds to
make venture capital investments in private companies.
Answer: TRUE
5) Angel capitalists or angels are wealthy individual investors who do not operate as a business
but invest in early-stage companies in exchange for a portion of equity.
Answer: TRUE
6) A prospectus is another term for a firm's annual report showing the firm's prospects for the
coming year.
Answer: FALSE
7) Which of the following is an attribute of investment bankers?

A) They make long-term investments for banking institutions.
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B) They bear the risk of selling a security issue.

C) They act as middlemen between the issuer and the banker.
D) They provide the issuer with advice relating to the amounts of dividend to be paid.
Answer: B
8) A prospectus is a portion of the security registration statement that describes the key aspects
of the issue, the issuer, and its management and financial position.
Answer: TRUE
9) An underwritten issue of common stock is one in which a firm purchases insurance to cover
unexpected losses suffered by shareholders.
Answer: FALSE
10) A(n)________ is hired by a firm to find prospective buyers for its new stock or bond issue.
A) securities analyst
B) trust officer
C) commercial loan officer
D) investment banker
Answer: D
11) When an investment bank buys new securities from a firm and takes on the responsibility of
reselling those securities to the public it is engaged in ________.
A) market manipulation
B) underwriting
C) the road show
D) underpricing the security offering
Answer: B
12) ________ is a financial intermediary that specializes in selling new security issues.
A) An investment bank
B) A commercial bank
C) A securities dealer
D) A stock exchange
Answer: A
13) The term red herring refers to ________.

A) the fact that most firms conducting an IPO are losing money, also known as running red ink
B) a firm that is conducting an IPO without fully complying with all government regulations
C) the fact that IPOs are typically underpriced
D) an early version of the prospectus with red printing to indicate that the information the
document contains is not final
Answer: D
14) The IPO offer price is the price at which a newly public firm's shares begin trading in the
secondary market.
Answer: FALSE
15) Which ordering below best describe the level of responsibility for helping a firm conduct an
IPO offering (ordering goes from most responsible to least responsible)?
A) originating investment bank > underwriting syndicate > selling group
B) originating investment bank > selling group > underwriting syndicate
C) underwriting syndicate > originating investment bank > selling group
D) selling group > underwriting syndicate > originating investment bank
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Answer: A
16) A group formed by an investment banker to share the financial risk associated with
underwriting new securities is called a(n) ________.
A) underwriting syndicate
B) selling group
C) investment banking consortium
D) broker pool
Answer: A
17) The term initial public offering describes a transaction in which a firm sells securities
directly to an investor or to a small group of investors.
Answer: FALSE
18) The document that a company conducting an initial public offering produces to describe the
key aspects of the securities offered for sale is called the ________.
A) annual report to stockholders
B) term sheet
C) prospectus
D) tombstone
Answer: C
19) When a firm sells stock to the public for the first time the transaction is called ________.
A) an initial public offering
B) a seasoned equity offering
C) a private placement
D) a secondary market offering
Answer: A
20) A venture capitalist is considering investing in a very risky, early stage startup. Compared
to investments that the VC might make in less risky companies ________.
A) the VC will pay more for the equity it receives and it will demand a greater share of the
startup's equity
B) the VC will pay less for the equity it receives and it will demand a greater share of the
startup's equity
C) the VC will pay more for the equity it receives and it will be willing to take a smaller share of
the startup's equity
D) the VC will pay less for the equity it receives and it will be willing to take a larger share of
the startup's equity
Answer: B
21) Based on the risks of the investments that they make, venture capital firms generally look
for rates of return in the 5% to 15% range.
Answer: FALSE
22) Venture capital firms are usually organized as corporations, and the public shareholders of
the VC firm have a stake in the investments that the firm makes.
Answer: FALSE
23) One difference between angel investors and venture capitalists is ________.
A) venture capitalists are typically businesses, whereas angel investors are usually individuals
B) venture capitalists invest in risky startups, whereas angel investors put their money into
more mature businesses
27
C) venture capitalists make private equity investments whereas angel investors buy shares in
companies in the same way that the rest of the investing public does
D) angel investors are active and typically take a seat of the board of directors of any firm that
they provide financing for, whereas venture capital investors are more passive
Answer: A
24) When venture capitalists invest money in a firm, they are making a private equity
investment.
Answer: TRUE
2.5 Financial markets in crisis
1) When home prices are rising it is easier for homeowners who have fallen behind on their
mortgages to get caught up because ________.
A) they can sell their house and buy a smaller one
B) lenders will allow homeowners to use the built-up equity in their home to refinance their
mortgages
C) they can rent out an extra room in their homes to earn extra income
D) with rising home prices homeowners will pay less in property taxes and use the savings to
make mortgage payments
Answer: B
2) Subprime mortgages are ________.

A) mortgages that charge the borrower an interest rate that is less than the prime rate of
interest
B) mortgages on pieces of real estate located in less than prime neighborhoods
C) loans to borrowers with lower incomes and/or poorer credit histories compared to prime
borrowers
D) mortgages on which the borrower has already fallen behind on payments or defaulted
Answer: C
3) Securitization is the process of pooling mortgages or other types of loans and selling the
claims or securities against that pool in the secondary market.
Answer: TRUE
4) A crisis in the financial sector often spills over into other industries because when financial
institutions ________ borrowing, activity in most other industries ________.
A) increase; slows down
B) contract; slows down
C) increase; increases
D) contract; increases
Answer: B
5) Securitization made it harder for banks to lend money because they could not pass the risk
on to other investors.
Answer: FALSE
6) Mortgage-backed securities are securities that represent claims on the cash flows generated
by a pool of mortgages.
Answer: TRUE
7) Prior to the 2008 financial crisis, most investors viewed mortgage-backed securities as
28
relatively safe investments.

Answer: TRUE
8) Subprime mortgages are mortgage loans made to borrowers with high incomes and better
than average credit histories.
Answer: FALSE
9) Recessions associated with a banking crisis tend to be more severe than other recessions
because many businesses rely on credit to operate.
Answer: TRUE
10) The process of pooling mortgages or other types of loans and selling the claims or securities
against that pool in the secondary market is called ________.
A) valuation
B) securitization
C) private placement
D) capital restructuring
Answer: B
11) The primary risk of mortgage-backed securities is ________.

A) that the prices of have high volatility
B) that the prices of housing will increase
C) that the government will not be able to meet the guarantees on the cash flows
D) that homeowners may not be able to, or choose not to, repay their loans
Answer: D
12) Which of the following is TRUE of mortgage-backed securities?

A) Mortgage-backed securities assure a flat 15% return.
B) Mortgage-backed securities are guaranteed by the U.S. government.
C) Mortgage-backed securities can only be purchased by investment banks.
D) Mortgage-backed securities represent claims on the cash flows generated by a pool of
homeloans.
Answer: D
13) When home prices are falling, we would expect a(n) ________.
A) high mortgage default rates
B) low mortgage default rates
C) unchanged mortgage default rates
D) higher percentage of owner home equity
Answer: A
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Chapter 3 Financial Statements and Ratio Analysis

3.1 The stockholder's report
1) The Financial Accounting Standards Board (FASB) is the federal regulatory body that
governs the sale and listing of securities.
Answer: FALSE
2) GAAP is the accounting profession's rule-setting body.

Answer: FALSE
3) Generally accepted accounting principles are authorized by the Financial Accounting

Standards Board (FASB).
Answer: TRUE
4) The Sarbanes-Oxley Act of 2002 established the Public Company Accounting Oversight Board
(PCAOB) which is a not-for-profit corporation that oversees auditors of public corporations.
Answer: TRUE
5) The Sarbanes-Oxley Act of 2002 was passed to eliminate many of the disclosure and conflict-
of-interest problems of corporations.
Answer: TRUE
6) The Sarbanes-Oxley Act of 2002 established the Private Company Accounting Oversight
Board (PCAOB) which is a for-profit corporation that oversees CEOs of public corporations.
Answer: FALSE
7) Publicly owned corporations with more than $5 million assets are required by the Securities
and Exchange Commission (SEC) to provide their stockholders with an annual stockholders'
report.
Answer: TRUE
8) The letter to stockholders is the primary communication from management in an annual

report.
Answer: TRUE
9) Common stock dividends paid to stockholders is equal to the earnings available for common
stockholders divided by the number of shares of common stock outstanding.
Answer: FALSE
10) The income statement is a financial summary of a firm's operating results during a specified
period while the balance sheet is a summary statement of a firm's financial position at a given
point in time.
Answer: TRUE
11) The common stock entry in balance sheet is the par value of common stock.
Answer: TRUE
12) Paid-in capital in excess of par represents the proceeds in excess of par value received from
the original sale of common stock.
Answer: TRUE
30
13) Earnings per share represents amount earned during the period on each outstanding share
of common stock.
Answer: TRUE
14) Net fixed assets represent the difference between gross fixed assets and the amount of
depreciation expense from the most recent year.
Answer: FALSE
15) Earnings per share results from dividing earnings available for common stockholders by the
number of shares of common stock authorized.
Answer: FALSE
16) Retained earnings represent the cumulative total of all earnings, net of dividends that have
been retained and reinvested in the firm since its inception.
Answer: TRUE
17) The balance sheet is a statement which balances a firm's assets (what it owns) against its
debt (what it owes) and its equity (what is provided by owners).
Answer: TRUE
18) The amount paid in by the original purchasers of common stock is shown by two entries in
the firm's balance sheet—common stock and paid-in capital in excess of par on common stock.
Answer: TRUE
19) The original price per share received by the firm on a single issue of common stock is equal
to the sum of the common stock and paid-in capital in excess of par accounts divided by the
number of shares outstanding.
Answer: TRUE
20) The statement of cash flows reconciles the net income earned during a given year, and any
cash dividends paid, with the change in retained earnings between the start and end of that
year.
Answer: FALSE
21) The statement of cash flows provides insight into a firm's operating, investment, and
financing cash flows and reconciles them with changes in its cash and marketable securities
during the period of concern.
Answer: TRUE
22) A U.S. parent company's foreign equity accounts are translated into dollars using the
historical rate or average rate based on the company's discretion.
Answer: FALSE
23) A U.S. parent company's foreign retained earnings are not adjusted for currency movements
to reflect each year's operating profits or losses.
Answer: FALSE
24) The Financial Accounting Standards Board (FASB) Standard No. 52 mandates that U.S.-
based companies translate their foreign-currency-denominated assets and liabilities into dollars
using the current rate (translation) method.
Answer: TRUE
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25) A firm's annual stockholders' report ________.

A) is only accessible to the shareholders of the firm
B) summarizes and documents the firm's financial activities during the past year
C) documents the list of all investors who bought the firm's shares during the past year
D) summarizes and documents the firm's financial plan and budgets during the past year
Answer: B
26) The rule-setting body, which authorizes generally accepted accounting principles is the
________.
A) IFRS
B) FASB
C) SEC
D) Federal Reserve System
Answer: B
27) Accounting practices and procedures used to prepare financial statements are called
________.
A) SEC
B) IFRS
C) GAAP
D) IRB
Answer: C
28) The federal regulatory body governing the sale and listing of securities is called the
________.
A) IRS
B) FASB
C) GAAP
D) SEC
Answer: D
29) The stockholders' annual report must include ________.

A) common-size financial statements
B) an income statement
C) an advance tax statement
D) the margin of safety report
Answer: B
30) The 2002 Sarbanes-Oxley Act was designed to ________.

A) limit the compensation that could be paid to corporate CEOs
B) eliminate the many disclosure and conflict-of-interest problems of corporations
C) provide uniform international accounting standards
D) provide the guidelines to minimize the tax
Answer: B
31) The 2002 law that established the Public Company Accounting Oversight Board (PCAOB)
was called ________.
A) the McCain-Feingold Act
B) the Harkins-Oxley Act
C) the Sarbanes-Harkins Act
D) the Sarbanes-Oxley Act
Answer: D
32
32) The Public Company Accounting Oversight Board (PCAOB) ________.

A) is a not-for-profit corporation that oversees auditors of public corporations
B) is a not-for-profit corporation that oversees managers of public corporations
C) is a for-profit corporation that oversees auditors of public corporations
D) is a for-profit corporation that oversees managers of public corporations
Answer: A
33) The stockholder's report includes ________.

A) an estimated interest cost report
B) an estimated dividend report
C) a break-even sales report
D) a statement of retained earnings
Answer: D
34) Total assets less net fixed assets equals ________.

A) gross assets
B) current assets
C) depreciation
D) liabilities and equity
Answer: B
35) A(n) ________ provides a financial summary of a firm's operating results during a specified
period.
A) income statement
B) balance sheet
C) statement of cash flows
D) statement of retained earnings
Answer: A
36) Gross profit is ________.

A) operating profits minus depreciation
B) operating profits minus cost of goods sold
C) sales revenue minus operating expenses
D) sales revenue minus cost of goods sold
Answer: D
37) Operating profit is ________.

A) gross profit minus operating expenses
B) sales revenue minus cost of goods sold
C) earnings before depreciation and taxes
D) sales revenue minus depreciation expense
Answer: A
38) Net profit after taxes is ________.

A) gross profits minus operating expenses
B) sales revenue minus cost of goods sold
C) EBITDA minus interest
D) EBIT minus interest and taxes
Answer: D
39) Operating profit is known as ________.

A) earnings after interest and taxes
B) earnings before interest and taxes
33
C) earnings before depreciation and taxes

D) earnings after tax
Answer: B
40) Earnings available for common stockholders is calculated as net profits ________.
A) before taxes minus preferred dividends
B) after taxes minus preferred dividends
C) after taxes minus common dividends
D) before taxes minus common dividends
Answer: B
41) Which of the following is a current liability?

A) accounts receivable
B) cash
C) notes payable
D) inventory
Answer: C
42) Which of the following represents a current asset?

A) automobiles
B) buildings
C) marketable securities
D) equipment
Answer: C
43) Which of the following is a fixed asset?

A) land
B) accounts payable
C) accruals
D) notes payable
Answer: A
44) The net value of fixed assets is also called its ________.
A) market value
B) par value
C) book value
D) intrinsic value
Answer: C
45) Retained earnings on the balance sheet represents the ________.

A) net profit after taxes
B) amount of proceeds in excess of the par value received from the original sale of common
stock
C) net profit after taxes minus preferred dividends
D) cumulative total of all earnings reinvested in the firm
Answer: D
46) The ________ represents a summary statement of a firm's financial position at a given point
in time.
A) income statement
B) balance sheet
C) statement of cash flows
D) statement of retained earnings
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Answer: B
47) The statement of cash flows ________.

A) shows the financial position of a firm at a given point of time.
B) summarizes all the purchase and sale of fixed assets and raw materials
C) provides insight into a firm's operating, investment, and financing cash flows
D) classifies a firm's cash flows as operating, investing, financing, and other activities
Answer: C
48) When preparing the retained earnings statement, ________ is(are) subtracted in order to
derive at the ending balance of retained earnings.
A) net profits after taxes
B) interest expense
C) depreciation
D) dividends
Answer: D
49) A firm has the following accounts and financial data for 2019:
The firm's earnings available to common shareholders for 2019 is ________.

A) -$224.25
B) $195.40
C) $302.40
D) $516.60
Answer: C
50) A firm has the following accounts and financial data for 2019:
The firm's earnings per share for 2019 is ________.

A) $0.5335
B) $0.5125
C) $0.3204
D) $0.3024
Answer: D
51) A firm had the following accounts and financial data for 2019:
35
The firm's net profit after taxes for 2019 is ________.

A) -$206.40
B) $213.80
C) $320.40
D) $206.25
Answer: C
52) On the balance sheet, net fixed assets represent ________.

A) gross fixed assets at cost minus depreciation expense
B) gross fixed assets at market value minus depreciation expense
C) gross fixed assets at cost minus accumulated depreciation
D) gross fixed assets at market value minus accumulated deprecation
Answer: C
53) Paid-in capital in excess of par represents the amount of proceeds ________.
A) in deficit of the par value from the original sale of common stock
B) in excess of the par value from the original sale of common stock
C) in excess of the par value from the current value of common stock
D) in excess of the par value from the intrinsic value of common stock
Answer: B
54) Firm ABC had operating profits of $100,000, taxes of $17,000, interest expense of $34,000,
and preferred dividends of $5,000. What was the firm's net profit after taxes?
A) $66,000
B) $49,000
C) $44,000
D) $83,000
Answer: B
55) Candy Corporation had pretax profits of $1.2 million, an average tax rate of 34 percent, and
it paid preferred stock dividends of $50,000. There were 100,000 shares outstanding and no
interest expense. What was Candy Corporation's earnings per share?
A) $3.91
B) $4.52
C) $7.42
D) $7.59
Answer: C
56) A firm's year-end retained earnings balances are $670,000 and $560,000, for 2018 and
2019 respectively. The firm paid $10,000 in dividends in 2019. The firm's net profit after taxes
in 2019 was ________.
A) -$100,000
B) -$110,000
C) $100,000
D) $110,000
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Answer: A
57) A firm's year-end retained earnings balances are $320,000 and $400,000, for 2018 and
2019 respectively. The firm reported net profits after taxes of $100,000 in 2019. The firm's
dividend payment for 2019 is ________.
A) $0
B) $20,000
C) $80,000
D) $100,000
Answer: B
58) A firm has a year-end retained earnings balance of $220,000 for 2018. The firm reported
net profits after taxes of $50,000 and paid dividends of $30,000 in 2019. The firm's retained
earnings balance at 2019 year end is ________.
A) $240,000
B) $250,000
C) $270,000
D) $300,000
Answer: A
59) A firm's year-end retained earnings balance are $670,000 and $560,000 for 2018 and 2019,
respectively. The firm reported net profits after taxes of $100,000 in 2019. The firm paid
dividends of ________ in 2019.
A) $10,000
B) $100,000
C) $110,000
D) $210,000
Answer: D
60) Information on the accounting policies, procedures, calculations, and transactions

underlying entries in the financial statements can be found on ________.
A) the notes to the financial statements
B) the statement of retained earnings
C) the proxy statement
D) the management discussion and analysis (MD&A)
Answer: A
61) FASB Standard No. 52 mandates that U.S.-based companies must translate their foreign-
currency-denominated assets and liabilities into dollars using the ________.
A) historical rate
B) current rate
C) average rate
D) rate prescribed by the SEC
Answer: B
62) At the end of 2019, Long Life Light Bulb Corporation announced a gross profit of $1 million.
The company has also established that over the course of this year that it has incurred
$345,000 in operating expenses and $125,000 in interest expenses. The company is subject to a
21% tax rate and has declared $57,000 of total preferred stock dividends.
(a) Calculate the earnings available for common stockholders?
(b) Compute the increased retained earnings for 2019 if the company were to declare a $4.25
37
common stock dividend. The company has 15,000 shares of common stock outstanding.
Answer:
63) Reliable Auto Parts has 5,000 shares of common stock outstanding. The company also has
the following amounts in revenue and expense accounts.
Calculate
(a) gross profits.
(b) operating profits.
(c) net profits before taxes.
(d) net profits after taxes (assume a 21 percent tax rate).
(e) earnings available to common stockholders.
(f) earnings per share.
38
Answer:
64) Colonial Furniture's net profits before taxes for 2019 totaled $354,000. The company's total
retained earnings were $338,000 for 2018 year-end and $389,000 for 2019 year-end. Colonial is
subject to a 21 percent tax rate. What was the cash dividend declared by Colonial Furniture in
2019?
Answer:
65) On December 31, 2018, Bradshaw Corporation had $485,000 as an ending balance for its
retained earnings account. During 2019, the corporation declared a $3.50/share dividend to its
stockholders. The company has 35,000 shares of common stock outstanding. When the books
were closed for 2019 year end, the corporation had a final retained earnings balance of
$565,000. What was the net profit earned by Bradshaw Corporation during 2019?
Answer:
39
66) Ag Silver Mining, Inc. has $500,000 of earnings before interest and taxes at the year end.
Interest expenses for the year were $10,000. The firm expects to distribute $100,000 in
dividends. Calculate the earnings after taxes for the firm assuming a 21 percent tax on ordinary
income.
Answer:
67) Sunshine Corporation had a retained earnings balance of $850,000 at the beginning of
2019. By the end of 2019, the company's retained earnings balance stood at $950,000. During
2019, the company earned $245,000 as net profits after paying its taxes. The company was then
able to pay its preferred stockholders a sum of $45,000. Compute the common stock dividend
per share in 2019 assuming 10,000 shares of common stock outstanding.
Answer:
3.2 Using financial ratios
1) The basic inputs to an effective financial analysis are the firm's income statement and the
balance sheet.
Answer: TRUE
2) Both current and prospective shareholders are interested in the firm's current and future
level of risk and return, which directly affect share price.
Answer: TRUE
3) Creditors are primarily interested in short-term liquidity of the company and its ability to
make interest and principal payments.
Answer: TRUE
4) Time-series analysis is the evaluation of a firm's financial performance in comparison to other

firm(s) at the same point in time.
Answer: FALSE
5) Cross-sectional analysis involves the comparison of different firms' financial ratios at the
same point in time.
Answer: TRUE
6) Benchmarking is a type of cross-sectional analysis in which a firm's ratios are compared to a

key competitor firm within the same industry, primarily to identify areas for improvement.
40
Answer: TRUE
7) Time-series analysis evaluates the performance of various firms at the same point in time
using financial ratios.
Answer: FALSE
8) Ratios merely direct an analyst to potential areas of concern and it does not provide
conclusive evidence as to the existence of a problem.
Answer: TRUE
9) A single key ratio of a firm provides all the information required to judge the overall
performance of the firm.
Answer: FALSE
10) Due to inflationary effects, inventory costs and depreciation write-offs can differ from their
replacement values, thereby distorting profits.
Answer: TRUE
11) In ratio analysis, the financial statements being used for comparison should be dated at the
same point in time during the year. If not, the effect of seasonality may produce erroneous
conclusions and decisions.
Answer: TRUE
12) The use of the unaudited financial statements for ratio analysis is preferable because it
reflects the firm's TRUE financial condition.
Answer: FALSE
13) The use of differing accounting treatments—especially relative to inventory and

depreciation—can distort the results of ratio analysis, regardless of whether cross-sectional or
time-series analysis is used.
Answer: TRUE
14) Ratios provide a ________ measure of a company's performance and condition.

A) definitive
B) gross
C) relative
D) absolute
Answer: C
15) Present and prospective shareholders are mainly concerned with a firm's ________.
A) risk and return
B) profitability
C) leverage
D) liquidity
Answer: A
16) ________ analysis involves the comparison of different firms' financial ratios at the same
point in time.
A) Time-series
B) Cross-sectional
C) Marginal
D) Technical
Answer: B
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17) ________ analysis involves comparison of current to past performance and the evaluation of
developing trends.
A) Time-series
B) Cross-sectional
C) Marginal
D) Break-even
Answer: A
18) Which of the following is used to analyze a firm's financial performance over different
years?
A) time-series analysis
B) break-even analysis
C) gap analysis
D) marginal analysis
Answer: A
19) Which of the following is TRUE of benchmarking?

A) It is an analysis in which a firm's ratio values are analyzed to project the fundamental values
of the assets for upcoming years or business cycle.
B) It is an analysis in which a firm's ratio values are compared with those of a key competitor or
with a group of competitors that it wishes to emulate.
C) It is an analysis in which a firm's financial performance over time is evaluated using financial
ratio analysis.
D) It is a financial statement analysis technique which is primarily used for forecasting future
performance.
Answer: B
20) Cross-sectional ratio analysis is used to ________.

A) correct expected problems in operations
B) isolate the causes of problems
C) provide conclusive evidence of the existence of a problem
D) measure relative performance of a firm with its peers
Answer: D
21) Time-series analysis is often used to ________.

A) assess developing trends
B) correct errors of judgment
C) evaluate the value of a firm or its assets
D) standardize results
Answer: A
22) Which of the following is a limitation of ratio analysis?

A) Financial ratios cannot be used to assess a firm's profitability.
B) Ratios that reveal large deviations from the norm merely indicate the possibility of a
problem.
C) It is difficult to access audited financial statements for ratio analysis.
D) Ratio analysis assumes that inflation has no effect on a firm's business.
Answer: B
23) An analyst should be careful when conducting ratio analysis to ensure that ________.
A) the overall performance of a firm is not judged on a single ratio
B) the role of inflation is ignored
C) ratios being compared should be calculated using financial statements dated at different
42
points in time during the year

D) different accounting procedures are used
Answer: A
24) Without adjustment, inflation may tend to cause ________ firms to appear more efficient and
profitable than ________ firms.
A) larger; smaller
B) older; newer
C) smaller; larger
D) newer; older
Answer: B
25) Which of the following groups of ratios primarily measure risk?

A) liquidity, activity, and profitability
B) liquidity, profitability, and market
C) liquidity, activity, and debt
D) activity, debt, and profitability
Answer: C
26) Discuss the limitations of ratio analysis and the cautions which must be taken when
reviewing a cross-sectional and time-series analysis.
Answer: In summarizing a large number of ratios, all aspects of a firm's activities can be
assessed. However, limitations of ratio analysis must be recognized. A comparison of current
and past ratios may reveal mismanagement. But, the ratio does not give definitive cause to the
problem. Additional investigation is necessary to confirm the possible problem. The analyst
must be cautious of the following points: 1) a single ratio does not provide sufficient information
to judge the overall performance of the firm, 2) the dates of the financial statements should be
the same, 3) audited statements should be used, 4) similar accounting treatment of comparative
data is essential, and 5) inflation and differing asset ages can distort ratio comparisons.
3.3 Liquidity ratios
1) The liquidity of a business firm refers to its ability to pay its short-term obligations as they
come due.
Answer: TRUE
2) The two basic measures of liquidity are the debt-to-equity ratio and the asset turnover ratio.
Answer: FALSE
3) The liquidity of a business firm is measured by its ability to satisfy its long-term obligations
as they come due.
Answer: FALSE
4) The current ratio provides a measure of a firm's ability to meet its long-term obligations.
Answer: FALSE
5) The ________ of a business firm is measured by its ability to satisfy its short-term obligations
as they come due.
A) activity
B) liquidity
C) debt
D) profitability
43
Answer: B
6) The two basic measures of liquidity are ________.

A) inventory turnover and current ratio
B) current ratio and quick ratio
C) gross profit margin and ROE
D) current ratio and total asset turnover
Answer: B
7) A firm has a current ratio of 1. To increase that ratio the firm might ________.
A) develop a better inventory management system so the firm doesn't have to hold as many
items in inventory at one time
B) hold lower cash balances at the bank and increase holdings of interest-earning marketable
securities
C) take out a long-term bank loan and simultaneously offer customers better credit terms,
allowing them to pay their bills more slowly
D) issue bonds and use the proceeds to purchase new equipment
Answer: C
8) If the only information you are given about Ryan Corporation, a large public company in
business for many years, is that it has a current ratio of 2.9, what could you infer from this?
A) It can likely meet its short-term obligations without difficulty.
B) You could determine that Ryan has too much liquidity because the average current ratio
among firms in Ryan's industry is 2.0.
C) Nothing, you would also need the current ratio's from the last few years of the S&P 500
Index.
D) You could determine that Ryan is running a great risk that it will not be able to pay short-
term liabilities when they come due.
Answer: A
9) Which of the following is TRUE of the current ratio?

A) The more predictable a firm's cash flows, the higher the acceptable current ratio.
B) A higher current ratio indicates a higher return on equity.
C) The more predictable a firm's current ratio, the higher the current liabilities.
D) A higher current ratio indicates a greater degree of liquidity.
Answer: D
10) Which of the following is excluded when calculating the quick ratio?
A) accounts receivable
B) accounts payable
C) cash
D) inventory
Answer: D
11) Clearly firms want to be able to pay their bills when they come due, so having liquidity is
important. Can a firm have too much liquidity? Explain.
Answer: Liquid assets like cash generally do not earn a very high rate of return. If a firm holds
too much cash (or other short-term assets), the low return on those assets will drag down the
overall rate of return that the firm can provide investors, who may complain that by over
investing in liquidity the firm is not maximizing shareholder wealth.
12) In general, large retail chain stores (like Walmart and Target) tend to operate with lower
current and quick ratios than do firms in the computer hardware industry. Why might this be
so?
44
Answer: Liquidity represents a safety cushion against the ups and down of a business. The
grocery business is much less risky than the computer hardware business because people have
to buy groceries whether the economy is booming or in recession. Thus, the liquidity needs of a
grocery store are more predictable, and they need a smaller safety cushion compared to a
hardware manufacturer.
3.4 Activity ratios
1) ________ ratios are a measure of the speed with which various accounts are converted into
sales or cash.
A) Activity
B) Liquidity
C) Debt
D) Profitability
Answer: A
2) Nico Corporation has cost of goods sold of $300,000 and inventory of $30,000, then the
inventory turnover is ________ and the average age of inventory is ________.
A) 36.5; 10
B) 10; 36.5
C) 36.0; 10
D) 30; 36.0
Answer: B
3) The ________ measures the activity, or liquidity, of a firm's stock of goods.

A) average collection period
B) inventory turnover ratio
C) average payment period
D) total asset turnover ratio
Answer: B
4) A(n) ________ is useful in evaluating credit policies.

A) average payment period
B) current ratio
C) average collection period
D) inventory turnover ratio
Answer: C
5) The ________ ratio may indicate poor collections procedures or a relaxed credit policy.
B) inventory turnover
D) quick
Answer: C
6) ABC Corp. extends credit terms of 45 days to its customers. Its credit collection would likely
be considered poor if its average collection period was ________.
A) 30 days
B) 36 days
C) 44 days
D) 57 days
Answer: D
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7) A firm with a total asset turnover lower than industry standard may have ________.
A) excessive debt
B) excessive interest costs
C) insufficient sales
D) insufficient fixed assets
Answer: C
8) An unusually high ________ may indicate a firm is experiencing stockouts and lost sales.
B) inventory turnover ratio
D) quick
Answer: B
9) If you divide the inventory turnover ratio into 365, you get a measure of ________.
A) financial efficiency
B) the average age of the inventory
C) sales turnover
D) the average collection period
Answer: B
10) The ________ is useful in evaluating credit policies that a firm extends to its customers.
B) current ratio
D) inventory turnover ratio
Answer: C
11) Which of the following ratios is difficult for the creditors of a firm to analyze from the
published financial statements?
A) debt equity ratio
B) average payment period
C) quick ratio
D) total asset turnover
Answer: B
12) Nico Corporation has annual purchases of $300,000 and accounts payable of $30,000, then
average purchases per day are ________ and the average payment period is ________.
A) 36.5; 821.9
B) 82.2; 365
C) 821.9; 36.5
D) 833.3; 36.0
Answer: C
13) The ________ ratio indicates the efficiency with which a firm uses its assets to generate sales.
A) inventory turnover
B) total asset turnover
C) quick
D) current asset turnover
Answer: B
46
14) A firm's total asset turnover increased from 0.75 to 0.90. Which of the following is TRUE
about the given data?
A) The firm is generating more dollars of sales per dollar of assets now than it was before.
B) The firm is generating fewer dollars of sales per dollar of assets now than it was before.
C) By cutting back on assets, the firm runs the risk of creating problems like inventory
stockouts and production delays.
D) The firm's stock price will go up because it is using asset more efficiently.
Answer: A
15) The average age of inventory is viewed as the average length of time inventory is held by a
firm or as the average number of days' sales in inventory.
Answer: TRUE
16) The average age of inventory can be calculated as inventory divided by 365.
Answer: FALSE
17) The average age of inventory can be calculated as inventory turnover divided by 365.
Answer: FALSE
18) The average age of inventory can be calculated as 365 divided by inventory turnover.
Answer: TRUE
19) The average payment period can be calculated as accounts payable divided by average
sales per day.
Answer: FALSE
20) The average payment period can be calculated as accounts payable divided by average
purchases per day.
Answer: TRUE
21) The total asset turnover ratio measures the liquidity of a firm's assets.
Answer: FALSE
22) In a recent year Walmart reported total asset turnover of 2.44 whereas Target reported
total asset turnover of 1.84. One interpretation of this is that Walmart managed its assets more
efficiently than did Target. Can you think of another reason that might explain the difference in
turnover ratios that does not imply that Target managers are performing poorly relative to their
peers at Walmart?
Answer: This question points out the problem with naively asserting that a higher turnover
ratio is better. Target specifically tries to appeal to a more upscale customer than Walmart.
Their aisles are not as packed with merchandise (i.e., they do not have as much to sell per
square foot of floor space), and they may sell goods that are priced higher and do not sell as
fast as the goods that Walmart sells. They may invest more in the look and feel of their interior
space. All of these lead to lower asset turnover. However, by appealing to more upscale
consumers, Target may charge slightly higher prices and may be just as profitable as Walmart
while pursuing a different type of strategy.
23) Below are recent inventory turnover ratios for four companies. The companies, listed in no
particular order are Tiffany & Co. (a manufacturer and retailer of fine jewelry), Deere & Co.
(maker of heavy duty agricultural equipment), Boeing (aircraft manufacturer), and Sprouts (a
grocery chain focusing on organic products). Think about which of these companies operate in
businesses that tend to have very slow or very fast inventory turnover. Which one below is the
inventory turnover ratio for Sprouts?
A) 1.7
47
B) 14.4
C) 0.7
D) 5.7
Answer: B
24) In 1979 International Business Machines Corp. (IBM) was one of the world's largest
companies, and it dominated the market for huge mainframe computers. Back then, IBM's
inventory turnover ratio was about 3.3. Through the years, IBM switched from mainframe to
personal computers, and today the company earns most of its revenues from a variety of
services rather than from selling hardware. By 2017, IBM's inventory turnover ratio had risen
to 23.9. What do you think might account for the tremendous increase in IBM's inventory
turnover between 1979 and 2017?
Answer: In the late 70s, IBM's turnover ratio was relatively low because they built a product
that took a long time to make, and therefore the company's inventory balances were high. As
the firm shifted to personal computers, which took less time to build and sold more rapidly, the
inventory turnover ratio increased. Today, IBM is mostly a services business, so there is little
need for the company to hold much inventory.thus making its inventory turnover ratio quite
high.
3.5 Debt ratios
1) The less fixed-cost debt (financial leverage) a firm uses, the greater will be its risk and
return.
Answer: FALSE
2) In general, the more debt a firm uses, the smaller its financial leverage.
Answer: FALSE
3) The lower the fixed-payment coverage ratio, the lower is the firm's financial leverage.
Answer: FALSE
4) The higher the debt ratio, the more the financial leverage a firm has and thus, the greater
will be its risk and return.
Answer: TRUE
5) Typically, higher coverage ratios are preferred, but a very high ratio may indicate under-
utilization of fixed-payment obligations, which may result in unnecessarily low risk and return.
Answer: TRUE
6) The higher the value of the times interest earned ratio, the higher is the proportion of the
firm's interest income compared to its contractual interest payments.
Answer: FALSE
7) ________ is a term used to describe the magnification of risk and return introduced through
the use of fixed-cost financing, such as preferred stock and debt.
A) Financial leverage
B) Operating leverage
C) Fixed-payment coverage
D) Benchmarking
Answer: A
8) The ________ ratio measures the proportion of total assets financed by the firm's creditors.
A) total asset turnover
48
B) inventory turnover
C) current
D) debt
Answer: D
9) The ________ ratio measures a firm's ability to pay contractual interest payments.
A) times interest earned
B) fixed-payment coverage
C) debt
D) average payment period
Answer: A
10) The ________ ratio indicates whether a firm will be able to meet interest obligations due on
outstanding debt.
A) debt-to-equity
B) interest turnover
C) total assets turnover
D) times interest earned
Answer: D
11) The higher, the value of the ________ ratio, the better able a firm is to fulfill its interest
obligations.
A) dividend payout
B) average collection period
C) times interest earned
D) average payment period
Answer: C
12) When assessing the fixed-payment coverage ratio, ________.

A) the lower its value the more risky is the firm
B) the lower its value, the higher is the firm's financial leverage
C) preferred stock dividend payments can be disregarded
D) the higher its value, the more difficult it is for a firm to pay its debts
Answer: A
13) The magnification of risk and return introduced through the use of fixed-cost financing,
such as debt and preferred stock is called financial leverage.
Answer: TRUE
14) The financial leverage multiplier is the ratio of a firm's total assets to common stock equity.
Answer: TRUE
3.6 Profitability ratios
1) The gross profit margin measures the percentage of each sales dollar left after a firm has
paid for its goods and operating expenses.
Answer: FALSE
49
2) Key Financial Data
Income Statement, Dreamscape, Inc.

For the Year Ended December 31, 2020
Prepare a common-size income statement for Dreamscape, Inc. for the year ended December
31, 2020. Evaluate the company's performance against industry average ratios and against last
year's results.
Answer: Common-Size Income Statement
Dreamscape, Inc.
50
Dreamscape, Inc. performs significantly below industry average. All profitability ratios
(gross profit margin, operating profit margin, and net profit margin) trail the industry norms. In
2019 expenses as a percent of sales were high.
Dreamscape, Inc. improved the management of operating expenses in 2020 meeting industry
averages. However, cost of goods sold as a percent of sales increased and is a full 5 percent
above the industry average, further reducing the gross profit margin. Interest expense is two
times the average indicating high cost of debt or a high debt level. The firm must concentrate
on reducing the cost of goods sold and interest expense to improve performance.
3) Two frequently cited ratios of profitability that can be read directly from the common-size
income statement are ________.
A) the earnings per share and the return on total assets
B) the gross profit margin and the earnings per share
C) the gross profit margin and the return on total assets
D) the gross profit margin and the net profit margin
Answer: D
4) The ________ is a popular approach for evaluating profitability in relation to sales by

expressing each item on the income statement as a percent of sales.
A) retained earnings statement
B) common-size balance sheet
C) common-size income statement
D) profit and loss statement
Answer: C
5) In 2018, Walmart reported sales of $500.3 billion, gross profits of $126.9 billion, EBIT of
$20.4 billion, and net income of $9.9 billion. The company's cost of goods sold that year
equalled ________.
A) 2%
B) $373.4 billion
C) $353 million
D) 4.1%
Answer: B
6) In 2017, Apple Inc. reported sales of $229.2 billion, cost of goods sold of $141 billion, and net
income of $48.4 billion. Apple's gross profit margin that year was ________.
A) 38.4%
B) 21.1%
C) 61.5%
51
D) 17.4%
Answer: A
7) In 2018, Target Corp. reported sales of $71.9 billion, cost of goods sold of $51.1 billion,
operating profit of $4.3 billion, and net income of $2.9 billion. Target has no preferred stock
outstanding. It's net profit margin that year was ________.
A) 6%
B) 28.9%
C) 4%
D) 5.7%
Answer: C
8) In 2018, Target Corp. reported sales of $71.9 billion, cost of goods sold of $51.1 billion,
operating profit of $4.3 billion, and net income of $2.9 billion. Target has no preferred stock
outstanding. It's operating profit margin that year was ________.
A) 20.7%
B) 8.4%
C) 4.0%
D) 6.0%
Answer: D
9) The ________ indicates the percentage of each sales dollar remaining after the firm has paid
for its goods.
A) net profit margin
B) operating profit margin
C) gross profit margin
D) earnings available to common shareholders
Answer: C
10) The ________ measures the percentage of profit earned on each sales dollar before interest
and taxes but after all costs and expenses.
Answer: B
11) A firm with a gross profit margin which meets industry standard and a net profit margin
which is below industry standard may have excessive ________.
A) general and administrative expenses
B) cost of goods sold
C) dividend payments
D) principal payments
Answer: A
12) The ________ measures the percentage of each sales dollar remaining after all costs and
expenses, including interest, taxes, and preferred stock dividends, have been deducted.
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Answer: A
13) The ________ measures the overall effectiveness of management in generating profits with
its available assets.
A) total asset turnover
B) price/earnings ratio
C) return on equity
D) return on total assets
Answer: D
14) The ________ ratio measures the return earned on the common stockholders' investment in
the firm.
B) price/earnings
C) return on equity
Answer: C
15) A firm with sales of $1,000,000, net profits after taxes of $30,000, total assets of
$1,500,000, and common stockholders' investment of $750,000 has a return on equity of
________.
A) 2 percent
B) 15 percent
C) 3 percent
D) 4 percent
Answer: D
16) The net profit margin measures the percentage of each sales dollar remaining after all costs
and expenses, including interest, taxes, and common stock dividends, have been deducted.
Answer: TRUE
17) If a firm has no liabilities or debt of any kind on its balance sheet, then which of the
following is TRUE?
A) ROE > ROA
B) ROE < ROA
C) ROE = ROA
D) ROA = net profit margin
Answer: C
18) If a firm uses any debt at all and if the firm generates positive earnings for common
stockholders, then which of the following below is TRUE?
A) ROE > ROA
B) ROE < ROA
C) ROE = ROA
D) Gross profit margin < net profit margin
Answer: A
19) Return on total assets (ROA) measures the overall effectiveness of management in
generating profits with its available assets.
Answer: TRUE
20) The more money a firm borrows ________.

53
A) the lower is its ROE because more interest expense reduces earnings
B) the larger is the gap between its ROA and its ROE
C) the lower is its operating profit margin
D) the higher is its gross profit margin
Answer: B
21) The ________ ratios are primarily used as measures of return.

A) liquidity
B) activity
C) debt
D) profitability
Answer: D
3.7 Market ratios
1) A firm's P/E ratio tends to be higher if ________.

A) its risk and its growth prospects are lower
B) its risk is higher and its growth prospects are lower
C) its risk and its growth prospects are higher
D) its risk is lower and its growth prospects are higher
Answer: D
2) All other things being equal, a firm's P/E ratio will be lower if investors think the firm's
growth prospects are very good.
Answer: FALSE
3) Earnings per share represents the dollar amount earned and distributed to shareholders.
Answer: FALSE
4) The ________ ratio reflects how much investors are willing to pay for a company's stock per
dollar of earnings that the company generates.
A) debt
B) price/earnings
C) return on equity
Answer: B
5) Holding all other factors constant, a higher price/earnings (P/E) ratio indicates that investors
have more confidence in a firm's future performance.
Answer: TRUE
6) Suppose a firm that is normally very profitable barely does better than breaking even this
year, i.e., it earns a very small profit. That firm's P/E ratio is likely to be ________.
A) very high
B) zero
C) negative
D) the lowest among all firms in its industry
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Answer: A
7) The P/E ratio measures the ________.

A) market value of the stock relative to earnings per share
B) intrinsic value of the stock relative to earnings per share
C) book value of the stock relative to earnings per share
D) market price of the stock relative to retained earnings
Answer: A
8) Book value per share is the ratio of ________.
A) common stock equity to number of outstanding common shares
B) retained earnings to number of outstanding common shares
C) fixed assets to number of outstanding common shares
D) total liabilities to number of outstanding common shares
Answer: A
9) During the 2008-2009 recession, the average P/E ratio of firms in the U.S. stock market
reached an extraordinarily high level because ________.
A) investors believed short-term growth prospects for U.S. firms were extraordinarily good at
that time
B) stock prices generally boomed during the recession
C) earnings per share were unusually low during the recession
D) investors believed long-term growth prospects coming out of the recession were not very
good
Answer: C
10) Over long periods of time, the average P/E ratio of firms in the U.S. stock market is closest
to ________.
A) 0.2
B) 2.0
C) 20
D) 200
Answer: C
11) In its 2018 fiscal year, the data storage company, NetApp Inc., reported that it had 267.9
million shares of common stock outstanding, trading at a price of about $68 per share. On the
firm's balance sheet, the value of common stock equity was reported as $2.067 billion.
NetApp's market/book ratio was ________.
A) 8.8
B) 7.7
C) 68
D) greater than 100
Answer: A
12) Which of the following is TRUE?

A) For most companies the market/book ratio is less than 1.0 because book value is a
conservative estimate of what a firm's equity is really worth.
B) For most companies the market/book ratio is greater than 1.0 because the stock market
tends to overvalue things.
C) For most companies the market/book ratio is greater than 1.0 because book value is a
backward-looking measure based largely on historical costs, whereas market value is forward
looking and depends on how investors believe the company will perform in the future.
D) For most companies the market/book ratio is very close to 1.0 because on average, book
value provides a good estimate of the market value of a firm's equity.
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Answer: C
13) In early 2018, Facebook's market/book ratio was close to 7.0. A market/book ratio that
much greater than 1.0 for Facebook means that ________.
A) Facebook has a huge number of common shares outstanding
B) the book value of Facebook's equity is far less than the total market value of the company's
stock
C) Facebook's stock is overvalued
D) Facebook's book value is inflated because so many of its assets are intangible
Answer: B
14) For most companies we would expect the market/book ratio to be greater than 1.0.
Answer: TRUE
15) Market ratios only measure a firm's risk.

Answer: FALSE
3.8 A complete ratio analysis

1) Earnings per share represents the dollar amount earned and distributed to shareholders.
Answer: FALSE
2) The DuPont formula allows a firm to break down its return into the net profit margin, which
measures the firm's profitability on sales, and its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales.
Answer: TRUE
3) The DuPont system allows a firm to break its return on equity into a profit-on-sales
component, an efficiency-of-asset-use component, and a liquidity component.
Answer: FALSE
4) According to the basic DuPont equation, a firm's ROA is the product of what other two ratios?
A) net profit margin and return on equity
B) net profit margin and total asset turnover
C) net profit margin and the financial leverage multiplier
D) ROE and the financial leverage multiplier
Answer: B
5) The ________ is used by financial managers as a structure for dissecting a firm's financial
statements to assess its financial condition.
A) statement of cash flows
B) DuPont system of analysis
C) break-even analysis
D) technical analysis
Answer: B
6) The modified DuPont formula relates the firm's return on total assets (ROA) to its ________.
A) return on equity (ROE)
B) operating leverage multiplier
C) net profit margin
D) total asset turnover
Answer: A
7) In the DuPont system of analysis, the return on equity is equal to ________.

56
A) (net profit margin) × (total asset turnover)

B) (stockholders' equity) × (financial leverage multiplier)
C) (return on total assets) × (financial leverage multiplier)
D) (return on total assets) × (total asset turnover)
Answer: C
8) A firm with a low net profit margin can improve its return on total assets by ________.
A) increasing its debt ratio
B) increasing its total asset turnover
C) decreasing its fixed asset turnover
D) decreasing its total asset turnover
Answer: B
9) Other things being equal, a decrease in total asset turnover will result in ________ in the
return on total assets.
A) an increase
B) a decrease
C) no change
D) an undetermined change
Answer: B
10) The modified DuPont equation says that a firm with a low return on total assets can improve
its return on equity, all else remaining the same, by ________.
A) financing more of its assets with debt.
B) increasing its total asset turnover
C) using less debt
D) decreasing its total asset turnover
Answer: A
11) The three basic ratios used in the DuPont system of analysis are ________.
A) net profit margin, total asset turnover, and return on investment
B) net profit margin, total asset turnover, and return on equity
C) net profit margin, total asset turnover, and financial leverage multiplier
D) net profit margin, financial leverage multiplier, and return on equity
Answer: C
12) The financial leverage multiplier is an indicator of how much ________ a corporation is
utilizing.
A) operating leverage
B) long-term debt
C) total debt
D) total assets
Answer: C
13) The financial leverage multiplier is the ratio of ________.

A) current assets to common stockholders' equity
B) total assets to common stockholders' equity
C) total assets to total debt
D) current assets to current liabilities
Answer: B
14) Using the DuPont system of analysis, holding other factors constant, an increase in financial
leverage will result in ________.
A) an increase in the return on equity
57
B) a decrease in the gross profit margin

C) an increase in the gross profit margin
D) an increase in retained earnings
Answer: A
Table 3.2
Dana Dairy Products Key Ratios
Income Statement
Dana Dairy Products
Balance Sheet
Dana Dairy Products
December 31, 2019
58
15) The current ratio for Dana Dairy Products in 2019 was ________. (See Table 3.2)
A) 1.58
B) 0.63
C) 1.10
D) 0.91
Answer: D
16) Since 2018, the liquidity of Dana Dairy Products ________. (See Table 3.2)
A) has deteriorated
B) has remained the same
C) has improved
D) is not determinable
Answer: A
17) The net working capital for Dana Dairy Products in 2019 was ________. (See Table 3.2)
A) $10,325
B) -$10,325
C) -$1,425
D) $14,250
Answer: C
18) The inventory turnover for Dana Dairy Products in 2019 was ________. (See Table 3.2)
A) 43
B) 5
C) 20
D) 25
Answer: C
19) The inventory management at Dana Dairy Products ________ since 2018. (See Table 3.2)
A) has deteriorated
C) has improved slightly
59
D) cannot be determined
Answer: C
20) The average collection period for Dana Dairy Products in 2019 was ________. (See Table 3.2)
A) 32.5 days
B) 11.8 days
C) 25.3 days
D) 35.9 days
Answer: A
21) If Dana Dairy Products has credit terms which specify that accounts receivable should be
paid in 25 days, the average collection period ________ since 2018. (See Table 3.2)
A) has deteriorated
C) has improved
D) cannot be determined
Answer: A
22) Dana Dairy Products had a ________ degree of financial leverage than the industry standard,
resulting in ________. (See Table 3.2)
A) lower; lower return on total assets
B) lower; lower return on equity
C) higher; higher return on equity
D) higher; higher return on total assets
Answer: B
23) The debt ratio for Dana Dairy Products in 2019 was ________. (See Table 3.2)
A) 50 percent
B) 11 percent
C) 55 percent
D) 44 percent
Answer: C
24) Dana Dairy Products' gross profit margin was inferior to the industry standard. This may
have resulted from ________. (See Table 3.2)
A) a high sales price
B) the high cost of goods sold
C) excessive selling and administrative expenses
D) excessive interest expense
Answer: B
25) The gross profit margin and net profit margin for Dana Dairy Products in 2019 were
________. (See Table 3.2)
A) 13 percent and 0.9 percent, respectively
B) 13 percent and 1.5 percent, respectively
C) 2 percent and 0.9 percent, respectively
D) 2 percent and 1.5 percent, respectively
Answer: A
26) The return on total assets for Dana Dairy Products for 2019 was ________. (See Table 3.2)
A) 0.9 percent
B) 5.5 percent
C) 25 percent
D) 2.5 percent
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Answer: D
27) The return on equity for Dana Dairy Products for 2019 was ________. (See Table 3.2)
A) 0.6 percent
B) 5.6 percent
C) 0.9 percent
D) 50 percent
Answer: B
28) Using the modified DuPont formula allows the analyst to break Dana Dairy Products return
on equity into 3 components: the net profit margin, the total asset turnover, and a measure of
leverage (the financial leverage multiplier). Which of the following mathematical expressions
represents the modified DuPont formula relative to Dana Dairy Products' 2019 performance?
(See Table 3.2)
A) 5.6(ROE) = 2.5(ROA) × 2.22(Financial leverage multiplier)
B) 5.6(ROE) = 3.3(ROA) × 1.70(Financial leverage multiplier)
C) 4.0(ROE) = 2.5(ROA) × 2.00(Financial leverage multiplier)
D) 2.5(ROE) = 5.6(ROA) × 2.22(Financial leverage multiplier)
Answer: A
29) As the financial leverage multiplier increases, this may result in ________.
A) an increase in the net profit margin and return on investment, due to the decrease in interest
expense as debt decreases
B) an increase in the net profit margin and return on investment, due to the increase in interest
expense as debt increases
C) a decrease in the net profit margin and return on investment, due to the increase in interest
expense as debt increases
D) a decrease in the net profit margin and return on investment, due to the decrease in interest
expense as debt decreases
Answer: C
30) In an effort to analyze Clockwork Company finances, Jim realized that he was missing the
company's net profits after taxes for the current year. Find the company's net profits after taxes
using the following information.
Return on total assets = 2%

Total asset turnover = 0.5
Cost of goods sold = $105,000
Gross profit margin = 0.30
Answer: Sales = Cost of goods sold/(1 - Gross profit margin) = 105,000/(1 - 0.30) = $150,000
Total assets = Sales/(Total asset turnover)
= 150,000/0.50 = $300,000
Net profits after taxes = (ROA) × (Total assets)
= (0.02) × (300,000) = $6,000
31) Given the following balance sheet, income statement, historical ratios and industry
averages, calculate the Pulp, Paper, and Paperboard, Inc. financial ratios for the most recent
year. Analyze its overall financial situation for the most recent year. Analyze its overall financial
situation from both a cross-sectional and time-series viewpoint. Break your analysis into an
evaluation of the firm's liquidity, activity, debt, and profitability.
Income Statement
Pulp, Paper, and Paperboard, Inc.
61
62
Balance Sheet
Pulp, Paper, and Paperboard, Inc.
December 31, 2019
Historical and Industry Average Ratios

Pulp, Paper and Paperboard, Inc.
63
Answer: Historical and Industry Average Ratios

Pulp, Paper and Paperboard, Inc.
LIQUIDITY: The liquidity of the firm is on target with the industry standard in 2019 and shows
no trend since 2017. The firm's liquidity is stable.
ACTIVITY: Inventory and accounts receivable management has deteriorated since 2018 and is
inferior when compared to the industry standard. The low inventory turnover may be caused by
overstocking and/or obsolete inventories. The high average collection period may have resulted
from poor collections procedures or from relaxed credit terms. Further investigation is
necessary to determine the cause of the variances.
DEBT: The firm has less debt than the industry average. The trend since 2017 has been toward
reducing the debt ratio. The firm, therefore, is subject to less financial risk than any other firm
in the industry.
PROFITABILITY: Although the gross profit margin is inferior to the industry average, the
operating and net profit margin far exceed the standards, boosting return on total assets and
return on equity. The trend in the gross profit margin is unfavorable and may either be caused
by a slide in product prices or an escalation in cost of sales. The cause of the poor gross profit
margin should be investigated.
Overall, the firm needs to focus attention on inventory and accounts receivable management
and the cause of the poor gross profit margin. In general, the firm is in good financial condition.
64
32) Complete the balance sheet for General Aviation, Inc. based on the following financial data.
Balance Sheet
General Aviation, Inc.
December 31, 2019
Key Financial Data (2019)

1. Sales totaled $720,000.
2. The gross profit margin was 38.7 percent.
3. Inventory turned 6 times.
4. There are 360 days in a year.
5. The average collection period was 31 days.
6. The current ratio was 2.35.
7. The total asset turnover was 2.81.
8. The debt ratio was 49.4 percent.
9. Total current assets equal $159,565.
65
Answer: Balance Sheet

General Aviation, Inc.
December 31, 2019
33) Construct the DuPont system of analysis using the following financial data for Key Wahl
Industries and determine which areas of the firm need further analysis.
Key Financial Data
66
Answer:
Ratios for Key Wahl Industries
Total asset turnover = = 0.67
Debt ratio = = 50%
Financial leverage multiplier = =2
ROA = = 5%
ROE = ROA × Financial leverage multiplier = 10%
Net profit margin = = 7.5%

DuPont System of Analysis: Key Wahl Industries performs equally to industry averages
according to the return on equity. However, when dissecting the financial data further into the
three key components of the DuPont system (a profit-on-sale, efficiency-of-asset use, and a use-
of-leverage component), some areas of improvement may be highlighted. Key Wahl Industries
has a lower net profit margin and return on total assets than industry averages. Nevertheless,
the firm makes up for the low profit margin through excessive use of leverage (a 50 percent
debt ratio versus 33 percent for the industry). Financial risk could be reduced resulting in the
same return on equity by increasing the net profit margin and reducing debt.
Table 3.1
Information (2019 values)

1. Sales totaled $110,000
2. The gross profit margin was 25 percent.
3. Inventory turnover was 3.0.
4. There are 360 days in the year.
5. The average collection period was 65 days.
6. The current ratio was 2.40.
7. The total asset turnover was 1.13.
8. The debt ratio was 53.8 percent.
34) Inventory for CEE in 2019 was ________. (See Table 3.1)
A) $36,667
B) $32,448
C) $27,500
D) $9,167
Answer: C
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35) Notes payable for CEE in 2019 was ________. (See Table 3.1)
A) $113,466
B) $52,372
C) $41,372
D) $10,609
Answer: D
36) Accounts receivable for CEE in 2019 was ________. (See Table 3.1)
A) $14,056
B) $19,861
C) $14,895
D) $18,333
Answer: B
37) Net fixed assets for CEE in 2019 were ________. (See Table 3.1)
A) $45,484
B) $48,975
C) $54,511
D) $69,341
Answer: A
38) Total assets for CEE in 2019 were ________. (See Table 3.1)
A) $45,895
B) $124,300
C) $ 58,603
D) $97,345
Answer: D
39) Long-term debt for CEE in 2019 was ________. (See Table 3.1)
A) $30,763
B) $52,372
C) $10,608
D) $41,372
Answer: A
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Chapter 4 Long- and Short-Term Financial Planning

4.1 The financial planning process
1) Strategic financial plans are planned long-term financial actions and the anticipated financial
impact of those actions.
Answer: TRUE
2) A financial planning process begins with short-term, or operating, plans and budgets that in
turn guide the formulation of long-term, or strategic, financial plans.
Answer: FALSE
3) The key input to the short-term financial planning process is ________.

A) the audit report
B) the pro forma balance sheet
C) the sales forecast
D) the pro forma income statement
Answer: C
4) Operating financial plans are planned short-term financial actions and the anticipated
financial impact of those actions.
Answer: TRUE
5) The sales forecast and various forms of operating and financial data are the key outputs of
the short-run (operating) financial planning.
Answer: FALSE
6) The financial planning process begins with ________ financial plans that in turn guide the
formation of ________ plans and budgets.
A) short-term; long-term
B) short-term; short-term
C) long-term; long-term
D) long-term; short-term
Answer: D
7) Short-term financial plans and long-term financial plans generally cover periods ranging from
________ years and ________ years, respectively.
A) one to two; two to ten
B) five to ten; ten to twenty
C) zero to one; five to ten
D) one to ten; ten to fifteen
Answer: A
8) The key aspects of a financial planning process are ________.

A) cash planning and investment planning
B) operations planning and investment planning
C) investment planning and profit planning
D) cash planning and profit planning
Answer: D
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9) Pro forma financial statements are used for ________.

A) cash budgeting
B) preparing financial statements
C) profit planning
D) auditing
Answer: C
10) The primary purpose in preparing pro forma financial statements is ________.
A) for cash planning
B) to ensure the ability to pay dividends
C) to reduce risk
D) for profit planning
Answer: D
11) ________ consider proposed fixed-asset outlays, research and development activities,
marketing and product development actions, capital structure, and major sources of financing.
A) Short-term financial plans
B) Long-term financial plans
C) Pro forma statements
D) Cash budgeting
Answer: B
12) ________ generally reflect(s) the anticipated financial impact of planned long-term actions.
A) A cash budget
B) Strategic financial plans
C) Operating financial plans
D) A pro forma income statement
Answer: B
13) The key outputs of the short-term financial planning process are the ________.
A) cash budget, pro forma income statement, and pro forma balance sheet
B) sales forecast and capital assets journal
C) sales forecast and schedule of changes in working capital
D) income statement, balance sheet, and source and use statement
Answer: A
14) Key inputs to short-term financial planning are ________.

A) cash flow statements and income statement
B) pro forma financial statements
C) sales forecasts, and operating and financial data
D) leverage analysis and pro forma income statement
Answer: C
15) Once sales are forecasted, ________ must be generated to estimate required raw materials.
A) a production plan
B) a cash budget
C) an operating budget
D) a pro forma statement
Answer: A
4.2 Measuring the firm's cash flow
70
1) In the statement of cash flows, the cash flows from financing activities result from debt and
equity financing transactions; including incurrence and repayment of debt, cash inflow from the
sale of stock, and cash outflows to repurchase stock or pay cash dividends.
Answer: TRUE
2) Depreciation deductions, like any other business expenses, reduce the income that a firm
reports on its income statement.
Answer: TRUE
3) Suppose that under the Tax Cuts and Jobs Act a firm that invests in equipment can
immediately deduct the full cost of that equipment or it can depreciate the equipment under the
MACRS system. For tax purposes the firm should ________.
A) use the MACRS system because doing so better matches the firms costs to its revenues
B) use the MACRS system because the firm will report higher profits in the year the equipment
is purchased than it would report if it fully expensed the cost of the asset
C) deduct the full cost of the asset immediately because doing so reduces taxes and increases
cash flow
D) deduct the full cost of the asset immediately because profits in years after the equipment is
purchased will be higher
Answer: C
4) Prior to passage of the Tax Cuts and Jobs Act, most large corporations faced a 35% marginal
tax rate. Under the new tax law, the marginal tax rate is 21%. In terms of the effect of this tax
change on a firm's decision to purchase assets that it will use for several years ________.
A) the tax change is beneficial because it lowers the after-tax cost of these assets
B) the tax change increases the tax benefits that the firm obtains when it acquires long-lived
assets, whether it immediately deducts the full cost of those assets or depreciates the cost over
time
C) the tax law reduces the tax benefits that a firm obtains when it acquires long-lived assets,
whether it immediately deducts the full cost of those assets or depreciates the cost over time
D) the tax change has no effect because depreciation does not affect a firm's cash flow
Answer: C
5) If the Tax Cuts and Jobs Act requires a firm to fully deduct the cost of new equipment when it
is purchased rather than depreciating that cost over several years, the investment becomes less
attractive financially.
Answer: FALSE
6) When a firm acquires a long-lived asset such as equipment, if the tax law allows it managers
would generally prefer to ________.
A) depreciate the equipment over a long life
B) depreciate the equipment over a short life
C) immediately take a deduction for the full cost of the asset when it is purchased
D) take no deduction at all for the cost of the equipment
Answer: C
7) The Tax Cuts and Jobs Act allows firms to immediately deduct the full cost of many assets
rather than depreciating that cost over several years using the MACRS rules. Suppose a firm
buys a new assets and immediately deducts its full cost. The firm will have ________.
A) lower profits and higher cash flows than it would have had under the MACRS system
B) lower profits and lower cash flows than it would have had under the MACRS system
C) higher profits and higher cash flows than it would have had under the MACRS system
D) higher profits and lower cash flows than it would have had under the MACRS system
Answer: A
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8) Non-cash charges are expenses that involve an actual outlay of cash during the period but
are not deducted on the income statement.
Answer: FALSE
9) Under the basic MACRS procedures, the depreciable value of an asset is its full cost,
including outlays for installation.
Answer: TRUE
10) Business firms are permitted to systematically charge a portion of the market value of fixed
assets as depreciation against annual revenues.
Answer: FALSE
11) Given a financial manager's preference for faster receipt of cash flows, a longer depreciable
life is preferred to a shorter one.
Answer: FALSE
12) For tax purposes, using MACRS recovery periods, assets in the first four property classes
are depreciated by the double-declining balance method using the half-year convention and
switching to straight line when advantageous.
Answer: TRUE
13) The MACRS depreciation method requires use of the half-year convention. Assets are
assumed to be acquired in the middle of the year and only one-half of the first year's
depreciation is recovered in the first year.
Answer: TRUE
14) Allocation of the historic costs of fixed assets against the annual revenue they generate is
called ________.
A) arbitraging
B) securitization
C) depreciation
D) amortization
Answer: C
15) The Modified Accelerated Cost Recovery System (MACRS) is a depreciation method used
for ________ purposes.
A) tax
B) financial reporting
C) budget
D) cost accounting
Answer: A
16) A corporation ________.

A) must use the straight-line depreciation method for tax purposes and double declining
depreciation method financial reporting purposes
B) can use straight-line depreciation method for tax purposes and MACRS depreciation method
financial reporting purposes
C) can use different depreciation methods for tax and financial reporting purposes
D) must use different depreciation method for tax purposes, but strictly mandated depreciation
methods for financial reporting purposes
Answer: C
17) The depreciable value of an asset, under MACRS, is the ________.
72
A) current cost
B) current cost minus salvage value
C) the original cost plus installation
D) the original cost plus installation costs, minus salvage value
Answer: C
MACRS RATE
Recovery 3 5 10
year years years 7 years years
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 18 14
4 7 12 12 12
5 12 9 9
6 5 9 8
7 9 7
8 4 6
9 6
10 6
11 4
18) Under MACRS, an asset which originally cost $10,000 is being depreciated using a 5-year
normal recovery period. What is the depreciation expense in year 3?
A) $1,900
B) $1,200
C) $1,500
D) $2,100
Answer: A
normal recovery period. The depreciation expense in year 5 is ________.
A) $10,000
B) $12,000
C) $21,000
D) $9,000
Answer: D
normal recovery period. The depreciation expense in year 11 is ________.
A) $3,000
B) $4,000
C) $0
D) $6,000
Answer: B
21) Given a financial manager's preference for faster receipt of cash flows, ________.
A) a longer depreciable life is preferred to a shorter one
B) a shorter depreciable life is preferred to a longer one
C) the manager is not concerned with depreciable life, because depreciation is a noncash
73
expense
D) the manager is not concerned with depreciable life, because once purchased, depreciation is
considered a sunk cost
Answer: B
22) In general, ________.

A) a longer depreciable life is preferred, because it will result in a faster receipt of cash flows
B) a shorter depreciable life is preferred, because it will result in a faster receipt of cash flows
C) a shorter depreciable life is preferred, because management can then purchase new assets,
as the old assets are written off
D) a longer depreciable life is preferred, because management can postpone purchasing new
assets, since the old assets still have a useful life
Answer: B
23) The depreciable value of an asset, under MACRS, is ________.

A) the full cost excluding installation costs
B) the full cost minus salvage value
C) the full cost including installation costs
D) the full cost including installation costs adjusted for the salvage value
Answer: C
MACRS RATE
Recovery 3 5 10
year years years 7 years years
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 18 14
4 7 12 12 12
5 12 9 9
6 5 9 8
7 9 7
8 4 6
9 6
10 6
11 4
24) Under MACRS, an asset which originally cost $100,000, incurred installation costs of
$10,000, and has an estimated salvage value of $25,000, is being depreciated using a 5-year
normal recovery period. What is the depreciation expense in year 1?
A) $15,000
B) $12,750
C) $11,250
D) $22,000
Answer: D
25) Darling Paper Container, Inc. purchased several machines at a total cost of $300,000. The
installation cost for this equipment was $25,000. The firm plans to depreciate the equipment
using the MACRS 5-year normal recovery period. Prepare a depreciation schedule showing the
depreciation expense for each year.
Answer:
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Depreciation Schedule
26) Free cash flow (FCF) is the cash flow a firm generates from its normal operations;
calculated as EBIT minus taxes plus depreciation.
Answer: FALSE
27) A firm's operating cash flow (OCF) is the cash flow it generates from its normal operations:
producing and selling its output of goods or services.
Answer: TRUE
28) The net fixed asset investment (NFAI) is defined as the change in net fixed assets plus
depreciation.
Answer: TRUE
29) The net current asset investment (NCAI) is defined as the change in current assets minus
the change in sum of the accounts payable and accruals.
Answer: TRUE
30) A firm's free cash flow (FCF) represents the amount of cash flow available to investors
(stockholders and bondholders) after the firm has met all operating needs and after having paid
for net fixed asset investments and net current asset investments.
Answer: TRUE
31) A firm's free cash flow (FCF) equals the sum of operating cash flows, financing cash flows,
and investing cash flows.
Answer: FALSE
32) Operating cash flow (OCF) is equal to a firm's net operating profits after taxes minus all
non-cash charges.
Answer: FALSE
33) In the statement of cash flows, cash flows from operating activities are cash flows directly
related to purchase and sale of fixed assets.
Answer: FALSE
34) Depreciation is considered to be an outflow of cash.

Answer: FALSE
35) The statement of cash flows allows the financial manager and other interested parties to
analyze a firm's past and possibly future profitability.
Answer: FALSE
36) To assess whether any developments have occurred that are contrary to a company's
financial policies, the financial manager should pay special attention to both the major
categories of cash flow and the individual items of cash inflow and outflow.
Answer: TRUE
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37) It would be correct to define operating cash flow (OCF) as net operating profit after taxes
plus depreciation.
Answer: TRUE
38) Operating cash flow (OCF) is calculated by deducting depreciation from net operating profit
after taxes.
Answer: FALSE
39) Net operating profit after taxes (NOPAT) represents a firm's earnings before interest and
after taxes.
Answer: TRUE
40) Net operating profit after taxes (NOPAT) represents a firm's earnings after deducting both
interest and taxes.
Answer: FALSE
41) A firm's operating cash flow (OCF) is defined as ________.

A) gross profit minus operating expenses
B) gross profit minus depreciation
C) EBIT times one minus the tax rate plus depreciation
D) EBIT plus depreciation
Answer: C
42) Which of the following is an example of noncash charges?

A) depreciation
B) accruals
C) interest expense
D) dividends paid
Answer: A
43) Which of the following is a source of cash flows?

A) increase in marketable securities
B) increase in accounts payable
C) decrease in notes payable
D) repurchase of stock
Answer: B
44) ________ is a noncash charge.

A) Labor expense
B) Depreciation
C) Salaries
D) Rent
Answer: B
45) In the statement of cash flows, retained earnings are handled through the adjustment of
________.
A) "Revenue" and "Cost" accounts
B) "Current Assets" and "Current Liabilities" accounts
C) "Depreciation" and "Purchases" accounts
D) "Net Profits After Taxes" and "Dividends Paid" accounts
Answer: D
46) The cash flows from operating activities section of the statement of cash flows includes
________.
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A) principal received
B) cost of raw materials
C) dividends paid
D) stock repurchases
Answer: B
47) The cash flows from operating activities section of the statement of cash flows includes
________.
A) labor expense
B) proceeds from the sale of fixed assets
C) principal paid
D) dividends paid
Answer: A
48) The cash flows from financing activities section of the statement of cash flows includes
________.
A) labour expense
B) cost of raw materials
C) purchase of long-term assets
D) dividends paid
Answer: D
49) The three categories of a firm's statement of cash flows are ________.
A) cash flow from operating activities, cash flow from investment activities, and cash flow from
noncash activities
B) cash flow from operating activities, cash flow from noncash activities, and cash flow from
financing activities
C) cash flow from equity activities, cash flow from investment activities, and cash flow from
D) cash flow from operating activities, cash flow from investment activities, and cash flow from
Answer: D
50) Which of the following is a cash inflow?

A) a decrease in accounts payable
B) a decrease in accounts receivable
C) an increase in dividend payment
D) a decrease in accrued liabilities
Answer: B
51) Which of the following is a cash outflow?

A) an increase in accounts payable
B) a decrease in notes receivable
C) an increase in accounts receivable
D) an increase in accrued liabilities
Answer: C
52) Which of the following line items of the statement of cash flows must be obtained from the
income statement?
A) accruals in current liabilities
B) interest expenses
C) accounts receivable
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D) cash dividends paid on both preferred and common stocks

Answer: B
53) Cash flows directly related to production and sale of a firm's products and services are
called ________.
A) cash flow from operating activities
B) cash flow from investment activities
C) cash flow from financing activities
D) cash flow from equity activities
Answer: A
54) Cash flows associated with the purchase and sale of fixed assets and business interests are
called cash flow from ________.
A) operating activities
B) investment activities
C) financing activities
D) equity activities
Answer: B
55) Cash flows that result from debt and equity financing transactions, including incurrence and
repayment of debt, cash inflows from the sale of stock, and cash outflows to pay cash dividends
or repurchase stock are called cash flow from ________.
A) operating activities
B) investment activities
C) financing activities
D) miscellaneous activities
Answer: C
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Table 4.1
TRUE Sandpaper Co.

Balance Sheets
For the Years Ended 2018 and 2019
56) The largest single source of funds for the firm in 2019 is ________. (See Table 4.1)
A) an increase in net profits after taxes
B) an increase in notes payable
C) an increase in long-term debt
D) an increase in inventory
Answer: C
57) Common stock dividends paid in 2019 amounted to ________. (See Table 4.1)
A) $100
B) $50
C) $600
D) $150
Answer: B
58) The firm may have increased long-term debts to finance ________. (See Table 4.1)
A) an increase in net fixed assets
B) an increase in current assets
C) accounts receivable payments
D) an increase in dividends
Answer: B
59) The firm ________ fixed assets worth ________. (See Table 4.1)
A) purchased; $0
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B) purchased; $200
C) sold; $0
D) sold; $200
Answer: B
60) The firm's cash flow from operating activities is ________. (See Table 4.1)
A) $50
B) $350
C) $150
D) $200
Answer: A
61) The depreciation expense for 2019 is ________. (See Table 4.1)
A) $0
B) $200
C) $50
D) $1,000
Answer: B
62) A corporation sold a fixed asset for $100,000. This is ________.

A) an investment cash flow and a source of funds
B) an operating cash flow and a source of funds
C) an operating cash flow and a use of funds
D) an investment cash flow and a use of funds
Answer: A
63) A corporation raises $500,000 in long-term debt to acquire additional plant capacity. This is
considered as ________.
A) an investment cash flow
B) a financing cash flow
C) a financing cash flow and investment cash flow, respectively
D) a financing cash flow and operating cash flow, respectively
Answer: C
64) Which of the following is a cash flow from financing activities?

A) purchase of a long-term asset
B) decrease in accounts payable
C) increase in accounts payable
D) repurchasing stock
Answer: D
65) Which of the following represents a cash flow from operating activities?
A) dividends paid
B) increase or decrease in current liabilities
C) increase or decrease in fixed assets
D) repurchasing stock
Answer: B
66) For the year ended December 31, 2019, a corporation had cash flow from operating
activities of -$10,000, cash flow from investment activities of $4,000, and cash flow from
financing activities of $9,000. The statement of cash flows would show a ________.
A) net decrease of $3,000 in cash and marketable securities
B) net decrease of $5,000 in cash and marketable securities
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C) net increase of $3,000 in cash and marketable securities

D) net increase of $5,000 in cash and marketable securities
Answer: C
activities of $20,000, cash flow from investment activities of -$15,000, and cash flow from
financing activities of -$10,000. The statement of cash flows would show a ________.
A) net increase of $5,000 in cash and marketable securities
C) net decrease of $15,000 in cash and marketable securities
Answer: B
activities of $12,000, cash flow from investment activities of - $10,000, and cash flow from
financing activities of $4,000. The statement of cash flows would show a ________.
A) net decrease of $18,000 in cash and marketable securities
C) net increase of $6,000 in cash and marketable securities
Answer: C
69) A firm has just ended the calendar year making a sale in the amount of $200,000 of
merchandise purchased during the year at a total cost of $150,500. Although the firm paid in
full for the merchandise during the year, it has yet to collect at year end from the customer. One
possible problem this firm may face is ________.
A) low profitability
B) insolvency
C) inability to receive credit
D) high leverage
Answer: B
70) Calculate net operating profit after taxes (NOPAT) if a firm has sales of $1,000,000,
operating profit (EBIT) of $100,000, interest expense of $50,000, and a tax rate of 30%.
A) $35,000
B) $700,000
C) $70,000
D) $45,000
Answer: C
71) Calculate a firm's free cash flow if it has net operating profit after taxes of $60,000,
depreciation expense of $10,000, net fixed asset investment requirement of $40,000, a net
current asset requirement of $30,000 and a tax rate of 30%.
A) $0
B) $30,000
C) -$30,000
D) $60,000
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Answer: A
72) NICO Corporation had net fixed assets of $2,000,000 at the end of 2019 and $1,800,000 at
the end of 2018. In addition, the firm had a depreciation expense of $200,000 during 2019 and
$180,000 during 2018. Using this information, NICO's net fixed asset investment for 2019 was
________.
A) $20,000
B) $0
C) $380,000
D) $400,000
Answer: D
73) NICO Corporation had current assets of $2,000,000 at the end of 2019 and $1,800,000 at
the end of 2018. In addition, NICO had accounts payable of $1,000,000 in 2019 and $1,500,000
in 2018. Using this information, NICO's net current asset investment for 2019 was ________.
A) $700,000
B) -$300,000
C) $300,000
D) -$700,000
Answer: A
74) During 2019, Xeron Corporation had EBIT of $100,000, a change in net fixed assets of
$400,000, an increase in net current assets of $100,000, an increase in spontaneous current
liabilities of $400,000, a depreciation expense of $50,000, and a tax rate of 30%. Based on this
information, NICO's free cash flow is ________.
A) -$630,000
B) -$50,000
C) $650,000
D) -$30,000
Answer: D
75) Given the financial data for New Electronic World, Inc. (NEW), compute the following
measures of cash flows for the NEW for the year ended December 31, 2019.
(a) Operating cash flow
(b) Free cash flow
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For the year ended December 31,
Answer:
(a) OCF = EBIT - Taxes + Depreciation
OCF = $30,000 - $8,000 + $3,000 = $25,000
(b) FCF = OCF - Net fixed asset investment (NFAI) - Net current asset investment (NCAI)
NFAI = Change in net fixed assets + Depreciation
= ($24,000 -$ 22,000) + 3,000 = $5,000
NCAI = Change in current assets - change in (Accounts payable + Accruals)
= ($99,000 - $87,000) - ($32,000 - $26,000)
= $6,000
FCF = $25,000 - $5,000 - $6,000 = $14,000
76) Identify each expense or revenue as a cash flow from operating activities (O), a cash flow
from investment activities (I), or a cash flow from financing activities (F).
Administrative expenses
Rent payment
Interest on a note payable
Sale of equipment
Dividend payment
Stock repurchase
Sale of finished goods
Labor expense
Sale of a bond issue
Repayment of a long-term debt
Selling expenses
Depreciation expense
Sale of common stock
Purchase of fixed assets
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Answer:
77) Calculate the change in the key balance sheet accounts between 2018 and 2019 and classify
each as a source (S), a use (U), or neither (N), and indicate which type of cash flow it is: an
operating cash flow (O), and investment cash flow (I) or a financing cash flow (F).
ABC Corp.
Balance Sheet Changes and Classification
of Key Accounts between 2014 and 2015
Answer: ABC Corp.

Balance Sheet Changes and Classification
of Key Accounts between 2014 and 2015
Table 4.2
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Magna Fax, Inc.

Balance Sheet
For the Years Ended December 31, 2018 and 2019
78) The credit manager at First National Bank has just received the income statement and
balance sheet for Magna Fax, Inc. for the year ended December 31,2019. (See Table 4.2.) The
bank requires the firm to report its earnings performance and financial position quarterly as a
condition of a loan agreement. The bank's credit manager must prepare two key financial
statements based on the information sent by Magna Fax, Inc. This will be passed on to the
commercial loan officer assigned to this account, so that he may review the financial condition
of the firm.
(a) Prepare a statement of retained earnings for the year ended December 31, 2019.
(b) Prepare a summary of cash inflows and cash outflows for the year ended December 31,
2019.
(c) Prepare a statement of cash flows for the year ended December 31, 2019, organized by cash
flow from operating activities, cash flow from investment activities, and cash flow from
financing activities.
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Answer:
(a)
Magna Fax, Inc.
Statement of Retained Earnings
(b)
Magna Fax, Inc.
Statement of Cash Flows
(c)
Magna Fax, Inc.
Statement of Cash Flows
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4.3 Cash planning: cash budgets
1) Generally, firms that have cash flows with highly seasonal cash flows or cash flows that are
just generally harder to forecast prepare cash budgets more frequently compared to firms with
cash flows that are less seasonal and/or more predictable.
Answer: TRUE
2) Which of the following would be the least likely to utilize a cash budget?
A) top management
B) middle management
C) public investors
D) lenders
Answer: C
3) An internal sales forecast is based on the relationships that can be observed between a firm's
sales and certain key economic indicators such as the gross domestic product, new housing
starts, or disposable personal income.
Answer: FALSE
4) The ________ is a financial projection of a firm's short-term cash surpluses or shortages.

A) operating financial plan
B) cash budget
C) strategic financial journal
D) capital assets journal
Answer: B
5) The primary purpose in preparing a cash budget is ________.

A) to evaluate the intrinsic value of a financial assets
B) to estimate a firm's short-term cash requirements
C) for risk analysis
D) to estimate sales
Answer: B
6) The cash budget is a statement of a firm's planned inflows and outflows of cash that is used
to estimate its long-term cash requirement.
Answer: FALSE
7) Cash budgets and pro forma statements are useful not only for internal financial planning but
also are routinely required by the Internal Revenue Service (IRS).
Answer: FALSE
8) A cash budget gives the financial manager a clear view of the timing of a firm's expected
profitability over a given period.
Answer: FALSE
9) Since depreciation and other noncash charges represent a scheduled write-off of an earlier
cash outflow, they should not be included in the cash budget, though depreciation charges will
affect the taxes that a firm pays.
Answer: TRUE
10) In cash budgeting, the impact of depreciation is reflected in a reduction in tax payments.
Answer: TRUE
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11) In cash budgeting, other cash receipts are cash receipts expected to result from sources
other than sales.
Answer: TRUE
12) A firm's net cash flow is the mathematical difference between the firm's beginning cash and
its cash disbursements in each period.
Answer: FALSE
13) The excess cash balance is the amount available for investment by a firm if the desired
minimum cash balance is less than the period's ending cash.
Answer: TRUE
14) The required total financing figures in the cash budget refer to the monthly changes in
borrowing.
Answer: FALSE
15) If the net cash flow is less than the minimum cash balance, financing is required.
Answer: FALSE
16) If the ending cash is greater than the minimum cash balance, excess cash exists.
Answer: TRUE
17) Using simulations, a firm can determine the amount of financing needed to protect it
adequately against a cash shortage.
Answer: TRUE
18) As the typical cash budget shows cash flows only on a monthly basis, the information
provided by the cash budget is not necessarily adequate for ensuring solvency.
Answer: TRUE
19) As the typical cash budget shows cash flows on a monthly basis, the information provided by
the cash budget is adequate for ensuring solvency.
Answer: FALSE
20) An external sales forecast is based on ________.

A) the relationships between a firm's sales and certain key economic indicators such as GDP
and consumer confidence
B) a buildup, or consensus of sales forecasts through a firm's own sales channels
C) the prediction of a firm's sales over a given period through the analysis of the sales trends of
its competitors
D) developing the pro forma income statement to forecast sales and then express the various
income statement items as percentage of projected sales
Answer: A
21) An internal forecast is based on ________.

A) a buildup, or consensus, of sales forecasts through a firm's own sales channels, adjusted for
88
additional factors such as production capabilities

B) the relationships between a firm's sales and certain economic indicators
C) the prediction of a firm's sales over a given period through surveys sent to financial analysts
D) developing the pro forma income statement to forecast sales and then express the various
Answer: A
22) A firm's final sales forecast is usually a function of ________.

A) its net income
B) the salesperson's estimates of demand
C) internal and external factors in combination
D) its accounts receivable
Answer: C
23) A firm has projected sales in May, June, and July of $100, $200, and $300, respectively. The
firm makes 20 percent of sales for cash and collects the balance one month following the sale.
The firm's total cash receipts in July is ________.
A) $220
B) $200
C) $180
D) $140
Answer: A
24) In preparing a cash budget, the ________ seasonal and uncertain a firm's cash flows, the
________ the number of budgeting intervals it should use.
A) more; greater
B) more; fewer
C) less; greater
D) less; fewer
Answer: A
25) The key input to any cash budget is ________.

A) the sales forecast
B) the production plan
C) the pro forma balance sheet
D) the current tax laws
Answer: A
26) Cash disbursements include ________.

A) amortization expense
B) rent payments
C) depreciation expense
D) depletion
Answer: B
27) A projected excess cash balance for the month may be ________.
A) financed with short-term securities
B) financed with long-term securities
C) invested in marketable securities
D) invested in long-term securities
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Answer: C
28) If a firm expects short-term cash surpluses, it can plan ________.

A) long-term investments
B) short-term borrowing
C) short-term investments
D) leverage decisions
Answer: C
29) A firm has actual sales in November of $1,000 and projected sales in December and January
of $3,000 and $4,000, respectively. The firm makes 10 percent of its sales for cash, collects 40
percent of its sales one month following the sale, and collects the balance two months following
the sale. The firm's total cash receipts in January is ________.
A) $400
B) $2,100
C) $2,000
D) $3,300
Answer: B
30) In April, a firm had an ending cash balance of $35,000. In May, the firm had total cash
receipts of $40,000 and total cash disbursements of $50,000. The minimum cash balance
required by the firm is $25,000. At the end of May, the firm had ________.
A) an excess cash balance of $25,000
B) an excess cash balance of $0
C) required financing of $10,000
D) required financing of $25,000
Answer: B
31) In October, a firm had an ending cash balance of $35,000. In November, the firm had a net
cash flow of $40,000. The minimum cash balance required by the firm is $25,000. At the end of
November, the firm had ________.
A) an excess cash balance of $50,000
B) an excess cash balance of $75,000
C) required total financing of $15,000
D) required total financing of $5,000
Answer: A
32) In the month of August, a firm had total cash receipts of $10,000, total cash disbursements
of $8,000, depreciation expense of $1,000, and a beginning cash balance of $500. The ending
cash balance for August totals ________.
A) $1,500
B) $5,500
C) $2,500
D) $3,500
Answer: C
33) In the month of August, a firm had total cash receipts of $10,000, total cash disbursements
of $8,000, depreciation expense of $1,000,and a beginning cash balance of $500. At the end of
August, the firm wants a minimum cash balance of $3,000. At the end of August, the firm
________.
A) required total financing of $500
B) had an excess cash balance of $5,500
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C) had an excess cash balance of $500

D) required total financing of $2,500
Answer: A
34) Which of the following represents a way of coping with uncertainty in a cash budget?
A) careful estimation of cash budgets outputs
B) developing a pro forma income statement to forecast sales and then express the various
C) always using the prior year's data for estimates of the future
D) using scenario analysis, or "what if" approach, to analyze cash flows under a variety of
circumstances
Answer: D
35) Gerry Jacobs, a financial analyst for Best Value Supermarkets, has prepared the following
sales and cash disbursement estimates for the period August through December of the current
year.
Ninety percent of sales are for cash, the remaining 10 percent are collected one month later. All
disbursements are on a cash basis. The firm wishes to maintain a minimum cash balance of $50.
The beginning cash balance in September is $25. Prepare a cash budget for the months of
October, November, and December, noting any needed financing or excess cash available.
Answer:
Best Value Supermarkets should arrange for a line of credit for at least $235 during the four
month period.
36) Terrel Manufacturing expects stable sales through the summer months of June, July, and
August of $500,000 per month. The firm will make purchases of $350,000 per month during
these months. Wages and salaries are estimated at $60,000 per month plus 7 percent of sales.
The firm must make a principal and interest payment on an outstanding loan in June of
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$100,000. The firm plans a purchase of a fixed asset costing $75,000 in July. The second quarter
tax payment of $20,000 is also due in June. All sales are for cash.
(a) Construct a cash budget for June, July, and August, assuming the firm has a
beginning cash balance of $100,000 in June.
(b) The sales projections may not be accurate due to the lack of experience by a newly-hired
sales manager. If the sales manager believes the most optimistic and pessimistic estimates of
sales are $600,000 and $400,000, respectively, what are the monthly net cash flows and
required financing or excess cash balances?
Answer:
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If the most pessimistic sales figure ($400,000) materializes, the financial manager should
expect a financing requirement of $209,000 and should arrange for a line of credit to cover the
firm's cash deficit. However, if the most optimistic estimate materializes, the financial manager
will need to arrange for investing a total of $349,000 over the three month period.
37) In the preparation of a quarterly cash budget, the following revenue and cost information
have been compiled. Prepare and evaluate a cash budget for the months of October, November,
and December based on the information shown below.
∙ The firm collects 60 percent of sales for cash and 40 percent of its sales one month later.
∙ Interest income of $50,000 on marketable securities will be received in December.
∙ The firm pays cash for 40 percent of its purchases.
∙ The firm pays for 60 percent of its purchases the following month.
∙ Salaries and wages amount to 15 percent of the preceding month's sales.
∙ Sales commissions amount to 2 percent of the preceding month's sales.
∙ Lease payments of $100,000 must be made each month.
∙ A principal and interest payment on an outstanding loan is due in December of $150,000.
∙ The firm pays dividends of $50,000 at the end of the quarter.
∙ Fixed assets costing $600,000 will be purchased in December.
∙ Depreciation expense each month of $45,000.
∙ The firm has a beginning cash balance in October of $100,000 and maintains a minimum
cash balance of $200,000.
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Answer:
The firm has excess cash during the three month period and can invest the excess cash in
marketable securities.
38) Harry's House of Hamburgers (HHH) wants to prepare a cash budget for months of
September through December. Using the following information, prepare the cash budget
schedule and interpret the results.
∙ Sales were $50,000 in June and $60,000 in July. Sales have been forecasted to be $65,000,
$72,000, $63,000, $59,000, and $56,000 for months of August, September, October, November,
and December, respectively. In the past, 10 percent of sales were on cash basis, and the
collection were 50 percent in the first month, 30 percent in the second month, and 10 percent
in the third month following the sales.
∙ Every four months (three times a year) $500 of dividends from investments are expected.
The first dividend payment was received in January.
∙ Purchases are 60 percent of sales, 15 percent of which are paid in cash, 65 percent are paid
one month later, and the rest is paid two months after purchase.
∙ $8,000 dividends are paid twice a year (in March and September).
∙ The monthly rent is $2,000.
∙ Taxes are $6,500 payable in December.
∙ A new hamburger press will be purchased in October for $2,300.
∙ $1,500 interest will be paid in November.
∙ $1,000 loan payments are paid every month.
∙ Wages and salaries are $1,000 plus 5 percent of sales in each month.
∙ August's ending cash balance is $3,000.
∙ HHH would like to maintain a minimum cash balance of $10,000.
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Answer: Cash Budget
No financing required. The company may invest the excess cash in marketable securities.
4.4 Profit planning: pro forma statements
1) Profit planning's main focus is on the firm's cash receipts and disbursements throughout the
year.
Answer: FALSE
2) Compared to the short-term focus of cash planning, profit planning has a broader emphasis
that encapsulates the firm's overall financial position.
Answer: TRUE
3) Firms construct pro forma financial statements by studying past relationships between key
accounts on the income statement and balance sheet and making judgments about whether
those relationships will continue in the near future.
Answer: TRUE
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4) The two main inputs required to construct pro forma financial statements are the ________.
A) actual financial statements and cash budget from the prior year
B) actual financial statements for the last two years
C) actual financial statements from last year and the sales forecast for the next year
D) the cash budget from last year and the sales forecast for the next year
Answer: C
5) Development of pro forma financial statements helps a financial manager to project the
amount of external financing required to support a given level of sales as well as overall
financial performance of the firm in the coming year.
Answer: TRUE
6) The primary purpose in preparing pro forma financial statements is ________.

A) for cash planning
B) to ensure the ability to pay dividends
C) for risk analysis
D) for profit planning
Answer: D
7) ________ are projected financial statements.

A) Pro forma statements
B) Statements of retained earnings
C) Cash budgets
D) Cash flow statements
Answer: A
4.5 Preparing the pro forma income statement
1) Since the percentage-of-sales method assumes that all the form's costs and expenses are
variable, it tends to understate profits when sales are increasing and overstate profits when
sales are decreasing.
Answer: TRUE
2) The key inputs for preparing pro forma income statements using the percent-of-sales method
are the ________.
A) sales forecast for the preceding year and financial statements for the coming year
B) sales forecast for the coming year and the cash budget for the preceding year
C) sales forecast for the coming year and financial statements for the preceding year
D) cash budget for the coming year and sales forecast for the preceding year
Answer: C
3) In a period of rising sales, utilizing past cost and expense ratios (percent-of-sales method)
when preparing pro forma financial statements will tend to ________.
A) overstate costs and overstate profits
B) overstate costs and understate profits
C) understate costs and overstate profits
D) understate costs and understate profits
Answer: B
96
4) The percentage-of-sales method of preparing pro forma income statements assumes that
________.
A) sales are fixed
B) all costs inversely vary with sales
C) all costs are independent
D) all costs are variable
Answer: D
5) The percent-of-sales method of developing a pro forma income statement forecasts sales and
other line items as a ________.
A) percentage of projected sales
B) percentage of average sales over a period
C) percentage of projected total assets
D) percentage of average total assets over a period
Answer: A
6) The best way to adjust for the presence of fixed costs when preparing a pro forma income
statement is ________.
A) to proportionately vary the fixed costs with the change in sales
B) to adjust for projected fixed-asset outlays
C) to disproportionately vary the costs with the change in sales
D) to break the firm's historical costs into fixed and variable components
Answer: D
7) The percent-of-sales method to prepare a pro forma income statement assumes a firm has no
fixed costs. Therefore, the use of the past cost and expense ratios generally tends to ________
profits when sales are increasing.
A) accurately predict
B) overstate
C) understate
D) have no effect on
Answer: C
8) For firms with high fixed costs, the percent-of-sales approach for preparing a pro forma
income statement tends to ________.
A) overestimate profits when sales are increasing
B) underestimate profits when sales are increasing
C) underestimate profits when assets are increasing
D) overestimate profits when assets are increasing
Answer: B
97
Table 4.4
Use the percent-of-sales method to prepare a pro forma income statement for the year ended
December 31, 2019, for Hennesaw Lumber, Inc.
Hennesaw Lumber, Inc. estimates that its sales in 2019 will be $4,500,000. Interest expense is
to remain unchanged at $105,000 and the firm plans to pay cash dividends of $150,000 during
2019. Hennesaw Lumber, Inc.'s income statement for the year ended December 31, 2018 is
shown below. From your preparation of the pro forma income statement, answer the following
multiple choice questions.
9) The pro forma net profits after taxes for 2019 are ________. (See Table 4.4)
A) $272,550
B) $207,000
C) $122,550
D) $57,000
Answer: A
10) The pro forma cost of goods sold for 2019 is ________. (See Table 4.4)
A) $3,500,000
B) $3,750,000
C) $3,825,000
D) $4,000,000
Answer: C
11) The pro forma operating expenses for 2019 are ________. (See Table 4.4)
A) $150,000
B) $200,000
C) $210,000
D) $225,000
Answer: D
12) The amount that will transfer from the 2019 income statement to the 2019 balance sheet as
an addition to retained earnings is ________. (See Table 4.4)
98
A) $150,000
B) $57,000
C) $122,550
D) $272,550
Answer: C
13) Income Statement

Huddleston Manufacturing Company
Huddleston Manufacturing estimates its sales in 2019 will be $3 million. Interest expense is
expected to remain unchanged at $70,000, and the firm plans to pay cash dividends of $140,000
during 2019. Use the percent-of-sales method to prepare a pro forma income statement for the
year ended December 31, 2019, based on the 2018 income statement shown above.
Answer:
Pro Forma Income Statement
Huddleston Manufacturing Company
99
Table 4.6
Income Statement
Ace Manufacturing, Inc.
14) Ace Manufacturing, Inc., is preparing pro forma financial statements for 2019. The firm
utilized the percent-of-sales method to estimate costs for the next year. Sales in 2018 were $2
million and are expected to increase to $2.4 million in 2019. The firm has a 40 percent tax rate.
(a) Given the 2018 income statement in Table 4.6, estimate net profit and retained earnings
for 2019.
(b) If $200,000 of the cost of goods sold and $40,000 of selling expense are fixed costs; and
the interest expense and dividends are not expected to change, what is he dollar effect on net
income and retained earnings? What is the significance of this effect?
Answer:
(a)
Pro forma income statement: December 31, 2019
100
(b)
Net profit after tax is understated by $50,560 and retained earnings by $70,560, using the
percent-of-sales method. In planning the addition of assets (current or fixed) and the financing
of those assets, the straight percent-of-sales method understates net profit and retained
earnings. This, therefore, overstates additional financing needed to add those assets. The
judgmental approach allows the firm to obtain a more accurate estimate of the line of credit or
long-term financing that will be necessary in the next planning period.
4.6 Preparing the pro forma balance sheet
1) One basic weakness of the simplified pro forma approaches lies in the assumption that
certain variables, such as cash, accounts receivable, and inventories, can be forced to take on
certain "desired" values.
Answer: TRUE
2) In a period of rising sales utilizing past cost and expense ratios (percent-of-sales method),
when preparing pro forma financial statements and planning financing, will tend to ________.
A) understate retained earnings and understate the additional financing needed
B) overstate retained earnings and overstate the additional financing needed
C) understate retained earnings and overstate the financing needed
D) overstate retained earnings and understate the financing needed
Answer: C
3) Under the judgmental approach for developing a pro forma balance sheet, the "plug" figure
required to bring the statement into balance may be called the ________.
A) cash balance
B) retained earnings
C) external financing required
D) accounts receivable
Answer: C
4) The ________ method of developing a pro forma balance sheet estimates values of certain
balance sheet accounts while external financing is used as a balancing, or plug, figure.
A) percent-of-sales
B) accrual
C) judgmental
101
D) cash
Answer: C
5) A firm has prepared the coming year's pro forma balance sheet resulting in a plug figure in a
preliminary statement—called the external financing required—of $230,000. The firm should
prepare to ________.
A) repurchase common stock totaling $230,000
B) arrange for a loan of $230,000
C) do nothing; the balance sheet balances
D) invest in marketable securities totaling $230,000
Answer: B
6) A firm has prepared the coming year's pro forma balance sheet resulting in a plug figure in a
preliminary statement—called the external financing required—of negative $250,000. The firm
may prepare to ________.
A) sell common stock totaling $250,000
B) arrange for a loan of $250,000
C) do nothing; the balance sheet balances
D) invest in marketable securities totaling $250,000
Answer: D
7) One basic weakness of the simplified pro forma approaches lies in the assumption that the
firm's past financial condition is an accurate indicator of its future.
Answer: TRUE
8) A weakness of the percent-of-sales method of preparing a pro forma income statement is

________.
A) that it forecasts income and then expresses the various income statement items as
percentages of projected income
B) the assumption that the firm faces linear total revenue and total operating cost functions
C) the assumption that the firm's past financial condition is an accurate predictor of its future
D) the difficulty faced in calculation and preparation of such statements
Answer: C
9) Utilizing past cost and expense ratios (percent-of-sales method) when preparing pro forma
financial statements will tend to ________.
A) understate profits when sales are decreasing
B) understate profits when sales are increasing
C) overstate profits when sales are increasing
D) neither understate nor overstate profits
Answer: B
10) Utilizing past cost and expense ratios (percent-of-sales method) when preparing pro forma
financial statements will tend to ________.
A) understate profits when sales are decreasing and overstate profits when sales are increasing
B) understate profits, no matter what the change in sales, as long as fixed costs are present
C) understate profits when sales are increasing and overstate profits when sales are decreasing
D) overstate profits, no matter what the change in sales, as long as fixed costs are present
Answer: C
11) The weakness of the judgmental approach to preparing a pro forma balance sheet is
________.
A) the assumption that the values of certain accounts can be forced to take on desired levels
B) the assumption that the firm faces linear total revenue and total operating cost functions
102
C) the assumption that the firm's past financial condition is an accurate predictor of its future
D) ease of calculation and preparation
Answer: A
12) If transportation costs were a huge portion of a firm's expenses and the firm expected gas
prices to increase greatly in the next year, then in preparing its pro forma income statement the
firm should ________.
A) use the percentage of transportation costs from last year's sales
B) decrease the percentage of transportation costs from the percentage of last year's sales
C) increase the percentage of transportation costs from the percentage of last year's sales
D) double the percentage of transportation costs from the percentage of last year's sales
Answer: C
13) In the development of pro forma statements, a firm that requires external funds means that
its projected level of cash is in excess of its needs and that funds would therefore be available
for repaying debt, repurchasing stock, or increasing the dividend to stockholders.
Answer: FALSE
Table 4.3
The financial analyst for Sportif, Inc. has compiled sales and disbursement estimates for the
coming months of January through May. Historically, 75 percent of sales are for cash with the
remaining 25 percent collected in the following month. The ending cash balance in January is
$3,000.
14) The total cash receipts for April are ________. (See Table 4.3)
A) $5,000
B) $7,500
C) $9,250
D) $10,000
Answer: D
15) The net cash flow for February is ________. (See Table 4.3)
A) -$1,250
B) -$1,000
C) $5,750
D) $750
Answer: A
16) Calculate the amount of accounts receivable assuming that a pro forma balance sheet dated
at the end of May was prepared from the information presented. (See Table 4.3)
Answer: $2,500.
17) The firm has a negative net cash flow in the month(s) of ________. (See Table 4.3)
103
A) January, February, and March

B) February and March
C) January and February
D) February
Answer: C
18) The ending cash balance for March is ________. (See Table 4.3)
A) $250
B) $6,750
C) $2,500
D) $500
Answer: B
19) The ending cash balance for February is ________. (See Table 4.3)
A) $750
B) $1,750
C) $2,500
D) -$1,000
Answer: B
20) At the end of May, the firm has an ending cash balance of ________. (See Table 4.3)
A) $9,000
B) $16,750
C) $14,250
D) $12,000
Answer: B
21) The firm has a total financing requirement of ________ for the period from February through
May. (See Table 4.3)
A) $0
B) $1,750
C) $1,250
D) $ 750
Answer: A
22) If a pro forma balance sheet dated at the end of May was prepared from the information
presented, the marketable securities would total ________. (See Table 4.3)
A) $9,000
B) $9,500
C) $12,000
D) $16,750
Answer: D
104
Table 4.5
A financial manager at General Talc Mines has gathered the financial data essential to prepare
a pro forma balance sheet for cash and profit planning purposes for the coming year ended
December 31, 2019. Using the percent-of-sales method and the following financial data, prepare
the pro forma balance sheet in order to answer the following multiple choice questions.
(a) The firm estimates sales of $1,000,000.
(b) The firm maintains a cash balance of $25,000.
(c) Accounts receivable represents 15 percent of sales.
(d) Inventory represents 35 percent of sales.
(e) A new piece of mining equipment costing $150,000 will be purchased in 2019.
Total depreciation for 2019 will be $75,000.
(f) Accounts payable represents 10 percent of sales.
(g) There will be no change in notes payable, accruals, and common stock.
(h) The firm plans to retire a long term note of $100,000.
(i) Dividends of $45,000 will be paid in 2019.
(j) The firm predicts a 4 percent net profit margin.
Balance Sheet
General Talc Mines
December 31, 2018
23) The pro forma total current assets amount is ________. (See Table 4.5)
A) $470,900
B) $500,000
C) $525,000
D) $575,000
Answer: C
24) The pro forma net fixed assets amount is ________. (See Table 4.5)
A) $500,000
105
B) $575,000
C) $600,000
D) $650,000
Answer: B
25) The pro forma current liabilities amount is ________. (See Table 4.5)
A) $400,000
B) $450,000
C) $475,000
D) $500,000
Answer: D
26) The pro forma total liabilities amount is ________. (See Table 4.5)
A) $500,000
B) $550,000
C) $700,000
D) $650,000
Answer: B
27) The pro forma accumulated retained earnings amount is ________. (See Table 4.5)
A) $90,000
B) $175,000
C) $140,000
D) $130,000
Answer: D
28) The external financing required in 2019 will be ________. (See Table 4.5)
A) $230,000
B) $240,000
C) $0
D) $195,000
Answer: B
29) General Talc Mines may prepare to ________. (See Table 4.5)
A) arrange for a loan equal to the external funds requirement
B) eliminate the dividend to cover the needed financing
C) cancel the retirement of the long term note to cover the needed financing
D) repurchase common stock equal to the external funds requirement
Answer: A
30) The external funds requirement results primarily from ________. (See Table 4.5)
A) the payment of dividends
B) the retirement of debt and purchase of new fixed assets
C) low profit margin
D) high cost of sales
Answer: B
31) If General Talc Mines cannot raise the external financing required through traditional credit
channels, the firm may ________. (See Table 4.5)
A) increase sales
B) purchase additional fixed assets to raise productivity
C) sell common stock
D) factor accounts receivable
106
Answer: C
Table 4.7
The income statement and balance sheet for the ZZZ Mattress Co. for the year ended December
31, 2018 follow.
Balance Sheet
ZZZ Mattress Company
December 31, 2018
107
32) The ZZZ Mattress Co. has been requested by the 1st National Bank, a major creditor, to
prepare a pro forma balance sheet for the year ending, December 31, 2019. Using the percent-
of-sales method and the following financial data, prepare the pro forma income statement and
balance sheet and discuss the resulting external financing required. (See Table 4.7)
∙ 2019 sales are estimated at $330,000.
∙ Accounts receivable represent 20 percent of sales.
∙ A minimum cash balance of $1,650 is maintained.
∙ Inventory represents 32 percent of sales.
∙ Fixed-asset outlays in 2019 are $20,000. Total depreciation expense for 2019 will be
$15,000.
∙ Accounts payable represents 15 percent of sales.
∙ Notes payable and accruals will remain the same.
∙ No long-term debt will be retired in 2019.
∙ No common stock will be repurchased in 2019.
∙ The firm will pay dividends equal to 50 percent of its earnings after taxes.
Answer:
Balance Sheet
ZZZ Mattress Company
December 31, 2019
108
A 10 percent growth rate in sales cannot be supported by the firm's internally generated funds.
A larger line of credit or a request for a long-term loan for the additional $8,390 is necessary to
finance operations.
Table 4.8
Balance Sheet
Wirl Wind Company
109
33) The Wirl-Wind Company of America is trying to plan for the next year. Using the current
income statement and balance sheet given in Table 4.8, and the additional information
provided, prepare the company's pro forma statements.
∙ Sales are projected to increase by 15 percent.
∙ Total of $75,000 in dividends will be paid.
∙ A minimum cash balance of $650,000 is desired.
∙ A new asset for $50,000 will be purchased.
∙ Depreciation expense for next year is $50,000.
∙ Marketable securities will remain the same.
∙ Accounts receivable, inventory, accounts payable, notes payable, and accruals will increase
by 15 percent.
∙ $30,000 new issue of bond will be sold.
∙ No new stock will be issued.
Answer:
110
The Wirl Wind Company of America will have an excess cash of $156,474 which can be used to
pay debt.
1) The two main weaknesses of pro forma financial statements are ________.
A) they produce inaccurate forecasts and they cannot be used by anyone outside the firm
B) they assume that the firm's past financial condition is an accurate indicator of its future and
that managers can force particular accounts to take on particular desired values
C) stockholders take the pro forma forecasts too seriously, which causes volatility in stock
prices when actual outcomes deviate from forecasts
D) pro forma statements provide useful forecasts of profits, but not cash flows, and they rely too
much on the assumption that income statement items will grow at the same rate as sales
Answer: B
2) By necessity, building pro forma financial statements requires that managers make many
assumptions which will not turn out to be TRUE. Therefore, pro forma financial statements are
of little use as a financial management tool.
Answer: FALSE
111
3) Pro forma financial statements highlight situations in which actual outcomes deviate from
projections, which in turn helps managers understand why a firm's results are not in alignment
with its forecasts.
Answer: TRUE
4) In the next planning period, a firm plans to change its policy of all cash sales and initiate a
credit policy requiring payment within 30 days. The statements that will be directly affected
immediately are the ________.
A) pro forma income statement, balance sheet, and cash budget
B) pro forma balance sheet and cash budget
C) cash budget and statement of retained earnings
D) pro forma income statement and pro forma balance sheet
Answer: B
112

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Principles of Managerial Finance, 15e (Zutter & Smart)

Chapter 4 Long- and Short-Term Financial Planning..........................................................................................................67

Chapter 1 The Role of Managerial Finance

1) A firm is a business organization that sells goods and services.

4) Financial managers evaluating decision alternatives or potential actions must consider

7) Which of the following is an example of a firm's stakeholder?

stocks of these two companies should trade at the same price.

11) Which of the following is TRUE of stakeholders?

12) Which of the following is TRUE regarding cash flow?

14) Which of the following is TRUE of cash flows and risk?

16) The primary goal of a financial manager is ________.

17) Corporate owners earn a return ________.

B) earnings per share

24) Finance is ________.

likely explanation for that difference is that ________.

33) An effective ethics program ________.

1.2 Managing the firm.

4) The primary principle that finance borrows from economics is ________.

9) A corporation's stockholders elect its CEO.

15) A treasurer is commonly responsible for handling ________.

16) Which of the following is TRUE of accrual basis accounting?

20) As the risk of a stock investment increases, investors' ________.

21) The principal-agent problem arises when ________.

1.3 Organization forms, taxation, and the principal-agent

1) Which of the following legal forms of organization is most expensive to organize?

4) Which of the following forms of organizations is the easiest to form?

5) A major weakness of a partnership is ________.

6) Which of the following is a strength of a corporation?

7) Which of the following legal forms of organizations is characterized by unlimited liability?

8) Which of the following is TRUE of a partnership and a corporation?

9) Which of the following is TRUE of sole proprietorships and corporations?

14) The term "double taxation" means that ________.

16) Corporate governance refers to ________.

17) Agency costs are ________.

20) Dividends are periodic distributions of cash to the stockholders of a firm.

27) The board of directors is typically responsible for ________.

29) Which of the following is an example of agency cost?

40) All dividend income received by a corporation is exempted from taxation.

Range of taxable income Marginal rate

Range of taxable income Marginal rate

1.4 Developing skills for your career.

Chapter 2 The Financial Market Environment

1) A financial institution is an intermediary that channels the savings of individuals, businesses,

2) Commercial banks advise firms on major transactions such as mergers or financial

3) As a key participant in financial transactions, individuals are ________.

4) Government is typically a ________.

5) Government can obtain funds ________.

7) Investment banks are institutions that ________.

8) Which of the following serves as an intermediary channeling the savings of individuals,

2.2 Financial markets

13) The over-the-counter (OTC) market is ________.

14) Which of the following is TRUE of a primary market?

15) Which of the following is TRUE of a secondary market?

16) Which of the following is TRUE of preferred stock?

18) Which of the following is TRUE of international equity markets?

19) Which of the following is TRUE of a dealer market?

20) Which of the following is TRUE of a securities exchange?

24) Most money market transactions are made in ________.

27) Which of the following is an example of marketable securities?

32) Most businesses raise money by selling their securities in a ________.

40) An efficient market is one where ________.

43) The money market is a market ________.

2.3 Regulation of financial markets and institutions