SMU Classification: Restricted

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FNCE 101
Practice 1 – Lecture 1 & 2ish Solutions
ERRATUM to Q7. Explanation added to Q17.
Answer is highlighted in red

1. The percentage of the next dollar you earn that must be paid in taxes is referred to as the
_____ tax rate.
A. mean
B. residual
C. total
D. average
E. marginal

2. The cash flow of a firm which is available for distribution to the firm's creditors and
stockholders is called the:
A. operating cash flow.
B. net capital spending.
C. net working capital.
D. cash flow from assets.
E. cash flow to stockholders.

Note: Eliminate A as operating CF is not free for distribution. Eliminate capital spending
(capex). Eliminate NWC as this is not free for distribution. Eliminate E. as this is not
available for distribution to creditors. You are left with D. Assets belongs to both creditors
and stockholders & the cashflows from assets are used to service debt + interest to creditors &
pay dividends to stockholders.

3. Which one of the following is defined as a firm's short-term assets and its short-term
liabilities?
A. working capital
B. debt
C. investment capital
D. net capital
E. capital structure

4. Which of the following accounts are included in working capital management?

I. accounts payable
II. accounts receivable
III. fixed assets
IV. inventory
A. I and II only
B. I and III only
C. II and IV only
D. I, II, and IV only
E. II, III, and IV only

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Note: Current asset and current liabilities are part of working capital. Look for these in the
answers. This eliminates III. Fixed assets.

5. Which one of the following is classified as an intangible fixed asset?

A. accounts receivable
B. production equipment
C. building
D. trademark
E. inventory

6. Which one of the following is included in a firm's market value but yet is excluded from
the firm's accounting value?
A. real estate investment
B. good reputation of the company
C. equipment owned by the firm
D. money due from a customer
E. an item held by the firm for future sale

Note: (A) & (E) will be on the books as book value. C will be fixed asset. D will be A/P. (B)
is in accordance to market expectations and not on the books.

7. Which of the following are included in current liabilities?

I. note payable to a supplier in eight months (A/P=CL)
II. amount due from a customer next month (A/R = CA)
III. account payable to a supplier that is due next week (A/P=CL)
IV. loan payable to the bank in fourteen months (Long term debt)
A. I and III only
B. II and III only
C. I, II, and III only
D. I, III, and IV only
E. I, II, III, and IV

Note: CL = due within 12 months.

8. Which one of the following will increase the value of a firm's net working capital?
A. using cash to pay a supplier
B. depreciating an asset
C. collecting an accounts receivable
D. purchasing inventory on credit
E. selling inventory at a profit

Note: NWC = CA-CL

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(A): CA (i.e. cash) decreases by the same amount as CL (i.e. A/P decreases); (B) Non-cash
item; (C) A/R decreases but Cash increases by same amount. ; (D) A/R increases but A/P also
increases by same amount => changes in CA and CL cancel out. No change to NWC; (E) Net
Inflow of cash due to the profit. i.e. Inventory decreases but cash increases and by a larger
amount => CA overall increases.

9. Which one of the following statements concerning net working capital is correct?
A. Net working capital increases when inventory is purchased with cash.
B. Net working capital must be a positive value.
C. Total assets must increase if net working capital increases.
D. A decrease in the cash balance also decreases net working capital.
E. Net working capital is the amount of cash a firm currently has available for spending.

Note:(A): No change in NWC as cash decreases while inventory increases by same amount.
(B) NWC can be zero or negative (C) Total asset include CA & fixed assets. NWC pertains
only to CA. (D) NWC = CA-CL. CA (i.e. cash) decreases=> NWC decreases. (E) This refer
to FCF not NWC.

10. Which one of the following accounts is the most liquid?

A. inventory
B. building
C. accounts receivable
D. equipment
E. land

11. Which one of the following represents the most liquid asset?
A. $100 account receivable that is discounted and collected for $96 today
B. $100 of inventory which is sold today on credit for $103
C. $100 of inventory which is discounted and sold for $97 cash today
D. $100 of inventory that is sold today for $100 cash
E. $100 accounts receivable that will be collected in full next week

12. Shareholders' equity:

A. increases in value anytime total assets increases.
B. is equal to total assets plus total liabilities.
C. decreases whenever new shares of stock are issued.
D. includes long-term debt, preferred stock, and common stock.
E. represents the residual value of a firm.

Note: remember that FCF can be distributed to shareholders i.e. excess (residual) CF.

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13. The book value of a firm is:

A. equivalent to the firm's market value provided that the firm has some fixed assets.
B. based on historical cost.
C. generally greater than the market value when fixed assets are included.
D. more of a financial than an accounting valuation.
E. adjusted to the market value whenever the market value exceeds the stated book value.

14. You recently purchased a grocery store. At the time of the purchase, the store's market
value equaled its book value. The purchase included the building, the fixtures, and the
inventory. Which one of the following is most apt to cause the market value of this store to be
lower than the book value?
A. a sudden and unexpected increase in inflation
B. the replacement of old inventory items with more desirable products
C. improvements to the surrounding area by other store owners
D. construction of a new restricted access highway located between the store and the
surrounding residential areas
E. addition of a stop light at the main entrance to the store's parking lot

Note: (D) will make it more difficult for residents to access the store.

15. For a tax-paying firm, an increase in _____ will cause the cash flow from assets to
increase.
A. depreciation
B. net capital spending
C. change in net working capital
D. taxes
E. production costs

Note: (A). Recall depreciation is a tax shield for tax-paying firms.

16.Which one of the following is NOT included in cash flow from assets?
A. accounts payable
B. inventory
C. sales
D. interest expense
E. cash account

Note: A=L+E => CF from assets belong to both debtholders & equityholders => interest
expense not paid yet.

17. A positive cash flow to stockholders indicates which one of the following with certainty?
A. The dividends paid exceeded the net new equity raised.
B. The amount of the sale of common stock exceeded the amount of dividends paid.
C. No dividends were distributed but new shares of stock were sold.
D. Both the cash flow to assets and the cash flow to creditors must be negative.
E. Both the cash flow to assets and the cash flow to creditors must be positive.

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Note: Net new equity raised => cashflows from financing via shares issue. (A): Dividend
paid>cashflow from financing vis share issue => there is FCF net of financing from
operations &/or investing activities to be paid out as dividends. (B) & (C): This means net
cash is being paid by stockholders to firms (negative CF to stockholders). (D): A=L+E => E
must be negative & not positive. (E) This doesn’t directly imply that any CF is paid to
stockholders. Firm could have retained 100% of FCF. Second point: A=L+E. CF from A =
$10 mn (+); CF paid to debtholders = $15 mn (+); how to service the debt payment shortfall?
Raised financing from shareholders of $5mn. So even if CF from asset >0, CF to
debtholders>0, this doesn’t not mean CF to shareholders>0. In this example, CF to
shareholders = -$5 mn (-)

18. Your firm has total assets of $4,900, fixed assets of $3,200, long-term debt of $2,900, and
short-term debt of $1,400. What is the amount of net working capital?
A. -$100
B. $300
C. $600
D. $1,700
E. $1,800
Note: NWC = CA – CL = 4900-3200-1400 = 300

19. Jake owns The Corner Market which he is trying to sell so that he can retire and travel.
The Corner Market owns the building in which it is located. This building was built at a cost
of $647,000 and is currently appraised at $819,000. The counters and fixtures originally cost
$148,000 and are currently valued at $65,000. The inventory is valued on the balance sheet at
$319,000 and has a retail market value equal to 1.2 times its cost. Jake expects the store to
collect 98 percent of the $21,700 in accounts receivable. The firm has $26,800 in cash and has
total debt of $414,700. What is the market value of this firm?
A. $857,634
B. $900,166
C. $919,000
D. $1,314,866
E. $1,333,700
Note: MV of firm = 819000 (MV of building) +65000+1.2*319000+0.98*21700+26800-
414700 = 900 166.

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20. Given the tax rates as shown, what is the average tax rate for a firm with taxable income
of $311,360?

A. 28.25 percent
B. 31.09 percent
C. 33.62 percent
D. 35.48 percent
E. 39.00 percent
Note: Tax rate = 0.15*(50000)/311360 + 0.25*(75000)/311360 +
0.34*25000/311360+0.39*211360/311360 = 33.62%

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21. Crandall Oil has total sales of $1,349,800 and costs of $903,500. Depreciation is $42,700
and the tax rate is 34 percent. The firm does not have any interest expense. What is the
operating cash flow?
A. $129,152
B. $171,852
C. $179,924
D. $281,417
E. $309,076

Earnings before interest & taxes = 1349800-903500-42700=403600

Tax=0.34*403600=137224
Operating CF = 403600+42700-137224=309076

22. At the beginning of the year, a firm had current assets of $121,306 and current liabilities
of $124,509. At the end of the year, the current assets were $122,418 and the current
liabilities were $103,718. What is the change in net working capital?
A. -$19,679
B. -$11,503
C. -$9,387
D. $1,809
E. $21,903

Change in NWC = Change in CA – Change in CL = (122418-121306) – (103718-

124509)=21903

23. Beach Front Industries has sales of $546,000, costs of $295,000, depreciation expense of
$37,000, interest expense of $15,000, and a tax rate of 32 percent. The firm paid $59,000 in
cash dividends. What is the addition to retained earnings?
A. $76,320
B. $81,700
C. $95,200
D. $103,460
E. $121,680

Earnings before tax = 546000-295000-37000-15000=199000

Taxes = 0.32*199000=63680
Net income=199000-63680=135320
Retained earnings = net income-59000=76320
(this is income statement, not statement of cashflow, so we do not add back depreciation to net income)

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24. The Widget Co. purchased new machinery three years ago for $4 million. The machinery
can be sold to the Roman Co. today for $2 million. The Widget Co.'s current balance sheet
shows net fixed assets of $2,500,000, current liabilities of $1,375,000, and net working capital
of $725,000. If all the current assets were liquidated today, the company would receive $1.9
million in cash. The book value of the Widget Co.'s assets today is _____ and the market
value of those assets is _____.
A. $4,600,000; $3,900,000
B. $4,600,000; $3,125,000
C. $5,000,000; $3,125,000
D. $5,000,000; $3,900,000
E. $6,500,000; $3,900,000

NWC = CA – CL => CA=NWC+CL = 725000+1375000 = 2.1 mn

BV of asset = fixed asset +CA = 2.5+2.1 = 4.6 mn
MV = 2 +1.9 = 3.9 mn

25. Shareholder A sold shares of Pinewood Cabinets stock to Shareholder B. The stock is
listed on the Tokyo Stock Exchange. This trade occurred in which one of the following?
A. primary, dealer market
B. secondary, dealer market
C. primary, auction market
D. secondary, auction market
E. secondary, OTC market

26. Which form of business structure is most associated with agency problems?
A. sole proprietorship
B. general partnership
C. limited partnership
D. corporation
E. limited liability company

27. Which one of the following is an agency cost?

A. accepting an investment opportunity that will add value to the firm
B. increasing the quarterly dividend
C. investing in a new project that creates firm value
D. hiring outside accountants to audit the company's financial statements
E. closing a division of the firm that is operating at a loss

(D) Because shareholders cannot trust the managers 100% due to agency problems, they must
hire outside accountants (costly) to audit the managers.

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28. Which one of the following is least likely to be an agency problem?

A. increasing the size of a firm
B. concentrating on maximizing current profits
C. closing a division with net losses
D. increasing the market value of the firm's shares
E. obtaining a patent for a new product

Note: (A): managers can acquire/buy poor companies in order to grow the size of the current
firms => increasing size (=total assets) is not the goal of a corporation. (B) The goal is not to
maximize current profits (accounting number) but share price. (C) This could be an agency
problem in myopic cost cutting exercise by firms, esp. when the division, despite net losses, is
critical to other divisions of the overall business. E.g close down IT division to cut short-term
costs as IT division typically runs at net losses since it is a supporting division. But w/o IT,
other divisions cannot function properly. (D) This is aligned with maximizing long-term value
of shareholder as market value (=price of stock) reflects future CFs for a company. (E) This
could be motivated by the manager’s personal interest to stem competition from rivals &
when competition is stemmed, the manager needs not work hard. Best choice = D

29. Which one of the following business types is best suited to raising large amounts of
capital?
A. sole proprietorship
B. limited liability company
C. corporation
D. general partnership
E. limited partnership

30. Which of the following are advantages of the corporate form of business ownership?
I. limited liability for firm debt
II. double taxation
III. ability to raise capital
IV. unlimited firm life
A. I and II only
B. III and IV only
C. I, III, and IV only
D. II, III, and IV only
E. I, II, III, and IV

- The End -