Deck 9: For the Investor

Question 1

A firm has a degree of financial leverage of 1.20.If earnings before interest and tax increase by 20%, then net income:

A)will not necessarily change.
B)will increase by 20%.
C)will decrease by 24%.
D)will decrease by 20%.
E)None of the answers are correct.

Answer 1

E

Question 2

Using financial leverage is a good financial strategy from the viewpoint of stockholders of companies having:

A)a high debt ratio.
B)cyclical highs and lows.
C)steady or rising profits.
D)a steadily declining current ratio.
E)none of the answers are correct.

Answer 2

C

Question 3

A summarized income statement for Leveraged Inc.is presented below. $\begin{array}{lr}\text { Sales } & \$ 1,000,000 \\\text { Cost of Sales } &600,000\\\text {Gross Profit }&\$400,000\\\text { Operating Expenses}&250,000\\\text {Operating Income }&\$150,000\\\text {Interest Expense }&30,000\\\text {Earnings Before Tax }&\$120,000\\\text { Income Tax}&40,000\\\text { Net Income}&\$80,000\\\end{array}$ The degree of financial leverage is:

A)$150,000/$30,000
B)$150,000/$120,000
C)$1,000,000/$400,000
D)$150,000/$80,000
E)$400,000/$120,000

Answer 3

$150,000/$120,000

Question 4

Which of the following is not a reason to interpret book value with caution?

A)Land may be worth more than it cost
B)Depreciable assets may be held
C)Investments may be worth more than their purchase price
D)Patents may have a high market value
E)All of the answers are correct.

Question 5

What is the effect of the exercise of stock options?

A)They generate cash to the issuing firm and therefore increase profit per share.
B)They are an expense at the time of exercise.This lowers net income.
C)They increase debt and lower borrowing capacity but have no effect on profit.
D)They increase the number of shares outstanding.
E)They have no immediate effect on profitability.

Question 6

The ratio percentage of earnings retained is the same as that termed:

A)dividend yield.
B)dividend payout.
C)this year's retained earnings to net income.
D)return on common equity.
E)book value.

Question 7

Dawn Alive reported the following for 2012. $\begin{array}{lr}\text {Ending market price }&\$40.75\\\text { Earnings per share:}\\\text { Basic } & 2.50 \\\text { Diluted } & 2.08 \\\text { Dividends per share } & 1.10\end{array}$ The price/earnings ratio and dividend payout were:

A)19.59 and 52.88%
B)16.30 and 52.88%
C)16.30 and 44.00%
D)19.59 and 44.00%
E)37.04 and 52.88%

Question 8

Smith reported the following for 2012. $\begin{array}{lr}\text { Beginning market price } & \$ 20.00 \\\text { Average market price } & 24.00 \\\text { Ending market price } & 26.00\\\text { Earnings per share: }\\\text { Basic } & 1.80 \\\text { Diluted } & 1.60 \\\text { Cash dividends per share } & 1.00\\\end{array}$ The price earnings ratio and dividend payout were:

A)16.25 and 62.50%.
B)16.25 and 65.00%.
C)17.00 and 62.50%.
D)15.00 and 62.50%.
E)15.00 and 60.00%.

Question 9

Interest expense creates magnification of earnings through financial leverage because:

A)the interest rate is variable.
B)interest accompanies debt financing.
C)the use of interest causes higher earnings.
D)interest costs are cheaper than the required rate of return to equity owners.
E)while earnings available to pay interest rise, earnings to residual owners rise faster.

Question 10

The best dividend payout ratio:

A)approximates 50%.
B)continues at the same level as was historically paid.
C)is similar to the industry average.
D)is higher than that of competitors.
E)does not follow any rule of thumb for dividend payout.

Question 11

In 2012, ABC Company reported earnings per share of $2.00 for 10,000 shares.In 2013, there was a 2-for-1 stock split, for which 2013 earnings per share were reported at $2.10.The appropriate earnings per share presentation for a 2-year comparative analysis would be: $$\begin{array} { l c r } &{ 2013 } &{ 2012 } \\\hline\text { I. } & 2.10 & \$ 2.00 \\\text { II. } & \$ 2.05 & \$ 2.00 \\\text { III. } & \$ 1.05 & \$ 2.00 \\\text { IV. } & \$ 1.05 & \$ 1.00\end{array}$$

A)I
B)II
C)III
D)IV
E)none of the answers are correct

Question 12

The price/earnings ratio:

A)measures the past earning ability of the firm.
B)is a gauge of future earning power as seen by investors.
C)relates price to dividends.
D)relates price to total net income.
E)All of the answers are correct.

Question 13

The earnings per share is computed for:

A)common stock.
B)non-redeemable preferred.
C)redeemable preferred.
D)common stock and non-redeemable preferred stock.
E)common stock and fully diluted preferred stock.

Question 14

Which of the following ratios usually reflects investors opinions of the future prospects for the firm?

A)Dividend yield
B)Book value per share
C)Price/earnings ratio
D)Earnings per share
E)Dividend payout

Question 15

Book value per share may not approximate market value per share because:

A)the book value is after tax.
B)book values are based on replacement costs rather than market values.
C)book value is related to book figures and market value is related to the future potential as seen by investors.
D)investors do not understand book value.
E)book value is not related to dividends.

Question 16

Stable dividend policy would most commonly imply:

A)a high price/earnings ratio.
B)a stable dividend yield.
C)stable dividends per share.
D)stable earnings per share.
E)increasing dividends per share.

Question 17

Which of the following is not a true statement regarding stock options?

A)They may cause dilution of earnings per share
B)They generally allow the purchase of common stock at favorable terms
C)They involve a compensation expense
D)Exercise improves the short-term liquidity and debt position of the issuing firm
E)The potential dilution can be disregarded in financial analysis

Question 18

The following data were gathered from the annual report of Desk Products. $\begin{array}{lr}\text { Market price per share } & \$ 30,00 \\\text { Number of common shares } & 10,000 \\\text { Preferred stock. } 5 \% \$ 100 \text { par } & \$ 10,000\\\text { Common equity }&\$140,000\\\end{array}$ The book value per share is:

A)$30.00.
B)$15.00.
C)$14.00.
D)$13.75.
E)$13.50.

Question 19

Which of the following ratios represents dividends per common share in relation to market price per common share?

A)Dividend payout
B)Dividend yield
C)Price/earnings
D)Book value per share
E)Percentage of earnings retained

Question 20

Good Boss Inc.had the following pattern of results related to stock appreciation rights. $\begin{array}{lr}\text { Shares in the plan } & 20,000 \\\text { Option price } & \$ 15.00 \\\text { Market price- } &\\\text { end year } 1 & \$ 20.00 \\\text { end year } 2 & \$ 18.00 \\\text { end year } 3 & \$ 22.00\\\end{array}$ The compensation expense would be: $\begin{array}{lrrr}&\text { Year } 1 & \text { Year } 2 & \text { Year 3} \\\text { I. } & \$ 100,000 & \$-0- & \$ 40,000 \\\text { II. } & 100,000 & 60,000 & 40,000 \\\text { III. } & 100,000 & (40,000) & 80,000 \\\text { IV. } & 400,000 & -0- & 40,000\end{array}$

A)I
B)II
C)III
D)IV
E)none of the answers are correct

Question 21

When market value is below book value, this relationship indicates that the investors view the company as having strong future potential.

Question 22

Stock appreciation rights can have a material impact on reported earnings.

Question 23

If financial leverage is used, a rise in EBIT will cause a lessor rise in net income.

Question 24

Some employees prefer restricted stock over options because they receive actual shares of stock.

Question 25

Using financial leverage results in a fixed change that can materially affect the earnings available to the common shareholders.

Question 26

A firm might have a low dividend payout ratio if it were planning a major expansion.

Question 27

The percentage of earnings retained is computed by dividing retained earnings by total stockholders' equity.

Question 28

Operating leverage refers to the existence of fixed operating costs.

Question 29

The price/earnings ratio expresses the relationship between selling prices of the company's products and the related earnings.

Question 30

In computing earnings per share, preferred dividends are subtracted from net income.

Question 31

The use of debt financing creates financial leverage.

Question 32

Nonrecurring items such as extraordinary income and disposal of a segment require separate earnings per share disclosure.

Question 33

Stock appreciation rights give the employee compensation at a future date, based on the market price at the date of exercise in excess of a pre-established dollar market.

Question 34

Book value per share measures the current value of the net assets on a per share basis.

Question 35

Total earnings from securities include both dividends and price appreciation.

Question 36

The degree of financial leverage is the multiplication factor by which debt to equity changes as new debt is issued.

Question 37

A disadvantage of interest expense over dividends is its tax deductibility.

Question 38

Dividend yield relates dividends per share to market price per share.

Question 39

When a stock split occurs, earnings per share must be adjusted retroactively.

Question 40

In general, new firms, growing firms, and firms perceived as growth firms will have a relatively low percentage of earnings retained.

Question 41

SFAS No.123(R) results in greater international comparability in the accounting for share-based transactions.

Question 42

The use of financing with a fixed charge (such as interest) is termed financial leverage.

Question 43

Stock options do not require a cash outlay from the company, while stock appreciation rights often do require a cash outlay.