Review Test 1 (Questions created by Mary Lou Poloskey for another text, can be used as part of your review for test) 1. Why is value maximization superior to profit maximization as a goal for management? Solution: While profit maximization appears to be a logical goal at first glance, it has some serious drawbacks. First, since profit is the difference between revenues and expenses, it can be distorted by some creative accounting measures. Second, accounting profits are quite different from cash flows. Cash flows are the focus of investors and therefore managers. Third, profit maximization does not recognize when cash flows occur. Finally, profit maximization as a goal ignores the risk involved in generating the cash flows. To determine the value of a firm’s stock, consider (1) the size of the expected cash flows, (2) the timing of the cash flows, and (3) the riskiness of the cash flows. Thus, value maximization as a goal overcomes all the shortcomings of profit maximization as a goal. 2. Which of the following is / are advantages of the corporate form of organization? a. Reduced start-up costs b. Greater access to capital markets c. Unlimited liability d. Single taxation Solution: b (Shares in a corporation can be sold to raise capital from investors who are not involved in the business. This greatly increases the amount of capital that can be raised to fund the business.) 3. Drayton, Inc. has current assets of $256,312, and total assets of $861,889. It also has current liabilities of $141,097, common equity of $200,000, and retained earnings of $133,667. How much long-term debt does the firm have? Solution: Assets Liabilities and Equity Total current $256,312.00 Total current liabilities $141,097.00 assets Long-term debt $387,125.00Common stock 200,000.00 Retained earnings 133,667.00 Total assets $861,889.00 Total liabilities and stockholders’ $861,889.00 equity $861,889 – 141,097-200,000-133,667 = $387,125 (long-term debt) 4. Ellicott Testing Company produced revenues of $745,000 in 2011. It had expenses (excluding depreciation) of $312,640, depreciation of $65,000, and interest expense of $41,823. It pays an average tax rate of 34 percent. What was the firm’s net income after taxes? Solution: Amount Revenues $745,000.00 Costs 312,640.00 EBITDA $432,360.00 Depreciation 65,000.00 EBIT $367,360.00 Interest 41,823.00EBT $325,537.00 Taxes (34%) 110,682.58 Net income $214,854.42 5. What is the difference between book-value balance sheets and market-value balance sheets? Which provides better information to investors and management? Solution: Book-value balance sheets are accounting statements that use historical information. Market-value statements contain current information and show what line items are worth today. Although market values can be harder to identify, they provide better economic information than book value. 6. What are agency costs? Explain. Solution: Agency costs are the costs that result from a conflict between a firm’s management (agents) and its owners or shareholders (principals). When management acts in ways that do not benefit shareholders, it results in agency costs. These costs could be either direct or indirect. When a management action results in a loss of cash flow to the firm, it is an indirect cost. Direct costs result from inappropriate actions or expenses by management that lower the firm’s income and cash flows. 7. If the nominal rate of interest is 7.5 percent and the real rate is 4 percent, what is the expected inflation premium? Solution: Using the Fisher equation, i = r + ∆Pe + r ∆Pe where i = 0.075 and r =0.04, solving for ∆Pe = 3.37% Use the following Greenfern Corporation Financial Statements for Questions 8 – 10:Greenfern Corporation Income Statement for the Fiscal Year Ended July 31, 2013 Net sales $73,236 Cost of products sold 52,092 Gross margin $21,144 Marketing, research, administrative exp. 9,333 Depreciation 1,060 Operating income (loss) $ 10,751 Interest expense 649 Earnings (loss) before income taxes 10,102 Income taxes 3,536 Net earnings (loss) Greenfern Corporation Balance Sheet as of 7/31/2013 Assets Liabilities and Stockholders’ Equity Cash and marketable securities $ 8,302 Accounts payable $ 6,379 $ 6,566Investment securities 816 Accrued and other liabilities 5,663 Accounts receivable 7,844 Taxes payable 4,821 Total inventories 8,900 Debt due within one year 10,778 Deferred income taxes 878 Prepaid expenses & other receivables 2,803 Total current assets $29,543 Total current liabilities $27,641 Property, plant, and equip., at cost 62,467 Long-term debt 24,280 Less: Accumulated depreciation 22,196 Deferred income taxes 6,903 Net plant and equipment $40,271 Other non-current liabilities 5,608 Net goodwill & other intangible assets 13,345 Total liabilities $64,432 Other non-current assets 2,925 Common stock 3,667 Retained earnings 17,985 Total stockholders’ equity (deficit) Total assets $86,084 Total liabilities and stockholders’ equity $86,084 8. Refer above to the balance sheet and income statement for Greenfern Corporation for the year ended July 31, 2013. What are the company’s current ratio and quick ratio? What do these ratios tell us about Greenfern? Solution: Current assets $21,652Current ratio = Current liabilities $29,543 1.07 = $27,641 Current assets − Inventory Quick ratio = Current liabilities $29,543 − 8,900 0.75 = $27,641 The current ratio of just over one tells us that Greenfern’s cash, and other current assets, such as accounts receivable and inventory, if liquidated, are just enough to cover the short-term liabilities, or obligations. Since inventory can be much less liquid then other current assets, the quick ratio of Greenfern indicates that if we exclude inventory, the remaining current assets can cover 75% of the short-term liabilities. 9. Refer above to the balance sheet and income statement for Greenfern Corporation for the year ended July 31, 2013. Calculate the following ratios: (Note: Formulas might be slightly different from current text) Inventory turnover ratio Days’ sales outstanding Total asset turnover