2: (97) Profitability and Per-Share Ratios

1: (44) Profitability
2: (14) Factors Affecting Reported Profitability
3: (39) Per-Share Ratios

1: (44) Profitability

Question: 1 A company’s year-end selected financial data is shown below.

Year 2 Year 1

Current assets $250,000 $175,000

Total assets 600,000 500,000

Total liabilities 300,000 225,000

Net sales 200,000 150,000

Net income 75,000 60,000

The company’s rate of return on assets and rate of return on equity for Year 2 are

A. 36% and 25%, respectively.

Answer (A) is incorrect.
Return on assets of 36% results from dividing Year 2 net sales ($200,000) by average total
assets ($550,000). Return on equity of 25% results from dividing Year 2 net income
($75,000) by Year 2 total equity ($300,000 [$600,000 total assets – $300,000 total liabilities]).

B. 13% and 25%, respectively.

Answer (B) is incorrect.
Return on assets of 13% results from dividing Year 2 net income ($75,000) by Year 2 total
assets ($600,000). Return on equity of 25% results from dividing Year 2 net income
($75,000) by Year 2 total equity ($300,000 [$600,000 total assets – $300,000 total liabilities]).

C. 12% and 22%, respectively.

Answer (C) is incorrect.
Return on assets of 12% results from dividing Year 1 net income ($60,000) by Year 1 total
 assets ($500,000). Return on equity of 22% results from dividing Year 1 net income
($60,000) by Year 1 equity ($275,000).

D. 14% and 26%, respectively.

Answer (D) is correct.
Return on assets equals net income divided by average total assets. The return on assets
equals 14% {$75,000 ÷ [($600,000 + $500,000) ÷ 2]}. Return on equity equals net income
divided by average total equity. Total equity equals total assets minus total liabilities. Thus,
the return on equity equals 26% {$75,000 ÷ [($300,000 + $275,000) ÷ 2]}.

Question: 2 Based on potential sales of 500 units per year, a new product has estimated traceable
costs of $990,000. What is the target price to obtain a 15% profit margin on sales?

A. $1,980
Answer (A) is incorrect.
The cost per unit is $1,980 ($990,000 ÷ 500 units).

B. $1,935
Answer (B) is incorrect.
The amount of $1,935 is 85% of $2,277.

C. $2,277
Answer (C) is incorrect.
The amount of $2,277 results from multiplying $990,000 by 1.15 and dividing by 500 units

D. $2,329
Answer (D) is correct.
Costs of the product must be 85% of sales to achieve a 15% profit on sales. Thus, sales must
be $1,164,706 ($990,000 ÷ .85). The price per unit is $2,329 ($1,164,706 ÷ 500).
Question: 3 A financial analyst who works for Company Z has collected the following information on
Company Z and its three main competitors.

Company Z Company A Company B Company C

Net income $1,000,000 $ 5,000,000 $ 850,000 $2,545,000

Interest expense $ 200,000 $ 750,000 $ 100,000 $ 565,000

Average total assets $2,500,000 $10,000,000 $1,250,000 $7,750,000

Income tax rate 40% 45% 30% 50%

Based on the collected information, the financial analyst calculated each company’s
return on assets. Which one of the following statements is most correct?

A. Company Z’s management is operating more efficiently than Company B’s management.
Answer (A) is incorrect.
Company Z has a lower return on assets (40%) than Company B (68%).

B. Company B’s management is operating more efficiently than Company A’s management.
Answer (B) is correct.
Company B has a greater return on total assets than Company A. Company A has a 50%
return ($5,000,000 ÷ $10,000,000) compared to the 68% return for Company B ($850,000 ÷
$1,250,000). Company Z has a 40% return ($1,000,000 ÷ $2,500,000), while Company C has
a return of 32.8% ($2,545,000 ÷ $7,750,000).

C. Company C’s management is making the best use of the assets.

Answer (C) is incorrect.
Company C has the lowest return on assets of any of the four companies.

D. Company A’s management is making the least use of the assets.

Answer (D) is incorrect.
Company A is returning less than Company B.

Fact Pattern: The financial statements for Dividendosaurus, Inc., for the current year are as
follows:
Balance Sheet Statement of Income and Retained Earnings
Cash $100 Sales $ 3,000
 Accounts receivable 200 Cost of goods sold (1,600)
Inventory 50 Gross profit $ 1,400
Net fixed assets 600 Operations expenses (970)
Total $950 Operating income $ 430
Interest expense (30)
Accounts payable $140
Income before tax $ 400
Long-term debt 300
Income tax (200)
Capital stock 260
Retained earnings 250 Net income $ 200
Add: Jan. 1 retained earnings 150
Total $950
Less: Dividends (100)
Dec. 31 retained earnings $ 250

Question: 4 Dividendosaurus has return on assets of

A. 21.1%
Answer (A) is correct.
The return on assets is the ratio of net income to total assets. For Dividendosaurus, it equals
21.1% ($200 net income ÷ $950 total assets).

B. 42.1%
Answer (B) is incorrect.
The ratio of income before tax to total assets is 42.1%.

C. 45.3%
Answer (C) is incorrect.
The ratio of income before interest and tax to total assets is 45.3%.

D. 39.2%
Answer (D) is incorrect.
The ratio of net income to common equity is 39.2%.

Question: 5 A company’s Year 4 gross profit margin remained unchanged from Year 3. However,
the company’s Year 4 net profit margin increased from Year 3. Which one of the
following could explain the change from Year 3 to Year 4?
 A. Preferred dividends increased.
Answer (A) is incorrect.
Dividends come from retained earnings, not net profit margin. Thus, there would be no effect
on the net profit margin.

B. Corporate income tax rates decreased.

Answer (B) is correct.
Gross profit margin, which is equal to sales revenue less cost of goods sold, did not change
from Year 3 to Year 4. Thus, a change in sales or cost of goods sold would not explain the
increase in net profit margin. A change in income tax rates would explain the increase
because tax is applied to gross profit margin to arrive at net profit margin. Lower tax rates
would result in a higher net profit margin in Year 4.

C. Sales decreased at a slower rate than operating expenses.

Answer (C) is incorrect.
Sales decreasing at a slower rate than operating expenses would decrease net profit margin
because of the rising expenses.

D. Cost of goods sold decreased relative to sales.

Answer (D) is incorrect.
Gross profit margin did not change from Year 3 to Year 4. The increase in net profit margin
would be caused by a factor other than cost of goods sold or sales.

Question: 6 A construction company is preparing to finalize the financial statements for the most
recent year. Results are sales of $690,000, cost of sales of $378,900, and
administrative expenses of $120,800. The controller has just found a sales invoice for a
job completed on the last day of the year. The revenue and related costs for the job
have not yet been recorded in the accounting system. The job’s revenues are $95,000
with costs totaling $65,000. What is the impact of this job on year-end profitability?

A. A decrease in the company’s gross profit margin and an increase in the net profit margin.
Answer (A) is correct.
Gross and net profit margin, before and after the unrecorded invoice, are calculated below:
Before After
 Sales $690,000 100% $785,000 100%
Cost of sales $378,900 54.91% $443,900 56.55%

Gross profit $311,100 45.09% $341,100 43.45%

Administrative expenses $120,800 17.51% $120,800 15.39%

Net profit $190,300 27.58% $220,300 28.06%

The gross profit margin decreases from 45.09% to 43.45%, while the net profit margin
increases from 27.58% to 28.06%.

B. An increase in the company’s gross profit margin and a decrease in the net profit margin.
Answer (B) is incorrect.
Gross profit margin is gross profit divided by sales; net profit margin is net profit divided by
sales.

C. Decreases in the company’s gross profit margin and net profit margin.
Answer (C) is incorrect.
The net profit margin increases.

D. Increases in the company’s gross profit margin and net profit margin.
Answer (D) is incorrect.
The gross profit and net profit both increase, but the gross profit margin does not. Also, the
$65,000 costs are all costs of sales, not administrative expenses.

Question: 7 If the return on equity is 12% and the debt ratio is 40%, what is the return on assets?

A. 12.0%
Answer (A) is incorrect.
Return on assets is not the same as return on equity.

B. 4.8%
Answer (B) is incorrect.
4.8% results from failing to subtract the debt ratio from 1.
 C. 20.0%
Answer (C) is incorrect.
20% is the difference between the debt ratio and (1 – debt ratio).

D. 7.2%
Answer (D) is correct.
The entire income accrues to the equity holders. If total assets equal $100, then equity must
be 60% of that, or $60. A 12% return on $60 would be $7.20. Return on assets is calculated
using the following formula:
Return on assets = Return on equity × (1 – Debt ratio)

For this problem, the calculation is 12% × 60% = 7.2%

Question: 8 According to the DuPont formula, which one of the following will not increase a
profitable firm’s return on equity?

A. Lowering equity multiplier.

Answer (A) is correct.
Lowering the equity multiplier would not increase a profitable firm’s return on equity. The
DuPont model depicts return on assets as total asset turnover (sales divided by average total
assets) times the profit margin (net income divided by sales).

B. Increasing total asset turnover.

Answer (B) is incorrect.
Increasing total asset turnover would increase a profitable firm’s return on equity.

C. Increasing net profit margin.

Answer (C) is incorrect.
Increasing net profit margin would increase a profitable firm’s return on equity.

D. Lowering corporate income taxes.

Answer (D) is incorrect.
Lowering corporate income taxes would increase a profitable firm’s return on equity.
 Fact Pattern: The financial statements for Dividendosaurus, Inc., for the current year are as follows:
Balance Sheet Statement of Income and Retained Earnings
Cash $100 Sales $ 3,000
Accounts receivable 200 Cost of goods sold (1,600)
Inventory 50 Gross profit $ 1,400
Net fixed assets 600 Operations expenses (970)
Total $950 Operating income $ 430
Interest expense (30)
Accounts payable $140
Income before tax $ 400
Long-term debt 300
Income tax (200)
Capital stock 260
Retained earnings 250 Net income $ 200
Add: Jan. 1 retained earnings 150
Total $950
Less: Dividends (100)
Dec. 31 retained earnings $ 250

Question: 9 Dividendosaurus has a profit margin of

A. 14.33%
Answer (A) is incorrect.
The ratio of income before interest and taxes to sales is 14.33%.

B. 46.67%
Answer (B) is incorrect.
The ratio of gross profit to sales is 46.67%.

C. 6.67%
Answer (C) is correct.
The profit margin is the ratio of net income to sales. For Dividendosaurus, it equals 6.67%
($200 net income ÷ $3,000 sales).

D. 13.33%
Answer (D) is incorrect.
The ratio of income before tax to sales is 13.33%.
Question: 10 A company has sales of $100,000, cost of sales of $40,000, interest expense of
$4,000, taxes of $18,000, and operating expenses of $15,000. What is the company’s
operating profit margin?

A. 41%
Answer (A) is incorrect.
Operating profit margin is equal to operating income divided by net sales. Operating income includes
COGS and operating expenses but not interest or taxes. The amount of 41% of 41% incorrectly
includes the interest expense in the operating income calculation.

B. 60%
Answer (B) is incorrect.
Operating profit margin is equal to operating income divided by net sales. Operating income
includes COGS and operating expenses but not interest or taxes. The amount of 60% fails to
subtract the operating expenses of $15,000 from the net sales in order to calculate the
correct operating income of $45,000.

C. 23%
Answer (C) is incorrect.
Operating profit margin is equal to operating income divided by net sales. Operating income
includes COGS and operating expenses but not interest or taxes. The amount of 23%
incorrectly includes the interest expense and the taxes in the operating income calculation.

D. 45%
Answer (D) is correct.
Operating profit margin is equal to operating income divided by net sales. Operating income
includes COGS and operating expenses but not interest or taxes. Thus, the company’s
operating income is equal to $45,000 ($100,000 sales – $40,000 COGS – $15,000 operating
expenses). The amount of $45,000 divided by $100,000 of net sales results in an operating
profit margin of 45%.

Question: 11 In Year 3, gross profit margin remained unchanged from Year 2. But, in Year 3, the
company’s net profit margin declined from the level reached in Year 2. This could have
happened because, in Year 3,

A. Sales increased at a faster rate than operating expenses.

 Answer (A) is incorrect.
Sales increasing faster than operating expenses would have resulted in an increase, not a
decrease, to net profit margin.

B. Cost of goods sold increased relative to sales.

Answer (B) is incorrect.
A change in cost of goods sold would have affected gross profit margin

C. Corporate tax rates increased.

Answer (C) is correct.
Gross profit margin is net sales minus cost of goods sold. Net profit margin is gross profit
margin minus all remaining expenses and losses, one of which is income taxes. If corporate
tax rates increased, net profit margin would decrease, leaving gross profit margin unchanged.

D. Common share dividends increased.

Answer (D) is incorrect.
Any impact on dividends cannot be determined from the information given.

Question: 12 A banker is reviewing the bank’s current portfolio of outstanding loans and
collected the following financial data (in thousands) on four companies that the
bank has loaned money to.

Company A Company B Company C Company D

Earnings before interest

and income taxes ¥5,000 ¥12,500 ¥4,300 ¥2,450

Interest expense ¥3,950 ¥9,000 ¥2,675 ¥1,250

On the basis of the information provided above, which company has
the highest relative likelihood of defaulting on an outstanding loan?

A. Company A.
Answer (A) is correct.
Company A has interest expense of ¥3,950 and earnings before interest and taxes (EBIT) of ¥5,000.
Thus, the amount of interest expense represents 79% of EBIT (¥3,950 ÷ ¥5,000). Because this is the
highest ratio of all the companies, Company A has the highest relative likelihood of defaulting.
 B. Company B.
Answer (B) is incorrect.
Company B’s interest expense of ¥9,000 represents 72% of its EBIT (¥12,500). However,
Company A has a higher ratio and is therefore more likely to default.

C. Company D.
Answer (C) is incorrect.
Company D has interest expense of ¥1,250, which represents only 51% of its EBIT (¥2,450).

D. Company C.
Answer (D) is incorrect.
Company C’s interest expense of ¥2,675 is only 62% of Company C’s EBIT (¥4,300).

Question: 13 A company is currently reviewing the most recent fiscal year’s results of operations and
noted an increase in the return on assets ratio when compared to the prior year. Which
one of the following could have caused the increase?

A. Sales remained the same and expenses and total assets decreased.
Answer (A) is correct.
Return on assets is calculated as Net income ÷ Average total assets. Constant sales and a
decrease in expenses results in higher net income. Additionally, total assets decreased.
Thus, the numerator has increased and the denominator has decreased, resulting in an
increased return on assets ratio.

B. Sales decreased by the same dollar amount that expenses increased.

Answer (B) is incorrect.
A decrease in sales and increase in expenses results in lower net income overall. Given no
information indicating a decrease in average total assets, this would result in a decreased
return on assets ratio.

C. Sales remained the same and ending inventory decreased.

 Answer (C) is incorrect.
The return on assets is based on the average total assets. Thus, a decrease in ending
inventory will be averaged with the beginning inventory and will not have an overall effect on
the return on assets ratio.

D. Sales increased by the same dollar amount as expenses and total assets.
Answer (D) is incorrect.
An increase in sales equal to an increase in expenses results in an unchanged net income.
Additionally, assets increased. With increased assets and unchanged net income, the return
on assets ratio decreases.

Question: 14 Spear Corp. had sales of $2,000,000, a profit margin of 11%, and assets of
$2,500,000. Spear decided to reduce its debt ratio to 0.40 from 0.50 by selling new
common stock and using the proceeds to repay principal on some outstanding long-
term debt. After the refinancing, what is Spear’s return on equity (ROE)?

A. 5.3%
Answer (A) is incorrect.
The amount of 5.3% is not the return on equity. ROE measures the amount of income a
company earns per dollar invested by the equity holders. It equals net income divided by
average amount of equity (or total equity based on the data of this question).

B. 3.5%
Answer (B) is incorrect.
The amount of 3.5% is not the return on equity. ROE measures the amount of income a
company earns per dollar invested by the equity holders. It equals net income divided by
average amount of equity (or total equity based on the data of this question).

C. 22.9%
Answer (C) is incorrect.
The amount of 22.9% is not the return on equity. ROE measures the amount of income a
company earns per dollar invested by the equity holders. It equals net income divided by
average amount of equity (or total equity based on the data of this question).

D. 14.7%
Answer (D) is correct.
The debt ratio equals total debt (liabilities) divided by total assets. Therefore, Spear’s total
 liabilities after the repayment of long-term debt are $1,000,000 ($2,500,000 total assets × 0.4
debt ratio). According to the basic accounting equation, assets equal liabilities plus equity.
Thus, Spear’s equity equals $1,500,000 ($2,500,000 assets – $1,000,000 liabilities). ROE
measures the amount of income a company earns per dollar invested by the equity holders. It
equals net income divided by average amount of equity (or total equity based on the data
provided in this question). Net income for the period is $220,000 ($2,000,000 sales ×
11% profit margin). Therefore, the return on equity is 14.7% ($220,000 net income ÷
$1,500,000 equity).

Question: 15 For a given level of sales and holding all other financial statement items constant, a
company’s return on equity (ROE) will

A. Decrease as their total assets increase.

Answer (A) is correct.
A firm’s return on equity is a measure of how much equity capital is employed to generate its
level of earnings. In this case, an increase in total assets means an increase in equity (since
all other financial statement items are being held constant). Equity is the denominator, and an
increase in the denominator means a decrease in the overall ratio.

B. Decrease as their cost of goods sold as a percent of sales decrease.

Answer (B) is incorrect.
If cost of goods sold as a percent of sales decreases, return on equity will increase because
net income will be higher.

C. Increase as their debt ratio decreases.

Answer (C) is incorrect.
The debt ratio is total liabilities to total assets. If this ratio decreases, then either liabilities
went down or assets went up or both; since all other financial statement line items are held
constant, it will have no effect on, or will decrease, the return on equity.

D. Increase as their equity increases.

Answer (D) is incorrect.
If equity increases, return on equity will decrease.

Question: 16 A company has net sales of $4,000,000 and net income of $800,000. It has operating
income of $1,200,000. Average total assets are $18,000,000 and average total equity
is $10,000,000. The company has a return on equity of
 A. 40%
Answer (A) is incorrect.
The amount of 40% incorrectly uses sales in the numerator instead of net income.

B. 10%
Answer (B) is incorrect.
The amount of 10% results from averaging total assets and total equity in the denominator.

C. 8%
Answer (C) is correct.
The return on equity is calculated by dividing net income by average total equity. Thus,
dividing the $800,000 of income by the $10,000,000 of total equity results in a return of 8%.

D. 12%
Answer (D) is incorrect.
The amount of 12% incorrectly uses operating income in the numerator instead of net income

Question: 17 A company had $450,000 in assets, $250,000 in liabilities, and $200,000 in common
equity at the beginning of the fiscal year. The company’s management is projecting
that net income for the current fiscal year will be $55,000 and common equity at the
end of the fiscal year will be $210,000. How much will the company’s return on equity
be at the end of the fiscal year?

A. 22.0%
Answer (A) is incorrect.
Net income should be divided by average equity rather than liabilities.

B. 26.8%
Answer (B) is correct.
Return on equity is calculated as Net income ÷ Average equity. The net income earned in the
current fiscal year is $55,000, and the average equity is $205,000 [($200,000 beginning +
$210,000 ending) ÷ 2]. The return on equity is therefore 26.8% ($55,000 ÷ $205,000).
 C. 12.2%
Answer (C) is incorrect.
Net income should be divided by average equity instead of total assets.

D. 27.5%
Answer (D) is incorrect.
Net income should be divided by average equity rather than the beginning equity balance.

When a fixed asset is sold for less than book value, which one of the following will
Question: 18 decrease?

A. Net profit.
Answer (A) is correct.
When an asset is sold for less than book value, an accrual-basis loss is incurred. This
reduces net profit.

B. Current ratio.
Answer (B) is incorrect.
Cash will be received and current liabilities will remain unchanged, raising the current ratio.

C. Net working capital.

Answer (C) is incorrect.
Cash will be received and current liabilities will remain unchanged, raising net working
capital.

D. Total current assets.

Answer (D) is incorrect.
Cash will be received, raising current assets.
Question: 19 At the end of Year 1, a company had average total assets of ¥450 million, average total
liabilities of ¥150 million, and net income of ¥135 million. The company’s management
projects average total assets to increase by ¥50 million in Year 2 due to the planned
purchase of a new manufacturing plant. The company will issue ¥30 million in new debt
at the beginning of Year 2. No debt was paid down during Year 1. If management
projects net income to increase by 25% in Year 2, by approximately how much does
the company’s return on total assets increase between Year 1 and Year 2?

A. 11%
Answer (A) is incorrect.
The return on stockholders’ equity (not return on assets) is 11%

B. 20%
Answer (B) is incorrect.
A 20% increase is the result of incorrectly substituting total average liabilities in Year 2 as
income in the return on assets ratio.

C. 13%
Answer (C) is correct.
The original return on assets was 30% (¥135 ÷ ¥450). A 25% increase in income and an
increase in assets results in a 33.75% return on assets (¥168.75 ÷ ¥500). Dividing 33.75% by
30% results in a ratio of 1.125, or approximately a 13% increase.

D. 17%
Answer (D) is incorrect.
The return on stockholders’ equity (not return on assets) with new bonds deducted results in
17%.

Question: 20 A corporation experienced the following year-over-year changes:

Net profit margin Increased 25%

Total asset turnover Increased 40%

Total assets Decreased 10%

Total equity Increased 40%

Using DuPont analysis, what is the year-over-year change in return on equity (ROE)?
A. Increased 63.0%.
Answer (A) is incorrect.
The year-over-year change is not calculated by simply dividing the increase in the net profit
margin by the increase in the total asset turnover.

B. Increased 12.5%.
Answer (B) is correct.
The ROE using the DuPont analysis is calculated as follows:
Net profit margin × Total asset turnover × Equity multiplier (Total assets ÷ Total equity)

The best way to solve this problem is to use actual numbers for the return on equity
comparison of this year to last year. Assuming that last year the corporation had a net profit
margin of .025, total asset turnover of 1.05, total assets of $500,000, and total equity of
$200,000, last year’s ROE is equal to 6.56% [.025 × 1.05 × ($500,000 ÷ $200,000)].

By using the information given in the problem, the current-year amounts can be calculated,
resulting in a net profit margin of .03125 (increased by 25%), total asset turnover of 1.47
(increased by 40%), total assets of $450,000 (decreased by 10%), and total equity of
$280,000 (increased by 40%). Therefore, this year’s ROE is equal to 7.38% [.03125 × 1.47 ×
(450,000 ÷ 280,000)].

The increase in ROE from last year to this year can now be calculated as 12.5% [(7.38 –
6.56) ÷ 6.56].

C. Increased 95.0%.
Answer (C) is incorrect.
The DuPont Model for ROE is as follows: Net profit margin × Total asset turnover × Equity
multiplier (Total assets ÷ Total equity). The year-over-year change is not calculated by simply
adding and subtracting the increases and decreases from last year to this year. The incorrect
amount of 95% results from adding and subtracting the year-over-year changes (25% + 40%
– 10% + 40%).

D. Increased 10.0%.
Answer (D) is incorrect.
This answer choice incorrectly multiplies the year-over-year change for the net profit margin
by the year-over-year change for the total asset turnover to get an increase in ROE of 10.0%.
Question: 21 The president of a company is establishing performance goals for each of the
company’s manufacturing plants. The data below represent prior-year results for one of
the plants.

Revenues $ 400,000

Variable costs 100,000

Fixed costs 200,000

Average assets 1,000,000

Average liabilities 200,000

The plant’s return on assets is

A. 30.0%
Answer (A) is incorrect.
Return on assets is calculated as net income over average total assets. Net income is equal
to revenues less variable and fixed expenses. This answer choice fails to subtract fixed costs
when calculating net income.

B. 10.0%
Answer (B) is correct.
Return on assets is calculated as net income over average total assets. Net income is equal
to $100,000 ($400,000 revenues – $100,000 variable costs – $200,000 fixed costs). Average
total assets is stated as $1,000,000. Thus, return on assets is equal to 10.0% ($100,000 ÷
$1,000,000).

C. 12.5%
Answer (C) is incorrect.
Return on assets is calculated as net income over average total assets. This answer choice
incorrectly subtracts average liabilities from average assets to calculate the denominator.
Please note that the average assets are given and do not need to be adjusted for liabilities.

D. 37.5%
Answer (D) is incorrect.
Return on assets is calculated as net income over average total assets. Net income is equal
to revenues less variable and fixed expenses. This answer choice fails to subtract fixed costs
when calculating net income. In addition, it incorrectly subtracts average liabilities from
average assets to calculate the denominator. Please note that the average assets are given
and do not need to be adjusted for liabilities.
Question: 22 A company has a net profit margin of 5%, an operating profit margin of 10%, and a
gross profit margin of 25%. Sales revenue is $5,000,000. Selling, general, and
administrative expenses are $750,000. What is the cost of goods sold?

A. $4,750,000
Answer (A) is incorrect.
The difference between sales revenue and net profit is $4,750,000, which includes expenses
other than cost of goods sold.

B. $3,750,000
Answer (B) is correct.
Gross profit is equal to sales revenue minus cost of goods sold. Thus, the cost of goods sold
is equal to sales revenue minus gross profit. Given a gross profit percentage of 25% and
sales revenue of $5,000,000, the gross profit is $1,250,000 ($5,000,000 × 25%), and cost of
goods sold is $3,750,000 ($5,000,000 – $1,250,000).

C. $3,250,000
Answer (C) is incorrect.
Using a gross profit margin of 35% rather than 25% yields $3,250,000.

D. $4,250,000
Answer (D) is incorrect.
The difference between sales revenue and selling, general, and administrative expenses is
$4,250,000.

Question: 23 In the current year, a firm had $15 million in sales, while total fixed costs were held to
$6 million. The firm’s total assets averaged $20 million and the debt-to-equity ratio was
calculated at 0.60. If the firm’s EBIT is $3 million, the interest on all debt is 9%, and the
tax rate is 40%, what is the firm’s return on equity?

A. 18.6%
Answer (A) is incorrect.
A failure to deduct income taxes results in 18.6%.
B. 11.16%
Answer (B) is correct.
The first step is to determine the amount of equity. Since the debt-to-equity ratio is .6, 60D =
100E, and D = .6E. Additionally, since A = L + E, we can substitute D for L, plug in the value
of assets and solve for E as follows:

1. $20 million = D + E
2. $20 million = .6E + E
3. $20 million = 1.6E
Thus, E (equity) equals $12.5 million. Debt is therefore $7.5 million (.6 × $12.5 million).

At 9%, interest on $7.5 million of debt is $675,000. Earnings before taxes are $2,325,000
($3,000,000 EBIT – $675,000 interest). At a 40% tax rate, taxes are $930,000, which leaves
a net income of $1,395,000. Return on equity is calculated by dividing the $1,395,000 net
income by the $12,500,000 of equity capital, giving an ROE of 11.16%.

C. 24.0%
Answer (C) is incorrect.
Using the wrong amount of equity results in 24.0%.

D. 14.4%
Answer (D) is incorrect.
A failure to deduct interest expense results in 14.4%.

Fact Pattern: The information below pertains to Devlin Company.

Statement of Financial Position as of May 31 Income Statement for the year ended May 31
(in thousands) (in thousands)

Year 2 Year 1 Year 2 Year 1

Assets Net sales $480 $460

Current assets Costs and expenses
Cash $ 45 $ 38 Costs of goods sold 330 315
Trading securities 30 20 Selling, general, and
Accounts receivable (net) 68 48 administrative 52 51
Inventory 90 80 Interest expense 8 9
 Prepaid expenses 22 30 Income before taxes $ 90 $ 85

Total current assets $255 $216 Income taxes 36 34

Investments, at equity 38 30 Net income $ 54 $ 51

Property, plant, and equipment (net) 375 400
Intangible assets (net) 80 45

Total assets $748 $691

Liabilities
Current liabilities
Accounts payable $ 70 $ 42
Accrued expenses 5 4
Notes payable 35 18
Income taxes payable 15 16
Total current liabilities $125 $ 80
Long-term debt 35 35
Deferred taxes 3 2
Total liabilities $163 $117
Equity
Preferred stock, 6%, $100 par
value, cumulative $150 $150
Common stock, $10 par value 225 195
Additional paid-in capital -- common stock 114 100
Retained earnings 96 129
Total equity $585 $574
Total liabilities and equity $748 $691

Question: 24 Devlin Company’s rate of return on assets for the year ended May 31, Year 2, was

A. 7.5%
Answer (A) is correct.
The rate of return on assets equals net income divided by average total assets. Accordingly,
the rate of return is 7.5% {$54 ÷ [($748 + $691) ÷ 2]}.

B. 7.2%
Answer (B) is incorrect.
The figure of 7.2% uses ending total assets instead of average total assets.

B. 7.2%
 Answer (B) is incorrect.
The figure of 7.2% uses ending total assets instead of average total assets.

D. 7.8%
Answer (D) is incorrect.
Net income divided by beginning total assets equals 7.8%.

Question: 25 If Company A has a higher rate of return on assets than Company B, the reason may
be that Company A has a <List A> profit margin on sales, a <List B> asset turnover
ratio, or both.

List B
List A

A. Higher Lower

Answer (A) is incorrect.

A higher profit margin on sales or a higher asset-turnover ratio may explain a higher return on
assets.

B. Lower Higher

Answer (B) is incorrect.

A higher profit margin on sales or a higher asset-turnover ratio may explain a higher return on
assets.

C. Higher Higher

Answer (C) is correct.

The DuPont model treats the return on assets as the product of the profit margin and the
asset turnover:

If one company has a higher return on assets than another, it may have a higher profit
margin, a higher asset turnover, or both.

D. Lower Lower
 Answer (D) is incorrect.
A higher profit margin on sales or a higher asset-turnover ratio may explain a higher return on
assets.

Question: 26 The DuPont formula involves which combination of financial elements in its
computation?

A. Net profit margin, total asset turnover, and equity multiplier.

Answer (A) is correct.
The DuPont model begins with the standard equation for return on equity (ROE) and breaks it
down into three different efficiency components.
ROE = Net profit margin × Asset turnover × Equity multiplier

B. Total asset turnover, sales turnover, and equity multiplier.

Answer (B) is incorrect.
The DuPont model also involves net profit margin.

C. Total asset turnover and sales turnover profitability.

Answer (C) is incorrect.
The DuPont model also involves net profit margin and equity multiplier.

D. Profit margin, sales turnover, and asset-use efficiency.

Answer (D) is incorrect.
The DuPont model also involves total asset turnover and equity multiplier.

Question: 27 Which one of the following actions may increase a company’s return on assets?

A. Reduction of long-term debt through the issuance of common stock.

Answer (A) is incorrect.
This action would not affect ROA.
 B. Gain recorded on the sale of capital equipment.
Answer (B) is correct.
Return on assets, or ROA (also called return on total assets, or ROTA), is a straightforward
measure of how well management is deploying the firm’s assets in the pursuit of a profit.
ROA is calculated by dividing a firm’s net income by its average total assets. A gain recorded
on the sale of capital equipment increases net income. Thus, ROA is increased.

C. Purchase of a new corporate headquarters.

Answer (C) is incorrect.
ROA is calculated by dividing a firm’s net income by its average total assets. Since this action
causes total assets to increase, ROA would decrease overall.

D. An increase in inventory levels for a future store expansion.

Answer (D) is incorrect.
ROA is calculated by dividing a firm’s net income by its average total assets. Since this action
causes total assets to increase, ROA would decrease overall.

Fact Pattern: For the year just ended, Beechwood Corporation had income from operations of
$198,000 and net income of $96,000. The liabilities and shareholders’ equity section of
Beechwood’s statement of financial position is shown below.
January 1 December 31

Accounts payable $ 32,000 $ 84,000

Accrued liabilities 14,000 11,000
7% bonds payable 95,000 77,000
Common stock ($10 par value) 300,000 300,000
Reserve for bond retirement 12,000 28,000
Retained earnings 155,000 206,000

Total liabilities and shareholders’ equity $608,000 $706,000

Question: 28 Beechwood’s return on shareholders’ equity for the year just ended is

A. 19.2%
Answer (A) is correct.
Return on equity consists of net income divided by total equity. Since the numerator is
 derived from the income statement, the balance sheet accounts in the denominator must be
averaged. Beechwood’s return is thus calculated as follows:
ROE = $96,000 ÷ {[($300,000 + $300,000) ÷ 2] +

[($12,000 + $28,000) ÷ 2] +

[($155,000 + $206,000) ÷ 2]}

= $96,000 ÷ ($300,000 + $20,000 + $180,500)

= $96,000 ÷ $500,500

= 0.1918

B. 32.0%
Answer (B) is incorrect.
This percentage results from failing to include the reserve for bond retirement and retained
earnings in the denominator.

C. 19.9%
Answer (C) is incorrect.
This percentage results from failing to include the reserve for bond retirement in total equity.

D. 39.5%
Answer (D) is incorrect.
This percentage results from improperly using income from operations rather than net income
in the numerator.

Question: 29 The following data pertain to Canova, Inc., for the year ended December 31:

Net sales $ 600,000

Net income 150,000

Total assets, January 1 2,000,000

Total assets, December 31 3,000,000

What was Canova’s rate of return on assets for the year?
 A. 20%
Answer (A) is incorrect.
Twenty percent results from dividing net sales by ending total assets.

B. 24%
Answer (B) is incorrect.
Twenty-four percent results from dividing net sales by average total assets.

C. 6%
Answer (C) is correct.
Return on assets equals net income divided by average total assets, or 6% {$150,000 ÷
[($2,000,000 + $3,000,000) ÷ 2]}.

D. 5%
Answer (D) is incorrect.
Five percent results from using ending total assets instead of the average total assets.

Fact Pattern: The data presented below show actual figures for selected accounts of McKeon Company
for the fiscal year ended May 31, Year 1, and selected budget figures for the Year 2 fiscal year.
McKeon’s controller is in the process of reviewing the Year 2 budget and calculating some key ratios
based on the budget. McKeon Company monitors yield or return ratios using the average financial
position of the company. (Round all calculations to three decimal places if necessary.)
5/31/Year 2 5/31/Year 1

Current assets $210,000 $180,000

Noncurrent assets 275,000 255,000

Current liabilities 78,000 85,000

Long-term debt 75,000 30,000

Common stock ($30 par value) 300,000 300,000

Retained earnings 32,000 20,000

Year 2
Operations

Sales* $350,000
Cost of goods sold 160,000
Interest expense 3,000
Income taxes (40% rate) 48,000
Dividends declared and paid in Year 2 60,000
Administrative expense 67,000

*All sales are credit sales.

Current Assets

5/31/Year 2 5/31/Year 1

Cash $ 20,000 $10,000

Accounts receivable 100,000 70,000

Inventory 70,000 80,000

Prepaid expenses 20,000 20,000

Question: 30 The Year 2 return on equity for McKeon Company is

A. 0.221
Answer (A) is correct.
Return on equity equals net income of $72,000 ($350,000 sales – $160,000 COGS – $3,000
interest expense – $48,000 taxes – $67,000 administrative expenses) divided by the average
stockholders’ equity (yield or return ratios are based on average financial position in these
questions). The average equity of $326,000 is found by averaging the $320,000 sum of the
common stock and retained earnings at May 31, Year 1, with the $332,000 ending balance.
Dividing the $72,000 net income by $326,000 produces a rate of return of 22.1%.

B. 0.040
Answer (B) is incorrect.
Return on equity equals net income divided by average stockholders’ equity.

C. 0.361
Answer (C) is incorrect.
Return on equity equals net income divided by average stockholders’ equity.
 D. 0.240
Answer (D) is incorrect.
Return on equity equals net income divided by average stockholders’ equity.

Question: 31 Selected financial data for the year is shown below:

Beginning of Year End of Year

Assets $9,600,000 $10,000,000

Liabilities $6,200,000 $6,800,000
Shares outstanding 1,400,000 1,500,000
Market price per share $2.40 $2.50
Sales $22,000,000
Earnings before interest and taxes $1,700,000
Interest expense $500,000
Tax rate 40%
Using the above data the firm’s return on equity using the DuPont model is

A. 22%
Answer (A) is correct.
The DuPont model depicts return on equity as the profit margin (net income divided by sales)
times total asset turnover (sales divided by average total assets) times the equity multiplier
(average total assets divided by average total equity). Thus, the return on equity using the
DuPont model is

3.27% ($720,000 ÷ $22,000,000)

× 2.24 ($22,000,000 ÷ $9,800,000)

× 2.97 ($9,800,000 ÷ $3,300,000)

22%

B. 36%
 Answer (B) is incorrect.
This percentage uses the incorrect net income amount when calculating profit margin. The
net income amount only deducts interest expense from earnings before interest and tax and
fails to deduct taxes.

C. 15%
Answer (C) is incorrect.
This percentage incorrectly uses net income instead of sales for the equity multiplier.

D. 19%
Answer (D) is incorrect.
This percentage uses ending equity instead of average equity for the equity multiplier.

Question: 32 Company ABC’s profit margin declined between 2014 and 2015 as shown below.

2015 2014

Sales price $20 100% $20 100%

Cost of goods sold $ 5 25% $ 4 20%

Gross profit $15 75% $16 80%

Which one of the following is the best explanation for the decline?

A. There was a decrease in sales.

Answer (A) is incorrect.
Sales did not change; they were 100% each year.

B. There was a decrease in depreciation of the manufacturing equipment.

Answer (B) is incorrect.
A decrease in depreciation would reduce the cost of goods sold.

C. There was an increase in advertising expenses.

 Answer (C) is incorrect.
Advertising expenses are deducted below gross profit, so there is no information given with
respect to advertising expenses.

D. There was a write-down of inventory in 2015.

Answer (D) is correct.
Sales stayed the same, but cost of goods sold increased. This could occur because of a
write-down of inventory in the later year (2015).

Question: 33 A corporation has a return on equity of 20%, a return on assets of 15%, and a dividend
payout ratio of 30%. The corporation’s sustainable equity growth rate is

A. 14.0%
Answer (A) is correct.
The sustainable growth rate equals the return on equity times the difference of 1 and the
dividend payout ratio (1 – dividend payout ratio). Thus, the return on equity of 20% is
multiplied by .7 (1.0 – .3), resulting in a sustainable equity growth rate of 14%.

B. 4.5%
Answer (B) is incorrect.
The amount of 4.5% incorrectly uses the return on assets in the calculation.

C. 6.0%
Answer (C) is incorrect.
The amount of 6.0% incorrectly multiplies the return on equity by the dividend payout ratio.

D. 50.0%
Answer (D) is incorrect.
The amount of 50.0% incorrectly combines the return on equity with the dividend payout ratio.

Question: 34 The following information pertains to the year ended December 31:
 Sales $720,000

Net income 120,000

Average total assets 480,000

Which one of the following formulas depicts the use of the DuPont model to calculate
return on assets?

A. (720,000 ÷ 480,000) × (720,000 ÷ 120,000)

Answer (A) is incorrect.
The DuPont model depicts return on assets as total asset turnover (sales divided by average total
assets) times the profit margin (net income divided by sales).

B. (720,000 ÷ 480,000) × (120,000 ÷ 720,000)

Answer (B) is correct.
The DuPont model depicts return on assets as total asset turnover (sales divided by average
total assets) times the profit margin (net income divided by sales). Therefore, the ROA
calculation uses the formula [($720,000 ÷ $480,000) × ($120,000 ÷ $720,000)].

C. (480,000 ÷ 720,000) × (720,000 ÷ 120,000)

Answer (C) is incorrect.
The DuPont model depicts return on assets as total asset turnover (sales divided by average
total assets) times the profit margin (net income divided by sales).

D. (480,000 ÷ 720,000) × (120,000 ÷ 720,000)

Answer (D) is incorrect.
The DuPont model depicts return on assets as total asset turnover (sales divided by average
total assets) times the profit margin (net income divided by sales).

Question: 35 A company had $5 million in sales, $3 million in cost of goods sold, and $1 million in
selling and administrative expenses during the last fiscal year. If the company’s income
tax rate was 25%, what was the company’s gross profit margin percentage?

A. 40%
Answer (A) is correct.
Gross profit margin percentage equals gross profit divided by net sales. Gross profit equals
 revenues less the cost of goods sold. Gross profit is $2 million ($5 million – $3 million). Gross
profit margin percentage equals 40% ($2 million ÷ $5 million).

B. 20%
Answer (B) is incorrect.
Gross profit equals to revenues less the cost of goods sold. Selling and administrative
expenses are not deducted.

C. 30%
Answer (C) is incorrect.
Income tax is not included in the calculation of gross profit margin percentage.

D. 50%
Answer (D) is incorrect.
Gross profit margin percentage is 40%

Question: 36 A corporation’s return on equity can be calculated if you know its

A. Market-to-book ratio and equity multiplier.

Answer (A) is incorrect.
The equity multiplier and return on assets could calculate return on equity.

B. Sustainable equity growth rate and dividend payout ratio.

Answer (B) is correct.
The sustainable equity growth rate can be found by multiplying return on equity by 1 minus
the dividend payout ratio. Thus, the return on equity can be derived given the sustainable
growth rate and the dividend payout ratio.

C. Debt-equity ratio and market-to-book ratio.

Answer (C) is incorrect.
The market-to-book ratio cannot be used to calculate return on equity
 D. Dividend yield and earnings yield.
Answer (D) is incorrect.
These numbers would not provide the information needed to find the net income or average
total equity.

Question: 37 Selected items from the equity section of a company’s balance sheet are shown below.

Year 2 Year 1

Common stock, 5,000,000 shares $ 50,000,000 $ 50,000,000

Total equity 200,000,000 182,500,000

The increase in equity was caused by $20,000,000 in net income less a common stock
dividend payment of $0.50 per share. The company’s sustainable growth rate is

A. 10.46%
Answer (A) is incorrect.
The ROE for Year 2 is 10.46%.

B. 9.15%
Answer (B) is correct.
The sustainable growth rate equals the return on equity (ROE) times the difference of 1 and
the dividend payout ratio. The ROE equals Net income ÷ Average total equity.
Sustainable growth
rate = ROE × (1 – Dividend payout ratio)

= {$20,000,000 ÷ [($200,000,000 + $182,500,000) ÷ 2]} × [1 – ($2,500,000 ÷

$20,000,000)]

= ($20,000,000 ÷ $191,250,000) × (1 – 0.125)

= 0.1046 × 0.875

= 0.0915

= 9.15%

C. 9.59%
 Answer (C) is incorrect.
The ROE for Year 2 should be calculated using the average equity amount of $191,250,000
rather than the beginning equity balance of $182,500,000.

D. 8.75%
Answer (D) is incorrect.
The ROE for Year 2 should be calculated using the average equity amount of $191,250,000
rather than the ending equity balance of $200,000,000.

Question: 38 A company reported the following financial data.

Sales $2,000,000

Cost of goods sold 800,000

Operating expenses 400,000

Interest expense 200,000

Income tax 300,000

The company’s operating profit margin percentage is

A. 80%
Answer (A) is incorrect.
An operating profit margin of 80% does not include COGS in the calculation of net sales

B. 15%
Answer (B) is incorrect.
Operating profit margin equals operating income divided by net sales. Operating income
includes COGS and operating expenses but not interest or taxes.

C. 30%
Answer (C) is incorrect.
Operating profit margin equals operating income divided by net sales. Operating income
includes COGS and operating expenses but not interest expense.
 D. 40%
Answer (D) is correct.
Operating profit margin equals operating income divided by net sales. Operating income
includes COGS and operating expenses but not interest or taxes. Thus, the company’s
operating income is equal to $800,000 ($2,000,000 sales – $800,000 COGS – $400,000
operating expenses). The amount of $800,000 divided by $2,000,000 of net sales results in
an operating profit margin of 40%.

Question: 39 According to its public financial statements, a company’s gross profit margin decreased
by 5% while its operating profit margin increased by 3%. Which one of the following
factors could cause both of these changes?

A. Sale of fully-depreciated production machinery at a gain and replacement of the machines with
newer models.
Answer (A) is incorrect.
Selling fully-depreciated production machinery at a gain and replacing the machines with
newer models would decrease both gross profit and overall profit margin.

B. An increase in the cost per unit of the goods purchased from a supplier.
Answer (B) is incorrect.
An increase in the cost per unit of the goods purchased from a supplier would decrease both
gross profit and overall profit margin.

C. A lowered selling price to increase quantities sold.

Answer (C) is correct.
The lower price could reduce gross profit, but the increased volume would increase overall
profit margin because there would not be any increase in general and administrative
expenses.

D. A change to the variable costing income statement format.

Answer (D) is incorrect.
A variable cost income statement does not show gross profit.

Question: 40 A firm is experiencing a growth rate of 9% with a return on assets of 12%. If the debt
ratio is 36% and the market price of the stock is $38 per share, what is the return on
equity?
 A. 18.75%
Answer (A) is correct.
Assume that the firm has $100 in assets, with debt of $36 and equity of $64. Income (return) is $12.
The $12 return on assets equates to an 18.75% return on equity ($12 ÷ $64).

B. 12.0%
Answer (B) is incorrect.
The figure of 12.0% is the return on assets, not return on equity.

C. 9.0%
Answer (C) is incorrect.
The figure of 9.0% is the growth rate, not a return.

D. 7.68%
Answer (D) is incorrect.
The figure of 7.68% is based on 64% of the ROA.

Question: 41 When calculating ratios involving income, an adjustment is most likely to be made for

A. Fixed overhead costs.

Answer (A) is incorrect.
Income is less likely to be adjusted for recurring costs.

B. Selling expenses.
Answer (B) is incorrect.
Income is less likely to be adjusted for recurring costs.

C. Gross profit.
 Answer (C) is incorrect.
Income is less likely to be adjusted for recurring costs.

D. Nonrecurring gains and losses.

Answer (D) is correct.
Nonrecurring gains and losses are sometimes added to or subtracted from income to arrive
at income from continuing operations. Because ratios are used to predict the future,
nonrecurring items not likely to recur should not be considered.

Question: 42 Last year, a corporation had a total asset turnover ratio of 1.5, a profit margin of 10%,
and an equity multiplier of 2. This year, if the profit margin is 8%, but the return on
equity stays the same, then what could be true?

A. The equity multiplier increases to 2.2, and the total asset turnover remains 1.5.
Answer (A) is incorrect.
This would yield a return on equity of 26.4% (8% × 1.5 × 2.2).

B. The equity multiplier remains 2.0, and the total asset turnover increases to 1.7.
Answer (B) is incorrect.
This would yield a return on equity of 27.2% (8% × 1.7 × 2.0).

C. The equity multiplier increases to 3.0, and the total asset turnover decreases to 1.25.
Answer (C) is correct.
The return on equity (ROE) for last year is 30% (10% × 1.5 × 2). Given these facts, this year’s
ROE is also 30% (8% × 1.25 × 3.0).

D. The equity multiplier remains 2.0, and the total asset turnover increases to 3.5.
Answer (D) is incorrect.
This would yield a return on equity of 56% (8% × 3.5 × 2.0).
Question: 43 Two companies have identical return on assets. Company X purchased most of its
assets many years ago when prices were relatively low. Company Y purchased most
of its assets in recent years when prices were relatively high. Both companies have
identical debt levels, and record their assets at historical cost. The return on assets
ratio is most likely

A. Overstated for Company X.

Answer (A) is correct.
The return on assets equals net income divided by average total assets. Both companies
have identical returns on assets and record assets at historical cost. Since Company X
purchased most assets at relatively low prices, the net income is also relatively low compared
with Company Y. Thus, the return on assets ratio is overstated for Company X.

B. Overstated for both companies.

Answer (B) is incorrect.
Company Y’s return on assets ratio is not overstated.

C. Overstated for Company Y.

Answer (C) is incorrect.
Company X’s return on assets ratio, not Company Y’s, is overstated.

D. Accurate for both companies.

Answer (D) is incorrect.
Company X’s return on assets ratio is overstated.

Question: 44 A financial analyst has calculated gross profit margin and net profit margin for a
company. Economists are forecasting a reduction in the corporate income tax rate.
This would

A. Increase the gross profit margin and increase the net profit margin.
 Answer (A) is incorrect.
Taxes are not deducted in the calculation of gross profit but after gross profit. Therefore, there is no
change in the gross profit margin.

B. Decrease the gross profit margin and increase the net profit margin.
Answer (B) is incorrect.
A change in tax rates will not affect the gross profit margin because taxes are not included in
the calculation. The only components of gross profit margin are net sales and cost of goods
sold.

C. Not change the gross profit margin and increase the net profit margin.
Answer (C) is correct.
The only components of gross profit margin are net sales and cost of goods sold. Tax
expense is a component of net profit margin. A reduction in the corporate income tax rate
decreases tax expense. Such a reduction, therefore, will not affect gross profit margin but will
increase the net profit margin.

D. Increase the gross profit margin and not change the net profit margin.
Answer (D) is incorrect.
A change in tax rates will not affect the gross profit margin because taxes are not included in
the calculation. The only components of gross profit margin are net sales and cost of goods
sold. Net profit margin will increase with lower taxes.
2: (14) Factors Affecting Reported Profitability

Question: 1 If gross profit margin has decreased substantially over the past 3 years, which one of
the following best explains this decrease?

A. Ending merchandise inventory is higher than expected.

Answer (A) is incorrect.
Gross profit margin is net sales minus cost of goods sold. Thus, a higher ending inventory
results in a lower cost of goods sold, which results in an increase of gross profit margin.

B. The cost of merchandise inventory has decreased while sales prices have remained the same.
Answer (B) is incorrect.
Gross profit margin is net sales minus cost of goods sold. Lower costs of merchandise will
result in a lower cost of goods sold, which increases, not decreases, gross profit margin.

C. Cost of goods sold has remained steady while total expenses have increased.
Answer (C) is incorrect.
Gross profit margin is net sales minus cost of goods sold. Thus, gross profit margin remains
unchanged if both sales and cost of goods sold remain steady.

D. A physical count of merchandise inventory showed missing inventory higher than expected.
Answer (D) is correct.
A physical count showing missing inventory results in a higher cost of goods sold, which
results in a decrease of gross profit margin.

Question: 2 A company bought a new machine and estimated that the machine will have a useful
life of 10 years and a salvage value of $5,000. After the machine has been put in
service for 2 years, the company has decided to change the estimate of the useful life
to 7 years. Which one of the following statements describes the proper way to revise a
useful life estimate?

A. Retroactive changes must be made to correct previously recorded depreciation.

 Answer (A) is incorrect.
Previous depreciation is kept as is. Only the depreciation going forward will be adjusted to account for
the new useful life.

B. Revisions in useful life are permitted only if approved by the SEC.

Answer (B) is incorrect.
A change in the useful life is considered a change in accounting estimates. A change in
accounting estimate is not required to be submitted to the SEC.

C. Only future years will be affected by the revision.

Answer (C) is incorrect.
Current-year depreciation will also be affected.

D. Both current and future years will be affected by the revision.

Answer (D) is correct.
A change in useful life is accounted for in the current year by taking the current book value
and dividing it by the new remaining useful life. This will change depreciation in the current
and future years

Question: 3 At the beginning of last year, a manufacturing company increased its selling price by
$10 per unit. This price increase has no effect on the volume of sales. As a result,
operating profit margin will

A. Increase as a result of the price increase.

Answer (A) is correct.
Operating profit margin is the percentage of revenues that remains with the firm after costs of
merchandise, selling expenses, and general and administrative expenses have been paid.
Increasing sales will increase this profit margin.

B. Change as a result of the price increase, but the direction of such change cannot be
determined.
Answer (B) is incorrect.
Operating profit margin is the percentage of revenues that remains with the firm after costs of
merchandise, selling expenses, and general and administrative expenses have been paid.
Increasing sales will increase this profit margin; the direction can be determined.
 C. Remain unchanged.
Answer (C) is incorrect.
Operating profit margin is the percentage of revenues that remains with the firm after costs of
merchandise, selling expenses, and general and administrative expenses have been paid.
Increasing sales will increase this profit margin.

D. Decline as a result of the price increase.

Answer (D) is incorrect.
Operating profit margin is the percentage of revenues that remains with the firm after costs of
merchandise, selling expenses, and general and administrative expenses have been paid.
Operating profit margin will not decline as a result of the price increase; instead, it will
increase.

Question: 4 A company’s finished goods inventory was miscounted, and the correct balance is
$130,000 lower. Management is concerned about correcting the error because
bonuses are only earned if the minimum gross profit margin is 45%. Selected financial
information is shown below.

Revenues $1,000,000

Cost of goods sold 500,000

Salaries 57,000

Accounts receivable 22,000

Cash 43,000
With the corrected inventory, will the bonus target be met?

A. No, the working capital will decrease.

Answer (A) is incorrect.
The bonus target is not met due to the increase in cost of goods sold.

B. Yes, the gross profit margin will increase.

Answer (B) is incorrect.
The gross profit margin will decrease from $500,000 to $370,000 due to the adjustment to
cost of goods sold.
 C. No, the cost of goods sold will increase.
Answer (C) is correct.
The cost of goods sold will increase as a result of the $130,000 adjustment to ending
inventory. When ending inventory is overstated, cost of goods sold is understated. An
increase to cost of goods sold remedies this understatement. As a result, the new cost of
goods sold is $630,000, which results in a new gross profit margin of $370,000. As a
percentage, the gross profit margin is 37%, which does not meet the 45% threshold required
for the bonuses.

D. Yes, the gross profit margin will not change.

Answer (D) is incorrect.
The new gross profit margin is equal to 37% due to the $130,000 adjustment to cost of goods
sold.

Question: 5 If gross profit margin has remained fairly constant for the past several years, which one
of the following is the best explanation?

A. Net sales and net income have remained constant.

Answer (A) is incorrect.
The cost of goods sold must have also remained steady.

B. The cost of goods has remained steady.

Answer (B) is incorrect.
Net sales must have also remained steady.

C. The cost of goods sold and sales have decreased by the same dollar amount.
Answer (C) is incorrect.
The cost of goods sold and sales must have decreased by the same percentage, not dollar
amount.

D. The cost of goods sold and sales have decreased by the same percentage.
Answer (D) is correct.
Gross profit margin is the percentage of gross revenues that remains with the firm after
paying for merchandise. The key analysis with respect to the gross profit margin is whether it
is keeping up with the increase or decrease in sales. For example, a 10% increase in sales
should be accompanied by at least a 10% increase in the gross profit margin.
Question: 6 A change in the estimate for credit losses should be

A. Considered as an extraordinary item.

Answer (A) is incorrect.
Extraordinary items are no longer used.

B. Treated as affecting only the period of the change.

Answer (B) is correct.
A change in estimate for credit losses requires prospective application (i.e., the effect of the
change should be treated as affecting the period of the change and any future periods).
Changes in estimates are viewed as normal recurring corrections, and retrospective
treatment is prohibited.

C. Treated as an error.
Answer (C) is incorrect.
A change in estimate is not an error. When new information is learned, estimates sometimes
need adjusting.

D. Handled retroactively.
Answer (D) is incorrect.
Only the effects of changes in accounting principle and corrections of prior-period financial
statement errors are handled retroactively.

Question: 7 Which one of the following ratios would be most affected by miscellaneous or non-
recurring income?

A. Gross profit margin.

Answer (A) is incorrect.
Gross profit margin is expressed as gross profit divided by net sales. Gross profit is equal to
revenues less the cost of goods sold, not including miscellaneous or non-recurring income.
Therefore, this ratio would not be affected by those amounts.

B. Operating profit margin.

 Answer (B) is incorrect.
Operating profit margin is equal to operating income divided by net sales. Neither sales nor
operating income would include miscellaneous or non-recurring income. Therefore, this ratio
would not be affected by those amounts.

C. Debt-to-equity ratio.
Answer (C) is incorrect.
The debt-to-equity ratio is expressed as total debt divided by stockholders’ equity. Neither
debt nor stockholders’ equity would include miscellaneous or non-recurring income.
Therefore, this ratio would not be affected by those amounts.

D. Net profit margin.

Answer (D) is correct.
Net profit margin is expressed as net income over sales. Net income would include
miscellaneous or non-recurring income. This ratio would be the most affected because the
amounts for miscellaneous or non-recurring income would be included in the numerator of
the ratio.

Question: 8 Which of the following is an item with high earnings persistence?

A. Extraordinary loss.
Answer (A) is incorrect.
This is an item with low earnings persistence.

B. Sales from a new product.

Answer (B) is correct.
Additional revenue from a successful new product and lower costs attributable to improved
operating efficiency are examples of high persistence items. Items of low persistence include
extraordinary items or one-time or rare transactions such as gains and losses on disposals of
capital assets. Zero-persistence items also exist, for example, the immediate expensing of
intangibles.

C. Gain on disposal of old equipment.

Answer (C) is incorrect.
This is an item with low earnings persistence.
 D. Extraordinary gain.
Answer (D) is incorrect.
This is an item with low earnings persistence

Question: 9 During the current year, an entity changed its method of accounting for depreciation
because it believed that the result would provide more reliable and relevant
information. In its financial statements for the year, how should the entity report the
adjustment resulting from the change in accounting principle?

A. Not disclose in the financial statements.

Answer (A) is incorrect.
The change must be disclosed in the financial statements.

B. Disclose as a separate type of depreciation expense, directly following depreciation expense in

the current year.
Answer (B) is incorrect.
The change in principle must be reported as an adjustment to beginning retained earnings for
the earliest period presented in the financial statements.

C. Include in the determination of profit or loss for the current period as a cumulative effect
adjustment.
Answer (C) is incorrect.
The adjustment must be made to the beginning retained earnings of the earliest period
presented in the financial statements

D. Report as an adjustment to beginning retained earnings of the earliest period presented in the
financial statements.
Answer (D) is correct.
When a change in accounting principle occurs, retrospective application, if practicable, is
required for all direct effects and the related income tax effects of the change. Retrospective
application requires that carrying amounts of assets, liabilities, and retained earnings at the
beginning of the first period reported be adjusted for the cumulative effect of the new principle
on all periods not reported.

Question: 10 A chain of supermarkets specializing in gourmet food, has been using the average cost
method to value its inventory. During the current year, the company changed to the
first-in, first-out method of inventory valuation. The president of the company reasoned
 that this change was appropriate since it would more closely match the flow of physical
goods. This change should be reported on the financial statements as

A. Change in accounting estimate.

Answer (A) is incorrect.
A change in inventory valuation method is a change in accounting principle, not a change in
accounting estimate.

B. Correction of an error.
Answer (B) is incorrect.
A change in inventory valuation method is a change in accounting principle, not a correction
of an error.

C. Affecting only future periods.

Answer (C) is incorrect.
This change is retrospective in that it affects only previous periods, not future periods

D. Cumulative-effect type accounting change.

Answer (D) is correct.
The change in inventory valuation method is a change in accounting principle, which should
be presented on a retrospective basis to maintain consistency and comparability.

Question: 11 Which one of the following factors is least likely to be taken into account when
analyzing a company’s selling expenses?

A. Possibility that the expense, such as sales promotion expense, will yield future benefits.
Answer (A) is incorrect.
Many advertising expenses can lead to future benefits. For example, a customer is induced
to buy a product by an advertising campaign. If the customer likes the product, he may
continue to buy that product for the rest of his life even though he never sees another
advertisement. Thus, the initial advertisement led to many years of sales.

B. Changes in the unit selling prices.

Answer (B) is correct.
A change in selling prices should not impact selling expenses.
 C. Percentage of variable and fixed selling expenses in relation to revenue.
Answer (C) is incorrect.
The proportion of fixed and variable expenses could influence the level of expenses. For
example, a large fixed cost in the form of an advertising campaign may result in a change in
selling commissions, even though salespeople are doing nothing different

D. Variance of the expense compared with prior years.

Answer (D) is incorrect.
Comparing expenses to prior years is an effective means of analyzing expense

Question: 12 Items reported as prior-period adjustments

A. Do not affect the presentation of prior-period comparative financial statements.

Answer (A) is incorrect.
A prior-period adjustment will affect the presentation of prior-period comparative financial
statements.

B. Do not require further disclosure in the body of the financial statements.

Answer (B) is incorrect.
Prior-period adjustments should be fully disclosed in the notes or elsewhere in the financial
statements.

C. Are reflected as adjustments of the opening balance of the retained earnings of the earliest
period presented.
Answer (C) is correct.
Prior-period adjustments are made for the correction of errors. The effects of errors on prior-
period financial statements are reported as adjustments to beginning retained earnings for
the earliest period presented in the retained earnings statement. Such errors do not affect the
income statement for the current period.

D. Do not include the effect of a mistake in the application of accounting principles, as this is
accounted for as a change in accounting principle rather than as a prior-period adjustment.
 Answer (D) is incorrect.
Accounting errors of any type are corrected by a prior-period adjustment.

Question: 13 An analyst is reviewing the financial statements of a company whose operating income
has declined from the prior year. The following ratios have been calculated.

Prior Year Current Year

Gross profit margin 15% 20%

Operating profit margin 12% 10%

Inventory turnover 10.4 9.8

Based on the above, the analyst could infer that the decrease in operating income may
be due to

A. Higher interest expense.

Answer (A) is incorrect.
The decrease in operating income may be due to an increase in advertising expense.
Operating profit includes selling and administrative expenses while gross profit margin does
not. However, it does not include interest expense.

B. Accumulation of unused inventory.

Answer (B) is incorrect.
The decrease in operating income may be due to an increase in advertising expense.
Inventory turnover has decreased. However, this question asks for the reason for the
decrease in operating income. There is nothing to indicate that the increase in inventory has
caused the reduction in profits.

C. An increase in advertising expense.

Answer (C) is correct.
Operating profit margin decreased, but gross profit margin increased. This could be because
advertising expenses increased. Operating profit includes selling and administrative
expenses while gross profit margin does not.

D. Lower revenue per unit sold.

Answer (D) is incorrect.
The decrease in operating income may be due to an increase in advertising expense. Lower
revenue per unit sold would decrease both gross profit margin and operating margin.
Question: 14 A publicly-traded corporation made a large arithmetical error in the preparation of its
year-end financial statements by improper placement of an extra digit in the calculation
of allowance for credit losses. The error caused the net income to be reported at
almost half of the proper amount. In accordance with U.S. GAAP, correction of the
error when discovered in the next year should be treated as

A. An increase in the opening accounts receivable balance.

Answer (A) is incorrect.
Correction of the error when discovered in the next year should be treated as a prior-period adjustment
to the opening retained earnings balance, not as an increase in the opening accounts receivable
balance.

B. A component of income for the year in which the error is discovered, but separately listed on the
income statement.
Answer (B) is incorrect.
Correction of the error when discovered in the next year should be treated as a prior-period
adjustment to the opening retained earnings balance. It is not a component of this year’s
income and thus should be included in retained earnings.

C. An increase in credit loss expense for the year in which the error is discovered.
Answer (C) is incorrect.
Correction of the error when discovered in the next year should be treated as a prior-period
adjustment to the opening retained earnings balance, not simply as an increase in credit loss
expense in the next year.

D. A prior period adjustment to the opening retained earnings balance.

Answer (D) is correct.
An accounting error results from (1) a mathematical mistake, (2) a mistake in the application
of GAAP, or (3) an oversight or misuse of facts existing when the statements were prepared.
An accounting error related to a prior period is reported as a prior-period adjustment by
restating the prior-period statements.
3: (39) Per-Share Ratios

Question: 1 A corporation had 250,000 shares of common stock outstanding on January 1. The
financial manager of the corporation on September 30 is projecting net income of
$750,000 for the current year. If the management of the corporation is planning on
declaring a $55,000 preferred stock dividend and a 2-for-1 common stock split on
December 31, earnings per common share on December 31 is expected to equal

A. $2.78
Answer (A) is incorrect.
Stock dividends and stock splits are considered to have occurred at the beginning of the period.
Therefore, the amount of weighted-average shares outstanding for the year is 500,000 shares, not
250,000 shares.

B. $1.50
Answer (B) is incorrect.
The preferred dividends must be subtracted from net income in determining the income
available to common shareholders in the calculation of earnings per common share.

C. $1.39
Answer (C) is correct.
Earnings per common share is equal to net income available to common shareholders
divided by the number of weighted-average shares outstanding. Income available to common
shareholders is equal to net income minus any preferred dividends, or $695,000 ($750,000 –
$55,000). Regarding weighted-average shares outstanding, stock dividends and stock splits
are deemed to have occurred at the beginning of the period. Thus, the number of weighted-
average shares outstanding for the period is 500,000 (250,000 × 2). As a result, earnings per
common share for the period is $1.39 ($695,000 ÷ 500,000).

D. $3.00
Answer (D) is incorrect.
The preferred dividends must be subtracted from net income to determine the income
available to common shareholders. Additionally, stock dividends and stock splits are deemed
to have occurred at the beginning of the period; thus, 500,000 shares, not 250,000 shares,
should be used.
Question: 2 Selected year-end information from the balance sheet of a publicly-traded company as
of December 31, Year 1, follows.

Common stock (par value $1 per share) $1,000,000

Additional paid-in capital 2,000,000

Retained earnings 500,000

Year 2 is nearly over and it is expected that net income will be $200,000, the dividend
payout ratio will be 30%, and there will be no shares issued or redeemed during the
year. If comparable firms are trading at a market to book ratio of two times, what is the
expected market price per share at the end of Year 2?

A. $7.40
Answer (A) is incorrect.
The amount of $7.40 miscalculates the dividend payout.

B. $6.28
Answer (B) is incorrect.
The amount of $6.28 fails to include the initial retained earnings in the calculation.

C. $7.28
Answer (C) is correct.
The first step is to find the expected book value per share at the end of Year 2. There are
1,000,000 shares outstanding ($1,000,000 ÷ $1 par value). If the company has income of
$200,000, of which 30% is paid out as dividends, then retained earnings will increase by
$140,000 (70% × $200,000). Therefore, the new total for retained earnings will be $640,000
(the original $500,000 plus the $140,000 from Year 2). Thus, total equity becomes
$3,640,000, or $3.64 per share. If the price to book ratio is 2, book value of $3.64 is multiplied
by 2 for a share price of $7.28.

D. $7.00
Answer (D) is incorrect.
The amount of $7.00 is the value at the end of Year 1, not Year 2.
Question: 3 During the most recent fiscal year, a company earned net income after tax of
$3,288,000. The company paid preferred share dividends of $488,000 and common
share dividends of $1,000,000. The current market price of common shares is $56 per
share, and the shares are trading at a price-earnings rate of 8. How many common
shares does the company have outstanding?

A. 400,000
Answer (A) is correct.
Using known relationships, outstanding common stock can be determined as follows:
Price-earnings ratio = Market price ÷ Earnings per share

8 = $56 per share ÷ Earnings per share

Earnings per share = $56 per share ÷ 8

= $7
Net income $3,288,000
Less: Dividends on preferred stock (488,000)

Income available to common shareholders $2,800,000

Earnings per share = Income available to common shareholders ÷ Common shares

outstanding
$7 = $2,800,000 ÷ Common shares outstanding
Common shares
outstanding = $2,800,000 ÷ $7
= 400,000

B. 469,714
Answer (B) is incorrect.
Improperly dividing net income (instead of income available to common shareholders) by
earnings per share results in 469,714 shares.

C. 411,000
Answer (C) is incorrect.
Improperly dividing net income (instead of income available to common shareholders) by the
price-earnings ratio (instead of earnings per share) results in 411,000 shares.

C. 411,000
 Answer (C) is incorrect.
Improperly dividing net income (instead of income available to common shareholders) by the
price-earnings ratio (instead of earnings per share) results in 411,000 shares.

Question: 4 The following is the equity section of Harbor Co.’s balance sheet at December 31:

Common stock $10 par, 100,000 shares authorized, 50,000 shares issued, of which
5,000 have been reacquired and are held in treasury $ 450,000
Additional paid-in capital-common stock 1,100,000
Retained earnings 800,000
Subtotal $2,350,000
Minus: Treasury stock (at cost) (150,000)
Total stockholders’ equity $2,200,000
Harbor has insignificant amounts of convertible securities, stock warrants, and stock
options. What is the book value per share of Harbor’s common stock?

A. $46
Answer (A) is incorrect.
The amount of $46 results from measuring the treasury shares at $10 per share and
including those shares in the denominator.

B. $49
Answer (B) is correct.
The book value per share of common stock equals net assets available to common
shareholders divided by ending common shares outstanding. Net assets available to
common shareholders can also be stated as total equity minus liquidation value of preferred
stock. Given no preferred shares, the numerator equals equity (assets minus liabilities). Thus,
the book value per share of common stock is $49 [$2,200,000 equity ÷ (50,000 shares issued
– 5,000 shares held in treasury)].

C. $31
Answer (C) is incorrect.
The amount of $31 results from not including retained earnings in the numerator

D. $44
Answer (D) is incorrect.
The amount of $44 results from including treasury shares in the denominator.
Question: 5 The common stock of a company is currently selling at $80 per share. The leadership
of the company intends to pay a $4 per share dividend next year. With the expectation
that the dividend will grow at 5% perpetually, what will the market’s required return on
investment be for the common stock?

A. 7.5%
Answer (A) is incorrect.
The yield and growth rate are 5% each, a total of 10%.

B. 10%
Answer (B) is correct.
The dividend growth model estimates the cost of retained earnings using the dividends per
share, the market price, and the expected growth rate. The current dividend yield is 5% ($4 ÷
$80). Adding the growth rate of 5% to the yield of 5% results in a required return of 10%.

C. 5%
Answer (C) is incorrect.
The amount of 5% represents only half of the return elements (either yield or growth).

D. 5.25%
Answer (D) is incorrect.
The growth rate is based on market value, not yield.

Question: 6 The common stock of a company has a market price of $36. The company has
50,000,000 common shares outstanding and net income of $200,000,000. At the end
of the fiscal year, the company declared common dividends of $1 per share. What is
the price/earnings ratio of the stock?

A. 4
Answer (A) is incorrect.
The earnings per share is $4.
 B. 12
Answer (B) is incorrect.
Subtracting common stock dividends from net income results in 3.

C. 9
Answer (C) is correct.
The formula for the price-earnings (P/E) ratio is market price per share divided by earnings
per share (EPS). EPS equals net income available to common shareholders divided by
average shares outstanding. Thus, EPS is $4 ($200,000,000 ÷ 50,000,000). Therefore, the
P/E ratio is 9 ($36 ÷ $4).

D. 36
Answer (D) is incorrect.
The formula for the price-earnings ratio is market price per share divided by earnings per
share. Dividing $36 market price by $1 common dividends per share results in 36.

Question: 7 A company paid out one-half of last year’s earnings in dividends. Earnings increased
by 20%, and the amount of its dividends increased by 15% in the current year. The
company’s dividend payout ratio for the current year was

A. 57.5%
Answer (A) is incorrect.
The figure of 57.5% is 115% of the prior-year payout ratio.

B. 78%
Answer (B) is incorrect.
The figure of 78% equals 65% of 120%.

C. 47.9%
Answer (C) is correct.
The prior-year dividend payout ratio was 50%. Hence, if prior-year net income was X, the
total dividend payout would have been 50%X. If earnings increase by 20%, current-year
 income will be 120%X. If dividends increase by 15%, the total dividends paid out will be
57.5%X (115% × 50%X), and the new dividend payout ratio will be 47.9% (57.5%X ÷
120%X).

D. 50%
Answer (D) is incorrect.
The prior-year payout ratio is 50%.

Fact Pattern: Assume the following information pertains to Ramer Company, Matson Company, and for
their common industry for a recent year.
Industry

Ramer Matson Average

Current ratio 3.50 2.80 3.00

Accounts receivable turnover 5.00 8.10 6.00

Inventory turnover 6.20 8.00 6.10

Times interest earned 9.00 12.30 10.40

Debt to equity ratio 0.70 0.40 0.55

Return on investment 0.15 0.12 0.15

Dividend payout ratio 0.80 0.60 0.55

Earnings per share $3.00 $2.00 --

Question: 8 Some of the ratios and data for Ramer and Matson are affected by income taxes.
Assuming no interperiod income tax allocation, which of the following items would be
directly affected by income taxes for the period?

A. Return on investment and earnings per share.

Answer (A) is correct.
Income taxes are an expense of the business and affect rates of return and earnings per
share. Any ratio that uses net income as a part of the calculation is affected, e.g., return on
investment, EPS, and dividend payout.
 B. Current ratio and debt to equity ratio.
Answer (B) is incorrect.
Neither ratio is based on net income.

C. Accounts receivable turnover and inventory turnover.

Answer (C) is incorrect.
These turnover ratios are based on asset accounts and figures at the top of the income
statement, not net income.

D. Debt to equity ratio and dividend payout ratio.

Answer (D) is incorrect.
The debt to equity ratio is not affected by taxes.

Question: 9 T Corporation is considering the acquisition of S Company with common stock. The
following financial information is available regarding the two companies:

T S

Net income $8,000,000 $2,000,000

Common shares outstanding 4,000,000 1,600,000

Earnings per share $2.00 $1.25

Price/earnings ratio 12 8
T plans to offer S’s shareholders a 20% premium over the market price of the S stock.
What would be the earnings per share for the surviving company immediately following
the merger?

A. $1.667
Answer (A) is incorrect.
The surviving company’s net income includes S’s net income of $2,000,000.

B. $2.143
 Answer (B) is incorrect.
The amount of $2.143 does not take into account the premium that T offered to pay S’s
shareholders

C. $2.083
Answer (C) is correct.
First, calculate how much cash is needed to purchase S. To calculate the price of S stock,
the price/earnings ratio of 8 should be multiplied by the earnings per share of $1.25. Thus,
the price of S stock is $10 + $2 for the 20% premium ($10 × 20%). $19,200,000 is needed for
the acquisition (1,600,000 total shares × $12 price of share). In order to have enough cash to
purchase S, T must issue more shares of its own stock. The price of T’s stock is $24 (12
price/earnings ratio × $2.00 earnings per share). Therefore, 800,000 additional shares must
be issued to have cash to purchase the new stock ($19,200,000 needed cash ÷ $24 T’s stock
price). The earnings per share for the surviving company is $2.083 ($10,000,000 combined
net income ÷ 4,800,000 T’s total common shares outstanding).

D. $1.714
Answer (D) is incorrect.
The amount of $1.714 fails to include the premium to be paid on the stock and fails to include
S’s net income in the combined net income.

Question: 10 A drop in the market price of a firm’s common stock will immediately increase its

A. Dividend yield.
Answer (A) is correct.
Dividend yield equals dividends per common share divided by the market price per common
share. Hence, a drop in the market price of the stock will increase this ratio, holding all else
constant.

B. Return on equity.
Answer (B) is incorrect.
The return on equity is based on the book value in its calculation rather than the market price
of the common stock.

C. Dividend payout ratio.

 Answer (C) is incorrect.
The dividend payout ratio is based on the book value in its calculation rather than the market
price of the common stock.

D. Market-to-book ratio.
Answer (D) is incorrect.
The market-to-book ratio is based on the book value in its calculation rather than the market
price of the common stock.

Question: 11 A publicly traded corporation in an industry with an average price-earnings ratio of 20

has the following summary financial results.

Sales $1,000,000

Expenses 500,000

Operating income $ 500,000

Taxes 300,000

Net income $ 200,000

Assets $2,500,000
Liabilities 1,000,000
Shareholders’ equity 1,500,000
A competitor wishes to make a bid to acquire the stock of the company. What is the
current market value?

A. $20,000,000
Answer (A) is incorrect.
The price-earnings ratio is expressed as the market price per share divided by the earnings
per share. However, this can also be expressed as the total market price over the total
earnings. The amount of $20,000,000 incorrectly uses sales instead of earnings as the
denominator in the ratio to solve for the market value.

B. $1,500,000
 Answer (B) is incorrect.
The shareholders’ equity amount of $1,500,000 is not the same as the current market value
of the stock. Shareholders’ equity is carried at book value, not market value, and contains
other items of equity besides stock.

C. $4,000,000
Answer (C) is correct.
The price-earnings ratio is expressed as the market price per share divided by the earnings
per share. However, this can also be expressed as the total market price over the total
earnings. Earnings (net income) are equal to $200,000, and the price-earnings ratio is equal
to 20. Therefore, the market value can be solved for as follows:
20 = Market value ÷ $200,000

Market value = 20 × $200,000

= $4,000,000

D. $10,000,000
Answer (D) is incorrect.
The price-earnings ratio is expressed as the market price per share divided by the earnings
per share. However, this can also be expressed as the total market price over the total
earnings. The amount of $10,000,000 incorrectly uses operating income instead of earnings
as the denominator in the ratio to solve for the market value.

Question: 12 A company had 150,000 shares outstanding on January 1. On March 1, 75,000

additional shares were issued through a stock dividend. Then on November 1, the
company issued 60,000 shares for cash. The number of shares to be used in the
denominator of the EPS calculation for the year is

A. 225,000 shares.
Answer (A) is incorrect.
The 225,000 number of shares ignores the November 1 issuance.

B. 285,000 shares.
Answer (B) is incorrect.
The year-end number of outstanding shares is 285,000.
 C. 222,500 shares.
Answer (C) is incorrect.
The weighted-average number of shares is 222,500 if the stock dividend is not treated as
retroactive.

D. 235,000 shares.
Answer (D) is correct.
The weighted average number of common shares outstanding during the year is the EPS
denominator. Shares issued in a stock dividend are assumed to have been outstanding as of
the beginning of the earliest accounting period presented. Thus, the 75,000 shares issued on
March 1 are deemed to have been outstanding on January 1. The EPS denominator equals
235,000 shares {[150,000 × (12 months ÷ 12 months)] + [75,000 × (12 months ÷ 12 months)]
+ [60,000 × (2 months ÷ 12 months)]}.

Question: 13 Ute Co. had the following capital structure during Year 1 and Year 2:

Preferred stock, $10 par, 4% cumulative,

25,000 shares issued and outstanding $ 250,000

Common stock, $5 par, 200,000 shares

issued and outstanding 1,000,000

The preferred stock is not convertible. Ute reported net income of $500,000 for the
year ended December 31, Year 2. Ute paid no preferred dividends during Year 1 and
paid $16,000 in preferred dividends during Year 2. In its December 31, Year 2, income
statement, what amount should Ute report as basic earnings per share?

A. $2.48
Answer (A) is incorrect.
The amount of $2.48 results from subtracting $4,000 of preferred dividends from net income.

B. $2.45
Answer (B) is correct.
The amount of BEPS equals income available to common shareholders, divided by the
weighted-average number of common shares outstanding. Cumulative preferred dividends,
whether or not declared, are included in the calculation. The annual amount is $10,000
($250,000 × 4%). However, only an amount equal to the dividend that should be declared
(whether or not paid) for the current year is included. Thus, the amount of BEPS reported is
$2.45 [($500,000 NI – $10,000 cumulative preferred dividends) ÷ 200,000 common shares].
 C. $2.50
Answer (C) is incorrect.
The amount of $2.50 does not consider the $10,000 preferred dividend for Year 2.

D. $2.42
Answer (D) is incorrect.
The amount of $2.42 results from including in the calculation of BEPS $6,000 of the $10,000
cumulative preferred dividend for Year 1. The company paid a $16,000 preferred dividend in
Year 2. But only $10,000 should have been included in the calculation for Year 2.

Question: 14 A corporation computed the following items from its financial records for the year:

Price-earnings ratio 12

Payout ratio .6

Asset turnover ratio .9

The dividend yield on common stock is

A. 5.0%
Answer (A) is correct.
Dividend yield is computed by dividing the dividend per share by the market price per share.
The payout ratio (.6) is computed by dividing dividends by net income per share (EPS). The
P/E ratio (12) is computed by dividing the market price per share by net income per share.
Thus, assuming that net income per share (EPS) is $X, the market price must be $12X and
the dividends per share $.6X (.6 × $X net income per share). Consequently, the dividend
yield is 5.0% ($.6X dividend ÷ $12X market price per share).

B. 7.5%
Answer (B) is incorrect.
The figure of 7.5% equals asset turnover divided by the P/E ratio.

C. 10.8%
 Answer (C) is incorrect.
The figure of 10.8% equals 12% times the asset turnover ratio.

D. 7.2%
Answer (D) is incorrect.
The figure of 7.2% equals 12% times the payout ratio.

Question: 15 Boe Corp.’s equity balances, which include no accumulated other comprehensive
income, were as follows at December 31:

6% noncumulative preferred stock,

$100 par (liquidation value

$105 per share) $100,000

Common stock, $10 par 300,000

Retained earnings 95,000

At December 31, Boe’s book value per common share was

A. $13.00
Answer (A) is correct.
The preferred stock is noncumulative, so the equity of the preferred shareholders equals the
liquidation value of $105,000 (1,000 shares × $105 per share). Given total equity of $495,000
($100,000 + $300,000 + $95,000), common equity is $390,000 ($495,000 – $105,000). Therefore,
book value per common share equals $13.00 ($390,000 ÷ 30,000 shares).

B. $12.80
Answer (B) is incorrect.
The amount of $12.80 results from deducting the preferred stock dividend from common
equity and dividing by the number of common shares outstanding.

C. $12.97
 Answer (C) is incorrect.
The sum of common stock and retained earnings, minus the preferred stock dividend, divided
by the number of common stock shares outstanding equals $12.97.

D. $13.17
Answer (D) is incorrect.
The sum of common stock and retained earnings divided by the shares outstanding of
common stock equals $13.17.

Question: 16 A stock began the month with a stock price of $50 per share, paid a dividend of $2 per
share during the month, and ended the month with a price of $52 per share. What total
return did investors earn on the stock during this month?

A. 8.00%
Answer (A) is correct.
Investors earned $2 in dividends and $2 in stock appreciation. Therefore, they made $4 on
the beginning price of $50, or 8%.

B. 0.00%
Answer (B) is incorrect.
The dividend and stock appreciation would both be considered earnings.

C. 7.69%
Answer (C) is incorrect.
Earnings are calculated based on the beginning stock price because that was the investment
required in the period to earn the $4.

D. 4.00%
Answer (D) is incorrect.
The dividend and stock appreciation would both be considered earnings
Fact Pattern: The Dawson Corporation projects the following for the year:
Earnings before interest and taxes $35 million
Interest expense $5 million
Preferred stock dividends $4 million
Common stock dividend-payout ratio 30%
Common shares outstanding 2 million
Effective corporate income tax rate 40%

Question: 17 If Dawson Corporation’s common stock is expected to trade at a price-earnings ratio of

8, the market price per share (to the nearest dollar) would be

A. $72
Answer (A) is incorrect.
The amount of $72 ignores the effect of preferred dividends.

B. $56
Answer (B) is correct.
Net income is $18,000,000 [($35,000,000 EBIT – $5,000,000 interest) × (1.0 – .4 tax rate)],
and EPS is $7 [($18,000,000 NI – $4,000,000 preferred dividends) ÷ 2,000,000 common
shares]. Consequently, the market price is $56 ($7 EPS × 8 P/E ratio).

C. $104
Answer (C) is incorrect.
The amount of $104 ignores income taxes.

D. $68
Answer (D) is incorrect.
The amount of $68 ignores the deductibility of interest.

Question: 18 A corporation expects net income of $800,000 for the next fiscal year. Its targeted and
current capital structure is 40% debt and 60% common equity. The director of capital
budgeting has determined that the optimal capital spending for next year is
$1.2 million. If the corporation follows a strict residual dividend policy, what is the
expected dividend-payout ratio for next year?

A. 40.0%
 Answer (A) is incorrect.
The percentage is the ratio of debt in the ideal capital structure.

B. 66.7%
Answer (B) is incorrect.
This percentage is the ratio between earnings and investment.

C. 90.0%
Answer (C) is incorrect.
This percentage is the reinvestment ratio.

D. 10.0%
Answer (D) is correct.
Under the residual theory of dividends, the residual of earnings paid as dividends depends on
the available investments and the debt-equity ratio at which cost of capital is minimized. The
rational investor should prefer reinvestment of retained earnings when the return exceeds
what the investor could earn on investments of equal risk. However, the firm may prefer to
pay dividends when investment returns are poor and the internal equity financing would move
the firm away from its ideal capital structure. If the corporation wants to maintain its current
structure, 60% of investments should be financed from equity. Hence, it needs $720,000
($1,200,000 × 60%) of equity funds, leaving $80,000 of net income ($800,000 NI – $720,000)
available for dividends. The dividend-payout ratio is therefore 10% ($80,000 ÷ $800,000 NI).

Fact Pattern: Presented below are partial year-end financial statement data for companies A and B.
Company A Company B Company A Company B

Cash $100 $200 Sales $600 $5,800

Accounts Receivable unknown 100 Cost of Goods Sold 300 5,000
Inventories unknown 100 Administrative Expenses 100 500
Net Fixed Assets 200 100 Depreciation Expense 100 100
Accounts Payable 100 50 Interest Expense 20 10
Long-Term Debt 200 50 Income Tax Expense 40 95
Common Stock 100 200 Net Income 40 95
Retained Earnings 150 100

Question: 19 If Company A has 60 common shares outstanding, then it has a book value per share,
to the nearest cent, of
 A. $5.00
Answer (A) is incorrect.
The amount of $5.00 is the book value per share for Company B

B. $2.50
Answer (B) is incorrect.
The amount of $2.50 results if common stock is omitted from the numerator.

C. $4.17
Answer (C) is correct.
The book value per share for Company A equals the sum of common stock and retained
earnings, divided by the number of shares, or $4.17 [($100 + $150) ÷ 60].

D. $1.67
Answer (D) is incorrect.
The amount of $1.67 results if retained earnings is omitted from the numerator.

Question: 20 A corporation has annual earnings per share of $12. It has a dividend payout ratio of
40% and an annual dividend yield of 4%. The stock price per share must be

A. $180
Answer (A) is incorrect.
The amount of $180 incorrectly uses the inverse of the payout ratio instead of the payout
ratio.

B. $300
Answer (B) is incorrect.
The amount of $300 incorrectly uses the $12 of earnings instead of the $4.80 dividend

C. $120
 Answer (C) is correct.
Given earnings of $12 and a dividend payout ratio of 40%, the dividend per share is $4.80
($12 × .40). Dividend yield equals dividend per share divided by price per share. Thus, price
per share equals dividend per share divided by dividend yield. Accordingly, price per share
must be $120 ($4.80 ÷ .04).

D. $420
Answer (D) is incorrect.
The amount of $420 incorrectly adds the $4.80 dividend to earnings to arrive at the amount of
the dividend

Fact Pattern: Alberto Corp. has common and preferred shares outstanding with the following

Common Preferred For the year just ended, the company had the
Shares Shares following statement of income:
Number of shares Sales revenue $1,000,000
outstanding 50,000 25,000
Cost of goods sold (300,000)
Dividends paid during
Depreciation expense (100,000)
the year $100,000 $50,000
Year-end market price Earnings before interest and tax $ 600,000
per share $10 $5
Interest expense (100,000)
Book value of equity $500,000 $250,000
Earnings before tax $ 500,000
Tax expense (250,000)

Net income $ 250,000

characteristics:

Question: 21 Alberto Corp. has earnings per share of

A. $5.00
Answer (A) is incorrect.
The amount of $5.00 fails to deduct the preferred dividends from the numerator.

B. $2.67
 Answer (B) is incorrect.
The amount of $2.67 includes all outstanding shares, common and preferred, in the
denominator.

C. $4.00
Answer (C) is correct.
EPS equals the income available for distribution to common shareholders divided by the
number of common shares outstanding, or $4.00 [($250,000 NI – $50,000 preferred
dividends) ÷ 50,000 common shares].

D. $3.33
Answer (D) is incorrect.
The amount of $3.33 fails to deduct the preferred dividends from the numerator and includes
all outstanding shares in the denominator.

Question: 22 The common stock of a beverage company has a current market price of $34. The
beverage company is estimated to earn $2 per share in the next year. The average
price/earnings ratio of companies in the beverage industry is 15. Using the
price/earnings ratio as the comparable valuation method, the beverage company’s
stock is

A. $4 undervalued.
Answer (A) is incorrect.
The stock price is overvalued by $4, not undervalued

B. $4 overvalued.
Answer (B) is correct.
The starting point is to determine what the beverage company’s stock price should be using
the average price/earnings (PE) ratio of the beverage industry (15). Next, this amount is
compared to the beverage company’s current stock price ($34). The beverage company’s
stock price is overvalued by the excess of its current stock price over the industry adjusted
stock price and vice-versa.
Industry P/E ratio = Market price ÷ Earnings per share

15 = Market price ÷ $2
 Market price = 15 × $2

Market price = $30

Thus, the beverage company’s stock is $4 overvalued ($34 current market price – $30
industry adjusted market price).

C. $2 overvalued.
Answer (C) is incorrect.
The stock price is overvalued, but not by the difference between the beverage company’s P/E
ratio [17 ($34 ÷ $2 EPS)] and the industry’s P/E ratio (15).

D. $2 undervalued.
Answer (D) is incorrect.
The stock price is overvalued, not undervalued.

Question: 23 In calculating diluted earnings per share when a company has convertible bonds
outstanding, the number of common shares outstanding must be <List A> to adjust for
the conversion feature of the bonds, and the net income must be <List B> by the
amount of interest expense on the bonds, net of tax.

List A List B

A. Increased Decreased

Answer (A) is incorrect.

The net income must be increased.

B. Increased Increased

Answer (B) is correct.

The weighted-average number of shares outstanding must be increased to reflect the shares
into which the bonds could be converted. Also, the effect of the bond interest on net income
must be eliminated. In this way, earnings per share is calculated as if the bonds had been
converted into common shares as of the start of the year.
 C. Decreased Decreased

Answer (C) is incorrect.

The weighted-average number of shares outstanding must be increased, and the net income
must be increased.

D. Decreased Increased

Answer (D) is incorrect.

The weighted-average number of shares outstanding must be increased.

Question: 24 What return on equity do investors seem to expect for a firm with a $50 share price, an
expected dividend of $5.50, a β of .9, and a constant growth rate of 4.5%?

A. 15.50%
Answer (A) is correct.
Dividing the $5.50 dividend by the $50 share price produces an 11% dividend yield. Adding the 11%
yield to the 4.5% growth rate produces a total return of 15.5%. The beta coefficient is irrelevant.

B. 15.95%
Answer (B) is incorrect.
This percentage adjusted the growth rate upward by the β.

C. 16.72%
Answer (C) is incorrect.
This percentage adjusted the share price by the β

D. 15.05%
Answer (D) is incorrect.
This percentage adjusted the growth rate by the β, which is not required.
Question: 25 The equity section of a Statement of Financial Position is presented below.

Preferred stock, $100 par $12,000,000

Common stock, $5 par 10,000,000

Additional paid-in capital -- common stock 18,000,000

Retained earnings 9,000,000

Net worth $49,000,000

The book value per share of common stock is

A. $18.50
Answer (A) is correct.
The book value per common share equals the net assets (equity) attributable to common
shareholders divided by the common shares outstanding, or $18.50 [($10,000,000 common
stock + $18,000,000 additional paid-in capital + $9,000,000 RE) ÷ ($10,000,000 ÷ $5 par)].

B. $100
Answer (B) is incorrect.
The amount of $100 is the par value of a preferred share

C. $14.00
Answer (C) is incorrect.
The amount of $14.00 fails to include retained earnings in the portion of equity attributable to
common shareholders.

D. $5.00
Answer (D) is incorrect.
The amount of $5.00 is the par value per share

Question: 26 Which one of the following events will most likely result in a higher price-earnings ratio
for a company’s common shares?
 A. The rate of growth in dividends is expected to decline.
Answer (A) is incorrect.
A decline in the rate of dividend growth will cause the share price to decline, which will result
in a lower P/E ratio.

B. The dividend yield increases when the dividend per share remains unchanged.
Answer (B) is incorrect.
An increasing dividend yield indicates that share price must be falling.

C. The economy is expected to enter a recession.

Answer (C) is incorrect.
It is impossible to determine the impact on the P/E ratio. Earnings may decline and share
prices may decline, but the end result cannot be predicted.

D. Investors’ required rate of return on the common shares falls.

Answer (D) is correct.
A decrease in investors’ required rate of return will cause share prices to go up, which will
result in a higher P/E ratio.

Question: 27 Information concerning common stock as of November 30, the end of the company’s
current fiscal year, is presented below.

Number of shares outstanding 460,000

Par value per share $ 5.00

Dividends paid per share in current year 6.00

Market price per share 54.00
Basic earnings per share 18.00
Diluted earnings per share 12.00
The price-earnings ratio for the common stock is

A. 4.5 times.
Answer (A) is incorrect.
The figure of 4.5 times is calculated using the $12.00 diluted earnings per share instead of
the basic earnings per share of $18.00.
 B. 3.0 times.
Answer (B) is correct.
The figure of 3.0 times is calculated using the $18.00 basic earnings per share. The formula
for the price-earnings ratio is market price per share ($54.00) divided by basic earnings per
share ($18.00).

C. 10.8 times.
Answer (C) is incorrect.
The figure of 10.8 times is calculated using the $5.00 par value instead of basic earnings per
share of $18.00.

D. 9.0 times.
Answer (D) is incorrect.
The figure of 9.0 times is calculated using the $6.00 of dividends instead of basic earnings
per share.

Question: 28 Selected information regarding a corporation’s outstanding equity is shown below.

Common stock, $10 par value,

350,000 shares outstanding $3,500,000

Preferred stock, $100 par value,

10,000 shares outstanding 1,000,000

Preferred stock dividend paid 60,000

Common stock dividend paid 700,000

Earnings per common share 3

Market price per common share 18

What is the corporation’s dividend yield?

A. 11.11%
 Answer (A) is correct.
The corporation’s yield on common stock is 11.11% as shown below.
Dividend yield = Dividends per common share ÷ Market price per common share

= ($700,000 ÷ 350,000) ÷ $18

= 11.11%

B. 20.00%
Answer (B) is incorrect.
Yield on common stock should be calculated using the formula common stock dividends per
share divided by market price per common share, not total common stock dividends paid
divided by total common stock outstanding.

C. 16.66%
Answer (C) is incorrect.
To calculate the dividend yield, we must use dividends per common share in the numerator
rather than the earnings per common share.

D. 16.88%
Answer (D) is incorrect.
To calculate the dividend yield, dividends per common share must be divided by market price
per common share.

Question: 29 Ten years ago, perpetual preferred shares with a par value of $50 and an annual
dividend rate of 6% were issued. Currently, there are no dividends in arrears. Since the
issue date, interest rates have risen, and the shares are now selling at $38. The
market’s current required rate of return on these shares is

A. 6.00%
Answer (A) is incorrect.
The figure of 6.00% is the company’s annual dividend rate.

B. 7.89%
 Answer (B) is correct.
The required rate of return on these shares is calculated by dividing the dividend by the
market price. Thus, $3 (6% × $50) must be divided by $38 to yield 7.89%.

C. 15.79%
Answer (C) is incorrect.
The figure of 15.79% results from incorrectly using the dividend rate instead of calculating the
dividend to divide by $38.

D. 4.56%
Answer (D) is incorrect.
The market’s current required rate of return is 7.89%.

Question: 30 A corporation paid a dividend of $3 per share last year. If investors expected the
dividend per share to grow by 5% per year forever, what required return of investors is
consistent with a current share price of $63 per share?

A. 15%
Answer (A) is incorrect.
The required return only includes the growth rate of 5% and the current dividend yield of 5%
($3.15 ÷ 63).

B. 3%
Answer (B) is incorrect.
$3 is the dividend the corporation paid, not the required return.

C. 10%
Answer (C) is correct.
The dividend growth model estimates the cost of retained earnings using the dividends per
share, the market price, and the expected growth rate. The current dividend yield is 5%
($3.15 ÷ $63). Adding the growth rate of 5% to the yield of 5% results in a required return of
10%.
 D. 5%
Answer (D) is incorrect.
The required return includes both the growth rate of 5% and the current dividend yield of 5%
($3.15 ÷ $63).

Question: 31 A corporation had 40,000 shares of common stock outstanding on November 30, Year
1. On May 20, Year 2, a 10% stock dividend was declared and distributed. On June 1,
Year 2, options were issued to its existing stockholders giving them the immediate right
to acquire one additional share of stock for each share of stock held. The option price
of the additional share was $6 per share, and no options have been exercised as of
year end. The average price of common stock for the year was $20 per share. The
price of the stock as of November 30, Year 2, the end of the fiscal year, was $30 per
share, and the corporation’s net income for the fiscal year was $229,680. The
corporation had no outstanding debt during the year, and its tax rate was 30%. The
basic earnings per share (rounded to the nearest cent) of common stock for the fiscal
year ended November 30, Year 2, was

A. $3.82 per share.

Answer (A) is incorrect.
BEPS is calculated by dividing net income available to common shareholders by the
weighted average shares outstanding.

B. $3.38 per share.

Answer (B) is incorrect.
BEPS is calculated by dividing net income available to common shareholders by the
weighted average shares outstanding.

C. $5.22 per share.

Answer (C) is correct.
BEPS is net income available to common shareholders divided by the weighted average
number of common shares outstanding during the year. The denominator will include the
40,000 shares already outstanding plus the 4,000-share stock dividend (stock dividends and
stock splits are deemed to have occurred at the beginning of the earliest period presented).
Thus, 44,000 shares are considered to have been outstanding throughout the year. The stock
options have no effect on the weighted-average shares outstanding because they were not
exercised in the current period. BEPS is $5.22 ($229,680 ÷ 44,000).

D. $5.74 per share.

 Answer (D) is incorrect.
BEPS is calculated by dividing net income available to common shareholders by the
weighted average shares outstanding

Question: 32 For the year ended May 31, Year 2, a company had per-share earnings of $4.80. The
company’s outstanding stock for the Year 1-Year 2 fiscal year consisted of $2,000,000
of 10% preferred with $100 par value and 1,000,000 shares of common. On June 1,
Year 2, the common stock split 3 for 1, and the company redeemed one-half of the
preferred stock at par value. The company’s net income for the year ended May 31,
Year 3, was 10% higher than in Year 2. Earnings per share in Year 3 on the company’s
common stock were

A. $5.40
Answer (A) is incorrect.
Not increasing the number of common shares outstanding to allow for the stock split results
in $5.40.

B. $5.28
Answer (B) is incorrect.
Using Year 2 net income available to common shareholders increased by 10% for Year 3
instead of net income available to common shareholders for Year 3 results in $5.28. It also
results from not increasing the number of common shares outstanding to allow for the stock
split.

C. $1.76
Answer (C) is incorrect.
Using Year 2 net income available to common shareholders increased by 10% for Year 3
instead of net income available to common shareholders for Year 3 results in $1.76.

D. $1.80
Answer (D) is correct.
The EPS for Year 2 of $4.80 indicates a net income available to common shareholders of
$4,800,000. Dividends on preferred stock would have been $200,000 ($2,000,000 × 10%).
Thus, the net income must have been $5,000,000. A 10% increase for Year 3 would result in
net income of $5,500,000. Only $100,000 ($1,000,000 × 10%) would be required for
preferred dividends in Year 3, leaving $5,400,000 for common shareholders. After the 3-for-1
split, EPS would be $1.80 ($5,400,000 ÷ 3,000,000 shares).
Question: 33 Of the following items, the one item that would not be considered in evaluating the
adequacy of the budgeted annual operating income for a company is

A. Industry average for earnings on sales.

Answer (A) is incorrect.
The industry average for earnings on sales is a measure of financial performance

B. Internal rate of return.

Answer (B) is correct.
When a company prepares the first draft of its pro forma income statement, management
must evaluate whether earnings meet company objectives. This evaluation is based on such
factors as desired earnings per share, average earnings for other firms in the industry, a
desired price-earnings ratio, and needed return on investment. The internal rate of return is
used to evaluate long-term investments, not budgets. It is the discount rate at which a
project’s net present value is zero.

C. Earnings per share.

Answer (C) is incorrect.
EPS is a measure of financial performance.

D. Price-earnings ratio.
Answer (D) is incorrect.
The P/E ratio is a measure of financial performance.

Fact Pattern: Bull & Bear Investment Banking is working with the management of Clark, Inc., in order to
take the company public in an initial public offering. Selected financial information for Clark is as follows.
Long-term debt (8% interest rate) $10,000,000
Common equity:
Par value ($1 per share) 3,000,000
Additional paid-in-capital 24,000,000
Retained earnings 6,000,000
Total assets 55,000,000
Net income 3,750,000
Dividend (annual) 1,500,000
Question: 34 If public companies in Clark’s industry are trading at a market to book ratio of 1.5, what
is the estimated value per share of Clark?

A. $27.50
Answer (A) is incorrect.
The amount of $27.50 results from using total assets rather than total equity in calculating
book value per share.

B. $21.50
Answer (B) is incorrect.
The amount of $21.50 results from improperly including long-term debt in calculating book
value per share.

C. $13.50
Answer (C) is incorrect.
The amount of $13.50 results from failing to include retained earnings in calculating book
value per share.

D. $16.50
Answer (D) is correct.
A firm’s book value per share consists of total equity divided by the number of common
shares outstanding. Clark’s total equity is $33,000,000 ($3,000,000 + $24,000,000 +
$6,000,000) and the number of common shares is 3,000,000, making the book value per
share $11.00 ($33,000,000 ÷ 3,000,000). Since the industry average market to book ratio is
1.5, Clark’s stock price is expected to be $16.50 ($11.00 × 1.5).

Fact Pattern: The Dawson Corporation projects the following for the year:
Earnings before interest and taxes $35 million
Interest expense $5 million
Preferred stock dividends $4 million
Common stock dividend-payout ratio 30%
Common shares outstanding 2 million
Effective corporate income tax rate 40%
Question: 35 The expected common stock dividend per share for Dawson Corporation is

A. $2.34
Answer (A) is incorrect.
The amount of $2.34 results from treating preferred dividends as tax deductible.

B. $2.10
Answer (B) is correct.
The company’s net income is $18,000,000 [($35,000,000 EBIT – $5,000,000 interest) × (1.0
– .4 tax rate)]. Thus, the earnings available to common shareholders equal $14,000,000
($18,000,000 – $4,000,000 preferred dividends), and EPS is $7 ($14,000,000 ÷ 2,000,000
common shares). Given a dividend-payout ratio of 30%, the dividend to common
shareholders is expected to be $2.10 per share ($7 × 30%).

C. $2.70
Answer (C) is incorrect.
The amount of $2.70 ignores the effect of preferred dividends.

D. $1.80
Answer (D) is incorrect.
The amount of $1.80 is based on a 60% effective tax rate and ignores the effect of preferred
dividends.

Question: 36 A company’s financial data for the recent fiscal year follows.

Common stock 5,000,000 shares outstanding

Preferred stock 1,000,000 shares

Net income $50,000,000

Common stock dividends $8,000,000

Preferred stock dividends $2,000,000

The company would have reported basic and diluted earnings per share of
 A. $9.60 and $9.60, respectively.
Answer (A) is correct.
Basic earnings per share (EPS) is calculated as Income available to common shareholders ÷
Weighted-average shares outstanding. The income available to common shareholders is
equal to Net income – Preferred dividends. Note that common dividends are not subtracted
because they represent income that is available to common shareholders. Accordingly, the
income available to common shareholders is $48,000,000 ($50,000,000 – $2,000,000). The
weighted-average shares outstanding are given as 5,000,000 shares. Thus, the basic EPS is
$9.60 ($48,000,000 ÷ 5,000,000). Furthermore, there is no mention of a security that could
potentially dilute EPS; thus, the diluted EPS also equals $9.60.

B. $10.00 and $9.60, respectively.

Answer (B) is incorrect.
Preferred dividends must be subtracted from net income to determine the income available to
common shareholders.

C. $9.60 and $8.00, respectively.

Answer (C) is incorrect.
No potentially dilutive securities are mentioned in the question. Thus, diluted EPS should be
equal to basic EPS.

D. $10.00 and $6.67, respectively.

Answer (D) is incorrect.
Preferred dividends must be subtracted from net income to determine the income available to
common shareholders. No potentially dilutive securities are mentioned in the question. Thus,
diluted EPS should be equal to basic EPS.

Fact Pattern: Bull & Bear Investment Banking is working with the management of Clark, Inc., in order to
take the company public in an initial public offering. Selected financial information for Clark is as follows.
Long-term debt (8% interest rate) $10,000,000
Common equity:
Par value ($1 per share) 3,000,000
Additional paid-in-capital 24,000,000
Retained earnings 6,000,000
Total assets 55,000,000
Net income 3,750,000
Dividend (annual) 1,500,000
Question: 37 If public companies in Clark’s industry are trading at twelve times earnings, what is the
estimated value per share of Clark?

A. $15.00
Answer (A) is correct.
Clark’s basic earnings per share is $1.25 ($3,750,000 ÷ 3,000,000). Since the industry
average is for the stock to trade at 12 times earnings, Clark’s stock price is expected to be
$15.00 ($1.25 × 12).

B. $9.00
Answer (B) is incorrect.
The amount of $9.00 results from improperly subtracting the annual dividend from net
income.

C. $24.00
Answer (C) is incorrect.
The amount of $24.00 results from dividing retained earnings, rather than net income, by the
number of shares.

D. $12.00
Answer (D) is incorrect.
The amount of $12.00 results from using the par value of the stock rather than earnings per
share.

Question: 38 If the capital gains were taxed at a lower rate than regular dividend income, then the
<List A> the dividend payout percentage of a company, the <List B>, everything else
equal.

List A List B

A. Lower Lower its stock price would be

Answer (A) is incorrect.

A lower dividend payout ratio is associated with a higher, not a lower, stock price when the tax
environment favors capital gains over dividends.
 B. Higher Lower its book value of equity would be

Answer (B) is incorrect.

There is no relationship between the book value of equity and the relative taxation of
dividends and capital gains.

C. Lower Lower its cost of equity would be

Answer (C) is correct.

Lower dividend payout ratios will be favored by investors if dividends are taxed at a higher
rate than capital gains. The cost of equity for the company will be lower under the lower
dividend payout policy because more retained earnings will be available for reinvestment.

D. Higher Higher its stock price would be

Answer (D) is incorrect.

A higher dividend payout ratio is associated with a lower stock price when the tax
environment favors capital gains over dividends. The reason is that the after-tax return to
investors is lower for dividend payments than for capital gains (share price appreciation).

Question: 39 A company has 100,000 outstanding common shares with a market value of $20 per
share. Dividends of $2 per share were paid in the current year and the company has a
dividend payout ratio of 40%. The price-earnings ratio of the company is

A. 2.5
Answer (A) is incorrect.
EPS divided by dividends per share equals 2.5.

B. 10
Answer (B) is incorrect.
Share price divided by dividends per share equals 10

C. 50
 Answer (C) is incorrect.
Price per share divided by the dividend-payout percentage equals 50.

D. 4
Answer (D) is correct.
The P/E ratio equals the share price divided by EPS. If the dividends per share equaled $2
and the dividend-payout ratio was 40%, EPS must have been $5 ($2 ÷ .4). Accordingly, the
P/E ratio is 4 ($20 share price ÷ $5 EPS).