Investments An

Introduction 11th
Edition Mayo Test
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TRUE/FALSE

F 1. The relationship between a firm and its state of

incorporation is specified in the bylaws.

T 2. Stockholders in a publicly held corporation have

limited liability.

F 3. Corporate retained earnings are taxed on the

individual investor's federal income form.

T 4. Both corporate earnings and cash dividends received

by stockholders are taxed by the federal government.

F 5. Most stockholders have cumulative voting rights.

T 6. Cumulative voting gives more power to minority

stockholders.

T 7. Some firms have more than one class of common stock.

T 8. If a firm retains earnings, total equity increases.

T 9. If a firm operates at a loss, its retained earnings

are decreased.

F 10. Most stockholders of publicly held stock have

pre-emptive rights.

T 11. The payout ratio is dividends divided by earnings.

F 12. Dividend increases usually occur prior to an increase

in earnings.

F 13. The ex-dividend date follows the date of record.

T 14. Managements are often reluctant to reduce dividends

because reductions may be viewed as indicating financial
weakness.

T 15. Cash dividends are subject to federal income taxes.

T 16. If an investor buys stock on the ex-dividend date,

that individual will not receive the dividend.

T 17. The price of a stock generally adjusts downward for

the distribution of dividends.

F 18. Stock dividends reduce the firm's total equity.

F 19. Stock dividends increase the firm's cash.

F 20. A two-for-one stock split doubles the number of shares
and their price.

F 21. Stock splits and stock dividends increase the earning

capacity of the firm.

T 22. A one-for-two reverse split increases a stock’s price.

F 23. Dividend reinvestment plans are a means to postpone

federal income tax on dividends.

T 24. Repurchases of shares may be viewed as an alternative

to paying cash dividends.

T 25. A major advantage associated with dividend

reinvestment plans is forced saving.

T 26. A higher payout ratio implies a lower growth rate.

T 27. Preferred stock is legally equity and represents

ownership.

F 28. Since preferred stock represents equity, it generally

has the right to vote.

F 29. If a cumulative preferred stock pays a dividend, it is

said to be in arrears.

F 30. Preferred stock pays a fixed amount of interest.

T 31. Preferred stock dividends are usually cumulative.

F 32. The current ratio and the quick ratio are measures of
asset usage.

T 33. The quick ratio excludes inventory, plant, and

equipment.

T 34. If accounts receivable are collected, the quick ratio

is unaffected.

T 35. The quick ratio is a better measure of liquidity than

the current ratio for manufacturers.

T 36. An inventory turnover of 3.0 suggests that inventory

is sold every four months.
F 37. If inventory is sold for cash, inventory turnover is
increased, but inventory turnover is not affected if
inventory is sold on credit.

T 38. If the firm's current ratio exceeds 1:1 and the firm
retires an account payable, the quick ratio increases.
T 39. If accounts receivable are collected more rapidly,
the average collection period (days sales outstanding) is
reduced.

T 40. If a firm's inventory turnover is 4 and days sales

outstanding (average collection period) is 60, then it takes
about five months for newly acquired inventory to generate
cash.

F 41. A times-interest-earned of 0.9 means that interest

will not be paid.

T 42. Coverage ratios may be used to measure the safety of

debt and other fixed obligations.

T 43. Ratios may be used in both time-series and cross

section types of analysis.

T 44. The gross profit margin on sales tends to exceed the

operating profit margins on sales.

F 45. The return on assets employs operating income instead

of net income.

F 46. The return on equity measures earnings before interest

and taxes.

T 47. The proportion of a firm's assets that are financed by

debt is measured by the debt ratio.

F 48. An increase in retained earnings will increase the

debt to equity ratio.

F 49. An increase in assets financed by equity increases the

debt ratio.

T 50. The greater the numerical value of the debt ratio, the
riskier the firm.

T 51. Firms with too much debt are undercapitalized.

F 52. The more financially leveraged a firm, the smaller is

its debt ratio.

T 53. When a firm makes a profitable sale, its total assets

increase.
T 54. If the ratio of debt to equity increases, the
proportion of assets financed by debt is increased.

T 55. The net profit margin increases as the firm’s interest

expense declines.
T 56. Cash flow depends on depreciation as well as the
firm's earnings.

F 57. Lower depreciation increases earnings and cash flow.

F 58. The statement of cash flow places emphasis on

management's ability to retire debt.

F 59. Lower cash flow may be the result of higher

depreciation expense.

F 60. An increase in as asset is a cash inflow.

MULTIPLE CHOICE

a 1. Advantages of the corporate form of business include

a. limited liability for stockholders
b. avoidance of state taxation
c. limited life
d. deductibility of dividends

d 2. Stockholders generally have which of the following

rights?
1. right to vote
2. right to share in the firm's earnings
3. right to sell the stock
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. all of the above

c 3. Cumulative voting permits a stockholder to

a. collect extra dividends
b. vote all the shares for one individual
c. cast the total number of votes for one individual
d. vote by proxy

d 4. Earnings are
a. retained
b. distributed
c. invested
d. retained and/or distributed

c 5. Pre-emptive rights permit stockholders to

a. collect dividends before they are reinvested
b. participate in dividend reinvestment plans
c. maintain the proportionate share of ownership
d. vote their shares

b 6. Cash dividends
1. are paid from earnings
2. increase the capacity of the firm to grow
3. reduce the firm's assets
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. all of the above

c 7. The procedure for the distribution of dividends

does not include
a. the ex-dividend date
b. the date of record
c. the settlement date
d. the date of announcement
a 8. Dividend policy depends on
1. the firm's earnings
2. investment opportunities available to the firm
3. corporate income taxes
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. all of the above

a 9. Stock dividends increase

a. the number of shares outstanding
b. the firm's assets
c. the firm's equity
d. the stock's price

b 10. Stock dividends cause

a. the price of a share of stock to rise
b. the price of a share of stock to fall
c. the value of the firm to rise
d. the value of the firm to fall

a 11. Which of the following occurs when a stock is split

two-for-one?
a. the price of the stock decreases
b. the firm's assets decrease
c. the firm's liabilities decrease
d. the firm’s equity decreases

a 12. Which of the following occurs when a 10 percent

stock dividend is paid?
a. the firm's retained earnings decrease
b. the firm's equity is increased
c. the stock's par value is decreased
d. the stock's price is increased

a 13. If a firm has substantial excess cash, it may

1. repurchase some of its shares
2. increase its cash dividends
3. increase its liabilities
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. only 2

c 14. Dividend reinvestment plans offer which advantages?

1. deferment of federal income taxes
2. a convenient means to accumulate shares
3. dollar cost averaging
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. only 2
b 15. Preferred stock generally pays
a. a variable dividend
b. a fixed dividend
c. a stock dividend
d. no dividend

b 16. Preferred stock and long-term bonds are similar

because
a. they both have voting power
b. interest and dividend payments are fixed
c. interest and dividend payments are legal
obligations
d. interest and dividend payments are tax-deductible
expenses

d 17. Preferred stock dividends are

1. a legal obligation
2. not a legal obligation
3. exempt from federal income taxation
4. not exempt from federal income taxation
a. 1 and 3
b. 1 and 4
c. 2 and 3
d. 2 and 4

c 18. Analysis of preferred stock uses

a. operating income (EBIT)
b. earnings after dividends to common stock
c. earnings after taxes
d. earnings after interest but before taxes

b 19. Earnings per preferred share are

a. earnings before interest and taxes
b. the ratio of earnings to number of preferred shares
c. the ratio of EBIT to number of preferred shares
d. the ratio of preferred shares to common shares

b 20. The current ratio is unaffected by

a. using cash to retire an account payable
b. the collection of an account receivable
c. selling inventory for a profit
d. selling bonds and using the funds to
finance inventory

d 21. The quick ratio

a. excludes accounts payable
b. excludes accounts receivable
 c. includes inventory
d. includes cash and cash equivalents

a 22. Activity ratios measure

a. how rapidly assets flow through the firm
b. how frequently the firm's stock is traded
c. how rapidly employees turn over
d. the profitableness of accounts receivable
d 23. Inventory turnover may increase if
a. the firm increases its accounts payable
b. the firm uses less debt financing
c. the firm increases its inventory
d. the firm lowers the prices of its goods

b 24. Days sales outstanding (receivables turnover) measures

a. the speed with which accounts payable are paid
b. the speed with which accounts receivable
are collected
c. the safety of accounts receivable
d. the safety of accounts payable

d 25. Coverage ratios measure a firm's

a. ability to use debt financing
b. use of plant and equipment
c. ability to cover (i.e., sell) its inventory
d. ability to meet fixed payments such as interest

c 26. As the debt ratio increases,

1. fewer assets are debt financed
2. more assets are debt financed
3. the ratio of debt to equity increases
4. the ratio of debt to equity decreases
a. 1 and 3
b. 1 and 4
c. 2 and 3
d. 2 and 4

c 27. As times-interest-earned increases,

a. bondholders' position deteriorates
b. net income decreases
c. interest payments become more assured
d. taxes decrease

c 28. The return on equity

a. is the ratio of sales to equity
b. measures what the firm earns on assets
c. is the ratio of net income to total equity
d. measures what the firm earns on sales

a 29. The debt ratio is a measure

1. of financial leverage
2. of the use of debt financing
3. of asset utilization
a. 1 and 2
b. 1 and 3
c. 2 and 3
d. all of the above
c 30. Owners of bonds would prefer
1. a debt ratio of 60 percent to a debt ratio of
40 percent
2. a debt ratio of 40 percent to a debt ratio of
60 percent
3. a times-interest-earned of 5.1 to a
times-interest-earned of 3.9
4. a times-interest-earned of 3.9 to a
times-interest-earned of 5.1
a. 1 and 3
b. 1 and 4
c. 2 and 3
d. 2 and 4

b 31. Creditors would prefer

1. a quick ratio of 1.2 to a quick ratio of 0.8
2. a quick ratio of 0.8 to a quick ratio of 1.2
3. days sales outstanding of 46 to a
days sales outstanding of 35
4. days sales outstanding of 35 to a
days sales outstanding of 46
a. 1 and 3
b. 1 and 4
c. 2 and 3
d. 2 and 4

d 32. Operating income is not affected by

a. depreciation
b. cost of goods sold
c. rent payments
d. interest earned

a 33. Which of the following has no impact on cash flow?

a. the firm's equity
b. depreciation expense
c. taxes paid
d. net income

c 34. Which of the following is a cash inflow?

a. distributing a stock dividend.
b. retiring an account payable
c. collecting an account receivable
d. paying property taxes

b 35. Which of the following is a cash outflow?

a. splitting the stock two for one
b. acquiring inventory
c. retaining earnings
d. switching from straight-line depreciation
to accelerated depreciation
PROBLEMS

1. A firm's stock sells for $100 a share. What will be the

price after a
a. two-for-one split
b. four-for-one split
c. one-for-two reverse split?

2. A firm's balance sheet has the following entries:

Cash $30,000,000
Total assets 100,000,000
Common stock (10,000,000 20,000,000
shares outstanding, $2 par)
Additional paid-in capital 5,000,000
Retained earnings 35,000,000

What will be each of these balance sheet entries after a

a. $2 a share cash dividend
b. four-for-one split
c. 5 percent stock dividend (current price of the
stock is $20)?

3. Construct a balance sheet from the following information.

Accrued interest payable $4,000

Accumulated depreciation 30,000
Trade accounts payable 10,000
Retained earnings 86,000
Accrued wages 11,000
Work in process 5,000
Finished goods 30,000
Plant and equipment 100,000
Cash and marketable securities 10,000
Land 10,000
Accounts receivable 32,000
Allowance for doubtful accounts 2,000
Bank note (due in six months) 15,000
Long-term debt 15,000
Raw materials 7,000
Investments 10,000
Taxes due 1,000
Additional paid-in capital 20,000
$1 par value common stock
20,000 shares authorized
10,000 shares outstanding
4. Determine a firm's earnings per share from the following
information.
Corporate income tax rate 25%
Number of shares outstanding 10,000
Cost of goods sold $60,000
Interest earned 2,400
Selling and administrative expense 15,000
Interest expense 5,000
Sales 100,000
Annual credit sales 90,000

5. Given the following information, construct the statement

of changes in financial position. What happened to the firm's
liquidity position during the year?
Net income $16.7
Decrease in accounts receivable 6.1
Increase in accounts payable 13.6
Sale of bonds 55.1
Dividends 14.8
Retirement of bonds 10.8
Increase in inventory 15.2
Depreciation expense 56.0
Cost of goods sold 72.1
Reduction in income taxes payable 5.0
Sale of stock 0.4
Purchase of plant and equipment 91.0
Beginning cash 1.1
Repurchase of stock 5.6

6. Using the income statement and balance sheet constructed

in (1) and (2), compute the following ratios. Compare the
results with the industry averages. What strengths and
weaknesses are apparent?
RATIO INDUSTRY AVERAGE
Current ratio 2:1
Acid test (quick ratio) 1:1
Inventory turnover
a. annual sales 2.5
b. cost of goods sold 1.2
Receivables turnover
a. annual credit sales 5.0x
b. annual sales 6.0x
Days sales outstanding 75 days
Operating profit margin 26%
Net profit margin 19%
Return on assets 10%
Return on equity 15%
Debt/equity 33%
Debt ratio (debt/total assets) 25%
Times-interest-earned 7.1x
ADDITIONAL INFORMATION:
last year's inventory $40,000
credit sales $90,000
7. An analysis of last year's financial statements produced
the following results.

Current ratio 3.6

Quick ratio 2.2
Days sales outstanding 78.0 days
Inventory turnover 4.4
Fixed asset turnover 6.4
Operating profit margin 11.9%
Net profit margin 6.1%
Return on assets 8.8%
Return on equity 13.7%
Debt ratio 35.5%
Times-interest-earned 9.3X
Payout ratio 41.4%

Use the following data to compute the comparable financial

ratios for next fiscal year. Has the firm's financial
position changed?

Current assets
Cash and short-term investments $ 14,657,000
Accounts receivable 71,873,000
Inventory 56,372,0001
Plant and equipment 26,881,000
Long-term investments and other assets 20,606,000
Total assets $190,389,000

Current liabilities $ 37,481,000

Long-term debt 17,895,000

Equity 135,013,000
Total liabilities and equity $190,389,000

Sales $254,553,000
Cost of goods sold 149,903,000
Selling, administrative, and other expenses 69,609,000
Earnings before interest and taxes 35,041,000
Interest 2,529,000
Taxes 13,972,540
Net income $ 18,540,000

Earnings per share $4.13

Dividends per share $1.80
1
Average inventory = $56,530,000
8. The inventory turnover for an industry is 6 (every two
months) but Slow Corp. turns over its inventory 4 times a year
(every three months). If annual sales are $1,000,000 and the
interest cost to carry inventory is 12 percent, what is the
potential savings in interest expense if the firm achieves the
industry for the turnover of its inventory?

9. What is the debt/net worth ratio and the debt to total

assets ratio for a firm with total debt of $600,000 and
equity of $400,000?

10. If the industry average days sales outstanding is 65 days

and a firm with sales of $1,034,550 has receivables of
$268,700, how much in interest expense could the firm save if
the receivables turn over as quickly as the industry average
and the cost of carrying the receivables is 9%?
SOLUTIONS TO THE PROBLEMS

1. a. $50 a share

b. $25 a share

c. $200 a share

2. a. Cash $10,000,000
Total assets 80,000,000
Common stock (10,000,000 20,000,000
shares outstanding, $2 par)
Additional paid-in capital 5,000,000
Retained earnings 15,000,000

b. Cash $30,000,000
Total assets 100,000,000
Common stock (40,000,000 20,000,000
shares outstanding, $.50 par)
Additional paid-in capital 5,000,000
Retained earnings 35,000,000

c. Cash $30,000,000
Total assets 100,000,000
Common stock (10,500,000 21,000,000
shares outstanding, $2 par)
Additional paid-in capital 14,000,000
Retained earnings 25,000,000
3. Firm XYZ
Balance Sheet for the Period Ending December 31, 20XX
Assets
Current assets
Cash and marketable securities $10,000
Accounts receivable $32,000
Less allowance for doubtful
accounts (2,000) 30,000
Inventory
Finished goods 30,000
Work in process 5,000
Raw materials 7,000 42,000
Total current assets $82,000

Long-term assets
Plant and equipment $100,000
Less accumulated
depreciation (30,000) 70,000
Land 10,000
Total long-term assets $80,000

Investments $ 10,000
Total assets $172,000

Liabilities and Stockholders' Equity

Current liabilities
Accounts payable $10,000
Accrued wages 11,000
Bank notes 15,000
Accrued interest payable 4,000
Accrued taxes 1,000
Total current liabilities $41,000
Long-term debt $15,000
Total liabilities $56,000

Stockholders' equity
Common stock ($1 par value; 20,000
shares authorized; 10,000 shares
outstanding) $10,000
Paid-in capital 20,000
Retained earnings 86,000
Total stockholders' equity $116,000

Total liabilities and stockholders' equity $172,000

4. Determination of the firm's earnings per share:
Sales $100,000
Cost of goods sold 60,000
Gross profits on sales 40,000
Selling and administrative expenses 15,000
Operating income 25,000
Interest expense 5,000
Interest earned 2,400
Earnings before taxes 22,400
Taxes 5,600
Earnings available to stockholders $16,800

Number of shares outstanding 10,000

Earnings per share $1.68

5. Statement of Changes in Financial Position

for the Period Ending December 31, 20XX
Operating activities
Net income $16.7
Depreciation 56.0
Decrease in accounts receivable 6.1
Increase in inventory (15.2)
Increase in accounts payable 13.6
Decrease in income taxes payable (5.0)
Net cash provided by operating activities $72.2

Investment activities
Increase in plant (91.0)
Net cash used in investing activities ($91.0)

Financing activities
Proceeds from sale of long-term debt 55.1
Payments on long-term debt (10.8)
Dividends (14.8)
Repurchase of stock (5.6)
Sale of stock 0.4
Net cash provided by financing activities $24.3

Cash at beginning of the year $1.1

Cash at the end of the year $6.6

The firm's cash position has increased, but that does not mean
the firm is more liquid since inventory and accounts payable
increased while accounts receivable declined. You should also
note that the firm increased its investment in plant by using
the cash generated through depreciation and the issuing of new
long-term debt. The earnings and sale of stock did not cover
dividends and stock repurchases. This indicates that the firm
is more financially leveraged.
6. Ratio analysis of financial statements:
Current ratio:
Current assets/Current liabilities
$82,000/$41,000 = 2

Acid test (quick ratio):

(Current assets - inventory)/Current liabilities
($82,000 - 42,000)/$41,000 = .976

Inventory turnover:
Sales/Average inventory
$100,000/[($42,000 + 40,000)/2] = 2.4
or
Cost of goods sold/Average inventory
$60,000/[($42,000 + 40,000)/2] = 1.5

Receivables turnover:
Annual credit sales/Accounts receivable
$90,000/$30,000 = 3
or
Annual sales/Accounts receivable
$100,000/$30,000 = 3.3

Days sales outstanding (average collection period):

Receivables/ Credit sales per day =
$30,000/($90,000/360) = 120 days

Operating profit margin:

Earnings before interest and taxes/Sales
$25,000/$100,000 = 25%

Net profit margin:

Earnings after taxes/Sales
$16,800/$100,000 = 16.8%

Return on assets:
Earnings after taxes/Assets
$16,800/$172,000 = 9.8%

Return on equity:
Earnings after taxes/Equity
$16,800/$116,000 = 14.5%

Debt/Net worth ratio:

$56,000/$116,000 = 48.3%

Debt ratio:
 Debt/Total assets
$56,000/$172,000 = 32.6%

Times-interest earned:
Earnings before interest and taxes/Interest
$25,000/$5,000 = 5.0
 Times-interest earned (using net interest expense):
Earnings before interest and taxes/Interest
$25,000/($5,000 - 2,400) = 9.6

Strengths: The current ratio, acid test, and inventory

turnover are comparable to the industry averages. The
operating profit margin exceeds the industry average. In
general, the firm's financial performance is acceptable.

Weaknesses: There are two basic weaknesses. The first is the

slow collection of accounts receivable which take 120 days to
collect while the industry average is only 75 days. The firm
is also using more financial leverage than the average firm as
its debt ratio is 32.6 percent versus an industry average of
24 percent. This increased use of debt financing may be the
result of carrying too many accounts receivable. If the firm
were to collect its accounts receivable more rapidly, then it
could retire some of its debt financing and reduce the debt
ratio.

The increased use of debt financing could explain why the net
profit margin is below the industry average. Since the
operating profit margin is higher than the industry average,
the lower net profit margin cannot be explained by the firm's
operations. Either interest expense or higher taxes must be
the source of the lower net profit margin. If the lower net
profit margin is the result of higher interest expense, then
this is probably the result of carrying too many accounts
receivable.

7. Current ratio:
current assets = $142,902 = 3.8
current liabilities $37,481

Quick ratio:
current assets minus inventory = $86,530 = 2.3
current liabilities $37,481

Days sales outstanding (average collection period):

receivables = $71,873 = 102 days
sales per day $254,553/360

Inventory turnover:
sales = $254,553 = 4.7
 average inventory $56,530

Fixed asset turnover:

annual sales = $254,553 = 9.5
fixed assets $26,881
Operating profit margin:
earnings before interest and taxes = $35,041 = 13.8
sales $254,553

Net profit margin:

earnings after taxes = $18,540 = 7.2%
sales $254,553

Return on assets:
earnings after taxes = $18,540 = 9.7%
total assets $190,389

Return on equity:
earnings after taxes = $18,540 = 16.3%
equity $135,013

Debt ratio:
debt = $55,375 = 31.5%
total assets $190,389

Times-interest-earned:
earnings before interest and taxes = $35,041 = 11.5X
interest expense $2,529

Payout ratio:
dividends = $1.80 = 43.6%
earnings per share $4.13

The firm's liquidity position is virtually unchanged; but the

average collection period (days sales outstanding) has
deteriorated from 78 days to 101 days. Inventory turnover has
remained stable (4.7 versus 4.4).

The firm is currently turning over its fixed assets more

rapidly (9.5 versus 6.4). The increased fixed asset turnover
suggests that the firm decreased its fixed assets or
generated more sales for a given amount of fixed assets.

There has also been an improvement in profitability. Both the

operating and net profit margins are higher, and the return
on assets and return on equity are also higher.

Debt ratio declined slightly. Debt is now financing 31.5

percent of assets while previously debt financed 35.5 percent
of assets. Times-interest-earned has also slightly improved.
The payout ratio rose from 41.4 percent to 43.6 percent.
Since the firm's profitability increased, this suggests that
the management raised the cash dividend. One implication of a
higher the dividend is that management expects the increased
profitability to be maintained. Managements often increase
dividends only if they anticipate that increased
profitability will be sustained.
8. The current level of inventory is
Inventory turnover: Sales/Average inventory
1,000,000/X = 4
X = $250,000.

The level of inventory implied by the industry average is

Inventory turnover: Sales/Average inventory
1,000,000/X = 6
X = $166,667.

The potential reduction in inventory:

$250,000 - 166,667 = $83,333.

The potential savings in interest expense (if the firm can

achieve the industry average for the turnover of its
inventory):
$83,888 x 0.12 = $10,000.

9. Debt/Net worth: $600,000/$400,000 = 1.5

Debt ratio (Debt/Total assets):

$600,000/($600,000 + $400,000) = 0.6 = 60%

10. (This problem essentially repeats #8 but applies the

concept to receivables.) Desired receivables based on the
industry average:
65 = X/($1,034,550/365)
X = $184,235

Reduction in receivables: $268,700 - $184,235 = $84,465

Reduction in interest expense: 0.09 x $84,465 = $7,602