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Price Per Share, Liquidity, Bonds, Accounting Reporting Process, Interest Expense

Use the following information to answer questions 1 and 2: You are analyzing a large, stable company. For the year ending 12/31/02, the company reported earnings of $58,900, and book value at the end of 2002 was $371,700. You expect earnings to grow at 5 percent a year in perpetuity, and the dividend payout ratio of 70 percent to continue. The company borrows at 8%, and has a cost of equity of 12%. The company has 25,000 shares outstanding.
1. What is your estimate of price per share using the dividend discount model at 12/31/02?
a. $20.62
b. $21.65
c. $23.56
d. $24.74

2. What is your estimate of price using the residual income valuation model at 12/31/02?
a. $20.62
b. $21.65
c. $23.56
d. $24.72

3. Liquidity of a company is generally defined as a measure of
a. the ability of a company to pay its employees in a timely manner.
b. the ability to pay interest and principal on all debt.
c. the ability to pay dividends.
d. the ability to pay current liabilities.

4. How much would you be prepared to pay for a $500 bond that comes due in 5 years and pays $80 interest annually, and your required return is 8%? (Pick the closest answer.)
a. $740
b. $660
c. $608
d. $500

5. Which of the following are examples of judgments made in the accounting reporting process?
I. useful life of machinery
II. allowance for doubtful accounts
III. obsolescence of assets
IV. interest payment on bonds
a. I, II, III, and IV
b. I, II, and III
c. II and III
d. I and III

6. 10-K reports are
a. another name for annual report to stockholders.
b. quarterly filings made by a company with the SEC.
c. annual filings made by a company with the SEC.
d. filings made by a company with the SEC when a company changes auditors.

7. Byfort Company reports the following in its financial statements:
2001 2002
Accounts receivable, net $ 34,289 $ 29,678
Net sales $360,007 $450,000

How much did the company collect in cash from sales during 2002?
a. $445,389
b. $454,611
c. $484,289
d. $488,900

8. Hert Corporation acquired a capital lease that is carried on its books at a present value of $100,000 (discounted at 12%). Its annual rental payment is $15,000. What is the amount of interest expense from this lease?
a. First Year: $12,000; Second Year: $10,200
b. First Year: $12,000; Second Year: $11,640
c. First Year: $12,000; Second Year: $12,350
d. First Year: $15,000; Second Year: $15,000

9. Dylan Corporation issues a zero-coupon bond with $100,000 face value and a 5-year maturity, and the market rate is 7%. Interest on corporate bonds is normally paid semiannually. In the liability section of Dylan's balance sheet, the proceeds from selling the zero-coupon immediately after issuance will be closest to
a. $70,892
b. $71,299
c. $70,000
d. $100,000

10. Which of the following would rarely be classified as a current asset?
a. prepaid insurance
b. goodwill
c. marketable securities
d. work-in-progress

11. The use of LIFO rather than FIFO for inventory costing under normal economic conditions results in
I. lower net income
II. higher total assets
III. higher retained earnings
IV. unchanged retained earnings
a. II and III
b. I, II, and IV
c. I only
d. I and IV

12. One advantage of LIFO over FIFO under normal conditions is that
a. it reports higher retained earnings.
b. it results in higher cash flows.
c. it results in higher current ratios.
d. it results in higher gross margins.

13. Target Inc. has 30 million shares outstanding and trades at $50 per share. Target has net identifiable assets with a book value of $1 billion and a fair value of $1.2 billion. Acquirer Corporation purchases all of Target Inc. stock for $60 per share. How much will Acquirer record as goodwill upon acquiring Target?
a. $300 million
b. $500 million
c. $600 million
d. $800 million
Use the following information to answer questions 14 and 15: The following information can be found in Manufacturer Company's financial statements:
2002 2001
COGS $2,500,000 $2,000,000
Inventory $180,000 $140,000
Net income $125,000 $100,000
Retained earnings $500,000 $400,000
LIFO reserve $40,000 $30,000
Tax rate 40% 40%

14. If Manufacturer used FIFO, its retained earnings as of the end of fiscal 2002 would be
a. $540,000
b. $440,000
c. $524,000
d. $506,000

15. If Manufacturer used FIFO, its net income for fiscal 2002 would be
a. $165,000
b. $149,000
c. $135,000
d. $131,000

16. Which of the following combinations of accounting practices will lead to the highest reported earnings in an inflationary environment?
a. depreciation method: straight line; inventory method: LIFO
b. depreciation method: double-declining balance; inventory method: LIFO
c. depreciation method: straight-line; inventory method: FIFO
d. depreciation method: double-declining balance; inventory method: FIFO

Use the following information to answer questions 17-18: The following information was extracted from Smurm Corporation's 2002 annual report:
Common stock
Shares outstanding 12/31/01 90 million
New shares issued 4/1/02 10 million
Shares outstanding 12/31/02 100 million

Preferred stock
$10 par, 10%, convertible into 2 shares of common stock, shares outstanding 50 million

Options
1 million options, each to purchase one common share at $50 per share

Market price of stock
Average for year $75
Beginning of year $70
End of year $78

Preferred dividends paid
$50,000,000
Net income for 2002 $350,000,000

17. Using the treasury stock method, the options would result in how many extra shares being recognized in the diluted EPS calculation?
a. 500,000
b. 358,975
c. 333,333
d. 285,714

18. Basic earnings per share for 2002 was
a. $3.50
b. $3.16
c. $3.08
d. $3.00

True/False
19. The expected return on a security under the Capital Asset Pricing Model is a linear function of its unsystematic risk.

20. Rational investors will only tolerate more systematic risk if the expected return is greater.

21. Treasury bills are assumed to have a beta of zero.

22. The development of the financial statements is management's responsibility, and the auditor is not concerned with the process of development.

23. A company issues a $100,000 9% bond and receives $99,000 (ignoring transaction costs). This implies that the effective interest rate is less than 9%.

24. The LIFO Conformity rule states that if a company uses LIFO for tax purposes, it must also use it for financial reporting purposes.

25. The capitalization of interest costs during construction increases future net income.

26. Software costs may be capitalized once a company can show that the product is technologically feasible.

27. A company that capitalizes costs rather than expensing them will have a higher asset turnover.

28. If a company depreciates an asset at a faster rate for tax purposes than for financial reporting purposes, that will give rise to a deferred tax liability.

29. R&D expenses for tangible assets that have alternative future uses qualify as deferred charges.

30. Accrual accounting would tend to result in greater volatility of profits than would cash-based accounting.

31. A firm with up-to-date, modern asset management practices, including cash management, just-in-time, and securitizing of accounts receivable, would tend to have a greater current ratio (current assets/current liabilities) than would a firm following more traditional asset management techniques.

32. For a given return on assets, the use of financial (debt) leverage results in a higher return on equity than if no financial leverage were used.

33. Interest rate risk on bonds is greater the longer the time to maturity is and the lower the coupon rate.

34. Duration is a better measure of default risk than it is a measure of interest rate risk.

35. Zero coupon bonds have less reinvestment risk but have more price risk for a given time to maturity than do coupon bonds with the same time to maturity, all else being equal.

36. Defined benefit pension plans place more financial risk on firms than do defined contribution pension plans.

37. When a financial services firm securitizes its mortgages with recourse, it is reducing its interest rate risk but not the credit risk it bears on the mortgages it originated.

38. Long-term bond issues are part of capital paid-in, in the owners' equity section of the firm's balance sheet.

39. Inventory turnover ratios should be greater for automotive firms than for food markets.

40. On average, bank liabilities tends to be more liquid than the liabilities of a manufacturing firm.

Solution Preview

Please see attached file
Use the following information to answer questions 1 and 2: You are analyzing a large, stable company. For the year ending 12/31/02, the company reported earnings of $58,900, and book value at the end of 2002 was $371,700. You expect earnings to grow at 5 percent a year in perpetuity, and the dividend payout ratio of 70 percent to continue. The company borrows at 8%, and has a cost of equity of 12%. The company has 25,000 shares outstanding.

1. What is your estimate of price per share using the dividend discount model at 12/31/02?
a. $20.62
b. $21.65
c. $23.56
d. $24.74

Answer: d. $24.74

D0= Dividend per share = 70% x $58,900 / 25,000 shares= $1.6492

Using the Dividend Discount (Constant Growth) Model
Po= Div1/ (r-g)
Div0 = $1.6492

Dividend for next year= Div1 = 1.7317 =(1+5.%) *1.6492
Cost of equity= r= 12.00%
growth rate of dividends/earnings= g= 5%
Current stock price= Po=
Plugging in the values:
Po= $24.74 =1.7317/(12.%-5.%)

2. What is your estimate of price using the residual income valuation model at 12/31/02?
a. $20.62
b. $21.65
c. $23.56
d. $24.72

Answer: d. $24.72

the residual income model values stock as the sum of two components:
The current book value of equity (BV)
The present value of expected future residual income

Book value per share = $371,700 / 25,000 shares= $14.87

Earnings for 12/31/2002= $58,900
growth rate of earnings= 5%
Therefore, earnings for 12/31/2003= $61,845 =(1+5.%) x$58,900.
BV for 2002= $371,700
Cost of equity= 12%
Therefore, equity charge= $44,604 =12.% x$371,700.
Residual income next year= $17,241 =$61,845. - $44,604.
Number of shares= 25000
Therefore, residual income per share= $0.6896 =$17,241. / 25,000.

Residual income per share for next year= Res1 = $0.6896
Cost of equity= r= 12%
growth rate of residual income= g= 5%
Present value of residual income per share= PV= ? To be determined
Plugging in the values:
PV= $9.85 =0.6896/(12.%-5.%)

Value of stock= $24.72 =$14.87 + $9.85

3. Liquidity of a company is generally defined as a measure of
a. the ability of a company to pay its employees in a timely manner.
b. the ability to pay interest and principal on all debt.
c. the ability to pay dividends.
d. the ability to pay current liabilities.

Answer: d. the ability to pay current liabilities.

4. How much would you be prepared to pay for a $500 bond that comes due in 5 years and pays $80 interest annually, and your required return is 8%? (Pick the closest answer.)
a. $740
b. $660
c. $608
d. $500

Answer: b. $660

Data
No of years to maturity= 5
Face value= $500
Frequency = A Annual Coupon payments
Discount rate annually= 8.00% (Yield to maturity)
Maturity value = Face Value= $500

Calculation of bond price:
Interest payment per period= $80.00
No of Periods =n= 5 =1 x 5
Discount rate per period = r = 8.00% =8.%/1
PVIF (5 periods, 8.% rate)= 0.680583
PVIFA (5 periods , 8.% rate)= 3.99271
PVIFA X Interest Payment= $319.42 =3.99271 x 80
PVIF X Redemption value= $340.29 =0.680583 x 500
Price= $659.71 =319.42+340.29

Answer: Price= $660.00 (rounding off)

5. Which of the following are examples of judgments made in the accounting reporting process?
I. useful life of machinery
II. allowance for doubtful accounts
III. obsolescence of assets
IV. interest payment on bonds

a. I, II, III, and IV
b. I, II, and III
c. II and III
d. I and III

Answer: c. II and III

6. 10-K reports are
a. another name for annual report to stockholders.
b. quarterly filings made by a company with the SEC.
c. annual filings made by a company with the SEC.
d. filings made by a company with the SEC when a company changes auditors.

Answer: c. annual filings made by a company with the SEC.

A Form 10-K report is the official annual business and financial report filed by public companies with the Securities and Exchange Commission.
(source: http://www2.lib.udel.edu/subj/bsec/resguide/annual10.htm)

7. Byfort Company reports the following in its financial statements:
2001 2002
Accounts receivable, net $34,289 $29,678
Net sales $360,007 $450,000

8. How much did the company collect in cash from sales during 2002?
a. $445,389
b. $454,611
c. $484,289
d. $488,900

Answer: b. $454,611

Cash collection=Account receivable at the beginning of year + Sales during year - Accounts receivables at the end of year= $454,611 =34289+450000-29678

8. Hert Corporation acquired a capital lease that is carried on its books at a present value of $100,000 (discounted at 12%). Its annual rental payment is ...

$2.19