Answer Options:
a. Actions that increase reported net income will always increase cash flow.
b. One way to increase EVA is to generate the same level of operating income but with less total invested capital.
c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free.
d. One way to increase EVA is to achieve the same level of operating income but with more total invested capital obtained at a higher cost of capital.
e. If a firm reports positive net income, its EVA must also be positive.
Answer: b
Question: If a firm’s marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.
a. True
b. False
Answer: a. True
Question: When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for RF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.
a. True
b. False
Answer: a. True
Question: The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of the stockholders’ claims against the firm’s existing assets. Put another way retained earnings are stockholders’ reinvested earnings.
Answer Options:
a. True
b. False
Answer: a. True
Question: The cost of debt, rd, is normally less than rs, so rd(1 – T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 – T).
a. True
b. False
Answer: a. True
Question: When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock’s expected future rate of return. This problem leaves us unsure of the true value of rs.
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Options:
a. Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies’ debt ratios to be lower than they would be if interest and dividends were both deductible.
b. Interest paid to an individual is counted as income for federal tax purposes and taxed at the individual’s regular tax rate, which in 2014 could go up to 39.6%, but qualified dividends received were taxed at a maximum tax rate of 15% for individuals earning less than $400,000 and married taxpayers filing jointly earning less than $450,000.
c. The maximum federal tax rate on corporate income in 2014 was 50%.
d. Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax purposes.
e. The maximum federal tax rate on personal income in 2014 was 50%.
Answer: b
Question: The amount shown on the December 31, 2015, balance sheet as “retained earnings” is equal to the firm’s net income for 2015 minus any dividends it paid.
Answer Options:
a. True
b. False
Answer: False
Question: The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Options:
a. MVA stands for market value added, and it is defined as follows:
MVA = (Shares outstanding)(Stock price) + Book value of common equity.
b. The primary difference between EVA and accounting net income is that when net income is calculated, a deduction is made to account for the cost of common equity, whereas EVA represents net income before deducting the cost of the equity capital the firm uses.
c. MVA gives us an idea about how much value a firm’s management has added during the last year.
d. MVA gives us an idea about how much value a firm’s management has added over the firm’s life.
e. EVA stands for economic value added, and it is defined as follows:
EVA = NOPAT – (Total invested capital)(AT cost of capital %)
Answer: e
Question: Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout, announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument.
Answer Options:
a. True
b. False
Answer: b. False
Question: The higher the firm’s flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.
a. True
b. False
Answer: b. False
Question: The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.
a. True
b. False
Answer: a. True
Question: On its 12/31/14 balance sheet, Barnes Inc showed $510 million of retained earnings, and exactly that same amount was shown the following year. Assuming that no earnings restatements were issued, which of the following statements is CORRECT?
Answer Options:
a. If the company lost money in 2014, it must have paid dividends.
b. The company must have had zero net income in 2014.
c. The company must have paid out half of its 2014 earnings as dividends.
d. The company must have paid no dividends in 2014.
e. Dividends could have been paid in 2014, but they would have had to equal the earnings for the year.
Answer: d
Question: If the information content, or signaling, hypothesis is correct, then a change in a firm’s dividend policy can have an important effect on its stock price and cost of equity.
Answer Options:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
a. Dividends paid reduce the net income that is reported on a company’s income statement.
b. If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, this will cause a decline in its current assets as shown on the balance sheet.
c. If a company issues new long-term bonds to purchase fixed assets during the current year, this will increase both its reported current assets and current liabilities at the end of the year.
d. Accounts receivable are reported as a current liability on the balance sheet.
e. If a company pays more in dividends than it generates in net income, its retained earnings as reported on the balance sheet will decline from the previous year’s balance.
Answer Options:
a. Dividends paid reduce the net income that is reported on a company’s income statement.
b. If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, this will cause a decline in its current assets as shown on the balance sheet.
c. If a company issues new long-term bonds to purchase fixed assets during the current year, this will increase both its reported current assets and current liabilities at the end of the year.
d. Accounts receivable are reported as a current liability on the balance sheet.
e. If a company pays more in dividends than it generates in net income, its retained earnings as reported on the balance sheet will decline from the previous year’s balance.
Answer: e. If a company pays more in dividends than it generates in net income, its retained earnings as reported on the balance sheet will decline from the previous year’s balance.