[Level 1] Revision Phase with SAPP

Buổi 13 - Corporate Finance - Reading 34: Measures of Leverage & Reading 35: Working Capital Management


LOS 34.a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk

Question 34.1:
 Business risk is best described as resulting from the combined effects of a firm's:
A) financial risk and sales risk.
B) sales risk and operating risk.
C) operating risk and financial risk.
B is correct. Business risk is the combination of sales risk, which is the variability of a firm's sales, and operating risk, which is the additional variability in operating earnings (EBIT) caused by fixed operating costs.
Schweser note
Business risk refers to the risk associated with a firm’s operating income and is the result of
uncertainty about a firm’s revenues and the expenditures necessary to produce those
revenues. Business risk is the combination of sales risk and operating risk.
Sales risk is the uncertainty about the firm’s sales.
Operating risk refers to the additional uncertainty about operating earnings caused by
fixed operating costs. The greater the proportion of fixed costs to variable costs, the
greater a firm’s operating risk.

Financial risk refers to the additional risk that the firm’s common stockholders must bear when a firm uses fixed cost (debt) financing

LOS 34.b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.

Question 34.2: Smith Company's earnings per share are more sensitive to changes in operating income than are those of Jones Company. This implies that Smith Company has a higher degree of:
A) total leverage.
B) financial leverage.
C) operating leverage
B is correct.The degree of financial leverage (DFL) is the percent change in earnings per share for a given percent change in operating income. The degree of operating leverage (DOL) is the percent change in operating income for a given percent change in sales. The degree of total
leverage (DTL) is the percent change in earnings per share for a given percent change in sales, and is the product of DOL and DFL. Based on the information given, Smith has a higher DFL than Jones, but we cannot conclude that Smith has a higher DTL than Jones.

Question 34.3: Under what conditions will the percentage change in a company's earnings per share be larger than the percentage change in its earnings before interest and taxes (EBIT)? The company's degree of:
A) operating leverage is positive.
B) total leverage is greater than one.
C) financial leverage is greater than one.
C is correct. Earnings per share will increase by a greater percentage than EBIT if a company has financial leverage (i.e., a degree of financial leverage greater than one).
Schweser note
The degree of operating leverage (DOL) is defined as the percentage change in operating
income (EBIT) that results from a given percentage change in sales.

Question 34.4: A company with which of the following leverage measures would exhibit the least sensitivity of earnings per share to a change in sales?
           Degree of operating leverage            Degree of financial leverage
A)                         1.5                                                   3.0
B)                         2.0                                                   2.5
C)                         2.5                                                   2.0
A is correct. The degree of total leverage (DTL) measures the sensitivity of earnings per share to a change in sales. With a DOL of 1.5 and a DFL of 3.0, the DTL is 1.5 × 3.0 = 4.5. With DOL of 2.0 and DFL of 2.5, or with DOL of 2.5 and DFL of 2.0, the DTL would be 2.0 × 2.5 = 5.0.
Schweser note
The degree of total leverage (DTL) combines the degree of operating leverage and financial
leverage. DTL measures the sensitivity of EPS to change in sales.

LOS 34.c: Analyze the effect of financial leverage on a company’s net income and return on equity.

Question 34.5: For a profitable company, issuing debt in order to retire common stock will most likely:
A) increase both net income and return on equity.
B) decrease both operating income and net income.
C) increase both the level and variability of return on equity.
C is correct. An increase in debt will increase interest expense, which will decrease net income but not operating income, which is calculated before subtracting interest expense. For a profitable firm, the decrease in net income will be offset by the decrease in equity from the
repurchase of common stock, so that ROE increases. The effect of the increase in financial leverage will, however, increase the variability of ROE for a given change in operating earnings.
Schweser note
The use of financial leverage significantly increases the risk and potential reward to common stockholders. The interest expense associated with using debt represents a fixed cost that reduces net income. However, the lower net income value is spread over a smaller base of shareholders’ equity, serving to magnify the ROE.

LOS 34.e: Calculate and interpret the operating breakeven quantity of sales.

Question 34.6: Fireball Company has fixed operating costs of $120,000 and fixed financing costs of $120,000. Fireball's variable costs are $4 per unit of output. If Fireball sells 200,000 units for $5 each, it will generate:
A) a net profit.
B) an operating loss.
C) an operating profit but a net loss
C is correct.
Step 1: Understand the question and find the right formula
Operating profit = Revenue - varianble cost - fixed operating cost
Net profit = Operating profit - fixed financing cost
Step 2: Calculate
Revenue = 200,000 × $5 = $1,000,000. Variable costs = 200,000 × $4 = $800,000. Operating income = $1,000,000 – $800,000 – $120,000 = $80,000. Net income = $80,000 – $120,000 = –$40,000. 

LOS 34.d: Calculate the breakeven quantity of sales and determine the company’s net
income at various sales levels

Question 34.7:  Archer Company produces components that sell for $3.50 per unit. Archer has fixed financing costs of $125,000 and fixed operating costs of $275,000. Archer's variable costs are $2.50 per unit. Archer will:
A) break even if it sells 275,000 units.
B) experience a net loss if it sells 325,000 units.
C) earn positive net income if it sells 375,000 units.
B is correct. 

Question 34.8: Other things equal, a company's operating breakeven level of sales is most likely to increase when:
A) the tax rate is increased.
B) its scale of operations is increased.
C) fixed interest charges are increased.
B is correct. Operating breakeven is calculated as fixed operating costs divided by price minus variable costs per unit. Tax rates and interest charges do not affect the operating breakeven quantity of sales.


LOS 35.a: Describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position.

Question 35.1:
 Drags on liquidity are most likely to include:
A) inventory obsolescence.
B) paying vendors too soon.
C) suppliers requiring payment sooner.
A is correct. Drags on liquidity either delay or reduce cash inflows. Obsolete inventory can be expected to sell more slowly and often will require write-downs of inventory value. Paying vendors sooner than is optimal and shorter payment periods for suppliers accelerate cash outflows and are referred to as pulls on liquidity.
Schweser note
Drags on liquidity delay or reduce cash inflows, or increase borrowing costs. Examples
include uncollected receivables and bad debts, obsolete inventory (takes longer to sell and
can require sharp price discounts), and tight short-term credit due to economic conditions.
Pulls on liquidity accelerate cash outflows. Examples include paying vendors sooner than is
optimal and changes in credit terms that require repayment of outstanding balances.

Question 35.2: A company is most likely faced with a drag on liquidity if its:
A) weighted average collection period increases from 42 days to 46 days.
B) largest vendor changes its invoice terms from “3/10 net 30” to “3/10 net 60.”
C) inventory turnover was below the industry average last year and is above the industry average this year.
A is correct. An increase in the weighted average collection period indicates that customers are taking longer to pay their outstanding accounts. This represents a drag on the company's liquidity. A vendor that changes its payment terms from "net 30" to "net 60" is allowing the company 60 days to pay instead of 30. This extension of trade credit is a source of liquidity for the company. An inventory turnover ratio that is increasing relative to the industry average is a sign of good inventory management, which can also be a source of liquidity for a company.

LOS 35.b: Compare a company’s liquidity measures with those of peer companies

Question 35.3:
 While analyzing HMS Inc., Fred Browne notes that the company's liquidity as measured by its quick ratio has decreased over time while its current liabilities have remained constant. This could be explained by:
A) a decrease in inventory.
B) an increase in marketable securities.
C) a decrease in accounts receivable.
C is correct. The quick ratio is defined as: (cash + marketable securities + accounts receivable) / current liabilities. If current liabilities have remained constant, cash, marketable securities, or accounts receivable must have decreased. Inventory is not included in the quick ratio.

Question 35.4: Which of the following working capital management outcomes is least desirable?
A) Low operating cycle.
B) High inventory turnover.
C) High cash conversion cycle
C is correct.The cash conversion cycle measures the amount of time it takes for the firm to turn the firm's cash investments in inventory back into cash. A high cash conversion cycle implies that the company has too much invested in working capital.
Schweser note
High cash conversion cycles are considered undesirable. A conversion cycle that is too high implies that the company has an excessive amount of investment in workingcapital.

LOS 35.c: Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company’s effectiveness with that of peer companies

Question 35.5: From a liquidity management perspective, an increase in the number of days of payables is best described as:
A) liquidity neutral.
B) a pull on liquidity.
C) a source of liquidity
C is correct. An increase in the number of days of payables suggests a company is taking longer to pay its vendors. This reduces the cash conversion cycle and represents effective working capital management, a source of liquidity for a company. A decrease in days of payables would be a pull on liquidity because the company is paying its vendors more quickly, which uses cash.

Question 35.6: Which of the following would most likely indicate deterioration of a firm's working capital management?
A) An increase in days of payables outstanding.
B) An increase in days of receivables outstanding.
C) A decreased amount of cash and cash equivalents.
B is correct. An increase in days of receivables outstanding, other things equal, will lengthen both the operating and cash conversion cycles, indicating poorer working capital management. An increase in days of payables outstanding, other things equal, would decrease the cash conversion cycle. A decrease in cash and marketable securities could simply indicate better management of cash (e.g., buying back its common stock or investing excess cash in profitable business opportunities or securities).

LOS 35.d: Describe how different types of cash flows affect a company’s net daily cash position.

Question 35.7: A company's excess cash balances can most appropriately be invested in:
A) common stock.
B) corporate bonds
C) commercial paper.
C is correct. Excess cash balances should be invested to earn a positive return, but should remain in liquid instruments with relatively stable values. Examples include U.S. Treasury bills, short-term federal agency securities, bank certificates of deposit, banker's acceptances, time deposits, repurchase agreements, commercial paper, money market mutual funds, and adjustable-rate preferred stock.
Schweser note
To manage its cash position effectively, a firm should analyze its typical cash inflows and outflows by category and prepare forecasts over short-term (daily or weekly balances for the
next several weeks), medium-term (monthly balances for the next year), and long-term time
horizons. A firm can use these forecasts to identify periods when its cash balance may become low enough to require short-term borrowing, or high enough to invest excess cash in short-term securities

Question 35.8: At the beginning of the year, Breidel Company changes its inventory accounting method (for both financial and tax reporting) from first in first out to average cost. Assuming an environment of increasing prices, how will this accounting change affect Breidel's forecasts of its net cash position?
A) No effect because this accounting change does not affect cash flows.
B) Less net cash in both the short-term forecast and the long-term forecast.
C) No effect on the short-term forecast but greater net cash in the long-term forecast.
C is correct. Changing the inventory accounting method has no immediate cash flow effects and therefore should not change a firm's short-term forecast (typically 4 to 6 weeks) of its net cash position. However, because the average cost inventory method will result in lower gross
profit compared to FIFO, it will also result in decreased taxes. The firm's long-term forecast (typically 3 to 5 years) of its net cash position should reflect a decrease in cash outflows for taxes, and consequently greater net cash in future periods.

LOS 35.e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines.

Question 35.9: McDermott Company routinely takes advantage of trade discounts on terms of 2/15 net 90. The cost of short-term borrowing for McDermott is 10.2%. If McDermott begins forgoing trade discounts and paying invoices on their due dates, this would most likely:
A) increase its cost of short-term funding.
B) improve its business relationships with its suppliers.
C) be viewed by analysts as efficient accounts payable management.
A is correct. 

Question 35.10: Shawn Wright, CFA, is evaluating the short-term investment policy for Hegeman Industries. Wright should most likely conclude that Hegeman's investment policy is:
A) inappropriate if it restricts the types of securities that can be held.
B) appropriate if it lists specific issuers from which Hegeman may purchase securities.
C) appropriate if it limits the proportion of the total portfolio that can be held in various types of issues.
C is correct. An appropriate short-term investment policy statement should include limitations on the proportions of the total short-term securities portfolio that can be invested in the various types of permitted securities. The policy statement should also include limitations on the types of securities that can be held. It would be overly restrictive, however, to include a specific listing of issuers from which securities could be purchased.
Schweser note
It is advisable to have a written investment policy statement. An investment policy statement typically begins with a statement of the purpose and objective of the investment portfolio, some general guidelines about the strategy to be employed to achieve those objectives, and the types of securities that will be used. The investment policy statement will also include specific information on who is allowed to purchase securities, who is responsible for complying with company guidelines, and what steps will be taken if the investment guidelines are not followed. Finally, the investment policy statement will include limitations on the specific types of securities permitted for investment of short-term funds, limitations on the credit ratings of portfolio securities, and limitations on the proportions of the total shortterm securities portfolio that can be invested in the various types of permitted securities.