Essay Part 2

2020
CMA US PART II
ESSAY QUESTIONS AND ANSWERS

PROF. RAVI GUPTA
1|CMA (Part II) Prof. Ravi Gupta Essay Questions

Index
Section Name No. of Page
Cases Number
A Financial Statement 1 03-07
Analysis
B Corporate Finance 5 07-15
C Decision Analysis 6 16-29
D Risk Management 1 29-31
E Investment 9 31-52
Decisions
F Professional Ethics 2 52-58

Section A – Financial Statement Analysis
Case- 1
The accounting staff of CCB Enterprises has completed the preparation of financial statements for the 20X5
calendar year. The Statement of Income for the current year and the Comparative Statement of Financial
Position for 20X5 and 20X4 are reproduced below.
The accounting staff calculates selected financial ratios after the financial statements are prepared. Average
balance sheet account balances are used in computing ratios involving only balance sheet items. The ratios have
not been calculated for 20X5. Financial ratios that were calculated for 20X4 and their respective values are as
follows.
• Times interest earned 5.16 times

• Return on total assets 12.5%
• Return on equity 29.1%
CCB Enterprises
Statement of Income
Year Ended December 31, 20X5
($000 omitted)
Revenue:
Net sales $800,000
Other 60,000
Total revenue $860,000
Operating expenses:
Cost of goods sold $540,000
Research and development 25,000
Selling and administrative 155,000
Total operating expenses $720,000
Earnings before interest and taxes (EBIT) $140,000

Interest 20,000
Earnings before income taxes (EBT) 120,000
Income taxes 48,000
Net income $ 72,000
CCB Enterprises Statement of Financial Position

December 31, 20X5 and 20X4
($000 omitted)
20X5 20X4
Assets
Current assets:
Cash and cash equivalents $ 2,000 $ 1,000
Available for sale marketable securities 24,000 20,000
Receivables, less allowance for doubtful accounts ($1,100 in

48,000 50,000
20X5 and $1,400 in 20X4)
Inventories, at lower of FIFO cost or market 65,000 62,000
Prepaid items and other current assets 5,000 3,000
Total current assets $144,000 $136,000
Other assets:
Long-term investments $106,000 $106,000
Deposits 10,000 8,000
Total other assets $116,000 $114,000
Property, plant and equipment: $12,000 $12,000

Land
Buildings and equipment, less accumulated depreciation

268,000 248,000
($126,000 in 20X5 and $122,000 in 20X4)
Total property, plant and equipment $280,000 $260,000
Total assets $540,000 $510,000
Liabilities and Stockholders’ Equity
Current liabilities:
Short-term loans $22,000 $24,000
Accounts payable 72,000 71,000
Salaries, wages and other 26,000 27,000
Total current liabilities $120,000 $122,000
Long-term debt 160,000 171,000
Total liabilities $280,000 $293,000
Stockholders’ equity:
Common stock, at par $44,000 $42,000
Paid-in capital in excess of par 64,000 61,000
Total paid-in capital $108,000 $103,000
Retained earnings 152,000 114,000
Total stockholders’ equity $260,000 $217,000
Total liabilities and stockholders’ equity $540,000 $510,000

A. Explain how the use of financial ratios can be advantageous to management.
B. Calculate the following financial ratios for 20X5 for CCB Enterprises (round your answer to three
decimal places).
1. times interest earned

2. return on assets
3. return on equity
4. debt to equity ratio
5. current ratio
6. quick (acid test) ratio
Answers:
A. Among the Management accounts’ responsibilities is the measurement of economic events and
transactions and the communication of information about them to interested parties including
management. Financial ratios are a part of this communication process that includes analysis,
interpretation, and evaluation of the financial statements, Ratios display a relationship between
various elements of financial data and are used to assist management in interpreting and explaining
financial statements and can be effective tools in evaluating a company’s liquidity, debt positions and
profitability. Financial ratios are an important part of evaluating a company’s past performance and are
useful in projecting its financial future.
B.
1. Times interest earned = EBIT ÷ Interest Expenses

= $140,000 ÷ $20,000 = 7 times
2. Return on Assets = Net Income ÷ Average assets

= $72,000 ÷ ($540,000 + $510,000) ÷2 = 13.7%
3. Return on Equity = Net Income ÷ Average equity

= $72,000 ÷ ($26,000 + $217,000) ÷ 2 = 30.2%
4. Debt to equity ratio = Total liabilities ÷ Total equity

= $280,000 ÷ $260,000 = 1.077
5. Current ratio = Current assets ÷ Current liabilities

= $144,000 ÷ $120,000 = 1.2

6. Quick (acid-test) ratio = Cash + Marketable securities + net receivables ÷ Current liabilities
= $2,000 + $24,000 +$48,000 ÷ $120,000 = 0.617
Section B – Corporate Finance

Case- 2
Sentech Scientific Inc., a manufacturer of test instruments, is in contract negotiations with the labor union that
represents its hourly manufacturing employees. Negotiations have reached an impasse, and it appears that a
strike is imminent. The controller has called the general accounting manager into his office to discuss liquidity
issues if and when a strike does occur.
The controller asks the accounting manager to recommend measures to assess liquidity if a strike were to occur.
Although some of the nonunion employees could probably produce test instruments during a strike, the
controller would rather be conservative and assume no shipments during this time frame. Since the customers
may go to other sources to obtain the products they need during a strike, cash receipts for current outstanding
amounts owed by customers may not be paid on a timely basis.
A. Define liquidity and explain its importance to Sentech.

B. Identify three measures that could be used to assess liquidity and explain how to calculate these
measures.
C. Determine which liquidity measure identified above would best fit the controller’s requirements, and
explain why. Include in your discussion the reasons why the other measures would not be as
appropriate.
D. Identify and describe three different types of short-term credit that Sentech could use to finance its
operations during a strike.
Answers:
A. Liquidity is the ability of an assets to be converted into cash without significant price concessions.
Liquidity is important to sentech because current obligations will continue if there is a strike.
Understanding the company’s ability to meet its obligations even if normal – and foe how long- it could
weather a strike. Lack of liquidity can limit a company’s financial flexibility, making it unable to take
advantage of discounts and other profitable opportunities. Liquidity problem can also lead to financial
distress or bankruptcy.
B. Measures of liquidity include the following.
• Current ration: Current assets/current liabilities

• Quick ration (or acid-test ratio): (cash + marketable securities + net accounts receivable) ÷
Current liabilities. The quick ratio excludes inventory and prepaid expenses from cash
resources.
• Cash ratio: (cash and cash equivalents + marketable securities) ÷ Current liabilities only cash
and securities that are easily convertible into cash are used.
• Net working capital: Current assets – Current liabilities
• Net working capital ratio: Net working capital ÷ Total assets
• Accounts receivables: 365 ÷ Account receivable turnover ration
• Inventory turnover: Annual cost of goods sold ÷ Average inventory
• Days sales in inventory: 365 ÷ inventory turnover ratio
C. Based on the parameters set down by the controller, either the quick ration or the cash ratio
could be best. The reason that these ratios are best is because they focus on the most liquid
assets, excluding prepaid expenses and inventories. |During a sticker inventories would not be
a source of cash. The cash ratio excludes receivable as well, and would be the most conservative
measures. The cash ratio would reflect the fact that the collection of receivable would be
slowed during a strike.
D. Types of short-term credit includes:
• Short-term loans- borrowing from banks for 1 year or less

• Trade credit – borrowing from suppliers by delaying payment
• Commercial paper – only available to large credit-worthy business
• Line of credit – can borrow up to a certain limit from bank without asking.
Case- 3
Han Electronics Inc. is an electronics retailer with a fitness equipment retailer subsidiary. Han is a mature
company with declining sales while the subsidiary is growing and profitable. The management of Han is
considering several strategic options for the company as a whole. They considered purchasing additional
companies to continue to diversify their product mix, or split out some or all of the subsidiary into a
separate company so that each company could go in a different direction. Ultimately, the concern is that
Han is failing. Management wants to maximize shareholder value, turn the company around, and continue
as a going concern.
A. 1. Define mergers and acquisitions.

2. Does this scenario describe a merger or an acquisition?
3. Identify three possible synergies or benefits of mergers and acquisitions.

B. 1. Identify and describe the following two types of divestitures: spin-offs and equity carve-outs.
2. Identify whether either of these divestiture types is described in the scenario above.
Answers
A. 1. A merger is the combination of two or more companies in which only one firm survives as the legal
entity. An acquisition occurs when one company acquires another as part of its overall business
strategy.
2. the scenario describes a potential strategic acquisition as management was hoping to work on
product mix.
3. Some of the synergies of a business combination are the economies realized where that performance
of the combined firm exceeds that of its previously separate parts. There are economies of scale where
the benefits of size cause the average unit cost to falls as volume increases. Acquisitions can increase
sales, market share, or help a company gain market dominance. There may be other marketing and
strategic benefits, or the acquisitions might bring technological advance to the product table, or it may
fill a gap in the product line, which would enhance sales made throughout the firm. It may be possible
for duplicate facilities to be eliminated after a merger or departments like marketing, accounting,
purchasing, and other operations can be consolidated. The sale force may be reduced to avoid
duplication of effort in a particular territory. The companies may be able to concentrate a greater
volume of activity into a given facility and into a given number of people to have a more efficient
unitization of resources.
B. 1. A spinoff is a form of divestiture resulting in a subsidiary of division becoming an independent

company’s shareholders on a pro-data bases. An equity carve-out is a public sale of stock in a
subsidiary in which the parent usually retains majority control. Only the spinoff is described in the
scenario above.
2. If Han Electronics Inc. were to decide to split the subsidiary off into its own separate company, it
would be a spinoff.
Case- 4
The Gershenfeld Foundation was established 25 years ago to encourage, promote, and support research in the
physical sciences. A wide range of industrial corporations contribute money in support of the foundation’s
work. The foundation has awarded research grants at a rate commensurate with its contributions and portfolio
earnings.

Gershenfeld’s contributions have increased significantly the past few months. The results of the foundation’s
recent fund drive exceeded the expectations of the Board of Trustees. New research grants are being reviewed
and evaluated, but a final decision on which grants to fund and the amount of funding will not be made for at
least 60 days. Thus, Gershenfeld has an excess cash position that is expected to continue for two months.
The Board of Trustees has instructed the foundation’s Executive Director to invest the excess cash during this
interim period. The Executive Director has been instructed to earn the highest possible yield while maintaining
marketability and safety of principal. The types of investments that the Executive Director is considering for the
use of $3.5 million of excess cash are (1) certificates of deposit, (2) U.S. treasury bills, and (3) preferred stock of
domestic corporations.
A. Define each of the following financial instrument characteristics and explain the effect each has on
the yield of investments.
1. Default risk.
2. Marketability.
3. Maturity.
B. Evaluate each type of investment being considered by Gershenfeid’s Executive Director in terms of
default risk, marketability, and maturity.
C. Discuss the suitability of each type of investment being considered by the Executive Director for
Gershenfeld Foundation’s particular situation.
Answers
A.
1. Default risk the probability of a security issuer being unable to meet its contractual obligations of
interest and principal payments. A greater default risk increases the yield because the investor is paid
a premium for taking the default for taking the default risk
2. Marketability of a security is the ability to buy and sell the security on a secondary market and relates
to the owner’s ability to convert it into cash. A lower marketability increases the yield because the
investor is paid a premium for the lack of market ability.
3. Maturity is the length of time remaining until a security is redeemed by the original issuer. A longer
maturity means an investor has a greater exposure to risk. This risk increases the yield.
10 | C M A ( P a r t I I ) Prof. Ravi Gupta Essay Questions

B.
1. Certificate Deposit:
Default risk: The risk of the issuing bank failing, a probability that is low in most cases.
Marketability: Negotiable CDs issued by top money center banks are marketable in the national money
markets. Other negotiable CDs may have a poor secondary market.
Maturity: Original maturities are short-term and generally range from 30 days to one year.
2. U.S Treasury Bills:
Default risk is negligible because the bills are guaranteed by the U.S governments.
Marketability: The market activity is excellent and the transaction costs involved in their sale in the
secondary market are small.
Maturity: Treasury bills are auctioned weekly by the treasury with short-term maturities of 3 months, 6
months, and one year.
3. Preferred Stock Domestic Corporation:
Default risk preferred stock does not have default risk as such, because the preferred stock investor does
not have to be repaid by the company. However, a company issuing preferred stock can declare bankruptcy
and be liquidated. preferred stockholders would have priority over common stock holders in a bankruptcy,
but there is no guarantee that preferred stockholders would receive their invested funds back.
Marketability: Marketability of preferred stock is very good for a listed issue. The realized price dimension
of marketability is not as good because of the volatility of preferred stock prices.
Maturity: Preferred stock has no maturity.
C Certificate of deposit (CDs) are suitable investment for Greshenfeld in its situation. The common
denomination is $100,000, so its appeal is mostly to large investors such as Greshenfeld. CDs carry an
acceptable default risk and can be purchased with the desired maturity of two months. Yield on CDs are
greater than those on U.S treasury bills.
U.S treasury bills also are a suitable investment for Greshenfeld in its situation. They are the most
conservative of the three types of investments being considered, having the lowest default risk and
greatest marketability. However, the yield on U.S Treasury bills less than the yield on CDs.

Preferred stock of domestic corporation is not suitable investment for Greshenfeld in this situation. Such a
stock purchases is generally considered a long-term investment
Case- 5
Mednovation Inc. has developed a medical device to be marketed to medical facilities. The Board of
Directors recently approved the proposal to upgrade existing production equipment and facilities for the
new product. The project calls for extra financing either through debt or equity. In order to make a proper
financing decision, management is interested in measuring the overall cost of capital through the following
possible instruments.
• Issue common stock: Common stock is currently trading at $21 per share. The firm is expected to pay cash
dividends of $3.60 per share next year and will continue to remain at the same payout level. The flotation
costs are expected to be $3 per share. The stock price is expected to rise to $22 per share.
• Issue preferred stock: Mednovation has $150 par value preferred stock with a current market price of
$120 a share. The company currently pays an annual dividend of $20 per share.
• Issue bonds: Newly issued 20-year bonds can be sold at a par value of $1,000 with a 15% coupon rate.
The firm has a 40% marginal income tax rate.
A. Define and explain the concept of cost of capital.
B. Calculate the cost of capital for Mednovation raised through common stock, preferred stock, and
debt. Show your calculations for each instrument.
C. Identify and describe one advantage and one disadvantage to Mednovation of raising capital through
common stock, preferred stock and debt, respectively.
D. Calculate Mednovation’s weighted average cost of capital, assuming the company decided to raise
capital using the following weights: 25% common stock, 30% preferred stock and 45% bonds. Show
your calculations.
E. Define and explain the two types of public offering. Which type of offering can Mednovation use to
raise capital through common stock?
Answers:
A. Cost of capital refers to the opportunity cost of capital. A company’s cost of capital is a composite of
the cost of various sources of funds comprising a company’s capital structure. It is the minimum rate

of return that must be earned on new investments that will not dilute the interests of the
shareholders.
B. Common stock: $3.6 / (21-3) = 20%
Preferred stock: $20/120 = 16.7%
Debt: 15% (1-40%) = 9%
C. The benefit if raising cash in the form of equity and stock offerings Is that it provides a wider range of
potential cash inflow. By offering the public the ability to invest in the company, Mednovation has more
capital potential opportunities for cash inflow than from banks offering loans. The ease of raising the
capital also comes with the disadvantage of additional regulation and requirements necessary to make
the intimal public offering. It is also costlier to raise capital through equity offerings as there are for
taking on debt. Another disadvantage is the dilution affect. Common stockholders having voting rights
in the company and new stockholders will dilute the current stockholders voting power.
Preferred stock is similar to debt in that it has a dividend, like the coupon payment for bonds, that is
paid our before common stock dividends. Preferred stock holders also have rights to assets if the
company liquidates before common stockholders but after bond holders.
Preferred stock is more expensive than debt but cheaper than common stock. The downside to both
preferred stock and common stock is that if dividends are paid, they are not tax deductible like coupon
payments for bonds.
The form of raising capital involving debt has the benefit of taking the interest accrued on the debt as
a tac deduction. By incurring debt and using the interest to reduce taxable income, Mednovation will
be able to shield itself from extra taxes and be able to save cash in the form of reduced tax payments.
One potential disadvantage is that taking on too much debt may be negative signal to lenders and
investors who may be debt to equity ratio which may be used as to deny additional loans in the future
if it is too heavily weighted rearguing debt.
D. 20%*25% + 16.7%*30% + 9%*45% = 5% + 5% + 4% = 14%
E. There’re two types of public offerings: Initial public offering and secondary public offering. Initial public
offering refers to a company’s first public issue of common stock.
Secondary public offering refers to the issuance of new stock for public sale from a company that has
already made its initial public offering.
Mednovation can use secondary public offering to raise capital since it already has common stock
trading.

Case -6
APEX Corp. is a midsize retail company selling home appliances. APEX faces competition from large national
chains as well as local retailers and needs to raise money to finance its expansion into new markets. The
company is currently operating at breakeven but believes that the expansion will help it become more
profitable. Based on the company’s analysis, it plans to open up to ten new retail locations without adding
costs to its human resources, accounting, information technology and legal departments. Since the
company cannot fund the expansion through operations, it is considering financing options such as issuing
more common stock, creating a class of preferred stock, or issuing bonds, convertible securities, or
warrants.
A. Define operating leverage and describe how the operating leverage created by the expansion will
affect the company’s return and business risk.
B. Define financial leverage
C. Define and identify two characteristics of common stock and preferred stock.
D. Describe the maturity, par value, and coupon rate for a bond.
E. Identify and explain one advantage and one disadvantage of raising capital through common stock,
preferred stock, and bond.
Answer:
A. Operating leverage is the use of fixed operating costs by the firm to increase profitability. Operating
leverage affects the level and variability of the firm’s after-tax earnings. And hence the overall risk
and return of the firm. Operating leverage is present any time a firm has fixed operating costs than
don’t change as volume changes. A change in the volume of sales results in a more than proportional
change in operating profit.
In this scenario, if the company opens up more locations, they will have an increase in sales without
an increase in the fixed costs of the HR, IT, Accounting and legal department, so these fixed costs
are leveraged across more locations and should create a higher return =, which lowers the firm’s
risk.
B. Financial leverage is similar to operating leverage in that it uses fixed costs to increase profitability,
by borrowing or undertaking long-term leases, the company is committed to paying these fixed
financing costs. But if operating profits (e.g. EBIT) are high enough to permit debt service or lease
payments, remaining operating profits flow to shareholders. The shareholders have less of their
money at stake, as some of the investment is paid for borrowed money or leased. This, the ROE is
high. But if operating is not enough to cover debt service or lease payments, the lenders can take
control, wiping out the shareholders.

C. Common stocks are securities that represents the ultimate ownership and risk position in a
corporation. Their liability is restricted to the amount of their investment. In the event of liquation,
these stockholders have a residual claim, on the assets of the company after the claim of all
creditors and preferred stockholders are settled in full. It has no maturity date, and shareholders
can liquidate their investments by selling their stocks in the secondary markets. Common stock
dividend is not foxed or guaranteed, it is discretionary of the company strategy. Common stock
dividend is not tax deductible as interest or lease payments.
Preferred stock is a hybrid form of financing, combining features of debt and common stock. In the
event of liquation, preferred stockholders. Preferred stock carries a stipulated dividend: the actual
payment of a dividend is a discretionary rather than a fixed obligation of the company. The
maximum return to preferred stockholders do not share in the residual earnings of the company.
Most preferred stock is held by corporate investors.
D. A bond is a long-term debt instruments with a final maturity generally being 10 years or more. The
maturity is the time when the company is obligated to pay the bondholders the par value of the
bond.
The par value is the amount to be paid to the lender at the bond’s maturity. Par value is also called
face value or principal. Most bonds pay interest that is calculated based on the bonds’ par value.
The coupon rate is the stated rate of interest on a bond. The indenture is the legal agreement, also
called the deed of trust, between the corporation issuing bonds and the bondholders, establishing
the terms of the bond issue and naming the trustee.
E. Common stock does not have a maturity date or require a regular interest payment. However, the
cost of capital of common stock is generally higher than that of a bond, and the current
stockholders’ voting power will be diluted. If the company is not publicly traded, an initial public
offering is expensive, complex and time-consuming, and it will be subject to more regulations.
Preferred stock does not have a maturity date and will not dilute the current shareholders’ voting
power. However, the cost of capital of preferred stock is generally higher than that of a bond and
is not as attractive to investors.
Bonds generally have a lower cost of capital and have tax benefits on interest payments. However,
making regular interest payments can be a burden to the company a there might be a bond
covenant which prohibits the issuer from undertaking certain activities or requires the issuer to
meet specified requirements.

Section C – Decision Making
Case- 7
OneCo, Inc. produces a single product. Cost per unit, based on the manufacture and sale of 10,000 units per
month at full capacity, is shown below.
Direct materials $ 4.00
Direct labor 1.30
Variable overhead 2.50
Fixed overhead 3.40
Sales commission 0.90
$12.10
The $0.90 sales commission is paid for every unit sold through regular channels. Market demand is such that
OneCo is operating at full capacity, and the firm has found it can sell all it can produce at the market price of
$16.50.
Currently, OneCo is considering two separate proposals:
• Gatsby, Inc. has offered to buy 1,000 units at $14.35 each. Sales commission would be $0.35 on this
special order.
• Zelda Productions, Inc. has offered to produce 1,000 units at a delivered cost to OneCo of $14.50 each.
A. What would be the effect on OneCo's operating income of each of the following actions?
1. Acceptance of the proposal from Gatsby, but rejection of the proposal from Zelda.
2. Acceptance of the proposal from Zelda, but rejection of the proposal from Gatsby.
3. Acceptance of both proposals.
B. Assume Gatsby has offered a second proposal to purchase 2,000 units at the market price of $16.50,
but has requested product modifications that would increase direct materials cost by $0.30 per unit and
increase direct labor and variable overhead by 15%. The sales commission would be $0.35 per unit.
1. Should OneCo accept this order? Explain your recommendation.

2. Would your recommendation be different if the company had excess capacity? Explain your answer.
C. Identify and describe at least two factors other than the effect on income that OneCo should consider
before making a decision on the proposals.
Answers:
A. The cost to produce the units is irrelevant, because OnceCo can sell all that it produces at a market price
of $16.50. The net realizable value per unit is $15.50 ($16.50- $.90 sale commission)
1. The option would decrease net income by $1,600. The net realizable value per unit sold to Gatsby
is $14.00 ($14.35 - $0.35 sale commission). In order to supply Gatsby, OnceCo would be displacing
sale in the regular market having a NRV of $15.60. That reduction of $1.60 per unit multiplied by
1,000 units would decrease net income by $1,600.
Alternate solution: Normal profit per unit is $4.40 ($16.50 - $12.10). The profit per unit sold to
Gatsby is $2.80 ($14.35-$11.55). Gatsby cost is ($11.55 ($4.00 + $1.30 + $2.50 +$3.40 + $0.35). The
difference of $1.60 per unit ($4.40 - $2.80) * 1,000 units would decrease net income by $1,600.
2. The second option would increase net income by $1,100. The extra units could be sold in the regular
market at a NRV of $15.60 ($16.50 - $0.90 commission). The cost is $14.50. Thus, profit would
increase by $1.10 per unit, or $1,100 in total.
Alternate solution: Selling price $16.50 – Cost to purchase from Zelda $14.50 – sale commission
$0.90 = profit per unit $1.10. Increase in net income $1.10 * 1,000 units =$1,100.
3. The third operation would decrease income by $500. Regular business is unaffected. As explained
above, the 1,000 units bought cost $14.50 each, and the NRV of the produced units sold to Gatsby
is $14.00. The net differences $0.50 per unit. $0.50 * 1,000 units = $500.00.
Alternate solution: Action 1 Decrease in Net Income of $(1,600) + Action 2 increase in Net Income
of $1,100 = Net decrease in Net income of $(500).
B.
1. Direct Material $4.00 + $0.30 = $4.30. Direct Labor $1.30 * 1.15 = $1.495.
Variable Overhead $2.50 * 1.15 = $2.875. Total cost $12.42 ($4.30 + $1.495 + $2.875 +$3.40 + $0.35).
profit per unit $4.08 ($16.50 - $12.42). Market profit $4.40 ($16.50 - $12.10). Decrease in net income
($4.08 - $4.40) = $(0.32) * 2,000 = $(640) decrease. Do not accept proposal.
2. If there is excess capacity, accept the proposal. Revenue would contribute to fixed costs.
C. Other factors to consider are: the effect on market price/competition, effect on sales
force/commissions, quality of Zelda products, and follow-on Gatsby business. There may be other
considerations. Some other considerations are: impact on employees: reaction of customers.
Case- 8
Candice Company has decided to introduce a new product. The new product can be manufactured by either a
capital-intensive method or a labor-intensive method. The manufacturing method will not affect the quality
of the product. The estimated manufacturing costs for each of the two methods are as follows.

Capital- Labor-
Intensive Intensive
Raw materials $5.00 $5.60
0.5DLH@$12 0.8DLH@$9
Direct labor
= $6.00 = $7.20
0.5DLH@$6 = 0.8DLH@$6
Variable overhead
$3.00 = $4.80
Directly traceable
incremental fixed
$2,440,000 $1,320,000
manufacturing
costs
Candice’s market research department has recommended an introductory unit sales price of $30. The
incremental selling expenses are estimated to be $500,000 annually plus $2 for each unit sold regardless of the
manufacturing method used.
A. Calculate the estimated break-even point in annual unit sales of the new product if Candice Company uses
the
1. capital-intensive manufacturing method.
2. labor-intensive manufacturing method.
B. Determine the annual unit sales volume at which Candice Company would be indifferent between the two
manufacturing methods.
C. Candice’s management must decide which manufacturing method to employ. One factor it must consider is
operating leverage.
1. Explain operating leverage and the relationship between operating leverage and business risk.
2. Explain the circumstances under which Candice should employ each of the two manufacturing methods.
D. Identify the business factors other than operating leverage that Candice must consider before selecting the
capital-intensive or labor-intensive manufacturing method.

Answers:
A. Breakeven units = Total fixed costs ÷ Unit contribution margin
1. Capital-Intensive Method
Unit contribution margin: Selling price $30.00 – raw material $5.00 - direct labor $6.00 – variable
overhead $3.00 – variable selling $2.00 = unit contribution margin $14.00.
Break even units, capital-intensive method = $1,4440,000 + $5000,000 = $210,000
$14.00
2. Labor-Intensive Method
Unit contribution margin: selling price $30.00 - raw materials $5.60 – direct labor $7.20 – variable
overhead $4.80 – variable selling $2.00-unit contribution margin $10.40.
Breakeven units, labor-intensive method = $1,320,000 + $500,000 = $175,000

10.40
B. Candice Company would be indifferent between the two manufacturing method at the volume (X)
where total cost is equal.
Total variable costs, capital intensive method = $5.00 +$6.00 + $3.00 +$2.00 = $16
Total fixed costs, capital intensive method = $2,440,000 + $500,000 = $2,940,000
Total variable costs, labor intensive method = $5.60 + $7.20 + $4.80 + $2.00 = $19.60
Total fixed costs, labor intensive method = $1,320,000 + $500,000 = $1,820,000
$16X + $2,940,000 = $19.60X + $1,820,000
$1,120,000 = $3.60X
X = 311,111 units
C.
1. Operating leverage is the extent to which firm’s operations employ fixed operating expenses. The
greater the proportion of fixed expenses used to produce a product, the greater the degree of
operating leverage. This, Candice’s capital-intensive manufacturing method utilize a greater degree
of operating leverage.
The greater the degree of operating leverage, the greater the change in operating income (loss)
relative to a small fluctuation in sales volume. Thus, there is a higher degree of variability in
operating income if operating leverage is high. The greater the operating leverage and the resultant
variability in operating income the greater the degree of business risk.
2. Candice should comply the capital- intensive manufacturing method if annual sales are expected to
exceed 311,111 units and the labor-intensive manufacturing method if annual sales are not
expected to exceed 311,111 units.
D. Candice must consider the following business factors other than operating leverage before selecting a
manufacturing method:
• Variability or uncertainty with respect to demand, both quantity and selling price.
• The ability to produce and market the new product quickly.
The ability to discontinue the production and marketing of the new product while incurring the least amount
of loss
Case – 9
The City of Blakston owns and operates a community swimming pool. The pool is open each year for 90 days
during the summer months of June, July, and August. A daily admission is charged to patrons of the pool. By
law, 10% of all recreational and sporting fees must be remitted to a state tourism promotion fund. The City
Manager has set a goal that pool admission revenue, after subtracting the state fee and variable costs, must be
sufficient to cover the fixed costs. Variable costs are assumed to be 15% of gross revenue. Fixed costs for the
three-month period total $33,000. The following budget for the pool has been prepared for the current year.
Adult admissions: 30 per day × 90

$13,500
days × $5.00
Student admissions: 120 per day ×

27,000
90 days × $2.50
Total revenue 40,500
State tourism fee 4,050
Net revenue 36,450
Variable costs 6,075
Fixed costs 33,000
Expected deficit $(2,625)
The City Manager is trying to determine what admission mix is necessary to break even and what actions
could be taken to eliminate the expected deficit.
A. Given the anticipated mix of adult and student admissions, how many total admissions must the pool
have in order to break even for the season?
B. Regardless of the admissions mix, what is the highest number of admissions that would be necessary
to break even for the season?
C. Regardless of the admissions mix, what is the lowest number of admissions that would be necessary
to break even for the season?
D. Explain how sensitivity analysis can be used in cost-volume-profit analysis.

Answers:
A. The contribution margin is 75% or 3.75 per adult admission, and $1.875 per student admission. The mix
is 20% adult (30 ÷ 150) and 80% student (120 ÷ 150). The weighted average contribution margin is:
WACM = (0.20 * $3.75) + (.80 * $1.875) = $2.25
The breakeven point is Fixed cost ÷ WACM
$33,000 ÷ $2.25 = 14,667 per season
100% - state fee of 10% - variable cost of 15%
B. The highest number even assumes that all admission are students:
$33,000 ÷ $1.875 = 17,600 per season
C. The lowest number to break even assumes that all admission is the adult rate:
$33,000 ÷ $3.75 = 8,800 per season
D. Sensitivity analysis can help the analyst model what the result would be if the assumptions does not
hold true. The analyst could change the sales price and calculate the new break-even point. The
analyst could change certain cost variables.
Case- 10
Kolobok Inc. produces premium ice cream in a variety of flavors. Over the past several years, the company has
experienced rapid and continuous growth and is planning to increase manufacturing capacity by opening
production facilities in new geographic areas. These initiatives have put pressure on management to better
understand both their potential markets and associated costs. Kolobok’s management identified three aspects
of their current operation that could affect the new market expansion decision: (1) a highly competitive ice
cream market, (2) the company’s current marketing strategy, and (3) the company’s current cost structure.
Total
Material Market Unit Boxes
Product Markup Materials Total Sales
& Labor adjustment Price Sold
& Labor
Vanilla $29.00 $20.00 $1.00 $50.00 10,200 $ 295,800 $ 510,000
Chocolate 28.00 20.00 7.00 55.00 12,500 350,000 687,500
Caramel 26.00 20.00 2.00 48.00 12,900 335,400 619,200
Raspberry 27.00 20.00 2.00 49.00 13,600 367,200 666,400
Total 49,200 $1,348,400 $2,483,100
Since the company began operations in 1990, Kolobok has used the mark-up approach for establishing prices
for six-gallon containers of ice cream. The product prices include the cost of materials and labor, a markup for
profit and overhead cost (a standard $20), and a market adjustment. The market adjustment is used to
appropriately position a variety of products in the market. The goal is to price the products in the middle of
comparable ice creams offered by competitors while maintaining high quality and high differentiation. Sales for
20X7 based on Kolobok’s mark-up pricing are presented below by product.
For the year 20X7, Kolobok’s before-tax return on sales was 7%. The company’s overhead expenses were
$500,000, selling expenses $250,000, administrative expenses $180,000, and interest expenses were $30,000.
Kolobok’s marginal tax rate is 30%.
Kolobok is considering replacing mark-up pricing with target costing and has prepared the table below to better
compare the methods. Kolobok tries to appeal to the top 30% of the retail sales customers, including
restaurants and cafes. In positioning Kolobok’s products, three dimensions are considered: price, quality, and
product differentiation. Accordingly, there are three main competitors in the market as follows.
Competitor A – Low cost, low quality, high standardization
Competitor B – Average cost, moderate quality, average differentiation
Competitor C – High cost, high quality, high differentiation
Kolobok
Competitor Competitor Competitor
Product Target
A Pricing B Pricing C Pricing
Prices
Vanilla $49 $55 $55 $53
Chocolate 50 53 56 53
Caramel 51 50
Raspberry 51 52 50
Kolobok has also been reviewing its purchasing, manufacturing, and distribution processes. Assuming that sales
volumes will not be affected by the new target prices, the company believes that improvements will yield a
$125,000 decrease in labor expense and a 25% reduction in overhead expense.
A. Define and compare the two alternative pricing methods: mark-up pricing and target costing.
B. Assuming that the sales volumes will not be affected by the new product pricing based on target
costing and that the process improvements will be implemented, calculate Kolobok’s before-tax
return on sales using the proposed target prices.
C. Recommend which pricing method (mark-up or target) Kolobok should use in the future and explain
why.

Answers:
A. The main difference between the two method of pricing is a different starting point for determining
product price. Mark-up pricing is based on existing costs and a desired return. The price is then
determined by adding the product cost and the desired mark-up. This method provides little
incentive to reduce costs as long as sales are profitable.
Using target costing, product prices are determined by reviewing competitive pricing and setting
prices according to market strategies and positioning. Target costing moves from the existing
market prices to the process of managing the product costs in order to earn a desired return. Target
costing motivates process improvements. The process is intended to increase or maintain sales
while increasing product profitability by reducing product costs through the elimination non-value
added activities.
B. Calculate Earnings Before Taxes:

Sales revenue:
Vanilla: $53 * 10,200 = $540,600
Chocolate: $53 * 12,500 = $662,500
Caramel: $50 * 12,900 = $645,000
Raspberry: $50 * 13,600 = $680,000
Total sale revenue: $540,000 + $662,500 + $645,000 + $680,000 = $2,528,100
Expenses:
Material & labor: $1,348,400 * $125,000 = $1223,400
Overhead: $250,000
Administrative expenses: $180,000
Interest expenses: $30,000
Total expenses: $1,223,400 + $375,000 + $250,000 + $250,000 +$180,.000 +$30,000 = $2,058,400
Earnings Before Taxes: $2,528,100 - $2058,400 = $469,700
C. The preferable pricing method for Kolobok is target costing, as it is projected to significantly
increase the return on sales from 7% to 18.5% ($469,700 ÷ $2,528,100) while maintaining the
existing sales level. Target costing will also motivate management to improve internal processes to
reduce costs to further improve profitability, particularly for any product where the proposed target
price is lower than the previous price. This method will also force Kolobok to be continually aware
of the actions of its competitors and trends in the marketplace in order to make adjustments when
needed.

Case- 11
Super Sonic Company manufactures audio speakers. The average costs for the production of speakers are
summarized below.
The pricing calculations are based on budgeted production and sales of 33,000 units per year. The company has
invested $1,000,000 in this product and expects a return on investment of 12%. The markup rate on total cost
is 48%. A recent marketing research study reveals that due to increased competition the company must reduce
the selling price to $45 in order to maintain the same level of sales volume.
A. Calculate the original target selling price of the product. Show your calculations.
B. Using the market-based pricing approach, calculate the target cost per unit given the competitive target
price of $45. Show your calculations
C. Identify and explain one advantage and one disadvantage of cost-based pricing and market- based
pricing, respectively.
D. Define value engineering and explain how value engineering can help Super Sonic.
E. Identify and explain one reason why Super Sonic may want to set its selling price below $45.
Answer:
A.
Direct materials $10.00
Direct labor 20.50
Variable manufacturing overhead 1.50
Fixed manufacturing overhead 13.00
Unit product cost $45.00
Target selling price = $45.00 + (48% * $45.00) $66.60

Fixed manufacturing OH $429,000 ÷ 33,000 units = $13.00
B. Target revenue = 45*33,000 = 1,485,000

Less Target Return = 12%1,000,000 = 120,000
Target full (absorption) cost = 1,365,000
Target absorption cost per unit = 1,365,000 ÷ 33,000 = $41.36

C. Both cost plus and market-based pricing are long term pricing approaches. Under cost-plus approach, a
company determines the full absorption cost of the product and applies a markup percentage to cover
other operating cost plus a desired profit. The advantage is that the price is set at the level that will
cover the cost fully and generate the desired markup rate. The disadvantage of these pricing approaches
is that the price may be too high and not competitive. The company often faces the trade-off between
costs, markup and customer
reductions.
Market-based pricing starts with a target price. A target price is determined based on market factors
such as how much customers are willing to pay and their competitors’ prices for similar products.
Advantage-the estimated price will meet the market competition price expectation. Disadvantage-To
meet the target price, companies may face tremendous pressure to reduce cost. Companies may
sacrifice the quality of the product to meet the short-term goal of cost reduction. Determining a target
price can be difficult in a market where products are differentiated from one another.
D. Value Engineering is a systematic evaluation of all aspects of the product features and business process,
with the objective of reducing costs while satisfying customer needs. An important step in value
engineering is to identify value-added activities versus non-value-added activities. One of goals of value
engineering is to eliminate non-value-added costs and to increase the efficiency of value-added
activities. To manage and reduce cost, the company must place emphasis of cost management efforts
on the locked-in costs of the product in the design stage -the costs that have not been incurred but,
based on decisions of design already been made, will be incurred in the future (locked-in cost). Value
engineering also involves functional analysis. The company analyzes and gains understanding of the
technical and business aspects of the entire value chain to manage cost and look for room for
continuous improvement in efficiency and cost reduction.
E. Depending on the elasticity, a lower selling price may bring greater revenues. As unit sales increase,
the fixed costs can be covered by more contribution margin.
Case- 12
Buckeye Grain, a corn and wheat processing company, has decided to introduce a new product that can be
manufactured by either a capital-intensive method or a labor-intensive method. The method chosen will have
no effect on the quality of the finished product. Estimated costs for the two methods are as follows.

Buckeye Grain sells the new product at $60 per unit during its initial stage of product life cycle. The incremental
selling expenses are estimated to be $1,000,000 annually plus $4 for each unit sold, regardless of the
manufacturing method. Fixed costs are all directly traceable incremental costs.
When deciding which manufacturing method to use, the company’s management team take into account the
operating leverage.
A. Calculate the estimated breakeven point in annual unit sales of the new product if the company uses
the capital-intensive manufacturing method and labor-intensive manufacturing method, respectively.
Show your calculations.
B. Calculate the annual unit sales volume at which the company would be indifferent between the two
manufacturing methods. Show your calculations.
C. Explain how the level of sales can affect the company’s choice of manufacturing method.
D. Identify the four stages of the product life cycle.
E. Identify the pricing strategy that the company might use when the new product is in its second stage
of the product life cycle. Explain your answer.
F. Explain operating leverage and its relationship with business risk.
Answer:
A.
1. Unit contribution Capital-intensive Labor-intensive
margin
- Selling price $60.00 $60.00
- Raw materials 10.00 11.20
- Direct materials 12.00 14.40
- Variable overhead 6.00 9.60
- Variable selling 4.00 4.00
Contribution margin $28.00 $20.80
Capital-intensive Breakeven = ($4,880,000 + $1,000,000) ÷ $28.00 = 210,000 units
Labor-intensive Breakeven = ($2,640,000 + $1,000,000) ÷ $20.80 = 175,000 units
B. Indifference point occurs where total costs are equal

($60 - $28) X + $5,880,000 = ($60.00 - $20.80) X + $3,640,000
$7.20 X = $2,240,000
X= 311,111 units

C. Is sale are expected to be greater than 311,111 units, the capital-intensive method should be chosen as
each unit has a greater contribution margin and fixed costs have been covered. If sales are expected to
be less than 3111,111 units, Buckeye Gain should select the labor-intensive method as there is less
business risk.
D. The time span between the initial concept of a product or service and time when the entity no longer
produces the product. Stages are introduction, growth, maturity, and decline.
E. When selling a product in its growth stage, competitors might release the same product at a lower price,
or they might work on making the product netter, the company might need to work on getting more
customer. This could require more marketing and lowering the prices. The company might adopt a
competitive pricing strategy.
F. Operating leverage is the extent to which a firm’s operating expenses. The greater the proportion of
fixed expenses used to produce a product, the greater the degree of operating leverage. This, Buckeye
Gain’s capital-intensive method utilizes a greater degree of operating leverage. The greater the degree
of operating leverage. The greater the degree of operating leverage, the greater the change in operating
income relative to a small fluctuation in sale volume. The greater the operating leverage and the
resultant variability in operating income, the greater the degree of business risk.
Case- 13
NuCo Inc., a medical supplies manufacturing company, is developing a new product, which will compete with
similar products introduced within the last year. NuCo’s strategy has traditionally been to compete on price,
because of its ability to keep costs under control. For the new product, NuCo is planning a selling price lower
than the existing products, possibly appealing to a broader customer base. A financial analyst is determining
the selling price for the new product launch.
The company requires a 15% after-tax return on investment (ROI) and their effective income tax rate is 35%.
Forecasted data for the new product are shown below.

A. Using cost plus-based pricing, what selling price should be set for the new product? Show your
calculations.
B. Assume that the marketplace will accept a price of $200. Using market-based pricing, what target cost
would allow NuCo to reach their required 15% after-tax ROI? Show your calculations.
C. Identify and describe one way to reduce fixed costs, working capital, and direct labor hours per unit,
respectively.
D. Explain the difference between cost-based pricing and market-based pricing.
E. Define target pricing and identify the main steps in developing target prices and target costs.
F. Define and explain the role of price elasticity of demand in pricing decisions. Explain how the level of
elasticity affects the way changing prices can change total revenue.
Answer:
A. (2,500,000 + 750,000) * 0.15 = $487,500 =15% after-tax ROI
487,500 / 10,000 = $48.75 ROI per unit

48.75 / (1-0.35) = $75 before-tax ROI per unit
350,000 / 10,000 = $35 fixed cost per unit

$25 * 2 hours = $50 labor per unit
$3 * 25 pounds = $75 material per unit
$10 * 2 direct labor hours = $20 variable overhead per unit
$50 + $75 + $20 = $145 variable cost per unit
($75 before-tax ROI per unit + $35 fixed cost per unit + $145 variable cost per unit) = $255 selling price
B. Market based selling price –desired profit = target cost

$200 - $75 before - tax ROI per unit = $125 target cost
C. To reduce fixed costs: Reduce space, reduce S&A staff

To reduce working capital: Reduce inventory, receivables, increase terms from vendors
To reduce direct labor hours per unit: use cheaper workers, improve worker efficiency
D. Cost-based pricing starts with calculating the cost of producing a product or service and then
adding a profit factor to determine the selling price (cost base + markup = selling price). Market-based
pricing starts with determining a price that a product or service can be sold in the marketplace and then
subtracting the desired profit factor from that selling price to determine a target cost (market price –
desired profit = target cost). It is then the responsibility of engineers and designers to use value
engineering, continuous improvement and controls to produce the product at or below this maximum
cost.
The fundamental difference is the starting point. With a cost-based pricing approach, cost is a given
and it is the starting point. This differs from market-based pricing in which the market determines the
price and this price is the starting point. Ultimately with cost-
based pricing the product is put on the market with the hope that the price will be accepted. With
market-based pricing, cost is to be managed to allow for desired profit and a selling price that the
market has determined. Market based pricing can foster an environment of efficiency, cost control and
the elimination of non-value-added activities. Cost-based pricing generally does not provide this kind
of motivation for management to be continuously improving operations and reducing cost.
E. Target pricing is setting selling price for a product or service based on the value of the product or service
to the customer, constrained by competitor’s prices or similar items. Main steps in developing target
prices and target costs:
• Establish a target price in the context of market needs and competition.

• Establish the target profit margin.
• Determine the allowable cost that must be achieved.
• Calculate the probable cost of current products and processes.
• Establish the target cost.
• Implement cost reductions, e.g. life-cycle costing once production is under way.
F. Price elasticity of demand indicates how the demand for a given product will change based on a change
in price for that product. Price elasticity of demand = percentage change in quantity demanded /
percentage change in price.
A product is considered elastic if it has a price elasticity of demand that is greater than one. This means
the demand for the product is very sensitive to price movements.
A product is considered inelastic if it has a price elasticity of demand that is less than one. This means
the demand for the product is not sensitive to price movements. A product is considered to have unitary
elasticity if it has a price elasticity of demand that is one.
Elasticity is important to management in making pricing decisions because it identifies how pricing
changes can affect a firm’s total revenue. When demand is elastic, a change in price will cause total
revenue to move in the opposite direction. When demand is inelastic, a change in price will cause total
revenue to move in the same direction. When demand is unit elastic, total revenue will be unchanged
by a price change. If this company hopes to increase revenues by decreasing profits, it is assuming the
product is elastic.
Section D – Risk Management

Case- 14
Pearson Foods is the second largest company in the breakfast cereal and fruit juice markets. For the past five
years, Pearson’s profits have exceeded the industry average, and management has decided to pursue a plan for
growth. Two promising opportunities are being evaluated.

• Pearson’s first opportunity would be to enter the high energy, low-fat cereals market. This project
would entail developing new products using new or expanded facilities and would be financed out of
earnings and through a series of long-term debt offerings over the next two years. The debt offerings
would raise Pearson’s debt as a percent of total capital from 22% to 30% at the end of the two-year
period.
• The second opportunity would be to acquire Safin Bakery, a long established and well-known bread and
bakery goods company. The acquisition could be completed by the end of the calendar year and would
be financed by cash and long-term notes. The debt as a percent of total capital would rise to 40% by the
end of the calendar year. Safin Bakery would be merged into Pearson Foods but operate independently
as a separate division for two years. At the end of two years, Pearson would be able to consolidate the
administrative, financial, and operating functions.
Both projects meet the investment criteria established by Pearson’s management, and the Treasurer will be
preparing an evaluation of the two projects in terms of the financing differences, the impact on profitability,
and the operational and managerial problems.
A. As part of a risk assessment process, identify the strategic advantages and disadvantages of Pearson
Foods’ opportunity to use internal expansion by developing new products for the high energy, low-fat
cereals market.
B. As part of a risk assessment process, identify the strategic advantages and disadvantages of Pearson
Foods’ opportunity to use external expansion by acquiring Safin Bakery.
Answer:
A. The strategic advantages that Pearson Food could realize by expanding internally though the
development of new products for the low-fat, high-energy food market include the following.
• The new products complement the existing product line, creating operational efficiencies, and
brand loyalty.
• The company would incur less debt than if it purchases another company.
• The company could capitalize on the low-fat diet trend.
• The company has management know-how in the industry.
The strategic disadvantages that Pearson Foods could realize by expanding internally through the
development of new products for the low-fat high-energy food marketing include the following.
• New product development requires large outlays for research, new facilities, test marketing,
etc.
• New product development decreases cash availability.
• The increased debt ration could increase the firm’s risk, and thus its stock price is at risk.
• The company would incur the risk of product failure.
• It takes a long time to develop a new product and realize and profits.

B. The strategic advantages that Pearson Foods could realize by expanding externally through the
acquisition of Safin Bakery include the following.
• The acquisition would result in immediate, quantifiable earnings and cash flows.
• The company would acquire a complete company with a proven track record and established
markets.
• Managerial and technical expertise would already be in place.
• Safin’s established distribution channels could provide new markets for Pearson’s other
products.
• The addition of Safin would diversify Pearson’s product base.
• The acquisition could create synergies for both companies, accomplishing together what they
could not do alone.
• Safin could create new growth possibilities for Pearson’s employees.
The strategic disadvantages that Pearson Food could realize by expanding externally through the acquisition
of Safin Bakery include the following.
• In order to make the acquisition, the company would have to incur a large amount of debt,
which could impair its financial flexibility, debt rating and stock price.
• Pearson lacks knowledge and experience with Safin’s products.
Safin would have to be integrated with Pearson in two years – including the computer system, the
accounting system, and the culture.
An independent operation could lead to suboptimal decisions.
Section E – Investment Decision

Case- 15
Bell Company is a large diversified manufacturer organized into profit centers. Division managers are awarded
a bonus each year if the division exceeds profit goals. While division managers are generally given control in
operating their division, all capital expenditures over $500,000 must be approved by the home office. Bob
Charleson was recently appointed division manager of the Central Division.
Twelve months ago, Charleson’s predecessor, who has been fired, was able to convince the home office to
invest $700,000 in modern manufacturing equipment with an expected life of 5 years. Included within the
$700,000 investment was a special packaging machine at a cost of $200,000. This packaging machine has a 5-
year useful life and is being depreciated on the straight-line basis using a zero salvage value. Charleson has just
learned of a new packaging process that would save the Central Division $60,000 a year in packaging cost over
the 5-year life of the equipment. As a result of the introduction of new technology the current packaging
machine could be sold for $75,000. Acquisition and installation of the new packaging process equipment would
cost $210,000. Central Division’s cost of capital is 10% and it has an effective income tax rate of 40%. The new
equipment has a zero salvage value and is depreciated over five years on a straight-line basis.
A. Calculate the net present value of acquiring the new packaging process. Show your calculations.

B. From a financial standpoint, should Bell Company invest in the new packaging technology? Explain your
answer.
C. Identify and explain three non-financial or behavioral factors that could cause Charleson to change the
investment decision made in the previous question.
Answer:
A. The present value calculated as follows:

Year 0 cash flows:
New packaging process equipment: $(210,000) * 1.00 = $(210,000)
Cash received from sale of existing packaging equipment: $75,000 * 1.00 = $75,000
Tax benefit from loss on sale of old equipment:
Sale price $75,000
Book value of old equipment after one year’s depreciation: $200,000 – ($200,000 ÷ 5) = $160,000
Loss on sale of old equipment: $75,000 - $160,000 = $(85,000)
Tax benefit from loss on sale: $85,000 * 40% tax rate = $34,000
Year 1 through 5 annual cash flows, discounted as annuities:

Depreciation tax shield, new equipment, PV of an annuity @10% for 5 years: ($210,000 ÷ 5) * 0.40
* 3.791 = $63,689
Depreciation tax shield lost, old equipment, PV of an annuity @10% for 4 years: ($200,000 ÷ 5) *
0.40 * 3.170 = $(50,720)
Annual after-tax operating savings, PV of an annuity @10% for 5 years: $60,000 * (1 – 0.40) * 3.791
= $136,476
Net Present Value = $(210,000) + $75,000 + $34,000 + $63,689 + $(50720) + $136,476 = $48,445.
B. The net present value calculated using a discount rate of 10%, the firm’s cost of capital, is positive.
A positive NPV indicate that the project earns more than the firm’s cost of capital and thus should
be accepted.
C. Non-financial and behavioral factors that could cause the company to change the investment
decision made solely on the basis of financial terms include:
• Charleson’s bonus may be negatively affected by the decision to replace the packaging
equipment with the new technology, since the sale yields short-term accounting loss of
$85,000. Such a loss may cause the central division to miss its profit targets, and Charleson’s
to miss his bonus.
• What kind of warranty will the new equipment have? Since technology is new, there may
some risk of its not working reliably.

• There will be a learning curve therefore increasing training costs.
Case- 16
Grandeur Industries is currently in the process of reviewing capital budget submissions from its various
divisions. Grandeur uses the Capital Asset Pricing Model (CAPM) for a variety of purposes, including the
determination of benchmark investment returns. The company’s overall cost of capital is 16% and its beta value
is 1.2. The risk free rate is 4% and the expected return on the market is 14%. The following projects from
different divisions are under consideration and there is no capital rationing in effect.
Internal Rate of Project

Project
Return Beta
A 16% 1.4
B 18% 1.6
C 12% 0.7
D 17% 1.1
A.
1. Calculate the required return for all four projects. Show your calculations.
2. Which of the four projects under consideration should Grandeur accept? Support your decision.
B.
1. Define and explain beta.
2. Describe four factors that would impact the beta value that is chosen for use in evaluating a
project.
Answer:
A.
1. The Capital Asset Pricing Model (CAPM) when used in an investment analysis context postulates
that the return on an investment should be at least equal to the Risk-Free Rate plus a Risk Premium.
The Risk Premium is based on the risk (volatility) of the investment relative to the overall market
(as measured by Beta) times the incremental return on the market above the risk-free rate.
The CAPM allows firms (users) to assess the size of risk premium necessary to compensate for
bearing risk. It is a way to estimate the required rate of return on a security or investment. Once
the required return has been determining, it lets the user know whether the expected return from
the investment is sufficient to warrant acceptance of the investment.
The model is:
R = RF + β (RM – RF)

Where: R = Required rate of return
RF = Risk free rate of return
Β = Beta coefficient
RM = Market rate of return
Using the project’s beta’s to calculate risk-adjusted required rates of return for each project results in
the following required rates of return for each project. Ach project’s required rate of return is compared
with its IRR to determine whether the project should be accepted or rejected. If a project’s IRR is greater
than its risk-adjusted required rate of return, it should be rejected.
Project A: Required return = 4% + 1.4%(14% - 4%) = 18%
The project’s internal Rate of Return (IRR) is 16%, which is lower than the required rate of 18%, so the
project should be REJECTED.
Project B: Required Return = 4% + 1.6 (14% - 4%) = 20%
The project’s Internal Rate of Return (IRR) is 18%, which is lower than the required rate of 20%, so the
Project should be REJECTED.
Project C: Required Rate of Return = 4% +0.7 (14% - 4%) = 11%
The project’s Internal Rate of Return (IRR) is 12%, which is greater than the required rate of 11%, so the
project should be ACCEPTED.
Project D: Required Rate of Return = 4% +1.1 (14% - 4%) = 15%
The project’s Internal Rate of Return (IRR) is 17% which is greater than the required rate of 15%, so the
project should be ACCEPTED.
B.
1. Beta is measure of an investment’s volatility in relation to the market’s volatility. The beta of the
market as a whole is 1.0. A stock that increases and decreases to a greater extent than the market
has a beta that is greater than 1.0. A stock that increases and decreases to a lesser extent than the
market has a beta that is less than 1.0. High beta stocks are risker than low beta stocks because
they are Moe volatile, but they have potential for higher return and also for greater losses.
2. Factors that have an influence on the Beta value for a project include:
• The industry that the division undertaking the project is in and its risk characteristics.
• Experience the division has with similar projects, if any.
• Ability of the division to realize estimated returns on projects in the past.
• Strength of the management team of the division
• Level of competition expected.

• The geographical location of the project. Certain countries are riskier to operate in than
others.
• The degree to which the project involves new technology or unproven operating
conditions.
Case – 17
Orion Corp. is a logistics and transportation company. The finance director, John Kochar, is in the process of
evaluating a number of proposed capital investment projects. The following information relates to the firm’s
finances.
• Some years ago the firm issued 10,000 bonds, each with a face value of $1,000 and paying an annual
coupon rate of 9.2%. These bonds are now trading at $1,040 per bond. A coupon payment on these
bonds was made yesterday and the bonds mature next year.
• The firm has no other debt or preferred stock outstanding.
• The firm has 2,000,000 shares of common stock outstanding. The stock is currently selling for $14.80
per share and the firm is expected to pay a dividend of $1.48 per share next year. The dividend is
expected to grow at a constant rate of 4% per year in the foreseeable future.
• The firm’s corporate tax rate is 30%.
Kochar is reviewing the capital investment projects shown below. All projects are in Orion’s usual line of
business and are being considered independently of each other. The following information is available. (Note
that the net present values of the projects are estimated using the weighted average cost of capital.)
Project Initial Outlay IRR NPV
A $450,000 17.0% $18,800
B 128,000 19.5% 2,300
C 262,000 16.2% 9,800
D 180,000 10.5% (7,000)
E 240,000 16.5% 22,500
F 160,000 11.1% (900)
The firm is also evaluating another proposed capital investment, Project X, that is in a completely different line
of business from Orion’s usual operations. The project is expected to be financed from the existing capital
structure and does not fall within any capital rationing restrictions. The following forecasted net after-tax cash
flows relate to Project X.

Year 0 Year 1 Year 2 Year 3 Year 4
$(200,000) $60,000 $80,000 $80,000 $80,000
A. Based on the information provided, calculate Orion’s weighted average cost of capital. Show your
calculations.
B. Identify which projects should be accepted by Orion. Provide a brief defense of the decision criteria that
you have used in arriving at your recommendations.
C. Referring to Project X, state whether the firm should use its weighted average cost of capital to evaluate
this project. Explain your answer.
D. Based on an analysis of two firms with operations similar to Project X, Kochar has determined that the
project’s beta is 1.5. The risk-free rate is 5% and the market risk premium is 10%.
Calculate the net present value of Project X and provide a recommendation as to whether the project
should be accepted. Show your calculations.
E. In the past the firm has typically used the payback period method for evaluating risky projects and
accepted projects with a payback period less than 3 years.
1. Calculate the payback period for Project X. Based on the firm’s payback period threshold, what
decision should the firm make regarding Project X?
2. Provide one reason why using the payback period can result in the firm making a sub-optimal
decision.
Answer:
A. The weighted average cost of capital is weighted according to the market Values of the components of
capital and their market rates of return.
The market value of the bonds is $10,400,000 (10,000 bonds at a market value $1,040 each). The market
value of the common stock is $29,600,000 (2,000,000 shares outstanding at a market value of $14.80
per share). Total capital is $10,400,000 + $26,600,000) = $40,000,000. The bonds constitute 26% of tat
($26,600,000 ÷ $40,000,000).
The market rate of return of the bonds is 5%. Since the bonds mature in only one year, their market
rate of return can be calculated without a financial calculator. The market price of the bond is the
present value of the expected future cash flows from the bond. The expected future cash flows will be
received in one year’s time, and they include the final interest payment of 9.2% on the $1,000 per value
of the bonds, or $92.00 per bond, and the $1,000 return of principal on each bond on the bond’s
maturity date. This the future cash flow to be received in one year’s time in $1,092.

The interest rate that would result in a present value of $1,040 for that future cash flow of $1,092 is 5%,
calculated as follows:
$1,092 - 1 = 0.05 or 5%
$1,040
The after-tax market rate of return on the n=bonds is 0.05 * (1 – 0.30), which equal 0.035 or 3.5%.
The market rate of return of the stock is 14%, calculated using the dividend growth model to calculate
the cost of retained earnings:
Cre = D1 + G
P0
Where:
Cre = cost of retained earnings, expressed as a percentage
D1 = The next annual dividend to be paid (the previous annual dividend multiplied by (1 + the
annual) if the anticipated dividend is not given)
P0 = common stock price today
G = The annual expected % growth rate in dividends
$1.48 ÷ $14.80 + 0.04 = 0.14 or 14%
The weighted average cost of capital is (0.035 * 0.26) + (0.14 * 0.74) = 0.1127 or 11.27%.
$1,040 * (1 + the interest rate) = the $1,092 value in one year. Therefore, $1,092 ÷ $1,040 = (1 + the interest
rate). Subtracting 1 from the result, we get the market rate of return on the bonds of 5%. Note that this would
not work if the bonds’ maturity date were more than one year in the future because the investors would receive
more than one future annual cash flow, and the amounts of the annual cash flow, and amounts of the annual
cash flows would not be the same every year. Interest only would be received prior to the maturity date and
on the maturity date both interest and principal would be received.
B. The projects with positive net present values should be accepted: A, B, C, and E. All of the projects with
positive NPVs also have IRRs that are higher than the required rate of return, which is here the weighted
average cost of capital. However, if the IRR and the NPV of any project were in conflict, the NPV should
be used because this criterion maximizes the value of the firm, whereas the IRR can give misleading
results.
C. The weighted average cost of capital should not be used to evaluate Project X because Project X is not
in the same line of business as the firm’s current operations. It is likely that Project X would alter the

firm’s business risk, in which case the weighted average cost of capital would be inappropriate. The firm
should use a project-specified, hurdle rate that reflects that projects systematic risk.
D. Using the Capital Asset Pricing Model, Project X’s hurdle rate is 20%, calculated as follows:
R = RF + β (RM – RF)
Where: R = Required rate of return

RF = Risk free rate of return
Β = Beta coefficient
RM = Market rate of return
R = 0.05 + (1.5 * 0.10) = 0.20 or 20%

Since Project X’s hurdle rate is 20%, Project net present value is:
NPV = [($60,000 * 0.8333) + ($80,000 * 0.694) + ($80,000 * 0.579) + ($80,000 * 0.482)] - $200,000 =
$(9,620)
Since the NPV is negative, the project should be rejected.
E.
1. Project X’s payback period is 2.75 years, calculated as follows:
The final year in which the cumulative cash flow is negative + the positive value of the negative
cumulative inflow amount from the final negative year divided by the cash flow for the following year.
The final year in which the cumulative cash flow is negative is Year 2: $(200,000) + $60,000 +$80,000 =
$(60,000). (The year 3 cash flow of $80,000 will create a positive cumulative cash flow of $20,000.)
Thus:
2 + ($60,000 / $80,000) = 2.75 years
Based on the threshold payback period that the firm uses, it would accept the project because the firm
recovers it initial investment in less than 3 years.
2. Project C should be rejected because it has negative NPV. The payback period leads to a sub-optimal
decision because it ignores the time value of money. The payback period also ignores the cash flow
in later years but in this case even with year 4’s net cash flows, the project’s NPV remains negative.
Case – 18
Macro Solutions Inc., a hardware manufacturer, has experienced rapid growth. Macro is considering two new
capital expenditure projects and has a weighted average cost of capital of 10%. Project A requires an investment
of $155,000 and Project B requires an investment of
$240,000. Wendy Alexander, CFO of Macro, has been asked to analyze both projects and provide a
recommendation. She has compiled the following data.

A. Calculate the internal rate of return (IRR) for each project. Show your calculations.
B. Based on the IRR of each project, and a capital rationing constraint of $275,000, what
recommendations should Alexander make regarding the projects? Explain your answer.
C. If Macro has no capital rationing constraints, what recommendation should Alexander make
regarding the projects? Explain your answer.
D. Calculate the payback period for both projects. Show your calculations.
Assuming a four-year maximum payback requirement and no other constraint, what

recommendation should Alexander make? Explain your answer.
E. Identify and explain two advantages of using net present value (NPV) over IRR and one advantage
of using IRR over NPV
Identify and explain three weaknesses of the payback method.
F. Define and explain sensitivity analysis. Explain two ways Alexander can use sensitivity analysis to
further evaluate proposed projects.
Answer:
A. $155,000 / $43,000 = 3.605

PV of an annuity, 5 years with a factor of 3.605 = 12% Project A IRR
$240,000 / $60,000 = 4
PV of an annuity, 5 years with a factor of 4 = 8% Project B IRR
B. Based on
IRR, Project A would be recommended because the IRR of Project A exceeds the WACC Project A IRR
=12% would be recommended because 12% > 10%
Project B would be rejected because the IRR of Project B is below the WACC
Project B IRR = 8% would be rejected because 8% < 10%

Project A is the only project that would be recommended based on IRR and it is also within the capital
rationing constraint of $275,000. Project A would be recommended and Project B would not be
recommended.
C. Alexander would have no change in her recommendations.

Project A would be recommended and Project B would be rejected.
Although there is no longer a $275,000 capital rationing constraint, it is irrelevant because Project B
has an IRR of 8% which is below the company’s cost of capital of 10%.
D. Project A investment =$155,000

Year 1 cash flow $43,000 + Year 2 cash flow $43,000 + Year 3 cash flow $43,000 =
$129,000 = 3 years
$155,000 $129,000 = $26,000
$26,000 / $43,000= 0.6 years
3years + 0.6 years = 3.6 years’ payback Project A
Project B investment = $240,000

Year 1 cash flow $60,000 + Year 2 cash flow $60,000 + Year 3 cash flow $60,000 + Year 4
cash flow $60,000 = $240,000
4 years’ payback Project B
Both Project A and Project B would be recommended because they meet the sole criteria of a four-
year payback requirement.
E. Advantages of NPV over IRR include:

• Result is in dollar amount that is mores straight-forward.
• Supports different discount rates over the life of the project.
• Supports conventional and unconventional cash flow pattern
Advantages of IRR over NPV include:

• Easier to compare projects of different sizes.
• Avoids estimation of discount rate
Weaknesses of payback method include:

• Ignores time value of money.
• Not all cash flows are covered.
• Ignores project profitability.

F. Sensitivity analysis is a tool used to determine the effect of a change in one of the variables of a model
to the output of that model. By conducting sensitivity analysis, one can determine the effects of
variances from projections and identify risk by finding specific assumptions that can produce large
changes in profitability. IRR and payback calculations can be determined with differing projections for
cash flows or investment (amount and timing), thus giving a range of possible outcomes to utilize to
further analyze projects. Sensitivity analysis provides insight to how volatile the outcome of a financial
model is to a change in a specific variable or input. Sensitivity analysis can identify breakeven points.
Sensitivity analysis can help to define the maximum outflow and minimum inflow necessary to make
and keep a capital investment project successful and therefore provide for effective decision making.
Case – 19
Globex Corporation is a multinational construction company based in Istanbul, Turkey. The company operates
primarily in Turkey, Eurasia and the Middle East regions. The management team is considering two new
mutually exclusive projects.
• The first project involves a giant construction project of a bridge that crosses the Bosphorus strait in
Istanbul. The firm would be a subcontractor and would build only part of the motorway that will connect the
bridge to a main motorway system in the Asian side of Istanbul.
• The second investment option is a construction project of a sports center in Qatar that will be used for the
FIFA World Cup. The project is a high profile project and the firm can gain a significant reputation if the
project is successful.
Both projects require an $80 million initial investment for the investors of the firm and their IRR and payback
figures are shown below.
The planned completion date for the bridge project is May, Year 1 and for the sports center, the completion
date is December Year 3. The sports center project also requires $1 million of additional working capital in the
short term. The hurdle rate for the company is 10%.
A. Define working capital and discuss the effects of both projects on the firm’s working capital.
B. Define political risk and discuss the political risk for both projects and how a firm would mitigate this
risk.
C. Define mutually exclusive projects. Identify and explain which project would you recommend based
on the information presented, assuming both projects have the same level of political risk.
D. What other additional information would be helpful to evaluate those projects? Explain your answer.
E. Define hurdle rate and explain how does a firm develop its hurdle rate.
Answer:

A. Working capital is operating liquidity available to a firm. Net working capital is calculated as operating
current assets less operating current liabilities. Current assets include accounts receivables and
inventory. Current liabilities often include mainly accounts payable which represents debts payable in
12 months.
The sport center project will require$1,000,000cashexpenseinshorttermandthiswillaffect the working

capital of the firm negatively. The bridge project does not require significant cash expense in short term
and won’t affect the working capital negatively.
B. Politicalriskisthepossibilityofchangesinthereturnsofinvestmentsbecauseofgovernmental and
legislative issues. Government change, military coups, new legislations riots, etc. can cause significant
political risk for investor firms. The risk is higher as the period of a project gets longer.
Political risk is lower in the bridge construction project as the project is in the same country where the
company is based. Sports center project may face a higher political risk as it relates to a large investment
in a foreign country and a higher risk due to the FIFA World Cup. To mitigate political risk, a firm can
purchase political risk insurance, conduct research on the riskiness of a country, and outsourcing the
project to a domestic firm, etc.
C. When the acceptance of the project precludes the acceptance of another alternative project in can be
said that these projects are manually exclusive.
The sport center because the project has a higher IRR.
D. It would be helpful to have the NPV of both projects. Each of the bridge construction and sports center
projects has roughly the same initial investment outlay but different useful lives. Modern financial
theory specifies that we should choose the project with the higher NPV. The IRR method will generate
multiple results if future cash flows are a mix of positive and negative cash flows. Also IRR assumes that
positive cash inflows will be reinvested at IRR for the remaining time period of the project. This
assumption may not be true in the real world. Management should choose the project that increases
the stakeholders value and this can be achieved by choosing the project with a higher NPV.
E. Hurdle rate is the minimum acceptable rate of return on an investment and is also referred to as there
required rate of return. In order to accept a given capital project, the economic return on the project
must exceed the “hurdle rate”
The firm develop hurdle rate by using Weighted average cost of capital any may adjust the hurdle rate
for riskier projects by using the discount rate.

Case -20
Focused Solution Inc. is a management consulting company. As part of its annual planning process, the
company is reviewing proposed capital projects. Staff generated investment project proposals consistent
with the company’s strategic objectives and the executive team has narrowed the proposals down to two
proposed projects as described below.
• Proposal I. The first project relates to opening a new office in either New York or Chicago. The company
had purchased a building in Chicago several years ago for this purpose and have already partially
rehabilitated the building. The company is also working with a client with some projects in New York that
they may not be able to take if they do not build the New York office.
• Proposal II. The other project includes a technology upgrade of the latest mini-tablet computers for all
consultants and an expansion of the headquarters in San Francisco.
The president selected Proposal II as he believes that the consultants need to project a professional image
and could continue to travel to both New York and Chicago. The CFO requested that additional criteria be
reviewed before the project selection was finalized. The CFO noted that there were several projects
undertaken in the past that did not generate the expected cash flows or anticipated return on investment.
He also wanted to ensure that the selected projects met the company’s hurdle rate. The president agreed
to post-audits on the projects from the prior year and for additional capital budgeting analysis on each of
the proposed projects.
A. Identify and describe three steps in the capital budgeting process.

B. Identify and explain the role of the post-audit in the capital budgeting process.
C. Define hurdle rate, sunk cost, and opportunity cost. Explain how each is relevant to capital budgeting.
D. Should the company use cash flows or accounting profits in its capital budgeting analysis? Explain.
E. Should the company consider total amounts or incremental amounts in its capital budgeting process?
Explain.
F. Describe how the company should be considering the impact of income taxes and inflation on their
cash flows.
G. Explain the decision criteria used to determine acceptable projects when using NPV and IRR,
respectively.
Answer:
A. The remaining steps in capital budgeting that the executives should undertake
include:
• Estimating after tax incremental operating cash flows for investment projects
• Evaluating project incremental cash flows
• Selecting projects based on a value-maximizing acceptance criterion
• Secure project financing either internally or externally
• Revaluating implemented investment projects continually and performing post-audits for completed
projects.

B. A post completion audit is a formal comparison of the actual costs and benefits of a project with
original estimates. A key element of the audit is feedback, meaning that results of the audit are given
to relevant personnel so that future decision making can be improved.
Post completion audits allow management to determine how close the actual results of an
implemented project have come to its original estimate. When used properly, progress reviews and
post completion audits can help identify forecasting weakness and any important factors that were
omitted. With a good feedback system, any lesson learned can be used to improve the quality of future
capital budgeting decision making.
Post audit also exerts discipline in the investment planning and control process. If managers are aware
that post-completion audits are to be undertaken, they may take more care when developing initial
assumptions and estimates and when making investment decisions. They may also take more care
when managing an investment project through to completion.
C. Hurdle rate is the minimum required rate of return on an investment in a discounted cash flow analysis,
the rate at which a project is acceptable.
Sunk costs are unrecoverable past outlays that as they cannot be recovered, should not affect present
actions or future decisions. The building cost in Chicago is a sunk cost.
Opportunity costs are what is lost by not taking the next best investment alternative. The loss of the
New York work could be an opportunity cost of going with a different option.
D. Cash, not accounting income, is central to all decisions of the firm. Benefits expected from a project
should be expressed in terms of cash flows rather than income flows. The firm invests cash now in
hope of receiving even greater cash returns in the future. Only cash can be reinvested in the firm or
paid to shareholders in the form of dividends.
E. Incremental costs should be used so that only the differences between the cash
flows of the firm with and without the project are analyzed. For example, if a firm contemplates a
new project that is likely to compete with existing projects, it is not appropriate to express cash flows
in terms of estimate total sales of the new project. If cash flows will erode if they do not invest, they
must factor this into our analysis. The key is to analyze the situation with and without the new
investment and make sure all relevant costs and benefits are brought into play. Only incremental cash
flows matter.
F. The initial investment outlay, as well as the appropriate discount rate will be expressed in after-tax
terms. Thus, all forecast flows need to be stated on an equivalent, after tax basis. The method of
depreciation is an important consideration of the impact of income taxes because depreciation lowers
taxable income. Everything else being equal, the greater the depreciation charges, the lower the taxes
paid. Although depreciation itself is a non-cash expense, it does affect the firms cash flow by directly
influencing the cash outflow of taxes paid.
Anticipated inflation must also be considered. Often there is a tendency to assume

erroneously that price levels will remain unchanged throughout the life of a project. If
the required rate of return for a project to be accepted embodies a premium for inflation as it usually
does, then estimate cash flows must also reflect inflation. Such cash flows are affected in several ways
if cash inflows ultimate arise from the sale of a product, expected future prices affect these inflows.
As for cash outflows, inflation affects both expected future wages and material costs.
G. When NPV is used to determine acceptable project, the company must estimate
“hurdle rate,” often the weighted average cost of capital (WACC). This hurdle rate may be adjusted
based on the riskiness of the proposed project. Each year’s cash flow of the proposed project is
estimated and then discount back to present using the hurdle rate. NPV is calculated by add
discounted future cash flows together and subtract initial cash outlay in the present. If NPV is positive,
the decision rule says go ahead; if the NPV is negative, the decision rule says don’t go ahead.
Using the IRR decision rule starts the same way: find a hurdle rate and estimate the cash flows of the
project. Instead of discounting future cash flows using the hurdle rate, an internal rate of return (IRR)
is calculated for the proposed project. This IRR is the rate at which the discounted future flows equal
the (undiscounted) initial investment. IRR is compared to the hurdle rate. If IRR > hurdle rate, go ahead;
if IRR<hurdle rate, don’t go ahead. In nearly all real-life examples, the NPV decision rule leads to the
same go / no go answers as the IRR decision rule. In the rare case when the two decision rules lead to
different decisions, the analyst should examine if the cash flow pattern shifted more than once. If so,
the analyst can explain why the IRR rule is not appropriate.
Case – 21
Danny Chen was recently hired as the manager of capital planning for Suzhou Tool Company, a precision
tool company located in Fuzhou, China. Chen’s first assignment in this new position is to draft a company-
wide policy for the development, approval, acquisition, installation, and retirement of capital assets. In
preparation for drafting the new policy, Chen has collected the following information.
• The company uses Weighted Average Cost of Capital (WACC) as its hurdle rate for approving capital
acquisition.
• The company’s targeted capital funding structure is 60% equity and 40% debt.
• The before-tax, average cost of debt financing is 10%.
• The risk-free rate is 7%.
• The historical beta for Suzhou Tool Company is 1.0.
• The expected return on all common stocks is 13%.
• The company’s effective income tax rate is 40%.

A. Define hurdle rate and explain why the WACC is often appropriate to use as a hurdle rate.
B. Calculate the WACC.
C. Explain the importance of beta in the capital assets pricing model (CAPM) and explain the importance
of beta in Suzhou’s WACC.
D. Explain the importance of changes in net working capital in capital budgeting and identify which
project time period(s) may be affected by changes in net working capital.
E. Explain how depreciation and income taxes affect cash flows in the capital budget for a project.
F. Identify and explain one method Chen can use to account for uncertainty in the cash flow forecasts.
G. Define a capital budget post completion audit. Explain the role of the post-audit in the capital
budgeting process.
Answer:
A. The hurdle rate is the minimum acceptable rate of return that companies will consider from a
prospective project or investment. (Also called Required Rate of Return)
The market, in setting prices for the debt and equity issued by the company, is implicitly suggesting the
relative risk/reward trade-off for this company, compared to others. If the proposed project is similar
in risk/reward to the rest of the company’s project, the market rates implied by the market prices
suggest an appropriate rate for the proposed project.
B. The after-tax cost of debt is determined by multiplying the cost of debt of 10% by one minus the tax
rate of 40%: 10%(1-.40) =6%.
The cost of equity using the CAPM is the risk-free rate of 7% plus the Company’s beta times the
difference between the expected return on common stock and the risk free rate: 7% + 1.0(13% -7%) =
13%
The weighted average cost of capital is then: 60%(13%) + 40%(6%) = 10.2%
C. Beta is a measure of the movement of the price of a particular stock compared with the movement of
the market as a whole during the same period. Beta is important to the CAPM because it adjusts the
expected return for the systematic risk of a particular stock. Beta incorporates the equity risk portion
of Suzhou’s proposed new project.
D. As capital investments are made which result in changes to the business there will likely be a change in
amount of working capital required to support these changes. The marginal increase or decrease in
working capital (inventory, accounts receivable, accounts payable, etc.) should be included in the cash
flows for the capital budget when evaluating the project b. Typically, these changes tend to be most
significant at the initiation (period 0) and termination of the projects. Sometimes, if the cash flow
forecasts include increasing revenues year by year, the change in net working capital could be a use of
cash in all years.

E. While depreciation is a non-cash item when evaluating the marginal cash flow for a capital budget, it
does affect the firm’s cash flow by directly influencing the cash outflow for taxes paid. There can be
significant differences between book depreciation and tax depreciation. Cash taxes should be included
in the capital budget for a project. The taxable earning should be computed by making necessary
adjustments to depreciation to reflect a tax basis. Then, the taxable earnings should be multiplied by
the marginal tax rate to determine the estimate for the cash taxes.
F. Chen could assign probabilities to specific scenarios, and the cash flows resulting from Those scenarios.
The cash flows are weighted by the probability, and the weighted average CF is discounted at the risk-
free rate. A certainty equivalent approach could be used. This means determining the CF with certainty
required for the investor to be indifferent with the proposed (uncertain) CF. A simpler approach is to
increase the discount rate if the project is thought to be riskier than normal, or reduce the discount rate
if the project is thought to be safer than normal.
G. The post audit is a set of procedures for evaluating the results of a capital budgeting project. Post
completion audit helps management in determining how closely the actual results of a project have
come to its original estimates. Post audit can help identify forecasting weaknesses and any important
factors that were omitted. Post audit also exerts discipline in the investment planning and control
process. If managers are aware that post-completion audits are to be undertaken, they may take more
care when developing initial assumptions and estimates and when making investment decisions. They
may also take more care when managing an investment project through to completion.
Case – 22
HotSpot Systems is considering a proposal to develop a new line of electronic games based on books and
movies targeting the teenage market. The Oceanport office complex, one of the company’s five facilities,
has been idle for the past 15 months. The project, which is expected to last seven years, would utilize the
entire capacity of the Oceanport office. HotSpot Systems uses the internal rate of return method (IRR) for
evaluating capital expenditure proposals. The established hurdle rate is 11%, and the company’s marginal
income tax rate is 30%. HotSpot’s management team is reviewing the following items to determine whether
they should be included in the project’s annual cash flows to be used in calculating the IRR.
• If the project is not approved, HotSpot will sell the Oceanport office complex for $2,000,000. HotSpot
currently carries the Oceanport office complex at a book value of $1,500,000.
• HotSpot expects to pay licensing costs to the owners of the books and movies.
• Research and development totaling $350,000 has already been expended on the design of the new games.

• Additional computer equipment incorporating the latest technology will be purchased for
$125,000 and installed for the project. For tax purposes, the life of the equipment would be five years, and
HotSpot uses straight-line depreciation for tax purposes.
• A one-time increase in working capital of $75,000 is required to begin the project.
• A major introductory advertising program to promote the new games is planned to begin immediately
upon project approval.
• At the end of the project’s life, the Oceanport office complex will be sold in excess of the value recorded
for financial reporting purposes.
A. Calculate the net cash flow impact if HotSpot sells the Oceanport office complex. Show your
calculations.
B. Explain how the potential net cash flow from the sale of Oceanport should be considered in the
decision to pursue the project.
C. Identify and explain one advantage and one disadvantage of a licensing agreement based on a
percentage of game sales, as compared to a licensing agreement based on a flat fee
D. For the following items which are being reviewed by Hotspot’s management, indicate how the item
would be included in the project’s cash flow and the year in which the cash flows will be affected.
a. Research and development.

b. Additional computer equipment.
c. Working capital increase.
d. Introductory advertising program.
e. Sale of the Oceanport office at the end of the project.
E. Explain how IRR is determined and what IRR measures.
F. Explain how IRR is used in project appraisal and approval.
G. Compare and contrast IRR to the net present value (NPV) method of evaluating capital expenditure.
Answer:
A. Cash in $2 million, less taxes payable on gain ($500,000 x 30% = $150,000)

for net cash inflow of $1,850,000.
B. This $1.85 million is an opportunity cost; i.e. it will be lost, or pushed later, if the company decides to
use Oceanport to make the games. Thus the $18.5 million should be included as a zero period cost.
C. The flat fee is riskier. If the license owners accept a percentage of sales, they share the risk of poorer
than expected sales. Flat fee will benefit the company if sales are lower, percentage of sales will hurt
the company if sales are very strong.
D.

a. Research and development. These are sunk costs which have already been incurred and will not change
whether the project is accepted or rejected. Since these costs are not relevant to the decision, they
should not be included in the cash flow analysis for the project.
b. Additional computer equipment. The purchase price of the computers and the cost of installation
represent an investment of capital and should be included as a cash outflow at time zero. The computers
are to be depreciated over five years so the tax savings will result in a cash inflow during Years 1 through
5. If the equipment has any value at the end of the project and is sold, this may result in a cash inflow
in Year 7
c. Working capital increase. The one-time increase in working capital would be treated as cash outflow at
the beginning of the project (time zero). The release of the working capital would be treated as a cash
inflow at the end of the project (Year7).
d. Introductory advertising program. This is a one-time operating expense which would be tax deductible
and would, therefore, be included as a net cash outflow. It appears that the advertising would take
place before the product is ready for sale, the net advertising expense should be factored into the cash
flows at the beginning of the project (time zero).
e. Sale of the Oceanport office at the end of the project. The net proceeds from the sale of the office
building would be included as a cash inflow at the end of the project (Year 7). These proceeds would be
adjusted for any taxes paid resulting from a tax gain on the sale.
E. The internal rate of return is the discount rate at which the present value of the cash inflows equals the
present value of the cash outflows. The IRR is determined by developing the annual cash flows for a
project and determining the interest rate which, when applied to the cash flows, would result in a zero
net present value. A project’s IRR is often calculated through an iterative, trial and error process.
F. The IRR is a measure of the interest rate (yield) returned on the capital invested in the project over the
life of the project. This discounted cash flow method takes into account both the magnitude and time
of the expected cash flows over the life of the project.
The IRR is used in project appraisal and approval by comparing the project’s IRR to the firm’s hurdle
rate to determine whether or not the project is a productive use of capital. Projects with an IRR lower
than the hurdle rate are rejected, and projects with an IRR equal to or higher than the hurdle rate is
accepted.
G. NPV discounts each future flow at the hurdle rate and compares to the initial cost. NPV has an
advantage in that it shows the dollar amount of additional value the project is expected to produce for

the company’s owners. IRR gives a percentage result which can be readily compared to other uses, such
as investing in securities.
Case- 23
Encino Company, a diversified manufacturer, is considering three potential projects. To evaluate capital
projects, the finance department uses the net present value method and the payback period method. The
company has a hurdle rate of 13%. Capital projects are acceptable under the payback period if the initial
investment is recouped in 3 years. For the upcoming fiscal year, the Board of Directors has approved a capital
projects budget of up to $8,000,000. Data on the various projects under consideration are shown below.
A. Identify and explain two advantages and two disadvantages of using payback period method and net
present value method, respectively.
B. Which project(s) should Encino select based on the payback period method? Explain your answer.
C. Which project(s) should Encino select based on the net present value method? Explain your answer.
D. Assume the Board of Directors revises the capital budget upward to $10,000,000.
Which project(s) should the company select based on the payback period method and which
project(s) should the company select based on the net present value method? Explain
your answer.
E. Define sensitivity analysis and explain how management could use sensitivity analysis in its capital
budgeting process.
F. Discuss two qualitative factors that Encino should consider when making capital budgeting decisions.
Answer:
A. Advantages of Payback period

- Simple to use as it does not involve any accrual accounting conventions
- Quickly identifies projects which will recoup the company’s investment quickly
- Useful in case of uncertainty

Disadvantages of Payback period
- Does not consider the time value of money
- Does not consider cash flows after the payback period
- Does not consider a project’s return on investment
- Ignores project profitability and risk
Advantages of NPV
- Considers the time
- value of money
- Considers the impact of all cash flows associated with the project
- NPV tells whether a project will create value for the company or investors, and by how much in term
of dollars
Disadvantages of NPV
- Does not fully account for opportunity costs
- NPV is very sensitive to discount rate which is subject to estimation
- NPV is not useful for comparing two projects of different size
B. With a budget of $8 million, the company should select Project 2 under the payback method because it
has the fastest payback period and is below the 3-year maximum identified by management. Project 3
could not be accepted due to capital budget limitations, even though the payback period is below the
3 years stipulated by management.
C. With a budget of $8 million, the company should select Project 2 under the NPV method because its
NPV is positive and higher than Project 3.
D. With a budget of $10 million, the company should select both Project 2 and Project 3 under the payback
method because they have the fastest payback period and are below the 3-year maximum identified
by management.
With a budget of $10 million, the company should select both Project 2 and Project 3 under the NPV
method because its NPV is positive for both.
E. Sensitivity analysis is a “what-if” technique to examine how results will change if the predicted financial
outcomes are not achieved or if the underlying assumptions change
Management could use sensitivity in the estimate of the initial investment by assuming the project is
delayed and incurs more costs or by adjusting the expectations of the amount of cash inflows. The
discount rate could also be adjusted, as well.
F. Non-financial considerations include:

• The impact on the environment. An option may not have the highest return but might benefit the
environment.
• Additional job opportunities that may be created in the community
• The overall growth strategy for the company might be enhanced by accepting a project that will initially
generate a loss or a lower gain than the alternatives
Section F – Professional Ethics

Case- 24
Pro-Kleen specializes in cleaning carpets and upholstery for residences and businesses. Three years ago, the
company upgraded its equipment in order to remain competitive and take advantage of new technology. At
that time, Pro-Kleen purchased two truck-mounted steam cleaners; the details are shown below.
Purchase date March 15, 20X5
Cost $200,000
Estimated life 8 years
Salvage value $20,000
Pro-Kleen takes one-half year’s depreciation in both the year of acquisition and the year of disposal and uses
the straight-line method for calculating depreciation expense.
Based on recent information, John Morgan, Pro-Kleen’s assistant controller, has changed the estimated useful
lives of the equipment to five years. The salvage value of the equipment has been reduced to $10,000 due to
unexpected obsolescence. These revisions are effective January 1, 20X8. After revising the depreciation
amounts for the current year’s financial reporting, Morgan was told by the controller, Eileen Ryan, that the
revision was significant enough to change the small profit projected for the year into a loss. As a result, Ryan
has asked Morgan to reduce by half the total depreciation expense for the current year.
A. Referring to the specific standards outlined in IMA’s Statement of Ethical Professional Practice,
identify and discuss the specific ethical conflicts that Ryan’s instruction presents to Morgan.
B. According to IMA’s Statement of Ethical Professional Practice, identify the steps that Morgan should
take to resolve this situation.
C. Without considering Ryan’s instruction to reduce depreciation expense, calculate Pro-Kleen’s revised
annual depreciation expense.
D. Discuss the impact in the current year and future years on the Balance Sheet and Income Statement if
Pro-Kleen were to change to the declining balance method of depreciation. No calculations are
necessary.

Answer:
A. The standards from the IMA statement of Ethical Professional Practice that specifically relate to John
Morgan and the situation are Pro-Kleen are the following.
Competence:
Perform profession duties in accordance with relevant laws, regulations and technical standards.
Integrity:
Refrain from engaging in any conduct that would prejudice carrying out duties ethically abstain from
engaging in or supporting any activity that might discredit the profession.
Credibility:
Communication information fairly and objectively. Provide all relevant information that could
reasonably be expected to influence an intended user’s understanding of the reports, analyses or
recommendations.
B. Initially, Morgan should follow Pro-Kleen’s policy regarding the resolution of unethical behavior. If there
is no policy or the policy does not resolve the issue, he should consider the courses of action
recommended in the IMA statement of ethical professional practice.
Since Morgan’s immediate supervisor appears to be involved in the situation, he should present the
issue to the next higher level of management. He can also contract the IMA ethics helpline to the next
higher level of management. He can also contract the IMA ethics helpline to request how key elements
of the IMA statement of ethical professional practice could be applied to the ethical issue. Morgan
should consider consulting an attorney to learn of any legal obligations, rights, and risks concerning the
issue. If resolution efforts are not successful, he may wish to consider dissociating from the
organization.
C. Pro-Kleen’s revised annual depreciation expensed is $53,500 calculated as follows.

Original annual depreciation = (cost – salvage) ÷ Estimated life
= ($200,000 - $20,000) ÷ 8 = $22,500
Net book value, Jan. 1, 20x8 = $200,000 – (22,500 * 2.5)

= $143,750
Revised annual depreciation = (net book value – salvage) ÷ remaining life
= ($1,43,750 - $10,000) ÷ 2.5
= $53,500
D. A change to the declining balance method of depreciation means that the book value of the asset will
decline at a faster rate, and the depreciation expanse will be greater in each successive year resulting
in a decreases in income.

Case – 25
John is the regional controller for emerging market operations of Honest Corporation, a large American
multinational manufacturer of machine tools. He has responsibility for accounting, financial reporting, and
policy compliance for 20 international subsidiaries throughout the world.
In his position, compliance with the foreign corrupt practices act (FCPA) and Sarbanes-Oxley (SOX) legislation is
a high work priority. This high priority is especially important because Honest Corporation pleaded guilty several
years ago to making improper payments to government officials in a foreign country. John was specifically hired
to control foreign operations in high-risk countries to prevent such behavior from repeating. His hiring was part
of the settlement with the U.S. government to avoid prosecution of Honest Corporation management. John is
therefore very familiar with both the theory and the practice of FCPA in the international environment. John
also enjoys the full support from his management.
In general, Honest Corporation is rightfully proud of the ethical business environment that it created in the
aftermath of its problems with the FCPA. Its code of ethics has received awards from several external
organizations as a model for socially responsible business management. Its ethics hotline is used in a meaningful
way by employees throughout the world. Senior management sees itself as a role model for the rest of the
company.
Until recently Honest Corporation has not had a direct presence in Corruptia, a large country governed by an
extended royal family, because of concerns about corruption and the legal environment of the country. These
concerns are well founded; the royal family is known to be involved indirectly in most major businesses of
Corruptia. Published business research on the country states that nothing gets done without their “approval.”
Senior management of Honest Corporation was prepared, until now, to forgo business opportunities in
Corruptia because of these concerns. Therefore, instead of a direct presence in the country, Honest Corporation
has worked with local distributors in Corruptia to sell its products. Honest Corporation’s headquarters has
controlled the work with these local distributors, so John has not been involved with Corruptia activity. John
knows, however, that the cooperation with the distributors has sometimes been difficult since the distributors
do not understand the compliance issues and business restrictions that a multinational company must address.
The work with these distributors was limited to the sale of equipment to the distributor. The distributor
assumed, thereafter, all post services support and maintenance work. This support work is normally a large part
of Honest Corporation’s business in other parts of the world.
Now, however, a new CEO has joined Honest Corporation with a mandate from the board of directors to grow
the business faster than the worldwide market. The new CEO believes that this goal can only be achieved
through aggressive overseas expansion involving acquisitions of distributors with large customer support bases.
For this reason, Honest Corporation purchased its largest distributor in Corruptia and converted that distributor
into a wholly owned subsidiary.
This distributor was owned, until now, by its founder and has operated as a purely local business for all of its
existence. Its founder will remain in the business as the Honest Corporation country manager because of his
close business and personal connections to the Corruptia royal family.
John’s boss, the CFO, has asked him to develop a plan to address compliance issues with SOX and the FCPA in
the new subsidiary. John therefore traveled to Corruptia to assess the local environment. He learned that the

new subsidiary has no ethics or compliance environment in place on which he can base his efforts. Instead he
found an environment of well-intentioned and skilled people who are used to working in an informal
undocumented manner consistent with the culture and commercial practices of Corruptia. Decision making in
the new subsidiary has, until now, been based upon the founder’s wishes and desires. John found his new
colleagues to be very proud of their homeland and their business success. He learnt, as well, that most of them
have never traveled outside their home country. John realized, therefore, that his compliance plan must start
from scratch.
A. Referring to the IMA’s Statement of Management Accounting regarding “Values and Ethics: From
Inception to Practice”, identify and discuss the potential conflicts that John might face as he tries to
implement an ethics based compliance culture at the new subsidiary.
B. According to the IMA’s Statement, identify the actions that John should take to implement an ethics
based compliance culture.
Answer:
A. John will face the following potential issues as he tries to implement an ethics based compliance
culture at the new subsidiary:
1. Cross cultural communication issues:

John does not have any experience working with people from Corruptia. In addition, the employees
of the new subsidiary have limited experience with foreigners. Furthermore, John known that there
have been some conflicts with the distributor in the past regarding Honest Corporation’s business
practices. This could be a sign of potential future problems. Finally, the employees of the new
subsidiary are proud of their company and their country culture. John will have to be sensitive to
these feelings. He will need to be tactful enough to differentiate between legitimate cultural
differences and inappropriate business behavior. This combination of facts will make
communication especially difficult.
2. Informal control environment:

The control environment of the new subsidiary has been based upon informal rules and procedures
that were largely dependent upon the founder of the company. This condition will be not
acceptable in an environment that is compliant with SOX and FCPA.
3. The Company Founder

The company founder may not be willing to changes his approach to business based upon the
requirements of corporate headquarters. Honest Corporation must implement a control
environment that is more rules oriented and formalized compared to the environment that the
company is used to. The question will be whether the tone at the top of the subsidiary, as
communicated by the former founder/new country manager, is aligned to the overall Honest
Corporation standards. Another question will be whether the former founder/ new country
manager provides an appropriate example for the rest of the staff based upon his own behavior.

4. General environment is high risk regarding corruption:
There are several risk factors in the general environment of the new subsidiary that john will have
to consider. They include:
• The general commercial environment of Corruptia, which is widely seen as being corrupt.
• The political system in which the Corruptia country leasers appear involved in most
business activities.
• The founder and new country manager of the subsidiary has personal contacts to the royal
family and may not be willing to change his approach to business based upon the
acquisition of his company by Honest Corporation.
5. New CO of Honest Corporation:

The new CO of Honest Corporation has made a fundamental change in the corporation’s approach
to Corruptia. The previous policy to avoid Corruptia has changed in order to achieve revenue
growth targets. This change could create the impression that Honest Corporation’s business
standards have changed as well to achieve a financial result. John needs to keep senior
management informed regarding his work to avoid situational where it might appear that revenue
objectives take priority over ethical business practices. Jon also needs to learn how much support
he will have from the new CEO in his case conflict situations arise.
B. John should take the following actions to implement an ethics based compliance culture in the new
subsidiary:
1. Conduct initial employee training.

John ‘s initial visit to the new subsidiary has shown that there is a large gap between the local
standards of behavior and the requirements of Honest Corporation. General training of the new
colleagues is therefore necessary as the first step towards closing this gap.
The training Corporation’s code of ethics.

• Honest Corporation’s code of ethics.
• Standards for interpersonal behavior within the company.
• Prohibited business practices
• Dissemination and understanding of the company core values
• Use of the hotline.
• What is the FCPA and SOX and why is it important.
• Explanation of the history of Honest Corporation and the FCPA in order to make the
training more practical.
The goal of this initial training is to establish a common understanding between corporate
headquarters and the new local subsidiary regarding basic expectations about behavior and
acceptable business practices. Everyone, including the founder, should attend the training. The
training audience should be a mixture of manger and staff level employees so that
management’s commitment to the training is visible the rest of the staff.
2. Identify existing internal controls that would help ensure compliance with required behavior, and
when necessary, implement new controls.

John needs to help create an internal control environment that will provide assurance to corporate
headquarters that the new subsidiary is operating as per corporate policy and required standards
of behavior. Initially, he should determine what controls already exit that achieve this goal.
Thereafter he must implement new controls whenever he finds gaps in the control environment.
He can full fill these tasks using the following techniques:

• Continual Process Improvement:
Constant monitoring of business processes as a basis to learn from experience and to adapt
to new situations before they create major problem. John’s goal is to help create a “leaning
organization” which provides the basis for the organization to manage the impact to the
organization.
• Business Process Reengineering:

Analyzing the individual activities of a process as a basis to determine the most effective
way to fulfill the process. By using this approach Jon will understand the risk associated
with each activity. This understanding provides the basis to predict how a reasonable
person in Corruptia would behave in a certain circumstance. Thereafter John will be able to
establish controls based upon an understanding of the business process activity and the
associated risk to identify deviations from expected desired behavior.
• Quality Management:
Prevent mistakes from occurring by identifying and evaluating risk situation in advance.
Once risk situations are identified, John can develop alternative strategies to avoid the risk
situations. The goal is to identify situations where risk exist that will result in employee
behavior that does not follow accepted norms of ethical behavior. As the situations are
identified and risks are analyzed, John can implement controls to monitor the risks.
3. Follow –up and monitor the implementation status of the controls and the business environment
in the new subsidiary.
Once the controls related to ethical or behavioral issues are identifies, John will have to monitor
their status to understand the state of ethical compliance in the new subsidiary Monitoring the
status of the controls is important for two reasons:
• The outcome informs senior management about the implementation status of the company
ethics policy in the new subsidiary.
• Based upon this awareness the company’s management can take remediation action if
issues are identified.
Two approaches to monitoring will help:
• Human Performance Feedback Loop:

Includes ethics in the performance management process for individual employees of the new
subsidiary. The approach will be focused on the individual and will be conducted openly
between individuals and their immediate supervisors. Ideally the approach will be built into
subsidiary’s human resource management processes and is measures against specific goals to
ensure that it is effective and understood. Once weakness in this approach it that John will have
to rely on the feedback from local managers when he uses this technique.

He will have to judge whether the feedback is reliable.
• Survey Tools:
Submitting questions to the subsidiary’s employees regarding the company ethics policies and
asking for anonymous written Reponses. In this approach, the employee of the new subsidiary
will provide answers based upon standard choice. The entire employee population, or at least
large portions, will be involved. John will able to obtain the Feedback directly. Without
involvement by local management.
4. Evaluate the results of the monitoring and the implementation status and, if necessary, determine
corrective cores of actions.
After a reasonable period of time John will have gathered enough information to evaluate the
implementation status of the new subsidiary. He will be able to identify strengths and weaknesses
and have enough information to propose corrective actions.
When developing corrective course of actions, John need to consider the cause of the problem.
There could several reasons
• Inadequate training of the new employees.
• Cross cultural communication issues (language barriers, cultural differences, etc.)
• Individual behavior.
The appropriate corrective action to any issues will depend upon the cause of the problem.
5. Perform follow-up training based upon the initial training and related work experience in the
meantime.
John should perform follow-up training after a reasonable period of time. This timeframe depends
upon the results of the monitoring of the environment in the new subsidiary and feedback, if any
from the ethics hotline.
The training should be focused on actual work experiences of the new employees and first
experience of the new subsidiary in the Honest Corporation group. This time the training audience
should be divided between managers and staff so that the training content is more practical and
relevant to the real work environment of the employees
Example of the topic to include in this tanning include:
• How to apply theoretical core values in real life situations.

• Showing how individuals can provide leadership regarding ethical behavior

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ESSAY QUESTIONS AND ANSWERS

1|CMA (Part II) Prof. Ravi Gupta Essay Questions

B Corporate Finance 5 07-15

C Decision Analysis 6 16-29

D Risk Management 1 29-31

2|CMA (Part II) Prof. Ravi Gupta Essay Questions

• Times interest earned 5.16 times

Net sales $800,000

Total revenue $860,000

Cost of goods sold $540,000

Research and development 25,000

Selling and administrative 155,000

Total operating expenses $720,000

Earnings before interest and taxes (EBIT) $140,000

3|CMA (Part II) Prof. Ravi Gupta Essay Questions

Earnings before income taxes (EBT) 120,000

Income taxes 48,000

Net income $ 72,000

CCB Enterprises Statement of Financial Position

Cash and cash equivalents $ 2,000 $ 1,000

Available for sale marketable securities 24,000 20,000

Receivables, less allowance for doubtful accounts ($1,100 in

Inventories, at lower of FIFO cost or market 65,000 62,000

Prepaid items and other current assets 5,000 3,000

Total current assets $144,000 $136,000

Long-term investments $106,000 $106,000

Deposits 10,000 8,000

Total other assets $116,000 $114,000

Property, plant and equipment: $12,000 $12,000

4|CMA (Part II) Prof. Ravi Gupta Essay Questions

Buildings and equipment, less accumulated depreciation

Total property, plant and equipment $280,000 $260,000

Total assets $540,000 $510,000

Liabilities and Stockholders’ Equity

Short-term loans $22,000 $24,000

Accounts payable 72,000 71,000

Salaries, wages and other 26,000 27,000

Total current liabilities $120,000 $122,000

Long-term debt 160,000 171,000

Total liabilities $280,000 $293,000

Common stock, at par $44,000 $42,000

Paid-in capital in excess of par 64,000 61,000

Total paid-in capital $108,000 $103,000

Retained earnings 152,000 114,000

Total stockholders’ equity $260,000 $217,000

Total liabilities and stockholders’ equity $540,000 $510,000

5|CMA (Part II) Prof. Ravi Gupta Essay Questions

1. times interest earned

1. Times interest earned = EBIT ÷ Interest Expenses

2. Return on Assets = Net Income ÷ Average assets

3. Return on Equity = Net Income ÷ Average equity

4. Debt to equity ratio = Total liabilities ÷ Total equity

5. Current ratio = Current assets ÷ Current liabilities

6|CMA (Part II) Prof. Ravi Gupta Essay Questions

Section B – Corporate Finance

A. Define liquidity and explain its importance to Sentech.

B. Measures of liquidity include the following.

• Current ration: Current assets/current liabilities

7|CMA (Part II) Prof. Ravi Gupta Essay Questions

D. Types of short-term credit includes:

• Short-term loans- borrowing from banks for 1 year or less

A. 1. Define mergers and acquisitions.

8|CMA (Part II) Prof. Ravi Gupta Essay Questions

D. 20%25% + 16.7%30% + 9%*45% = 5% + 5% + 4% = 14%